Managerial Accounting: Assignment 2

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FinancialandManagerialAccounting8thEditionbyJohnWild.pdf

Information for Decisions

Financial & Managerial Accounting

8th edition

JOHN J. WILD KEN W. SHAW

Financial & Managerial Accounting

8thedition

John J. Wild University of Wisconsin at Madison

Ken W. Shaw University of Missouri at Columbia

INFORMATION FOR DECISIONS

To my students and family, especially Kimberly, Jonathan, Stephanie, and Trevor. To my wife Linda and children Erin, Emily, and Jacob.

FINANCIAL AND MANAGERIAL ACCOUNTING: INFORMATION FOR DECISIONS, EIGHTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2018, 2016, and 2013. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 LWI 21 20 19 18

ISBN 978-1-260-24785-5 (bound edition) MHID 1-260-24785-6 (bound edition) ISBN 978-1-260-41719-7 (loose-leaf edition) MHID 1-260-41719-0 (loose-leaf edition)

Executive Portfolio Manager: Steve Schuetz Product Developers: Michael McCormick, Christina Sanders Marketing Manager: Michelle Williams Content Project Managers: Lori Koetters, Brian Nacik Buyer: Sandy Ludovissy Design: Debra Kubiak Content Licensing Specialist: Melissa Homer Cover Image: Runner: ©Maridav/Shutterstock; Statistics icons: ©A-spring/Shutterstock; Background image: ©Vector work/Shutterstock Compositor: Aptara®, Inc.

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data Names: Wild, John J., author. | Shaw, Ken W., author. Title: Financial and managerial accounting : information for decisions / John J. Wild, University of Wisconsin at Madison, Ken W. Shaw, University of Missouri at Columbia. Description: 8th Edition. | Dubuque, IA : McGraw-Hill Education, [2018] | Revised edition of Financial and managerial accounting, [2018] | Includes bibliographical references and index. Identifiers: LCCN 2018035310| ISBN 9781260247855 (alk. paper) | ISBN 1260247856 (alk. paper) Subjects: LCSH: Accounting. | Managerial accounting. Classification: LCC HF5636 .W674b 2018 | DDC 658.15/11—dc23 LC record available at https://lccn.loc.gov/2018035310

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

iii

About the Authors JOHN J. WILD is a distinguished pro- fessor of accounting at the University of Wisconsin at Madison. He previously held appointments at Michigan State University and the University of Manchester in England. He received his BBA, MS, and PhD from the University of Wisconsin.

John teaches accounting courses at both the undergraduate and graduate levels. He has received numerous teaching honors, in- cluding the Mabel W. Chipman Excellence-in-

Teaching Award and the departmental Excellence-in-Teaching Award, and he is a two-time recipient of the Teaching Excellence Award from business graduates at the University of Wisconsin. He also received the Beta Alpha Psi and Roland F. Salmonson Excellence-in-Teaching Award from Michigan State University. John has received several research honors, is a past KPMG Peat Marwick National Fellow, and is a recipient of fellowships from the American Accounting Association and the Ernst and Young Foundation.

John is an active member of the American Accounting Association and its sections. He has served on several committees of these organizations, including the Outstanding Accounting Educator Award, Wildman Award, National Program Advisory, Publications, and Research Committees. John is author of Financial Accounting, Managerial Accounting, Fundamental Accounting Principles, and College Accounting, all published by McGraw-Hill Education.

John’s research articles on accounting and analysis appear in The Accounting Review; Journal of Accounting Research; Journal of Accounting and Economics; Contemporary Accounting Research; Journal of Accounting, Auditing and Finance; Journal of Accounting and Public Policy; Accounting Horizons; and other journals. He is past associate editor of Contemporary Accounting Research and has served on several editorial boards including The Accounting Review and the Journal of Accounting and Public Policy.

In his leisure time, John enjoys hiking, sports, boating, travel, people, and spending time with family and friends.

Courtesy of John J. Wild

KEN W. SHAW is an associate profes- sor of accounting and the KPMG/Joseph A. Silvoso Distinguished Professor of Accounting at the University of Missouri. He previously was on the faculty at the University of Maryland at College Park. He has also taught in international programs at the University of Bergamo (Italy) and the University of Alicante (Spain). He received an accounting degree from Bradley University and an MBA and PhD from the

University of Wisconsin. He is a Certified Public Accountant with work experience in public accounting.

Ken teaches accounting at the undergraduate and graduate levels. He has received numerous School of Accountancy, College of Business, and university-level teaching awards. He was voted the “Most Influential Professor” by four School of Accountancy graduating classes and is a two-time recipient of the O’Brien

Excellence in Teaching Award. He is the advisor to his school’s chapter of the Association of Certified Fraud Examiners.

Ken is an active member of the American Accounting Association and its sections. He has served on many committees of these organizations and presented his research papers at na- tional and regional meetings. Ken’s research appears in the Journal of Accounting Research; The Accounting Review; Contemporary Accounting Research; Journal of Financial and Quantitative Analysis; Journal of the American Taxation Association; Strategic Management Journal; Journal of Accounting, Auditing, and Finance; Journal of Financial Research; and other journals. He has served on the editorial boards of Issues in Accounting Education; Journal of Business Research; and Research in Accounting Regulation. Ken is co-author of Fundamental Accounting Principles, Managerial Accounting, and College Accounting, all published by McGraw-Hill Education.

In his leisure time, Ken enjoys tennis, cycling, music, and coaching his children’s sports teams.

Courtesy of Ken W. Shaw

Author Letter Using Learning Science and Data Analytics We use data to make decisions and maximize performance. Like the runner on the cover who uses data to track her progress, we used stu- dent performance data to identify content areas that can be made more direct, concise, and systematic.

Learning science reveals that students do not read large chunks of text, so we streamlined this edition to present it in a more focused, succinct, blocked format to improve student learning and retention. Our new edition delivers the same content in 112 fewer pages. Visual aids and numer- ous videos offer additional learning aids. New summary Cheat Sheets conclude each chapter to visually reinforce key concepts and procedures.

Our new edition has over 1,500 videos to engage students and improve outcomes: •   Concept Overview Videos—cover each chapter’s learning objectives with multimedia presentations that include Knowledge Checks to

engage students and assess comprehension. •  Need-to-Know Demos—walk-through demonstrations of key procedures and analysis to ensure success with assignments and tests. •  Guided Examples (Hints)—step-by-step walk-through of assignments that mimic Quick Studies, Exercises, and General Ledger.

iv

Difference Makers in Teaching . . . Learning Science Learning analytics show that students learn better when material is broken into “blocks” of content. Each chapter opens with a visual preview. Learning objective numbers highlight the location of re- lated content. Each “block” of content concludes with a Need-to-Know (NTK) to aid and reinforce student learning. Visual aids and concise, bullet-point dis- cussions further help students learn.

Learning Objectives

CONCEPTUAL C1 Explain the steps in processing

transactions and the role of source documents.

C2 Describe an account and its use in recording transactions.

C3 Describe a ledger and a chart of accounts.

PROCEDURAL P1 Record transactions in a journal and post

entries to a ledger.

P2 Prepare and explain the use of a trial balance.

P3 Prepare financial statements from business transactions.

C4 Define debits and credits and explain double-entry accounting.

ANALYTICAL A1 Analyze the impact of transactions on

accounts and financial statements.

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Chapter Preview

2 Recording Transactions

NTK 2-4

TRIAL BALANCE

P2 Trial balance preparation and use

Error identification

NTK 2-5

FINANCIAL STATEMENTS

P3 Financial statement preparation

A2 Debt ratio

NTK 2-3

RECORDING TRANSACTIONS

P1 Journalizing and posting

A1 Processing transactions— Examples

NTK 2-1

SYSTEM OF ACCOUNTS

Using financial statements

C1 Source documents

C2 Types of accounts C3 General ledger

NTK 2-2

DEBITS AND CREDITS

T-account

C4 Debits and credits

Normal balance

wiL16960_ch02_044-083.indd 44 5/3/18 2:14 PM

New Revenue Recognition •   Wild uses  the popular gross method 

for merchandising transactions (net method is covered in an appendix). The gross method is widely used in practice and best for student success.

•   Adjusting entries for new revenue rec- ognition rules are included in an ap- pendix.  Assignments  are  clearly  marked and separated. Wild is GAAP  compliant.

154 Chapter 4 Accounting for Merchandising Operations

Z-Mart’s Merchandise Inventory account at the end of the year has a balance of $21,250, but a physical count shows only $21,000 of inventory exists. The adjusting entry to record this $250 shrinkage is

Dec . 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Adjust for $250 shrinkage.

Assets = Liabilities + Equity −250 −250

Sales Discounts, Returns, and Allowances—Adjusting Entries Revenue recognition rules require sales to be reported at the amount expected to be received. This means that period-end adjusting entries are commonly made for Expected sales discounts. Expected returns and allowances (revenue side). Expected returns and allowances (cost side).

These three adjustments produce three new accounts: Allowance for Sales Discounts, Sales Refund Payable, and Inventory Returns Estimated. Appendix 4B covers these accounts and the adjusting entries.

Preparing Financial Statements The financial statements of a merchandiser are similar to those for a service company described in prior chapters. The income statement mainly differs by the addition of cost of goods sold and gross profit. Net sales is affected by discounts, returns and allowances, and some additional expenses such as delivery expense and loss from defective merchandise. The balance sheet dif- fers by the addition of merchandise inventory as part of current assets. (Appendix 4B explains inventory returns estimated as part of current assets and sales refund payable as part of current liabilities.) The statement of retained earnings is unchanged.

Closing Entries for Merchandisers Closing entries are similar for service companies and merchandising companies. The difference is that we close some new temporary accounts that come from merchandising activities. Z-Mart has temporary accounts unique to merchandisers: Sales (of goods), Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. The third and fourth closing entries are identical for a mer- chandiser and a service company. The differences are in red in the closing entries of Exhibit 4.11.

EXHIBIT 4.11 Closing Entries for a Merchandiser

Step 1: Close Credit Balances in Temporary Accounts to Income Summary.

Step 2: Close Debit Balances in Temporary Accounts to Income Summary.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,100 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . 2,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,700 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,800 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,300 Close debit balances in temporary accounts.

Step 3: Close Income Summary.

Dec . 31 Income Summary . . . . . . 12,900 Retained Earnings . . 12,900

Step 4: Close Dividends.

Dec . 31 Retained Earnings . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . 4,000

Dec . 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Close credit balances in temporary accounts.

wiL47856_ch04_142-189.indd 154 9/20/18 9:12 AM

Up-to-Date This book reflects changes in accounting for revenue recognition, investments, leases, and extraordinary items. It is important that students learn GAAP accounting.

Less Is More Wild has markedly fewer pages than competing books covering the same material. •  The text is to the point and uses visuals to aid student learning. •  Bullet-point discussions and active writing aid learning. •  The 8th edition has 112 fewer pages than the 7th edition—a 10% reduction!

Visual Learning •   Learning  analytics  tell  us  to-

day’s students do not read large blocks of text. Wild has adapted  to student needs by having in- formative visual aids through- out. Many visuals and exhibits are new to this edition.

$180 3

= $60 each

2. Last-in, first-out (LIFO) Costs flow in the reverse

order incurred.

3. Weighted average Costs flow at an average

of costs available.

1. First-in, first-out (FIFO) Costs flow in the order

incurred.

× 2× 1

Income Statement Net sales.................... $100

Cost of goods sold.. 45

Gross profit................ $ 55

Balance Sheet Inventory.................... $135

Income Statement Net sales.................... $100

Cost of goods sold.. 70

Gross profit................ $ 30

Balance Sheet Inventory.................... $1 10

Income Statement Net sales.................... $100

Cost of goods sold.. 60

Gross profit................ $ 40

Balance Sheet Inventory.................... $120

$65 May 3

$45 May 1 G

o o d s

s o l d

G o o d s

s o l d

G o o d s

s o l d

G o o d s

l e f t

G o o d s

l e f t

G o o d s

l e f t

$70 May 6

$65 May 3

$45 May 1

$70 May 6

$70 May 6

$65 May 3

$45 May 1

v

Videos •   A growing number of students now learn 

accounting online. Wild offers over 1,500 videos designed to increase student en- gagement and improve outcomes.

•   Hundreds  of  hint  videos  or  Guided  Examples provide a narrated, animated, step-by-step walk-through of select exer- cises similar to those assigned. These short presentations, which can be turned on or off by instructors, provide reinforcement when students need it most. (Exercise PowerPoints are available for instructors.)

•   Concept  Overview  Videos  cover  each  chapter’s learning objectives with nar- rated, animated presentations that fre- quently  assess  comprehension.  Wild’s  concept overview presentations cover learning objectives broken down into over 700 videos. 

Chapter 7 Accounting for Receivables 277

Recovering a Bad Debt If an account that was written off is later collected, two en- tries are made. The first is to reverse the write-off and reinstate the customer’s account. The second is to record the collection of the reinstated account. If on March 11 Kent pays in full his account previously written off, the entries are

Exhibit 7.6 portrays the allowance method. It shows the creation of the allowance for future write-offs—adding to a cookie jar. It also shows the decrease of the allowance through write- offs—taking cookies from the jar.

A dj

us tin

g en

tr ie

s

Adjusting entries add to allowance for doubtful accounts.

Allowance for doubtful accounts

Write-o�s

Allowance for doubtful accounts

Bad debt write-o�s subtract from allowance for doubtful accounts.

Increase Allowance Decrease Allowance

Bad Debts Expense… # Allow. for Doubtful Accts… #

Allow. for Doubtful Accts… # Accts Receivable—J.Kent… #

EXHIBIT 7.6 Increases and Decreases to the Allowance for Doubtful Accounts

Assets = Liabilities + Equity +520 −520

Assets = Liabilities + Equity +520 −520

Mar . 11 Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 520

Reinstate account previously written off.

Mar . 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Record full payment of account.

Kent paid the entire amount previously written off, but sometimes a customer pays only a por- tion. If we believe this customer will later pay in full, we return the entire amount owed to accounts receivable (in the first entry only). If we expect no further collection, we return only the amount paid.

A retailer uses the allowance method. Record the following transactions.

Dec. 31 The retailer estimates $3,000 of its accounts receivable are uncollectible at its year-end. Feb. 14 The retailer determines that it cannot collect $400 of its accounts receivable from a customer

named ZZZ Company. Apr. 1 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its

recovery of this bad debt.

Solution

P2

Entries under Allowance Method

NEED-TO-KNOW 7-3

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 3,000

Record estimated bad debts.

Feb . 14 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Write off an account.

Apr . 1 Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 400

Reinstate an account previously written off.

Apr . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Record cash received on account. Do More: QS 7-4, QS 7-5, E 7-5

wiL47856_ch07_270-301.indd 277 9/21/18 10:06 AM

Need-to-Know Demos Need-to-Know demonstrations are located at key junctures in each chapter. These demonstrations pose questions about the material just presented—content that students “need to know” to learn  accounting. Accompanying solutions walk students through key procedures and analysis neces- sary to be successful with homework and test materials. Need-to-Know demonstrations are supplemented with narrated, animated, step-by-step walk- through videos led by an instructor and available via Connect.

Comprehensive Need-to-Know Comprehensive Need-to-Knows are problems that draw  on material from the entire chapter. They include a complete solution, allowing students to review the entire problem-solving process and achieve success.

vi

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s net sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase of 0.4 cents in research and development costs, which can be a positive development if these costs lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling, general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that segment’s operating income margin (Operating income/Segment net sales). The Americas seg- ment has a 32% operating income margin. This type of graphic can raise questions about the profitability of each segment and lead to discussion of further expansions into more profitable segments. For example, the Japan segment has an operating margin of 46%. A natural question for management is what potential is there to expand sales into the Japan segment and maintain

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$0

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7 Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6 Income before provision for income taxes . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s net sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase of 0.4 cents in research and development costs, which can be a positive development if these costs lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling, general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that segment’s operating income margin (Operating income/Segment net sales). The Americas seg- ment has a 32% operating income margin. This type of graphic can raise questions about the profitability of each segment and lead to discussion of further expansions into more profitable segments. For example, the Japan segment has an operating margin of 46%. A natural question for management is what potential is there to expand sales into the Japan segment and maintain

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$0

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7 Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6 Income before provision for income taxes . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

Difference Makers in Teaching . . . Driving Decisions Whether we prepare, analyze, or apply accounting infor- mation, one skill remains essential: decision making. To help develop good decision-making habits and to show the relevance of accounting, we use a learning framework. •   Decision Insight provides context for business decisions. •   Decision Ethics and Decision Maker are role-playing

scenarios that show the relevance of accounting. •   Decision Analysis provides key tools to assess company

performance.

260 Chapter 7 Accounting Information Systems

The five components of accounting systems are source documents, input devices, information processors, information storage, and output devices. These components apply whether a system is computerized or manual. Exhibit 7.2 shows these components.

SYSTEM COMPONENTS Point: Computerized systems provide more accuracy and speed than manual.

Output Devices

Source Document

Input Devices

Information Processor

Information Storage

Cloud Storage

AppleApple

EXHIBIT 7.2 Accounting System Components

Source Documents Source documents provide the information processed by an ac- counting system. Examples include bank statements and checks, invoices from suppliers, cus- tomer bills, sales receipts, and employee earnings records. Accurate source documents are crucial to accounting information systems. Input of wrong information damages the reliability of the information system.

Input Devices Input devices take information from source documents and transfer it to information processing. These devices convert data on source documents to a form usable by the system. Journal entries are a type of input device. Keyboards and scanners are the most com- mon input devices in business.

Information Processors Information processors summarize information for use in analysis and reporting. An information processor includes journals, ledgers, working papers, and posting procedures. Each assists in transforming raw data to useful information.

Information Storage Information storage keeps data accessible to information pro- cessors. After being input and processed, data are stored for use in future analyses and reports. Auditors rely on this database when they audit both financial statements and a company’s con- trols. Modern systems depend increasingly on cloud storage.

Output Devices Output devices make accounting information available to users. Common output devices are printers, monitors, and smartphones. Output devices provide users a variety of items including customer bills, financial statements, and internal reports.

Point: Control procedures limit the possibility of entering wrong data.

Point: Controls ensure that only authorized individuals input data into the system.

©Amble Design/Shutterstock

Match each of the numbered descriptions with the principle, component, or descriptor that it best reflects. Indicate your answer by entering the letter A through J in the blank provided.

System Principles and Components

NEED-TO-KNOW 7-1

C1

A. Control principle B. Relevance principle C. Compatibility principle D. Flexibility principle

E. Cost-benefit principle F. Source documents G. Input devices H. Information processors

I. Information storage J. Output devices

System’s Fine Print Nintendo’s stock increased greatly after the huge success of Pokémon Go. However, few investors read Nintendo’s disclosures that said it owned less than one-third of the company that developed the app. When investors realized this, the stock dropped 17%, representing over $6 billion in value. ■

Decision Insight

©Eric Audras/Getty Images

the benefits of producing a specific report must outweigh the costs of time and effort to produce that report. Decisions regarding other system principles (control, relevance, compatibility, and flexibility) are also affected by the cost-benefit principle.

wiL16960_ch07_258-289.indd 260 8/1/18 1:04 PM

When a buyer is responsible for paying transportation costs, the payment is made to a carrier or directly to the seller. The cost principle requires that transportation costs of a buyer (often called transportation-in or freight-in) be part of the cost of merchandise inventory. Z-Mart’s entry to record a $75 freight charge from UPS for merchandise purchased FOB shipping point is

Point: If we place an order online and receive free shipping, we have terms FOB destination.

(d) Nov . 24 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Paid freight costs on goods.

Assets = Liabilities + Equity +75 −75

When a seller is responsible for paying shipping costs, it records these costs in a Delivery Expense account. Delivery expense, also called transportation-out or freight-out, is reported as a selling expense in the seller’s income statement.

Itemized Costs of Purchases In summary, purchases are recorded as debits to Merchandise Inventory (or Inventory). Purchases discounts, returns, and allowances are credited to (subtracted from) Merchandise Inventory. Transportation-in is debited (added) to Merchandise Inventory. Z-Mart’s itemized costs of merchandise purchases for the year are in Exhibit 5.8.

The accounting system described here does not provide separate records (accounts) for total purchases, total pur- chases discounts, total purchases returns and allowances, and total transportation-in. Many companies collect this information in supple- mentary records to evaluate these costs. Supplementary records, or supplemental records, refer to information outside the usual ledger accounts.

Point: INcoming freight costs are charged to INventory. When inventory EXits, freight costs are charged to EXpense.

Itemized Costs of Merchandise Purchases

Invoice cost of merchandise purchases . . . . . . . . . $ 235,800

Less: Purchases discounts received . . . . . . . . . . . . (4,200)

Purchases returns and allowances . . . . . . . . . (1,500)

Add: Costs of transportation-in . . . . . . . . . . . . . . . .       2,300

Total net cost of merchandise purchases . . . . . . $232,400

EXHIBIT 5.8 Itemized Costs of Merchandise Purchases

Point: Some companies have separate accounts for purchases discounts, returns and allowances, and transportation-in. These accounts are then transferred to Merchandise Inventory at period- end. This is a hybrid system of perpetual and periodic. That is, Merchandise Inventory is updated on a perpetual basis but only for purchases and cost of goods sold.

Payables Manager As a new accounts payable manager, you are being trained by the outgoing manager. She explains that the system prepares checks for amounts net of favorable cash discounts, and the checks are dated the last day of the discount period. She tells you that checks are not mailed until five days later, adding that “the company gets free use of cash for an extra five days, and our department looks better.” Do you continue this policy? ■ Answer: One point of view is that the late payment policy is unethical. A deliberate plan to make late payments means the company lies when it pretends to make payment within the discount period. Another view is that the late payment policy is acceptable. Some believe attempts to take discounts through late payments are accepted as “price negotiation.”

Decision Ethics

Prepare journal entries to record each of the following purchases transactions of a merchandising com- pany. Assume a perpetual inventory system using the gross method for recording purchases.

Oct. 1 Purchased $1,000 of goods. Terms of the sale are 4∕10, n∕30, and FOB shipping point; the in- voice is dated October 1.

3 Paid $30 cash for freight charges from UPS for the October 1 purchase. 7 Returned $50 of the $1,000 of goods from the October 1 purchase and received full credit. 11 Paid the amount due from the October 1 purchase (less the return on October 7). 31 Assume the October 11 payment was never made. Instead, payment of the amount due, less the

return on October 7, occurred on October 31.

Solution

P1 Merchandise Purchases

NEED-TO-KNOW 5-2

Oct . 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Purchased goods, terms 4∕10, n∕30. Oct . 3 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Paid freight on purchases FOB shipping point.

[continued on next page]

wiL16960_ch05_166-213.indd 173 8/2/18 7:20 AM

Chapter 2 Analyzing and Recording Transactions 61

sheet lists its assets: cash, supplies, prepaid insurance, and equipment. The upper right side of the balance sheet shows that it owes $6,200 to creditors and $3,000 in services to customers who paid in advance. The equity section shows an ending capital balance of $33,195. Note the link between the ending balance of the statement of owner’s equity and the capital balance. (This presentation of the balance sheet is called the account form: assets on the left and liabili- ties and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity. Either presentation is acceptable.)

Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. Most of your cus- tomers want to buy on credit. How can you use the balance sheets of customers to decide which ones to extend credit to? ■ Answer: We use the accounting equation (Assets = Liabilities + Equity) to identify risky customers to whom we would not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would be to extend credit. A low equity means the business already has many creditor claims to it.

Decision Maker

©REDPIXEL.PL/Shutterstock

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. We usually put dollar signs be- side only the first and last numbers in a column. Apple’s financial statements in Appendix A show this. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level. Apple, like many large companies, rounds its financial statement amounts to the nearest million. This decision is based on the impact of rounding for users’ decisions.

Prepare a trial balance for Apple using the following condensed data from its recent fiscal year ended September 30 ($ in millions).

Preparing Trial Balance

NEED-TO-KNOW 2-4

P2Owner, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . $128,249 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Cost of sales (and other expenses) . . . . . . . . . . 141,048

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289

Revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Owner, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,553

Investments and other assets. . . . . . . . . . . . . . . . . . 303,373

Land and equipment . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Selling and other expense . . . . . . . . . . . . . . . . . . . . 39,835

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Solution ($ in millions)

APPLE Trial Balance

September 30

Do More: E 2-8, E 2-10

APPLE

Debit Credit

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Land and equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Investments and other assets . . . . . . . . . . . . . . . . . . . . . . 303,373

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Owner, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,249

Owner, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,553

Revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Cost of sales (and other expenses) . . . . . . . . . . . . . . . . . . 141,048

Selling and other expense . . . . . . . . . . . . . . . . . . . . . . . . . 39,835

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $598,755 $598,755

wiL16960_ch02_044-083.indd 61 5/3/18 2:15 PM

It is important to assess a company’s risk of failing to pay its debts. Companies finance their assets with either liabilities or equity. A company that finances a relatively large portion of its assets with liabilities is said to have higher financial leverage. Higher financial leverage means greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). One measure of the risk associated with liabilities is the debt ratio as defined in Exhibit 2.17.

Costco’s total liabilities, total assets, and debt ratio for the past three years are shown in Exhibit 2.18. Costco’s debt ratio ranges from a low of 0.63 to a high of 0.70. Its ratio exceeds Walmart’s in each of the last three years, suggesting a higher than average risk from financial leverage. So, is financial leverage good or bad for Costco? The answer: If Costco is making more money with this debt than it is paying the lenders, then it is successfully borrowing money to make more money. A company’s use of debt can turn unprofitable quickly if its return from that money drops below the rate it is paying lenders.

This problem extends Need-To-Know 1-6 from Chapter 1: Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month. a. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions. b. 2 Expressions paid $600 cash for furniture for the shop. c. 3 Expressions paid $500 cash to rent space in a strip mall for August. d. 4 Expressions purchased $1,200 of equipment on credit for the shop (recorded as accounts

payable). e. 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. f. 16 Expressions provided $100 of haircutting services on account. g. 17 Expressions received a $100 check for services previously rendered on account. h. 18 Expressions paid $125 to an assistant for hours worked for the grand opening. i. 31 Cash received from services provided during the second half of August was $930. j. 31 Expressions paid $400 cash toward the account payable entered into on August 4. k. 31 Worthy made a $900 cash withdrawal from the company for personal use.

Required

1. Open the following ledger accounts in balance column format (account numbers are in parentheses): Cash (101); Accounts Receivable (102); Furniture (161); Store Equipment (165); Accounts Payable (201); J. Worthy, Capital (301); J. Worthy, Withdrawals (302); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

COMPREHENSIVE

Journalizing and Posting Transactions, Statement Preparation, and Debt Ratio

NEED-TO-KNOW 2-5

EXHIBIT 2.17 Debt Ratio Debt ratio =

Total liabilities Total assets

62 Chapter 2 Analyzing and Recording Transactions

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Debt RatioDecision Analysis

Investor You consider buying stock in Converse. As part of your analysis, you compute the company’s debt ratio for 2017, 2018, and 2019 as 0.35, 0.74, and 0.94, respectively. Based on the debt ratio, is Converse a low-risk investment? Has the risk of buying Converse stock changed over this period? (The industry debt ratio averages 0.40.) ■ Answer: The debt ratio suggests that Converse’s stock is of higher risk than normal and that this risk is rising. The average industry ratio of 0.40 supports this conclusion. The 2019 debt ratio for Converse is twice the industry norm. Also, a debt ratio approaching 1.0 indicates little to no equity.

Decision Maker

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

Company $ millions Current Year 1 Year Ago 2 Years Ago

Costco Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $25,268 $20,831 $22,174 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,347 $33,163 $33,017 Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.70 0.63 0.67 Walmart Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .59 0 .58 0 .58

wiL16960_ch02_044-083.indd 62 7/12/18 5:20 AM

Accounting Analytics New to this edition, Accounting Analysis  assignments have students evaluate the most current financial statements from Apple, Google, and Samsung. Students  compute key metrics and compare perfor- mance between companies and industry. These assignments are auto-gradable in Connect and are included after Problem  Set B in the text.

Chapter 7 Accounting for Receivables 299

Required

1. Prepare the adjusting entry to record bad debts expense on March 31, 2020, under each separate assumption. There is a zero unadjusted balance in the Allowance for Doubtful Accounts at March 31.

a. Bad debts are estimated to be 1% of total revenues. b. Bad debts are estimated to be 2% of accounts receivable. (Round to the dollar.) 2. Assume that Business Solutions’s Accounts Receivable balance at June 30, 2020, is $20,250 and that

one account of $100 has been written off against the Allowance for Doubtful Accounts since March 31, 2020. If Rey uses the method in part 1b, what adjusting journal entry is made to recognize bad debts expense on June 30, 2020?

3. Should Rey consider adopting the direct write-off method of accounting for bad debts expense rather than one of the allowance methods considered in part 1? Explain. ©Alexander Image/Shutterstock

Check (2) Dr. Bad Debts Expense, $48

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in accounting so that the financial professional can focus on the impacts of each transaction on various financial reports and perfor- mance measures.

GL 7-1 General Ledger assignment GL 7-1, based on Problem 7-5A, focuses on transactions related to accounts and notes receivable and highlights the impact each transaction has on interest revenue.

GL

COMPANY ANALYSIS A1

Accounting Analysis

AA 7-1 Use Apple’s financial statements in Appendix A to answer the following. 1. What is the amount of Apple’s accounts receivable as of September 30, 2017? 2. Compute Apple’s accounts receivable turnover as of September 30, 2017. 3. How long does it take, on average, for the company to collect receivables for the fiscal year ended

September 30, 2017? 4. Apple’s most liquid assets include (a) cash and cash equivalents, (b) short-term marketable securities,

(c) accounts receivable, and (d ) inventory. Compute the percentage that these liquid assets (in total) make up of current liabilities as of September 30, 2017, and as of September 24, 2016.

5. Did Apple’s liquid assets as a percentage of current liabilities improve or worsen as of its fiscal 2017 year-end compared to its fiscal 2016 year-end?

APPLE

AA 7-2 Comparative figures for Apple and Google follow.

Apple Google

Current One Year Two Years Current One Year Two Years $ millions Year Prior Prior Year Prior Prior

Accounts receivable, net . . $ 17,874 $ 15,754 $ 16,849 $ 18,336 $14,137 $11,556

Net sales . . . . . . . . . . . . . . . 229,234 215,639 233,715 110,855 90,272 74,989

COMPARATIVE ANALYSIS A1 P2

APPLE GOOGLE

Required

1. Compute the accounts receivable turnover for (a) Apple and (b) Google for each of the two most recent years using the data shown.

2. Compute how many days, on average, it takes to collect receivables for the two most recent years for (a) Apple and (b) Google.

3. Which company more quickly collects its accounts receivable in the current year?

Hint: Average collection period equals 365 divided by the accounts receivable turnover.

wiL47856_ch07_270-301.indd 299 9/21/18 10:06 AM

Keep It Real Research shows that students learn best when using current data from real companies. Wild uses  the most current data from real companies for assignments, examples, and analysis in the text. See  Chapter 13 for use of real data.

APPLE

Samsung GOOGLE

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s net sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase of 0.4 cents in research and development costs, which can be a positive development if these costs lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling, general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that segment’s operating income margin (Operating income/Segment net sales). The Americas seg- ment has a 32% operating income margin. This type of graphic can raise questions about the profitability of each segment and lead to discussion of further expansions into more profitable segments. For example, the Japan segment has an operating margin of 46%. A natural question for management is what potential is there to expand sales into the Japan segment and maintain

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$0

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7 Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6 Income before provision for income taxes . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s net sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase of 0.4 cents in research and development costs, which can be a positive development if these costs lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling, general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that segment’s operating income margin (Operating income/Segment net sales). The Americas seg- ment has a 32% operating income margin. This type of graphic can raise questions about the profitability of each segment and lead to discussion of further expansions into more profitable segments. For example, the Japan segment has an operating margin of 46%. A natural question for management is what potential is there to expand sales into the Japan segment and maintain

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$0

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7 Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6 Income before provision for income taxes . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

vii

852 Chapter 21 Flexible Budgets and Standard Costs

Refer to the information in QS 21-14. Compute the overhead volume variance for November and classify it as favorable or unfavorable.

QS 21-15 Volume variance P4

Alvarez Company’s output for the current period yields a $20,000 favorable overhead volume variance and a $60,400 unfavorable overhead controllable variance. Standard overhead applied to production for the period is $225,000. What is the actual total overhead cost incurred for the period?

QS 21-16 Overhead cost variances

P4

Refer to the information in QS 21-16. Alvarez records standard costs in its accounts. Prepare the journal entry to charge overhead costs to the Work in Process Inventory account and to record any variances.

QS 21-17A Preparing overhead entries

P6

Refer to the information from QS 21-18. Compute the variable overhead spending variance and the vari- able overhead efficiency variance and classify each as favorable or unfavorable.

QS 21-19A Overhead spending and efficiency variances P5

Farad, Inc., specializes in selling used trucks. During the month, Farad sold 50 trucks at an average price of $9,000 each. The budget for the month was to sell 45 trucks at an average price of $9,500 each. Compute the dealership’s sales price variance and sales volume variance for the month and classify each as favor- able or unfavorable.

QS 21-20 Computing sales price and volume variances A1

AirPro Corp. reports the following for November. Compute the total overhead variance and controllable overhead variance for November and classify each as favorable or unfavorable.

QS 21-14 Controllable overhead variance

P4 Actual total factory overhead incurred . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,175 Standard factory overhead:

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 .10 per unit produced

Fixed overhead ($12,000∕12,000 predicted units to be produced) . . . . $1 per unit Predicted units to produce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 units

Actual units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,800 units

QS 21-18A Total variable overhead cost variance

P5

Mosaic Company applies overhead using machine hours and reports the following information. Compute the total variable overhead cost variance and classify it as favorable or unfavorable.

Actual machine hours used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700 hours

Standard machine hours (for actual production) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 hours

Actual variable overhead rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4 .15

Standard variable overhead rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4 .00

In a recent year, BMW sold 182,158 of its 1 Series cars. Assume the company expected to sell 191,158 of these cars during the year. Also assume the budgeted sales price for each car was $30,000 and the actual sales price for each car was $30,200. Compute the sales price variance and the sales volume variance.

QS 21-21 Sales variances A1

MM Co. uses corrugated cardboard to ship its product to customers. Management believes it has found a more efficient way to package its products and use less cardboard. This new approach will reduce shipping costs from $10.00 per shipment to $9.25 per shipment. (1) If the company forecasts 1,200 shipments this year, what amount of total direct materials costs would appear on the shipping depart- ment’s flexible budget? (2) How much is this sustainability improvement predicted to save in direct materials costs for this coming year?

QS 21-22 Sustainability and standard costs

P1

wiL47856_ch21_820-867.indd 852 9/4/18 9:51 AM

Doing What’s Right Companies increasingly issue sustainability reports, and accountants are being asked to prepare, analyze, and audit them.  Wild includes brief sections in the managerial chapters. This material focuses on the importance of sustainability within the  context of accounting, including standards from the Sustainability Accounting Standards Board (SASB). Sustainability assign- ments cover chapter material with a social responsibility twist.

Chapter 18 Managerial Accounting Concepts and Principles 667

Value Chain The value chain refers to the series of activities that add value to a company’s products or services. Exhibit 18.18 illustrates a possible value chain for a retail cookie company. Companies can use lean practices across the value chain to increase efficiency and profits.

Acquire raw materials Baking Sales Service

EXHIBIT 18.18 Typical Value Chain (cookie retailer)

How Lean Principles Impact the Value Chain Adopting lean principles can be challenging because systems and procedures that a company follows must be realigned. Managerial account- ing has an important role in providing accurate cost and performance information. Developing such a system is important to measuring the “value” provided to customers. The price that cus- tomers pay for acquiring goods and services is a key determinant of value. In turn, the costs a company incurs are key determinants of price.

Corporate Social Responsibility In addition to maximizing shareholder value, cor- porations must consider the demands of other stakeholders, including employees, suppliers, and society in general. Corporate social responsibility (CSR) is a concept that goes beyond fol- lowing the law. For example, to reduce its impact on the environment, Three Twins Ice Cream uses only cups and spoons made from organic ingredients. United By Blue, an apparel and jewelry company, removes one pound of trash from waterways for every product sold. Many companies extend the concept of CSR to include sustainability, which considers fu- ture generations when making business decisions.

Triple Bottom Line Triple bottom line focuses on three measures: financial (“profits”), social (“people”), and environmental (“planet”). Adopting a triple bottom line impacts how businesses report. In response to a growing trend of such reporting, the Sustainability Accounting Standards Board (SASB) was established to develop report- ing standards for businesses’ sustainability activities. Some of the business sectors for which the SASB has developed reporting standards include health care, nonrenewable re- sources, and renewable resources and alternative energy.

Point: Companies like Microsoft, Google, and Walt Disney, ranked at the top of large multinational companies in terms of CSR, disclose CSR results on their websites.

Economic

EnvironmentalSo ci

al

Triple Bottom Line

Balanced Scorecard The balanced scorecard aids continuous improvement by augmenting financial measures with information on the “drivers” (indicators) of future financial performance along four dimensions: (1) financial—profitabil- ity and risk, (2) customer—value creation and product and service differentiation, (3) internal business processes— business activities that create customer and owner satisfaction, and (4) learning and growth— organizational change, innovation, and growth. ■

Decision Insight

In creating sustainability accounting standards, the Sustainability Accounting Standards Board (SASB) has created reporting guidelines. The SASB considers sustainability information as material if its disclosure would affect the views of equity investors on a company’s financial condition or operating performance.

Material information can vary across industries; for example, while environmental “planet” issues such as air quality, wastewater management, and biodiversity impacts are important for investments in companies in the nonrenewable resources sectors, such issues are likely not as important for investments in banks. In contrast, “people” issues such as diversity and inclusion, fair labor practices, and employee health are considered material for most sectors, particularly those that use considerable direct labor.

SUSTAINABILITY AND ACCOUNTING

©MoringaConnect

wiL16960_ch18_650-685.indd 667 6/1/18 9:37 AM

Cheat Sheets New to this edition, Cheat Sheets are provided at the end of each chapter. Cheat Sheets are roughly one page in length and  include key procedures, concepts, journal entries, and formulas.

194 Chapter 5 Accounting for Merchandising Operations

If the invoice is paid on (or before) November 12 within the discount period, it records

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Purchases Discounts . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490

Gross Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Discounts Lost . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

If the invoice is paid after the discount period, it records

SALES—Periodic For sales transactions, the perpetual and periodic entries are identical except that under the periodic system the cost-side entries are not made at the time of each sale nor for any subsequent returns. Instead, the cost of goods sold is computed at period-end based on a physical count of inventory. This entry is shown in Exhibit 5A.1.

APPENDIX

Work Sheet—Perpetual System5D This appendix along with assignments is available online.

MERCHANDISING ACTIVITIES Merchandise: Goods a company buys to resell. Cost of goods sold: Costs of merchandise sold. Gross profit (gross margin): Net sales minus cost of goods sold. Computing net income (service company vs. merchandiser):

EqualsMinusEqualsMinus Expenses Netincome

Net sales

Merchandiser

Expenses NetincomeRevenues

Service Company Minus Equals

Gross profit

Cost of goods sold

Inventory: Costs of merchandise owned, but not yet sold. It is a current asset on the balance sheet. Merchandise Cost Flows:

Net purchases

Merchandise available for sale

Cost of goods sold

Ending inventory

Beginning inventory

Perpetual inventory system: Updates accounting records for each pur- chase and each sale of inventory. Periodic inventory system: Updates accounting records for purchases and sales of inventory only at the end of a period.

Summary: Cheat Sheet

MERCHANDISING PURCHASES Cash discount: A purchases discount on the price paid by the buyer; or, a sales discount on amount received for the seller. Credit terms example: “2/10, n/60” means full payment is due within 60 days, but the buyer can deduct 2% of the invoice amount if payment is made within 10 days. Gross method: Initially record purchases at gross (full) invoice amounts. Purchasing Merchandise for Resale Entries:

Transportation Costs and Ownership Transfer Rules:

Purchasing merchandise Merchandise Inventory . . . . . . . . 500 on credit Accounts Payable . . . . . . . . 500

Paying within discount period Accounts Payable . . . . . . . . . . . . 500 (Inventory reduced by Merchandise Inventory . . . 10 discount taken) Cash . . . . . . . . . . . . . . . . . . 490

Paying outside discount Accounts Payable . . . . . . . . . . . . 500 period Cash . . . . . . . . . . . . . . . . . . 500

Recording purchases Cash or Accounts Payable . . . . . 30 returns or allowances Merchandise Inventory . . . 30

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . . #

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Connect helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. Connect grades homework automatically and gives immediate feedback. ▪ Wild has auto-gradable and algorithmic

assignments; most focus on one learning objective and are targeted at introductory students.

▪ 90% of Wild’s Quick Study, Exercise, and Problem Set A assignments are available in Connect with algorithmic options.

▪ Over 210 assignments new to this edition—all available in Connect with algorithmic options. Nearly all are Quick Studies (brief exercises) and Exercises.

General Ledger Problems offer students the ability to record financial transactions and see how these transactions flow into financial statements. Easy minimal-scroll navigation, instant “Check My Work” feedback, and fully integrated hyperlinking across tabs show how inputted data affect each stage of the accounting process. General Ledger Problems expose students to general ledger software similar to that in practice, without the expense and hassle of downloading additional software. Algorithmic versions are available. All are auto- gradable.

General Ledger Problems

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SUPERIOR ASSIGNMENTS

xi

Excel Simulations Simulated Excel Questions, assignable within Connect, allow students to practice their Excel skills—such as basic formulas and formatting—within the context of accounting. These questions feature animated, narrated Help and Show Me tutorials (when enabled), as well as automatic feedback and grading for both students and professors. These questions differ from Applying Excel in that students work in a simulated version of Excel. Downloading the Excel application is not required to complete Simulated Excel Questions.

Guided Examples The Guided Examples (Hints) in Connect provide a narrated, animated, step-by-step walk-through of most Quick Studies, Exercises, and General Ledger Problems similar to those assigned. These short presentations can be turned on or off by instructors and provide reinforcement when students need it most.

Exercise Presentations Animated PowerPoints, created from text assignments, enable instructors to be fully prepared for in-class demonstrations. Instructors also can use these with Tegrity (in Connect) to record online lectures.

NEW! Applying Excel Applying Excel enables students to work select chapter problems or examples in Excel. These problems are assignable in Connect and give students instant feedback as they work through the problems in Excel. Accompanying Excel videos teach students how to use Excel and the primary functions needed to complete the assignment. Short assessments can be assigned to test student comprehension of key Excel skills.

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Content Revisions Enhance Learning

Chapter 1 Updated opener—Apple and entrepreneurial assignment. Updated salary info for accountants. Revised business entity section along with adding LLC. Updated section on FASB objectives and accounting constraints. New layout for introducing the expanded accounting equation. New layout for introducing financial statements. Updated Apple numbers for NTK 1-5. New Cheat Sheet reinforces chapter content. Updated return on assets analysis using Nike and Under Armour. Added a new Exercise assignment and Quick Study assignment. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 2 NEW opener—Fitbit and entrepreneurial assignment. New visual for process to get from transactions to financial statements. New layout on four types of accounts that determine equity. Improved presentation of “Double-Entry System” section. Updated Apple data for NTK 2-4. Updated debt ratio analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added three new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 3 NEW opener—Snapchat and entrepreneurial assignment. Revised learning objectives and chapter preview—each type of adjusting entry is assigned its own learning objective. Updated “Recognizing Revenues and Expenses” section. New streamlined “Framework for Adjustments” section. Enhanced Exhibit 3.12 on summary of adjustments. Enhanced Exhibit 3.19 on steps of accounting cycle with images. Streamlined section on classified balance sheet. Updated profit margin analysis using Visa and Mastercard. Updated current ratio analysis using Costco and Walmart. Improved layouts for Exhibits 3A.1 through 3A.5. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 4 NEW opener—Build-A-Bear and entrepreneurial assignment. Updated introduction for servicers vs. merchandisers using Liberty Tax and Nordstrom. Revised NTK 4-1 covers basics of merchandising. Reorganized “Purchases” section to aid learning. New Decision Insight on growing number of returns for businesses. Enhanced entries on payment of purchases within discount period vs. after discount period. Improved discussion of entries for sales with discounts vs. sales without discounts. Color-coded Exhibit 4.12 highlights different merchandising transactions. Updated acid-test ratio and gross margin analysis using Nike and Under Armour. Appendix 4B explains adjusting entries for future sales discounts, returns, and allowances. Appendix 4C covers the net method. Appendix 4D moved to online only. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 5 NEW opener—Shake Shack and entrepreneurial assignment. New Ethical Risk on the alleged fraud of Homex. Simplified introduction to inventory costing. Shortened explanation for specific identification. Enhanced layout to explain effects of inventory errors across years. Updated inventory turnover and days’ sales in inventory analysis using Costco and Walmart. Added colored arrow lines to Exhibits 5A.3 and 5A.4 to show cost flows from purchases to sales. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 6 NEW opener—Care.com and entrepreneurial assignment. New COSO framework to guide internal control, including COSO cube. New discussion of internal control failure at Amazon that cost customers $150 million. Simplified bank statement for learning. Revised “Bank Reconciliation” section to separate bank balance adjustments and book balance adjustments.

New summary image on adjustments for bank balance and for book balance. Removed collection expenses and NSF fees—most are immaterial and covered in advanced courses. Updated days’ sales uncollected analysis using Starbucks and Jack in the Box. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added eight new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 7 NEW opener—Facebook and entrepreneurial assignment. Updated company data in Exhibit 7.1. Streamlined direct write-off method. Enhanced Exhibit 7.6 showing allowances set aside for future bad debts along with journal entries. New calendar graphic added as learning aid with Exhibit 7.12. New Excel demo to compute maturity dates. Updated accounts receivable analysis using Visa and Mastercard. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 8 NEW opener—New Glarus Brewery and entrepreneurial assignment. Updated company data in Exhibit 8.1. Added entry with Exhibit 8.3 and Exhibit 8.4. Simplified “Partial-Year Depreciation” section. Added margin table to Exhibit 8.14 as a learning aid. New Decision Insight box on extraordinary repairs to SpaceX’s reusable orbital rocket. New simple introduction to finance leases and operating leases for the new standard. Updated asset turnover analysis using Starbucks and Jack in the Box. Simplified Appendix 8A by postponing exchanges without commercial substance to advanced courses. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added one new Exercise. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 9 NEW opener—Pandora and entrepreneurial assignment. Updated data in Exhibit 9.2. Streamlined “Short-Term Notes Payable” section. Simplified explanation of FICA taxes.

Updated payroll tax rates and explanations. Revised NTK 9-4. New W-4 form added to Appendix 9A. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 10 NEW opener—e.l.f. Cosmetics and entrepreneurial assignment. Updated IBM bond quote data. Simplified numbers in Exhibit 10.7. Simplified Exhibit 10.10 on premium bonds. Simplified numbers in Exhibit 10.11. Bond pricing moved to Appendix 10A. Simplified Exhibit 10.12 for teaching the note amortization schedule. Updated debt-to-equity analysis using Nike and Under Armour. New Excel computations for bond pricing in Appendix 10A. Simplified numbers in Exhibits 10B.1 and 10B.2. Revised Appendix 10C for new standard on finance leases and operating leases. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added four new Exercises. Added four new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 11 NEW opener—Yelp and entrepreneurial assignment. New Decision Insight on bots investing in stocks based on erroneous news. New AT&T stock quote explanation. New graphic visually depicting cash dividend dates. New table summarizing differences between small stock dividends, large stock dividends, and stock splits. Updated Apple statement of equity in Exhibit 11.10. Updated PE ratio and dividend yield using Amazon, Altria, Visa, and Mastercard. Simplified book value per share explanation and computations. New Cheat Sheet reinforces chapter content. Added six new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 12 NEW opener—Vera Bradley and entrepreneurial assignment. Slightly revised infographics on cash flows from operating, investing, and financing. Streamlined sections on analyzing the cash account and noncash accounts.

Instructors and students guided this edition’s revisions. Revisions include ∙ New Accounting Analysis assignments—all available in Connect—

using real-world data from Apple, Google, and Samsung. ∙ Many new and revised General Ledger and Excel assignments. ∙ New assignments that focus on financial statement preparation. ∙ Updated videos for each learning objective in new Concept Overview Video format. ∙ Many new Need-to-Know (NTK) demos and accompanying videos to reinforce

learning.

∙ New Cheat Sheets at each chapter-end visually reinforce key chapter concepts. ∙ More concise text covering the same content. New 8th edition has 112 fewer

pages than 7th edition. ∙ Over 210 new assignments—all available in Connect with algorithmic options. ∙ Gross method is used for merchandising transactions, reflecting practice—adjusting

entries for new revenue recognition rules are set in an appendix. ∙ Revised Investments chapter for the new standard.

xiii

New presentation to aid learning of indirect adjustments to income. Simplified T-accounts to reconstruct cash flows. New box on Tesla’s cash outflows and growing market value. Simplified reconstruction entries to help compute cash flows. Updated cash flow on total assets analysis using Nike and Under Armour. New Cheat Sheet reinforces chapter content. Added ten new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 13 Updated opener—Morgan Stanley and entrepreneurial assignment. Updated data for all analyses of Apple using horizontal, vertical, and ratio analysis. Updated comparative analysis using Google and Samsung. Streamlined section on ratio analysis. Streamlined the “Analysis Reporting” section. Shortened Appendix 13A. New Cheat Sheet reinforces chapter content. Added eight new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 14 NEW opener—MoringaConnect and entrepreneurial assignment. Added discussion on role of managerial accounting for nonaccounting and nonbusiness majors. New margin exhibit showing product and period cost flows. Added equation boxes for total manufacturing costs and cost of goods manufactured. Added lists of common selling and administrative expenses. Updated and edited several exhibits for clarity. New Cheat Sheet reinforces chapter content. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 15 NEW opener—HoopSwagg and entrepreneurial assignment. Revised discussions of manufacturing costs and link between job cost sheets and general ledger. Added graphic linking job cost sheets and general ledger accounts. Enhanced exhibit of 4-step overhead process. Added formula for computing applied overhead. New short discussion of cost-plus pricing. Added margin T-accounts and calculations for clarity.

New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 16 NEW opener—Azucar Ice Cream and entrepreneurial assignment. Revised discussion comparing process and job order costing systems. Added cost flow graphic. New margin graphic illustrating EUP. Revised discussion of weighted-average versus FIFO method of process costing. Revised discussion of using the process cost summary. New graphic on FIFO goods flow. Added margin T-accounts and calculations for clarity. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 17 NEW opener—Sycamore Brewing and entrepreneurial assignment. New graphic showing activities for service businesses. Added examples to discussion of ABC for service businesses. New Cheat Sheet reinforces chapter content. Added one new Discussion Question. Added one new Quick Study. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 18 NEW opener—Ellis Island Tropical Tea and entrepreneurial assignment. Added margin graphs of fixed, variable, and mixed costs. New Excel steps to create a line chart. Moved details of creating scatter plot to Appendix 18A, with Excel steps. Revised discussion of scatter plots. Moved details of creating a CVP chart to Appendix 18C, with Excel steps. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 19 NEW opener—Lantern Inn B&B and entrepreneurial assignment. New Cheat Sheet reinforces chapter content. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 20 NEW opener—Misfit Juicery and entrepreneurial assignment.

Added T-accounts and steps to exhibit margins. Added numbered steps to several exhibits. Expanded discussion of cost of goods sold budgeting. New exhibit for calculation of cash paid for interest. Expanded discussion with bulleted list on use of a master budget. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added one new Exercise. New assignment on CMA exam budgeting coverage. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 21 NEW opener—Away and entrepreneurial assignment. Added graph to flexible budget exhibit. Revised discussion of flexible budget. New exhibit and discussion of computing total cost variance. Edited discussion of direct materials cost variance. Edited discussion of evaluating labor variances. Edited discussion of overhead variance reports. New exhibit for summary of variances. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 22 NEW opener—Jibu and entrepreneurial assignment. Updated Walt Disney ROI example. New Decision Analysis on cash conversion cycle. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 23 NEW opener—Solugen and entrepreneurial assignment. Organized decision scenarios into three types: production, capacity, and pricing. Expanded discussion of product pricing. Added other pricing methods: value-based, auction-based, and dynamic. New Decision Insight on blockchain technology. New Decision Analysis on time and materials pricing of services. New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added one new Exercise.

Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 24 NEW opener—Fellow Robots and entrepreneurial assignment. Added example of investment in robotics. New discussion of postaudit of investment decisions. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Appendix A New financial statements for Apple, Google, and Samsung.

Appendix B New Decision Maker on postponed retail pricing. Continued Excel demos for PV and FV of lump sums. Continued Excel demos for PV and FV of annuities.

Appendix C New learning objective P4 for new category of stock investments. Revised and simplified Exhibit C.2 for new standard on investments. Reorganized text to first explain debt securities and then stock securities. Revised trading and available-for-sale securities to cover only debt securities given the new standard. New section on stock investments with insignificant influence. New Exhibit C.6 to describe accounting for equity securities by ownership level. Updated component-returns analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added four new Exercises. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Appendix D NEW appendix on lean principles and accounting. Describes lean business principles. Measures production efficiency. Illustrates how to account for product costs using lean accounting. New: 13 Discussion Questions, 14 Quick Studies, 14 Exercises, and 3 Problems.

xiv

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Acknowledgments John J. Wild, Ken W. Shaw, and McGraw-Hill Education recognize the following instructors for their valuable feedback and involvement in the development of Financial and Managerial Accounting. We are thankful for their suggestions, counsel, and encouragement.

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xvii

Brief Contents 1 Accounting in Business 2 2 Accounting for Business

Transactions 44

3 Adjusting Accounts for Financial Statements 84

4 Accounting for Merchandising Operations 142

5 Inventories and Cost of Sales 190 6 Cash, Fraud, and Internal Control 234 7 Accounting for Receivables 270 8 Accounting for Long-Term Assets 302 9 Accounting for Current Liabilities 340 10 Accounting for Long-Term Liabilities 380 11 Corporate Reporting and Analysis 416 12 Reporting Cash Flows 452 13 Analysis of Financial Statements 496 14 Managerial Accounting Concepts and

Principles 534

15 Job Order Costing and Analysis 570 16 Process Costing and Analysis 610

17 Activity-Based Costing and Analysis 656 18 Cost Behavior and Cost-Volume-Profit

Analysis 696

19 Variable Costing and Analysis 738 20 Master Budgets and Performance

Planning 770

21 Flexible Budgets and Standard Costs 820

22 Performance Measurement and Responsibility Accounting 868

23 Relevant Costing for Managerial Decisions 912

24 Capital Budgeting and Investment Analysis 946

A Financial Statement Information A-1 B Time Value of Money B C Investments C D Lean Principles and Accounting D-1 CA Chart of Accounts CA BR Brief Review BR-1

xviii

Preface iv

1 Accounting in Business 2 Importance of Accounting 3

Users of Accounting Information 4 Opportunities in Accounting 4

Fundamentals of Accounting 6 Ethics—A Key Concept 6 Generally Accepted Accounting Principles 7 Conceptual Framework 7

Business Transactions and Accounting 9 Accounting Equation 10 Transaction Analysis 11 Summary of Transactions 14

Communicating with Users 15 Income Statement 15 Statement of Retained Earnings 17 Balance Sheet 17 Statement of Cash Flows 17

Decision Analysis—Return on Assets 18 Appendix 1A Return and Risk 21 Appendix 1B Business Activities 22

2 Accounting for Business Transactions 44 Basis of Financial Statements 45

Source Documents 45 The “Account” Underlying Financial Statements 45 Ledger and Chart of Accounts 48

Double-Entry Accounting 49 Debits and Credits 49 Double-Entry System 49

Analyzing and Processing Transactions 51 Journalizing and Posting Transactions 51 Processing Transactions—An Example 52 Summarizing Transactions in a Ledger 57

Trial Balance 58 Preparing a Trial Balance 58 Financial Statements Prepared from Trial Balance 58

Decision Analysis—Debt Ratio 62

3 Adjusting Accounts for Financial Statements 84

Timing and Reporting 85 The Accounting Period 85 Accrual Basis versus Cash Basis 86 Recognizing Revenues and Expenses 86 Framework for Adjustments 87

Deferral of Expense 87 Prepaid Insurance 87 Supplies 88 Other Prepaid Expenses 89 Depreciation 89

Deferral of Revenue 91 Unearned Consulting Revenue 91

Accrued Expense 93 Accrued Salaries Expense 93 Accrued Interest Expense 94 Future Cash Payment of Accrued

Expenses 94

Accrued Revenue 95 Accrued Services Revenue 96 Accrued Interest Revenue 96 Future Cash Receipt of Accrued Revenues 96 Links to Financial Statements 97

Trial Balance and Financial Statements 98 Adjusted Trial Balance 98 Preparing Financial Statements 99

Closing Process 100 Temporary and Permanent Accounts 101 Recording Closing Entries 101 Post-Closing Trial Balance 104

Accounting Cycle 104 Classified Balance Sheet 105

Classification Structure 105 Classification Categories 106

Decision Analysis—Profit Margin and Current Ratio 108

Appendix 3A Alternative Accounting for Prepayments 111

Appendix 3B Work Sheet as a Tool 113 Appendix 3C Reversing Entries 115

Contents

Contents xix

Valuing Inventory at LCM and the Effects of Inventory Errors 200 Lower of Cost or Market 200 Financial Statement Effects of Inventory

Errors 201

Decision Analysis—Inventory Turnover and Days’ Sales in Inventory 203

Appendix 5A Inventory Costing under a Periodic System 209

Appendix 5B Inventory Estimation Methods 214

6 Cash, Fraud, and Internal Control 234 Fraud and Internal Control 235

Purpose of Internal Control 235 Principles of Internal Control 236 Technology, Fraud, and Internal Control 237 Limitations of Internal Control 237

Control of Cash 238 Cash, Cash Equivalents, and Liquidity 238 Cash Management 238 Control of Cash Receipts 239 Control of Cash Payments 241

Banking Activities as Controls 245 Basic Bank Services 245 Bank Statement 246 Bank Reconciliation 247

Decision Analysis—Days’ Sales Uncollected 250 Appendix 6A Documentation and

Verification 252

7 Accounting for Receivables 270 Valuing Accounts Receivable 271 Direct Write-Off Method 274 Allowance Method 275 Estimating Bad Debts 278

Percent of Sales Method 278 Percent of Receivables Method 278 Aging of Receivables Method 279

Notes Receivable 281 Computing Maturity and Interest 282 Recording Notes Receivable 283 Valuing and Settling Notes 283 Disposal of Receivables 285

Decision Analysis—Accounts Receivable Turnover 285

4 Accounting for Merchandising Operations 142

Merchandising Activities 143 Reporting Income for a Merchandiser 143 Reporting Inventory for a Merchandiser 144 Operating Cycle for a Merchandiser 144 Inventory Systems 144

Accounting for Merchandise Purchases 145 Purchases without Cash Discounts 145 Purchases with Cash Discounts 145 Purchases with Returns and Allowances 147 Purchases and Transportation Costs 148

Accounting for Merchandise Sales 150 Sales without Cash Discounts 150 Sales with Cash Discounts 151 Sales with Returns and Allowances 151

Adjusting and Closing for Merchandisers 153 Adjusting Entries for Merchandisers 153 Preparing Financial Statements 154 Closing Entries for Merchandisers 154 Summary of Merchandising Entries 155

More on Financial Statement Formats 156 Multiple-Step Income Statement 156 Single-Step Income Statement 157 Classified Balance Sheet 158

Decision Analysis—Acid-Test and Gross Margin Ratios 159

Appendix 4A Periodic Inventory System 163 Appendix 4B Adjusting Entries under New Revenue

Recognition Rules 167 Appendix 4C Net Method for Merchandising 168

5 Inventories and Cost of Sales 190 Inventory Basics 191

Determining Inventory Items 191 Determining Inventory Costs 192 Internal Controls and Taking

a Physical Count 192

Inventory Costing under a Perpetual System 193 Inventory Cost Flow Assumptions 193 Inventory Costing Illustration 194 Specific Identification 194 First-In, First-Out 195 Last-In, First-Out 195 Weighted Average 196 Financial Statement Effects of Costing Methods 197 Tax Effects of Costing Methods 198

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Warranty Liabilities 350 Multi-Period Estimated Liabilities 351

Contingent Liabilities 352 Accounting for Contingent Liabilities 352 Applying Rules of Contingent Liabilities 353 Uncertainties That Are Not Contingencies 353

Decision Analysis—Times Interest Earned Ratio 353

Appendix 9A Payroll Reports, Records, and Procedures 356

Appendix 9B Corporate Income Taxes 361

10 Accounting for Long-Term Liabilities 380 Basics of Bonds 381

Bond Financing 381 Bond Issuing 382 Bond Trading 382

Par Bonds 382 Discount Bonds 383

Bond Discount or Premium 383 Issuing Bonds at a Discount 384

Premium Bonds 386 Issuing Bonds at a Premium 386 Bond Retirement 388

Long-Term Notes Payable 390 Installment Notes 390 Mortgage Notes and Bonds 391

Decision Analysis—Debt Features and the Debt-to-Equity Ratio 392

Appendix 10A Bond Pricing 395 Appendix 10B Effective Interest

Amortization 397 Appendix 10C Leases and Pensions 398

11 Corporate Reporting and Analysis 416 Corporate Form of Organization 417

Corporate Advantages 417 Corporate Disadvantages 417 Corporate Organization and Management 418 Corporate Stockholders 418 Corporate Stock 419

Common Stock 420 Issuing Par Value Stock 420 Issuing No-Par Value Stock 421 Issuing Stated Value Stock 421 Issuing Stock for Noncash Assets 421

8 Accounting for Long-Term Assets 302 SECTION 1—PLANT ASSETS 303 Cost Determination 304

Machinery and Equipment 304 Buildings 304 Land Improvements 304 Land 304 Lump-Sum Purchase 305

Depreciation 305 Factors in Computing Depreciation 305 Depreciation Methods 305 Partial-Year Depreciation 309 Change in Estimates 310 Reporting Depreciation 310

Additional Expenditures 311 Ordinary Repairs 312 Betterments and Extraordinary Repairs 312

Disposals of Plant Assets 312 Discarding Plant Assets 313 Selling Plant Assets 313

SECTION 2—NATURAL RESOURCES 315 Cost Determination and Depletion 315 Plant Assets Tied into Extracting 316

SECTION 3—INTANGIBLE ASSETS 317 Cost Determination and Amortization 317 Types of Intangibles 317

Decision Analysis—Total Asset Turnover 320 Appendix 8A Exchanging Plant Assets 323

9 Accounting for Current Liabilities 340 Known Liabilities 341

Characteristics of Liabilities 341 Examples of Known Liabilities 342 Accounts Payable 343 Sales Taxes Payable 343 Unearned Revenues 343 Short-Term Notes Payable 343

Payroll Liabilities 346 Employee Payroll and Deductions 346 Employer Payroll Taxes 347 Internal Control of Payroll 348 Multi-Period Known Liabilities 348

Estimated Liabilities 349 Health and Pension Benefits 349 Vacation Benefits 350 Bonus Plans 350

Contents xxi

13 Analysis of Financial Statements 496 Basics of Analysis 497

Purpose of Analysis 497 Building Blocks of Analysis 497 Information for Analysis 498 Standards for Comparisons 498 Tools of Analysis 498

Horizontal Analysis 498 Comparative Statements 498 Trend Analysis 501

Vertical Analysis 502 Common-Size Statements 502 Common-Size Graphics 504

Ratio Analysis 506 Liquidity and Efficiency 506 Solvency 508 Profitability 509 Market Prospects 510 Summary of Ratios 511

Decision Analysis—Analysis Reporting 512 Appendix 13A Sustainable Income 515

14 Managerial Accounting Concepts and Principles 534

Managerial Accounting Basics 535 Purpose of Managerial Accounting 535 Nature of Managerial Accounting 536 Fraud and Ethics in Managerial Accounting 537 Career Paths 538

Managerial Cost Concepts 539 Types of Cost Classifications 539 Identification of Cost Classifications 541 Cost Concepts for Service Companies 541

Managerial Reporting 542 Manufacturing Costs 542 Nonmanufacturing Costs 542 Prime and Conversion Costs 543 Costs and the Balance Sheet 543 Costs and the Income Statement 543

Cost Flows and Cost of Goods Manufactured 546 Flow of Manufacturing Activities 546 Schedule of Cost of Goods Manufactured 547 Trends in Managerial Accounting 550

Decision Analysis—Raw Materials Inventory Turnover and Days’ Sales in Raw Materials Inventory 552

Dividends 422 Cash Dividends 422 Stock Dividends 423 Stock Splits 425 Financial Statement Effects of Dividends and

Splits 425

Preferred Stock 426 Issuance of Preferred Stock 426 Dividend Preference of Preferred Stock 427 Reasons for Issuing Preferred Stock 427

Treasury Stock 429 Purchasing Treasury Stock 429 Reissuing Treasury Stock 429

Reporting of Equity 431 Statement of Retained Earnings 431 Statement of Stockholders’ Equity 432

Decision Analysis—Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share 432

12 Reporting Cash Flows 452 Basics of Cash Flow Reporting 453

Purpose of the Statement of Cash Flows 453 Importance of Cash Flows 453 Measurement of Cash Flows 453 Classification of Cash Flows 454 Noncash Investing and Financing 455 Format of the Statement of Cash Flows 455 Preparing the Statement of Cash Flows 456

Cash Flows from Operating 457 Indirect and Direct Methods of Reporting 457 Applying the Indirect Method 457 Summary of Adjustments for Indirect Method 460

Cash Flows from Investing 461 Three-Step Analysis 461 Analyzing Noncurrent Assets 461

Cash Flows from Financing 463 Three-Step Analysis 463 Analyzing Noncurrent Liabilities 463 Analyzing Equity 464 Proving Cash Balances 464

Summary Using T-Accounts 466 Decision Analysis—Cash Flow Analysis 467 Appendix 12A Spreadsheet Preparation of the

Statement of Cash Flows 470 Appendix 12B Direct Method of Reporting

Operating Cash Flows 472

xxii Contents

Decision Analysis—Hybrid Costing System 627

Appendix 16A FIFO Method of Process Costing 631

17 Activity-Based Costing and Analysis 656 Assigning Overhead Costs 657

Alternative Methods of Overhead Allocation 657

Plantwide Overhead Rate Method 658 Departmental Overhead Rate Method 660 Assessing Plantwide and Departmental

Overhead Rate Methods 662

Activity-Based Costing 663 Steps in Activity-Based Costing 663 Applying Activity-Based Costing 664 Assessing Activity-Based Costing 668

Activity-Based Management 669 Activity Levels and Cost Management 669 Costs of Quality 670 Lean Manufacturing 671 ABC for Service Providers 671

Decision Analysis—Customer Profitability 673

18 Cost Behavior and Cost-Volume-Profit Analysis 696

Identifying Cost Behavior 697 Fixed Costs 698 Variable Costs 698 Graphing Fixed and Variable Costs against

Volume 698 Mixed Costs 698 Step-wise Costs 699 Curvilinear Costs 700

Measuring Cost Behavior 701 Scatter Diagram 701 High-Low Method 702 Regression 702 Comparing Cost Estimation Methods 702

Contribution Margin and Break-Even Analysis 703 Contribution Margin and Its Measures 703 Break-Even Point 704 Cost-Volume-Profit Chart 706 Changes in Estimates 706

Applying Cost-Volume-Profit Analysis 707 Margin of Safety 707 Computing Income from Sales and Costs 708

15 Job Order Costing and Analysis 570 Job Order Costing 571

Cost Accounting System 571 Job Order Production 571 Job Order vs. Process Operations 572 Production Activities in Job Order Costing 572 Cost Flows 573 Job Cost Sheet 573

Materials and Labor Costs 574 Materials Cost Flows and Documents 574 Labor Cost Flows and Documents 577

Overhead Costs 578 Set Predetermined Overhead Rate 579 Apply Estimated Overhead 579 Record Actual Overhead 581 Summary of Cost Flows 582 Using Job Cost Sheets for Managerial

Decisions 583 Schedule of Cost of Goods Manufactured 584

Adjusting Overhead 585 Factory Overhead Account 585 Adjust Underapplied or Overapplied

Overhead 585 Job Order Costing of Services 586

Decision Analysis—Pricing for Services 587

16 Process Costing and Analysis 610 Process Operations 611

Organization of Process Operations 611 Comparing Process and Job Order Costing

Systems 612 Equivalent Units of Production 613

Process Costing Illustration 614 Overview of GenX Company’s Process

Operation 614 Pre-Step: Collect Production and Cost Data 615 Step 1: Determine Physical Flow of Units 616

Step 2: Compute Equivalent Units

of Production 616 Step 3: Compute Cost per Equivalent Unit 617 Step 4: Assign and Reconcile Costs 617 Process Cost Summary 619

Accounting for Process Costing 620 Accounting for Materials Costs 621 Accounting for Labor Costs 622 Accounting for Factory Overhead 623 Accounting for Transfers 624 Trends in Process Operations 626

Contents xxiii

Investing and Financing Budgets 781 Capital Expenditures Budget 781 Cash Budget 781

Budgeted Financial Statements 785 Budgeted Income Statement 785 Budgeted Balance Sheet 786 Using the Master Budget 786 Budgeting for Service Companies 786

Decision Analysis—Activity-Based Budgeting 787

Appendix 20A Merchandise Purchases Budget 795

21 Flexible Budgets and Standard Costs 820 Fixed and Flexible Budgets 821

Fixed Budget Reports 822 Budget Reports for Evaluation 823 Flexible Budget Reports 823

Standard Costing 827 Standard Costs 827 Setting Standard Costs 827 Cost Variance Analysis 828

Materials and Labor Variances 830 Materials Variances 830 Labor Variances 832

Overhead Standards and Variances 833 Flexible Overhead Budgets 833 Standard Overhead Rate 833 Computing Overhead Cost Variances 835 Standard Costing—Management

Considerations 838

Decision Analysis—Sales Variances 839 Appendix 21A Expanded Overhead Variances and

Standard Cost Accounting System 844

22 Performance Measurement and Responsibility Accounting 868

Responsibility Accounting 869 Performance Evaluation 869 Controllable versus Uncontrollable Costs 870 Responsibility Accounting for Cost Centers 870

Profit Centers 872 Direct and Indirect Expenses 872 Expense Allocations 873 Departmental Income Statements 874 Departmental Contribution to Overhead 877

Computing Sales for a Target Income 709 Evaluating Strategies 710 Sales Mix and Break-Even 711 Assumptions in Cost-Volume-Profit Analysis 713

Decision Analysis—Degree of Operating Leverage 714

Appendix 18A Using Excel for Cost Estimation 716 Appendix 18B Variable Costing and Performance

Reporting 717 Appendix 18C Preparing a CVP Chart 720

19 Variable Costing and Analysis 738 Introducing Variable Costing and Absorption

Costing 739 Computing Unit Product Cost 740

Income Reporting Implications 741 Units Produced Equal Units Sold 741 Units Produced Exceed Units Sold 743 Units Produced Are Less Than Units Sold 744 Summarizing Income Reporting 745 Converting Income under Variable Costing to

Absorption Costing 746

Comparing Variable Costing and Absorption Costing 746 Planning Production 746 Setting Prices 748 Controlling Costs 748 CVP Analysis 749 Variable Costing for Service Firms 749

Decision Analysis—Pricing Special Orders 751

20 Master Budgets and Performance Planning 770

Budget Process and Administration 771 Budgeting Process 771 Benefits of Budgeting 772 Budgeting and Human Behavior 772 Budget Reporting and Timing 773 Master Budget Components 773

Operating Budgets 773 Sales Budget 775 Production Budget 775 Direct Materials Budget 776 Direct Labor Budget 777 Factory Overhead Budget 778 Selling Expense Budget 779 General and Administrative Expense Budget 780

xxiv Contents

24 Capital Budgeting and Investment Analysis 946

Capital Budgeting 947 Capital Budgeting Process 947 Capital Investment Cash Flows 948

Methods Not Using Time Value of Money 948 Payback Period 948 Accounting Rate of Return 951

Methods Using Time Value of Money 952 Net Present Value 952 Internal Rate of Return 956 Comparison of Capital Budgeting Methods 958 Postaudit 958

Decision Analysis—Break-Even Time 960 Appendix 24A Using Excel to Compute Net Present

Value and Internal Rate of Return 962

Appendix A Financial Statement Information A-1 Apple A-2 Google A-10 Samsung A-14 Appendix B Time Value of Money B Appendix C Investments C Appendix D Lean Principles and Accounting D-1 Index IND-1 Chart of Accounts CA Brief Review Managerial Analyses and Reports BR-1 Financial Reports and Tables BR-2 Selected Transactions and

Relations BR-3 Fundamentals and Analyses BR-4

Investment Centers 878 Return-on-Investment and Residual Income 878 Investment Center Profit Margin and Investment

Turnover 880

Nonfinancial Performance Evaluation Measures 881 Balanced Scorecard 881 Transfer Pricing 883

Decision Analysis—Cash Conversion Cycle 884 Appendix 22A Cost Allocations 887 Appendix 22B Transfer Pricing 889 Appendix 22C Joint Costs and Their Allocation 890

23 Relevant Costing for Managerial Decisions 912

Decisions and Information 913 Decision Making 913 Relevant Costs and Benefits 914

Production Decisions 914 Make or Buy 915 Sell or Process Further 916 Sales Mix Selection When Resources Are

Constrained 917

Capacity Decisions 919 Segment Elimination 919 Keep or Replace Equipment 920

Pricing Decisions 921 Normal Pricing 921 Special Offers 923

Decision Analysis—Time and Materials Pricing 925

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Financial & Managerial Accounting

Learning Objectives

CONCEPTUAL C1 Explain the purpose and importance of

accounting.

C2 Identify users and uses of, and opportunities in, accounting.

C3 Explain why ethics are crucial to accounting.

C4 Explain generally accepted accounting principles and define and apply several accounting principles.

PROCEDURAL P1 Analyze business transactions using the

accounting equation.

P2 Identify and prepare basic financial statements and explain how they interrelate.

C5 Appendix 1B—Identify and describe the three major activities of organizations.

ANALYTICAL A1 Define and interpret the accounting

equation and each of its components.

A2 Compute and interpret return on assets.

A3 Appendix 1A—Explain the relation between return and risk.

Chapter Preview

1 Accounting in Business

FINANCIAL STATEMENTS

P2 Income statement Statement of retained earnings

Balance sheet

Statement of cash flows

A2 Financial analysis

NTK 1-5

TRANSACTION ANALYSIS

A1 Accounting equation and its components

Expanded accounting equation

P1 Transaction analysis— Illustrated

NTK 1-3, 1-4

ETHICS AND ACCOUNTING

C3 Ethics C4 Generally accepted

accounting principles

Conceptual framework

NTK 1-1

ACCOUNTING USES

C1 Purpose of accounting

C2 Accounting information users

Opportunities in accounting

Learning Objectives are classified as conceptual, analytical, or procedural

Chapter Preview is organized by “blocks” of key content and learning objectives followed by Need-to-Know (NTK) guided video examples

NTK 1-2

3

“We ran the business . . . with just a few hundred bucks”—Steve Wozniak

Big Apple

CUPERTINO, CA—“When I designed the Apple stuff,” says Steve Wozniak, “I never thought in my life I would have enough money to fly to Hawaii or make a down payment on a house.” But some dreams do come true. Woz, along with Steve Jobs and Ron Wayne, founded Apple (Apple.com) when Woz was 25 and Jobs was 21.

The young entrepreneurs faced challenges, including how to read and interpret accounting data. They also needed to finance the company, which they did by selling Woz’s HP calcu- lator and Jobs’s Volkswagen van. The $1,300 raised helped them purchase the equipment Woz used to build the first Apple computer.

In setting up their company, the owners chose between a part- nership and a corporation. They decided on a partnership that in- cluded Ron as a third partner with 10% ownership. Days later, Ron withdrew when he considered the unlimited liability of a partner- ship. He sold his 10% share to Woz and Jobs for $800. Within nine months, Woz and Jobs converted Apple to a corporation.

As Apple grew, Woz and Jobs had to learn more accounting, along with details of preparing and interpreting financial state- ments. Important questions involving transaction analysis and financial reporting arose, and the owners took care to do things

right. “Everything we did,” asserts Woz, “we were setting the tone for the world.”

Woz and Jobs focused their accounting system to provide information for Apple’s business decisions. Today, Woz believes that Apple is key to the language of technology, just as account- ing is the language of business. In retrospect, Woz says, “Every dream I have ever had in life has come true ten times over.”

Sources: Apple website, January 2019; Woz.org, January 2019; Apple 2016 Sustainability Report, April 2016; Greenbiz, October 2014; iWoz: From Computer Geek to Cult Icon, W.W. Norton & Co., 2006; Founders at Work, Apress, 2007

©Miguel Medina/AFP/Getty Images

Why is accounting so popular on campus? Why are there so many openings for accounting jobs? Why is accounting so important to companies? The answer is that we live in an informa- tion age in which accounting information impacts us all.

Accounting is an information and measurement system that identifies, records, and commu- nicates an organization’s business activities. Exhibit 1.1 shows these accounting functions.

IMPORTANCE OF ACCOUNTING

Our most common contact with accounting is through credit checks, checking accounts, tax forms, and payroll. These experiences focus on recordkeeping, or bookkeeping, which is the recording of transactions and events. This is just one part of accounting. Accounting also includes analysis and interpretation of information.

Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur; Entrepreneurial Decision assignment returns to this feature with a mini-case

C1 Explain the purpose and importance of accounting.

Select transactions and events Input, measure, and log Prepare, analyze, and interpret

Identifying Recording Communicating

Examples are Apple’s sale of iPhones and TicketMaster’s receipt of ticket money.

Examples are dated logs of transactions measured in dollars.

Examples are reports that we analyze and interpret.

EXHIBIT 1.1 Accounting Functions

4 Chapter 1 Accounting in Business

Technology plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving accuracy. As technology makes more information available, the demand for accounting knowledge increases. Consulting, planning, and other financial services are closely linked to accounting.

Users of Accounting Information Accounting is called the language of business because it communicates data that help people make better decisions. People using accounting information are divided into two groups: exter- nal users and internal users. Financial accounting focuses on the needs of external users, and managerial accounting focuses on the needs of internal users.

External Users External users of accounting information do not directly run the organi- zation and have limited access to its accounting information. These users get accounting infor- mation from general-purpose financial statements. Following is a partial list of external users and decisions they make with accounting information. Lenders (creditors) loan money or other resources to an organization. Banks, savings and

loans, and mortgage companies are lenders. Lenders use information to assess if an organiza- tion will repay its loans.

Shareholders (investors) are the owners of a corporation. They use accounting reports to de- cide whether to buy, hold, or sell stock.

Boards of directors oversee organizations. Directors use accounting information to evaluate the performance of executive management.

External (independent) auditors examine financial statements to verify that they are prepared according to generally accepted accounting principles.

Nonmanagerial and nonexecutive employees and labor unions use external information to bargain for better wages.

Regulators have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) requires accounting reports for computing taxes.

Voters and government officials use information to evaluate government performance. Contributors to nonprofits use information to evaluate the use and impact of donations. Suppliers use information to analyze a customer before extending credit. Customers use financial reports to assess the stability of potential suppliers.

Internal Users Internal users of accounting information directly manage the organiza- tion. Internal reports are designed for the unique needs of managerial or executive employees, such as the chief executive officer (CEO). Following is a partial list of internal users and deci- sions they make with accounting information. Purchasing managers need to know what, when, and how much to purchase. Human resource managers need information about employees’ payroll, benefits, and performance. Production managers use information to monitor costs and ensure quality. Distribution managers need reports for timely and accurate delivery of products and services. Marketing managers use reports to target consumers, set prices, and monitor consumer needs. Service managers use reports to provide better service to customers. Research and development managers use information on projected costs and revenues of

innovations.

Opportunities in Accounting Accounting has four areas of opportunities: financial, managerial, taxation, and accounting- related. Exhibit 1.2 lists selected opportunities in each area.

C2 Identify users and uses of, and opportunities in, accounting.

23.90 15.00 15.34 17.89 19.45 13.67 13.60 25.65 15.45 18.85 23.56 18.85 17.23

+3.58% +12.3% +5.34% +5.94% +2.13% +6.43% -11.6% +23.1% +5.56% -3.67% +11.3% +2.54% +12.3%

400.20 253.95 285.32 248.20 989.26 320.34 208.98 432.62 765.23 564.23 256.25 524.65 754.62

530.000 320.000 430.000 900.000 600.000 380.000 220.000 750.000 250.000 120.000 158.000 245.000 658.000

Annual Repor t

–4% 2009 2007

2005 2003 2001

–2%

0%

2%

4%

6%

8%

10%

12%

Circuit City Best Buy

Return on Assets:

• Managers

• Officers and directors

• Internal auditors

• Sales sta ff

• Budget officers

• Controllers

Annual Budge t

–4% 2009 2007

2005 2003 2001

–2%

0%

2%

4%

6%

8%

10%

12%

Circuit City Best Buy

Return on Assets:

• Managers

• Officers and directors

• Internal auditors

• Sales sta ff

• Budget officers

• Controllers

Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting.

Chapter 1 Accounting in Business 5

• Preparation • Analysis • External auditing • Regulatory • Consulting • Planning • Criminal investigation

• Preparation • Planning • Regulatory • Investigations • Consulting • Enforcement • Legal services • Estate plans

• General accounting • Cost accounting • Budgeting • Internal auditing • Consulting • Controller • Treasurer • Strategy

• Lenders • Consultants • Analysts • Traders • Directors • Underwriters • Planners • Appraisers

• FBI investigators • Market researchers • Systems designers • Merger services • Business valuation • Forensic accounting • Litigation support • Entrepreneurs

Opportunities in Accounting

Financial Taxation Accounting-relatedManagerial

EXHIBIT 1.2 Accounting Opportunities

Exhibit 1.3 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting involves accounting services such as auditing and taxation. Opportunities also exist in government and not-for-profit agen- cies, including business regulation and law enforcement.

Accounting specialists are highly regarded, and their professional standing is often denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements, pass an exam, and be ethical. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), certified fraud examiner (CFE), and certified foren- sic accountant (CrFA).

Accounting specialists are in demand. Exhibit 1.4 reports average annual salaries for several accounting positions. Salaries vary based on location, company size, and other factors.

Public accounting

24%

Government and

not-for-profit 22%

Private accounting

54%

EXHIBIT 1.3 Accounting Jobs by Area

Point: The largest accounting firms are EY, KPMG, PwC, and Deloitte.

Point: Higher education yields higher pay: Master’s degree $73,738 Bachelor’s degree 56,665 Associate’s degree 39,771 High school degree 30,627 No high school degree 20,241

EXHIBIT 1.4 Accounting Salaries

Public Accounting Salary

Partner . . . . . . . . . . . . . . . . . . . . . . $245,000

Manager (6–8 years) . . . . . . . . . . 112,000

Senior (3–5 years) . . . . . . . . . . . . 90,000

Junior (0–2 years) . . . . . . . . . . . . 62,500

Private Accounting Salary

CFO . . . . . . . . . . . . . . . . . . . . . . . . $290,000

Controller/Treasurer . . . . . . . . . . . 180,000

Manager (6–8 years) . . . . . . . . . . 98,500

Senior (3–5 years) . . . . . . . . . . . . 81,500

Junior (0–2 years) . . . . . . . . . . . . . 58,000

Recordkeeping Salary

Full-charge bookkeeper . . . . . . . . $60,500

Accounts manager . . . . . . . . . . . . 58,000

Payroll manager . . . . . . . . . . . . . . 59,500

Accounting clerk (0–2 years) . . . . 39,500

Identify the following users of accounting information as either an (a) external or (b) internal user.

C1 C2 Accounting Users

NEED-TO-KNOW 1-1 1. Regulator 2. CEO 3. Shareholder

4. Marketing manager 5. Executive employee 6. External auditor

7. Production manager 8. Nonexecutive employee 9. Bank lender

Solution

1. a 2. b 3. a 4. b 5. b 6. a 7. b 8. a 9. a. Do More: QS 1-1, QS 1-2, E 1-1,

E 1-2, E 1-3

NEED-TO-KNOWs highlight key procedures and concepts in learning accounting; instructional audio/video recordings accompany each one

6 Chapter 1 Accounting in Business

Ethics—A Key Concept For information to be useful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that separate right from wrong. They are accepted standards of good and bad behavior.

Accountants face ethical choices as they prepare financial reports. These choices can affect the salaries and bonuses paid to workers. They even can affect the success of products and ser- vices. Misleading information can lead to a bad decision that harms workers and the business. There is an old saying: Good ethics are good business. Exhibit 1.5 gives a three-step process for making ethical decisions.

C3 Explain why ethics are crucial to accounting.

FUNDAMENTALS OF ACCOUNTING

Use ethics to recognize an ethical concern.

Consider all consequences.

Choose best option after weighing all consequences.

1. Identify ethical concerns 2. Analyze options 3. Make ethical decisionEXHIBIT 1.5 Ethical Decision Making

Point: A Code of Conduct is available at AICPA.org.

Fraud Triangle: Ethics under Attack The fraud triangle shows that three factors push a person to commit fraud. Opportunity. A person must be able to commit fraud with a low risk of getting caught. Pressure, or incentive. A person must feel pressure or have incentive to commit fraud. Rationalization, or attitude. A person justifies fraud or does not see its criminal nature.

The key to stopping fraud is to focus on prevention. It is less expensive and more effective to prevent fraud from happening than it is to detect it.

To help prevent fraud, companies set up internal controls. Internal controls are procedures to protect assets, ensure reliable accounting, promote efficiency, and uphold company policies. Examples are good records, physical controls (locks), and independent reviews.

Enforcing Ethics In response to major accounting scandals, like those at Enron and WorldCom, Congress passed the Sarbanes-Oxley Act, also called SOX, to help stop financial abuses. SOX requires documentation and verification of internal controls and emphasizes effec- tive internal controls. Management must issue a report stating that internal controls are effective. Auditors verify the effectiveness of internal controls. Ignoring SOX can lead to penalties and criminal prosecution of executives. CEOs and CFOs who knowingly sign off on bogus account- ing reports risk millions of dollars in fines and years in prison.

Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank, has two important provisions. Clawback Mandates recovery (clawback) of excessive pay. Whistleblower SEC pays whistleblowers 10% to 30% of sanctions exceeding $1 million.

O pp

or tu

nit y

Rationalization

Pressure

Point: An audit examines whether financial statements are prepared using GAAP.

Point: SOX requires a business that sells stock to disclose a code of ethics for its executives.

Ethics Pay The $100 million mark in total payments made by the SEC to whistleblowers was recently surpassed. Since the SEC began awarding whistleblowers a percentage of money from sanctions, over 14,000 tips have been reported. Many of the tips come from accountants. ■

Ethical Risk

Ethical Risk boxes highlight ethical issues from practice

Chapter 1 Accounting in Business 7

Generally Accepted Accounting Principles Financial accounting is governed by concepts and rules known as generally accepted account- ing principles (GAAP). GAAP wants information to have relevance and faithful representa- tion. Relevant information affects decisions of users. Faithful representation means information accurately reflects the business results.

The Financial Accounting Standards Board (FASB) is given the task of setting GAAP from the Securities and Exchange Commission (SEC). The SEC is a U.S. government agency that oversees proper use of GAAP by companies that sell stock and debt to the public.

International Standards Our global economy demands comparability in accounting re- ports. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. These standards are similar to, but sometimes different from, U.S. GAAP. The FASB and IASB are working to reduce differences between U.S. GAAP and IFRS.

Conceptual Framework The FASB conceptual framework in Exhibit 1.6 consists of the following. Objectives—to provide information useful to investors, creditors,

and others. Qualitative characteristics—to require information that has rele-

vance and faithful representation. Elements—to define items in financial statements. Recognition and measurement—to set criteria for an item to be

recognized as an element; and how to measure it.

Principles, Assumptions, and Constraint There are two types of accounting principles (and assumptions). General principles are the assumptions, concepts, and guidelines for preparing financial statements; these are shown in purple font in Exhibit 1.7, along with key as- sumptions in red font. Specific principles are de- tailed rules used in reporting business transactions and events; they are described as we encounter them.

Accounting Principles There are four general principles. Measurement principle (cost principle)

Accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. Information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence. Later chapters cover adjust- ments to market and introduce fair value.

Revenue recognition principle Revenue is recognized (1) when goods or services are pro- vided to customers and (2) at the amount expected to be received from the customer. Revenue (sales) is the amount received from selling products and services. The amount received is usually in cash, but it also can be a customer’s promise to pay at a future date, called credit sales. (To recognize means to record it.)

C4 Explain generally accepted accounting principles and define and apply several accounting principles.

Point: CPAs who audit financial statements must disclose if they do not comply with GAAP.

Objectives of financial accounting

Recognition and measurement

Qualitative characteristics Elements

EXHIBIT 1.6 Conceptual Framework

GAAPGAAP

Measurement

Full disclosure

P

Revenue recognition

Expense recognition

sepExpExpen tiogrecogrec tionionoongnitr

Business entity

Time period

F lFul sclosuuurescdiscd ssd clos

Monetary unit

Going concern

Cost-benefit

Principles

Assumptions

Constraint

EXHIBIT 1.7 Building Blocks for GAAP

Point: A company pays $500 for equipment. The cost principle requires it be recorded at $500. It makes no difference if the owner thinks this equipment is worth $700.

Example: A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded? Answer: It is recorded over time as it is earned; record $400 revenue for June and $400 for July.

8 Chapter 1 Accounting in Business

Expense recognition principle (matching principle) A company records the expenses it incurred to generate the revenue reported. An example is rent costs of office space.

Full disclosure principle A company reports the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Example: Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded? Answer: If revenue is earned over time, record $100 expense in June and $100 in July.

Measurement and Recognition Revenues for the Seattle Seahawks, Atlanta Falcons, Green Bay Packers, and other professional football teams include ticket sales, television broadcasts, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they are a liability until the NFL team plays the game for which the ticket was sold. At that point, the liability is removed and revenues are reported. ■

Decision Insight

©Shane Roper/CSM/REX/Shutterstock

Accounting Assumptions There are four accounting assumptions. Going-concern assumption Accounting information presumes that the business will con-

tinue operating instead of being closed or sold. This means, for example, that property is re- ported at cost instead of liquidation value.

Monetary unit assumption Transactions and events are expressed in monetary, or money, units. Examples of monetary units are the U.S. dollar and the Mexican peso.

Time period assumption The life of a company can be divided into time periods, such as months and years, and useful reports can be prepared for those periods.

Business entity assumption A business is accounted for separately from other business entities and its owner. Exhibit 1.8 describes four common business entities.

EXHIBIT 1.8 Attributes of Businesses

Sole Proprietorship Partnership Corporation Limited Liability Company (LLC)

Number of owners 1 owner; easy to set up . 2 or more, called partners; easy to set up .

1 or more, called stockholders; can get many investors by selling stock or shares of corporate ownership .*

1 or more, called members .

Business taxation No additional business income tax .

No additional business income tax .

Additional corporate income tax . No additional business income tax .

Owner liability Unlimited liability . Owner is per- sonally liable for proprietorship debts .

Unlimited liability . Partners are jointly liable for partnership debts .

Limited liability . Owners, called stock- holders (or shareholders), are not liable for corporate acts and debts .

Limited liability . Owners, called mem- bers, are not personally liable for LLC debts .

Legal entity Not a separate legal entity . Not a separate legal entity . A separate entity with the same rights and responsibilities as a person .

A separate entity with the same rights and responsibilities as a person .

Business life Business ends with owner death or choice .

Business ends with a partner death or choice .

Indefinite . Indefinite .

*When a corporation issues only one class of stock, it is called common stock (or capital stock).

Tax Services

Accounting Constraint The cost-benefit constraint, or cost constraint, says that infor- mation disclosed by an entity must have benefits to the user that are greater than the costs of providing it. Materiality, or the ability of information to influence decisions, is also sometimes mentioned as a constraint. Conservatism and industry practices are sometimes listed as well.

Point: Proprietorships, partner- ships, and LLCs are managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who hire managers to run the business.

Chapter 1 Accounting in Business 9

Entrepreneur You and a friend develop a new design for ice skates that improves speed. You plan to form a busi- ness to manufacture and sell the skates. You and your friend want to minimize taxes, but your big concern is potential lawsuits from customers who might be injured on these skates. What form of organization do you set up? ■ Answer: You should probably form an LLC. An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject to an additional business income tax. You also must examine the ethical and social aspects of starting a business where injuries are expected.

Decision Ethics Decision Ethics boxes are role-playing exercises that stress ethics in accounting

Solution

a. no b. no c. no d. no e. yes f. yes g. yes h. yes i. no j. yes k. yes l. yes

Part 1: Identify each of the following terms/phrases as either an accounting (a) principle, (b) assumption, or (c) constraint.

C3 C4 Accounting Guidance

NEED-TO-KNOW 1-2 1. Cost-benefit 2. Measurement 3. Business entity

4. Going-concern 5. Full disclosure 6. Time period

7. Expense recognition 8. Revenue recognition

Solution

1. c 2. a 3. b 4. b 5. a 6. b 7. a 8. a

Part 2: Complete the following table with either a yes or a no regarding the attributes of a partnership, corporation, and LLC.

Attribute Present Partnership Corporation LLC

Business taxed . . . . . . . . . . . a . e . i .

Limited liability . . . . . . . . . . . b . f . j .

Legal entity . . . . . . . . . . . . . . c . g . k .

Unlimited life . . . . . . . . . . . . d . h . l .

Do More: QS 1-3, QS 1-4, QS 1-5, QS 1-6, E 1-4, E 1-5,

E 1-6, E 1-7

Accounting shows two basic aspects of a company: what it owns and what it owes. Assets are resources a company owns or controls. The claims on a company’s assets—what it owes—are separated into owner (equity) and nonowner (liability) claims. Together, liabilities and equity are the source of funds to acquire assets.

Assets Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are web servers for an online services company, musical instru- ments for a rock band, and land for a vegetable grower. Assets include cash, supplies, equip- ment, land, and accounts receivable. A receivable is an asset that promises a future inflow of resources. A company that provides a service or product on credit has an account receivable from that customer.

Liabilities Liabilities are creditors’ claims on assets. These claims are obligations to pro- vide assets, products, or services to others. A payable is a liability that promises a future out- flow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes (loans) payable to banks, and taxes payable.

Equity Equity is the owner’s claim on assets and is equal to assets minus liabilities. Equity is also called net assets or residual equity.

Point: “On credit” and “on account” mean cash is paid at a future date.

BUSINESS TRANSACTIONS AND ACCOUNTING A1 Define and interpret the accounting equation and each of its components.

Point: Double taxation means that (1) the corporation income is taxed and (2) any dividends to owners are taxed as part of the owners’ personal income.

10 Chapter 1 Accounting in Business

Accounting Equation The relation of assets, liabilities, and equity is shown in the following accounting equation. The accounting equation applies to all transactions and events, to all companies and orga- nizations, and to all points in time.

Assets = Liabilities + Equity

We can break down equity to get the expanded accounting equation. Point: This equation can be rearranged. Example: Assets − Liabilities = Equity

Big Data The SEC keeps an online database called EDGAR (sec.gov/edgar) that has accounting information for thousands of companies, such as Columbia Sportswear, that issue stock to the public. The annual report filing for most publicly traded U.S. companies is known as Form 10-K, and the quarterly filing is Form 10-Q. Information ser- vices such as Finance.Yahoo.com offer online data and analysis. ■

Decision Insight

©Greg Epperson/Shutterstock

Part 1: Use the accounting equation to compute the missing financial statement amounts.

Accounting Equation

NEED-TO-KNOW 1-3

A1

Company Assets Liabilities Equity

Bose $150 $ 30 $ (a)

Vogue $ (b) $100 $300

Solution

a. $120 b. $400

Part 2: Use the expanded accounting equation to compute the missing financial statement amounts.

Company Assets Liabilities Common Stock Dividends Revenues Expenses

Tesla $200 $ 80 $100 $5 $ (a) $40

YouTube $400 $160 $220 $ (b) $ 120 $90

Solution

a. $65 b. $10 Do More: QS 1-7, QS 1-8,

E 1-8, E 1-9

We see that equity increases from owner investments, called stock issuances, and from reve- nues. It decreases from dividends and from expenses. Equity consists of four parts.

Equity

Assets = Liabilities + Contributed Capital + Retained Earnings

= Liabilities + Common Stock − Dividends + Revenues − Expenses

Common Stock

Common stock reflects inflows of cash and other net assets from stockholders in exchange for stock (stock is part of contributed capital and covered in later chapters).

Dividends Dividends are outflows of cash and other assets to stockholders that reduce equity.

Revenues

Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consulting services provided, facilities rented to others, and commissions from services.

Expenses

Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees.

+ − + −

Contributed capital

Retained earnings

Chapter 1 Accounting in Business 11

Transaction Analysis Business activities are described in terms of transactions and events. External transactions are exchanges of value between two entities, which cause changes in the accounting equation. An example is the sale of the AppleCare Protection Plan by Apple. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An example is Target’s use of its supplies, which are reported as expenses when used. Events are happen- ings that affect the accounting equation and are reliably measured. They include business events such as changes in the market value of certain assets and liabilities and natural events such as fires that destroy assets and create losses.

This section uses the accounting equation to analyze 11 transactions and events of FastFor- ward, a start-up consulting (service) business, in its first month of operations. Remember that after each transaction and event, assets always equal liabilities plus equity.

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consult- ing business named FastForward and set up as a corporation. FastForward evaluates the performance of footwear and accessories. Taylor owns and manages the business, which will publish online re- views and consult with clubs, athletes, and others who purchase Nike and Adidas products.

Taylor invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, cash (an asset) and stockholders’ equity each equals $30,000. Equity is increased by the owner’s investment (stock issuance), which is included in the column titled Common Stock. The effect of this transaction on FastForward is shown in the accounting equation as follows (we label the equity entries).

P1 Analyze business transac- tions using the accounting equation.

FASTForward

Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of Nike and Adidas footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It simply changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of footwear are assets because of the expected future benefits from the test results of their performance.

Assets = Liabilities + Equity

Cash = Common Stock (1) +$30,000 = +$30,000 Owner investment

Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to acquire equipment for testing footwear. Like Transaction 2, Transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected fu- ture benefits from testing footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.

Assets = Liabilities + Equity

Cash + Supplies = Common Stock Old Bal . $30,000 = $30,000 (2) − 2,500 + $2,500 ________ ________ ________ New Bal . $27,500 + $ 2,500 = $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Common Stock Old Bal . $27,500 + $2,500 = $30,000 (3) −26,000 + $26,000 _________ _______ ___________ ________ New Bal . $ 1,500 + $2,500 + $ 26,000 = $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

In vo

ic e

B ill

In vo

ic e

B ill Lones

Bes t Bu

y St ock

BANK

Assets Liabilities + Equity=

Real company names are in bold magenta

12 Chapter 1 Accounting in Business

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of footwear and accessories are needed. These additional supplies cost $7,100, but FastForward has only $1,500 in cash. Taylor arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount.

Example: If FastForward pays $500 cash in Transaction 4, how does this partial payment affect the liability to CalTech? Answer: The liability to CalTech is reduced to $6,600 and the cash balance is reduced to $1,000.

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common + Revenues Payable Stock Old Bal . $1,500 + $9,600 + $26,000 = $7,100 + $30,000 (5) +4,200 + $4,200 Consulting _________ ________ __________ ________ __________ _________ New Bal . $5,700 + $9,600 + $26,000 = $7,100 + $30,000 + $ 4,200

$41,300 $41,300

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transaction 5: Provide Services for Cash FastForward plans to earn revenues by selling online ad space and consulting with clients about footwear and accessories. It earns net income only if its revenues are greater than its expenses. In its first job, FastForward pro- vides consulting services and immediately collects $4,200 cash. The accounting equation re- flects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is shown in the far right column under Revenues because the cash received is earned by providing consult- ing services.

Point: Revenue recognition prin- ciple requires that revenue is rec- ognized when work is performed.

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 to rent its facilities. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is shown in the following accounting equation as Transaction 6. FastForward also pays the biweekly $700 salary of the company’s only em- ployee. This is shown in the accounting equation as Transaction 7. Both Transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, not assets, because their benefits are used in December (they have no future benefits after December). The accounting equation shows that both transactions reduce cash and equity. The far right column shows these decreases as Expenses.

Point: Expense recognition prin- ciple requires that expenses are recognized when the revenue they help generate is recorded.

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common Stock Payable Old Bal . $1,500 + $2,500 + $26,000 = $30,000 (4) + 7,100 +$7,100 _______ _______ ________ __________ ________ New Bal . $1,500 + $9,600 + $26,000 = $ 7,100 + $30,000

$37,100 $37,100

⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common + Revenues − Expenses Payable Stock Old Bal . $5,700 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 (6) −1,000 − $1,000 Rent _________ ________ __________ _________ __________ _________ _________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 Salaries _________ ________ __________ _________ __________ _________ _________ New Bal . $4,000 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 − $ 1,700

$39,600 $39,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Increases in expenses yield decreases in equity.

Chapter 1 Accounting in Business 13

Transaction 8: Provide Services and Facilities for Credit FastForward pro- vides consulting services of $1,600 and rents its test facilities for an additional $300 to Adidas on credit. Adidas is billed for the $1,900 total. This transaction creates a new asset, called ac- counts receivable, from Adidas. Accounts receivable is increased instead of cash because the payment has not yet been received. Equity is increased from the two revenue components shown in the Revenues column of the accounting equation.

Point: Transaction 8, like 5, records revenue when work is performed, not necessarily when cash is received.

Transaction 9: Receipt of Cash from Accounts Receivable The client in Transaction 8 (Adidas) pays $1,900 to FastForward 10 days after it is billed for consulting ser- vices. This Transaction 9 does not change the total amount of assets and does not affect liabili- ties or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward performed the services in Transaction 8, not when the cash is collected.

Point: Transaction 9 involved no added client work, so no added revenue is recorded.

Point: Receipt of cash is not always a revenue.

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (Transaction 4), leaving $6,200 unpaid. This transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an ex- pense even though cash flows out of FastForward (instead the expense is recorded when FastForward uses these supplies).

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $4,000 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 − $1,700 (8) + $1,900 + 1,600 Consulting + 300 Rental ________ _________ _______ _________ _______ _________ _______ __________ New Bal . $4,000 + $ 1,900 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $4,000 + $1,900 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700 (9) +1,900 − 1,900 _________ _________ _______ _________ _______ _________ _______ ________ New Bal . $5,900 + $ 0 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $5,900 + $ 0 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700 (10) −900 −900 _______ __________ _______ _________ _______ _________ ________ ________ New Bal . $5,000 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 + $6,100 − $1,700

$40,600 $40,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

14 Chapter 1 Accounting in Business

Summary of Transactions Exhibit 1.9 shows the effects of these 11 transactions of FastForward using the accounting equa- tion. Assets equal liabilities plus equity after each transaction.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock Old Bal . $5,000 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 + $6,100 − $1,700 (11) − 200 − $200 Dividends _______ _______ _______ ________ _______ _________ ______ _______ _______ New Bal . $4,800 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 − $200 + $6,100 − $1,700

$40,400 $40,400

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Increases in dividends yield decreases in equity.

Transaction 11: Payment of Cash Dividend FastForward declares and pays a $200 cash dividend to its owner (the sole shareholder). Dividends (decreases in equity) are not reported as expenses because they do not help earn revenue. Because dividends are not expenses, they are not used in computing net income.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock (1) $30,000 = $30,000 (2) − 2,500 + $2,500 __________ ________ __________ Bal . 27,500 + 2,500 = 30,000 (3) −26,000 + $26,000 __________ ________ ____________ __________ Bal . 1,500 + 2,500 + 26,000 = 30,000 (4) + 7,100 = +$7,100 __________ ________ ____________ _________ __________ Bal . 1,500 + 9,600 + 26,000 = 7,100 + 30,000 (5) + 4,200 + $4,200 __________ ________ ____________ _________ __________ ________ Bal . 5,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 (6) − 1,000 − $1,000 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,700 (8) + $1,900 + 1,600 + 300 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 1,900 + 9,600 + 26,000 = 7,100 + 30,000 6,100 − 1,700 (9) + 1,900 − 1,900 __________ ________ ____________ _________ __________ ________ ________ Bal . 5,900 + 0 + 9,600 + 26,000 = 7,100 + 30,000 + 6,100 − 1,700 (10) − 900 − 900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,000 + 0 + 9,600 + 26,000 = 6,200 + 30,000 + 6,100 − 1,700 (11) − 200 − $200 __________ ________ ________ ____________ _________ __________ ______ ________ ________ Bal . $ 4,800 + $ 0 + $ 9,600 + $ 26,000 = $ 6,200 + $ 30,000 − $ 200 + $6,100 − $ 1,700

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

Jan. 1 Jamsetji Tata invested $4,000 cash in Tata Company in exchange for its common stock. 5 The company purchased $2,000 of equipment on credit. 14 The company provided $540 of services for a client on credit. 21 The company paid $250 cash for an employee’s salary.

Transaction Analysis

NEED-TO-KNOW 1-4

P1

Do More: QS 1-10, QS 1-11, E 1-10, E 1-11, E 1-13

Chapter 1 Accounting in Business 15

Solution

Assets = Liabilities + Equity

Cash + Accounts + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock Jan. 1 $4,000 = $4,000 Jan. 5 + $2,000 +$2,000 Bal . 4,000 + 2,000 = 2,000 + 4,000 Jan. 14 + $540 + $540 Bal . 4,000 + 540 + 2,000 = 2,000 + 4,000 + 540 Jan. 21 −250 − $250 Bal . 3,750 + 540 + 2,000 = 2,000 + 4,000 + 540 − 250

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

$6,290 $6,290

Financial statements are prepared in the order below using the 11 transactions of FastForward. (These statements are unadjusted—we explain this in Chapters 2 and 3.) The four financial statements and their purposes follow.

COMMUNICATING WITH USERS P2 Identify and prepare basic financial statements and explain how they interrelate.

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from Trans- actions 5 and 8 and rental revenue of $300 from Transaction 8. Expenses are reported after revenues. Rent and salary expenses are from Transactions 6 and 7. Expenses are the costs to generate the revenues reported. Net income occurs when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Net income (or loss) is shown at the bottom of the state- ment and is the amount reported in December. Stockholders’ investments and dividends are not part of income.

Financial Statement Purpose

Income statement Describes a company’s revenues and expenses and computes net income or loss over a period of time.

Statement of retained earnings Explains changes in retained earnings from net income (or loss) and any dividends over a period of time.

Balance sheet Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.

Statement of cash flows Identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

Layout

Revenue – Expenses

Net income

Beg. retained earnings + Net income – Dividends

End. retained earnings

Assets = Liabilities + Equity

+/– Operating C.F. +/– Investing C.F. +/– Financing C.F.

Change in cash

Point: Net income is sometimes called earnings or profit.

Key terms are in bold and defined again in the glossary

16 Chapter 1 Accounting in Business

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . $ 4,800 Accounts payable . . . . . . . . . . . . . . . . $ 6,200 _____________ Supplies . . . . . . . . . . 9,600 Total liabilities . . . . . . . . . . . . . . . . . . 6,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . . . 4,200 _____________ Total equity . . . . . . . . . . . . . . . . . . . . . 34,200 _________ _____________ Total assets . . . . . . . . . $ 40,400 Total liabilities and equity . . . . . . . . . $ 40,400 _________ _____________ _________ _____________

Point: The income statement, the statement of retained earnings, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues

Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . . . . . . . . . $ 5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 ____________ Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 ____________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 _____________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,400 _____________ _____________

FASTFORWARD Statement of Cash Flows

For Month Ended December 31, 2019

Cash flows from operating activities

Cash received from clients ($4,200 + $1,900) . . . . . . . . . . . . . . $ 6,100 Cash paid for expenses ($2,500 + $900 + $1,000 + $700) . . . . (5,100) __________ Net cash provided by operating activities . . . . . . . . . . . . . . . . . . $ 1,000

Cash flows from investing activities

Cash paid for equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26,000) __________ Net cash used by investing activities . . . . . . . . . . . . . . . . . . . . . . (26,000)

Cash flows from financing activities

Cash investments from shareholders . . . . . . . . . . . . . . . . . . . . . . 30,000 Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . (200) __________ Net cash provided by financing activities . . . . . . . . . . . . . . . . . . 29,800 ___________ Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800

Cash balance, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . 0 ___________ Cash balance, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800 ___________ ___________

Point: A single ruled line means an addition or subtraction. Final totals are double underlined. Negative amounts may or may not be in parentheses.

EXHIBIT 1.10 Financial Statements and Their Links

Point: A statement’s heading iden- tifies the company, the statement title, and the date or time period.

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400 _____________ 4,400

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 _____________ Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . $     4,200 _____________ _____________

Point: Arrow lines show how the statements are linked. 1 Net income is used to compute retained earnings. 2 Retained earnings is used to

prepare the balance sheet. 3 Cash from the balance sheet is

used to reconcile the statement of cash flows.

3

2

1

Chapter 1 Accounting in Business 17

Statement of Retained Earnings The statement of retained earnings reports how retained earnings changes over the reporting period. This statement shows beginning retained earnings, events that increase it (net income), and events that decrease it (dividends and net loss). Ending retained earnings is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of retained earnings is the second report in Exhibit 1.10. The beginning balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports a beginning balance equal to the prior period’s ending balance (such as from November 30). FastForward’s statement shows the $4,400 of net income for the period, which links the income statement to the statement of retained earnings (see line 1 ). The state- ment also reports the $200 cash dividend and FastForward’s end-of-period retained earnings balance.

Balance Sheet FastForward’s balance sheet is the third report in Exhibit 1.10. This statement shows FastForward’s financial position at the end of business day on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity balance is $34,200. Line 2 shows the link between the ending balance of the statement of retained earnings and the retained earnings balance on the balance sheet. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Both are acceptable.) As always, the accounting equation balances: Assets of $40,400 = Liabilities of $6,200 + Equity of $34,200.

Statement of Cash Flows FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the $5,100 cash paid for supplies, rent, and employee salaries. Outflows are in paren- theses to denote subtraction. Net cash provided by operating activities for December is $1,000. The second section reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include long-term borrowing and repay- ing of cash from lenders and the cash investments from, and dividends to, stockholders. FastForward reports $30,000 from the owner’s initial investment and a $200 cash dividend. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows an increased cash balance of $4,800. The ending balance is also $4,800 as it started with no cash—see line 3 .

Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

Prepare the (a) income statement, (b) statement of retained earnings, and (c) balance sheet for Apple using the following condensed data from its fiscal year ended September 30, 2017 ($ in millions).

P2 Financial Statements

NEED-TO-KNOW 1-5

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223 Investments and other assets . . . . . . . . . . . 303,373

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 Land and equipment (net) . . . . . . . . . . . . . . 33,783

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289 Selling, general, and other expenses . . . . . 39,835

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 Accounts receivable . . . . . . . . . . . . . . . . . . . 17,874

Retained earnings, Sep . 24, 2016 . . . . . . . . . . . 96,998 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169 Retained earnings, Sep . 30, 2017 . . . . . . . 98,180

APPLE

©Pavel1964/Shutterstock

18 Chapter 1 Accounting in Business

Solution ($ in millions)

APPLE Income Statement

For Fiscal Year Ended September 30, 2017

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 Expenses Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $141,048 Selling, general, and other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,835 ______________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,883 ______________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 ______________ ______________

APPLE Statement of Retained Earnings

For Fiscal Year Ended September 30, 2017

Retained earnings, Sep . 24, 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,998 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351 ______________ 145,349 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169 ______________ Retained earnings, Sep . 30, 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 98,180 ______________ ______________

APPLE Balance Sheet

September 30, 2017

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 Accounts payable . . . . . . . . . . . . . . . . . . . $ 49,049 Accounts receivable . . . . . . . . . . . . . . . . . . . . . 17,874 Other liabilities . . . . . . . . . . . . . . . . . . . . . 192,223 ___________ Land and equipment (net) . . . . . . . . . . . . . . . . 33,783 Total liabilities . . . . . . . . . . . . . . . . . . . . . . 241,272 Investments and other assets . . . . . . . . . . . . . 303,373 Equity Common stock . . . . . . . . . . . . . . . . . . . . . 35,867 Retained earnings . . . . . . . . . . . . . . . . . . 98,180 ___________ Total equity . . . . . . . . . . . . . . . . . . . . . . . . 134,047 ___________ ___________ Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 Total liabilities and equity . . . . . . . . . . . . $375,319 ___________ ___________ ___________ ___________

Do More: QS 1-12, QS 1-13, QS 1-14, E 1-15, E 1-16,

E 1-17

Return on AssetsDecision Analysis

We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we use a company’s prior-year ratios and competitor ratios to identify good, bad, or average performance. This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Return on assets (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

Decision Analysis (a section at the end of each chapter) covers ratios for decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 13

A2 Compute and interpret return on assets.

EXHIBIT 1.11 Return on Assets Return on assets =

Net income Average total assets

Net income is from the annual income statement, and average total assets is computed by adding the begin- ning and ending amounts for that same period and dividing by 2. Nike reports total net income of $4,240 million for the current year. At the beginning of the current year its total assets are $21,396 million, and at the end of the current year they total $23,259 million. Nike’s return on assets for the current year is:

Return on assets = $4,240 million

($21,396 million + $23,259 million)/2 = 19.0%

Chapter 1 Accounting in Business 19

Is a 19.0% return on assets good or bad for Nike? To help answer this question, we compare (benchmark) Nike’s return with its prior performance and the return of its competitor, Under Armour (see Exhibit 1.12). Nike shows a stable pattern of good returns that reflects effective use of assets. Nike has outperformed Under Armour in each of the last three years. Its management performed well based on Nike’s return on assets.

EXHIBIT 1.12 Nike and Under Armour Returns

Return on Assets Current Year 1 Year Ago 2 Years Ago

Nike . . . . . . . . . . . . . . . . . . . 19 .0% 17 .5% 16 .3% Under Armour . . . . . . . . . . 7 .9 9 .4 11 .4

Business Owner You own a winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 14% return on its assets. The industry return for competitors of this manufacturer is 9%. Do you purchase this manufacturer? ■ Answer: The 14% return on assets for the manufacturer exceeds the 9% industry return. This is positive for a potential purchase. Also, this purchase is an opportunity to spread your risk over two businesses. Still, you should hesitate to purchase a business whose 14% return is lower than your current 21% return. You might better direct efforts to increase investment in your resort if it can earn more than the 14% alternative.

Decision Maker

Decision Analysis ends with a role-playing scenario to show the usefulness of ratios

After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month of business.

a. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for its common stock.

b. 2 Expressions paid $600 cash for furniture for the shop. c. 3 Expressions paid $500 cash to rent space in a strip mall for August. d. 4 Purchased $1,200 of equipment on credit for the shop (recorded as accounts payable). e. 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. f. 16 Expressions provided $100 of haircutting services on credit. g. 17 Expressions received a $100 check for services previously rendered on credit. h. 18 Expressions paid $125 cash to an assistant for hours worked for the grand opening. i. 31 Cash received from services provided during the second half of August was $930. j. 31 Expressions paid $400 cash toward the accounts payable entered into on August 4. k. 31 Expressions paid a $900 cash dividend to Worthy (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table similar to the one in Exhibit 1.9: Cash; Accounts Receivable; Furniture; Store Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Show the effects of each transaction using the accounting equation.

2. Prepare an income statement for August. 3. Prepare a statement of retained earnings for August. 4. Prepare a balance sheet as of August 31. 5. Prepare a statement of cash flows for August. 6. Determine the return on assets ratio for August.

PLANNING THE SOLUTION Set up a table like Exhibit 1.9 with the appropriate columns for accounts. Analyze each transaction and show its effects as increases or decreases in the appropriate columns. Be

sure the accounting equation remains in balance after each transaction. Prepare the income statement, and identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. Use information in the Equity columns to prepare the statement of retained earnings. Use information in the last row of the transactions table to prepare the balance sheet. Prepare the statement of cash flows; include all events listed in the Cash column of the transactions

table. Classify each cash flow as operating, investing, or financing. Calculate return on assets by dividing net income by average assets.

COMPREHENSIVE

Transaction Analysis, Statement Preparation, and Return on Assets

NEED-TO-KNOW 1-6

Comprehensive Need-to-Know is a review of key chapter content; the Planning the Solution section offers strategies in solving it

20 Chapter 1 Accounting in Business

SOLUTION 1.

Assets = Liabilities + Equity

Cash + Accounts + Furniture + Store = Accounts + Common − Dividends + Revenues − Expenses Receivable Equipment Payable Stock a. $3,000 $15,000 $18,000 b. − 600 + $600 _______ ______ _________ _________ Bal . 2,400 + 600 + 15,000 = 18,000 c. − 500 − $500 _______ ______ _________ _________ ______ Bal . 1,900 + 600 + 15,000 = 18,000 − 500 d. + 1,200 +$1,200 _______ ______ _________ _________ _________ ______ Bal . 1,900 + 600 + 16,200 = 1,200 + 18,000 − 500 e. + 825 + $ 825 _______ ______ _________ _________ _________ _______ ______ Bal . 2,725 + 600 + 16,200 = 1,200 + 18,000 + 825 − 500 f. + $100 + 100 _______ ______ ______ _________ _________ _________ _______ ______ Bal . 2,725 + 100 + 600 + 16,200 = 1,200 + 18,000 + 925 − 500 g. + 100 − 100 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 2,825 + 0 + 600 + 16,200 = 1,200 + 18,000 + 925 − 500 h. − 125 − 125 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 2,700 + 0 + 600 + 16,200 = 1,200 + 18,000 + 925 − 625 i. + 930 + 930 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 3,630 + 0 + 600 + 16,200 = 1,200 + 18,000 + 1,855 − 625 j. − 400 − 400 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 3,230 + 0 + 600 + 16,200 = 800 + 18,000 + 1,855 − 625 k. − 900 − $ 900 _______ ______ ______ _________ _________ _________ ________ _______ _______ Bal . $ 2,330 + 0 + $ 600 + $ 16,200 = $ 800 + $ 18,000 − $ 900 + $1,855 − $625 _______ ______ ______ _________ _________ _________ ________ _______ _______ _______ ______ ______ _________ _________ _________ ________ _______ _______

[continued on next page]

2.

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues

Haircutting services revenue . . . . . . . . . . . . . $ 1,855

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . $ 500

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . 625

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,230

3.

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1* . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . 1,230 1,230

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . 900

Retained earnings, August 31 . . . . . . . . . . . . . $ 330

* If Expressions had existed before August 1, the beginning retained earnings balance would equal the prior period’s ending balance.

Chapter 1 Accounting in Business 21

6. Return on assets = Net income

Average assets =

$1,230 ($18,000* + $19,130)∕2

= $1,230 $18,565

= 6.63%

*Uses the initial $18,000 investment as the beginning balance for the start-up period only.

4.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . $ 2,330 Accounts payable . . . . . . . . . . . . . . . . . . $ 800 Furniture . . . . . . . . . . . . . . . . . 600 Equity Store equipment . . . . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . . . . . . 18,000 Retained earnings . . . . . . . . . . . . . . . . . . 330 Total equity . . . . . . . . . . . . . . . . . . . . . . . . 18,330 Total assets . . . . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . . . . $19,130

5.

EXPRESSIONS Statement of Cash Flows

For Month Ended August 31

Cash flows from operating activities Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,855 Cash paid for expenditures ($500 + $125 + $400) . . . . . . . . . . (1,025) Net cash provided by operating activities . . . . . . . . . . . . . . . . . . $ 830 Cash flows from investing activities Cash paid for furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600) Cash flows from financing activities Cash investments from shareholders . . . . . . . . . . . . . . . . . . . . . . 3,000 Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . (900) Net cash provided by financing activities . . . . . . . . . . . . . . . . . . 2,100 Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330 Cash balance, August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Cash balance, August 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330

APPENDIX

Return and Risk 1A This appendix covers return and risk analysis. Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest re- turn such as 2%. We also could invest in a company’s stock, or even start our own business. How do we decide among these options? The answer depends on our trade-off between return and risk. Risk is the uncertainty about the return we will earn. All business investments involve risk, but some in- vestments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts). If we buy a share of eBay or any other company, we might get a large return. However, we have no guarantee of any return; there is even the risk of loss. Exhibit 1A.1 shows recent returns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds have a low expected return, but they also have low risk because they are backed by the U.S. govern- ment. High-risk corporate bonds have a much larger potential return but have much higher risk. The trade-off between return and risk is a normal part of business. Higher risk implies higher, but riskier, expected returns. To help us make better decisions, we use accounting information to assess both return and risk.

A3 Explain the relation between return and risk.

EXHIBIT 1A.1 Average Returns for Bonds with Different Risks

Annual Return

U.S. Treasury

Low-risk corporate

Medium-risk corporate

High-risk corporate

0% 4% 8% 12%

10.9%

8.3%

5.8%

2.5%

22 Chapter 1 Accounting in Business

APPENDIX

Business Activities1B This appendix explains how the accounting equation is linked to business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning is defining an organization’s ideas, goals, and actions.

Financing Financing activities provide the resources organizations use to pay for assets such as land, buildings, and equipment. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources loaned by creditors (lenders).

Investing Investing activities are the acquiring and disposing of assets that an organization uses to buy and sell its products or services. Some organizations require land and factories to operate. Others need only an office. Invested amounts are referred to as assets. Creditor and owner financing hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This yields the accounting equation: Assets = Liabilities + Equity.

Operating Operating activities involve using resources to research, develop, purchase, produce, distribute, and market products and services. Sales and revenues are the inflow of assets from selling products and services. Costs and expenses are the outflow of assets to support operating activities. Exhibit 1B.1 summarizes business activities. Planning is part of each ac- tivity and gives them meaning and focus. Investing (assets) and financing (li- abilities and equity) are opposite each other because they always are equal. Operating activities are below to show that they are the result of investing and financing.

C5 Identify and describe the three major activities of organizations.

Point: Investing (assets) and financing (liabilities plus equity) totals are always equal.

EXHIBIT 1B.1 Activities of Organizations

Operating

Planning

P

la nn

in g

Planning

In vo

ic e

B ill

In vo

ic e

B ill Lones

Bes t Bu

y St ock

BANK

Investing BANKBANKBANKBANKBANK

Financing

ACCOUNTING USES External users: Do not directly run the organization and have limited access to its accounting information. Examples are lenders, shareholders, boards of directors, external auditors, nonexecutive employees, labor unions, regulators, voters, donors, suppliers, and customers. Internal users: Directly manage organization operations. Examples are the CEO and other executives, research and development managers, purchasing managers, production managers, and other managerial-level employees. Private accounting: Accounting employees working for businesses. Public accounting: Offering audit, tax, and accounting services to others.

ETHICS AND ACCOUNTING Fraud triangle: Factors that push a person to commit fraud. ∙ Opportunity: Must be able to commit fraud with a low risk of getting

caught. ∙ Pressure, or incentive: Must feel pressure or have incentive to commit

fraud. ∙ Rationalization, or attitude: Justifies fraud or does not see its criminal

nature.

Summary: Cheat Sheet

SYSTEM OF ACCOUNTS Assets: Resources a company owns or controls that are expected to yield future benefits. Liabilities: Creditors’ claims on assets. These are obligations to provide assets, products, or services to others. Equity: Shareholders’ claim on assets. It consists of:

Common stock reflects inflows of cash and other net assets from stockholders in exchange for stock.

Dividends are outflows of cash and other assets to stockholders that reduce equity.

Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consult- ing services provided, facilities rented to others, and commissions from services.

Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees.

Common Stock+ Dividends−

Revenues+

Expenses−

Common business entities: Sole Proprietorship Partnership

Number of owners 1 owner; easy to set up . 2 or more, called partners; easy to set up .

Business taxation No additional business income tax . No additional business income tax .

Owner liability Unlimited liability . Owner is personally liable for proprietorship debts .

Unlimited liability . Partners are jointly liable for partnership debts .

Legal entity Not a separate legal entity . Not a separate legal entity .

Business life Business ends with owner death or choice . Business ends with a partner death or choice .

Corporation Limited Liability Company (LLC)

Number of owners 1 or more, called stockholders; can get many investors by selling stock or shares of corporate ownership .

1 or more, called members .

Business taxation Additional corporate income tax . No additional business income tax .

Owner liability Limited liability . Owners, called stockholders (or share- holders), are not liable for corporate acts and debts .

Limited liability . Owners, called members, are not personally liable for LLC debts .

Legal entity A separate entity with the same rights and responsibili- ties as a person .

A separate entity with the same rights and responsibilities as a person .

Business life Indefinite . Indefinite .

Chapter 1 Accounting in Business 23

Accounting (3) Accounting equation (10) Assets (9) Audit (6) Auditors (6) Balance sheet (15) Bookkeeping (3) Business entity assumption (8) Common stock (8, 10) Conceptual framework (7) Contributed capital (10) Corporation (8) Cost-benefit constraint (8) Cost constraint (8) Cost principle (7) Dividends (10) Dodd-Frank Wall Street Reform and

Consumer Protection Act (6) Double taxation (9) Equity (9) Ethics (6) Events (11) Expanded accounting equation (10) Expense recognition principle (8)

Expenses (10) External transactions (11) External users (4) Financial accounting (4) Financial Accounting Standards

Board (FASB) (7) Full disclosure principle (8) Generally accepted accounting

principles (GAAP) (7) Going-concern assumption (8) Income statement (15) Internal controls (6) Internal transactions (11) Internal users (4) International Accounting Standards

Board (IASB) (7) International Financial Reporting

Standards (IFRS) (7) Liabilities (9) Limited liability company (LLC) (8) Managerial accounting (4) Matching principle (8) Measurement principle (7) Members (8)

Monetary unit assumption (8) Net income (15) Net loss (15) Owner investments (10) Partnership (8) Proprietorship (8) Recordkeeping (3) Retained earnings (10) Return (21) Return on assets (ROA) (18) Revenue recognition principle (7) Revenues (10) Risk (21) Sarbanes-Oxley Act (SOX) (6) Securities and Exchange

Commission (SEC) (7) Shareholders (8) Shares (8) Sole proprietorship (8) Statement of cash flows (15) Statement of retained earnings (15) Stock (8) Stockholders (8) Time period assumption (8)

Key Terms A list of key terms concludes each chapter (a complete glossary is also available)

Multiple Choice Quiz

1. A building is offered for sale at $500,000 but is currently as- sessed at $400,000. The purchaser of the building believes the building is worth $475,000, but ultimately purchases the building for $450,000. The purchaser records the building at:

a. $50,000. c. $450,000. e. $500,000. b. $400,000. d. $475,000.

Summary of transactions:

TRANSACTION ANALYSIS Accounting equation: Applies to all transactions and events, to all compa- nies and organizations, and to all points in time.

Assets = Liabilities + Equity

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock (1) $30,000 = $30,000 (2) − 2,500 + $2,500 __________ ________ __________ Bal . 27,500 + 2,500 = 30,000 (3) −26,000 + $26,000 __________ ________ ____________ __________ Bal . 1,500 + 2,500 + 26,000 = 30,000 (4) + 7,100 = +$7,100 __________ ________ ____________ _________ __________ Bal . 1,500 + 9,600 + 26,000 = 7,100 + 30,000 (5) + 4,200 + $4,200 __________ ________ ____________ _________ __________ ________ Bal . 5,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 (6) − 1,000 − $1,000 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,700 (8) + $1,900 + 1,600 + 300 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 1,900 + 9,600 + 26,000 = 7,100 + 30,000 6,100 − 1,700 (9) + 1,900 − 1,900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,900 + 0 + 9,600 + 26,000 = 7,100 + 30,000 + 6,100 − 1,700 (10) − 900 − 900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,000 + 0 + 9,600 + 26,000 = 6,200 + 30,000 + 6,100 − 1,700 (11) − 200 − $200 __________ ________ ________ ____________ _________ __________ ______ ________ ________ Bal . $ 4,800 + $ 0 + $ 9,600 + $ 26,000 = $ 6,200 + $ 30,000 − $ 200 + $6,100 − $ 1,700

Transaction 1: Investment by owner Transaction 2: Purchase supplies for cash Transaction 3: Purchase equipment for cash Transaction 4: Purchase supplies on credit Transaction 5: Provide services for cash Transactions 6 and 7: Payment of expenses in cash Transaction 8: Provide services and facilities for credit Transaction 9: Receipt of cash from accounts receivable Transaction 10: Payment of accounts payable Transaction 11: Payment of cash dividends

FINANCIAL STATEMENTS Financial Statement Layout Purpose

Income statement Describes a company’s revenues and expenses and computes net income or loss over a period of time.

Statement of retained earnings

Explains changes in retained earnings from net income (or loss) and any dividends over a period of time.

Balance sheet Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.

Statement of cash flows

Identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

+/– Operating C.F. +/– Investing C.F. +/– Financing C.F.

Change in cash

Beg. retained earnings + Net income – Dividends

End. retained earnings

Assets = Liabilities + Equity

Revenue – Expenses

Net income

24 Chapter 1 Accounting in Business

2. On December 30 of the current year, KPMG signs a $150,000 contract to provide accounting services to one of its clients in the next year. KPMG has a December 31 year-end. Which accounting principle or assumption requires KPMG to record the accounting services revenue from this client in the next year and not in the current year? a. Business entity assumption b. Revenue recognition principle c. Monetary unit assumption d. Cost principle e. Going-concern assumption

3. If the assets of a company increase by $100,000 during the year and its liabilities increase by $35,000 during the same year, then the change in equity of the company during the year must have been: a. An increase of $135,000. d. An increase of $65,000. b. A decrease of $135,000. e. An increase of $100,000. c. A decrease of $65,000.

4. Brunswick borrows $50,000 cash from Third National Bank. How does this transaction affect the accounting equa- tion for Brunswick?

a. Assets increase by $50,000; liabilities increase by $50,000; no effect on equity.

b. Assets increase by $50,000; no effect on liabilities; equity increases by $50,000.

c. Assets increase by $50,000; liabilities decrease by $50,000; no effect on equity.

d. No effect on assets; liabilities increase by $50,000; eq- uity increases by $50,000.

e. No effect on assets; liabilities increase by $50,000; eq- uity decreases by $50,000.

5. Geek Squad performs services for a customer and bills the customer for $500. How would Geek Squad record this transaction? a. Accounts receivable increase by $500; revenues in-

crease by $500. b. Cash increases by $500; revenues increase by $500. c. Accounts receivable increase by $500; revenues

decrease by $500. d. Accounts receivable increase by $500; accounts payable

increase by $500. e. Accounts payable increase by $500; revenues increase

by $500. ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $450,000 is the actual cost incurred. 2. b; revenue is recorded when services are provided. 3. d;

4. a 5. a

Assets = Liabilities + Equity

+$100,000 = +$35,000 + ?

Change in equity = $100,000 − $35,000 = $65,000

A(B) Superscript letter A or B denotes assignments based on Appendix 1A or 1B.

Icon denotes assignments that involve decision making.

1. What is the purpose of accounting in society? 2. Technology is increasingly used to process accounting data.

Why then must we study and understand accounting? 3. Identify four kinds of external users and describe how

they use accounting information. 4. What are at least three questions business owners and

managers might be able to answer by looking at accounting information?

5. Identify three actual businesses that offer services and three actual businesses that offer products.

6. Describe the internal role of accounting for organizations. 7. Identify three types of services typically offered by ac-

counting professionals. 8. What type of accounting information might be useful

to the marketing managers of a business? 9. Why is accounting described as a service activity? 10. What are some accounting-related professions? 11. How do ethics rules affect auditors’ choice of clients?

12. What work do tax accounting professionals perform in ad- dition to preparing tax returns?

13. What does the concept of objectivity imply for information reported in financial statements?

14. A business reports its own office stationery on the balance sheet at its $400 cost, although it cannot be sold for more than $10 as scrap paper. Which accounting principle and/or assumption justifies this treatment?

15. Why is the revenue recognition principle needed? What does it demand?

16. Describe the four basic forms of business organization and their key attributes.

17. Define (a) assets, (b) liabilities, (c) equity, and (d) net assets.

18. What events or transactions change equity? 19. Identify the two main categories of accounting principles. 20. What do accountants mean by the term revenue? 21. Define net income and explain its computation.

Discussion Questions

Chapter 1 Accounting in Business 25

22. Identify the four basic financial statements of a business. 23. What information is reported in an income statement? 24. Give two examples of expenses a business might incur. 25. What is the purpose of the statement of retained earnings? 26. What information is reported in a balance sheet? 27. The statement of cash flows reports on what major activities? 28. Define and explain return on assets. 29.A Define return and risk. Discuss the trade-off between

them. 30.B Describe the three major business activities in organizations.

31.B Explain why investing (assets) and financing (liabilities and equity) totals are always equal.

32. Refer to Google’s financial statements in Appendix A near the end of the text. To what level of significance are dollar amounts rounded? What time period does its income statement cover?

33. Access the SEC EDGAR database (SEC.gov) and retrieve Apple’s 2017 10-K (filed November 3, 2017). Identify its auditor. What respon- sibility does its independent auditor claim regarding Apple’s financial statements?

GOOGLE

APPLE

QUICK STUDY

QS 1-1 Understanding accounting

C1

Choose the term or phrase below that best completes each statement. a. Accounting c. Recording e. Governmental g. Language of business b. Identifying d. Communicating f. Technology h. Recordkeeping (bookkeeping) 1. reduces the time, effort, and cost of recordkeeping while improving clerical accuracy. 2. requires that we input, measure, and log transactions and events. 3. is the recording of transactions and events, either manually or electronically.

Quick Study exercises offer a brief check of key points

Connect reproduces assignments online, in static or algorithmic mode, which allows instructors to monitor, promote, and assess student learning. It can be used for practice, homework, or exams

QS 1-2 Identifying accounting users

C2

Identify the following users as either external users (E) or internal users (I). a. Customers e. Managers i. Controllers b. Suppliers f. District attorney j. FBI and IRS c. External auditors g. Shareholders k. Consumer group d. Business press h. Lenders l. Directors

The fraud triangle asserts that the following three factors must exist for a person to commit fraud. A. Opportunity B. Pressure C. Rationalization Identify the fraud risk factor (A, B, or C) in each of the following situations.

1. The business has no cameras or security devices at its warehouse. 2. Managers are expected to grow business or be fired. 3. A worker sees other employees regularly take inventory for personal use. 4. No one matches the cash in the register to receipts when shifts end. 5. Officers are told to show rising income or risk layoffs. 6. A worker feels that fellow employees are not honest.

QS 1-3 Identifying ethical risks

C3

This icon highlights ethics-related assignments

QS 1-4 Identifying principles, assumptions, and constraints C4

Identify each of the following terms or phrases as an accounting (a) principle, (b) assumption, or (c) constraint.

1. Full disclosure 3. Going-concern 2. Time period 4. Revenue recognition

QS 1-5 Identifying attributes of businesses

C4

Complete the following table with either a yes or no regarding the attributes of a proprietorship, partner- ship, corporation, and limited liability company (LLC).

Attribute Present Proprietorship Partnership Corporation LLC

1 . Business taxed . . . . . . . . . . . . . . . . . .

2 . Limited liability . . . . . . . . . . . . . . . . . .

3 . Legal entity . . . . . . . . . . . . . . . . . . . . .

26 Chapter 1 Accounting in Business

QS 1-6 Identifying accounting principles and assumptions

C4

Identify the letter for the principle or assumption from A through F in the blank space next to each num- bered situation that it best explains or justifies. A. General accounting principle B. Measurement (cost) principle C. Business entity assumption

D. Revenue recognition principle E. Expense recognition (matching) principle F. Going-concern assumption

1. In December of this year, Chavez Landscaping received a customer’s order and cash prepay- ment to install sod at a house that would not be ready for installation until March of next year. Chavez should record the revenue from the customer order in March of next year, not in December of this year.

2. If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000. 3. Mike Derr owns both Sailing Passions and Dockside Digs. In preparing financial statements

for Dockside Digs, Mike makes sure that the expense transactions of Sailing Passions are kept separate from Dockside Digs’s transactions and financial statements.

QS 1-7 Applying the accounting equation A1

a. Total assets of Charter Company equal $700,000 and its equity is $420,000. What is the amount of its liabilities?

b. Total assets of Martin Marine equal $500,000 and its liabilities and equity amounts are equal to each other. What is the amount of its liabilities? What is the amount of its equity?

This icon highlights assignments that enhance decision-making skills

QS 1-8 Applying the accounting equation

A1

1. Use the accounting equation to compute the missing financial statement amounts (a), (b), and (c).

A B DC

Company Assets1 2 3 4

$ 75,000

85,000 (b)

$ (a)

20,000 25,000

1

3 2

$ 40,000

(c) 70,000

Liabilities= + Equity

A D EB F GC

1 2 3 4

1 2 $ 80,000

$ 40,000 $ 32,000 $ 16,000

$ 44,000 $ 20,000

$ 18,000 $ 8,000

(b) $ 0

$ 24,000 (a)

Company Assets ExpensesRevenuesLiabilities Common

Stock Dividends

2. Use the expanded accounting equation to compute the missing financial statement amounts (a) and (b).

QS 1-9 Identifying and computing assets, liabilities, and equity

A1

Use Google’s December 31, 2017, financial statements, in Appendix A near the end of the text, to answer the following. a. Identify the amounts (in $ millions) of its 2017 (1) assets, (2) liabilities, and (3) equity. b. Using amounts from part a, verify that Assets = Liabilities + Equity.GOOGLE

QS 1-10 Identifying effects of transactions using accounting equation— Revenues and Expenses

P1

Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Cash + Accounts = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation (identify each revenue and expense type, such as commissions revenue or rent expense). a. The company completed consulting work for a client and immediately collected $5,500 cash earned. b. The company completed commission work for a client and sent a bill for $4,000 to be received within

30 days. c. The company paid an assistant $1,400 cash as wages for the period. d. The company collected $1,000 cash as a partial payment for the amount owed by the client in transaction b. e. The company paid $700 cash for this period’s cleaning services.

Chapter 1 Accounting in Business 27

QS 1-11 Identifying effects of transactions using accounting equation— Assets and Liabilities

P1

Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Cash + Supplies + Equipment + Land = Accounts + Common − Dividends + Revenues − Expenses Payable Stock

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation. a. The owner invested $15,000 cash in the company in exchange for its common stock. b. The company purchased supplies for $500 cash. c. The owner invested $10,000 of equipment in the company in exchange for more common stock. d. The company purchased $200 of additional supplies on credit. e. The company purchased land for $9,000 cash.

QS 1-12 Identifying items with financial statements

P2

Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), or statement of cash flows (CF).

a. Assets b. Cash from operating activities c. Equipment d. Expenses

e. Liabilities f. Net decrease (or increase) in cash g. Revenues h. Total liabilities and equity

QS 1-13 Identifying income and equity accounts

P2

Classify each of the following items as revenues (R), expenses (EX), or dividends (D). 1. Cost of sales 2. Service revenue 3. Wages expense

4. Cash dividends 5. Rent expense 6. Rental revenue

7. Insurance expense 8. Consulting revenue

QS 1-14 Identifying assets, liabilities, and equity P2

Classify each of the following items as assets (A), liabilities (L), or equity (EQ). 1. Land 2. Common stock

3. Equipment 4. Accounts payable

5. Accounts receivable 6. Supplies

QS 1-15 Preparing an income statement

P2

On December 31, Hawkin’s records show the following accounts. Use this information to prepare a December income statement for Hawkin.

Equipment . . . . . . . . . . . $3,000 Accounts receivable . . . . . . . . . $ 600 Wages expense . . . . . . . . . . . $8,000

Cash . . . . . . . . . . . . . . . . 2,400 Services revenue . . . . . . . . . . . 16,000 Utilities expense . . . . . . . . . . 700

Rent expense . . . . . . . . . 1,500 Accounts payable . . . . . . . . . . . 6,000

QS 1-16 Computing and interpreting return on assets

A2

In a recent year’s financial statements, Home Depot reported the following results. Compute and interpret Home Depot’s return on assets (assume competitors average an 11.0% return on assets).

Sales . . . . . . . . . . . . . $95 billion Net income . . . . . . . . . . . . $8 billion Average total assets . . . . . . . $42 billion

QS 1-17 Identifying and computing assets, liabilities, and equity

A1

Use Samsung’s December 31, 2017, financial statements in Appendix A near the end of the text to an- swer the following. a. Identify the amounts (in millions of Korean won) of Samsung’s 2017 (1) assets, (2) liabilities, and

(3) equity. b. Using amounts from part a, verify that Assets = Liabilities + Equity.

Samsung

28 Chapter 1 Accounting in Business

EXERCISES

Exercise 1-1 Classifying activities reflected in the accounting system C1

Classify the following activities as part of the identifying (I), recording (R), or communicating (C) aspects of accounting.

1. Analyzing and interpreting reports. 2. Presenting financial information. 3. Keeping a log of service costs. 4. Measuring the costs of a product.

5. Preparing financial statements. 6. Acquiring knowledge of revenue transactions. 7. Observing transactions and events. 8. Registering cash sales of products sold.

Exercise 1-3 Describing accounting responsibilities

C2

Many accounting professionals work in one of the following three areas. A. Financial accounting B. Managerial accounting C. Tax accounting Identify the area of accounting that is most involved in each of the following responsibilities.

1. Internal auditing 2. External auditing 3. Cost accounting 4. Budgeting

5. Enforcing tax laws 6. Planning transactions to minimize taxes 7. Preparing external financial statements 8. Analyzing external financial reports

Exercise 1-4 Learning the language of business

C1 C2 C3

Match each of the numbered descriptions 1 through 5 with the term or phrase it best reflects. Indicate your answer by writing the letter A through H for the term or phrase in the blank provided. A. Audit B. GAAP

C. Ethics D. FASB

1. An assessment of whether financial statements follow GAAP. 2. Amount a business earns in excess of all expenses and costs associated with its sales and

revenues. 3. A group that sets accounting principles in the United States. 4. Accounting professionals who provide services to many clients. 5. Principles that determine whether an action is right or wrong.

G. Net income H. IASB

E. SEC F. Public accountants

Part A. Identify the following questions as most likely to be asked by an internal (I) or an external (E) user of accounting information.

1. Which inventory items are out of stock? 2. Should we make a five-year loan to that business? 3. What are the costs of our product’s ingredients? 4. Should we buy, hold, or sell a company’s stock? 5. Should we spend additional money for redesign of our product? 6. Which firm reports the highest sales and income? 7. What are the costs of our service to customers?

Part B. Identify the following users as either an internal (I) or an external (E) user. 1. Research and development executive 2. Human resources executive 3. Politician 4. Shareholder

5. Distribution manager 6. Creditor 7. Production supervisor 8. Purchasing manager

Exercise 1-2 Identifying accounting users and uses

C2

Match each of the numbered descriptions 1 through 7 with the term or phrase it best reflects. Indicate your answer by writing the letter A through G for the term or phrase in the blank provided. A. Ethics B. Fraud triangle C. Prevention

D. Internal controls E. Sarbanes-Oxley Act

1. Requires the SEC to pay whistleblowers. 2. Examines whether financial statements are prepared using GAAP; it does not ensure absolute

accuracy of the statements.

F. Audit G. Dodd-Frank Act

Exercise 1-5 Identifying ethical terminology

C3

Most Exercises and Quick Study assignments are supported with Guided Examples (“Hints”) in Connect using different numbers; an instructor can choose whether to make them available to students

Chapter 1 Accounting in Business 29

3. Requires documentation and verification of internal controls and increases emphasis on inter- nal control effectiveness.

4. Procedures set up to protect company property and equipment, ensure reliable accounting, promote efficiency, and encourage adherence to policies.

5. A less expensive and more effective means to stop fraud. 6. Three factors push a person to commit fraud: opportunity, pressure, and rationalization. 7. Beliefs that distinguish right from wrong.

Exercise 1-6 Distinguishing business organizations

C4

The following describe several different business organizations. Determine whether each description best refers to a sole proprietorship (SP), partnership (P), corporation (C), or limited liability company (LLC).

a. Micah and Nancy own Financial Services, which pays a business income tax. Micah and Nancy do not have personal responsibility for the debts of Financial Services.

b. Riley and Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the business.

c. IBC Services does not have separate legal existence apart from the one person who owns it. d. Trent Company is owned by Trent Malone, who is personally liable for the company’s debts. e. Ownership of Zander Company is divided into 1,000 shares of stock. The company pays a

business income tax. f. Physio Products does not pay income taxes and has one owner. The owner has unlimited lia-

bility for business debt. g. AJ Company pays a business income tax and has two owners. h. Jeffy Auto is a separate legal entity from its owner, but it does not pay a business income tax.

Exercise 1-7 Identifying accounting principles and assumptions

C4

Enter the letter A through H for the principle or assumption in the blank space next to each numbered description that it best reflects. A. General accounting principle B. Measurement (cost) principle C. Business entity assumption D. Revenue recognition principle

E. Specific accounting principle F. Expense recognition (matching) principle G. Going-concern assumption H. Full disclosure principle

1. A company reports details behind financial statements that would impact users’ decisions. 2. Financial statements reflect the assumption that the business continues operating. 3. A company records the expenses incurred to generate the revenues reported. 4. Concepts, assumptions, and guidelines for preparing financial statements. 5. Each business is accounted for separately from its owner or owners. 6. Revenue is recorded when products and services are delivered. 7. Detailed rules used in reporting events and transactions. 8. Information is based on actual costs incurred in transactions.

Exercise 1-8 Using the accounting equation

A1

Determine the missing amount from each of the separate situations a, b, and c below.

A B C Assets1

2 3 4

(a)$

154,000 100,000

(c)

$ 20,000 34,000 (b)

$ 45,000

40,000

Liabilities= + Equity

Exercise 1-9 Using the accounting equation

A1

Answer the following questions. Hint: Use the accounting equation. a. At the beginning of the year, Addison Company’s assets are $300,000 and its equity is $100,000. During

the year, assets increase $80,000 and liabilities increase $50,000. What is the equity at year-end? b. Office Store Co. has assets equal to $123,000 and liabilities equal to $47,000 at year-end. What is the

equity for Office Store Co. at year-end? c. At the beginning of the year, Quaker Company’s liabilities equal $70,000. During the year, assets in-

crease by $60,000, and at year-end assets equal $190,000. Liabilities decrease $5,000 during the year. What are the beginning and ending amounts of equity?

Check (c) Beg. equity, $60,000

30 Chapter 1 Accounting in Business

Zen began a new consulting firm on January 5. Following is a financial summary, including balances, for each of the company’s first five transactions (using the accounting equation form).

Assets = Liabilities + Equity

Transaction Cash + Accounts + Office + Office = Accounts + Common + Revenues Receivable Supplies Furniture Payable Stock

1. $40,000 + $       0 + $        0 + $        0 = $      0 + $40,000 + $      0 2. 38,000 + 0 + 3,000 + 0 = 1,000 + 40,000 + 0 3. 30,000 + 0 + 3,000 + 8,000 = 1,000 + 40,000 + 0 4. 30,000 + 6,000 + 3,000 + 8,000 = 1,000 + 40,000 + 6,000 5. 31,000 + 6,000 + 3,000 + 8,000 = 1,000 + 40,000 + 7,000

Identify the explanation from a through j below that best describes each transaction 1 through 5 above and enter it in the blank space in front of each numbered transaction. a. The company purchased office furniture for $8,000 cash. b. The company received $40,000 cash from a bank loan. c. The owner invested $1,000 cash in the business in exchange for its common stock. d. The owner invested $40,000 cash in the business in exchange for its common stock. e. The company purchased office supplies for $3,000 by paying $2,000 cash and putting $1,000 on credit. f. The company billed a customer $6,000 for services provided. g. The company purchased office furniture worth $8,000 on credit. h. The company provided services for $1,000 cash. i. The company sold office supplies for $3,000 and received $2,000 cash and $1,000 on credit. j. The company provided services for $6,000 cash.

Identify the explanation from a through j below that best describes each transaction 1 through 5 and enter it in the blank space in front of each numbered transaction. a. The company purchased $1,000 of office supplies on credit. b. The company collected $1,900 cash from an account receivable. c. The company sold land for $4,000 cash. d. The company paid $1,000 cash in dividends to shareholders. e. The company purchased office supplies for $1,000 cash. f. The company purchased land for $4,000 cash. g. The company billed a client $1,900 for services provided. h. The company paid $1,000 cash toward an account payable. i. The owner invested $1,900 cash in the business in exchange for its common stock. j. The company sold office supplies for $1,900 on credit.

The following table shows the effects of transactions 1 through 5 on the assets, liabilities, and equity of Mulan’s Boutique.

Assets = Liabilities + Equity

Cash + Accounts + Office + Land = Accounts + Common + Revenues Receivable Supplies Payable Stock $ 21,000 + $         0 + $3,000 +   $19,000 = $           0 + $43,000 + $         0

1. − 4,000 + 4,000 2. +    1,000 +1,000    3. +     1,900 + 1,900 4. − 1,000 − 1,000    5. + 1,900 −    1,900                                                                                 

$ 17,900 + $         0 + $4,000 +   $23,000 = $           0 + $43,000 + $1,900

Exercise 1-10 Analysis using the accounting equation

P1

Exercise 1-11 Identifying effects of transactions on the accounting equation

P1

Chapter 1 Accounting in Business 31

For each transaction a through f, identify its impact on the accounting equation (select from 1 through 5 below). a. The company pays cash toward an account payable. b. The company purchases equipment on credit. c. The owner invests cash in the business in exchange for its common stock. d. The company pays cash dividends to shareholders. e. The company purchases supplies for cash. f. The company provides services for cash.

1. Decreases an asset and decreases equity. 2. Increases an asset and increases a liability. 3. Decreases an asset and decreases a liability.

4. Increases an asset and decreases an asset. 5. Increases an asset and increases equity.

On October 1, Ebony Ernst organized Ernst Consulting; on October 3, the owner contributed $84,000 in assets in exchange for its common stock to launch the business. On October 31, the company’s records show the fol- lowing items and amounts. Use this information to prepare an October income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $11,360 Cash dividends . . . . . . . . . . . . . . . . . . . . . . . $ 2,000

Accounts receivable . . . . . . . . . . . . 14,000 Consulting revenue . . . . . . . . . . . . . . . . . . . . 14,000

Office supplies . . . . . . . . . . . . . . . . 3,250 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . 3,550

Land . . . . . . . . . . . . . . . . . . . . . . . . . 46,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . 7,000

Office equipment . . . . . . . . . . . . . . 18,000 Telephone expense . . . . . . . . . . . . . . . . . . . . 760

Accounts payable . . . . . . . . . . . . . . 8,500 Miscellaneous expenses . . . . . . . . . . . . . . . . 580

Common stock . . . . . . . . . . . . . . . . 84,000

Exercise 1-15 Preparing an income statement

P2

Check Net income, $2,110

Exercise 1-12 Identifying effects of transactions on the accounting equation

P1

Swiss Group reports net income of $40,000 for 2019. At the beginning of 2019, Swiss Group had $200,000 in assets. By the end of 2019, assets had grown to $300,000. What is Swiss Group’s 2019 return on assets? How would you assess its performance if competitors average an 11% return on assets?

Exercise 1-14 Analyzing return on assets

A2

Ming Chen began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Ming Chen (the owner) completed these transactions. a. Owner invested $60,000 cash in the company along with equipment that had a $15,000 market value

in exchange for its common stock. b. The company paid $1,500 cash for rent of office space for the month. c. The company purchased $10,000 of additional equipment on credit (payment due within 30 days). d. The company completed work for a client and immediately collected the $2,500 cash earned. e. The company completed work for a client and sent a bill for $8,000 to be received within 30 days. f. The company purchased additional equipment for $6,000 cash. g. The company paid an assistant $3,000 cash as wages for the month. h. The company collected $5,000 cash as a partial payment for the amount owed by the client in transaction e. i. The company paid $10,000 cash to settle the liability created in transaction c. j. The company paid $1,000 cash in dividends to the owner (sole shareholder).

Required

Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of the transactions on individual items of the accounting equation. Show new balances after each transaction.

Check Ending balances: Cash, $46,000; Expenses, $4,500

Exercise 1-13 Identifying effects of transactions using the accounting equation

P1

Assets = Liabilities + Equity

Cash + Accounts + Equipment = Accounts + Common – Dividends + Revenues – Expenses Receivable Payable Stock

Use the information in Exercise 1-15 to prepare an October statement of retained earnings for Ernst Consulting.

Exercise 1-16 Preparing a statement of retained earnings P2

32 Chapter 1 Accounting in Business

Use the information in Exercise 1-15 to prepare an October 31 balance sheet for Ernst Consulting. Hint: The solution to Exercise 1-16 can help.

Exercise 1-17 Preparing a balance sheet P2

Indicate the section (O, I, or F) where transactions 1 through 8 would appear on the statement of cash flows. O. Cash flows from operating activity F. Cash flows from financing activity I. Cash flows from investing activity

1. Cash purchase of equipment 2. Cash paid for dividends 3. Cash paid for advertising 4. Cash paid for wages

5. Cash paid on account payable to supplier 6. Cash received from clients 7. Cash paid for rent 8. Cash investment from shareholders

Exercise 1-19 Identifying sections of the statement of cash flows

P2

Selling and administrative costs . . . . . . . . . . . . . $  12,196

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,584

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,800

Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,413

Ford Motor Company, one of the world’s largest automakers, reports the following income statement accounts for the year ended December 31 ($ in millions). Use this information to prepare Ford’s income statement for the year ended December 31.

Exercise 1-20 Preparing an income statement for a company

P2

Match each transaction a through e to one of the following activities of an organization: financing activity (F), investing activity (I), or operating activity (O).

a. An owner contributes cash to the business in exchange for its common stock. b. An organization borrows money from a bank. c. An organization advertises a new product. d. An organization sells some of its land. e. An organization purchases equipment.

Exercise 1-21B Identifying business activities

C5

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . €75,350

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,946

Selling and administrative costs . . . . . . . . . . . . . €6,139

Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 4,988

BMW Group, one of Europe’s largest manufacturers, reports the following income statement accounts for the year ended December 31 (euros in millions). Use this information to prepare BMW’s income state- ment for the year ended December 31.

Exercise 1-22 Preparing an income statement for a company

P2

Use the information in Exercise 1-15 to prepare an October 31 statement of cash flows for Ernst Consulting. Assume the following additional information. a. The owner’s initial investment consists of $38,000 cash and $46,000 in land in exchange for its common

stock. b. The company’s $18,000 equipment purchase is paid in cash. c. The accounts payable balance of $8,500 consists of the $3,250 office supplies purchase and $5,250 in

employee salaries yet to be paid. d. The company’s rent, telephone, and miscellaneous expenses are paid in cash. e. No cash has been collected on the $14,000 consulting fees earned.

Exercise 1-18 Preparing a statement of cash flows

P2

Check Net increase in cash, $11,360

Answer the following questions. Hint: Use the accounting equation. a. On January 1, Lumia Company’s liabilities are $60,000 and its equity is $40,000. On January 3, Lumia

purchases and installs solar panel assets costing $10,000. For the panels, Lumia pays $4,000 cash and promises to pay the remaining $6,000 in six months. What is the total of Lumia’s assets after the solar panel purchase?

b. On March 1, ABX Company’s assets are $100,000 and its liabilities are $30,000. On March 5, ABX is fined $15,000 for failing emission standards. ABX immediately pays the fine in cash. After the fine is paid, what is the amount of equity for ABX?

c. On August 1, Lola Company’s assets are $30,000 and its liabilities are $10,000. On August 4, Lola issues a sustainability report following SASB guidelines. Investors react positively to this report. On August 5, a new investor contributes $3,000 cash and $7,000 in equipment in exchange for ownership in Lola. After the investment, what is the amount of equity for Lola?

Exercise 1-23 Using the accounting equation

A1

This icon highlights sustainability-related assignments

Chapter 1 Accounting in Business 33

Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with dollar amounts. The first transaction is completed as an example.

Required

a. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total eq- uity. For the income statement, identify how each transaction affects net income.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating ac- tivities, cash flows from investing activities, and cash flows from financing activities.

Problem Set B, located at the end of Problem Set A, is provided for each problem to reinforce the learning process

PROBLEM SET A

Problem 1-1A Identifying effects of transactions on financial statements

A1 P1

a. b.

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Investing Financing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests $900 cash in business in exchange for stock +900 +900 +900

2 Receives $700 cash for services provided

3 Pays $500 cash for employee wages

4 Buys $100 of equipment on credit

5 Purchases $200 of supplies on credit

6 Buys equipment for $300 cash

7 Pays $200 on accounts payable

8 Provides $400 services on credit

9 Pays $50 cash in dividends

10 Collects $400 cash on accounts receivable

[continued on next page]

The following financial statement information is from five separate companies. Problem 1-2A Computing missing information using accounting knowledge

A1 P1

Company Company Company Company Company A B C D E

December 31, 2018

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $55,000   $34,000   $24,000   $60,000 $119,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . .     24,500     21,500       9,000     40,000 ? December 31, 2019

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .     58,000     40,000 ?     85,000   113,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . ?     26,500     29,000     24,000     70,000 During year 2019

Stock issuances . . . . . . . . . . . . . . . . . . . .       6,000       1,400       9,750 ?       6,500 Net income (loss) . . . . . . . . . . . . . . . . . . .       8,500 ?       8,000     14,000     20,000 Cash dividends . . . . . . . . . . . . . . . . . . . . .       3,500       2,000       5,875              0     11,000

Required

1. Answer the following questions about Company A. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019? 2. Answer the following questions about Company B. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is net income for year 2019?

Check (1b) $41,500

(2c) $1,600

34 Chapter 1 Accounting in Business

3. Compute the amount of assets for Company C on December 31, 2019. 4. Compute the amount of stock issuances for Company D during year 2019. 5. Compute the amount of liabilities for Company E on December 31, 2018.

(3) $55,875

Problem 1-4A Preparing a statement of retained earnings P2

Use the information in Problem 1-3A to prepare a year-end statement of retained earnings for Armani Company.

Problem 1-5A Preparing a balance sheet

P2

Use the information in Problem 1-3A to prepare a year-end balance sheet for Armani Company.

Problem 1-7A Analyzing transactions and preparing financial statements

P1 P2

Gabi Gram started The Gram Co., a new business that began operations on May 1. The Gram Co. com- pleted the following transactions during its first month of operations.

May 1 G. Gram invested $40,000 cash in the company in exchange for its common stock. 1 The company rented a furnished office and paid $2,200 cash for May’s rent. 3 The company purchased $1,890 of office equipment on credit. 5 The company paid $750 cash for this month’s cleaning services. 8 The company provided consulting services for a client and immediately collected $5,400

cash. 12 The company provided $2,500 of consulting services for a client on credit. 15 The company paid $750 cash for an assistant’s salary for the first half of this month. 20 The company received $2,500 cash payment for the services provided on May 12. 22 The company provided $3,200 of consulting services on credit. 25 The company received $3,200 cash payment for the services provided on May 22. 26 The company paid $1,890 cash for the office equipment purchased on May 3. 27 The company purchased $80 of office equipment on credit. 28 The company paid $750 cash for an assistant’s salary for the second half of this month. 30 The company paid $300 cash for this month’s telephone bill. 30 The company paid $280 cash for this month’s utilities. 31 The company paid $1,400 cash in dividends to the owner (sole shareholder).

Problem 1-6A Preparing a statement of cash flows

P2

Following is selected financial information of Kia Company for the year ended December 31, 2019.

Cash used by investing activities . . . . . . . . . . $(2,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . 1,200 

Cash used by financing activities . . . . . . . . . . (2,800)

Cash from operating activities . . . . . . . . . . $6,000 

Cash, December 31, 2018 . . . . . . . . . . . . . 2,300

Required

Prepare the 2019 year-end statement of cash flows for Kia Company. Check Cash balance, Dec. 31, 2019, $3,500

Problem 1-3A Preparing an income statement

P2

As of December 31, 2019, Armani Company’s financial records show the following items and amounts.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . 9,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . 11,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Retained earnings, Dec . 31, 2018 . . . . . . . . . . 3,000

Retained earnings, Dec . 31, 2019 . . . . . . . . . . . . $ 5,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Consulting revenue . . . . . . . . . . . . . . . . . . . . . . . 33,000

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Selling and administrative expenses . . . . . . . . . . 8,000

Required

Prepare the 2019 year-end income statement for Armani Company.Check Net income, $15,000

Chapter 1 Accounting in Business 35

Required

1. Create the following table similar to the one in Exhibit 1.9.

Check (1) Ending balances: Cash, $42,780; Expenses, $5,030

Assets = Liabilities + Equity

Date Cash + Accounts + Office = Accounts + Common – Dividends + Revenues – Expenses Receivable Equipment Payable Stock

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

2. Prepare the income statement and the statement of retained earnings for the month of May, and the balance sheet as of May 31.

3. Prepare the statement of cash flows for the month of May.

(2) Net income, $6,070; Total assets, $44,750

Assets = Liabilities + Equity

Cash + Accounts + Office + Office + Office = Accounts + Common – Dividends + Revenues – Expenses Receivable Supplies Equipment Suite Payable Stock

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Determine the company’s net income. (2) Net income, $4,500

Problem 1-8A Analyzing effects of transactions

A1 P1

Lita Lopez started Biz Consulting, a new business, and completed the following transactions during its first year of operations. a. Lita Lopez invested $70,000 cash and office equipment valued at $10,000 in the company in exchange

for its common stock. b. The company purchased an office suite for $40,000 cash. c. The company purchased office equipment for $15,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $500 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,800 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash fee. h. The company paid $3,275 cash in dividends to the owner (sole shareholder). i. The company received $1,800 cash as partial payment from the client described in transaction f. j. The company made a partial payment of $700 cash on the equipment purchased in transaction d. k. The company paid $1,800 cash for the office secretary’s wages for this period.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Check (1) Ending balances: Cash, $14,525; Expenses, $2,300; Accounts Payable, $2,200

Sanyu Sony started a new business and completed these transactions during December.

Dec. 1 Sanyu Sony transferred $65,000 cash from a personal savings account to a checking account in the name of Sony Electric in exchange for its common stock.

2 The company rented office space and paid $1,000 cash for the December rent. 3 The company purchased $13,000 of electrical equipment by paying $4,800 cash and agreeing to

pay the $8,200 balance in 30 days. 5 The company purchased office supplies by paying $800 cash. 6 The company completed electrical work and immediately collected $1,200 cash for these services. 8 The company purchased $2,530 of office equipment on credit. 15 The company completed electrical work on credit in the amount of $5,000. 18 The company purchased $350 of office supplies on credit. 20 The company paid $2,530 cash for the office equipment purchased on December 8. 24 The company billed a client $900 for electrical work completed; the balance is due in 30 days. 28 The company received $5,000 cash for the work completed on December 15. 29 The company paid the assistant’s salary of $1,400 cash for this month. 30 The company paid $540 cash for this month’s utility bill. 31 The company paid $950 cash in dividends to the owner (sole shareholder).

Problem 1-9A Analyzing transactions and preparing financial statements

C4 P1 P2

36 Chapter 1 Accounting in Business

Required

1. Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Date Cash + Accounts + Office + Office + Electrical = Accounts + Common − Dividends + Revenues − Expenses Receivable Supplies Equipment Equipment Payable Stock

Check (1) Ending balances: Cash, $59,180; Accounts Payable, $8,550

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Prepare the income statement and the statement of retained earnings for the current month, and the balance sheet as of the end of the month.

3. Prepare the statement of cash flows for the current month.

Analysis Component

4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $65,000 and that Sony Electric obtained another $16,000 in cash by borrowing it from a bank. Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

(2) Net income, $4,160; Total assets, $76,760

Kyzera manufactures, markets, and sells cellular telephones. The average total assets for Kyzera is $250,000. In its most recent year, Kyzera reported net income of $65,000 on revenues of $475,000.

Required

1. What is Kyzera’s return on assets? 2. Does return on assets seem satisfactory for Kyzera given that its competitors average a 12% return on

assets? 3. What are total expenses for Kyzera in its most recent year? 4. What is the average total amount of liabilities plus equity for Kyzera?

Problem 1-10A Determining expenses, liabilities, equity, and return on assets

A1 A2

Check (3) $410,000

(4) $250,000

Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures for these businesses for a recent year follow.

Key Figures ($ millions) Coca-Cola PepsiCo

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . .  $46,542  $66,504

Net income . . . . . . . . . . . . . . . . . . . . . . .      8,634      6,462

Average assets . . . . . . . . . . . . . . . . . . . .    76,448    70,518

Required

1. Compute return on assets for (a) Coca-Cola and (b) PepsiCo. 2. Which company is more successful in its total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-11A Computing and interpreting return on assets

A2

Check (1a) 11.3%; (1b) 9.2%

All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” is most risky and “4” is least risky.

a. Lowest-risk corporate bond c. Company stock in a start-up b. Medium-risk corporate bond d. U.S. government Treasury bond

Problem 1-12AA Identifying risk and return

A3

A start-up company often engages in the following transactions during its first year of operations. Classify those transactions in one of the three major categories of an organization’s business activities. F. Financing I. Investing O. Operating

1. Shareholders investing in business 2. Purchasing a building 3. Purchasing land 4. Borrowing cash from a bank

Problem 1-13AB Describing business activities

C5 5. Purchasing equipment 6. Selling and distributing products 7. Paying for advertising 8. Paying employee wages

Chapter 1 Accounting in Business 37

An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity.

Problem 1-14AB Describing business activities C5

PROBLEM SET B

Problem 1-1B Identifying effects of transactions on financial statements

A1 P1

Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with dollar amounts. The first transaction is completed as an example.

Required

a. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total eq- uity. For the income statement, identify how each transaction affects net income.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating ac- tivities, cash flows from investing activities, and cash flows from financing activities.

a. b.

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Investing Financing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests $800 cash in business in exchange for stock +800 +800 +800

2 Purchases $100 of supplies on credit

3 Buys equipment for $400 cash

4 Provides services for $900 cash

5 Pays $400 cash for rent incurred

6 Buys $200 of equipment on credit

7 Pays $300 cash for wages incurred

8 Pays $50 cash in dividends

9 Provides $600 services on credit

10 Collects $600 cash on accounts receivable

The following financial statement information is from five separate companies. Problem 1-2B Computing missing information using accounting knowledge

A1 P1

Company Company Company Company Company V W X Y Z

December 31, 2018

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,000 $ 80,000 $141,500 $92,500 $144,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . .   25,000   60,000     68,500   51,500 ? December 31, 2019

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . .   59,000 100,000   186,500 ?   170,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . .   36,000 ?     65,800   42,000     42,000 During year 2019

Stock issuances . . . . . . . . . . . . . . . . . . .     5,000   20,000 ?   48,100     60,000 Net income (or loss) . . . . . . . . . . . . . . . ?   40,000     18,500   24,000     32,000 Cash dividends . . . . . . . . . . . . . . . . . . .     5,500     2,000              0   20,000       8,000

Required

1. Answer the following questions about Company V. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the net income or loss for the year 2019? [continued on next page]

Check (1b) $23,000

38 Chapter 1 Accounting in Business

2. Answer the following questions about Company W. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019? 3. Compute the amount of stock issuances for Company X during 2019. 4. Compute the amount of assets for Company Y on December 31, 2019. 5. Compute the amount of liabilities for Company Z on December 31, 2018.

(2c) $22,000

(4) $135,100

As of December 31, 2019, Audi Company’s financial records show the following items and amounts.Problem 1-3B Preparing an income statement

P2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100

Retained earnings, Dec . 31, 2018 . . . . . . . . . . . . . 900

Retained earnings, Dec . 31, 2019 . . . . . . . . . . . . . . . $1,300

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600

Consulting revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 6,600

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Selling and administrative expenses . . . . . . . . . . . . . 1,600

Required

Prepare the 2019 year-end income statement for Audi Company.Check Net income, $3,000

Use the information in Problem 1-3B to prepare a year-end statement of retained earnings for Audi Company.

Problem 1-4B Preparing a statement of retained earnings P2

Use the information in Problem 1-3B to prepare a year-end balance sheet for Audi Company.Problem 1-5B Preparing a balance sheet P2

Nina Niko launched a new business, Niko’s Maintenance Co., that began operations on June 1. The fol- lowing transactions were completed by the company during that first month.

June 1 Nina Niko invested $130,000 cash in the company in exchange for its common stock. 2 The company rented a furnished office and paid $6,000 cash for June’s rent. 4 The company purchased $2,400 of equipment on credit. 6 The company paid $1,150 cash for this month’s advertising of the opening of the business. 8 The company completed maintenance services for a customer and immediately collected $850 cash. 14 The company completed $7,500 of maintenance services for City Center on credit. 16 The company paid $800 cash for an assistant’s salary for the first half of the month. 20 The company received $7,500 cash payment for services completed for City Center on June 14. 21 The company completed $7,900 of maintenance services for Paula’s Beauty Shop on credit. 24 The company completed $675 of maintenance services for Build-It Coop on credit. 25 The company received $7,900 cash payment from Paula’s Beauty Shop for the work completed

on June 21. 26 The company made payment of $2,400 cash for equipment purchased on June 4. 28 The company paid $800 cash for an assistant’s salary for the second half of this month. 29 The company paid $4,000 cash in dividends to the owner (sole shareholder). 30 The company paid $150 cash for this month’s telephone bill. 30 The company paid $890 cash for this month’s utilities.

Problem 1-7B Analyzing transactions and preparing financial statements

P1 P2

Problem 1-6B Preparing a statement of cash flows

P2

Selected financial information of Banji Company for the year ended December 31, 2019, follows.

Cash from investing activities . . . . . . . . . . . . . . . $1,600

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . 400

Cash from financing activities . . . . . . . . . . . . . . . 1,800

Cash used by operating activities . . . . . . . . . . $(3,000)

Cash, December 31, 2018 . . . . . . . . . . . . . . . . 1,300

Required

Prepare the 2019 year-end statement of cash flows for Banji Company.

Chapter 1 Accounting in Business 39

Required

1. Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Date Cash + Accounts + Equipment = Accounts + Common – Dividends + Revenues – Expenses Receivable Payable Stock

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

2. Prepare the income statement and the statement of retained earnings for the month of June, and the balance sheet as of June 30.

3. Prepare the statement of cash flows for the month of June.

(2) Net income, $7,135; Total assets, $133,135

Check (1) Ending balances: Cash, $130,060; Expenses, $9,790

Problem 1-9B Analyzing transactions and preparing financial statements

C4 P1 P2

Rivera Roofing Company, owned by Reyna Rivera, began operations in July and completed these transac- tions during that first month of operations. July 1 Reyna Rivera invested $80,000 cash in the company in exchange for its common stock. 2 The company rented office space and paid $700 cash for the July rent. 3 The company purchased roofing equipment for $5,000 by paying $1,000 cash and agreeing to

pay the $4,000 balance in 30 days. 6 The company purchased office supplies for $600 cash. 8 The company completed work for a customer and immediately collected $7,600 cash for the work. 10 The company purchased $2,300 of office equipment on credit. 15 The company completed work for a customer on credit in the amount of $8,200. 17 The company purchased $3,100 of office supplies on credit. 23 The company paid $2,300 cash for the office equipment purchased on July 10. 25 The company billed a customer $5,000 for work completed; the balance is due in 30 days. 28 The company received $8,200 cash for the work completed on July 15. 30 The company paid an assistant’s salary of $1,560 cash for this month. 31 The company paid $295 cash for this month’s utility bill. 31 The company paid $1,800 cash in dividends to the owner (sole shareholder).

Problem 1-8B Analyzing effects of transactions

A1 P1

Neva Nadal started a new business, Nadal Computing, and completed the following transactions during its first year of operations. a. Neva Nadal invested $90,000 cash and office equipment valued at $10,000 in the company in

exchange for its common stock. b. The company purchased an office suite for $50,000 cash. c. The company purchased office equipment for $25,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $750 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,800 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash fee. h. The company paid $11,500 cash in dividends to the owner (sole shareholder). i. The company received $1,800 cash from the client described in transaction f. j. The company made a payment of $700 cash on the equipment purchased in transaction d. k. The company paid $2,500 cash for the office secretary’s wages.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Check (1) Ending balances: Cash, $5,350; Expenses, $3,250; Accounts Payable, $2,200

Assets = Liabilities + Equity

Cash + Accounts + Office + Office + Office = Accounts + Common – Dividends + Revenues – Expenses Receivable Supplies Equipment Suite Payable Stock

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Determine the company’s net income. (2) Net income, $3,550

40 Chapter 1 Accounting in Business

Required

1. Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Date Cash + Accounts + Office + Office + Roofing = Accounts + Common − Dividends + Revenues − Expenses Receivable Supplies Equipment Equipment Payable Stock

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Prepare the income statement and the statement of retained earnings for the month of July, and the balance sheet as of July 31.

3. Prepare the statement of cash flows for the month of July.

Analysis Component

4. Assume that the $5,000 purchase of roofing equipment on July 3 was financed from an owner investment of another $5,000 cash in the business in exchange for more common stock (instead of the purchase conditions described in the transaction above). Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

Check (1) Ending balances: Cash, $87,545; Accounts Payable, $7,100

(2) Net income, $18,245; Total assets, $103,545

Ski-Doo Company manufactures, markets, and sells snowmobiles and snowmobile equipment and acces- sories. The average total assets for Ski-Doo is $3,000,000. In its most recent year, Ski-Doo reported net income of $201,000 on revenues of $1,400,000.

Required

1. What is Ski-Doo Company’s return on assets? 2. Does return on assets seem satisfactory for Ski-Doo given that its competitors average a 9.5% return

on assets? 3. What are the total expenses for Ski-Doo Company in its most recent year? 4. What is the average total amount of liabilities plus equity for Ski-Doo Company?

Problem 1-10B Determining expenses, liabilities, equity, and return on assets

A1 A2

Check (3) $1,199,000

(4) $3,000,000

Problem 1-11B Computing and interpreting return on assets

A2

Check (1a) 1.6%; (1b) 4.5%

AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures for these businesses for a recent year follow.

Key Figures ($ millions) AT&T Verizon

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,723 $110,875

Net income . . . . . . . . . . . . . . . . . . . . . . .       4,184     10,198

Average assets . . . . . . . . . . . . . . . . . . . .   269,868   225,233

Required

1. Compute return on assets for (a) AT&T and (b) Verizon. 2. Which company is more successful in the total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-12BA Identifying risk and return

A3

All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” reflects the highest expected return and “4” the lowest expected return.

a. Low-risk corporate bond c. Money stored in a fireproof vault b. Stock of a successful company d. U.S. Treasury bond

Problem 1-13BB Describing business activities

C5

A start-up company often engages in the following activities during its first year of operations. Classify each of the following activities into one of the three major activities of an organization. F. Financing I. Investing O. Operating

1. Providing client services 2. Obtaining a bank loan 3. Purchasing machinery 4. Research for its products

5. Supervising workers 6. Shareholders investing in business 7. Renting office space 8. Paying utilities expenses

Chapter 1 Accounting in Business 41

Problem 1-14BB Describing business activities C5

Identify in outline format the three major business activities of an organization. For each of these activi- ties, identify at least two specific transactions or events normally undertaken by the business’s owners or its managers.

SERIAL PROBLEM Business Solutions

C4 P1

SP 1 On October 1, 2019, Santana Rey launched a computer services company, Business Solutions, that is organized as a corporation and provides consulting services, computer system installations, and custom program development.

Required

Create a table like the one in Exhibit 1.9 using the following headings for columns: Cash; Accounts Receivable; Computer Supplies; Computer System; Office Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Then use additions and subtractions within the table to show the dollar effects for each of the following October transactions for Business Solutions on the individual items of the accounting equation. Show new balances after each transaction.

Oct. 1 S. Rey invested $45,000 cash, a $20,000 computer system, and $8,000 of office equipment in the company in exchange for its common stock.

3 The company purchased $1,420 of computer supplies on credit from Harris Office Products. 6 The company billed Easy Leasing $4,800 for services performed in installing a new web server. 8 The company paid $1,420 cash for the computer supplies purchased from Harris Office Prod-

ucts on October 3. 10 The company hired Lyn Addie as a part-time assistant for $125 per day, as needed. 12 The company billed Easy Leasing another $1,400 for services performed. 15 The company received $4,800 cash from Easy Leasing as partial payment toward its account. 17 The company paid $805 cash to repair computer equipment damaged when moving it. 20 The company paid $1,728 cash for advertisements published in the local newspaper. 22 The company received $1,400 cash from Easy Leasing toward its account. 28 The company billed IFM Company $5,208 for services performed. 31 The company paid $875 cash for Lyn Addie’s wages for seven days of work this month. 31 The company paid $3,600 cash in dividends to the owner (sole shareholder).

Serial Problem starts here and continues throughout the text

©Alexander Image/Shutterstock

Check Ending balances: Cash, $42,772; Revenues, $11,408; Expenses, $3,408

GENERAL LEDGER PROBLEM

Accounting professionals apply many technology tools to aid them in their everyday tasks and decision making. The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so the accounting professional can focus on the impacts of each transaction on the full set of finan- cial statements. Chapter 2 is the first chapter to use this tool in helping students see the advantages of technology and, in particular, the power of the General Ledger tool in accounting practice, including financial analysis and “what-if” scenarios.

GL

COMPANY ANALYSIS A1 A2

Accounting Analysis

AA 1-1 Key financial figures for Apple’s two most recent fiscal years follow.

Accounting Analysis (AA) is a section aimed to refine company analysis, comparative analysis, and global analysis skills; Accounting Analysis assignments are available in Connect.

$ millions Current Year Prior Year

Liabilities + Equity . . . . . . . . . . . . . . . . . $375,319 $321,686 Net income . . . . . . . . . . . . . . . . . . . . . . . 48,351 45,687

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . 229,234 215,639

Required

1. What is the total amount of assets invested in Apple in the current year? 2. What is Apple’s return on assets for the current year? 3. How much are total expenses for Apple for the current year? 4. Is Apple’s current-year return on assets better or worse than competitors’ average of 10% return?

APPLE

42 Chapter 1 Accounting in Business

ETHICS CHALLENGE C3 C4

BTN 1-1 Tana Thorne works in a public accounting firm and hopes to eventually be a partner. The man- agement of Allnet Company invites Thorne to prepare a bid to audit Allnet’s financial statements. In dis- cussing the audit fee, Allnet’s management suggests a fee range in which the amount depends on the reported profit of Allnet. The higher its profit, the higher will be the audit fee paid to Thorne’s firm.

Required

1. Identify the parties potentially affected by this audit and the fee plan proposed. 2. What are the ethical factors in this situation? Explain. 3. Would you recommend that Thorne accept this audit fee arrangement? Why or why not? 4. Describe some ethical considerations guiding your recommendation.

Beyond the Numbers

Beyond the Numbers (BTN) is a special problem section aimed to refine communication, conceptual, analysis, and research skills. It includes many activities helpful in developing an active learning environment.

AA 1-2 Key comparative figures ($ millions) for both Apple and Google follow.COMPARATIVE ANALYSIS A1 A2

APPLE GOOGLE

Apple Google

Key Figures Current Year Prior Year Current Year Prior Year

Liabilities + Equity . . . . . . . . . . $375,319 $321,686 $197,295 $167,497 Net income . . . . . . . . . . . . . . . . 48,351 45,687 12,662 19,478

Revenues . . . . . . . . . . . . . . . . . . 229,234 215,639 110,855 90,272

Required

1. What is the total amount of assets invested for the current year in (a) Apple and (b) Google? 2. What is the current-year return on assets for (a) Apple and (b) Google? 3. How much are current-year expenses for (a) Apple and (b) Google? 4. Is the current-year return on assets better than the 10% return of competitors for (a) Apple and

(b) Google? 5. Relying only on return on assets, would we invest in Google or Apple?

Note: Reference to Google throughout the text refers to Alphabet Inc., as Google is a wholly owned subsidiary of Alphabet.

AA 1-3 Samsung is a leading global manufacturer that competes with Apple and Google. Key financial figures for Samsung follow.

Required

1. What is the return on assets for Samsung in the (a) current year and (b) prior year? 2. Does Samsung’s return on assets exhibit a favorable or unfavorable change? 3. Is Samsung’s current-year return on assets better or worse than that for (a) Apple and (b) Google?

GLOBAL ANALYSIS A1 A2

APPLE GOOGLE

Samsung Korean Won & USD Samsung* Apple Google in millions Current Year Prior Year Current Year Current Year

Average assets . . . . . . . . . . ₩281,963,207 ₩252,176,923 $348,503 $182,396

Net income . . . . . . . . . . . . . 42,186,747 22,726,092 48,351 12,662

Revenues . . . . . . . . . . . . . . . 239,575,376 201,866,745 229,234 110,855

*Figures prepared in accordance with International Financial Reporting Standards as adopted by the Republic of Korea.

BTN 1-2 Refer to this chapter’s opening feature about Apple. Assume that the owners, sometime during their first five years of business, desire to expand their computer product services to meet business demand regarding computing services. They eventually decide to meet with their banker to discuss a loan to allow Apple to expand and offer computing services.

COMMUNICATING IN PRACTICE C2 C4

APPLE

Chapter 1 Accounting in Business 43

Required

1. Prepare a half-page report outlining the information you would request from the owners if you were the loan officer.

2. Indicate whether the information you request and your loan decision are affected by the form of busi- ness organization for Apple.

BTN 1-3 Visit the EDGAR database at SEC.gov. Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker: RMCF) filed on May 23, 2017, covering its 2017 fiscal year.

Required

1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2013–2017. Describe the revenue trend for RMCF over this five-year period.

2. Has RMCF been profitable (see net income) over this five-year period? Support your answer.

TAKING IT TO THE NET A2

BTN 1-4 Teamwork is important in today’s business world. Successful teams schedule convenient meet- ings, maintain regular communications, and cooperate with and support their members. This assignment aims to establish support/learning teams, initiate discussions, and set meeting times.

Required

1. Form teams and open a team discussion to determine a regular time and place for your team to meet between each scheduled class meeting. Notify your instructor via a memorandum or e-mail message as to when and where your team will hold regularly scheduled meetings.

2. Develop a list of telephone numbers, LinkedIn pages, and/or e-mail addresses of your teammates.

TEAMWORK IN ACTION C1

BTN 1-5 Refer to this chapter’s opening feature about Apple. Assume that the owners decide to open a new company with an innovative mobile app devoted to microblogging for accountants and those learning accounting. This new company will be called AccountApp.

Required

1. AccountApp obtains a $500,000 loan and the two owners contribute $250,000 in total from their own savings in exchange for ownership of the new company.

a. What is the new company’s total amount of liabilities plus equity? b. What is the new company’s total amount of assets? 2. If the new company earns $80,250 in net income in the first year of operation, compute its return on

assets (assume average assets equal $750,000). Assess its performance if competitors average a 10% return.

ENTREPRENEURIAL DECISION A1 A2

APPLE

Check (2) 10.7%

BTN 1-6 You are to interview a local business owner. (This can be a friend or relative.) Opening lines of communication with members of the business community can provide personal benefits of business net- working. If you do not know the owner, you should call ahead to introduce yourself and explain your position as a student and your assignment requirements. You should request a 30-minute appointment for a face-to-face or phone interview to discuss the form of organization and operations of the business. Be prepared to make a good impression.

Required

1. Identify and describe the main operating activities and the form of organization for this business. 2. Determine and explain why the owner(s) chose this particular form of organization. 3. Identify any special advantages and/or disadvantages the owner(s) experiences in operating with this

form of business organization.

HITTING THE ROAD C4

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Explain the steps in processing

transactions and the role of source documents.

C2 Describe an account and its use in recording transactions.

C3 Describe a ledger and a chart of accounts.

PROCEDURAL P1 Record transactions in a journal and post

entries to a ledger.

P2 Prepare and explain the use of a trial balance.

P3 Prepare financial statements from business transactions.

C4 Define debits and credits and explain double-entry accounting.

ANALYTICAL A1 Analyze the impact of transactions on

accounts and financial statements.

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Chapter Preview

2 Accounting for Business Transactions

NTK 2-4

TRIAL BALANCE

P2 Trial balance preparation and use

Error identification

NTK 2-5

FINANCIAL STATEMENTS

P3 Financial statement preparation

A2 Debt ratio

NTK 2-3

RECORDING TRANSACTIONS

P1 Journalizing and posting

A1 Processing transactions— Examples

NTK 2-1

SYSTEM OF ACCOUNTS

Using financial statements

C1 Source documents

C2 Types of accounts C3 General ledger

NTK 2-2

DEBITS AND CREDITS

T-account

C4 Debits and credits

Normal balance

45

“I’m always confident”—James Park

Have a Fit

SAN FRANCISCO—James Park and Eric Friedman created a wooden box with a circuit board inside. James recalls that to fix an antenna, he “literally took a piece of foam and put it on the circuit board.” Their device could be used to track fitness activ- ity, such as steps taken. The device James and Eric built would later be known as a Fitbit (Fitbit.com).

As Fitbit grew, the co-founders struggled to track sales and expenses. “It was pretty challenging,” recalls James. “I would just try to use the weekend to see if I could catch up.” James and Eric knew that having reliable accounting data would help “manage the ups and downs of running a company.”

To address this concern, the co-founders took action. They set up recordkeeping processes, transaction analysis, control procedures, and financial statement reporting. “You need to see the data,” insists James.

With accounting data, James says he “can uncover insights that weren’t possible or very practical before . . . and enable the discovery of new insights and trends.”

Eric offers the following advice to aspiring entrepreneurs unsure of how to unlock the potential of accounting data: “Get your hands dirty and do it yourself. You learn more that way.”

Sources: Fitbit website, January 2019; Wareable.com, September 2016; Business Wire, November 2015; Fortune, July 2015; Marketing Land, March 2015; Fast Company, March 2014

©Daniel Boczarski/Stringer/Fitbit/Getty Images

Business transactions and events are the starting points of financial statements. The process to go from transactions and events to financial statements includes the following. Identify each transaction and event from source documents. Analyze each transaction and event using the accounting equation. Record relevant transactions and events in a journal. Post journal information to ledger accounts. Prepare and analyze the trial balance and financial

statements.

Source Documents Source documents identify and describe transactions and events entering the accounting sys- tem. They can be in hard copy or electronic form. Examples are sales receipts, checks, purchase orders, bills from suppliers, payroll records, and bank statements. For example, cash registers record each sale on a tape or electronic file. This record is a source document for recording sales in the accounting system. Source documents are objective and reliable evidence about transac- tions and events and their amounts.

The “Account” Underlying Financial Statements An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense. The general ledger, or simply ledger, is a record of all accounts used by a company. The ledger is often in electronic form. While most companies’ ledgers have similar accounts, a company often uses one or more unique accounts to match its type of operations. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. Exhibit 2.1 shows common asset, liability, and equity accounts.

Asset Accounts Assets are resources owned or controlled by a company. Resources have expected future benefits. Most accounting systems include (at a minimum) separate accounts for the assets described here. Cash A Cash account shows a company’s cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any funds that a bank accepts for de- posit (coins, checks, money orders, and checking account balances).

C2 Describe an account and its use in recording transactions.

BASIS OF FINANCIAL STATEMENTS C1 Explain the steps in process- ing transactions and the role of source documents.

Transactions analyzed with accounting equation

Transaction occurs with source documents

Z-Mart Stores

Transactions recorded and posted

Transactions reported in financial statements

Dec. 1 Cash C. Taylor, Capital

Receive investment by owner.

Account Titles and Explanation PRDate

30,000

Debit

30,000

Credit

307 101

General Journal

General Ledger

Dec. 1 G1 30,000 30,000

Date PR

Cash

Debit Credit Account no. 101

BalanceExplanation

Dec. 1 G1 30,000 30,000

Date PR

C. Taylor, Capital

Debit Credit Account no. 307

BalanceExplanation

4

3

1

2

Assets

Cash

Accoun ts paya

ble

Supplie s

Unearn ed con

sult. re venue

Prepai d insur

ance

Total li abilitie

s

Equipm ent

Liabilit ies

Equity

C. Tayl or, Cap

ital

Total a ssets

Total li abilitie

s and e quity

$

$

FASTF ORWA

RD

Income Statem

ent

For Mo nth En

ded De cembe

r 31,

Revenu es

+

Rental revenu

e

Total re venues

Expens es

Salarie s expe

nse

Rent ex pense

Utilitie s expe

nse

Total e xpense

s

Net inc ome

$

$

Plus: Investm

ents by owner

Net inc ome

Less: Withdr

awals b y owne

r

$FAST FORWA

RD

Statem ent of

Owner ’s Equi

ty

For Mo nth En

ded De cembe

r 31,

FASTF ORWA

RD

Balanc e Shee

t

Decem ber 31,

Point: Accounting records also are called accounting books or the books.

46 Chapter 2 Accounting for Business Transactions

Accounts Receivable Accounts receivable are held by a seller and are promises of payment from customers to sellers. Accounts receivable are increased by credit sales or sales on account (or on credit). They are decreased by customer payments. We record all increases and decreases in receivables in the Accounts Receivable account. When there are multiple customers, separate records are kept for each, titled Accounts Receivable—‘Customer Name’.

Note Receivable A note receivable, or promissory note, is a written promise of another en- tity to pay a specific sum of money on a specified future date to the holder of the note; the holder has an asset recorded in a Note (or Notes) Receivable account.

Prepaid Accounts Prepaid accounts (or prepaid expenses) are assets from prepayments of future expenses (expenses expected to be incurred in future accounting periods). When the ex- penses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts are prepaid insurance, prepaid rent, and prepaid ser- vices. Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal plans). When financial statements are prepared, (1) all expired and used prepaid accounts are recorded as expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future benefits). Chapter 3 covers prepaid accounts in detail.

Supplies Accounts Supplies are assets until they are used. When they are used up, their costs are reported as expenses. Unused supplies are recorded in a Supplies asset account. Supplies often are grouped by purpose—for example, office supplies and store supplies. Office supplies include paper and pens. Store supplies include packaging and cleaning materials.

Equipment Accounts Equipment is an asset. When equipment is used and wears down, its cost is gradually reported as an expense (called depreciation). Equipment often is grouped by its purpose—for example, office equipment and store equipment. Office equipment includes com- puters and desks. The Store Equipment account includes counters and cash registers.

Buildings Accounts Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits. When a building is used and wears down, its cost is reported as an expense (called depreciation). When several buildings are owned, separate ac- counts are sometimes kept for each of them.

Land The cost of land is recorded in a Land account. The cost of buildings located on the land is separately recorded in building accounts.

Point: Customers and others who owe a company are debtors.

Point: A note receivable is differ- ent than an account receivable because it comes from a formal contract called a promissory note. A note receivable usually requires interest, whereas an account receivable does not.

Point: At the beginning of the term, a prepaid college parking pass is an asset that allows a stu- dent to park on campus. Benefits of the parking pass expire as the term progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.

Point: Some assets are called intangible because they do not have physical existence. Coca-Cola reports billions in intangible assets.

Patents Land

Long-Term Notes Payable

= + Equity AccountsLiability Accounts

Accrued Liabilities

Unearned Revenue Short-Term Notes Payable

Accounts Payable

Dividends

Revenues Expenses

Common Stock

Buildings Equipment

Investment in Land Supplies

Prepaid Accounts Inventory

Notes Receivable Accounts Receivable

Cash

Asset Accounts

EXHIBIT 2.1 Accounts Organized by the Accounting Equation

Women Entrepreneurs Sara Blakely (in photo), the billionaire entrepreneur/owner of SPANX, has promised to do- nate half of her wealth to charity. The Center for Women’s Business Research reports the following for women-owned businesses.

• They total more than 11 million and employ nearly 20 million workers.

• They generate $2.5 trillion in annual sales and tend to embrace technology.

• They are philanthropic—70% of owners volunteer at least once per month. ■

Decision Insight

©Rob Kim/Getty Images

Chapter 2 Accounting for Business Transactions 47

Liability Accounts Liabilities are obligations to transfer assets or provide products or services to others. They are claims (by creditors) against assets. Creditors are individuals and organizations that have rights to receive payments from a company. Common liability accounts are described here.

Accounts Payable Accounts payable are promises to pay later. Payables can come from purchases of merchandise-for-resale, supplies, equipment, and services. We record all increases and decreases in payables in the Accounts Payable account. When there are multiple suppliers, separate records are kept for each, titled Accounts Payable—‘Supplier Name’.

Note Payable A note payable is a written promissory note to pay a future amount. It is re- corded as either a short-term note payable or a long-term note payable, depending on when it must be repaid. We explain short- and long-term classification in the next two chapters.

Unearned Revenue Accounts Unearned revenue is a liability that is settled in the future when a company delivers its products or services. When customers pay in advance for products or services (before revenue is earned), the seller records this receipt as unearned revenue. Examples of unearned revenue include magazine subscriptions collected in advance by a pub- lisher, rent collected in advance by a landlord, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions and Unearned Rent. When products and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees Revenue and Rent Revenue.1

Accrued Liabilities Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These often are recorded in separate liability accounts by the same title. If they are not a large amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial statements often report totals of several ledger accounts.)

Point: Accounts payable also are called trade payables.

Point: Two words that almost always identify liability accounts: “payable,” meaning liabilities that must be paid, and “unearned,” meaning liabilities that must be fulfilled.

1In practice, account titles vary. Subscription Fees Revenue is sometimes called Subscription Fees, Subscription Fees Earned, or Earned Subscription Fees. Rent Revenue is sometimes called Rent Earned, Rental Revenue, or Earned Rent Revenue. Titles can differ even within the same industry. Product sales are called net sales at Apple, revenues at Google, and revenue at Samsung. Revenues or fees is commonly used with service businesses, and net sales or sales is used with product businesses.

Unearned Revenue The Dallas Cowboys, Atlanta Falcons, New England Patriots, and most NFL teams have over $100 million in advance ticket sales in Unearned Revenue. When a team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenue. Teams in other major sports such as the National Women’s Soccer League and the Women’s National Basketball Association also have unearned revenue. ■

Decision Insight

©Mike Zarrilli/Getty Images

Equity Accounts The owner’s claim on a company’s assets is called equity, stockholders’ equity, or shareholders’ equity. Equity is the owner’s residual interest in the assets of a business after subtracting liabilities. Equity is impacted by four types of accounts.

= – + –Equity Dividends Revenues ExpensesCommon stock

We show this in Exhibit 2.2 by expanding the accounting equation. We also organize assets and liabilities into subgroups that have similar attributes. An important subgroup for both assets and liabilities is the current items. Current items are expected to be either collected or owed within the next year. The next chapter explains this. At this point, know that a classified balance sheet groups accounts into classifications (such as land and buildings into Plant Assets) and it reports current assets before noncurrent assets and current liabilities before noncurrent liabilities.

Point: A note payable is different than an account payable because it comes from a formal contract called a promissory note and requires interest.

48 Chapter 2 Accounting for Business Transactions

Owner Investments When an owner invests in a company, it increases both assets and equity. The increase to equity is recorded in the account titled Common Stock. Owner invest- ments are not revenues of the business.

Owner Distributions When a corporation distributes assets to its owners, it decreases both company assets and total equity. The decrease to equity is recorded in an account titled Dividends. Dividends are not expenses of the business; they are simply the opposite of owner investments.

Revenue Accounts Amounts received from sales of products and services to customers are recorded in revenue accounts, which increase equity. Examples of revenue accounts are Sales, Commissions Earned, Professional Fees Earned, Rent Revenue, and Interest Revenue. Revenues always increase equity.

Expense Accounts Amounts used for costs of providing products and services are recorded in expense accounts, which decrease equity. Examples of expense accounts are Advertising Expense, Salaries Expense, Rent Expense, Utilities Expense, and Insurance Expense. Expenses always decrease equity. A variety of revenues and expenses are in the chart of accounts at the end of this book. (Different companies use different account titles to describe the same thing. For example, some use Interest Revenue instead of Interest Earned.)

Point: Dividends account can be viewed as a contra equity account because it reduces the normal balance of equity.

Revenues ExpensesDividends

Dividends Revenues Expenses

Common Stock

Common Stock

Patents

Land

Long-Term Notes Payable

= + Equity AccountsLiability Accounts

Accrued Liabilities

Unearned Revenue Short-Term Notes Payable

Accounts Payable

Dividends

Common Stock

Buildings Equipment

Investment in Land

Supplies Prepaid Accounts

Inventory Notes Receivable

Accounts Receivable Cash

Asset Accounts

Long-Term Investments

Plant Assets

Current Assets Current Liabilities

Long-Term Liabilities

Intangible Assets

Revenues Expenses

EXHIBIT 2.2 Accounts Classified by the Expanded Accounting Equation

Sporting Accounts The Cleveland Cavaliers, Boston Celtics, Golden State Warriors, and other NBA teams have revenue accounts that include Ticket Sales, Broadcast Fees, and Advertising Revenues. Expense accounts include Player Salaries, NBA Franchise Costs, and Promotional Costs. ■

Decision Insight

C3 Describe a ledger and a chart of accounts.

Ledger and Chart of Accounts The collection of all accounts and their balances is called a ledger (or general ledger). A com- pany’s size and diversity of operations affect the number of accounts needed. A small company

can have as few as 20 accounts; a large company can require thousands. The chart of accounts is a list of all ledger accounts and has an identification number assigned to each account. Exhibit 2.3 shows a common numbering system of accounts for a smaller business.

These account numbers have a three-digit code that is useful in record- keeping. In this example, the first digit of asset accounts is a 1, the first digit of liability accounts is a 2, and so on. The second and third digits relate to the accounts’ subcategories. Exhibit 2.4 shows a partial chart of accounts for FastForward.

Asset accounts Liability accounts Equity accounts Revenue accounts Expense accounts

Chart of Accounts

101–199 201–299 301–399 401–499 501–699

EXHIBIT 2.3 Typical Chart of Accounts for a Smaller Business

Chapter 2 Accounting for Business Transactions 49

EXHIBIT 2.4 Partial Chart of Accounts for FastForward

Chart of Accounts

Assets

101 Cash 106 Accounts receivable 126 Supplies 128 Prepaid insurance 167 Equipment

Liabilities

201 Accounts payable

236 Unearned consulting revenue

Revenues Expenses 403 Consulting revenue 622 Salaries expense

406 Rental revenue 637 Insurance expense

640 Rent expense

652 Supplies expense

690 Utilities expense

307 Common stock

318 Retained earnings

319 Dividends

Equity

Classify each of the following accounts as either an asset (A), liability (L), or equity (EQ) account.

Classifying Accounts

NEED-TO-KNOW 2-1

C1 C2 C3

1. Prepaid Rent 2. Common Stock 3. Note Receivable 4. Accounts Payable

5. Accounts Receivable 6. Equipment 7. Interest Payable 8. Unearned Revenue

9. Land 10. Prepaid Insurance 11. Wages Payable 12. Rent Payable

Solution

1. A 2. EQ 3. A 4. L 5. A 6. A 7. L 8. L 9. A 10. A 11. L 12. L Do More: QS 2-2, QS 2-3

Debits and Credits A T-account represents a ledger account and is used to show the effects of transactions. Its name comes from its shape like the letter T. The layout of a T-account is shown in Exhibit 2.5.

The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. To enter amounts on the left side of an account is to debit the account. To enter amounts on the right side is to credit the account. The term debit or credit, by itself, does not mean increase or decrease. Whether a debit or a credit is an increase or decrease depends on the account.

The difference between total debits and total credits for an account, including any beginning balance, is the account balance. When total debits exceed total credits, the account has a debit balance. It has a credit balance when total credits exceed total debits. When total debits equal total credits, the account has a zero balance.

Double-Entry System Double-entry accounting demands the accounting equation remain in balance, which means that for each transaction: At least two accounts are involved, with at least one debit and one credit. Total amount debited must equal total amount credited.

This means total debits must equal total credits for all entries, and total debit account balances in the ledger must equal total credit account balances. The system for recording debits and credits follows the accounting equation—see Exhibit 2.6.

DOUBLE-ENTRY ACCOUNTING

C4 Define debits and credits and explain double-entry accounting.

EXHIBIT 2.5 The T-Account (Left side) (Right side)

Debit Credit

Account Title

Point: Dr. and Cr. come from 18th-century English where terms debitor and creditor were used instead of debit and credit. Dr. and Cr. use the first and last let- ters of these terms, just as we still do for Saint (St.) and Doctor (Dr.).

“Total debits equal total credits for

each entry.”

50 Chapter 2 Accounting for Business Transactions

Net increases or decreases on one side have equal net effects on the other side. For exam- ple, a net increase in assets must include an equal net increase on the liabilities and equity side. Some transactions affect only one side of the equation, such as acquiring a land asset by giving up a cash asset, but their net effect on this one side is zero.

The left side is the normal balance side for assets; the right side is the normal balance side for liabilities and equity. This matches their layout in the accounting equation, where assets are on the left side and liabilities and equity are on the right.

Equity increases from revenues and owner investments (stock issuances), and it decreases from expenses and dividends. We see this by expanding the accounting equation to include debits and credits in double-entry form, as shown in Exhibit 2.7.

Point: Assets are on the left-hand side of the equation and thus in- crease on the left. Liabilities and equity are on the right-hand side of the equation and thus increase on the right.

Debit for increases

+

Credit for decreases

= +

– +

Debit for decreases

Credit for increases

– +

Debit for decreases

Credit for increases

Assets Liabilities Equity

Normal Normal Normal

EXHIBIT 2.6 Debits and Credits in the Accounting Equation

= + – + – Dr. for

increases Cr. for

decreases

Assets Liabilities Dividends Revenues ExpensesCommon Stock

+ +– +– – +– –+ Dr. for

decreases Cr. for

increases

+ Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases

Equity

Normal Normal Normal Normal Normal Normal

EXHIBIT 2.7 Debit and Credit Effects for Component Accounts

Increases (credits) to common stock and revenues increase equity; increases (debits) to dividends and expenses decrease equity. The normal balance of each account is the side where increases are recorded.

The T-account for FastForward’s Cash account, reflecting its first 11 transactions (from Exhibit 1.9), is shown in Exhibit 2.8. The total increases (debits) in its Cash account are $36,100, and the total decreases (credits) are $31,300. Total debits exceed total credits by $4,800, result- ing in its ending debit balance of $4,800.

Point: DrEAD means debit (Dr) is the normal balance side for Expense, Asset, and Dividend accounts; credit the others.

Point: The ending balance is on the side with the larger dollar amount. Also, a plus (+) and minus (−) are not used in a T-account.

EXHIBIT 2.8 Computing the Balance for a T-Account

Cash

Receive investment by owner for stock 30,000 Purchase of supplies 2,500

Consulting services revenue earned 4,200 Purchase of equipment 26,000

Collection of account receivable 1,900 Payment of rent 1,000

Payment of salary 700

Payment of account payable 900

Payment of cash dividend 200

Balance 4,800

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

36,100

36,100 − 31,300

31,300

Identify the normal balance (debit [Dr] or credit [Cr]) for each of the following accounts.

Normal Account Balance

NEED-TO-KNOW 2-2 1. Prepaid Rent 2. Common Stock 3. Note Receivable 4. Accounts Payable

5. Accounts Receivable 6. Equipment 7. Interest Payable 8. Unearned Revenue

9. Land 10. Prepaid Insurance 11. Dividends 12. Utilities Expense

C4

Solution

1. Dr. 2. Cr. 3. Dr. 4. Cr. 5. Dr. 6. Dr. 7. Cr. 8. Cr. 9. Dr. 10. Dr. 11. Dr. 12. Dr. Do More: QS 2-4, QS 2-5,

QS 2-7, E 2-4

Point: Debit and credit are accounting directions for left and right.

Chapter 2 Accounting for Business Transactions 51

This section explains the analyzing, recording, and posting of transactions.

Journalizing and Posting Transactions The four steps of processing transactions are shown in Exhibit 2.9. Steps 1 and 2—transaction analysis and the accounting equation—already were covered. This section focuses on steps 3 and 4. Step 3 is to record each transaction chronologically in a journal. A journal is a complete record of each transaction in one place. It also shows debits and credits for each transaction. Recording transactions in a journal is called journalizing. Step 4 is to transfer (or post) entries from the journal to the ledger. Transferring journal entry information to the ledger is called posting.

ANALYZING AND PROCESSING TRANSACTIONS

P1 Record transactions in a journal and post entries to a ledger.

Services Contract

Deposit

TOTAL

1 30,000 Bank Statement

Client Billing Sales Receipt

Purchase Order Dec. 1 Cash Common Stock

30,000

2,500

30,000

2,500 SuppliesDec. 2 Cash

General Journal Debit for

increases

+

Credit for

decreases

= +

– 1 Debit for

decreases

Credit for

increases – + Debit for

decreases

Credit for

increasesAssets Liabilities

Equity

Assets = Liabilities + Equity

Step 1: Identify transactions and source documents.

Step 2: Analyze transactions using the accounting equation.

Step 3: Record journal entry.

General Journal

Ledger

Step 4: Post entry to ledger.

EXHIBIT 2.9 Steps in Processing Transactions

Journalizing Transactions Journalizing transactions requires an understanding of a journal. While companies can use various journals, every company uses a general journal. It can be used to record any transaction. Exhibit 2.10 shows how the first two transactions of FastForward are recorded in a general journal.

To record entries in a general journal, apply these steps; refer to Exhibit 2.10.

a Date the transaction: Enter the year at the top of the first column and the month and day on the first line of each journal entry.

b Enter titles of accounts debited and then enter amounts in the Debit column on the same line. Account titles are taken from the chart of accounts and are aligned with the left margin of the Account Titles and Explanation column.

c Enter titles of accounts credited and then enter amounts in the Credit column on the same line. Account titles are from the chart of accounts and are indented from the left margin of the Account Titles and Explanation column to separate them from debited accounts.

d Enter a brief explanation of the transaction on the line below the entry (it often references a source document). This explanation is indented about half as far as the credited account titles to avoid confusing it with accounts, and it is italicized.

A blank line is left between each journal entry for clarity. When a transaction is first recorded, the posting reference (PR) column is left blank (in a manual system). Later, when posting entries to the ledger, the identification numbers of the individual ledger accounts are entered in the PR column.

Balance Column Account T-accounts are simple and show how the accounting pro- cess works. However, actual accounting systems need more structure and therefore use a differ- ent formatting of T-accounts, called balance column accounts, shown in Exhibit 2.11.

Point: There are no exact rules for a journal entry explanation—it should be short yet describe why an entry is made.

Dec. 1

Dec. 2

Cash

Cash

Common Stock Receive investment by owner.

Purchase supplies for cash.

Supplies

Account Titles and Explanation PRDate

30,000

2,500

Debit

30,000

2,500

Credit 2019 a

d

General Journal

b c

EXHIBIT 2.10 Partial General Journal for FastForward

52 Chapter 2 Accounting for Business Transactions

Processing Transactions—An Example We use FastForward to show how double-entry accounting is used in analyzing and processing transactions. Analysis of each transaction follows the four steps of Exhibit 2.9.

Step 1 Identify the transaction and any source documents. Step 2 Analyze the transaction using the accounting equation. Step 3 Record the transaction in journal entry form applying double-entry accounting. Step 4 Post the entry (for simplicity, we use T-accounts to represent ledger accounts).

A1 Analyze the impact of transactions on accounts and financial statements.

Key:

Enter the debit account number from the ledger in the PR column of the journal (blue line).

C

D

A

B

Identify credit account in ledger: enter date, journal page, amount, and balance (gold line).

Enter the credit account number from the ledger in the PR column of the journal (green line).

Identify debit account in ledger: enter date, journal page, amount, and balance (red line).

Dec. 1 2019

Cash Common Stock

Receive investment by owner.

Account Titles and Explanation PRDate

30,000

Debit

30,000

Credit

307 101

General Journal

General Ledger

Dec. 1 G1 30,000 30,000

Date PR

Cash

Debit Credit Account No. 101

BalanceExplanation

Dec. 1 G1 30,000 30,000

Date PR

Common Stock

Debit Credit Account No. 307

BalanceExplanation

D

C

B

A

2019

2019

EXHIBIT 2.12 Posting an Entry to the Ledger

Dec. 2 Dec. 3 Dec. 10

Dec. 1 2019

G1 G1 G1 G1

30,000

4,200

2,500 26,000

30,000 27,500

1,500 5,700

Date PR Cash

General Ledger

Debit Credit Account No. 101

BalanceExplanation

EXHIBIT 2.11 Cash Account in Balance Column Format

Point: Posting is automatic with accounting software.

Point: The fundamental concepts of a manual system are identical to those of a computerized information system.

The balance column account format is similar to a T-account in having columns for debits and credits. It is different in including transaction date and explanation col- umns. It also has a column with the balance of the account after each entry is recorded. FastForward’s Cash account in Exhibit 2.11 is debited on December 1 for the $30,000 owner investment, yielding a $30,000 debit balance. The

account is credited on December 2 for $2,500, yielding a $27,500 debit balance. On December 3, it is credited for $26,000, and its debit balance is reduced to $1,500. The Cash account is debited for $4,200 on December 10, and its debit balance increases to $5,700; and so on.

The heading of the Balance column does not show whether it is a debit or credit balance. Instead, an account is assumed to have a normal balance. Unusual events can sometimes temporarily create an abnormal balance. An abnormal balance is a balance on the side where decreases are recorded. For example, a customer might mistakenly overpay a bill. This gives that customer’s account receiv- able an abnormal (credit) balance. An abnormal balance often is identified by setting it in brackets or entering it in red. A zero balance is shown by writing zero or a dash in the Balance column.

Posting Journal Entries Step 4 of processing transactions is to post journal entries to ledger accounts. All entries are posted to the ledger before financial statements are prepared so that account balances are up-to-date. When entries are posted to the ledger, the debits in journal entries are transferred into ledger accounts as debits, and credits are transferred into ledger ac- counts as credits. Exhibit 2.12 shows four parts to posting a journal entry. A Identify the led- ger account(s) that is debited in the entry. In the ledger, enter the entry date, the journal and page in its PR column, the debit amount, and the new balance of the ledger account. (G shows it came from the general journal.) B Enter the ledger account number in the PR col- umn of the journal. Parts C and D repeat the first two steps for credit entries and amounts. The posting process creates a link between the ledger and the journal entry. This link is a useful cross-reference for tracing an amount from one record to another.

Point: Explanations are included in ledger accounts only for unusual transactions or events.

Chapter 2 Accounting for Business Transactions 53

1. Receive Investment by Owner

2 Analyze Assets = Liabilities + Equity Common Cash Stock +30,000 = 0 +30,000

1 Identify FastForward receives $30,000 cash from Chas Taylor in exchange for common stock.

3 RecoRd (1) Cash 101 30,000 Common Stock 307 30,000

4 Post

(1) 30,000

Cash 101

(1) 30,000

Common Stock 307

Date Account Titles and Explanation PR Debit Credit

(2) 2,500

Supplies 126

(1) 30,000 (2) 2,500

Cash 101

4 Post

2. Purchase Supplies for Cash

1 Identify FastForward pays $2,500 cash for supplies. 2 analyze Assets = Liabilities + Equity

Cash Supplies −2,500 +2,500 = 0 + 0

Changes the composition of assets but not the total.

3 RecoRd (2) Supplies 126 2,500 Cash 101 2,500

Date Account Titles and Explanation PR Debit Credit

3. Purchase Equipment for Cash

1 Identify FastForward pays $26,000 cash for equipment.

Changes the composition of assets but not the total.

3 RecoRd (3) Equipment 167 26,000 Cash 101 26,000

(3) 26,000

Equipment 167 4 Post

(1) 30,000 (2) 2,500

(3) 26,000

Cash 101

2 analyze Assets = Liabilities + Equity Cash Equipment

−26,000 +26,000 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

FASTForward

4. Purchase Supplies on Credit

1 Identify FastForward purchases $7,100 of supplies on credit from a supplier.

3 RecoRd (4) Supplies 126 7,100 Accounts Payable 201 7,100

(4) 7,100

Accounts Payable 201

4 Post

(2) 2,500

(4) 7,100

Supplies 126

2 analyze Assets = Liabilities + Equity Accounts Supplies Payable

+7,100 = +7,100 + 0

Date Account Titles and Explanation PR Debit Credit

Study each transaction before moving to the next. The first 11 transactions are from Chapter 1, and we analyze five additional December transactions of FastForward (numbered 12 through 16).

Point: In Need-to-Know 2-5, we show how to use balance column accounts for the ledger.

5. Provide Services for Cash

1 Identify FastForward provides consulting services and immediately collects $4,200 cash.

2 analyze Assets = Liabilities + Equity Consulting Cash Revenue +4,200 = 0 +4,200

3 RecoRd (5) Cash 101 4,200 Consulting Revenue 403 4,200

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

Cash 101

(5) 4,200

Consulting Revenue 403

4 Post

Date Account Titles and Explanation PR Debit Credit ©Adie Bush/Getty Images

54 Chapter 2 Accounting for Business Transactions

9. Receipt of Cash on Account

1 Identify FastForward receives $1,900 cash from the customer billed in Transaction 8.

2 analyze

3 RecoRd (9) Cash 101 1,900 Accounts Receivable 106 1,900

4 Post

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000 (7) 700

Cash 101

(8) 1,900 (9) 1,900

Accounts Receivable 106

Assets = Liabilities + Equity Accounts

Cash Receivable +1,900 −1,900 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

8. Provide Consulting and Rental Services on Credit

1 Identify FastForward provides consulting services of $1,600 and rents its test facilities for $300. The customer is billed $1,900 for these services.

2 analyze

3 RecoRd (8) Accounts Receivable 106 1,900 Consulting Revenue 403 1,600

Rental Revenue 406 300

4 Post

(8) 1,900

Accounts Receivable 106

(5) 4,200

(8) 1,600

Consulting Revenue 403

(8) 300

Rental Revenue 406

Assets = Liabilities + Equity Accounts Consulting Rental

Receivable Revenue Revenue +1,900 = 0 +1,600 +300

Date Account Titles and Explanation PR Debit Credit

Point: The revenue recognition principle requires revenue to be recognized when the company provides products and services to a customer. This is not necessarily the same time that the customer pays.

Point: Transaction 8 is a compound journal entry, which is an entry that affects three or more accounts. The rule that total debits equal total credits continues.

6. Payment of Expense in Cash

1 Identify FastForward pays $1,000 cash for December rent. 2 analyze Assets = Liabilities + Equity

Rent Cash Expense −1,000 = 0 −1,000

3 RecoRd (6) Rent Expense 640 1,000 Cash 101 1,000

4 Post

(6) 1,000

Rent Expense 640

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(6) 1,000

Cash 101

Date Account Titles and Explanation PR Debit Credit

7. Payment of Expense in Cash

1 Identify FastForward pays $700 cash for employee salary. 2 analyze Assets = Liabilities + Equity

Salaries Cash Expense −700 = 0 −700

3 RecoRd (7) Salaries Expense 622 700 Cash 101 700

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(6) 1,000

(7) 700

Cash 101

(7) 700

Salaries Expense 622 4 Post

Date Account Titles and Explanation PR Debit Credit

Point: Salary usually refers to compensation of a fixed amount for a given time period. Wages is compensation based on time worked.

Chapter 2 Accounting for Business Transactions 55

10. Partial Payment of Accounts Payable

1 Identify FastForward pays CalTech Supply $900 cash toward the payable of Transaction 4.

2 analyze

3 RecoRd (10) Accounts Payable 201 900 Cash 101 900

4 Post

(10) 900 (4) 7,100

Accounts Payable 201

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

(10) 900

Cash 101

Assets = Liabilities + Equity Cash Accounts Payable −900 = −900 + 0

Date Account Titles and Explanation PR Debit Credit

11. Payment of Cash Dividend

1 Identify FastForward pays a $200 cash dividend.

2 analyze

3 RecoRd (11) Dividends 319 200 Cash 101 200

4 Post

(11) 200

Dividends 319

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

(10) 900

(11) 200

Cash 101

Assets = Liabilities + Equity Cash Dividends −200 = 0 −200

Date Account Titles and Explanation PR Debit Credit

Point: Dividends always decrease equity.

12. Receipt of Cash for Future Services

1 Identify FastForward receives $3,000 cash in advance of providing consulting services to a customer.

2 analyze

Accepting $3,000 cash requires FastForward to perform future services and is a liability. No revenue is recorded until services are provided.

3 RecoRd (12) Cash 101 3,000 Unearned Consulting

Revenue 236 3,000 (12) 3,000

Unearned Consulting Revenue 236

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700 (10) 900

(11) 200

Cash 101 4 Post

Assets = Liabilities + Equity Unearned

Cash Consulting Revenue +3,000 = +3,000 + 0

Date Account Titles and Explanation PR Debit Credit

Point: “Unearned” accounts are liabilities that must be fulfilled.

13. Pay Cash for Future Insurance Coverage

1 Identify FastForward pays $2,400 cash (insurance premium) for a 24-month insurance policy. Coverage begins on December 1.

2 Analyze

Changes the composition of assets from cash to prepaid insurance. Expense is recorded as insur- ance coverage expires.

3 RecoRd (13) Prepaid Insurance 128 2,400 Cash 101 2,400

(13) 2,400

Prepaid Insurance 128

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

Cash 101

4 Post

Assets = Liabilities + Equity Prepaid

Cash Insurance −2,400 +2,400 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

56 Chapter 2 Accounting for Business Transactions

14. Purchase Supplies for Cash

1 Identify FastForward pays $120 cash for supplies.

2 analyze

3 RecoRd (14) Supplies 126 120 Cash 101 120

(2) 2,500

(4) 7,100

(14) 120

Supplies 126

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

Cash 101

4 Post

Assets = Liabilities + Equity Cash Supplies

−120 +120 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

Point: Luca Pacioli, a 15th-century monk and famous mathematician, was the first to devise double- entry accounting.

15. Payment of Expense in Cash

1 Identify FastForward pays $305 cash for December utilities expense.

3 RecoRd (15) Utilities Expense 690 305 Cash 101 305

(15) 305

Utilities Expense 690

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 305

Cash 101

4 Post

2 Analyze Assets = Liabilities + Equity Utilities Cash Expense −305 = 0 −305

Date Account Titles and Explanation PR Debit Credit

16. Payment of Expense in Cash

2 Analyze Assets = Liabilities + Equity Salaries Cash Expense −700 = 0 −700

1 Identify FastForward pays $700 cash in employee salary for work performed in the latter part of December.

3 RecoRd (16) Salaries Expense 622 700 Cash 101 700

(7) 700

(16) 700

Salaries Expense 622

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 305

(16) 700

Cash 101

4 Post

Date Account Titles and Explanation PR Debit Credit

Chapter 2 Accounting for Business Transactions 57

Summarizing Transactions in a Ledger Exhibit 2.13 shows the ledger accounts (in T-account form) of FastForward after all 16 transac- tions are recorded and posted and the balances computed. The accounts are grouped into three columns following the accounting equation: assets, liabilities, and equity. Totals for the three columns obey the accounting equation:

Assets equal $42,395 ($4,275 + $0 + $9,720 + $2,400 + $26,000). Liabilities equal $9,200 ($6,200 + $3,000). Equity equals $33,195 ($30,000 − $200 + $5,800 + $300 − $1,400 − $1,000 − $305).

The accounting equation: $42,395 = $9,200 + $33,195. Common stock, dividends, revenue, and expense accounts reflect transactions that

change equity. Revenue and expense account balances are reported in the income statement.

Debit and Credit Rules Increase Accounts (normal bal.) Decrease

Asset . . . . . . . . . . . . Debit Credit Liability . . . . . . . . . . . Credit Debit Common Stock . . . . Credit Debit Dividends . . . . . . . . . Debit Credit Revenue . . . . . . . . . Credit Debit Expense . . . . . . . . . Debit Credit

EXHIBIT 2.13 Ledger for FastForward (in T-Account Form)

$42,395 = $9,200 + $33,195

Cash 101

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 305

(16) 700

Balance 4,275

Accounts Receivable 106

(8) 1,900 (9) 1,900

Balance 0

Supplies 126

(2) 2,500

(4) 7,100

(14) 120

Balance 9,720

Prepaid Insurance 128

(13) 2,400

Equipment 167

(3) 26,000

Accounts Payable 201

(10) 900 (4) 7,100

Balance 6,200

Unearned Consulting Revenue 236

(12) 3,000

Common Stock 307

(1) 30,000

Dividends 319

(11) 200

Consulting Revenue 403

(5) 4,200

(8) 1,600

Balance 5,800

Rental Revenue 406

(8) 300

Rent Expense 640

(6) 1,000

Utilities Expense 690

(15) 305

Accounts in this white area are on the income statement .

Salaries Expense 622

(7) 700

(16) 700

Balance 1,400

FASTForward

Assets = Liabilities + Equity General Ledger

58 Chapter 2 Accounting for Business Transactions

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. For each transaction, (a) analyze the transaction using the accounting equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Tata Company has the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Equipment (167); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Wages Expense (601).

Jan. 1 Jamsetji Tata invested $4,000 cash in the Tata Company in exchange for common stock. 5 Tata Company purchased $2,000 of equipment on credit. 14 Tata Company provided $540 of services for a client on credit.

Solution

Recording Transactions

NEED-TO-KNOW 2-3

P1 A1

Jan. 1 Receive Investment by Owner

a analyze Assets = Liabilities + Equity Common Cash Stock +4,000 = 0 +4,000

b RecoRd Jan . 1 Cash 101 4,000 Common Stock 307 4,000

c Post

Jan . 1 4,000

Cash 101

Jan . 1 4,000

Common Stock 307Date Account Titles and Explanation PR Debit Credit

Jan. 5 Purchase Equipment on Credit

b RecoRd Jan . 5 Equipment 167 2,000 Accounts Payable 201 2,000

Jan . 5 2,000

Accounts Payable 201

c Post

Jan . 5 2,000

Equipment 167 a analyze Assets = Liabilities + Equity

Accounts Equipment Payable

+2,000 = +2,000 + 0

Date Account Titles and Explanation PR Debit Credit

Do More: QS 2-6, E 2-7, E 2-9, E 2-11, E 2-12

Jan. 14 Provide Services on Credit

a analyze Assets = Liabilities + Equity Accounts Services Receivable Revenue +540 = 0 +540

b RecoRd Jan . 14 Accounts Receivable 106 540 Services Revenue 403 540

Jan . 14 540

Accounts Receivable 106

Jan . 14 540

Services Revenue 403

c Post

Date Account Titles and Explanation PR Debit Credit

A trial balance is a list of all ledger accounts and their balances at a point in time. Exhibit 2.14 shows the trial balance for FastForward after its 16 entries are posted to the ledger. (This is an unadjusted trial balance. Chapter 3 explains adjustments.)

Preparing a Trial Balance Preparing a trial balance has three steps.

1. List each account title and its amount (from the ledger) in the trial balance. If an account has a zero balance, list it with a zero in its normal balance column (or omit it).

2. Compute the total of debit balances and the total of credit balances. 3. Verify (prove) total debit balances equal total credit balances.

TRIAL BALANCE P2 Prepare and explain the use of a trial balance.

Chapter 2 Accounting for Business Transactions 59

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275

Accounts receivable . . . . . . . . . . . 0

Supplies . . . . . . . . . . . . . . . . . . . . . 9,720

Prepaid insurance . . . . . . . . . . . . . 2,400

Equipment . . . . . . . . . . . . . . . . . . . 26,000

Accounts payable . . . . . . . . . . . . . $ 6,200

Unearned consulting revenue . . . 3,000

Common stock . . . . . . . . . . . . . . . 30,000

Dividends . . . . . . . . . . . . . . . . . . . 200

Consulting revenue . . . . . . . . . . . 5,800

Rental revenue . . . . . . . . . . . . . . . 300

Salaries expense . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . 305

Totals . . . . . . . . . . . . . . . . . . . . . . . $45,300 $45,300

The total of debit balances equals the total of credit balances for the trial bal- ance in Exhibit 2.14. Equality of these two totals does not guarantee that no errors were made. For example, the column totals will be equal when a debit or credit of a correct amount is made to a wrong account. Another error not identified with a trial balance is when equal debits and credits of an incor- rect amount are entered.

Searching for Errors If the trial balance does not balance (when its columns are not equal), the error(s) must be found and corrected. An efficient way to search for an error is to check the journalizing, post- ing, and trial balance preparation in reverse order. Step 1 is to verify that the trial bal- ance columns are correctly added. If step 1 does not find the error, step 2 is to verify that account balances are accurately entered from the ledger. Step 3 is to see whether a debit (or credit) balance is mistakenly listed in the trial balance as a credit (or debit). A clue to this error is when the difference between total debits and total credits equals twice the amount of the incorrect account balance. Step 4 is to recompute each account balance in the ledger. Step 5 is to verify that each journal entry is properly posted. Step 6 is to verify that the original journal entry has equal debits and credits. At this point, the errors should be uncovered.

Point: A trial balance is not a financial statement but a tool for checking equality of debits and credits in the ledger.

EXHIBIT 2.14 Trial Balance (Unadjusted)

Example: If a credit to Unearned Revenue was incorrectly posted to the Revenue ledger account, would the ledger still balance? Answer: The ledger would bal- ance, but liabilities would be understated, equity would be overstated, and income would be overstated.

Accounting Quality Recording valid and accurate transactions enhances the quality of financial statements. Roughly 30% of employees in IT report observing misconduct such as falsifying accounting data. They also report increased incidences of such misconduct in recent years. Source: KPMG. ■

Ethical Risk

Financial Statements Prepared from Trial Balance Financial Statements across Time How financial statements are linked in time is shown in Exhibit 2.15. A balance sheet reports an organization’s financial position at a point in time. The income statement, statement of retained earnings, and statement of cash flows report financial performance over a period of time. The three statements in the middle column of Exhibit 2.15 explain how financial position changes from the beginning to the end of a reporting period.

A one-year (annual) reporting period is common, as are semiannual, quarterly, and monthly periods. The one-year reporting period is called the accounting, or fiscal, year. Businesses whose accounting year begins on January 1 and ends on December 31 are called calendar-year companies.

Financial Statement Preparation This section shows how to prepare financial statements from the trial balance. (These are unadjusted statements. Chapter 3 explains adjust- ments.) We prepare these statements in the following order.

Beginning Balance Sheet Ending Balance SheetIncome Statement

Statement of Cash Flows Statement of Retained Earnings

Cash $30,000 Liabilities $ 0 Other assets 0 Equity 30,000 Total assets $30,000 Total $30,000

Cash $ 4,275 Liabilities $ 9,200 Other assets 38,120 Equity 33,195 Total assets $42,395 Total $42,395

Expenses Net income

2,705 $3,395

Revenues $6,100

Point in time Point in timePeriod of time

EXHIBIT 2.15 Links between Financial Statements across Time

P3 Prepare financial statements from business transactions.

FASTForward

60 Chapter 2 Accounting for Business Transactions

1 Income Statement An income statement reports revenues earned minus expenses incurred over a period of time. FastForward’s income statement for December is shown at the top right side of Exhibit 2.16. Information about revenues and expenses is taken from the trial balance on the left side. Net income of $3,395 is the bottom line for the income statement. Owner investments and dividends are not part of income.

2 Statement of Retained Earnings The statement of retained earnings reports how retained earnings changes over the reporting period. FastForward’s statement of retained earnings is the second report in Exhibit 2.16. It shows the $3,395 of net income, the $200 divi- dend, and the $3,195 end-of-period balance. (The beginning balance in the statement of retained earnings is rarely zero, except in the first period of operations. The beginning balance in January 2020 is $3,195, which is December 2019’s ending balance.)

3 Balance Sheet The balance sheet reports the financial position of a company at a point in time. FastForward’s balance sheet is the third report in Exhibit 2.16. This statement shows financial condition at the close of business on December 31. The left side of the balance

Point: An income statement also is called an earnings statement, a statement of operations, or a P&L (profit and loss) statement. A balance sheet also is called a statement of financial position.

Point: Revenues and expenses are not reported in detail in the statement of retained earnings. Instead, their effects are reflected through net income.

EXHIBIT 2.16 Financial Statements Prepared from Trial Balance

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . $5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,705

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,395

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,395 3,395

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,195

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . . $ 4,275 Accounts payable . . . . . . . . . . . . $ 6,200

Supplies . . . . . . . . . . . 9,720 Unearned consulting revenue . . . 3,000

Prepaid insurance . . . 2,400 Total liabilities . . . . . . . . . . . . . . . 9,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . 3,195 Total equity . . . . . . . . . . . . . . . . . . 33,195

Total assets $42,395 Total liabilities and equity . . . . . . . $42,395

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275

Accounts receivable . . . . . . . . . . . 0

Supplies . . . . . . . . . . . . . . . . . . . . . 9,720

Prepaid insurance . . . . . . . . . . . . . 2,400

Equipment . . . . . . . . . . . . . . . . . . . 26,000

Accounts payable . . . . . . . . . . . . . $ 6,200

Unearned consulting revenue . . . 3,000

Common stock . . . . . . . . . . . . . . . 30,000

Dividends . . . . . . . . . . . . . . . . . . . 200

Consulting revenue . . . . . . . . . . . 5,800

Rental revenue . . . . . . . . . . . . . . . 300

Salaries expense . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . 305

Totals . . . . . . . . . . . . . . . . . . . . . . . $45,300 $45,300

Each account on the trial balance is either an asset (to balance sheet), liability (to balance sheet), or equity (to income statement or to statement of retained earnings) .

Point: A statement’s heading lists the 3 W’s: Who—name of organization, What—name of statement, When—point in time or period of time.

Point: Arrow lines show how the statements are linked.

Point: To foot a column of numbers is to add them.

Chapter 2 Accounting for Business Transactions 61

sheet lists its assets: cash, supplies, prepaid insurance, and equipment. The liabilities section of the balance sheet shows that it owes $6,200 to creditors and $3,000 in services to customers who paid in advance. The equity section shows an ending balance of $33,195. Note the link between the ending balance of the statement of retained earnings and the retained earnings bal- ance. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, fol- lowed by liabilities and then equity. Either presentation is acceptable.)

Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. Most of your cus- tomers want to buy on credit. How can you use the balance sheets of customers to decide which ones to extend credit to? ■ Answer: We use the accounting equation (Assets = Liabilities + Equity) to identify risky customers to whom we would not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would be to extend credit. A low equity means the business already has many creditor claims to it.

Decision Maker

©REDPIXEL.PL/Shutterstock

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. We usually put dollar signs be- side only the first and last numbers in a column. Apple’s financial statements in Appendix A show this. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level. Apple, like many large companies, rounds its financial statement amounts to the nearest million. This decision is based on the impact of rounding for users’ decisions.

Prepare a trial balance for Apple using the following condensed data from its recent fiscal year ended September 30 ($ in millions).

Preparing Trial Balance

NEED-TO-KNOW 2-4

P2Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,867 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Cost of sales (and other expenses) . . . . . . . . . . 141,048

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 47,169

Investments and other assets . . . . . . . . . . . . . . . . . . 303,373

Land and equipment . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Selling and other expense . . . . . . . . . . . . . . . . . . . . 39,835

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Retained earnings, beginning fiscal year . . . . . . . . . 96,998

Solution ($ in millions)

APPLE

APPLE Trial Balance

September 30

Do More: E 2-8, E 2-10

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Land and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Investments and other assets . . . . . . . . . . . . . . . . . . . . . . 303,373

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867

Retained earnings, beginning fiscal year . . . . . . . . . . . . . . 96,998

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Cost of sales (and other expenses) . . . . . . . . . . . . . . . . . . 141,048

Selling and other expense . . . . . . . . . . . . . . . . . . . . . . . . . 39,835

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $603,371 $603,371

It is important to assess a company’s risk of failing to pay its debts. Companies finance their assets with either liabilities or equity. A company that finances a relatively large portion of its assets with liabilities is said to have higher financial leverage. Higher financial leverage means greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). One measure of the risk associated with liabilities is the debt ratio as defined in Exhibit 2.17.

Costco’s total liabilities, total assets, and debt ratio for the past three years are shown in Exhibit 2.18. Costco’s debt ratio ranges from a low of 0.63 to a high of 0.70. Its ratio exceeds Walmart’s in each of the last three years, suggesting a higher than average risk from financial leverage. So, is financial leverage good or bad for Costco? The answer: If Costco is making more money with this debt than it is paying the lenders, then it is successfully borrowing money to make more money. A company’s use of debt can turn unprofitable quickly if its return from that money drops below the rate it is paying lenders.

This problem extends Need-to-Know 1-6 from Chapter 1: Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for com-

mon stock. 2 Expressions paid $600 cash for furniture for the shop. 3 Expressions paid $500 cash to rent space in a strip mall for August. 4 Expressions purchased $1,200 of equipment on credit for the shop (recorded as accounts pay-

able). 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. 16 Expressions provided $100 of haircutting services on account. 17 Expressions received a $100 check for services previously rendered on account. 18 Expressions paid $125 to an assistant for hours worked for the grand opening. 31 Cash received from services provided during the second half of August was $930. 31 Expressions paid $400 cash toward the account payable entered into on August 4. 31 Expressions paid a $900 cash dividend to Worthy (sole shareholder).

Required

1. Open the following ledger accounts in balance column format (account numbers are in parentheses): Cash (101); Accounts Receivable (102); Furniture (161); Store Equipment (165); Accounts Payable (201); Common Stock (307); Dividends (319); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

COMPREHENSIVE

Journalizing and Posting Transactions, Statement Preparation, and Debt Ratio

NEED-TO-KNOW 2-5

EXHIBIT 2.17 Debt Ratio Debt ratio =

Total liabilities Total assets

62 Chapter 2 Accounting for Business Transactions

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Debt RatioDecision Analysis

Investor You consider buying stock in Converse. As part of your analysis, you compute the company’s debt ratio for 2017, 2018, and 2019 as 0.35, 0.74, and 0.94, respectively. Based on the debt ratio, is Converse a low-risk investment? Has the risk of buying Converse stock changed over this period? (The industry debt ratio averages 0.40.) ■ Answer: The debt ratio suggests that Converse’s stock is of higher risk than normal and that this risk is rising. The average industry ratio of 0.40 supports this conclusion. The 2019 debt ratio for Converse is twice the industry norm. Also, a debt ratio approaching 1.0 indicates little to no equity.

Decision Maker

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

Company ($ millions) Current Year 1 Year Ago 2 Years Ago

Costco Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $25,268 $20,831 $22,174

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,347 $33,163 $33,017

Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.70 0.63 0.67

Walmart Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .59 0 .58 0 .58

Chapter 2 Accounting for Business Transactions 63

2. Post the journal entries from part 1 to the ledger accounts. 3. Prepare a trial balance as of August 31. 4. Prepare an income statement for August. 5. Prepare a statement of retained earnings for August. 6. Prepare a balance sheet as of August 31. 7. Determine the debt ratio as of August 31.

Extended Analysis

8. In the coming months, Expressions will have a greater variety of business transactions. Identify which accounts are debited and which are credited for the following transactions. Hint: We must use some accounts not opened in part 1.

a. Purchase supplies with cash. b. Pay cash for future insurance coverage. c. Receive cash for services to be provided in the future. d. Purchase supplies on account.

PLANNING THE SOLUTION Analyze each transaction and use the debit and credit rules to prepare a journal entry for each. Post each debit and each credit from journal entries to their ledger accounts and cross-reference each

amount in the posting reference (PR) columns of the journal and ledger. Calculate each account balance and list the accounts with their balances on a trial balance. Verify that total debits in the trial balance equal total credits. To prepare the income statement, identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. Use information in the ledger to prepare the statement of retained earnings. Use information in the ledger to prepare the balance sheet. Calculate the debt ratio by dividing total liabilities by total assets. Analyze the future transactions to identify the accounts affected and apply debit and credit rules.

SOLUTION 1. General journal entries.

[continued on next page]

General Journal Date Account Titles and Explanation PR Debit Credit

Aug . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 3,000

Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 15,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 18,000

Owner’s investment in exchange for stock.

2 Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 600

Purchased furniture for cash.

3 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 500

Paid rent for August.

4 Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 1,200

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 1,200

Purchased additional equipment on credit.

15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 825

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 825

Cash receipts from first half of August.

64 Chapter 2 Accounting for Business Transactions

16 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 100

Record revenue for services provided on account.

17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

Record cash received as payment on account.

18 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 125

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 125

Paid wages to assistant.

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 930

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 930

Cash receipts from second half of August.

31 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 400

Paid cash toward accounts payable.

31 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 900

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 900

Paid a cash dividend.

[continued from previous page]

2. Post journal entries from part 1 to the ledger accounts (in balance column format).

Cash Account No. 101

Date PR Debit Credit Balance

Aug . 1 G1 3,000 3,000

2 G1 600 2,400

3 G1 500 1,900

15 G1 825 2,725

17 G1 100 2,825

18 G1 125 2,700

31 G1 930 3,630

31 G1 400 3,230

31 G1 900 2,330

Accounts Receivable Account No. 102

Date PR Debit Credit Balance

Aug . 16 G1 100 100

17 G1 100 0

Furniture Account No. 161

Date PR Debit Credit Balance

Aug . 2 G1 600 600

Store Equipment Account No. 165

Date PR Debit Credit Balance

Aug . 1 G1 15,000 15,000

4 G1 1,200 16,200

Accounts Payable Account No. 201

Date PR Debit Credit Balance

Aug . 4 G1 1,200 1,200 31 G1 400 800

Common Stock Account No. 307

Date PR Debit Credit Balance

Aug . 1 G1 18,000 18,000

Dividends Account No. 319

Date PR Debit Credit Balance

Aug . 31 G1 900 900

Haircutting Services Revenue Account No. 403

Date PR Debit Credit Balance

Aug . 15 G1 825 825 16 G1 100 925 31 G1 930 1,855

Wages Expense Account No. 623

Date PR Debit Credit Balance

Aug . 18 G1 125 125

Rent Expense Account No. 640

Date PR Debit Credit Balance

Aug . 3 G1 500 500

General Ledger

Chapter 2 Accounting for Business Transactions 65

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . $ 2,330 Accounts payable . . . . . . . . . . . . . . . . . . $ 800

Furniture . . . . . . . . . . . . . . . . . 600 Equity Store equipment . . . . . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . . . . . . 18,000

Retained earnings . . . . . . . . . . . . . . . . . . 330

Total equity . . . . . . . . . . . . . . . . . . . . . . . . 18,330

Total assets . . . . . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . . . . $19,130

6.

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues

Haircutting services revenue . . . . . . . . . . . . $1,855

Operating expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . $500

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Total operating expenses . . . . . . . . . . . . . . . 625

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,230

4.

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1 . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,230

1,230

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . 900

Retained earnings, August 31 . . . . . . . . . . . . . . . . . . $ 330

5.

3. Prepare a trial balance from the ledger—see how it feeds the financial statements.

EXPRESSIONS Trial Balance

August 31

Debit Credit Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,330

Accounts receivable . . . . . . . . . . . . . . . . . . . 0

Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Store equipment . . . . . . . . . . . . . . . . . . . . . . 16,200

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 800

Common stock . . . . . . . . . . . . . . . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Haircutting services revenue . . . . . . . . . . . . 1,855

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 500

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,655 $20,655

7. Debt ratio = Total liabilities

Total assets =

$800 $19,130

= 4.18%

8a. Supplies debited 8c. Cash debited Cash credited Unearned Services Revenue credited 8b. Prepaid Insurance debited 8d. Supplies debited Cash credited Accounts Payable credited

Account (45) Account balance (49) Balance column account (51) Chart of accounts (48) Compound journal entry (54) Credit (49) Creditors (47) Debit (49)

Debt ratio (62) Debtors (46) Dividends (48) Double-entry accounting (49) General journal (51) General ledger (45) Journal (51) Journalizing (51)

Ledger (45) Posting (51) Posting reference (PR) column (51) Source documents (45) T-account (49) Trial balance (58) Unearned revenue (47)

Key Terms

66 Chapter 2 Accounting for Business Transactions

SYSTEM OF ACCOUNTS Asset Accounts Cash: A company’s cash balance. Accounts receivable: Held by a seller; promises of payment from custom- ers to sellers. Accounts receivable are increased by credit sales; often phrased as sales on account or on credit. Note receivable: Held by a lender; a borrower’s written promise to pay the lender a specific sum of money on a specified future date. Prepaid accounts (or expenses): Assets that arise from prepayment of future expenses. Examples are prepaid insurance and prepaid rent. More assets: Supplies, equipment, buildings, and land. Liability Accounts Accounts payable: Held by a buyer; a buyer’s promise to pay a seller later for goods or services received. More generally, payables arise from pur- chases of merchandise for resale, supplies, services, and other items. Note payable: Held by a borrower; a written promissory note to pay a future amount at a future date. Unearned revenue: A liability to be settled in the future when a company delivers its products or services. When a customer pays in advance for products or services (before revenue is earned), the seller records this receipt as unearned revenue. Accrued liabilities: Amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. Equity Accounts Common stock: When an owner invests in a company in exchange for stock, the company increases both assets and equity. Dividends: When a company pays dividends, it decreases both company assets and total equity. Revenue: Amounts received from sales of products and services to cus- tomers. Revenue increases equity. Expenses: Costs of providing products and services. Expenses decrease equity.

DEBITS AND CREDITS The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. Double-entry accounting transaction rules: ∙ At least two accounts are involved, with at least one debit and one credit. ∙ Total amount debited must equal total amount credited. Debits and credits in accounting equation:

= + – + – Dr. for

increases Cr. for

decreases

Assets Liabilities Dividends Revenues ExpensesCommon Stock

+ +– +– – +– –+ Dr. for

decreases Cr. for

increases

+ Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases

Equity

Normal Normal Normal Normal Normal Normal

Net increases or decreases on one side have equal net effects on the other side. Left side is the normal balance side for assets. Right side is the normal balance side for liabilities and equity.

Summary: Cheat Sheet

RECORDING TRANSACTIONS Receive owner investment for stock: (1) Cash 101 30,000 Common Stock 307 30,000

Date Account Titles and Explanation PR Debit Credit

(2) Supplies 126 2,500 Cash 101 2,500

Date Account Titles and Explanation PR Debit Credit

Purchase supplies for cash:

(3) Equipment 167 26,000 Cash 101 26,000

Date Account Titles and Explanation PR Debit Credit

Purchase equipment for cash:

(4) Supplies 126 7,100 Accounts Payable 201 7,100

Date Account Titles and Explanation PR Debit Credit

Purchase supplies on credit:

Provide services for cash:

(5) Cash 101 4,200 Consulting Revenue 403 4,200

Date Account Titles and Explanation PR Debit Credit

FINANCIAL STATEMENTS

(6) Rent Expense 640 1,000 Cash 101 1,000

Date Account Titles and Explanation PR Debit Credit

(7) Salaries Expense 622 700 Cash 101 700

Date Account Titles and Explanation PR Debit Credit

(15) Utilities Expense 690 305 Cash 101 305

Date Account Titles and Explanation PR Debit Credit

Payment of expenses in cash:

(8) Accounts Receivable 106 1,900 Consulting Revenue 403 1,600 Rental Revenue 406 300

Date Account Titles and Explanation PR Debit Credit

Provide consulting and rental services on credit:

(9) Cash 101 1,900 Accounts Receivable 106 1,900

Date Account Titles and Explanation PR Debit Credit

Receipt of cash on account:

(10) Accounts Payable 201 900 Cash 101 900

Date Account Titles and Explanation PR Debit Credit

Partial payment of accounts payable:

(11) Dividends 319 200 Cash 101 200

Date Account Titles and Explanation PR Debit Credit

Payment of cash dividend:

(12) Cash 101 3,000 Unearned Consulting Revenue 236 3,000

Date Account Titles and Explanation PR Debit Credit

Receipt of cash for future services:

(13) Prepaid Insurance 128 2,400 Cash 101 2,400

Date Account Titles and Explanation PR Debit Credit

Pay cash for future insurance coverage:

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . $5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,705

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,395

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,395 3,395

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,195

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . . $ 4,275 Accounts payable . . . . . . . . . . . . $ 6,200

Supplies . . . . . . . . . . . 9,720 Unearned consulting revenue . . . 3,000

Prepaid insurance . . . 2,400 Total liabilities . . . . . . . . . . . . . . . 9,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . 3,195 Total equity . . . . . . . . . . . . . . . . . . 33,195

Total assets $42,395 Total liabilities and equity . . . . . . . $42,395

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275

Accounts receivable . . . . . . . . . . . 0

Supplies . . . . . . . . . . . . . . . . . . . . . 9,720

Prepaid insurance . . . . . . . . . . . . . 2,400

Equipment . . . . . . . . . . . . . . . . . . . 26,000

Accounts payable . . . . . . . . . . . . . $ 6,200

Unearned consulting revenue . . . 3,000

Common stock . . . . . . . . . . . . . . . 30,000

Dividends . . . . . . . . . . . . . . . . . . . 200

Consulting revenue . . . . . . . . . . . . 5,800

Rental revenue . . . . . . . . . . . . . . . 300

Salaries expense . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . 305

Totals . . . . . . . . . . . . . . . . . . . . . . . $45,300 $45,300

Each account on the trial balance is either an asset (to balance sheet), liability (to balance sheet), or equity (to income statement or to statement of retained earnings) .

Chapter 2 Accounting for Business Transactions 67

Multiple Choice Quiz

1. Amalia Company received its utility bill for the current pe- riod of $700 and immediately paid it. Its journal entry to record this transaction includes a a. Credit to Utility Expense for $700. b. Debit to Utility Expense for $700. c. Debit to Accounts Payable for $700. d. Debit to Cash for $700. e. Credit to Accounts Receivable for $700.

2. On May 1, Mattingly Lawn Service collected $2,500 cash from a customer in advance of five months of lawn ser- vice. Mattingly’s journal entry to record this transaction includes a a. Credit to Unearned Lawn Service Fees for $2,500. b. Debit to Lawn Service Fees Earned for $2,500. c. Credit to Cash for $2,500. d. Debit to Unearned Lawn Service Fees for $2,500. e. Credit to Accounts Payable for $2,500.

3. Liang Shue contributed $250,000 cash and land worth $500,000 to open his new business, Shue Consulting. Which of the following journal entries does Shue Consulting make to record this transaction? a. Cash Assets . . . . . . . . . . . . . 750,000 Common Stock . . . . . . . . 750,000 b. Common Stock . . . . . . . . . . 750,000 Assets. . . . . . . . . . . . . . . . 750,000

c. Cash . . . . . . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . . . . . . 500,000 Common Stock . . . . . . . . 750,000 d. Common Stock . . . . . . . . . . 750,000 Cash . . . . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . . . . 500,000

4. A trial balance prepared at year-end shows total credits ex- ceed total debits by $765. This discrepancy could have been caused by a. An error in the general journal where a $765 increase in

Accounts Payable was recorded as a $765 decrease in Accounts Payable.

b. The ledger balance for Accounts Payable of $7,650 be- ing entered in the trial balance as $765.

c. A general journal error where a $765 increase in Accounts Receivable was recorded as a $765 increase in Cash.

d. The ledger balance of $850 in Accounts Receivable was entered in the trial balance as $85.

e. An error in recording a $765 increase in Cash as a credit.

5. Bonaventure Company has total assets of $1,000,000, lia- bilities of $400,000, and equity of $600,000. What is its debt ratio (rounded to a whole percent)? a. 250% c. 67% e. 40% b. 167% d. 150%

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; debit Utility Expense for $700, and credit Cash for $700. 2. a; debit Cash for $2,500 and credit Unearned Lawn Service Fees

for $2,500. 3. c; debit Cash for $250,000, debit Land for $500,000, and credit

Common Stock for $750,000.

4. d 5. e; Debt ratio = $400,000/$1,000,000 = 40%

Icon denotes assignments that involve decision making.

1. Provide the names of two (a) asset accounts, (b) liability accounts, and (c) equity accounts.

2. What is the difference between a note payable and an ac- count payable?

3. Discuss the steps in processing business transactions. 4. What kinds of transactions can be recorded in a general

journal? 5. Are debits or credits typically listed first in general journal

entries? Are the debits or the credits indented? 6. Should a transaction be recorded first in a journal or the

ledger? Why? 7. If assets are valuable resources and asset accounts have debit

balances, why do expense accounts also have debit balances? 8. Why does the recordkeeper prepare a trial balance?

9. If an incorrect amount is journalized and posted to the ac- counts, how should the error be corrected?

10. Identify the four financial statements of a business. 11. What information is reported in a balance sheet? 12. What information is reported in an income statement? 13. Why does the user of an income statement need to

know the time period that it covers? 14. Define (a) assets, (b) liabilities, and (c) equity. 15. Which financial statement is sometimes called the state-

ment of financial position?

16. Review the Apple balance sheet in Appendix A. Identify three accounts on its bal- ance sheet that carry debit balances and three accounts on its balance sheet that carry credit balances.

Discussion Questions

APPLE

68 Chapter 2 Accounting for Business Transactions

17. Review the Google balance sheet in Appendix A. Identify an asset with the word receivable in its account title and a liability with the word payable in its account title.

18. Review the Samsung balance sheet in Appendix A. Identify three current liabili- ties and three noncurrent liabilities in its balance sheet.

SamsungGOOGLE

QUICK STUDY

QS 2-1 Identifying source documents C1

Identify the items from the following list that are likely to serve as source documents. a. Sales receipt d. Prepaid insurance account g. Income statement b. Trial balance e. Invoice from supplier h. Bank statement c. Balance sheet f. Company revenue account i. Telephone bill

QS 2-2 Identifying financial statement accounts

C2

Classify each of the following accounts as an asset (A), liability (L), or equity (EQ) account. a. Cash d. Prepaid Insurance g. Accounts Payable b. Prepaid Rent e. Office Equipment h. Unearned Rent Revenue c. Office Supplies f. Common Stock i. Dividends

QS 2-3 Reading a chart of accounts

C3

A chart of accounts is a list of all ledger accounts and an identification number for each. One example of a chart of accounts is near the end of the book on pages CA and CA-1. Using that chart, identify the fol- lowing accounts as either an asset (A), liability (L), equity (EQ), revenue (R), or expense (E) account, along with its identification number. a. Advertising Expense d. Machinery g. Notes Payable b. Rent Revenue e. Accounts Payable h. Common Stock c. Rent Receivable f. Furniture i. Utilities Expense

QS 2-4 Identifying normal balance

C4

Identify the normal balance (debit or credit) for each of the following accounts. a. Fees Earned (Revenues) d. Wages Expense g. Wages Payable b. Office Supplies e. Accounts Receivable h. Building c. Dividends f. Prepaid Rent i. Common Stock

QS 2-5 Linking debit or credit with normal balance

C4

Indicate whether a debit or credit decreases the normal balance of each of the following accounts. a. Interest Payable e. Common Stock i. Dividends b. Service Revenue f. Prepaid Insurance j. Unearned Revenue c. Salaries Expense g. Buildings k. Accounts Payable d. Accounts Receivable h. Interest Revenue l. Land

QS 2-6 Analyzing transactions and preparing journal entries

P1

For each transaction, (1) analyze the transaction using the accounting equation, (2) record the transaction in journal entry form, and (3) post the entry using T-accounts to represent ledger accounts. Use the follow- ing (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Office Supplies (124); Trucks (153); Equipment (167); Accounts Payable (201); Unearned Landscaping Revenue (236); Common Stock (307); Dividends (319); Landscaping Revenue (403); Wages Expense (601), and Landscaping Expense (696). a. On May 15, DeShawn Tyler opens a landscaping company called Elegant Lawns by investing $7,000

in cash along with equipment having a $3,000 value in exchange for common stock. b. On May 21, Elegant Lawns purchases office supplies on credit for $500. c. On May 25, Elegant Lawns receives $4,000 cash for performing landscaping services. d. On May 30, Elegant Lawns receives $1,000 cash in advance of providing landscaping services to

a customer.

Identify whether a debit or credit results in the indicated change for each of the following accounts. a. To increase Land f. To decrease Prepaid Rent b. To decrease Cash g. To increase Notes Payable c. To increase Fees Earned (Revenues) h. To decrease Accounts Receivable d. To increase Salaries Expense i. To increase Common Stock e. To decrease Unearned Revenue j. To increase Store Equipment

QS 2-7 Analyzing debit or credit by account

A1

Chapter 2 Accounting for Business Transactions 69

Indicate the financial statement on which each of the following items appears. Use I for income statement, E for statement of retained earnings, and B for balance sheet. a. Services Revenue e. Equipment i. Dividends b. Interest Payable f. Prepaid Insurance j. Office Supplies c. Accounts Receivable g. Buildings k. Interest Expense d. Salaries Expense h. Rental Revenue l. Insurance Expense

QS 2-9 Classifying accounts in financial statements

P3

Prepare general journal entries for the following transactions of Green Energy Company. Use the follow- ing (partial) chart of accounts: Cash; Accounts Receivable; Supplies; Accounts Payable; Consulting Revenue; and Utilities Expense.

May 1 The company billed a customer $2,000 in consulting revenue for sustainable proposals. 3 The company purchased $300 of energy-efficient supplies on credit. 9 The company collected $500 cash as partial payment of the May 1 consulting revenue. 20 The company paid $300 cash toward the payable for energy-efficient supplies. 31 The company paid $100 cash for May’s renewable energy utilities.

QS 2-11 Preparing journal entries

P1

Determine the ending balance of each of the following T-accounts. QS 2-10 Computing T-account balance

C4 Cash

100 50 300 60 20

Accounts Payable

2,000 8,000 2,700

Supplies

10,000 3,800 1,100

a. b. c.

Accounts Receivable

600 150 150 150 100

Wages Payable

700 700

Cash

11,000 4,500 800 6,000 100 1,300

d. e. f.

A trial balance has total debits of $20,000 and total credits of $24,500. Which one of the following errors would create this imbalance? Explain. a. A $2,250 debit to Utilities Expense in a journal entry was incorrectly posted to the ledger as a $2,250

credit, leaving the Utilities Expense account with a $3,000 debit balance. b. A $4,500 debit to Salaries Expense in a journal entry was incorrectly posted to the ledger as a $4,500

credit, leaving the Salaries Expense account with a $750 debit balance. c. A $2,250 credit to Consulting Fees Earned (Revenues) in a journal entry was incorrectly posted to the

ledger as a $2,250 debit, leaving the Consulting Fees Earned account with a $6,300 credit balance. d. A $2,250 debit posting to Accounts Receivable was posted mistakenly to Land. e. A $4,500 debit posting to Equipment was posted mistakenly to Cash. f. An entry debiting Cash and crediting Accounts Payable for $4,500 was mistakenly not posted.

QS 2-8 Identifying a posting error

P2

QS 2-12 Preparing an income statement

P3

Liu Zhang operates Lawson Consulting, which began operations on June 1. On June 30, the company’s records show the following selected accounts and amounts for the month of June. Prepare a June income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . $5,000

Accounts receivable . . . . . . . 4,500

Equipment . . . . . . . . . . . . . . . . 6,500

Accounts payable . . . . . . . . . . $ 3,000

Common stock . . . . . . . . . . . . 10,500

Dividends . . . . . . . . . . . . . . . . 1,500

Service revenue . . . . . . . . . $12,000

Rent expense . . . . . . . . . . . 2,000

Wages expense . . . . . . . . . 6,000

QS 2-13 Preparing a statement of retained earnings P3

Use the information in QS 2-12 to prepare a June statement of retained earnings for Lawson Consulting. The Retained Earnings account balance at June 1 was $0. Hint: Net income for June is $4,000.

70 Chapter 2 Accounting for Business Transactions

QS 2-14 Preparing a balance sheet P3

Use the information in QS 2-12 and QS 2-13 to prepare a June 30 balance sheet for Lawson Consulting. Hint: The ending Retained Earnings account balance as of June 30 is $2,500.

Exercise 2-2 Identifying and classifying accounts

C2

Enter the number for the item that best completes each of the descriptions below. 1. Asset 2. Equity 3. Account 4. Liability 5. Three a. Balance sheet accounts are arranged into general categories. b. Common Stock and Dividends are examples of accounts. c. Accounts Payable and Note Payable are examples of accounts. d. Accounts Receivable, Prepaid Accounts, Supplies, and Land are examples of accounts. e. A(n) is a record of increases and decreases in a specific asset, liability, equity, revenue, or

expense item.

Exercise 2-3 Identifying a ledger and chart of accounts

C3

Enter the number for the item that best completes each of the descriptions below. 1. Chart 2. General ledger 3. Journal 4. Account 5. Source document a. A(n) of accounts is a list of all accounts a company uses, not including account balances. b. The is a record containing all accounts used by a company, including account balances. c. A(n) describes transactions entering an accounting system, such as a purchase order. d. Increases and decreases in a specific asset, liability, equity, revenue, or expense are recorded in

a(n) . e. A(n) has a complete record of every transaction recorded.

Exercise 2-4 Identifying type and normal balances of accounts

C4

For each of the following, (1) identify the type of account as an asset, liability, equity, revenue, or expense; (2) identify the normal balance of the account; and (3) enter debit (Dr.) or credit (Cr.) to identify the kind of entry that would increase the account balance. a. Land e. Accounts Receivable i. Fees Earned b. Cash f. Dividends j. Equipment c. Legal Expense g. License Fee Revenue k. Notes Payable d. Prepaid Insurance h. Unearned Revenue l. Common Stock

QS 2-15 Computing and using the debt ratio A2

In a recent year’s financial statements, Home Depot reported the following: Total liabilities = $38,633 million and Total assets = $42,966 million. Compute and interpret Home Depot’s debt ratio (assume com- petitors average a 60.0% debt ratio).

EXERCISES

Exercise 2-1 Steps in analyzing and recording transactions C1

Order the following steps in the accounting process that focus on analyzing and recording transactions. a. Prepare and analyze the trial balance. b. Analyze each transaction from source documents. c. Record relevant transactions in a journal. d. Post journal information to ledger accounts.

Groro Co. bills a client $62,000 for services provided and agrees to accept the following three items in full payment: (1) $10,000 cash, (2) equipment worth $80,000, and (3) to assume responsibility for a $28,000 note payable related to the equipment. For this transaction, (a) analyze the transaction using the account- ing equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Use the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Supplies (124); Equipment (167); Accounts Payable (201); Note Payable (245); Common Stock (307); and Revenue (404).

Exercise 2-5 Analyzing effects of a compound entry

A1

Use the information in each of the following separate cases to calculate the unknown amount. a. Corentine Co. had $152,000 of accounts payable on September 30 and $132,500 on October 31. Total

purchases on account during October were $281,000. Determine how much cash was paid on accounts payable during October.

b. On September 30, Valerian Co. had a $102,500 balance in Accounts Receivable. During October, the company collected $102,890 from its credit customers. The October 31 balance in Accounts Receivable was $89,000. Determine the amount of sales on account that occurred in October.

Exercise 2-6 Analyzing account entries and balances

A1

[continued on next page]

Chapter 2 Accounting for Business Transactions 71

Prepare general journal entries for the following transactions of a new company called Pose-for-Pics. Use the following (partial) chart of accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; Common Stock; Photography Fees Earned; and Utilities Expense.

Aug. 1 Madison Harris, the owner, invested $6,500 cash and $33,500 of photography equipment in the company in exchange for common stock.

2 The company paid $2,100 cash for an insurance policy covering the next 24 months. 5 The company purchased office supplies for $880 cash. 20 The company received $3,331 cash in photography fees earned. 31 The company paid $675 cash for August utilities.

Exercise 2-7 Preparing general journal entries

P1

Use the information in Exercise 2-7 to prepare a trial balance for Pose-for-Pics. Begin by opening these T-accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; Common Stock; Photography Fees Earned; and Utilities Expense. Then, (1) post the general journal entries to these T-accounts (which will serve as the ledger) and (2) prepare the August 31 trial balance.

Exercise 2-8 Preparing T-accounts (ledger) and a trial balance P2

Prepare general journal entries to record the transactions below for Spade Company by using the follow- ing accounts: Cash; Accounts Receivable; Office Supplies; Office Equipment; Accounts Payable; Common Stock; Dividends; Fees Earned; and Rent Expense. Use the letters beside each transaction to identify entries. After recording the transactions, post them to T-accounts, which serve as the general ledger for this assignment. Determine the ending balance of each T-account. a. Kacy Spade, owner, invested $100,750 cash in the company in exchange for common stock. b. The company purchased office supplies for $1,250 cash. c. The company purchased $10,050 of office equipment on credit. d. The company received $15,500 cash as fees for services provided to a customer. e. The company paid $10,050 cash to settle the payable for the office equipment purchased in

transaction c. f. The company billed a customer $2,700 as fees for services provided. g. The company paid $1,225 cash for the monthly rent. h. The company collected $1,125 cash as partial payment for the account receivable created in

transaction f. i. The company paid a $10,000 cash dividend to the owner (sole shareholder).

Exercise 2-9 Recording effects of transactions in T-accounts

A1

Check Cash ending balance, $94,850

After recording the transactions of Exercise 2-9 in T-accounts and calculating the balance of each account, prepare a trial balance. Use May 31 as its report date.

Exercise 2-10 Preparing a trial balance P2

c. During October, Alameda Company had $102,500 of cash receipts and $103,150 of cash disburse- ments. The October 31 Cash balance was $18,600. Determine how much cash the company had at the close of business on September 30.

1. Prepare general journal entries for the following transactions of Valdez Services. a. The company paid $2,000 cash for payment on a 6-month-old account payable for office supplies. b. The company paid $1,200 cash for the just completed two-week salary of the receptionist. c. The company paid $39,000 cash for equipment purchased. d. The company paid $800 cash for this month’s utilities. e. The company paid a $4,500 cash dividend to the owner (sole shareholder).

2. Transactions a, c, and e did not result in an expense. Match each transaction (a, c, and e) with one of the following reasons for not recording an expense.

This transaction is a distribution of cash to the owner. Even though equity decreased, that decrease did not occur in the process of providing goods or services to customers. This transaction decreased cash in settlement of a previously existing liability (equity did not change). Supplies expense is recorded when assets are used, not necessarily when cash is paid. This transaction involves the purchase of an asset. The form of the company’s assets changed, but total assets did not (and neither did equity).

Exercise 2-11 Analyzing and journalizing transactions involving cash payments

P1

72 Chapter 2 Accounting for Business Transactions

1. Prepare general journal entries for the following transactions of Valdez Services. a. Brina Valdez invested $20,000 cash in the company in exchange for common stock. b. The company provided services to a client and immediately received $900 cash. c. The company received $10,000 cash from a client in payment for services to be provided next year. d. The company received $3,500 cash from a client in partial payment of accounts receivable. e. The company borrowed $5,000 cash from the bank by signing a note payable.

2. Transactions a, c, d, and e did not yield revenue. Match each transaction (a, c, d, and e) with one of the following reasons for not recording revenue.

This transaction changed the form of an asset from a receivable to cash. Total assets were not increased (revenue was recognized when the services were originally provided). This transaction brought in cash (increased assets), and it also increased a liability by the same amount (represented by the signing of a note to repay the amount). This transaction brought in cash, but this is an owner investment. This transaction brought in cash, but it created a liability to provide services to the client in the next year.

Exercise 2-12 Analyzing and journalizing transactions involving receipt of cash

P1

Fill in each of the following T-accounts for Belle Co.’s seven transactions listed here. The T-accounts repre- sent Belle Co.’s general ledger. Code each entry with transaction number 1 through 7 (in order) for reference. 1. D. Belle created a new business and invested $6,000 cash, $7,600 of equipment, and $12,000 in web servers

in exchange for common stock. 2. The company paid $4,800 cash in advance for prepaid insurance coverage. 3. The company purchased $900 of supplies on account. 4. The company paid $800 cash for selling expenses. 5. The company received $4,500 cash for services provided. 6. The company paid $900 cash toward accounts payable. 7. The company paid $3,400 cash for equipment.

Exercise 2-13 Entering transactions into T-accounts

A1

Cash

Equipment

Common Stock

Supplies

Web Servers

Services Revenue

Prepaid Insurance

Accounts Payable

Selling Expenses

Exercise 2-14 Preparing general journal entries P1

Use information from Exercise 2-13 to prepare the general journal entries for Belle Co.’s first seven transactions.

Determine net income or net loss for the business during the year for each of the following separate cases. a. Owner made no investments in the business, and no dividends were paid during the year. b. Owner made no investments in the business, but dividends were $1,250 cash per month. c. No dividends were paid during the year, but the owner did invest an additional $55,000 cash in

exchange for common stock. d. Dividends were $1,250 cash per month, and the owner invested an additional $35,000 cash in exchange

for common stock.

A corporation had the following assets and liabilities at the beginning and end of this year.

Assets Liabilities

Beginning of the year . . . . . . . . . . . . $ 60,000 $20,000

End of the year . . . . . . . . . . . . . . . . . 105,000 36,000

Exercise 2-15 Computing net income

A1

Carmen Camry operates a consulting firm called Help Today, which began operations on August 1. On August 31, the company’s records show the following selected accounts and amounts for the month of August. Use this information to prepare an August income statement for the business.

Exercise 2-16 Preparing an income statement C3 P3

Chapter 2 Accounting for Business Transactions 73

Use the information in Exercise 2-16 to prepare an August statement of retained earnings for Help Today. The Retained Earnings account balance at August 1 was $0. Hint: Net income for August is $10,470.

Exercise 2-17 Preparing a statement of retained earnings P3

Use the information in Exercise 2-16 to prepare an August 31 balance sheet for Help Today. Hint: The ending Retained Earnings account balance as of August 31 is $4,470.

Exercise 2-18 Preparing a balance sheet P3

Compute the missing amount for each of the following separate companies in columns B through E. Exercise 2-19 Analyzing changes in a company’s equity

P3

110,000 $ 0

? 22,000

104,000

? $ 0

(47,000) 90,000 85,000

87,000 $ 0

(10,000) (4,000)

?

210,000 $ 0

(55,000) ?

110,000

2 1

3 4 5 6

A B C D E

CBS ABC CNN NBC

Equity, beginning of year

Equity, end of year

Owner investments during the year Dividends during the year Net income (loss) for the year

Check Net income, $10,470

Cash . . . . . . . . . . . . . . . . . . $25,360 Accounts receivable . . . . . . 22,360 Office supplies . . . . . . . . . . 5,250 Land . . . . . . . . . . . . . . . . . . 44,000 Office equipment . . . . . . . . 20,000

Accounts payable . . . . . . . . . . . $ 10,500 Common stock . . . . . . . . . . . . . 102,000 Dividends . . . . . . . . . . . . . . . . . 6,000 Consulting fees earned . . . . . . 27,000 Rent expense . . . . . . . . . . . . . . 9,550

Salaries expense . . . . . . . . . . $5,600 Telephone expense . . . . . . . . 860 Miscellaneous expenses . . . . 520

Posting errors are identified in the following table. In column (1), enter the amount of the difference be- tween the two trial balance columns (debit and credit) due to the error. In column (2), identify the trial balance column (debit or credit) with the larger amount if they are not equal. In column (3), identify the account(s) affected by the error. In column (4), indicate the amount by which the account(s) in column (3) is under- or overstated. Item (a) is completed as an example.

Exercise 2-20 Identifying effects of posting errors on the trial balance A1 P2

Exercise 2-21 Analyzing a trial balance error

P1 P2

You are told the column totals in a trial balance are not equal. After careful analysis, you discover only one error. Specifically, a correctly journalized credit purchase of an automobile for $18,950 is posted from the journal to the ledger with an $18,950 debit to Automobiles and another $18,950 debit to Accounts Payable. The Automobiles account has a debit balance of $37,100 on the trial balance. (1) Answer each of the following questions and (2) compute the dollar amount of any misstatement for parts a through d. a. Is the Debit column total of the trial balance overstated, understated, or correctly stated? b. Is the Credit column total of the trial balance overstated, understated, or correctly stated? c. Is the Automobiles account balance overstated, understated, or correctly stated in the trial balance? d. Is the Accounts Payable account balance overstated, understated, or correctly stated in the trial balance? e. If the Debit column total of the trial balance is $200,000 before correcting the error, what is the total

of the Credit column before correction?

(1) (2) (3) (4) Difference between Column with Identify Amount That Debit and Credit the Larger Account(s) Account(s) Is Over- or Description of Posting Error Columns Total Incorrectly Stated Understated

a . $3,600 debit to Rent Expense is $2,260 Credit Rent Expense Rent Expense posted as a $1,340 debit . understated $2,260

b . $6,500 credit to Cash is posted twice as two credits to Cash .

c . $10,900 debit to the Dividends account is debited to Common Stock .

d . $2,050 debit to Prepaid Insurance is posted as a debit to Insurance Expense .

e . $38,000 debit to Machinery is posted as a debit to Accounts Payable .

f . $5,850 credit to Services Revenue is posted as a $585 credit .

g . $1,390 debit to Store Supplies is not posted .

74 Chapter 2 Accounting for Business Transactions

Exercise 2-23 Preparing journal entries

P1

Prepare general journal entries for the following transactions of Sustain Company. Use the following (par- tial) chart of accounts: Cash; Prepaid Insurance; Accounts Receivable; Furniture; Accounts Payable; Unearned Revenue; Fees Earned; and Common Stock.

June 1 T. James, owner, invested $11,000 cash in Sustain Company in exchange for common stock. 2 The company purchased $4,000 of furniture made from reclaimed wood on credit. 3 The company paid $600 cash for a 12-month insurance policy on the reclaimed furniture. 4 The company billed a customer $3,000 in fees earned from preparing a sustainability report. 12 The company paid $4,000 cash toward the payable from the June 2 furniture purchase. 20 The company collected $3,000 cash for fees billed on June 4. 21 T. James invested an additional $10,000 cash in Sustain Company in exchange for common stock. 30 The company received $5,000 cash in advance of providing sustainability services to a customer.

Exercise 2-22 Calculating and interpreting the debt ratio

A2

a. Compute the debt ratio for each of the three companies. b. Which company has the most financial leverage?

67,000 $22,000

12,000 150,000

$ 40,000

68,000 27,000

$19,000

5,000 147,000

$ 30,000

17,000

ExpensesCompany Total Assets Net Income Total Liabilities

DreamWorks Pixar Universal

Aracel Engineering completed the following transactions in the month of June. a. Jenna Aracel, the owner, invested $100,000 cash, office equipment with a value of $5,000, and

$60,000 of drafting equipment to launch the company in exchange for common stock. b. The company purchased land worth $49,000 for an office by paying $6,300 cash and signing a long-

term note payable for $42,700. c. The company purchased a portable building with $55,000 cash and moved it onto the land acquired in b. d. The company paid $3,000 cash for the premium on an 18-month insurance policy. e. The company completed and delivered a set of plans for a client and collected $6,200 cash. f. The company purchased $20,000 of additional drafting equipment by paying $9,500 cash and signing

a long-term note payable for $10,500.

Problem 2-2A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

PROBLEM SET A

Problem 2-1A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Karla Tanner opened a web consulting business called Linkworks and completed the following transac- tions in its first month of operations.

Apr. 1 Tanner invested $80,000 cash along with office equipment valued at $26,000 in the company in exchange for common stock.

2 The company prepaid $9,000 cash for 12 months’ rent for office space. Hint: Debit Prepaid Rent for $9,000.

3 The company made credit purchases for $8,000 in office equipment and $3,600 in office sup- plies. Payment is due within 10 days.

6 The company completed services for a client and immediately received $4,000 cash. 9 The company completed a $6,000 project for a client, who must pay within 30 days. 13 The company paid $11,600 cash to settle the account payable created on April 3. 19 The company paid $2,400 cash for the premium on a 12-month insurance policy. Hint: Debit

Prepaid Insurance for $2,400. 22 The company received $4,400 cash as partial payment for the work completed on April 9. 25 The company completed work for another client for $2,890 on credit. 28 The company paid a $5,500 cash dividend. 29 The company purchased $600 of additional office supplies on credit. 30 The company paid $435 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of April 30.

Check (2) Ending balances: Cash, $59,465; Accounts Receivable, $4,490; Accounts Payable, $600

(3) Total debits, $119,490

Chapter 2 Accounting for Business Transactions 75

Denzel Brooks opened a web consulting business called Venture Consultants and completed the following transactions in March.

Mar. 1 Brooks invested $150,000 cash along with $22,000 in office equipment in the company in exchange for common stock.

2 The company prepaid $6,000 cash for six months’ rent for an office. Hint: Debit Prepaid Rent for $6,000.

3 The company made credit purchases of office equipment for $3,000 and office supplies for $1,200. Payment is due within 10 days.

6 The company completed services for a client and immediately received $4,000 cash. 9 The company completed a $7,500 project for a client, who must pay within 30 days. 12 The company paid $4,200 cash to settle the account payable created on March 3. 19 The company paid $5,000 cash for the premium on a 12-month insurance policy. Hint: Debit

Prepaid Insurance for $5,000. 22 The company received $3,500 cash as partial payment for the work completed on March 9. 25 The company completed work for another client for $3,820 on credit. 29 The company paid a $5,100 cash dividend. 30 The company purchased $600 of additional office supplies on credit. 31 The company paid $500 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use the account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of March.

Check (2) Ending balances: Cash, $136,700; Accounts Receivable, $7,820; Accounts Payable, $600

(3) Total debits, $187,920

Problem 2-3A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

g. The company completed $14,000 of engineering services for a client. This amount is to be received in 30 days.

h. The company purchased $1,150 of additional office equipment on credit. i. The company completed engineering services for $22,000 on credit. j. The company received a bill for rent of equipment that was used on a recently completed job. The

$1,333 rent cost must be paid within 30 days. k. The company collected $7,000 cash in partial payment from the client described in transaction g. l. The company paid $1,200 cash for wages to a drafting assistant. m. The company paid $1,150 cash to settle the account payable created in transaction h. n. The company paid $925 cash for minor maintenance of its drafting equipment. o. The company paid a $9,480 cash dividend. p. The company paid $1,200 cash for wages to a drafting assistant. q. The company paid $2,500 cash for advertisements on the web during June.

Required

1. Prepare general journal entries to record these transactions (use the account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Prepaid Insurance (108); Office Equipment (163); Drafting Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Engineering Fees Earned (402); Wages Expense (601); Equipment Rental Expense (602); Advertising Expense (603); and Repairs Expense (604). Post the journal entries from part 1 to the accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of June.

Check (2) Ending balances: Cash, $22,945; Accounts Receivable, $29,000; Accounts Payable, $1,333

(3) Trial balance totals, $261,733

Problem 2-4A Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Business transactions completed by Hannah Venedict during the month of September are as follows. a. Venedict invested $60,000 cash along with office equipment valued at $25,000 in a new business

named HV Consulting in exchange for common stock. b. The company purchased land valued at $40,000 and a building valued at $160,000. The purchase is

paid with $30,000 cash and a long-term note payable for $170,000. c. The company purchased $2,000 of office supplies on credit. [continued on next page]

76 Chapter 2 Accounting for Business Transactions

Problem 2-5A Computing net income from equity analysis, preparing a balance sheet, and computing the debt ratio

C2 A1 A2 P3

The accounting records of Nettle Distribution show the following assets and liabilities as of December 31, 2018 and 2019.

December 31 2018 2019

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 64,300 $ 15,640

Accounts receivable . . . . . . . . . . . . 26,240 19,100

Office supplies . . . . . . . . . . . . . . . . 3,160 1,960

Office equipment . . . . . . . . . . . . . . 44,000 44,000

Trucks . . . . . . . . . . . . . . . . . . . . . . . 148,000 157,000

December 31 2018 2019

Building . . . . . . . . . . . . . . . . . . . . . . $ 0 $80,000

Land . . . . . . . . . . . . . . . . . . . . . . . . 0 60,000

Accounts payable . . . . . . . . . . . . . . 3,500 33,500

Note payable . . . . . . . . . . . . . . . . . 0 40,000

Required

1. Prepare balance sheets for the business as of December 31, 2018 and 2019. Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.

2. Compute net income for 2019 by comparing total equity amounts for these two years and using the following information: During 2019, the owner invested $35,000 additional cash in the business (in exchange for common stock) and the company paid a $19,000 cash dividend.

3. Compute the 2019 year-end debt ratio (in percent and rounded to one decimal).

Check (2) Net income, $6,000

(3) Debt ratio, 19.5%

Yi Min started an engineering firm called Min Engineering. He began operations and completed seven transactions in May, which included his initial investment of $18,000 cash. After those seven transactions, the ledger included the following accounts with normal balances.

Problem 2-6A Analyzing account balances and reconstructing transactions

C1 C3 A1 P2 Cash . . . . . . . . . . . . . . . . . $37,600 Office supplies . . . . . . . . . 890

Prepaid insurance . . . . . . . 4,600

Office equipment . . . . . . . $12,900

Accounts payable . . . . . . . 12,900

Common stock . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . $ 3,370

Engineering fees earned . . . . . . . 36,000

Rent expense . . . . . . . . . . . . . . . . 7,540

Required

1. Prepare a trial balance for this business as of the end of May. 2. The following seven transactions produced the account balances shown above. a. Y. Min invested $18,000 cash in the business in exchange for common stock. b. Paid $7,540 cash for monthly rent expense for May. c. Paid $4,600 cash in advance for the annual insurance premium beginning the next period.

Check (1) Trial balance totals, $66,900 (2) Ending Cash balance, $37,600

Check (2) Ending balances: Cash, $12,665; Office Equipment, $50,900

(3) Trial balance totals, $291,350

d. Venedict invested her personal automobile in the company in exchange for more common stock. The automobile has a value of $16,500 and is to be used exclusively in the business.

e. The company purchased $5,600 of additional office equipment on credit. f. The company paid $1,800 cash salary to an assistant. g. The company provided services to a client and collected $8,000 cash. h. The company paid $635 cash for this month’s utilities. i. The company paid $2,000 cash to settle the account payable created in transaction c. j. The company purchased $20,300 of new office equipment by paying $20,300 cash. k. The company completed $6,250 of services for a client, who must pay within 30 days. l. The company paid $1,800 cash salary to an assistant. m. The company received $4,000 cash in partial payment on the receivable created in transaction k. n. The company paid a $2,800 cash dividend.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (108); Office Equipment (163); Automobiles (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Salaries Expense (601); and Utilities Expense (602). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of September.

[continued from previous page]

Chapter 2 Accounting for Business Transactions 77

Angela Lopez owns and manages a consulting firm called Metrix, which began operations on March 1. On March 31, Metrix shows the following selected accounts and amounts for the month of March.

Problem 2-7A Preparing an income statement, statement of retained earnings, and balance sheet

P3

Equipment . . . . . . . . . . . . . . $ 4,000

Salaries expense . . . . . . . . 3,000

Consulting revenue . . . . . . 12,000

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

Utilities expense . . . . . . . . . 200

Note payable . . . . . . . . . . . 2,400

Accounts receivable . . . . . . . . $ 3,500

Common stock . . . . . . . . . . . . 11,600

Dividends . . . . . . . . . . . . . . . . 2,000

Office supplies . . . . . . . . . . . . 1,500

Rental revenue . . . . . . . . . . . . 500

Advertising expense . . . . . . . . 400

Prepaid insurance . . . . . . . $1,000

Accounts payable . . . . . . . 1,300

Note receivable . . . . . . . . 2,500

Rent expense . . . . . . . . . . 2,000

Unearned revenue . . . . . . 300

Required

1. Prepare a March income statement for the business. 2. Prepare a March statement of retained earnings. The Retained Earnings account balance at March 1 was

$0, and the owner invested $11,600 cash in the company on March 2 in exchange for common stock. 3. Prepare a March 31 balance sheet. Hint: Use the Retained Earnings account balance calculated in part 2.

PROBLEM SET B

Problem 2-1B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Humble Management Services opened for business and completed these transactions in September.

Sep. 1 Henry Humble, the owner, invested $38,000 cash along with office equipment valued at $15,000 in the company in exchange for common stock.

2 The company prepaid $9,000 cash for 12 months’ rent for office space. Hint: Debit Prepaid Rent for $9,000.

4 The company made credit purchases for $8,000 in office equipment and $2,400 in office sup- plies. Payment is due within 10 days.

8 The company completed work for a client and immediately received $3,280 cash. 12 The company completed a $15,400 project for a client, who must pay within 30 days. 13 The company paid $10,400 cash to settle the payable created on September 4. 19 The company paid $1,900 cash for the premium on an 18-month insurance policy. Hint: Debit

Prepaid Insurance for $1,900. 22 The company received $7,700 cash as partial payment for the work completed on September 12. 24 The company completed work for another client for $2,100 on credit. 28 The company paid a $5,300 cash dividend. 29 The company purchased $550 of additional office supplies on credit. 30 The company paid $860 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (401); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of September.

Check (2) Ending balances: Cash, $21,520; Accounts Receivable, $9,800; Accounts Payable, $550

(3) Total debits, $74,330

d. Purchased office supplies for $890 cash. e. Purchased $12,900 of office equipment on credit (with accounts payable). f. Received $36,000 cash for engineering services provided in May. g. The company paid a $3,370 cash dividend. Prepare a Cash T-account, enter the cash effects (if any) of each transaction, and compute the ending

Cash balance. Code each entry in the T-account with one of the transaction codes a through g.

At the beginning of April, Bernadette Grechus launched a custom computer solutions company called Softworks. The company had the following transactions during April. a. Bernadette Grechus invested $65,000 cash, office equipment with a value of $5,750, and $30,000 of

computer equipment in the company in exchange for common stock. b. The company purchased land worth $22,000 for an office by paying $5,000 cash and signing a long-

term note payable for $17,000.

Problem 2-2B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

[continued on next page]

78 Chapter 2 Accounting for Business Transactions

Zucker Management Services opened for business and completed these transactions in November.

Nov. 1 Matt Zucker, the owner, invested $30,000 cash along with $15,000 of office equipment in the company in exchange for common stock.

2 The company prepaid $4,500 cash for six months’ rent for an office. Hint: Debit Prepaid Rent for $4,500.

4 The company made credit purchases of office equipment for $2,500 and of office supplies for $600. Payment is due within 10 days.

8 The company completed work for a client and immediately received $3,400 cash. 12 The company completed a $10,200 project for a client, who must pay within 30 days. 13 The company paid $3,100 cash to settle the payable created on November 4. 19 The company paid $1,800 cash for the premium on a 24-month insurance policy. 22 The company received $5,200 cash as partial payment for the work completed on November 12. 24 The company completed work for another client for $1,750 on credit. 28 The company paid a $5,300 cash dividend. 29 The company purchased $249 of additional office supplies on credit. 30 The company paid $831 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of November.

Check (2) Ending balances: Cash, $23,069; Accounts Receivable, $6,750; Accounts Payable, $249

(3) Total debits, $60,599

Problem 2-3B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

c. The company purchased a portable building with $34,500 cash and moved it onto the land acquired in b.

d. The company paid $5,000 cash for the premium on a two-year insurance policy. e. The company provided services to a client and immediately collected $4,600 cash. f. The company purchased $4,500 of additional computer equipment by paying $800 cash and signing a

long-term note payable for $3,700. g. The company completed $4,250 of services for a client. This amount is to be received within

30 days. h. The company purchased $950 of additional office equipment on credit. i. The company completed client services for $10,200 on credit. j. The company received a bill for rent of a computer testing device that was used on a recently com-

pleted job. The $580 rent cost must be paid within 30 days. k. The company collected $5,100 cash in partial payment from the client described in transaction i. l. The company paid $1,800 cash for wages to an assistant. m. The company paid $950 cash to settle the payable created in transaction h. n. The company paid $608 cash for minor maintenance of the company’s computer equipment. o. The company paid a $6,230 cash dividend. p. The company paid $1,800 cash for wages to an assistant. q. The company paid $750 cash for advertisements on the web during April.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Prepaid Insurance (108); Office Equipment (163); Computer Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Wages Expense (601); Computer Rental Expense (602); Advertising Expense (603); and Repairs Expense (604). Post the journal entries from part 1 to the accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of April.

Check (2) Ending balances: Cash, $17,262; Accounts Receivable, $9,350; Accounts Payable, $580

(3) Trial balance totals, $141,080

[continued from previous page]

Chapter 2 Accounting for Business Transactions 79

Problem 2-4B Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Nuncio Consulting completed the following transactions during June. a. Armand Nuncio, the owner, invested $35,000 cash along with office equipment valued at $11,000 in

the new company in exchange for common stock. b. The company purchased land valued at $7,500 and a building valued at $40,000. The purchase is paid

with $15,000 cash and a long-term note payable for $32,500. c. The company purchased $500 of office supplies on credit. d. A. Nuncio invested his personal automobile in the company in exchange for more common stock. The

automobile has a value of $8,000 and is to be used exclusively in the business. e. The company purchased $1,200 of additional office equipment on credit. f. The company paid $1,000 cash salary to an assistant. g. The company provided services to a client and collected $3,200 cash. h. The company paid $540 cash for this month’s utilities. i. The company paid $500 cash to settle the payable created in transaction c. j. The company purchased $3,400 of new office equipment by paying $3,400 cash. k. The company completed $4,200 of services for a client, who must pay within 30 days. l. The company paid $1,000 cash salary to an assistant. m. The company received $2,200 cash in partial payment on the receivable created in transaction k. n. The company paid a $1,100 cash dividend.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (108); Office Equipment (163); Automobiles (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Salaries Expense (601); and Utilities Expense (602). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of June.

Check (2) Ending balances: Cash, $17,860; Office Equipment, $15,600

(3) Trial balance totals, $95,100

Problem 2-5B Computing net income from equity analysis, preparing a balance sheet, and computing the debt ratio

C2 A1 A2 P3

The accounting records of Tama Co. show the following assets and liabilities as of December 31, 2018 and 2019.

December 31 2018 2019

Cash . . . . . . . . . . . . . . . . . . . . . . . . $30,000 $ 5,000

Accounts receivable . . . . . . . . . . . . 35,000 25,000

Office supplies . . . . . . . . . . . . . . . . 8,000 13,500

Office equipment . . . . . . . . . . . . . . 40,000 40,000

Machinery . . . . . . . . . . . . . . . . . . . . 28,000 28,500

December 31 2018 2019

Building . . . . . . . . . . . . . . . . . . $ 0 $250,000

Land . . . . . . . . . . . . . . . . . . . . 0 50,000

Accounts payable . . . . . . . . . . 4,000 12,000

Note payable . . . . . . . . . . . . . 0 250,000

Required

1. Prepare balance sheets for the business as of December 31, 2018 and 2019. Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.

2. Compute net income for 2019 by comparing total equity amounts for these two years and using the following information: During 2019, the owner invested $5,000 additional cash in the business (in exchange for common stock) and the company paid a $3,000 cash dividend.

3. Compute the December 31, 2019, debt ratio (in percent and rounded to one decimal).

Check (2) Net income, $11,000

(3) Debt ratio, 63.6%

Roshaun Gould started a web consulting firm called Gould Solutions. He began operations and completed seven transactions in April that resulted in the following accounts, which all have normal balances.

Problem 2-6B Analyzing account balances and reconstructing transactions

C1 C3 A1 P2 Cash . . . . . . . . . . . . . . . . . $20,000

Office supplies . . . . . . . . . 750

Prepaid rent . . . . . . . . . . . 1,800

Office equipment . . . . . . . $12,250

Accounts payable . . . . . . . 12,250

Common stock . . . . . . . . . 15,000

Dividends . . . . . . . . . . . . . . . . . . . $ 5,200

Consulting fees earned . . . . . . . . 20,400

Miscellaneous expenses . . . . . . . 7,650

80 Chapter 2 Accounting for Business Transactions

Required

1. Prepare a trial balance for this business as of the end of April. 2. The following seven transactions produced the account balances shown above. a. Gould invested $15,000 cash in the business in exchange for common stock. b. Paid $1,800 cash in advance for next month’s rent expense. c. Paid $7,650 cash for miscellaneous expenses. d. Purchased office supplies for $750 cash. e. Purchased $12,250 of office equipment on credit (with accounts payable). f. Received $20,400 cash for consulting services provided in April. g. The company paid a $5,200 cash dividend. Prepare a Cash T-account, enter the cash effects (if any) of each transaction, and compute the ending

Cash balance. Code each entry in the T-account with one of the transaction codes a through g.

Check (1) Trial balance totals, $47,650 (2) Ending Cash balance, $20,000

Victoria Rivera owns and manages a consulting firm called Prisek, which began operations on July 1. On July 31, the company’s records show the following selected accounts and amounts for the month of July.

Problem 2-7B Preparing an income statement, statement of retained earnings, and balance sheet

P3

Equipment . . . . . . . . . . . . . $12,000 Salaries expense . . . . . . . 9,000 Consulting revenue . . . . . 36,000 Cash . . . . . . . . . . . . . . . . . 24,000 Utilities expense . . . . . . . . 600 Note payable . . . . . . . . . . 7,200

Accounts receivable . . . . . . . . $10,500 Common stock . . . . . . . . . . . . 34,800 Dividends . . . . . . . . . . . . . . . . 6,000 Office supplies . . . . . . . . . . . . 4,500 Rental revenue . . . . . . . . . . . . 1,500 Advertising expense . . . . . . . . 1,200

Prepaid insurance . . . . . . . $3,000 Accounts payable . . . . . . . 3,900 Note receivable . . . . . . . . 7,500 Rent expense . . . . . . . . . . 6,000 Unearned revenue . . . . . . 900

Required

1. Prepare a July income statement for the business. 2. Prepare a July statement of retained earnings. The Retained Earnings account balance at July 1 was $0,

and the owner invested $34,800 cash in the company on July 2 in exchange for common stock. 3. Prepare a July 31 balance sheet. Hint: Use the Retained Earnings account balance calculated in part 2.

SERIAL PROBLEM Business Solutions

A1 P1 P2

This serial problem started in Chapter 1 and continues through most of the chapters. If the Chapter 1 seg- ment was not completed, the problem can begin at this point.

SP 2 On October 1, 2019, Santana Rey launched a computer services company called Business Solutions, which provides consulting services, computer system installations, and custom program devel- opment. Rey adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2019. The company’s initial chart of accounts follows.

Account No. Account No.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . 307

Accounts Receivable . . . . . . . . . . . . 106 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

Computer Supplies . . . . . . . . . . . . . . 126 Computer Services Revenue . . . . . . . . . . . . . 403

Prepaid Insurance . . . . . . . . . . . . . . . 128 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . 623

Prepaid Rent . . . . . . . . . . . . . . . . . . . 131 Advertising Expense . . . . . . . . . . . . . . . . . . . . 655

Office Equipment . . . . . . . . . . . . . . . 163 Mileage Expense . . . . . . . . . . . . . . . . . . . . . . 676

Computer Equipment . . . . . . . . . . . . 167 Miscellaneous Expenses . . . . . . . . . . . . . . . . 677

Accounts Payable . . . . . . . . . . . . . . . 201 Repairs Expense—Computer . . . . . . . . . . . . . 684 ©Alexander Image/Shutterstock

Required

1. Prepare journal entries to record each of the following transactions for Business Solutions.

Oct. 1 S. Rey invested $45,000 cash, a $20,000 computer system, and $8,000 of office equipment in the company in exchange for common stock.

2 The company paid $3,300 cash for four months’ rent. Hint: Debit Prepaid Rent for $3,300. 3 The company purchased $1,420 of computer supplies on credit from Harris Office Products. 5 The company paid $2,220 cash for one year’s premium on a property and liability insurance

policy. Hint: Debit Prepaid Insurance for $2,220. 6 The company billed Easy Leasing $4,800 for services performed in installing a new web server.

Chapter 2 Accounting for Business Transactions 81

8 The company paid $1,420 cash for the computer supplies purchased from Harris Office Prod- ucts on October 3.

10 The company hired Lyn Addie as a part-time assistant. 12 The company billed Easy Leasing another $1,400 for services performed. 15 The company received $4,800 cash from Easy Leasing as partial payment on its account. 17 The company paid $805 cash to repair computer equipment that was damaged when moving it. 20 The company paid $1,728 cash for advertisements published in the local newspaper. 22 The company received $1,400 cash from Easy Leasing on its account. 28 The company billed IFM Company $5,208 for services performed. 31 The company paid $875 cash for Lyn Addie’s wages for seven days’ work. 31 The company paid a $3,600 cash dividend. Nov. 1 The company reimbursed S. Rey in cash for business automobile mileage allowance (Rey

logged 1,000 miles at $0.32 per mile). 2 The company received $4,633 cash from Liu Corporation for computer services performed. 5 The company purchased computer supplies for $1,125 cash from Harris Office Products. 8 The company billed Gomez Co. $5,668 for services performed. 13 The company agreed to perform future services for Alex’s Engineering Co. No work has yet

been performed. 18 The company received $2,208 cash from IFM Company as partial payment of the October 28 bill. 22 The company paid $250 cash for miscellaneous expenses. Hint: Debit Miscellaneous Expenses

for $250. 24 The company completed work and sent a bill for $3,950 to Alex’s Engineering Co. 25 The company sent another bill to IFM Company for the past-due amount of $3,000. 28 The company reimbursed S. Rey in cash for business automobile mileage (1,200 miles at $0.32

per mile). 30 The company paid $1,750 cash for Lyn Addie’s wages for 14 days’ work. 30 The company paid a $2,000 cash dividend. 2. Open ledger accounts (in balance column format) and post the journal entries from part 1 to them. 3. Prepare a trial balance as of the end of November.

Check (2) Cash, Nov. 30 bal., $38,264 (3) Trial bal. totals, $98,659

GENERAL LEDGER PROBLEM

Using transactions from the following assignments along with the General Ledger tool, prepare journal entries for each transaction and identify the financial statement impact of each entry. The financial state- ments are automatically generated based on the journal entries recorded.

GL 2-1 Transactions from the FastForward illustration in this chapter GL 2-2 Based on Exercise 2-9 GL 2-3 Based on Exercise 2-12 GL 2-4 Based on Problem 2-1A Using transactions from the following assignments, record journal entries, create financial statements, and assess the impact of each transaction on financial statements.

GL 2-5 Based on Problem 2-2A GL 2-7 Based on Problem 2-4A GL 2-6 Based on Problem 2-3A GL 2-8 Based on the Serial Problem SP 2

GL

COMPANY ANALYSIS A1 A2

Accounting Analysis

AA 2-1 Refer to Apple’s financial statements in Appendix A for the following questions.

Required

1. What amount of total liabilities does Apple report for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016?

2. What amount of total assets does it report for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016?

3. Compute its debt ratio for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016. (Report ratio in percent and round it to one decimal.)

4. In which fiscal year did it employ more financial leverage: September 30, 2017, or September 24, 2016? Explain.

APPLE

82 Chapter 2 Accounting for Business Transactions

AA 2-2 Key comparative figures for Apple and Google follow.COMPARATIVE ANALYSIS A1 A2 Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Total liabilities . . . . . . . . . . . . . . . . . . . $241,272 $193,437 $ 44,793 $ 28,461 Total assets . . . . . . . . . . . . . . . . . . . . . 375,319 321,686 197,295 167,497

1. What is the debt ratio for Apple in the current year and for the prior year? 2. What is the debt ratio for Google in the current year and for the prior year? 3. Which of the two companies has the higher degree of financial leverage in the current year?

APPLE GOOGLE

BTN 2-2 Lila Corentine is an aspiring entrepreneur and your friend. She is having difficulty understand- ing the purposes of financial statements and how they fit together across time.

Required

Write a one-page memorandum to Corentine explaining the purposes of the four financial statements and how they are linked across time.

COMMUNICATING IN PRACTICE C1 C2 A1 P3

AA 2-3 Key comparative figures for Apple, Google, and Samsung follow.GLOBAL ANALYSIS A2 Samsung Apple Google

In millions Current Year Prior Year Current Year Current Year

Total liabilities . . . . . . . . . . . ₩ 87,260,662 ₩ 69,211,291 $241,272 $ 44,793

Total assets . . . . . . . . . . . . . 301,752,090 262,174,324 375,319 197,295

APPLE GOOGLE Samsung

Required

1. Compute Samsung’s debt ratio for the current year and prior year. 2. Is Samsung on a trend toward increased or decreased financial leverage? 3. Looking at the current-year debt ratio, is Samsung a more risky or less risky investment than (a) Apple

and (b) Google?

ETHICS CHALLENGE C1

BTN 2-1 Assume that you are a cashier and your manager requires that you immediately enter each sale when it occurs. Recently, lunch hour traffic has increased and the assistant manager asks you to avoid delays by taking customers’ cash and making change without entering sales. The assistant manager says she will add up cash and enter sales after lunch. She says that, in this way, customers will be happy and the register record will always match the cash amount when the manager arrives at three o’clock.

The advantages to the process proposed by the assistant manager include improved customer service, fewer delays, and less work for you. The disadvantage is that the assistant manager could steal cash by simply recording less sales than the cash received and then pocketing the excess cash. You decide to reject her suggestion without the manager’s approval and to confront her on the ethics of her suggestion.

Required

Propose and evaluate two other courses of action you might consider, and explain why.

Beyond the Numbers

BTN 2-3 Access EDGAR online (SEC.gov) and locate the 2016 10-K report of Amazon.com (ticker: AMZN) filed on February 10, 2017. Review its financial statements reported for years ended 2016, 2015, and 2014 to answer the following questions.

Required

1. What are the amounts of Amazon’s net income or net loss reported for each of these three years? 2. Do Amazon’s operating activities provide cash or use cash for each of these three years? Hint: See the

statement of cash flows. 3. If Amazon has 2016 net income of $2,371 million and 2016 operating cash flows of $16,443 million,

how is it possible that its cash balance at December 31, 2016, increases by only $3,444 million relative to its balance at December 31, 2015?

TAKING IT TO THE NET A1

Chapter 2 Accounting for Business Transactions 83

BTN 2-4 The expanded accounting equation consists of assets, liabilities, common stock, dividends, revenues, and expenses. It can be used to reveal insights into changes in a company’s financial position.

Required

1. Form learning teams of six (or more) members. Each team member must select one of the six compo- nents, and each team must have at least one expert on each component: (a) assets, (b) liabilities, (c) common stock, (d ) dividends, (e) revenues, and ( f ) expenses.

2. Form expert teams of individuals who selected the same component in part 1. Expert teams are to draft a report that each expert will present to his or her learning team addressing the following: a. Identify for its component the (i) increase and decrease side of the account and (ii) normal balance

side of the account. b. Describe a transaction, with amounts, that increases its component. c. Using the transaction and amounts in (b), verify the equality of the accounting equation and then

explain any effects on the income statement and statement of cash flows. d. Describe a transaction, with amounts, that decreases its component. e. Using the transaction and amounts in (d), verify the equality of the accounting equation and then

explain any effects on the income statement and statement of cash flows. 3. Each expert should return to his/her learning team. In rotation, each member presents his/her expert

team’s report to the learning team. Team discussion is encouraged.

TEAMWORK IN ACTION C1 C2 C4 A1

BTN 2-5 Assume that James Park and Eric Friedman of Fitbit plan on expanding their business to accommodate more product lines. They are considering financing expansion in one of two ways: (1) con- tributing more of their own funds to the business or (2) borrowing the funds from a bank.

Required

Identify at least two issues that James and Eric should consider when trying to decide on the method for financing their expansion.

ENTREPRENEURIAL DECISION A1 A2 P3

BTN 2-6 Angel Martin is a young entrepreneur who operates Martin Music Services, offering singing lessons and instruction on musical instruments. Martin wishes to expand but needs a $30,000 loan. The bank requests that Martin prepare a balance sheet and key financial ratios. Martin has not kept formal records but is able to provide the following accounts and their amounts as of December 31.

ENTREPRENEURIAL DECISION A1 A2 P3

Cash . . . . . . . . . . . . . . . . . . $ 3,600 Accounts receivable . . . . . . $ 9,600 Prepaid insurance . . . . . . . $ 1,500 Prepaid rent . . . . . . . . . . . . 9,400 Store supplies . . . . . . . . . . . 6,600 Equipment . . . . . . . . . . . . . 50,000 Accounts payable . . . . . . . 2,200 Unearned lesson fees . . . . . 15,600 Total equity* . . . . . . . . . . . . 62,900 Annual net income . . . . . . . 40,000

*The total equity amount reflects all owner investments, dividends, revenues, and expenses as of December 31.

Required

1. Prepare a balance sheet as of December 31 for Martin Music Services. (Report only the total equity amount on the balance sheet.)

2. Compute Martin’s debt ratio and its return on assets (the latter ratio is defined in Chapter 1). Assume average assets equal its ending balance.

3. Do you believe the prospects of a $30,000 bank loan are good? Why or why not?

BTN 2-7 Obtain a recent copy of the most prominent newspaper distributed in your area. Research the classified section and prepare a report answering the following questions (attach relevant printouts to your report). Alternatively, you may want to search the web for the required information. One suitable website is CareerOneStop (CareerOneStop.org). For documentation, print copies of websites accessed. 1. Identify the number of listings for accounting positions and the various accounting job titles. 2. Identify the number of listings for other job titles, with examples, that require or prefer accounting

knowledge/experience but are not specifically accounting positions. 3. Specify the salary range for the accounting and accounting-related positions if provided. 4. Indicate the job that appeals most to you, the reason for its appeal, and its requirements.

HITTING THE ROAD C1

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Learning Objectives

CONCEPTUAL C1 Explain the importance of periodic

reporting and the role of accrual accounting.

C2 Identify steps in the accounting cycle.

C3 Explain and prepare a classified balance sheet.

ANALYTICAL A1 Compute profit margin and describe its

use in analyzing company performance.

A2 Compute the current ratio and describe what it reveals about a company’s financial condition.

P6 Prepare financial statements from an adjusted trial balance.

P7 Describe and prepare closing entries.

P8 Explain and prepare a post-closing trial balance.

P9 Appendix 3A—Explain the alternatives in accounting for prepaids.

P10 Appendix 3B—Prepare a work sheet and explain its usefulness.

P11 Appendix 3C—Prepare reversing entries and explain their purpose.

PROCEDURAL P1 Prepare adjusting entries for deferral of

expenses.

P2 Prepare adjusting entries for deferral of revenues.

P3 Prepare adjusting entries for accrued expenses.

P4 Prepare adjusting entries for accrued revenues.

P5 Explain and prepare an adjusted trial balance.

Chapter Preview

3 Adjusting Accounts for Financial Statements

NTK 3-4

ACCRUED REVENUE

P4 Framework Examples

Summary

NTK 3-3

ACCRUED EXPENSE

P3 Framework Examples

NTK 3-2

DEFERRAL OF REVENUE

P2 Framework Examples

DEFERRAL OF EXPENSE

C1 Timing Accrual vs. cash

3-Step process

P1 Framework Examples

NTK 3-1 NTK 3-5, 6

REPORTING

P5 Adjusted trial balance

P6 Financial statements

P7 Closing process

P8 Post-closing trial balance

NTK 3-7

CLASSIFICATION AND ANALYSIS

C2 Accounting cycle C3 Classified

balance sheet

A1 Profit margin A2 Current ratio

85

“Creativity creates value”—Evan Spiegel

Snap!

VENICE, CA—Evan Spiegel met his future co-founder Bobby Murphy in college. “We weren’t cool,” recalls Bobby, “so we tried to build things to be cool!” One of their cool projects was an app that could send messages that disappeared after a few seconds. This app would later be called Snapchat (Snapchat.com).

The first headquarters of Snapchat was the home of Evan’s dad. However, within a matter of months, their app had over a million users.

As Snapchat grew, Evan and Bobby knew an effective ac- counting system was key to attracting investors. “One of the things I did underestimate,” admits Evan, “was how much more important communication becomes [when seeking investors].”

Investors wanted to know revenues, costs, assets, and liabilities for Snapchat. “You really need to explain . . . how your business works,” insists Evan.

To communicate “the Snap story,” the entrepreneurs learned how to defer and accrue revenues and expenses and to prepare financial statements for investors. This included learning the

accounting cycle. With accounting reports in hand, Evan and Bobby were able to secure additional financing. Exclaims Evan: “That was the greatest feeling of all time!”

Sources: Snapchat website, January 2019; Vanity Fair, October 2017; LA Times, March 2017; Forbes, January 2014

The Accounting Period The value of information is linked to its timeliness. Useful information must reach decision makers frequently. To provide timely information, accounting systems prepare reports at regular intervals. The time period assumption presumes that an organization’s activities can be divided into specific time periods such as a month, a three-month quarter, a six- month interval, or a year. Exhibit 3.1 shows various accounting, or reporting, periods. Most organizations use a year as their primary accounting period. Reports covering a one-year period are known as annual finan- cial statements. Many organizations also prepare interim financial statements covering one, three, or six months of activity.

TIMING AND REPORTING

C1 Explain the importance of periodic reporting and the role of accrual accounting.

$0 2019 2018 2017 2016 2015

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

Apple

“Apple announces annual income of . . .”

Jan. Mar. May June July Aug. Sept. Oct. Nov. TimeDec.

1

1 2 3 4

2 3 4 5 6 7 8 9 10 11 12 Monthly

Quarterly

1 2 Semiannually

1 Annually

Feb. Apr.

EXHIBIT 3.1 Accounting Periods

The annual reporting period is not always a calendar year ending on December 31. An organization can use a fiscal year consisting of any 12 consecutive months or 52 weeks. For example, Gap’s fiscal year consistently ends the final week of January or the first week of February each year.

©J. Emilio Flores/Corbis/Getty Images

86 Chapter 3 Adjusting Accounts for Financial Statements

Companies with little seasonal variation in sales often use the calendar year as their fiscal year. Facebook uses calendar-year reporting. Companies that have seasonal variations in sales often use a natural business year end, which is when sales are at their lowest level for the year. The natural business year for retailers such as Target and Dick’s Sporting Goods ends around January 31, after the holidays.

Accrual Basis versus Cash Basis After external transactions and events are recorded, several accounts require adjustments before their balances appear in financial statements. This is needed because internal transactions and events are not yet recorded. Accrual basis accounting records revenues when services and products are delivered and

records expenses when incurred (matched with revenues). Cash basis accounting records revenues when cash is received and records expenses when

cash is paid. Cash basis income is cash receipts minus cash payments.

Most agree that accrual accounting better reflects business performance than cash basis accounting. Accrual accounting also increases the comparability of financial statements from period to period.

Accrual Basis To compare these two systems, let’s consider FastForward’s Prepaid Insurance account. FastForward paid $2,400 for 24 months of insurance coverage that began on December 1, 2019. Accrual accounting requires that $100 of insurance expense be reported each month, from December 2019 through November 2021. (This means expenses are $100 in 2019, $1,200 in 2020, and $1,100 in 2021.) Exhibit 3.2 shows this allocation of insurance cost across the three years. Any unexpired premium is reported as a Prepaid Insurance asset on the accrual basis balance sheet.

©Vixit/Shutterstock

Insurance Expense 2021 Jan

$100

May $100

Sept $100

Feb $100

June $100

Oct $100

Mar $100

July $100

Nov $100

Apr $100

Aug $100

Dec $0

Insurance Expense 2019

2019 2020 2021

Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $100

Insurance Expense 2020 Jan

$100

May $100

Sept $100

Feb $100

June $100

Oct $100

Mar $100

July $100

Nov $100

Apr $100

Aug $100

Dec $100

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2019

Transaction:

EXHIBIT 3.2 Accrual Accounting for Allocating Prepaid Insurance to Expense

Cash Basis A cash basis income statement for December 2019 reports insurance ex- pense of $2,400, as shown in Exhibit 3.3. The cash basis income statements for years 2020 and 2021 report no insurance expense. The cash basis balance sheet never reports a prepaid insurance asset because it is immediately expensed. Also, cash basis income for 2019–2021 does not match the cost of insurance with the insurance benefits received for those years and months.

Insurance Expense 2021 Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $0

Insurance Expense 2020 Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $0

Insurance Expense 2019 Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $2,400

2019 2020 2021

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2019

Transaction:

EXHIBIT 3.3 Cash Accounting for Allocating Prepaid Insurance to Expense

Recognizing Revenues and Expenses We divide a company’s activities into time periods, but not all activities are complete when financial statements are prepared. Thus, adjustments are required to get proper account balances.

Point: Annual income statements for Exhibit 3.3 follow: Cash Basis 2019 2020 2021

Revenues . . . . . . . $ # $# $# Insurance exp . . . . $2,400 $0 $0

Point: Annual income statements for Exhibit 3.2 follow: Accrual Basis 2019 2020 2021

Revenues . . . . . . . $ # $ # $ # Insurance exp . . . . $100 $1,200 $1,100

Chapter 3 Adjusting Accounts for Financial Statements 87

We use two principles in the adjusting process: revenue recognition and expense recognition. Revenue recognition principle requires that revenue be recorded when goods or services

are provided to customers and at an amount expected to be received from customers. Adjustments ensure revenue is recognized (reported) in the time period when those services and products are provided.

Expense recognition (or matching) principle requires that expenses be recorded in the same accounting period as the revenues that are recognized as a result of those expenses.

Point: Recording revenue early overstates current-period income; recording it late understates current-period income.

Point: Recording expense early understates current-period in- come; recording it late overstates current-period income.

Framework for Adjustments Four types of adjustments exist for transactions and events that extend over more than one period.

Deferral of expense Deferral of revenue Accrued expense Accrued revenue

Adjustments are made using a 3-step process, as shown in Exhibit 3.4.

Clawbacks from Accounting Fraud Former executives at Saba Software, a cloud-based talent management sys- tem, were charged with accounting fraud by the SEC for falsifying revenue to boost income. This alleged overstate- ment of income led to a payback of millions of dollars to the company by the former CEO and former CFO. See SEC release 2015–28. ■

Ethical Risk

©Marco Marchi/Getty Images

Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2.

EXHIBIT 3.4 Three-Step Process for Adjusting Entries

Each adjusting entry made at the end of an accounting period reflects a transaction or event that is not yet recorded. An adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never the Cash account).

Prepaid expenses, or deferred expenses, are assets paid for in advance of receiving their bene- fits. When these assets are used, those advance payments become expenses.

Framework Adjusting entries for prepaid expenses increase expenses and decrease assets, as shown in the T-accounts of Exhibit 3.5. This adjustment shows the using up of prepaid ex- penses. To demonstrate accounting for pre- paid expenses, we look at prepaid insurance, supplies, and depreciation. In each case we decrease an asset (balance sheet) account and increase an expense (income statement) account.

Prepaid Insurance Prepaid insurance expires with time. We use our three-step process.

Step 1: We determine that the current balance of FastForward’s prepaid insurance is equal to its $2,400 payment for 24 months of insurance benefits that began on December 1, 2019. Step 2: As time passes, the benefits of the insurance gradually expire and a portion of the Prepaid Insurance asset becomes expense. For instance, one month’s insurance coverage expires by December 31, 2019. This expense is $100, or 1/24 of $2,400, which leaves $2,300.

DEFERRAL OF EXPENSE P1 Prepare adjusting entries for deferral of expenses.

Asset

Unadjusted balance

overstated

Expense

Dr. Expense… # Cr. Asset….. #

Decrease it Increase it EXHIBIT 3.5 Adjusting for Prepaid Expenses (decrease an asset and record an expense)

Insurance Dec. 1 Pay insurance premium and record asset Prepaid Insurance....... 2,400 Cash......................... 2,400

Dec. 31 Coverage expires and record expense

Two-Year Insurance Policy Total cost is $2,400 Monthly cost is $100

88 Chapter 3 Adjusting Accounts for Financial Statements

Supplies We count supplies at period-end and make an adjusting entry.

Step 1: FastForward purchased $9,720 of supplies in December, some of which were used during that same month. When financial statements are prepared at December 31, the cost of supplies used during December is expensed. Step 2: When FastForward computes (physically counts) its remaining unused supplies at December 31, it finds $8,670 of supplies remaining of the $9,720 total supplies. The $1,050 difference between these two amounts is December’s supplies expense. Step 3: The adjusting entry to record this expense and reduce the Supplies asset account, along with T-account postings, follows.

Step 3: The adjusting entry to record this expense and reduce the asset, along with T-account postings, follows.

Explanation After adjusting and posting, the $100 balance in Insurance Expense and the $2,300 balance in Prepaid Insurance are ready for reporting in financial statements. Not making the adjustment on or before December 31 would Understate expenses by $100 for the December income statement. Overstate prepaid insurance (assets) by $100 in the December 31 balance sheet.

The following highlights the adjustment for prepaid insurance.

Prepaid Insurance = $2,400

Reports $2,400 policy for 24 months’ coverage .

Deduct $100 from Prepaid Insurance Add $100 to Insurance Expense

Record current month’s $100 insurance expense and $100 reduction in prepaid .

Prepaid Insurance = $2,300

Reports $2,300 in coverage for remaining 23 months .

Before Adjustment Adjustment After Adjustment

Supplies Dec. 2,6,26 Purchase supplies and record asset

Dec. 31 Physical count Dec. 31 Record expense

Explanation The balance of the Supplies account is $8,670 after posting—equaling the cost of the remaining supplies. Not making the adjustment on or before December 31 would Understate expenses by $1,050 for the December income statement. Overstate supplies by $1,050 in the December 31 balance sheet.

Assets = Liabilities + Equity −100 −100

Adjustment (a) Dec . 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Record first month’s expired insurance.

Dec. 31 100

Insurance Expense 637

Dec . 1 2,400

Balance 2,300

Dec. 31 100

Prepaid Insurance 128

Assets = Liabilities + Equity −1,050 −1,050

Adjustment (b) Dec . 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Record supplies used.

Dec. 31 1,050

Supplies Expense 652

Dec . 2 2,500

6 7,100

26 120

Balance 8,670

Dec. 31 1,050

Supplies 126

Chapter 3 Adjusting Accounts for Financial Statements 89

The following highlights the adjustment for supplies.

Supplies = $9,720

Reports $9,720 in supplies .

Deduct $1,050 from Supplies Add $1,050 to Supplies Expense

Record $1,050 in supplies used and $1,050 as supplies expense .

Supplies = $8,670

Reports $8,670 in supplies .

Before Adjustment Adjustment After Adjustment

Other Prepaid Expenses Other prepaid expenses, such as Prepaid Rent and Prepaid Advertising, are accounted for exactly as insurance and supplies are.

Some prepaid expenses are both paid for and fully used up within a single period. One exam- ple is when a company pays monthly rent on the first day of each month. In this case, we record the cash paid with a debit to Rent Expense instead of an asset account.

Investor A publisher signs an Olympic skier to write a book. The company pays the skier $500,000 to sign plus future book royalties. A note to the company’s financial statements says that “prepaid expenses include $500,000 in author signing fees to be matched against future expected sales.” How does this affect your analysis? ■ Answer: Prepaid expenses are assets paid for in advance of receiving their benefits–they are expensed as they are used up. As an investor, you are concerned about the risk of future book sales. The riskier the likelihood of future book sales is, the more likely your analysis is to treat the $500,000, or a portion of it, as an expense, not a prepaid expense (asset).

Decision Maker

©Don Hammond/Design Pics

Depreciation A special category of prepaid expenses is plant assets, which are long-term tangible assets used to produce and sell products and services. Plant assets provide benefits for more than one period. Examples of plant assets are buildings, machines, vehicles, and fixtures. All plant assets (exclud- ing land) eventually wear out or become less useful. The costs of plant assets are gradually reported as expenses in the income statement over the assets’ useful lives (benefit periods). Depreciation is the allocation of the costs of these assets over their expected useful lives. Depre- ciation expense is recorded with an adjusting entry similar to that for other prepaid expenses.

Step 1: FastForward purchased equipment for $26,000 in early December to use in earning revenue. This equipment’s cost must be depreciated. Step 2: The equipment is expected to have a useful life (benefit period) of five years and to be worth about $8,000 at the end of five years. This means the net cost of this equipment over its useful life is $18,000 ($26,000 − $8,000). FastForward depreciates it using straight-line depreciation, which allocates equal amounts of the asset’s net cost to depreciation during its useful life. Dividing the $18,000 net cost by the 60 months (5 years) in the asset’s useful life gives a monthly cost of $300 ($18,000∕60). Step 3: The adjusting entry to record monthly depreciation expense, along with T-account postings, follows.

Point: Plant assets are also called Plant & Equipment or Property, Plant & Equipment (PP&E ).

Point: Depreciation does not necessarily measure decline in market value.

Point: An asset’s expected value at the end of its useful life is called salvage value.

Depreciation Dec. 3 Purchase equipment and record asset Equipment........... 26,000 Cash................ 26,000

Dec. 31 Allocate asset cost and record depreciation

Explanation After posting the adjustment, the Equipment account ($26,000) minus its Accumulated Depreciation ($300) account equals the $25,700 net cost. The $300 balance in the

Assets = Liabilities + Equity −300 −300

Adjustment (c) Dec . 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Accumulated Depreciation—Equipment . . . . . . . . . . . . 300

Record monthly equipment depreciation.

Dec. 31 300

Depreciation Expense—Equipment 612

Dec . 3 26,000

Equipment 167

Dec. 31 300

Accumulated Depreciation—Equipment 168

90 Chapter 3 Adjusting Accounts for Financial Statements

Depreciation Expense account is reported in the December income statement. Not making the adjustment at December 31 would Understate expenses by $300 for the December income statement. Overstate assets by $300 in the December 31 balance sheet.

The following highlights the adjustment for depreciation.

Equipment, net = $26,000

Reports $26,000 in equipment .

Deduct $300 from Equipment, net Add $300 to Depreciation Expense

Record $300 in depreciation and $300 as accumulated depreciation .

Equipment, net = $25,700

Reports $25,700 in equipment, net of accumulated depreciation .

Before Adjustment Adjustment After Adjustment

Dec . 3 26,000

Equipment 167 Accumulated Depreciation—Equipment 168

Dec . 31 300

Jan . 31 300

Feb . 28 300

Balance 900

EXHIBIT 3.6 Accounts after Three Months of Depreciation Adjustments

Accumulated Depreciation is a separate contra account. A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance. FastForward’s contra account of Accumulated Depreciation— Equipment is subtracted from the Equipment account in the balance sheet.

The Accumulated Depreciation contra account includes total depreciation expense for all prior periods for which the asset was used. To demonstrate, on February 28, 2020, after three months of adjusting entries, the Equipment and Accumulated Depreciation accounts appear as in Exhibit 3.6. The $900 balance in the Accumulated Depreciation account is subtracted from its related $26,000 asset cost. The difference ($25,100) between these two balances is called book value, or net amount, which is the asset’s costs minus its accumulated depreciation.

Point: Accumulated Depreciation has a normal credit balance; it decreases the asset’s reported value.

Point: The net cost of equipment is also called depreciable basis.

These account balances are reported in the assets section of the February 28 balance sheet in Exhibit 3.7. This presentation shows the full cost of assets and accumulated depreciation.

EXHIBIT 3.7 Equipment and Accumulated Depreciation on February 28 Balance Sheet

Assets (at February 28, 2020)

Cash $ .... Equipment $26,000 Less accumulated depreciation 900 25,100 Total Assets $

Commonly titled Equipment, net

For each separate case below, follow the three-step process for adjusting the prepaid asset account at December 31. Assume no other adjusting entries are made during the year.

1. Prepaid Insurance. The Prepaid Insurance account has a $5,000 debit balance to start the year, and no insurance payments were made during the year. A review of insurance policies shows that $1,000 of unexpired insurance remains at its December 31 year-end.

2. Prepaid Rent. On October 1 of the current year, the company prepaid $12,000 for one year of rent for facilities being occupied from that day forward. The company debited Prepaid Rent and credited Cash for $12,000. December 31 year-end statements must be prepared.

3. Supplies. The Supplies account has a $1,000 debit balance to start the year. Supplies of $2,000 were purchased during the current year and debited to the Supplies account. A December 31 physical count shows $500 of supplies remaining.

Prepaid Expenses

NEED-TO-KNOW 3-1

P1

Chapter 3 Adjusting Accounts for Financial Statements 91

4. Accumulated Depreciation. The company has only one fixed asset (equipment) that it purchased at the start of this year. That asset had cost $38,000, had an estimated life of 10 years, and is expected to be valued at $8,000 at the end of the 10-year life. December 31 year-end statements must be prepared.

Solution

1. Step 1: Prepaid Insurance equals $5,000 (before adjustment) Step 2: Prepaid Insurance should equal $1,000 (the unexpired part) Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Record expired insurance coverage ($5,000 − $1,000).

Dec . 31 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Record expired prepaid rent. *$12,000 − $3,000 = $9,000, where $3,000 is from: ($12,000∕12 months) × 3 months

2. Step 1: Prepaid Rent equals $12,000 (before adjustment) Step 2: Prepaid Rent should equal $9,000 (the unexpired part)* Step 3: Adjusting entry to get from step 1 to step 2

3. Step 1: Supplies equal $3,000 (from $1,000 + $2,000; before adjustment) Step 2: Supplies should equal $500 (what’s left) Step 3: Adjusting entry to get from step 1 to step 2*

4. Step 1: Accumulated Depreciation equals $0 (before adjustment) Step 2: Accumulated Depreciation should equal $3,000 (after current-period depreciation of $3,000)* Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Depreciation Expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Record depreciation for period. *($38,000 − $8,000)∕10 years Do More: QS 3-5, QS 3-6,

QS 3-7, QS 3-8, QS 3-9

Unearned revenue is cash received in advance of providing products and services. Unearned revenues, or deferred revenues, are liabilities. When cash is accepted, an obligation to provide products or services is accepted.

Framework As products or services are provided, the liability decreases and the unearned revenues become earned reve- nues. Adjusting entries for unearned reve- nue decrease the unearned revenue (balance sheet) account and increase the revenue (income statement) account, as shown in Exhibit 3.8.

DEFERRAL OF REVENUE P2 Prepare adjusting entries for deferral of revenues.

Point: To defer is to postpone. We postpone reporting amounts received as revenues until the product or service is provided.

Dr. Liability….. # Cr. Revenue… #

Liability Revenue

Decrease it Increase it EXHIBIT 3.8 Adjusting for Unearned Revenues (decrease a liability and record revenue)

Dec . 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Record supplies used. *$1,000 + $2,000 purchased − $ 2,500 supplies used = $500 remaining

92 Chapter 3 Adjusting Accounts for Financial Statements

Unearned revenues are common in sporting and concert events. When the Boston Celtics receive cash from advance ticket sales, they record it in an unearned revenue account called Deferred Game Revenues. The Celtics record revenue as games are played.

Unearned Consulting Revenue FastForward has unearned revenues. The company agreed on December 26 to provide consult- ing services to a client for 60 days for a fixed fee of $3,000.

Step 1: On December 26, the client paid the 60-day fee in advance, covering the period December 27 to February 24. The entry to record the cash received in advance is

This advance payment increases cash and creates a liability to do consulting work over the next 60 days (5 days this year and 55 days next year). Step 2: As time passes, FastForward earns this payment through consulting. By December 31, it has provided five days’ service and earned 5∕60 of the $3,000 unearned revenue. This amounts to $250 ($3,000 × 5∕60). The revenue recognition principle requires that $250 of unearned revenue be reported as revenue on the December income statement. Step 3: The adjusting entry to reduce the liability account and recognize earned revenue, along with T-account postings, follows.

Unearned Revenues

Thanks for cash in advance. I’ll work now

through Feb. 24

Dec. 26 Cash received in advance and record liability

Dec. 31 Provided 5 days of services and record revenue

Assets = Liabilities + Equity +3,000 +3,000

Dec . 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . 3,000

Received advance payment for services over the next 60 days.

Explanation The adjusting entry transfers $250 from unearned revenue (a liability account) to a revenue account. Not making the adjustment Understates revenue by $250 in the December income statement. Overstates unearned revenue by $250 on the December 31 balance sheet.

The following highlights the adjustment for unearned revenue.

Unearned Consulting Revenue = $3,000

Reports $3,000 in unearned revenue for consulting services promised for

60 days ($50 per day) .

Deduct $250 from Unearned Consulting Revenue

Add $250 to Consulting Revenue

Record 5 days of earned consulting revenue, which is 5∕60 of

unearned amount .

Unearned Consulting Revenue = $2,750

Reports $2,750 in unearned revenue for consulting services owed over next

55 days (55 days × $50 = $2,750) .

Before Adjustment Adjustment After Adjustment

Assets = Liabilities + Equity −250 +250

Adjustment (d) Dec . 31 Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . . 250

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Record earned revenue that was received in advance ($3,000 × 5∕60).

Dec . 5 4,200

12 1,600

31 250

Balance 6,050

Consulting Revenue 403

Dec. 31 250 Dec . 26 3,000

Balance 2,750

Unearned Consulting Revenue 236

Chapter 3 Adjusting Accounts for Financial Statements 93

For each separate case below, follow the three-step process for adjusting the unearned revenue liability account at December 31. Assume no other adjusting entries are made during the year.

a. Unearned Rent Revenue. The company collected $24,000 rent in advance on September 1, debiting Cash and crediting Unearned Rent Revenue. The tenant was paying 12 months’ rent in advance and moved in on September 1.

b. Unearned Services Revenue. The company charges $100 per month to spray a house for insects. A customer paid $600 on November 1 in advance for six treatments, which was recorded with a debit to Cash and a credit to Unearned Services Revenue. At year-end, the company has applied two treatments for the customer.

Solution

a. Step 1: Unearned Rent Revenue equals $24,000 (before adjustment) Step 2: Unearned Rent Revenue should equal $16,000 (current-period earned revenue is $8,000*) Step 3: Adjusting entry to get from step 1 to step 2

Unearned Revenues

NEED-TO-KNOW 3-2

P2

b. Step 1: Unearned Services Revenue equals $600 (before adjustment) Step 2: Unearned Services Revenue should equal $400 (current-period earned revenue is $200*) Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Unearned Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . 200

Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Record earned portion of revenue received in advance. *$100 × 2 treatments = Services revenue Do More: QS 3-10, QS 3-11

Dec . 31 Unearned Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Record earned portion of rent received in advance. *($24,000∕12 months) × 4 months’ rental usage

Accrued expenses are costs that are incurred in a period that are both unpaid and unrecorded. Accrued expenses are reported on the income statement for the period when incurred.

Framework Adjusting entries for recording accrued expenses increase the expense (income statement) account and increase a liability (balance sheet) account, as shown in Exhibit 3.9. This adjustment recognizes expenses in- curred in a period but not yet paid. Common examples of accrued expenses are salaries, interest, rent, and taxes. We use salaries and interest to show how to adjust accounts for accrued expenses.

Accrued Salaries Expense FastForward’s employee earns $70 per day, or $350 for a five-day workweek beginning on Monday and ending on Friday. Step 1: Its employee is paid every two weeks on Friday. On December 12 and 26, the wages are paid, recorded in the journal, and posted to the ledger. Step 2: The calendar in Exhibit 3.10 shows three working days after the December 26 payday (29, 30, and 31). This means the employee has earned three days’ salary by the close of business on Wednesday, December 31, yet this salary cost has not been paid or recorded. FastForward must report the added expense and liability for unpaid salary from December 29, 30, and 31.

ACCRUED EXPENSE

Point: Accrued expenses are also called accrued liabilities.

Dr. Expense….. # Cr. Liability… #

Expense Liability

Increase it Increase it EXHIBIT 3.9 Adjusting for Accrued Expenses (increase a liability and record an expense)

P3 Prepare adjusting entries for accrued expenses.

94 Chapter 3 Adjusting Accounts for Financial Statements

Step 3: The adjusting entry for accrued salaries, along with T-account postings, follows.

PaydayPaydaySalary expense incurred

Pay period begins

S M T W T F S 1 2 3 4 5 6

7 8 9 10 11 12 13

14 15 16 17 18 19 20

21 22 23 24 25 26 27

28 29 30 31

S M T W T F S 1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 27 28 29 30 31

December January

EXHIBIT 3.10 Salary Accrual and Paydays

Salaries Payable = $0

Reports $0 from employee salaries incurred but not yet paid in cash .

Add $210 to Salaries Payable Add $210 to Salaries Expense

Record 3 days’ salaries owed, but not yet paid, at $70 per day .

Salaries Payable = $210

Reports $210 salaries payable to employee but not yet paid .

Before Adjustment Adjustment After Adjustment

Explanation Salaries expense of $1,610 is reported on the December income statement, and $210 of salaries payable (liability) is reported in the balance sheet. Not making the adjustment Understates salaries expense by $210 in the December income statement. Understates salaries payable by $210 on the December 31 balance sheet.

The following highlights the adjustment for salaries incurred.

Accrued Interest Expense Companies accrue interest expense on notes payable (loans) and other long-term liabilities at the end of a period. Interest expense is incurred as time passes. Unless interest is paid on the last day of an accounting period, we need to adjust for interest expense incurred but not yet paid. This means we must accrue interest cost from the most recent payment date up to the end of the period. The formula for computing accrued interest is

Principal amount owed × Annual interest rate × Fraction of year since last payment

If a company has a $6,000 loan from a bank at 5% annual interest, then 30 days’ accrued interest expense is $25—computed as $6,000 × 0.05 × 30∕360. The adjusting entry debits Interest Expense for $25 and credits Interest Payable for $25.

Future Cash Payment of Accrued Expenses Accrued expenses at the end of one accounting period result in cash payment in a future period(s). Recall that FastForward recorded accrued salaries of $210. On January 9, the first

Point: Interest computations use a 360-day year, called the bankers’ rule.

Assets = Liabilities + Equity +210 −210

Adjustment (e) Dec . 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Record three days’ accrued salary (3 × $70).

Dec . 12 700

26 700

31 210

Balance 1,610

Salaries Expense 622

Dec. 31 210

Salaries Payable 209

©Plus One Pix/Alamy Stock Photo

Chapter 3 Adjusting Accounts for Financial Statements 95

payday of the next period, the following entry settles the accrued liability (salaries payable) and records salaries expense for seven days of work in January.

The $210 debit is the payment of the liability for the three days’ salary accrued on December 31. The $490 debit records the salary for January’s first seven working days (including the New Year’s Day holiday) as an expense of the new accounting period. The $700 credit records the total amount of cash paid to the employee.

For each separate case below, follow the three-step process for adjusting the accrued expense account at December 31. Assume no other adjusting entries are made during the year.

a. Salaries Payable. At year-end, salaries expense of $5,000 has been incurred by the company but is not yet paid to employees.

b. Interest Payable. At its December 31 year-end, the company holds a mortgage payable that has incurred $1,000 in annual interest that is neither recorded nor paid. The company intends to pay the interest on January 3 of the next year.

Solution

a. Step 1: Salaries Payable equals $0 (before adjustment) Step 2: Salaries Payable should equal $5,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Accrued Expenses

NEED-TO-KNOW 3-3

P3

b. Step 1: Interest Payable equals $0 (before adjustment) Step 2: Interest Payable should equal $1,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Record employee salaries earned but not yet paid.

Do More: QS 3-12, QS 3-13

Dec . 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Record interest incurred but not yet paid.

Accrued revenues are revenues earned in a period that are both unrecorded and not yet received in cash (or other assets). An example is a technician who bills customers after the job is done. If one-third of a job is complete by the end of a period, then the technician must record one-third of the expected billing as revenue in that period—even though there is no billing or collection.

Framework The adjusting entries for ac- crued revenues increase a revenue (income statement) account and increase an asset (balance sheet) account, as shown in Exhibit 3.11. Accrued revenues usually come from services, products, interest, and rent. We use service fees and interest to show how to adjust for accrued revenues.

ACCRUED REVENUE P4 Prepare adjusting entries for accrued revenues.

Point: Accrued revenues are also called accrued assets.

Dr. Asset…........ # Cr. Revenue… #

Asset Revenue

Increase it Increase it EXHIBIT 3.11 Adjusting for Accrued Revenues (increase an asset and record revenue)

Jan . 9 Salaries Payable (3 days at $70 per day) . . . . . . . . . . . . . . . . 210

Salaries Expense (7 days at $70 per day) . . . . . . . . . . . . . . . . 490

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Paid two weeks’ salary including three days accrued.

Assets = Liabilities + Equity −700 −210 −490

96 Chapter 3 Adjusting Accounts for Financial Statements

Accrued Services Revenue Accrued revenues are recorded when adjusting entries are made at the end of the accounting period. These accrued revenues are earned but unrecorded because either the buyer has not yet paid or the seller has not yet billed the buyer. FastForward provides an example.

Step 1: In the second week of December, FastForward agreed to provide 30 days of con- sulting services to a fitness club for a fixed fee of $2,700 (or $90 per day). FastForward will provide services from December 12 through January 10, or 30 days of service. The club agrees to pay FastForward $2,700 on January 10 when the service is complete. Step 2: At December 31, 20 days of services have already been provided. Because the con- tracted services have not yet been entirely provided, FastForward has neither billed the club nor recorded the services already provided. Still, FastForward has earned two-thirds of the 30-day fee, or $1,800 ($2,700 × 20∕30). The revenue recognition principle requires FastForward to report the $1,800 on the December income statement. The balance sheet reports that the club owes FastForward $1,800. Step 3: The adjusting entry for accrued services, along with T-account postings, follows.

Accrued Revenues

Jan. 10 Receive cash and reduce receivable

Dec. 31 Record revenue and receivable for services provided but unbilled

Pay me when I'm done

Explanation Accounts receivable are reported on the balance sheet at $1,800, and the $7,850 total of consulting revenue is reported on the income statement. Not making the adjustment Understates consulting revenue by $1,800 in the December income statement. Understates accounts receivable by $1,800 on the December 31 balance sheet.

The following highlights the adjustment for accrued revenue.

Example: What is the adjusting entry if the 30-day consulting period began on December 22? Answer: One-third of the fee is earned: Accounts Receivable . . . . . . . . 900 Consulting Revenue . . . . . . 900

Accounts Receivable = $0

Reports $0 from revenue earned but not yet received in cash .

Add $1,800 to Accounts Receivable Add $1,800 to Consulting Revenue

Record 20 days of earned revenue, which is 20∕30 of total contract .

Accounts Receivable = $1,800

Reports $1,800 in accounts receivable from services provided .

Before Adjustment Adjustment After Adjustment

Accrued Interest Revenue If a company is holding notes receivable that produce interest revenue, we must adjust the accounts to record any earned and yet uncollected interest revenue. The adjusting entry is similar to the one for accruing services revenue. Specifically, debit Interest Receivable (asset) and credit Interest Revenue.

Future Cash Receipt of Accrued Revenues Accrued revenues at the end of one accounting period result in cash receipts in a future period(s). Recall that FastForward made an adjusting entry for $1,800 to record 20 days’ accrued revenue earned from its consulting contract. When FastForward receives $2,700 cash on January 10 for the entire contract amount, it makes the following entry to remove the accrued asset (accounts receivable) and record revenue earned in January. The $2,700 debit is the cash received. The $1,800 credit is the removal of the receivable, and the $900 credit is revenue earned in January.

Assets = Liabilities + Equity +1,800 +1,800

Adjustment (f ) Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Record 20 days’ accrued revenue.

Dec . 12 1,900

31 1,800

Balance 1,800

Dec . 22 1,900

Accounts Receivable 106

Dec . 5 4,200

12 1,600

31 250

31 1,800

Balance 7,850

Consulting Revenue 403

Chapter 3 Adjusting Accounts for Financial Statements 97

Loan Officer The owner of a home theater store applies for a business loan. The store’s financial statements reveal large increases in current-year revenues and income. Increases are due to a promotion that let consumers buy now and pay nothing until January 1 of next year. The store recorded these sales as accrued revenue. Does your analysis raise any concerns? ■ Answer: While increased revenues and income are fine, your concern is with collectibility of these promotional sales. If the store sold products to customers with poor records of paying bills, then collectibility of these sales is low. Your analysis must assess this possibility and estimate losses.

Decision Maker

For each separate case below, follow the three-step process for adjusting the accrued revenue account at December 31. Assume no other adjusting entries are made during the year.

a. Accounts Receivable. At year-end, the company has completed services of $1,000 for a client, but the client has not yet been billed for those services.

b. Interest Receivable. At year-end, the company has earned, but not yet recorded, $500 of interest earned from its investments in government bonds.

Solution

a. Step 1: Accounts Receivable equals $0 (before adjustment) Step 2: Accounts Receivable should equal $1,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Accrued Revenues

NEED-TO-KNOW 3-4

P4

Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Record services revenue earned but not yet received.

b. Step 1: Interest Receivable equals $0 (before adjustment) Step 2: Interest Receivable should equal $500 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Do More: QS 3-3, QS 3-14

Dec . 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Record interest earned but not yet received.

Links to Financial Statements Exhibit 3.12 summarizes the four adjustments. Each adjusting entry affects one or more income statement (revenue or expense) accounts and one or more balance sheet (asset or liability) accounts, but never the Cash account.

Jan . 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700 Accounts Receivable (20 days at $90 per day) . . . . . . . 1,800 Consulting Revenue (10 days at $90 per day) . . . . . . . 900 Received cash for accrued asset and recorded earned

consulting revenue for January.

Assets = Liabilities + Equity +2,700 +900 −1,800

©Yin Yang/Getty Images

Paid (or received) cash before expense

(or revenue) recognized

Accrued expense

Accruals

Accrued revenue

Deferral of revenue†

Deferral of expense†

Deferrals

Dr. (increase) Expense Cr. (decrease) Asset*

Dr. (decrease) Liability Cr. (increase) Revenue

Dr. (increase) Expense Cr. (increase) Liability

Dr. (increase) Asset Cr. (increase) Revenue

Adjusting Entry

*For depreciation, the credit is to Accumulated Depreciation (contra asset). †Exhibit assumes that deferred expenses are initially recorded as assets and that deferred revenues are initially recorded as liabilities.

Paid (or received) cash after expense

(or revenue) recognized

Expense understated Asset overstated

Expense understated Liability understated

Liability overstated Revenue understated

Asset understated Revenue understated

BEFORE AdjustingFour Adjustments

EXHIBIT 3.12 Summary of Adjustments and Financial Statement Links

98 Chapter 3 Adjusting Accounts for Financial Statements

Adjusted Trial Balance An unadjusted trial balance is a list of accounts and balances before adjustments are recorded. An adjusted trial balance is a list of accounts and balances after adjusting entries have been recorded and posted to the ledger.

Exhibit 3.13 shows both the unadjusted and the adjusted trial balances for FastForward at December 31, 2019. The order of accounts in the trial balance usually matches the order in the chart of accounts. Several new accounts usually arise from adjusting entries.

Each adjustment (see middle columns) has a letter that links it to an adjusting entry explained earlier. Each amount in the Adjusted Trial Balance columns is computed by taking that account’s amount from the Unadjusted Trial Balance columns and adding or subtracting any adjustment(s). To demonstrate, Supplies has a $9,720 Dr. balance in the unadjusted columns. Subtracting the $1,050 Cr. amount shown in the Adjustments columns equals an adjusted $8,670 Dr. balance for Supplies. An account can have more than one adjustment, such as for Consulting Revenue. Also, some accounts might not require adjustment for this period, such as Accounts Payable.

TRIAL BALANCE AND FINANCIAL STATEMENTS P5 Explain and prepare an adjusted trial balance.

Dr. Cr. Dr. Cr.Cr. Dr.

FASTFORWARD Trial Balances

December 31, 2019

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

(f) $1,800

(d) 250

$ 0

0

0 0

6,200

3,000 30,000

$45,300

5,800

300

0 $ 4,275

9,720 2,400

26,000

0

0

0

1,400

1,000

305 $45,300 $3,710

(c) 300 (e) 210 (a) 100

(b) 1,050

1,800 $ 4,275

8,670 2,300

26,000

300 1,610

100 1,000 1,050

305 $47,610

(b) $1,050 (a) 100

(c) 300

(e) 210

$3,710

(d) 250 (f) 1,800

$ 300 6,200

210 2,750

30,000

$47,610

7,850

300

Acct. No.

Cash Account Title

Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock

101 106 126 128 167 168 201 209 236 307 318 319 403

406 612 622 637 640 652 690

Retained earnings Dividends 200 200 Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals

EXHIBIT 3.13 Unadjusted and Adjusted Trial Balances

FASTForward

Financial Officer At year-end, the president instructs you, the financial officer, not to record accrued expenses until next year because they will not be paid until then. The president also directs you to record in current-year sales a recent purchase order from a customer that requires merchandise to be delivered two weeks after the year-end. Your company would report a net income instead of a net loss if you follow these instructions. What do you do? ■ Answer: Omitting accrued expenses and recognizing revenue early mislead financial statement users. One action is to explain to the president what is required. If the president persists, you might talk to lawyers and any auditors involved.

Decision Ethics

Information for some adjustments is not available until after the period-end. This means that some adjusting and closing entries are recorded later than, but dated as of, the last day of the period. One example is a company that receives a December utility bill on January 10. When it receives the bill, the company records the expense and the payable as of December 31. The income statement and balance sheet include these adjustments even though amounts were not known at period-end.

Chapter 3 Adjusting Accounts for Financial Statements 99

Preparing Financial Statements We can prepare financial statements directly from information in the adjusted trial balance. Exhibit 3.14 shows how revenue and expense balances are transferred from the adjusted trial balance to the income statement (red lines). The net income and dividends amounts are then used to prepare the statement of retained earnings (black lines). Asset and liability balances are

Steps to Prepare Financial Statements Prepare income statement using revenue and expense accounts from trial balance

Prepare balance sheet using asset and liability accounts along with common stock from trial balance; pull updated retained earnings from step 2

Prepare statement of retained earnings using retained earnings and dividends from trial balance; pull net income from step 1

Prepare statement of cash flows from changes in cash flows for the period (illustrated later in the book)

Step 1

Step 2

Step 4

Step 3

$47,610

Acct. No. Account Title Debit

8,670 2,300

1,800 $ 4,275

26,000

300 1,610

100 1,000 1,050

305

101 Cash ........................................................... Accounts receivable .............................. Supplies .................................................... Prepaid insurance .................................. Equipment ................................................ Accumulated depreciation—Equip..... Accounts payable .................................. Salaries payable .....................................

106 126 128 167 168 201 209

Unearned consulting revenue ............236

Consulting revenue ...............................403 Rental revenue ........................................ 406 Depreciation expense—Equip. ..........612 Salaries expense ....................................622 Insurance expense ................................637 Rent expense ..........................................640 Supplies expense ...................................652 Utilities expense ..................................... Totals .........................................................

690

$ 300

210 6,200

2,750 30,000

300 7,850

$47,610

Credit

Common stock ....................................... Retained earnings .................................

307 318 0

200Dividends .................................................319

Step 2 Prepare statement of retained earnings

$ 3,785

200 $3,585

3,785 Less: Dividends .................................. . . . Retained earnings, December 31 ......

Retained earnings, December 1......... Plus: Net income ................................. . . ..

0

Assets

Liabilities

Equity

Cash ..................................................... $ 4,275

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

Accounts receivable ........................ 1,800

Unearned consulting revenue ....... 2,750 Salaries payable ................................ 210

8,670 2,300

Supplies .............................................. Prepaid insurance .............................

Total assets ........................................ $ 42,745 25,700

$26,000

6,200

Equipment .......................................... 300Less accumulated depreciation......

Common stock ................................... Retained earnings .............................. Total equity ......................................... Total liabilities and equity ...............

3,585

Total liabilities ....................................... 9,160

$

30,000

$ 42,745 33,585

Step 1 Prepare income statement

Revenues Consulting revenue ............................. $7,850

300 Rental revenue ..................................... Total revenues ......................................

Depreciation expense—Equip.......... Expenses

Salaries expense................................... Insurance expense............................... Rent expense......................................... Supplies expense ................................. Utilities expense.................................... Total expenses........................................ Net income................................................

300 1,610 100

305

1,000 1,050

4,365 $3,785

$8,150

Step 3 Prepare balance sheet

FASTFORWARD Balance Sheet

December 31, 2019

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

FASTFORWARD Income Statement

For Month Ended December 31, 2019

FASTFORWARD Adjusted Trial Balance

December 31, 2019

EXHIBIT 3.14 Preparing Financial Statements (Adjusted Trial Balance from Exhibit 3.13)FASTForward

P6 Prepare financial statements from an adjusted trial balance.

100 Chapter 3 Adjusting Accounts for Financial Statements

then transferred to the balance sheet (blue lines). The ending retained earnings is computed in the statement of retained earnings and transferred to the balance sheet (green line).

We prepare financial statements in the following order: (1) income statement, (2) state- ment of retained earnings, and (3) balance sheet. This order makes sense because the balance sheet uses information from the statement of retained earnings, which in turn uses information from the income statement. The statement of cash flows is usually the final statement prepared.

Point: Each trial balance amount is used in only one financial statement.

Use the following adjusted trial balance of Magic Company to prepare its December 31 year-end (1) in- come statement, (2) statement of retained earnings, and (3) balance sheet (unclassified). The Retained Earnings account balance was $45,000 on December 31 of the prior year.Preparing Financial

Statements from a Trial Balance

NEED-TO-KNOW 3-5

P6

Do More: QS 3-22, E 3-8, P 3-4

Solution

MAGIC COMPANY Adjusted Trial Balance

December 31

Account Title Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . 33,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . 8,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $199,000 $199,000

MAGIC COMPANY Income Statement

For Year Ended December 31

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . $79,000 Expenses Salaries expense . . . . . . . . . . . . . . . . . . $56,000 Office supplies expense . . . . . . . . . . . . 8,000 Total expenses . . . . . . . . . . . . . . . . . . . . 64,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . $15,000

Step 1

MAGIC COMPANY Statement of Retained Earnings

For Year Ended December 31

Retained earnings, December 31 prior year-end . . . . . . $45,000 Add: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 60,000 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained earnings, December 31 current year-end . . . . $40,000

Step 2

MAGIC COMPANY Balance Sheet December 31

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000 Accounts receivable . . . . . . . . . . . . . . . . 17,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Total assets . . . . . . . . . . . . . . . . . . . . . . $115,000

Liabilities

Accounts payable . . . . . . . . . . . . . . . . . $ 12,000 Long-term notes payable . . . . . . . . . . . . 33,000 Total liabilities . . . . . . . . . . . . . . . . . . . . 45,000

Equity

Common stock . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . 40,000 Total equity . . . . . . . . . . . . . . . . . . . . . . . 70,000 Total liabilities and equity . . . . . . . . . . . $115,000

Step 3

The closing process occurs at the end of an accounting period after financial statements are completed. In the closing process we (1) identify accounts for closing, (2) record and post the closing entries, and (3) prepare a post-closing trial balance. The closing process has two pur- poses. First, it resets revenue, expense, and dividends account balances to zero at the end of each

CLOSING PROCESS P7 Describe and prepare closing entries.

Chapter 3 Adjusting Accounts for Financial Statements 101

period (which updates the Retained Earnings account for inclusion on the balance sheet). This is done so that these accounts can properly measure income and divi- dends for the next period. Second, it helps summarize a period’s revenues and expenses. This section explains the closing process.

Temporary and Permanent Accounts Temporary accounts relate to one accounting period. They include all income statement accounts, the dividends account, and the Income Sum- mary account. They are temporary because the accounts are opened at the beginning of a period, used to record transactions and events for that period, and then closed at the end of the period. The closing process applies only to temporary accounts.

Permanent accounts report on activities related to one or more future accounting periods. They include asset, liability, and equity accounts (all balance sheet accounts). Permanent accounts are not closed each period and carry their ending balance into future periods.

Recording Closing Entries Closing entries transfer the end-of-period balances in revenue, expense, and dividends accounts to the permanent Retained Earnings account. Closing entries are necessary at the end of each period after financial statements are prepared because Revenue, expense, and dividends accounts must begin each period with zero balances. Retained Earnings must reflect prior periods’ revenues, expenses, and dividends.

An income statement reports revenues and expenses for a specific accounting period. Divi- dends are also for a specific accounting period. Because revenue, expense, and dividends accounts record information separately for each period, they must start each period with zero balances.

Exhibit 3.15 uses the adjusted account balances of FastForward (from the Adjusted Trial Balance columns of Exhibit 3.14 or from the left side of Exhibit 3.16) to show the four steps to close its temporary accounts.

1 2 To close revenue and expense accounts, we transfer their balances to Income Summary. Income Summary is a temporary account only used for the closing process that contains a credit for total revenues (and gains) and a debit for total expenses (and losses).

Point: If Apple did not make closing entries, prior-year revenue from iPhone sales would be in- cluded with current-year revenue.

TEMPORARY

PERMANEN T

Revenues Expenses Dividends Income Summary

Temporary Accounts (closed at period-end)

Assets Liabilities Common Stock Retained Earnings

Permanent Accounts (not closed at period-end)

Consulting Revenue

Rental Revenue

Balance 7,850

Balance 300

4,365 8,150

Balance 3,785

7,850

300

Balance 200 200

Close income statement credit balances1

Close income statement debit balances2

Close Income Summary account3

Close dividends account4

Four-Step Closing Process

Balance 30,000

200 3,785

Balance 33,585

Income Summary

Dividends

Revenue Accounts

Retained Earnings

1

3

4

Expense Accounts Depreciation Expense—Equip.

Balance

Salaries Expense

Balance

Insurance Expense

Balance

Rent Expense

Balance

Supplies Expense

Balance

Utilities Expense

Balance

300

1,610

100

1,000

1,050

305

2

3,785

300

1,610

100

1,000

1,050

305

Point: Retained Earnings is the only permanent account in Exhibit 3.15— meaning it is not closed, but it does have Income Summary closed to it.

EXHIBIT 3.15 Four-Step Closing Process

102 Chapter 3 Adjusting Accounts for Financial Statements

$47,610

8,670 2,300

1,800 $ 4,275

26,000

300 1,610

100 1,000 1,050

305

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid insurance . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . . . Accumulated depreciation—Equip. . . Accounts payable . . . . . . . . . . . . . . . . .

Common stock . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . .

200Dividends . . . . . . . . . . . . . . . . . . . . . . . Consulting revenue . . . . . . . . . . . . . . . . Rental revenue . . . . . . . . . . . . . . . . . . . . Depreciation expense—Equip. . . . . . . Salaries expense . . . . . . . . . . . . . . . . . . Insurance expense . . . . . . . . . . . . . . . . Rent expense . . . . . . . . . . . . . . . . . . . . . Supplies expense . . . . . . . . . . . . . . . . . Utilities expense . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . .

FASTFORWARD Adjusted Trial Balance

December 31, 2019 Dec. 31 Consulting Revenue . . . . . . . . . . . . . . . . . Rental Revenue . . . . . . . . . . . . . . . . . . . . . Income Summary . . . . . . . . . . . . . . . . .

Close revenue accounts.

Close Income Summary account.

7,850 300

1,610

8,150

Step 1:

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . .

Salaries Expense . . . . . . . . . . . . . . . . . Depreciation Expense—Equip. . . . . .

Insurance Expense . . . . . . . . . . . . . . . Rent Expense . . . . . . . . . . . . . . . . . . . . Supplies Expense . . . . . . . . . . . . . . . . Utilities Expense . . . . . . . . . . . . . . . . .

4,365 300

100 1,000 1,050

305

Step 2:

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . .

3,785 3,785

Step 3:

$ 300 6,200

Salaries payable . . . . . . . . . . . . . . . . . . . 210 Unearned consulting revenue . . . . . . . 2,750

30,000 0

300 7,850

$47,610

Close expense accounts.

CreditDebit

Retained Earnings . . . . . . . . . . . . . . . . . . .

Close dividends account.

Dec. 31 Dividends . . . . . . . . . . . . . . . . . . . . . . .

200 200

Step 4:

General Journal

3 The Income Summary balance, which equals net income or net loss, is transferred to the Retained Earnings account.

4 The Dividends account balance is transferred to the Retained Earnings account. After closing entries are posted, the revenue, expense, dividends, and Income Summary accounts have zero bal- ances and are said to be closed or cleared.

Exhibit 3.16 shows the four closing journal entries to apply the closing process of Exhibit 3.15. EXHIBIT 3.16 Preparing Closing Entries

Step 1: Close Credit Balances in Revenue Accounts to Income Summary The first closing entry transfers credit balances in revenue (and gain) accounts to the Income Summary account. We bring accounts with credit balances to zero by debiting them. For FastForward, this is step 1 in Exhibit 3.16. The $8,150 credit entry to Income Summary equals total revenues for the period. This leaves revenue accounts with zero balances, and they are now ready to record revenues for next period.

Step 2: Close Debit Balances in Expense Accounts to Income Summary The second closing entry transfers debit balances in expense (and loss) accounts to the Income Summary account. We bring expense accounts’ debit balances to zero by crediting them. With a balance of zero, these accounts are ready to record expenses for next period. This second clos- ing entry for FastForward is step 2 in Exhibit 3.16.

Step 3: Close Income Summary to Retained Earnings After steps 1 and 2, the balance of Income Summary equals December net income of $3,785 ($8,150 credit less $4,365 debit). The third closing entry transfers the balance of the Income Summary account to the Retained Earnings account. This entry closes the Income Summary account—see step 3 in Exhibit 3.16. (If a net loss occurred because expenses exceeded revenues, the third entry is re- versed: debit Retained Earnings and credit Income Summary.)

Step 4: Close Dividends Account to Retained Earnings The fourth closing entry transfers any debit balance in the Dividends account to the Retained Earnings account— see step 4 in Exhibit 3.16. This entry gives the Dividends account a zero balance, and the ac- count is now ready to record next period’s dividends.

Exhibit 3.17 shows the entire ledger of FastForward as of December 31 after adjusting and closing entries are posted. The temporary accounts (revenues, expenses, and dividends) have ending balances equal to zero.

103

Asset Accounts

Cash Acct . No . 101

Date Explan . PR Debit Credit Balance

2019

Dec . 1 (1) G1 30,000 30,000

2 (2) G1 2,500 27,500

3 (3) G1 26,000 1,500

5 (5) G1 4,200 5,700

6 (13) G1 2,400 3,300

12 (6) G1 1,000 2,300

12 (7) G1 700 1,600

22 (9) G1 1,900 3,500

24 (10) G1 900 2,600

24 (11) G1 200 2,400

26 (12) G1 3,000 5,400

26 (14) G1 120 5,280

26 (15) G1 305 4,975

26 (16) G1 700 4,275

Supplies Acct . No . 126

Date Explan . PR Debit Credit Balance

2019

Dec . 2 (2) G1 2,500 2,500

6 (4) G1 7,100 9,600

26 (14) G1 120 9,720

31 Adj.(b) G1 1,050 8,670

Accounts Receivable Acct . No . 106

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (8) G1 1,900 1,900

22 (9) G1 1,900 0

31 Adj.(f) G1 1,800 1,800

Accumulated Depreciation— Equipment Acct . No . 168

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(c) G1 300 300

Equipment Acct . No . 167

Date Explan . PR Debit Credit Balance

2019

Dec . 3 (3) G1 26,000 26,000

Prepaid Insurance Acct . No . 128

Date Explan . PR Debit Credit Balance

2019

Dec . 6 (13) G1 2,400 2,400

31 Adj.(a) G1 100 2,300

Revenue and Expense Accounts (Including Income Summary)

Depreciation Expense— Equipment Acct . No . 612

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(c) G1 300 300 31 Clos.(2) G1 300   0

Rental Revenue Acct . No . 406

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (8) G1 300 300 31 Clos.(1) G1 300   0

Consulting Revenue Acct . No . 403

Date Explan . PR Debit Credit Balance

2019

Dec . 5 (5) G1 4,200 4,200

12 (8) G1 1,600 5,800

31 Adj.(d) G1 250 6,050 31 Adj.(f) G1 1,800 7,850 31 Clos.(1) G1 7,850         0

Rent Expense Acct . No . 640

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (6) G1 1,000 1,000 31 Clos.(2) G1 1,000   0

Insurance Expense Acct . No . 637

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(a) G1 100 100 31 Clos.(2) G1 100 0

Salaries Expense Acct . No . 622

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (7) G1 700 700

26 (16) G1 700 1,400

31 Adj.(e) G1 210 1,610 31 Clos.(2) G1 1,610 0

Income Summary Acct . No . 901

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Clos.(1) G1 8,150 8,150 31 Clos.(2) G1 4,365 3,785 31 Clos.(3) G1 3,785           0

Utilities Expense Acct . No . 690

Date Explan . PR Debit Credit Balance

2019

Dec . 26 (15) G1 305 305 31 Clos.(2) G1 305   0

Supplies Expense Acct . No . 652

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(b) G1 1,050 1,050 31 Clos.(2) G1 1,050         0

EXHIBIT 3.17 General Ledger after the Closing Process for FastForward

FASTForward

Liability and Equity Accounts

Unearned Consulting Revenue Acct . No . 236

Date Explan . PR Debit Credit Balance

2019

Dec . 26 (12) G1 3,000 3,000

31 Adj.(d) G1 250 2,750

Accounts Payable Acct . No . 201

Date Explan . PR Debit Credit Balance

2019

Dec . 6 (4) G1 7,100 7,100

24 (10) G1 900 6,200

Salaries Payable Acct . No . 209

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(e) G1 210 210

Common Stock Acct . No . 307

Date Explan . PR Debit Credit Balance

2019

Dec . 1 (1) G1 30,000 30,000

Dividends Acct . No . 319

Date Explan . PR Debit Credit Balance

2019

Dec . 24 (11) G1 200 200

31 Clos.(4) G1 200 0

Retained Earnings Acct . No . 318

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Clos.(3) G1 3,785 3,785 31 Clos.(4) G1 200 3,585

104 Chapter 3 Adjusting Accounts for Financial Statements

Post-Closing Trial Balance A post-closing trial balance is a list of permanent accounts and their balances after all closing entries. It lists the balances for all accounts not closed. A post-closing trial balance verifies that (1) total debits equal total credits for permanent accounts and (2) all temporary accounts have zero balances. FastForward’s post-closing trial balance is in Exhibit 3.18 and often is the last step in the accounting process.

P8 Explain and prepare a post-closing trial balance.

Point: Only balance sheet (permanent) accounts are on a post-closing trial balance.

EXHIBIT 3.18 Post-Closing Trial Balance

FASTFORWARD Post-Closing Trial Balance

December 31, 2019 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,670 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 Accumulated depreciation—Equipment . . . . . . . . . . $ 300 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,200 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 Unearned consulting revenue . . . . . . . . . . . . . . . . . 2,750 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,585 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $43,045 $43,045

©IM_photo/Shutterstock

Staff Accountant A friend shows you the post-closing trial balance she is working on. You review the statement and see a line item for rent expense. How do you know that an error exists? ■ Answer: This error is apparent in a post-closing trial balance because Rent Expense is a temporary account. Post-closing trial balances only contain permanent accounts.

Decision Maker

C2 Identify steps in the accounting cycle.

The accounting cycle is the steps in preparing financial statements. It is called a cycle because the steps are repeated each reporting period. Exhibit 3.19 shows the 10 steps in the cycle. Steps 1 through 3 occur regularly as a company enters into transactions. Steps 4 through 9 are done at the end of a period. Reversing entries in step 10 are optional and are explained in Appendix 3C.

ACCOUNTING CYCLE

Use the adjusted trial balance solution for Magic Company from Need-to-Know 3-5 to prepare its closing entries—the accounts are also listed here for convenience.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 Dr . Accounts receivable . . . . . . . . . . . . . . . . . 17,000 Dr . Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Dr . Accounts payable . . . . . . . . . . . . . . . . . . . 12,000 Cr . Long-term notes payable . . . . . . . . . . . . . 33,000 Cr . Common stock . . . . . . . . . . . . . . . . . . . . . 30,000 Cr .

Retained earnings . . . . . . . . . . . . . . . . . . . . $45,000 Cr . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Dr . Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 79,000 Cr . Salaries expense . . . . . . . . . . . . . . . . . . . . . 56,000 Dr . Office supplies expense . . . . . . . . . . . . . . . 8,000 Dr .

Solution

Dec . 31 Fees Earned . . . . . . . . . . . . . . . . . . . . . . . 79,000 Income Summary . . . . . . . . . . . . . . 79,000 Close revenue account. Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . 64,000 Salaries Expense . . . . . . . . . . . . . . . 56,000 Office Supplies Expense . . . . . . . . . 8,000 Close expense accounts.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . 15,000 Retained Earnings . . . . . . . . . . . . . . 15,000 Close Income Summary. Dec . 31 Retained Earnings . . . . . . . . . . . . . . . . . . 20,000 Dividends . . . . . . . . . . . . . . . . . . . . 20,000 Close Dividends account.

Closing Entries

NEED-TO-KNOW 3-6

P7

Do More: QS 3-18, E 3-9, E 3-10

Chapter 3 Adjusting Accounts for Financial Statements 105

EXHIBIT 3.19 Steps in the Accounting Cycle*

$

33,785

$33,585 200Less: Withdrawals by owner .............

Retained earnings, December 31 .......

Retained earnings, December 1.......... Plus: Investments by owner ............... $30,000

Net income .................................. 3,785

0

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Assets Liabilities Equity

Cash

+ $1,500Old Bal. +

+

+

+

+ Supplies Equipment =

=

Accounts Payable

Common Stock

+ +

+

+

$2,500 $26,000 =

=

$30,000

(4) 7,100 +$7,100 New Bal. $9,600 $ 7,100$1,500 $26,000 $30,000

Date Account Titles and Explanation PR Debit Credit

(4) Supplies 126 7,100 Accounts Payable 201 7,100

(4) 7,100

201

2,500 (4) 7,100

Supplies 126

General Ledger

Accounts Payable

(2)

Cash Accounts receivable Supplies Prepaid insurance Equipment Accounts payable Unearned consulting revenue

6,200 3,000

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

$

4,275 0

9,720 2,400

26,000

$

Adjustment (b) Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

Dec. 31 1,050

652

Dec. 2 2,500 6 7,100

26 120

Balance 8,670

Dec. 31 1,050

126Supplies Expense Supplies

Dec. 31 1,050 1,050

Record supplies used.

Dr. Cr. Dr. Cr.Cr. Dr.

FASTFORWARD Trial Balances

December 31, 2019

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

(f) $1,800

$ 0

0 6,200

0 $ 4,275

9,720 2,400

26,000

1,800 $ 4,275

8,670 2,300

26,000

(b) $1,050 (a) 100

(c) 300

(e) 210

$ 300 6,200

210

Acct. No.

101 106 126 128 167 168 201 209

Cash Account Title

Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable

Dec. 31 Consulting Revenue................................ Rental Revenue........................................ Income Summary................................ Close revenue accounts.

7,850 300

1,610

8,150

Step 1:

Dec. 31 Income Summary.....................................

Salaries Expense................................ Depreciation Expense—Equip. .....

Insurance Expense............................ Rent Expense...................................... Supplies Expense.............................. Utilities Expense.................................

4,365 300

100 1,000 1,050

305

Step 2:

Step 3: Close expense accounts.

General Journal

FASTFORWARD Post-Closing Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated depreciation—Equipment . . . . . . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . S l i bl

$ 4,275 1,800 8,670 2,300

26,000 $ 300

6,200 210

Reversing entry recorded on Jan. 1, 2020

Salaries Expense

Salaries Payable

Date 2020

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 2020 Jan. 1

210210

210 0

Expl. Debit BalanceCredit

Salaries Payable 210 Salaries Expense 210

Jan. 1 210 210

Revenues Consulting revenue .............................. $7,850

300 Rental revenue ....................................... Total revenues .......................................

Depreciation expense—Equip............ Expenses

Salaries expense.................................... Insurance expense................................ Rent expense.......................................... Supplies expense................................... Utilities expense..................................... Total exenses

300 1,610 100

305

1,000 1,050

$8,150

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Assets Cash ........................................................ $ 4,275 Accounts receivable ........................... 1,800

8,670 2,300

Supplies ................................................. Prepaid insurance ...............................

$

FASTFORWARD Balance Sheet

December 31, 2019

Explanations   1. Analyze transactions Analyze transactions to prepare for journalizing.   2. Journalize Record accounts, including debits and credits, in a journal.   3. Post Transfer debits and credits from the journal to the ledger.   4. Prepare unadjusted trial balance Summarize unadjusted ledger accounts and amounts.   5. Adjust and post Record adjustments to bring account balances up to date; journalize and post adjustments.   6. Prepare adjusted trial balance Summarize adjusted ledger accounts and amounts.   7. Prepare financial statements Use adjusted trial balance to prepare financial statements.   8. Close accounts Journalize and post entries to close temporary accounts.   9. Prepare post-closing trial balance Test clerical accuracy of the closing procedures. 10. Reverse and post (optional step) Reverse certain adjustments in the next period—optional step; see Appendix 3C.

* Steps 4, 6, and 9 can be done on a work sheet. A work sheet is useful in planning adjustments, but adjustments (step 5) must always be journalized and posted. Steps 3, 4, 6, and 9 are automatic with a computerized system.

Accounting Cycle

5. Adjust and post accounts

6. Prepare adjusted trial balance7. Prepare financial statements8. Close accounts

9. Prepare post-closing trial balance

10. Reverse and post (optional)

2. Journalize 3. Post

4. Prepare unadjusted trial balance

1. Analyze transactions

C3 Explain and prepare a classified balance sheet.

This section describes a classified balance sheet. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. One example is FastForward’s balance sheet in Exhibit 3.14. A classified balance sheet organizes assets and liabilities into subgroups.

Classification Structure A classified balance sheet typically contains the categories in Exhibit 3.20 (there is no required layout). An important classification is the separation between current and noncurrent for both

CLASSIFIED BALANCE SHEET

106 Chapter 3 Adjusting Accounts for Financial Statements

assets and liabilities. Current items are expected to come due (either collected or owed) within one year or the company’s operating cycle, whichever is longer. The operating cycle is the time span from when cash is used to acquire goods and services until cash is received from the sale

of goods and services. Most operating cycles are less than one year, which means most companies use a one-year period to classify current and noncurrent items. To make it easy, assume an operating cycle of one year, unless we say otherwise.

A balance sheet lists current assets before noncurrent assets and cur- rent liabilities before noncurrent liabilities. Current assets and current liabilities are listed in order of how quickly they will be converted to, or paid in, cash.

Classification Categories The balance sheet for Snowboarding Components in Exhibit 3.21 shows the typical categories. Its assets are classified as either current or noncurrent. Its noncurrent assets include three main categories: long-term investments, plant assets, and intangible assets. Its liabilities are classified as either current or long-term. Not all companies use the same categories. Jarden, a producer of snowboards, reported a balance sheet with five asset classes: current assets; property, plant, and equipment; goodwill; intangibles; and other assets.

Current Assets Current assets are cash and other resources that are expected to be sold, collected, or used within one year or the company’s operating cycle, whichever is longer. Examples are cash, short-term investments, accounts receivable, short-term notes receivable, goods for sale (called merchandise or inventory), and prepaid expenses.

Long-Term Investments Long-term (or noncurrent) investments include notes re- ceivable and investments in stocks and bonds when they are expected to be held for more than the longer of one year or the operating cycle. Land held for future expansion is a long-term in- vestment because it is not used in operations.

EXHIBIT 3.20 Typical Categories in a Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities Noncurrent assets Noncurrent liabilities Long-term investments Equity Plant assets Intangible assets

©Sean Sullivan/Getty Images

Point: Current is also called short- term, and noncurrent is also called long-term.

SNOWBOARDING COMPONENTS Balance Sheet

January 31, 2019

Liabilities Current liabilities Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $15,300

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Notes payable (due within one year) . . . . . . . . . 3,000

Current portion of long-term liabilities . . . . . . . . 7,500

Total current liabilities . . . . . . . . . . . . . . . . . . . . . $ 29,000

Long-term liabilities (net of current portion) . . . . . 150,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179,000

Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . .   114,800 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   164,800

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . $343,800

Assets Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,500

Short-term investments . . . . . . . . . . . . . . . . . 2,100

Accounts receivable, net . . . . . . . . . . . . . . . . 4,400

Merchandise inventory . . . . . . . . . . . . . . . . . . 27,500

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . 2,400

Total current assets . . . . . . . . . . . . . . . . . . . . . $ 42,900

Long-term investments Notes receivable (due in three years) . . . . . . 1,500

Investments in stocks and bonds . . . . . . . . . . 18,000

Land held for future expansion . . . . . . . . . . . 48,000

Total long-term investments . . . . . . . . . . . . . . 67,500

Plant assets Equipment and buildings . . . . . . . . . . . . . . . . 203,200

Less accumulated depreciation . . . . . . . . . . . 53,000

Equipment and buildings, net . . . . . . . . . . . . 150,200

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,200

Total plant assets . . . . . . . . . . . . . . . . . . . . . . 223,400

Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,800

EXHIBIT 3.21 Example of a Classified Balance Sheet

Chapter 3 Adjusting Accounts for Financial Statements 107

Plant Assets Plant assets are tangible assets that are both long-lived and used to produce or sell products and services. Examples are equipment, machinery, buildings, and land that are used to produce or sell products and services.

Intangible Assets Intangible assets are long-term assets that benefit business op- erations but lack physical form. Examples are patents, trademarks, copyrights, franchises, and goodwill. Their value comes from the privileges or rights granted to or held by the owner.

Current Liabilities Current liabilities are liabilities due to be paid or settled within one year or the operating cycle, whichever is longer. They usually are settled by paying out cash. Current liabilities include accounts payable, notes payable, wages payable, taxes payable, inter- est payable, and unearned revenues. Also, any portion of a long-term liability due to be paid within one year or the operating cycle, whichever is longer, is a current liability. Unearned rev- enues are current liabilities when products or services are to be provided within one year or the operating cycle, whichever is longer.

Long-Term Liabilities Long-term liabilities are liabilities not due within one year or the operating cycle, whichever is longer. Notes payable, mortgages payable, bonds payable, and lease obligations are common long-term liabilities. If a company has both short- and long-term items in each of these categories, they are commonly separated into two accounts in the ledger.

Equity Equity is the owner’s claim on assets. For a corporation, this claim is reported in the equity section as common stock and retained earnings.

©Johannes Simon/Getty Images

Point: Only assets and liabilities (not equity) are classified as current or noncurrent.

Use the following account balances for Magic Company from Need-To-Know 3-5 to prepare its classified balance sheet as of December 31.

Solution

MAGIC COMPANY Balance Sheet December 31

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000

Accounts receivable . . . . . . . . . . . . . . . . . 17,000

Total current assets . . . . . . . . . . . . . . . . . . 30,000

Plant assets

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Total plant assets . . . . . . . . . . . . . . . . . . . . 85,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000

Liabilities Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . $ 12,000

Total current liabilities . . . . . . . . . . . . . . . . . . 12,000

Long-term notes payable . . . . . . . . . . . . . . . . . . 33,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 40,000

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Total liabilities and equity . . . . . . . . . . . . . . . . . $115,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 Dr .

Accounts receivable . . . . . . . . . . . . . . . . . . . . 17,000 Dr .

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Dr .

Accounts payable . . . . . . . . . . . . . . . . . . . . . . 12,000 Cr .

Long-term notes payable . . . . . . . . . . . . . . . . 33,000 Cr .

Common stock . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Cr .

Retained earnings . . . . . . . . . . . . . . . . . . . . . . $40,000 Cr .

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Dr .

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000 Cr .

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . 56,000 Dr .

Office supplies expense . . . . . . . . . . . . . . . . . 8,000 Dr .

Classified Balance Sheet

NEED-TO-KNOW 3-7

C3

Do More: QS 3-21, QS 3-23, E 3-12, P 3-7

Point: Plant assets are also called fixed assets; property, plant and equipment (PP&E); or long-lived assets.

Profit Margin A useful measure of a company’s operating results is the ratio of its net income to net sales. This ratio is called profit margin, or return on sales, and is computed as in Exhibit 3.22. This ratio shows the percent of profit in each dollar of sales.

A1 Compute profit margin and describe its use in analyzing company performance.

CFO Your health care equipment company consistently reports a 9% profit margin, which is similar to that of com- petitors. The treasurer argues that profit margin can be increased to 20% if the company cuts marketing expenses. Do you cut those expenses? ■ Answer: Cutting those expenses increases profit margin in the short run. However, over the long run, cutting such expenses can hurt current and future sales. You must explain that the company can cut the “fat” (expenses that do not create sales) but should be careful if cutting those that create sales.

Decision Maker

Profit margin = Net income

Net sales

EXHIBIT 3.22 Profit Margin

Visa’s profit margins are shown in Exhibit 3.23. Visa’s profit margin is superior to Mastercard’s in each of the last three years. For Mastercard to improve its profit margin, it must either reduce expenses or increase revenues at a relatively greater amount than expenses.

108 Chapter 3 Adjusting Accounts for Financial Statements

Profit Margin and Current RatioDecision Analysis

EXHIBIT 3.23 Computation and Analysis using Profit Margin

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Visa Net income . . . . . . . . . . . . . . . . . $ 6,699 $ 5,991 $ 6,328 Net sales . . . . . . . . . . . . . . . . . . $18,358 $15,082 $13,880

Profit margin . . . . . . . . . . . . . . . 36% 40% 46% Mastercard Profit margin . . . . . . . . . . . . . . . 31% 38% 39%

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Costco Current assets . . . . . . . . . . . . . . . $17,317 $15,218 $16,779 Current liabilities . . . . . . . . . . . . $17,495 $15,575 $16,539

Current ratio . . . . . . . . . . . . . . . 0.99 0.98 1.01 Walmart Current ratio . . . . . . . . . . . . . . . . 0 .86 0 .93 0 .97

Current Ratio An important use of financial statements is to help assess a company’s ability to pay its debts in the near future. Such analysis affects decisions by suppliers when allowing a company to buy on credit. It also affects decisions by creditors when lending money to a company, including loan terms such as interest rate and due date. The current ratio is one measure of a company’s ability to pay its short-term obligations. It is defined in Exhibit 3.24.

A2 Compute the current ratio and describe what it reveals about a company’s financial condition.

Current ratio = Current assets

Current liabilities

EXHIBIT 3.24 Current Ratio

Costco’s current ratio for each of the last three years is in Exhibit 3.25. A current ratio of over 1.0 means that current obligations can be covered with current assets. For the recent two years, Costco’s current ratio was slightly below 1.0. This means Costco could face challenges in covering current liabilities. Although Costco has a better ratio than Walmart in each of the last three years, management must continue to monitor current assets and liabilities.

EXHIBIT 3.25 Computation and Analysis using Current Ratio

Analyst You are analyzing a dirt bike company’s ability to meet upcoming loan payments. You compute its current ratio as 1.2. You find that a major portion of accounts receivable is due from one client who has not made any pay- ments in the past 12 months. Removing this receivable from current assets lowers the current ratio to 0.7. What do you conclude? ■ Answer: A current ratio of 1.2 suggests that current assets are sufficient to cover current liabilities. Removing the past-due receiv- able reduces the current ratio to 0.7. You conclude that the company will have difficulty meeting its loan payments.

Decision Maker

©sgpage902/Getty Images

Chapter 3 Adjusting Accounts for Financial Statements 109

The following information relates to Fanning’s Electronics on December 31, 2019. The company, which uses the calendar year as its annual reporting period, initially records prepaid and unearned items in bal- ance sheet accounts (assets and liabilities, respectively).

a. The company’s weekly payroll is $8,750, paid each Friday for a five-day workweek. Assume December 31, 2019, falls on a Monday, but the employees will not be paid their wages until Friday, January 4, 2020.

b. Eighteen months earlier, on July 1, 2018, the company purchased equipment that cost $20,000. Its useful life is predicted to be five years, at which time the equipment is expected to be worthless (zero salvage value).

c. On October 1, 2019, the company agreed to work on a new housing development. The company is paid $120,000 on October 1 in advance of future installation of similar alarm systems in 24 new homes. That amount was credited to the Unearned Services Revenue account. Between October 1 and December 31, work on 20 homes was completed.

d. On September 1, 2019, the company purchased a 12-month insurance policy for $1,800. The transac- tion was recorded with an $1,800 debit to Prepaid Insurance.

e. On December 29, 2019, the company completed a $7,000 service that has not been billed or recorded as of December 31, 2019.

Required

1. Prepare any necessary adjusting entries on December 31, 2019, in relation to transactions and events a through e.

2. Prepare T-accounts for the accounts affected by adjusting entries, and post the adjusting entries. Determine the adjusted balances for the Unearned Revenue and the Prepaid Insurance accounts.

3. Complete the following table and determine the amounts and effects of your adjusting entries on the year 2019 income statement and the December 31, 2019, balance sheet. Use up (down) arrows to indicate an increase (decrease) in the Effect columns.

COMPREHENSIVE 1

Preparing Year-End Accounting Adjustments

NEED-TO-KNOW 3-8

Amount in Effect on Effect on Effect on Effect on Entry the Entry Net Income Total Assets Total Liabilities Total Equity

PLANNING THE SOLUTION Analyze each situation to determine which accounts need to be updated with an adjustment. Calculate the amount of each adjustment and prepare the necessary journal entries. Show the amount of each adjustment in the designated accounts, determine the adjusted balance, and

identify the balance sheet classification of the account. Determine each entry’s effect on net income for the year and on total assets, total liabilities, and total

equity at the end of the year.

SOLUTION 1. Adjusting journal entries.

(a) Dec . 31 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 Accrue wages for last day of year ($8,750 × 1∕5) . (b) Dec . 31 Depreciation Expense—Equipment . . . . . . . . . . . . . . . . . . . . . 4,000 Accumulated Depreciation—Equipment . . . . . . . . . . . . . 4,000 Record depreciation expense for year

($20,000/5 years = $4,000 per year) . (c) Dec . 31 Unearned Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Record revenue earned ($120,000 × 20∕24) . (d) Dec . 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Adjust for expired portion of insurance ($1,800 × 4∕12) . (e) Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Record services revenue earned.

110 Chapter 3 Adjusting Accounts for Financial Statements

2. T-accounts for adjusting journal entries a through e.

(a) 1,750

Wages ExpenseWages Payable

(a) 1,750

Accounts Receivable

(e) 7,000

(d ) 600

Insurance ExpenseUnearned Services Revenue

Unadj . Bal . 120,000

(c) 100,000

Adj . Bal . 20,000

Unadj . Bal . 1,800

(d ) 600

Adj . Bal . 1,200

Prepaid Insurance

(b) 4,000

Depreciation Expense — EquipmentServices Revenue

(c) 100,000

(e) 7,000

Adj . Bal . 107,000

Accumulated Depreciation — Equipment

(b) 4,000

3. Financial statement effects of adjusting journal entries.

Amount in Effect on Effect on Effect on Effect on Entry the Entry Net Income Total Assets Total Liabilities Total Equity

a $ 1,750 $ 1,750 ↓ No effect $ 1,750 ↑ $ 1,750 ↓ b 4,000 4,000 ↓ $4,000 ↓ No effect 4,000 ↓ c 100,000 100,000 ↑ No effect $100,000 ↓ 100,000 ↑ d 600 600 ↓ $ 600 ↓ No effect 600 ↓ e 7,000 7,000 ↑ $7,000 ↑ No effect 7,000 ↑

Use the following year-end adjusted trial balance to answer questions 1–3.

COMPREHENSIVE 2

Preparing Financial Statements from Adjusted Account Balances

NEED-TO-KNOW 3-9 CHOI COMPANY

Adjusted Trial Balance December 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 910 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,200 Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . $ 29,100 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,480 Unearned rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,340 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,450 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . 5,970 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $281,880 $281,880

Chapter 3 Adjusting Accounts for Financial Statements 111

1. Prepare the annual income statement from the adjusted trial bal- ance of Choi Company.

Answer:

CHOI COMPANY Income Statement

For Year Ended December 31

Revenues Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,500 Expenses Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,450 Depreciation expense—Equipment . . . . . . . . . . . . . . 5,970 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,320 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,180

2. Prepare a statement of retained earnings from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Statement of Retained Earnings

For Year Ended December 31

Retained earnings, December 31 prior year-end . . . . . . $30,340 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,180

48,520 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Retained earnings, December 31 current year-end . . . . $27,520

3. Prepare a balance sheet (unclassified) from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Balance Sheet December 31

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050 Accounts receivable . . . . . . . . . . . . . . . . . . . . 400 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . 910 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . $217,200 Less accumulated depreciation . . . . . . . . . . . . 29,100 188,100 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $192,460

Liabilities Interest payable . . . . . . . . . . . . . . . . . . . . . . . . $ 4,480 Unearned rent . . . . . . . . . . . . . . . . . . . . . . . . . 460 Long-term notes payable . . . . . . . . . . . . . . . . 150,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 154,940

Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 27,520 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,520 Total liabilities and equity . . . . . . . . . . . . . . . . . $192,460

APPENDIX

Alternative Accounting for Prepayments 3A This appendix explains alternative accounting for deferred expenses and deferred revenues.

RECORDING PREPAYMENT OF EXPENSES IN EXPENSE ACCOUNTS An alternative method is to record all prepaid expenses with debits to expense accounts. If any prepaids remain unused or unexpired at the end of an accounting period, then adjusting entries transfer the cost of the unused portions from expense accounts to prepaid expense (asset) accounts. The financial statements are identical under either method, but the adjusting entries are different. To demonstrate the differences between these two methods, let’s look at FastForward’s cash payment on December 1 for 24 months of insurance coverage beginning on December 1. FastForward recorded that payment with a debit to an as- set account, but it could have recorded a debit to an expense account. These alternatives are shown in Exhibit 3A.1.

P9 Explain the alternatives in accounting for prepaids.

Payment Recorded as Asset

Dec . 1 Prepaid Insurance . . . . . . . 2,400 Cash . . . . . . . . . . . . . . 2,400

Payment Recorded as Expense

Dec . 1 Insurance Expense . . . . . . 2,400 Cash . . . . . . . . . . . . . 2,400

EXHIBIT 3A.1 Alternative Initial Entries for Prepaid Expenses

112 Chapter 3 Adjusting Accounts for Financial Statements

Payment Recorded as Asset

Dec . 31 Insurance Expense . . . . . . . . 100 Prepaid Insurance . . . . 100

Payment Recorded as Expense

Dec . 31 Prepaid Insurance . . . . . . . 2,300 Insurance Expense . . 2,300

EXHIBIT 3A.2 Adjusting Entry for Prepaid Expenses for the Two Alternatives

When these entries are posted, we see in Exhibit 3A.3 that the two methods give identical results.

EXHIBIT 3A.3 Account Balances under Two Alternatives for Recording Prepaid Expenses

Payment Recorded as Asset

Prepaid Insurance 128

Dec . 1 2,400 Dec . 31 100

Balance 2,300

Prepaid Insurance 128

Dec . 31 2,300

Payment Recorded as Expense

Insurance Expense 637

Dec . 31 100

Insurance Expense 637

Dec . 1 2,400 Dec . 31 2,300

Balance 100

RECORDING PREPAYMENT OF REVENUES IN REVENUE ACCOUNTS An alternative method is to record all unearned revenues with credits to revenue accounts. If any revenues are unearned at the end of an accounting period, then adjusting entries transfer the unearned portions from revenue accounts to unearned revenue (liability) accounts. The adjusting entries are different for these two alternatives, but the financial statements are identical. To demonstrate the differences between these two methods, let’s look at FastForward’s December 26 receipt of $3,000 for consulting services covering the period December 27 to February 24. FastForward recorded this transaction with a credit to a liability account. The alternative is to record it with a credit to a revenue account, as shown in Exhibit 3A.4.

Receipt Recorded as Liability

Dec . 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Unearned Consulting Revenue . . . 3,000

Receipt Recorded as Revenue

Dec . 26 Cash . . . . . . . . . . . . . . . . . . . 3,000 Consulting Revenue . . 3,000

EXHIBIT 3A.4 Alternative Initial Entries for Unearned Revenues

By the end of its accounting period on December 31, FastForward has earned $250 of this revenue. This means $250 of the liability has been satisfied. Depending on how the initial receipt is recorded, the adjust- ing entry is as shown in Exhibit 3A.5.

After adjusting entries are posted, the two alternatives give identical results, as shown in Exhibit 3A.6.

Receipt Recorded as Revenue

Dec . 31 Consulting Revenue . . . . . . . . . . . . . . . 2,750 Unearned Consulting Revenue . . 2,750

Receipt Recorded as Liability

Dec . 31 Unearned Consulting Revenue . 250 Consulting Revenue . . . . . . 250

EXHIBIT 3A.5 Adjusting Entry for Unearned Revenues for the Two Alternatives

EXHIBIT 3A.6 Account Balances under Two Alternatives for Recording Unearned Revenues

Unearned Consulting Revenue 236

Dec . 31 2,750

Unearned Consulting Revenue 236

Dec . 31 250 Dec . 26 3,000

Balance 2,750

Receipt Recorded as RevenueReceipt Recorded as Liability

Consulting Revenue 403

Dec . 31 2,750 Dec . 26 3,000

Balance 250

Consulting Revenue 403

Dec . 31 250

At the end of its accounting period on December 31, insurance protection for one month has expired. This means $100 ($2,400∕24) of insurance coverage expired and is an expense for December. The adjusting entry depends on how the original payment was recorded. This is shown in Exhibit 3A.2.

Chapter 3 Adjusting Accounts for Financial Statements 113

APPENDIX

Work Sheet as a Tool 3B Benefits of a Work Sheet (Spreadsheet) A work sheet is a document that is used internally by companies to help with adjusting and closing accounts and with preparing financial state- ments. It is an internal accounting aid and is not a substitute for journals, ledgers, or financial statements. A work sheet

Helps in preparing financial statements. Reduces the risk of errors when working with many accounts and adjustments. Links accounts and adjustments to financial statements. Shows the effects of proposed or “what-if” transactions.

Use of a Work Sheet When a work sheet is used to prepare financial statements, it is con- structed at the end of a period before the adjusting process. The complete work sheet includes a list of the accounts, their balances and adjustments, and their sorting into financial statement columns. It provides two columns each for the unadjusted trial balance, the adjustments, the adjusted trial balance, the income statement, and the balance sheet. To describe and interpret the work sheet, we use the information from FastForward. Preparing the work sheet has five steps.

1 Step 1. Enter Unadjusted Trial Balance Refer to Exhibit 3B.1—green section. The first step in preparing a work sheet is to list the title of every account and its account number that appears on its financial statements. This includes all accounts in the ledger plus any new ones from adjusting entries. The unadjusted balance for each account is then entered in the correct Debit or Credit column of the Unadjusted Trial Balance columns. The totals of these two columns must be equal. The light green section of Exhibit 3B.1 shows FastForward’s work sheet after completing this first step (dark green rows show accounts that arise because of the adjustments). Sometimes an account can require more than one adjustment, such as for Consulting Revenue. The addi- tional adjustment can be added to a blank line below (as in Exhibit 3B.1), squeezed on one line, or com- bined into one adjustment amount.

2 Step 2. Enter Adjustments Exhibit 3B.1—yellow section. The second step is to enter adjustments in the Adjustments columns. The adjustments shown are the same ones shown in Exhibit 3.13. An identifying letter links the debit and credit of each adjustment. This is called keying the adjustments. After preparing a work sheet, adjust- ments must still be entered in the journal and posted to the ledger. The Adjustments columns provide the information for adjusting entries in the journal.

3 Step 3. Prepare Adjusted Trial Balance Exhibit 3B.1—blue section. The adjusted trial balance is prepared by combining the adjustments with the unadjusted balances for each account. As an example, the Prepaid Insurance account has a $2,400 debit balance in the Unadjusted Trial Balance columns. This $2,400 debit is combined with the $100 credit in the Adjustments columns to give Prepaid Insurance a $2,300 debit in the Adjusted Trial Balance columns. The totals of the Adjusted Trial Balance columns confirm debits and credits are equal.

4 Step 4. Sort Adjusted Trial Balance Amounts to Financial Statements Exhibit 3B.1—orange section. This step involves sorting account balances from the adjusted trial balance to their proper financial statement columns. Expenses go to the Income Statement Debit column and rev- enues to the Income Statement Credit column. Assets and dividends go to the Balance Sheet Debit col- umn. Liabilities, retained earnings, and common stock go to the Balance Sheet Credit column.

5 Step 5. Total Statement Columns, Compute Income or Loss, and Balance Columns Exhibit 3B.1—purple section. Each financial statement column (from step 4) is totaled. The differ- ence between the Debit and Credit column totals of the Income Statement columns is net income or net loss. This occurs because revenues are entered in the Credit column and expenses in the Debit column. If the Credit total exceeds the Debit total, there is net income. If the Debit total exceeds the Credit total, there is a net loss. For FastForward, the Credit total exceeds the Debit total, giving a $3,785 net income.

P10 Prepare a work sheet and explain its usefulness.

FASTForward

114 Chapter 3 Adjusting Accounts for Financial Statements

8,150

8,150

7,850

300

4,365 3,785

8,150

300 1,610

100 1,000 1,050

305

4

43,245

43,245

4,275 1,800 8,670 2,300

26,000

200

39,460 3,785

43,245

300 6,200

210 2,750

30,000 0

300 6,200

210 2,750

30,000 0

7,850 200

300

47,610

4,275 1,800 8,670 2,300

26,000

300 1,610

100 1,000 1,050

305 47,610

3

(b) (a)

(c)

(e)

1,050 100

300

210

(d) (f)

250 1,800

3,710

(f)

(d)

2

1,800

250

(c) (e) (a)

(b)

300 210 100

1,050

3,710

0

0

Account

Unadjusted Trial Balance

Adjusted Trial Balance

Dr.

Adjustments

Cr. Dr. Cr.

Income Statement

Dr. Cr.

Balance Sheet

Dr. Cr.Dr. Cr.No.

1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

Enter all amounts available from ledger accounts. Column totals must be equal.

A work sheet organizes information used to prepare adjusting entries, financial statements, and closing entries.

5

List all accounts from the ledger; accounts necessary to make accounting adjustments are shaded in dark green.

1a 1b 4a 4b

5c

3

5a 2

5b

Enter adjustment amounts and use letters to cross-reference debit and credit adjustments. Column totals must be equal.

Combine unadjusted trial balance amounts with the adjustments to get the adjusted trial balance amounts. Column totals must be equal.

Extend all revenue and expense amounts to the income statement columns.

Extend all asset, liability, equity, and dividends amounts to these columns.

Enter two new lines for the (1) Net income or loss. (2) Totals.

Net income (loss) is extended to the credit (debit) column.

First “Totals” row for income statement columns dier by the amount of net income or net loss.

Cash Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock Retained earnings Dividends Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals Net income Totals

101 106 126 128 167

168 201

209 236 307 318 319 403

406 612 622 637 640 652 690

5d Ending balance of retained earnings is computed in the statement of retained earnings.

FastForward Work Sheet

For Month Ended December 31, 2019

A B C D E F G H I J K L M

6,200

3,000

30,000 0

5,800

300

45,300

4,275

9,720 2,400

26,000

200

1,400

1,000

305 45,300

EXHIBIT 3B.1 Work Sheet with Five-Step Process for Completion FASTForward

Chapter 3 Adjusting Accounts for Financial Statements 115

The net income from the Income Statement columns is then entered in the Balance Sheet Credit col- umn. Adding net income to the last Credit column means that it is to be added to retained earnings. If a loss occurs, it is added to the Debit column. This means that it is to be subtracted from retained earnings. The ending balance of retained earnings does not appear in the last two columns as a single amount, but it is computed in the statement of retained earnings using these account balances. When net in- come or net loss is added to the proper Balance Sheet column, the totals of the last two columns must balance. If they do not, one or more errors have occurred.

Work Sheet Applications and Analysis A work sheet does not substitute for financial statements. It is a tool we use to help prepare financial statements. FastForward’s financial statements are shown in Exhibit 3.14. Its income statement amounts are taken from the Income Statement columns of the work sheet. Amounts for its balance sheet and its statement of retained earnings are taken from the Balance Sheet columns of the work sheet. Work sheets are also useful in analyzing the effects of proposed, or what-if, transactions. This is done by entering financial statement amounts in the Unadjusted (what-if) columns. Proposed transactions are then entered in the Adjustments columns. We then compute “adjusted” amounts from these proposed transactions. The extended amounts in the financial statement columns produce pro forma financial statements because they show the statements as if the proposed transactions had occurred.

APPENDIX

Reversing Entries 3C Reversing entries are optional. They are recorded in response to accrued assets and accrued liabilities that were created by adjusting entries at the end of a reporting period. Reversing entries simplify re- cordkeeping. Exhibit 3C.1 shows an example of FastForward’s reversing entries. The top of the exhibit shows the adjusting entry FastForward recorded on December 31 for its employee’s earned but unpaid salary. The entry recorded three days’ salary of $210, which increased December’s total salary expense to $1,610. The entry also recognized a liability of $210. The expense is reported on December’s income statement. The expense account is then closed. The ledger on January 1, 2020, shows a $210 liability and a zero balance in the Salaries Expense account. At this point, the choice is made between using or not using reversing entries.

Accounting without Reversing Entries The path down the left side of Exhibit 3C.1 is described in the chapter. To summarize, when the next payday occurs on January 9, we record payment with a compound entry that debits both the expense and liability accounts and credits Cash. Posting that entry creates a $490 balance in the expense account and reduces the liability account balance to zero because the payable has been settled.

Accounting with Reversing Entries The right side of Exhibit 3C.1 shows reversing entries. A reversing entry is the exact opposite of an adjusting entry. For FastForward, the Salaries Payable liability account is debited for $210, meaning that this account now has a zero balance after the entry is posted on January 1. The Salaries Payable account temporarily understates the liability, but this is not a problem because financial statements are not prepared before the liability is settled on January 9. The credit to the Salaries Expense account is unusual because it gives the account an abnormal credit balance. We highlight an abnormal balance by circling it. Because of the reversing entry, the January 9 entry to record payment debits the Salaries Expense account and credits Cash for the full $700 paid. It is the same as all other entries made to record 10 days’ salary for the employee. We see that after the payment entry is posted, the Salaries Expense account has a $490 balance that reflects seven days’ salary of $70 per day (see the lower right side of Exhibit 3C.1). The zero balance in the Salaries Payable account is now correct. The lower section of Exhibit 3C.1 shows that the expense and liability accounts have exactly the same balances whether reversing entries are used or not.

P11 Prepare reversing entries and explain their purpose.

Point: Adjusting entries that cre- ate new asset or liability accounts likely require reversing.

116 Chapter 3 Adjusting Accounts for Financial Statements

Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Prepaid insurance expires:

Supplies are used up:

Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Depreciation of assets:

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Accumulated Depreciation—Equipment . . . . . . . . . 300

Salaries Expense

Accrue salaries expense on December 31, 2019

No reversing entry recorded on Jan. 1, 2020

WITHOUT Reversing Entries WITH Reversing Entries

Under both approaches, the expense and liability accounts have identical balances after the cash payment on January 9.

210 Salaries Payable 210

Salaries Expense

Salaries Payable

Date 2019 Dec. 12 700 700(7)

26 31

700 1,400 1,610

(16) 210(e)

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 210210

Expl. Debit BalanceCredit

Salaries Expense $490 Salaries Payable $ 0

Reversing entry recorded on Jan. 1, 2020— OR —

*Circled numbers in the Balance column indicate abnormal balances.

Salaries Expense 490 Salaries Payable 210

Cash 700 Salaries Expense

Salaries Payable

Date 2020 Jan. 9 490 490

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 210210

Expl. Debit BalanceCredit

NO ENTRY

Salaries Expense

Salaries Payable

Date 2020

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 2020

210210

2020 Jan. 9 0210

Expl. Debit BalanceCredit

Salaries Expense 700 Cash 700

Salaries Expense*

Salaries Payable

Date 2020 Jan. 1 Jan. 9 700 490

(e)

Expl. Debit

210

BalanceCredit

Date 2019 Dec. 31 210210 2020 Jan. 1 0210

Expl. Debit BalanceCredit

Salaries Expense*

Salaries Payable

Date 2020

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 2020 Jan. 1

210210

210 0

Expl. Debit BalanceCredit

Salaries Payable 210 Salaries Expense 210

Jan. 1 210

210

210

Pay the accrued and current salaries on January 9, the first payday in 2020

EXHIBIT 3C.1 Reversing Entries for an Accrued Expense

DEFERRAL OF EXPENSE Prepaid expenses: Assets paid for in advance of receiving their benefits. When these assets are used, the advance payments become expenses.

Summary: Cheat Sheet

Accumulated depreciation: A separate contra account. A contra account is an account linked with another account. It has an opposite normal bal- ance and is a subtraction from that other account’s balance.

Chapter 3 Adjusting Accounts for Financial Statements 117

ACCRUED EXPENSE Accrued expenses: Costs incurred in a period that are both unpaid and unrecorded. They are reported on the income statement for the period when incurred.

Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Salaries expense owed but not yet paid:

Record unearned revenue (cash received in advance):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Unearned Consulting Revenue . . . . . . . . . . . . . . . . 3,000

Reduce unearned revenue (products or services are provided):

Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . 250 Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 250

DEFERRAL OF REVENUE Unearned revenue: Cash received in advance of providing products and services. When cash is accepted, the company has a liability to provide products or services.

Accrued interest formula:

Principal amount owed × Annual interest rate × Fraction of year since last payment

Salaries Payable (3 days at $70 per day) . . . . . . . . . . . . 210 Salaries Expense (7 days at $70 per day) . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Payment of accrued expenses:

REPORTING AND ANALYSIS Unadjusted trial balance: A list of ledger accounts and balances before adjustments are recorded. Adjusted trial balance: A list of accounts and balances after adjusting entries have been recorded and posted to the ledger.

Revenue earned but not received in cash:

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Receipt of accrued revenue:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700 Accounts Receivable (20 days at $90 per day) . . . 1,800 Consulting Revenue (10 days at $90 per day) . . . 900

ACCRUED REVENUE Accrued revenues: Revenues earned in a period that are both unrecorded and not yet received in cash.

Steps to Prepare Financial Statements Prepare income statement using revenue and expense accounts from trial balance

Prepare balance sheet using asset and liability accounts along with common stock from trial balance; pull updated retained earnings from step 2

Prepare statement of retained earnings using retained earnings and dividends from trial balance; pull net income from step 1

Prepare statement of cash flows from changes in cash flows for the period (illustrated later in the book)

Step 1

Step 2

Step 4

Step 3

$47,610

Acct. No. Account Title Debit

8,670 2,300

1,800 $ 4,275

26,000

300 1,610

100 1,000 1,050

305

101 Cash ........................................................... Accounts receivable .............................. Supplies .................................................... Prepaid insurance .................................. Equipment ................................................ Accumulated depreciation—Equip..... Accounts payable .................................. Salaries payable .....................................

106 126 128 167 168 201 209

Unearned consulting revenue ............236

Consulting revenue ...............................403 Rental revenue ........................................ 406 Depreciation expense—Equip. ..........612 Salaries expense ....................................622 Insurance expense ................................637 Rent expense ..........................................640 Supplies expense ...................................652 Utilities expense ..................................... Totals .........................................................

690

$ 300

210 6,200

2,750 30,000

300 7,850

$47,610

Credit

Common stock ....................................... Retained earnings .................................

307 318 0

200Dividends .................................................319

Step 2 Prepare statement of retained earnings

$ 3,785

200 $3,585

3,785 Less: Dividends .................................. . . . Retained earnings, December 31 ......

Retained earnings, December 1......... Plus: Net income ................................... . . .

0

Assets

Liabilities

Equity

Cash ..................................................... $ 4,275

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

Accounts receivable ........................ 1,800

Unearned consulting revenue ....... 2,750 Salaries payable ................................ 210

8,670 2,300

Supplies .............................................. Prepaid insurance .............................

Total assets ........................................ $ 42,745 25,700

$26,000

6,200

Equipment .......................................... 300Less accumulated depreciation......

Common stock ................................... Retained earnings .............................. Total equity ......................................... Total liabilities and equity ...............

3,585

Total liabilities ....................................... 9,160

$

30,000

$ 42,745 33,585

Step 1 Prepare income statement

Revenues Consulting revenue ............................. $7,850

300 Rental revenue ..................................... Total revenues ......................................

Depreciation expense—Equip.......... Expenses

Salaries expense................................... Insurance expense............................... Rent expense......................................... Supplies expense ................................. Utilities expense.................................... Total expenses........................................ Net income................................................

300 1,610 100

305

1,000 1,050

4,365 $3,785

$8,150

Step 3 Prepare balance sheet

FASTFORWARD Balance Sheet

December 31, 2019

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

FASTFORWARD Income Statement

For Month Ended December 31, 2019

FASTFORWARD Adjusted Trial Balance

December 31, 2019

Preparing financial statements from adjusted trial balance:

CLOSING PROCESS Closing process: Occurs at period-end after financial statements have been prepared. Resets revenue, expense, and dividends balances to zero. Temporary accounts: Closed at period-end. They consist of revenue, expense, dividends, and Income Summary. Permanent accounts: Not closed at period-end. They consist of asset, liability, common stock, and retained earnings (all balance sheet accounts). Income Summary: A temporary account only used for the closing process that has a credit for total revenues and a debit for total expenses.

Balance 8,150 8,150

Expense Accounts

4,365 8,150

Balance 3,785

Income Summary

3,785

Balance 30,000

200 3,785

Balance 33,585

Retained Earnings 3 Close income statement credit balances1

Close income statement debit balances2

Close Income Summary account3

Close dividends account4

Four-Step Closing Process

Balance 200 200

Dividends

4

Balance 4,365 4,365 2

Revenue Accounts

1

Closing Process Journal Entries by Step

1

2

Consulting Revenue . . . . . . . . . . . . . 7,850 Rental Revenue . . . . . . . . . . . . . . . . . 300 Income Summary . . . . . . . . . . . . . 8,150

Income Summary . . . . . . . . . . . . . . . . 4,365 Depreciation Expense—Equip . . . . 300 Salaries Expense . . . . . . . . . . . . . . 1,610 Insurance Expense . . . . . . . . . . . . 100 Rent Expense . . . . . . . . . . . . . . . . 1,000 Supplies Expense . . . . . . . . . . . . . 1,050 Utilities Expense . . . . . . . . . . . . . . 305

Income Summary . . . . . . . 3,785 Retained Earnings . . . . 3,785

Retained Earnings . . . . . . 200 Dividends . . . . . . . . . . . 200

3

4

Post-closing trial balance: A list of permanent accounts (assets, liabili- ties, equity) and their balances after all closing entries.

118 Chapter 3 Adjusting Accounts for Financial Statements

CLASSIFIED BALANCE SHEET Classified balance sheet: Organizes assets and liabilities into meaningful subgroups. Current vs. long-term classification: Current items are to be col- lected or owed within one year. Long-term items are expected after one year. Current assets: Assets to be sold, collected, or used within one year. Examples are cash, short-term investments, accounts receivable, short- term notes receivable, merchandise, inventory, and prepaid expenses. Long-term investments: Assets to be held for more than one year. Examples are notes receivable, long-term investments in stock and bonds, and land held for future expansion. Plant assets: Tangible assets used to produce or sell products and services. Examples are equipment, machinery, buildings, and land used in operations. Intangible assets: Long-term assets that lack physical form. Examples are patents, trademarks, copyrights, franchises, and goodwill.

Current liabilities: Liabilities to be paid or settled within one year. Examples are accounts payable, wages payable, taxes payable, interest pay- able, unearned revenues, and current portions of notes or long-term debt. Long-term liabilities: Liabilities not due within one year. Examples are notes payable, mortgages payable, bonds payable, and lease obligations. Equity: The owner’s claim on assets. For a corporation, this is common stock and retained earnings.

Common Layout of Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities Noncurrent assets Noncurrent liabilities Long-term investments Plant assets Equity Intangible assets

Accounting cycle (104) Accounting period (85) Accrual basis accounting (86) Accrued expenses (93) Accrued revenues (95) Accumulated depreciation (90) Adjusted trial balance (98) Adjusting entry (87) Annual financial statements (85) Book value (90) Cash basis accounting (86) Classified balance sheet (105) Closing entries (101) Closing process (100) Contra account (90)

Current assets (106) Current liabilities (107) Current ratio (108) Depreciation (89) Expense recognition (or matching)

principle (87) Fiscal year (85) Income Summary (101) Intangible assets (107) Interim financial statements (85) Long-term investments (106) Long-term liabilities (107) Natural business year (86) Operating cycle (106) Permanent accounts (101)

Plant assets (89) Post-closing trial balance (104) Prepaid expenses (87) Pro forma financial statements (115) Profit margin (108) Revenue recognition principle (87) Reversing entries (115) Straight-line depreciation (89) Temporary accounts (101) Time period assumption (85) Unadjusted trial balance (98) Unclassified balance sheet (105) Unearned revenue (91) Work sheet (113)

Key Terms

Multiple Choice Quiz

1. A company forgot to record accrued and unpaid employee wages of $350,000 at period-end. This oversight would a. Understate net income by $350,000. b. Overstate net income by $350,000. c. Have no effect on net income. d. Overstate assets by $350,000. e. Understate assets by $350,000.

2. Prior to recording adjusting entries, the Supplies account has a $450 debit balance. A physical count of supplies shows $125 of unused supplies still available. The required adjusting entry is

a. Debit Supplies $125; credit Supplies Expense $125. b. Debit Supplies $325; credit Supplies Expense $325. c. Debit Supplies Expense $325; credit Supplies $325. d. Debit Supplies Expense $325; credit Supplies $125. e. Debit Supplies Expense $125; credit Supplies $125.

3. On May 1 of the current year, a two-year insurance policy was purchased for $24,000 with coverage to begin immedi- ately. What is the amount of insurance expense that appears on the company’s income statement for the current year ended December 31? a. $4,000 c. $12,000 e. $24,000 b. $8,000 d. $20,000

Chapter 3 Adjusting Accounts for Financial Statements 119

A(B,C) Superscript letter A, B, or C denotes assignments based on Appendix 3A, 3B, or 3C.

Icon denotes assignments that involve decision making.

1. What is the difference between the cash basis and the accrual basis of accounting?

2. Why is the accrual basis of accounting generally preferred over the cash basis?

3. What type of business is most likely to select a fiscal year that corresponds to its natural business year instead of the calendar year?

4. What is a prepaid expense and where is it reported in the financial statements?

5. What contra account is used when recording and re- porting the effects of depreciation? Why is it used?

6. What is an accrued revenue? Give an example. 7. What are the steps in recording closing entries? 8. What is the purpose of the Income Summary account? 9. Explain whether an error has occurred if a post-closing

trial balance includes a Depreciation Expense account. 10. What is a company’s operating cycle? 11. What classes of assets and liabilities are shown on a typical

classified balance sheet? 12. How is unearned revenue classified on the balance sheet?

13.A If a company initially records prepaid expenses with debits to expense accounts, what type of account is debited in the adjusting entries for those prepaid expenses?

14.C If a company recorded accrued salaries expense of $500 at the end of its fiscal year, what reversing entry could be made? When would it be made?

15. Refer to Apple’s most recent balance sheet in Appendix A. What five main noncurrent as- set categories are used on its classified balance sheet?

16. Refer to Google’s most recent balance sheet in Appendix A. Identify the six accounts listed as current liabilities.

17. Review Google’s balance sheet in Appendix A. Identify the amount for prop- erty and equipment. What adjusting entry is necessary (no numbers required) for this account when preparing finan- cial statements?

18. Refer to Samsung’s financial state- ments in Appendix A. What journal entry was likely recorded as of December 31, 2017, to close its Income Summary account?

Discussion Questions

APPLE

Samsung

GOOGLE

GOOGLE

4. On November 1, Stockton Co. receives $3,600 cash from Hans Co. for consulting services to be provided evenly over the period November 1 to April 30—at which time Stockton credits $3,600 to Unearned Consulting Fees. The adjusting entry on December 31 (Stockton’s year-end) would include a a. Debit to Unearned Consulting Fees for $1,200. b. Debit to Unearned Consulting Fees for $2,400. c. Credit to Consulting Fees Earned for $2,400. d. Debit to Consulting Fees Earned for $1,200. e. Credit to Cash for $3,600.

5. The following information is available for a company before closing the accounts. After all of the closing entries are made, what will be the balance in the Retained Earnings account?

a. $360,000 d. $150,000 b. $250,000 e. $60,000 c. $160,000

Total revenues . . $300,000

Total expenses . . 195,000

Retained earnings . . . $100,000

Dividends . . . . . . . . . . 45,000

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; the forgotten adjusting entry is: dr. Wages Expense, cr. Wages Payable.

2. c; Supplies used = $450 − $125 = $325 3. b; Insurance expense = $24,000 × (8∕24) = $8,000; adjusting entry

is: dr. Insurance Expense for $8,000, cr. Prepaid Insurance for $8,000.

4. a; Consulting fees earned = $3,600 × (2∕6) = $1,200; adjusting entry is: dr. Unearned Consulting Fees for $1,200, cr. Consulting Fees Earned for $1,200.

5. c; $100,000 + $300,000 − $195,000 − $45,000

QUICK STUDY

QS 3-1 Periodic reporting

C1

Choose from the following list of terms and phrases to best complete the statements below. a. Fiscal year c. Accrual basis accounting e. Cash basis accounting b. Timeliness d. Annual financial statements f. Time period assumption 1. presumes that an organization’s activities can be divided into specific time periods. 2. Financial reports covering a one-year period are known as . 3. A(n) consists of any 12 consecutive months. 4. records revenues when services are provided and records expenses when incurred. 5. The value of information is often linked to its .

120 Chapter 3 Adjusting Accounts for Financial Statements

QS 3-2 Computing accrual and cash income

C1

In its first year of operations, Roma Company reports the following.

∙ Earned revenues of $45,000 ($37,000 cash received from customers). ∙ Incurred expenses of $25,500 ($20,250 cash paid toward them). ∙ Prepaid $6,750 cash for costs that will not be expensed until next year.

Compute Roma’s first-year net income under the cash basis and the accrual basis of accounting.

QS 3-3 Identifying accounting adjustments

P1 P2 P3 P4

Classify the following adjusting entries as involving prepaid expenses (PE), unearned revenues (UR), accrued expenses (AE), or accrued revenues (AR).

a. To record revenue earned that was previously received as cash in advance. b. To record wages expense incurred but not yet paid (nor recorded). c. To record revenue earned but not yet billed (nor recorded). d. To record expiration of prepaid insurance. e. To record annual depreciation expense.

QS 3-4 Concepts of adjusting entries

P1 P2 P3 P4

During the year, a company recorded prepayments of expenses in asset accounts and cash receipts of unearned revenues in liability accounts. At the end of its annual accounting period, the company must make three adjusting entries. (1) Accrue salaries expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. ___ Cr. ___ (2) Adjust the Unearned Services Revenue account to recognize earned revenue. . . . . . . Dr. ___ Cr. ___ (3) Record services revenue earned for which cash will be received the following period.. . Dr. ___ Cr. ___

For each of the adjusting entries (1), (2), and (3), indicate the account to be debited and the account to be credited—from a through i below. a. Prepaid Insurance d. Unearned Services Revenue g. Accounts Receivable b. Cash e. Salaries Expense h. Accounts Payable c. Salaries Payable f. Services Revenue i. Depreciation Expense

QS 3-5 Prepaid (deferred) expenses adjustments

P1

For each separate case below, follow the three-step process for adjusting the prepaid asset account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Prepaid Insurance. The Prepaid Insurance account has a $4,700 debit balance to start the year. A

review of insurance policies shows that $900 of unexpired insurance remains at year-end. b. Prepaid Insurance. The Prepaid Insurance account has a $5,890 debit balance at the start of the year.

A review of insurance policies shows $1,040 of insurance has expired by year-end. c. Prepaid Rent. On September 1 of the current year, the company prepaid $24,000 for two years of rent

for facilities being occupied that day. The company debited Prepaid Rent and credited Cash for $24,000.

QS 3-6 Prepaid (deferred) expenses adjustments

P1

For each separate case below, follow the three-step process for adjusting the Supplies asset account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Supplies. The Supplies account has a $300 debit balance to start the year. No supplies were purchased

during the current year. A December 31 physical count shows $110 of supplies remaining. b. Supplies. The Supplies account has an $800 debit balance to start the year. Supplies of $2,100 were

purchased during the current year and debited to the Supplies account. A December 31 physical count shows $650 of supplies remaining.

c. Supplies. The Supplies account has a $4,000 debit balance to start the year. During the current year, supplies of $9,400 were purchased and debited to the Supplies account. The inventory of supplies available at December 31 totaled $2,660.

QS 3-7 Adjusting prepaid (deferred) expenses

P1

For each separate case, record the necessary adjusting entry. a. On July 1, Lopez Company paid $1,200 for six months of insurance coverage. No adjustments have

been made to the Prepaid Insurance account, and it is now December 31. Prepare the year-end adjust- ing entry to reflect expiration of the insurance as of December 31.

Chapter 3 Adjusting Accounts for Financial Statements 121

QS 3-8 Accumulated depreciation adjustments

P1

For each separate case below, follow the three-step process for adjusting the Accumulated Depreciation account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Accumulated Depreciation. The Krug Company’s Accumulated Depreciation account has a $13,500

balance to start the year. A review of depreciation schedules reveals that $14,600 of depreciation expense must be recorded for the year.

b. Accumulated Depreciation. The company has only one fixed asset (truck) that it purchased at the start of this year. That asset had cost $44,000, had an estimated life of five years, and is expected to have zero value at the end of the five years.

c. Accumulated Depreciation. The company has only one fixed asset (equipment) that it purchased at the start of this year. That asset had cost $32,000, had an estimated life of seven years, and is expected to be valued at $4,000 at the end of the seven years.

QS 3-9 Adjusting for depreciation

P1

For each separate case, record an adjusting entry (if necessary). a. Barga Company purchases $20,000 of equipment on January 1. The equipment is expected to last five

years and be worth $2,000 at the end of that time. Prepare the entry to record one year’s depreciation expense of $3,600 for the equipment as of December 31.

b. Welch Company purchases $10,000 of land on January 1. The land is expected to last forever. What depreciation adjustment, if any, should be made with respect to the Land account as of December 31?

QS 3-10 Unearned (deferred) revenues adjustments

P2

For each separate case below, follow the three-step process for adjusting the unearned revenue liability account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Unearned Rent Revenue. The Krug Company collected $6,000 rent in advance on November 1, deb-

iting Cash and crediting Unearned Rent Revenue. The tenant was paying 12 months’ rent in advance and occupancy began November 1.

b. Unearned Services Revenue. The company charges $75 per insect treatment. A customer paid $300 on October 1 in advance for four treatments, which was recorded with a debit to Cash and a credit to Unearned Services Revenue. At year-end, the company has applied three treatments for the customer.

c. Unearned Rent Revenue. On September 1, a client paid the company $24,000 cash for six months of rent in advance (the client leased a building and took occupancy immediately). The company recorded the cash as Unearned Rent Revenue.

QS 3-11 Adjusting for unearned (deferred) revenues

P2

For each separate case, record the necessary adjusting entry. a. Tao Co. receives $10,000 cash in advance for four months of evenly planned legal services beginning

on October 1. Tao records it by debiting Cash and crediting Unearned Revenue both for $10,000. It is now December 31, and Tao has provided legal services as planned. What adjusting entry should Tao make to account for the work performed from October 1 through December 31?

b. Caden started a new publication called Contest News. Its subscribers pay $24 to receive 12 monthly issues. With every new subscriber, Caden debits Cash and credits Unearned Subscription Revenue for the amounts received. The company has 100 new subscribers as of July 1. It sends Contest News to each of these subscribers every month from July through December. Assuming no changes in sub- scribers, prepare the year-end journal entry that Caden must make as of December 31 to adjust the Subscription Revenue account and the Unearned Subscription Revenue account.

b. Zim Company has a Supplies account balance of $5,000 at the beginning of the year. During the year, it purchases $2,000 of supplies. As of December 31, a physical count of supplies shows $800 of supplies available. Prepare the adjusting journal entry to correctly report the balance of the Supplies account and the Supplies Expense account as of December 31.

For each separate case below, follow the three-step process for adjusting the accrued expense account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Salaries Payable. At year-end, salaries expense of $15,500 has been incurred by the company but is

not yet paid to employees.

QS 3-12 Accrued expenses adjustments

P3

[continued on next page]

122 Chapter 3 Adjusting Accounts for Financial Statements

Molly Mocha employs one college student every summer in her coffee shop. The student works the five weekdays and is paid on the following Monday. (For example, a student who works Monday through Friday, June 1 through June 5, is paid for that work on Monday, June 8.) The coffee shop adjusts its books monthly, if needed, to show salaries earned but unpaid at month-end. The student works the last week of July, which is Monday, July 28, through Friday, August 1. If the student earns $100 per day, what adjust- ing entry must the coffee shop make on July 31 to correctly record accrued salaries expense for July?

QS 3-13 Accruing salaries

P3

For each separate case below, follow the three-step process for adjusting the accrued revenue account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Accounts Receivable. At year-end, the L. Cole Company has completed services of $19,000 for a

client, but the client has not yet been billed for those services. b. Interest Receivable. At year-end, the company has earned, but not yet recorded, $390 of interest

earned from its investments in government bonds. c. Accounts Receivable. A painting company bills customers when jobs are complete. The work for one

job is now complete. The customer has not yet been billed for the $1,300 of work.

QS 3-14 Accrued revenues adjustments

P4

Adjusting entries affect at least one balance sheet account and at least one income statement account. For the entries below, identify the account to be debited and the account to be credited from the following ac- counts: Cash; Accounts Receivable; Prepaid Insurance; Equipment; Accumulated Depreciation; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Insurance Expense; and Depreciation Expense. Indicate which of the accounts is the income statement account and which is the balance sheet account. a. Entry to record revenue earned that was previously received as cash in advance. b. Entry to record wage expenses incurred but not yet paid (nor recorded). c. Entry to record revenue earned but not yet billed (nor recorded). d. Entry to record expiration of prepaid insurance. e. Entry to record annual depreciation expense.

QS 3-15 Recording and analyzing adjusting entries

P1 P2 P3 P4

In making adjusting entries at the end of its accounting period, Chao Consulting mistakenly forgot to record: 1. $3,200 of insurance coverage that had expired (this $3,200 cost had been initially debited to the

Prepaid Insurance account). 2. $2,000 of accrued salaries expense. As a result of these two oversights, the financial statements for the reporting period will [choose one]: a. Understate assets by $3,200. c. Understate net income by $2,000. b. Understate expenses by $5,200. d. Overstate liabilities by $2,000.

QS 3-16 Determining effects of adjusting entries

P1 P3

Following are unadjusted balances along with year-end adjustments for Quinlan Company. Complete the adjusted trial balance by entering the adjusted balance for each of the following accounts.

QS 3-17 Preparing an adjusted trial balance

P5 $8,000

2,000 4,500

5,500 0

3,000 6,000

11,000

101 106 126 209 307 318 403 622 652

Cash Accounts receivable Supplies Salaries payable Common stock Retained earnings Consulting revenue Salaries expense Supplies expense

Account Title Dr.

$4,000

400 2,500

Dr.

$2,500

400

4,000

Cr.Cr.No. Unadjusted Trial Balance

Dr. Cr. Adjusted Trial BalanceAdjustments

$ 0

The ledger of Mai Company includes the following accounts with normal balances as of December 31: Common Stock $9,000; Dividends $800; Services Revenue $13,000; Wages Expense $8,400; and Rent Expense $1,600. Prepare its December 31 closing entries.

QS 3-18 Preparing closing entries from the ledger P7

b. Interest Payable. At its December 31 year-end, the company owes $250 of interest on a line-of-credit loan. That interest will not be paid until sometime in January of the next year.

c. Interest Payable. At its December 31 year-end, the company holds a mortgage payable that has in- curred $875 in annual interest that is neither recorded nor paid. The company intends to pay the inter- est on January 7 of the next year.

Chapter 3 Adjusting Accounts for Financial Statements 123

Identify which of the following accounts would be included in a post-closing trial balance. a. Accounts Receivable c. Goodwill e. Income Tax Expense b. Salaries Expense d. Land f. Salaries Payable

QS 3-19 Identifying post-closing accounts P8

The following are common categories on a classified balance sheet. A. Current assets C. Plant assets E. Current liabilities B. Long-term investments D. Intangible assets F. Long-term liabilities

For each of the following items, select the letter that identifies the balance sheet category where the item typically would best appear.

1. Land held for future expansion 5. Accounts payable 2. Notes payable (due in five years) 6. Store equipment 3. Accounts receivable 7. Wages payable 4. Trademarks 8. Cash

QS 3-21 Classifying balance sheet items

C3

List the following steps of the accounting cycle in their proper order. a. Posting the journal entries. b. Journalizing and posting adjusting entries. c. Preparing the adjusted trial balance. d. Journalizing and posting closing entries. e. Analyzing transactions and events.

QS 3-20 Identifying the accounting cycle

C2

f. Preparing the financial statements. g. Preparing the unadjusted trial balance. h. Journalizing transactions and events. i. Preparing the post-closing trial balance.

Use the following adjusted trial balance of Sierra Company to prepare its (1) income statement and (2) statement of retained earnings for the year ended December 31. The Retained Earnings account bal- ance was $5,500 on December 31 of the prior year.

QS 3-22 Preparing financial statements

P6 Cash Prepaid insurance Notes receivable (due in 5 years) Buildings Accumulated depreciation—Buildings Accounts payable Notes payable (due in 3 years) Common stock Retained earnings Dividends Consulting revenue Wages expense Depreciation expense—Buildings Insurance expense

Adjusted Trial Balance Debit Credit

$12,000 2,500 3,000 5,000 5,500

9,500

$37,500

$ 5,000 500

4,000 20,000

3,500 2,000 1,500

$37,500

1,000

Totals

Damita Company reported net income of $48,025 and net sales of $425,000 for the current year. Calculate the company’s profit margin and interpret the result. Assume that its competitors earn an average profit margin of 15%.

QS 3-24 Analyzing profit margin

A1

Use the information in the adjusted trial balance reported in QS 3-22 to prepare Sierra Company’s classi- fied balance sheet as of December 31.

QS 3-23 Preparing a classified balance sheet C3

Compute Chavez Company’s current ratio using the following information. QS 3-25 Identifying current accounts and computing the current ratio

A2

Accounts receivable . . . . . . . . . . . . $18,000 Long-term notes payable . . . . . . . . . . . . . . . $21,000

Accounts payable . . . . . . . . . . . . . . 11,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . 2,800

Buildings . . . . . . . . . . . . . . . . . . . . . 45,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . 3,560

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Unearned services revenue . . . . . . . . . . . . . 3,000

124 Chapter 3 Adjusting Accounts for Financial Statements

QS 3-26A Preparing adjusting entries

P9

Garcia Company had the following selected transactions during the year. (A partial chart of accounts fol- lows: Cash; Accounts Receivable; Prepaid Insurance; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Insurance Expense; Depreciation Expense.)

Jan. 1 The company paid $6,000 cash for 12 months of insurance coverage beginning immediately. Aug. 1 The company received $2,400 cash in advance for 6 months of contracted services beginning on

August 1 and ending on January 31. Dec. 31 The company prepared any necessary year-end adjusting entries related to insurance coverage

and services performed.

a. Record journal entries for these transactions assuming Garcia follows the usual practice of recording a prepayment of an expense in an asset account and recording a prepayment of revenue received in a liability account.

b. Record journal entries for these transactions assuming Garcia follows the alternative practice of re- cording a prepayment of an expense in an expense account and recording a prepayment of revenue received in a revenue account.

QS 3-28C Reversing entries

P11

On December 31, Yates Co. prepared an adjusting entry for $12,000 of earned but unrecorded consulting revenue. On January 16, Yates received $26,700 cash as payment in full for consulting work it provided that began on December 18 and ended on January 16. The company uses reversing entries. a. Prepare the December 31 adjusting entry. c. Prepare the January 16 cash receipt entry. b. Prepare the January 1 reversing entry.

The Adjusted Trial Balance columns of a 10-column work sheet for Planta Company follow. Complete the work sheet by extending the account balances into the appropriate financial statement columns and by entering the amount of net income for the reporting period.

QS 3-27B Extending accounts in a work sheet P10

$ 7,000 27,200 42,000

32,000

15,400

6,500 38,000 13,000 8,700

$189,800

$ 17,500

15,000 4,200 3,600

20,000 45,500

84,000

$189,800

101 106 153 154 183 201 209 233 307 318 319 401 611 622 640 677

Cash Accounts receivable Trucks Accumulated depreciation—Trucks Land Accounts payable Salaries payable Unearned fees Common stock Retained earnings Dividends Plumbing fees earned Depreciation expense—Trucks Salaries expense Rent expense Miscellaneous expenses Totals Net income Totals

Account Title

Unadjusted Trial Balance

Adjusted Trial Balance

Dr. Adjustments

Cr. Dr. Cr.

Income Statement

Dr. Cr. Balance Sheet

Dr. Cr.Dr. Cr.No.

Check Net income, $17,800

EXERCISES

Exercise 3-1 Preparing adjusting entries

P1 P2 P3

Prepare adjusting journal entries for the year ended (date of) December 31 for each of these separate situ- ations. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Supplies; Prepaid Insurance; Prepaid Rent; Equipment; Accumulated Depreciation—Equipment; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Supplies Expense; Insurance Expense; Rent Expense; and Depreciation Expense—Equipment. a. Depreciation on the company’s equipment for the year is computed to be $18,000. b. The Prepaid Insurance account had a $6,000 debit balance at December 31 before adjusting for the

costs of any expired coverage. An analysis of the company’s insurance policies showed that $1,100 of unexpired insurance coverage remains.

c. The Supplies account had a $700 debit balance at the beginning of the year; and $3,480 of supplies were purchased during the year. The December 31 physical count showed $300 of supplies available.

Check (c) Dr. Supplies Expense, $3,880

Chapter 3 Adjusting Accounts for Financial Statements 125

Exercise 3-2 Adjusting and paying accrued wages

P3

Pablo Management has five employees, each of whom earns $250 per day. They are paid on Fridays for work completed Monday through Friday of the same week. Near year-end, the five employees worked Monday, December 31, and Wednesday through Friday, January 2, 3, and 4. New Year’s Day (January 1) was an unpaid holiday. a. Prepare the year-end adjusting entry for wages expense. b. Prepare the journal entry to record payment of the employees’ wages on Friday, January 4.

Exercise 3-3 Adjusting and paying accrued expenses

P3

The following three separate situations require adjusting journal entries to prepare financial statements as of April 30. For each situation, present both: ∙ The April 30 adjusting entry. ∙ The subsequent entry during May to record payment of the accrued expenses. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Salaries Payable; Interest Payable; Legal Services Payable; Unearned Revenue; Revenue; Salaries Expense; Interest Expense; Legal Services Expense; and Depreciation Expense. a. On April 1, the company hired an attorney for a flat monthly fee of $3,500. Payment for April legal

services was made by the company on May 12. b. As of April 30, $3,000 of interest expense has accrued on a note payable. The full interest payment of

$9,000 on the note is due on May 20. c. Total weekly salaries expense for all employees is $10,000. This amount is paid at the end of the day

on Friday of each five-day workweek. April 30 falls on a Tuesday, which means that the employees had worked two days since the last payday. The next payday is May 3.

Check (b) May 20, Dr. Interest Expense, $6,000

Exercise 3-4 Preparing adjusting entries

P1 P3 P4

For each of the following separate cases, prepare adjusting entries required of financial statements for the year ended (date of) December 31. Entries can draw from the following partial chart of accounts: Cash; Interest Receivable; Supplies; Prepaid Insurance; Equipment; Accumulated Depreciation—Equipment; Wages Payable; Interest Payable; Unearned Revenue; Interest Revenue; Wages Expense; Supplies Expense; Insurance Expense; Interest Expense; and Depreciation Expense—Equipment. a. Wages of $8,000 are earned by workers but not paid as of December 31. b. Depreciation on the company’s equipment for the year is $18,000. c. The Supplies account had a $240 debit balance at the beginning of the year. During the year, $5,200 of

supplies are purchased. A physical count of supplies at December 31 shows $440 of supplies available. d. The Prepaid Insurance account had a $4,000 balance at the beginning of the year. An analysis of insur-

ance policies shows that $1,200 of unexpired insurance benefits remain at December 31. e. The company has earned (but not recorded) $1,050 of interest revenue for the year ended December

31. The interest payment will be received 10 days after the year-end on January 10. f. The company has a bank loan and has incurred (but not recorded) interest expense of $2,500 for the

year ended December 31. The company will pay the interest five days after the year-end on January 5.

Check (d) Dr. Insurance Expense, $2,800

(e) Cr. Interest Revenue, $1,050

Exercise 3-5 Preparing adjusting entries—accrued revenues and expenses

P3 P4

Prepare year-end adjusting journal entries for M&R Company as of December 31 for each of the following separate cases. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Interest Receivable; Equipment; Wages Payable; Salary Payable; Interest Payable; Lawn Services Payable; Unearned Revenue; Revenue; Interest Revenue; Wages Expense; Salary Expense; Supplies Expense; Lawn Services Expense; and Interest Expense. a. M&R Company provided $2,000 in services to customers in December, which are not yet recorded.

Those customers are expected to pay the company in January following the company’s year-end. b. Wage expenses of $1,000 have been incurred but are not paid as of December 31. c. M&R Company has a $5,000 bank loan and has incurred (but not recorded) 8% interest expense of

$400 for the year ended December 31. The company will pay the $400 interest in cash on January 2 following the company’s year-end.

d. M&R Company hired a firm that provided lawn services during December for $500. M&R will pay for December lawn services on January 15 following the company’s year-end.

e. M&R Company has earned $200 in interest revenue from investments for the year ended December 31. The interest revenue will be received on January 15 following the company’s year-end.

f. Salary expenses of $900 have been earned by supervisors but not paid as of December 31.

d. Two-thirds of the work related to $15,000 of cash received in advance was performed this period. e. The Prepaid Rent account had a $6,800 debit balance at December 31 before adjusting for the costs of

expired prepaid rent. An analysis of the rental agreement showed that $5,800 of prepaid rent had expired. f. Wage expenses of $3,200 have been incurred but are not paid as of December 31.

(e) Dr. Rent Expense, $5,800

126 Chapter 3 Adjusting Accounts for Financial Statements

For each of the following separate cases, prepare the required December 31 year-end adjusting entries. Entries can draw from this partial chart of accounts: Interest Receivable; Prepaid Insurance; Accumulated Depreciation—Equipment; Wages Payable; Unearned Revenue; Consulting Revenue; Interest Revenue; Wages Expense; Insurance Expense; Interest Expense; and Depreciation Expense—Equipment. a. Depreciation on the company’s wind turbine equipment for the year is $5,000. b. The Prepaid Insurance account for the solar panels had a $2,000 debit balance at December 31 before

adjusting for the costs of any expired coverage. Analysis of prepaid insurance shows that $600 of un- expired insurance coverage remains at year-end.

c. The company received $3,000 cash in advance for sustainability consulting work. As of December 31, one-third of the sustainability consulting work had been performed.

d. As of December 31, $1,200 in wages expense for the organic produce workers has been incurred but not yet paid.

e. As of December 31, the company has earned, but not yet recorded, $400 of interest revenue from in- vestments in socially responsible bonds. The interest revenue is expected to be received on January 12.

Exercise 3-6 Preparing adjusting entries

P1 P2 P3 P4

Income Statements For Year Ended December 31

Unadjusted Adjustments Adjusted

Revenues

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000 a . $25,000

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,500 36,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,500 61,500

Expenses

Depreciation expense—Computers . . . . . . . . . . . . . . . . . . 0 b . 1,600

Depreciation expense—Office furniture . . . . . . . . . . . . . . . 0 c . 1,850

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500 d . 15,750

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 e . 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 3,800

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 f . 580

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 2,500

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,245 g . 1,335

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,045 28,815

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,455 $32,685

Following are two income statements for Alexis Co. for the year ended December 31. The left number col- umn is prepared before adjusting entries are recorded, and the right column is prepared after adjusting en- tries. Analyze the statements and prepare the seven adjusting entries a through g that likely were recorded. Hint: The entry for a refers to fees that have been earned but not yet billed. None of the entries involve cash.

Exercise 3-7 Analyzing and preparing adjusting entries

P5

Following are the accounts and balances (in random order) from the adjusted trial balance of Stark Company. Prepare the (1) income statement and (2) statement of retained earnings for the year ended December 31 and (3) balance sheet at December 31. The Retained Earnings account balance was $14,800 on December 31 of the prior year.

Exercise 3-8 Preparing financial statements from a trial balance

P6 Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . $11,000 Accumulated depreciation—Buildings . . . . . . . . . . . . $15,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . 2,500 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . 500 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300

Accounts payable . . . . . . . . . . . . . . . . . . . . . 1,500 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Wages payable . . . . . . . . . . . . . . . . . . . . . . . 400 Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 7,500 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Insurance expense . . . . . . . . . . . . . . . . . . . . 1,800 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Depreciation expense—Buildings . . . . . . . . . . . . . . . 2,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . 14,800 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Services revenue . . . . . . . . . . . . . . . . . . . . . . 20,000

Chapter 3 Adjusting Accounts for Financial Statements 127

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . ¥504,459

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . 283,494

Advertising expense . . . . . . . . . . . . . . . . . . . . . ¥ 46,636

Other expense, net . . . . . . . . . . . . . . . . . . . . . . 157,811

Following are Nintendo’s revenue and expense accounts for a recent March 31 fiscal year-end (yen in millions). Prepare the company’s closing entries for (1) its revenues and (2) its expenses.

Exercise 3-9 Preparing closing entries

P7

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000

126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

168 Accumulated depreciation—Equipment . . . . . . . . . . . . . $   7,500

307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,600

319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

404 Services revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

612 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . 3,000

622 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400

652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $99,100 $99,100

The following adjusted trial balance contains the accounts and year-end balances of Cruz Company as of December 31. (1) Prepare the December 31 closing entries for Cruz Company. Assume the ac- count number for Income Summary is 901. (2) Prepare the December 31 post-closing trial balance for Cruz Company. Note: The Retained Earnings account balance was $37,600 on December 31 of the prior year.

Exercise 3-10 Preparing closing entries and a post-closing trial balance

P7 P8

Use the following adjusted year-end trial balance at December 31 of Wilson Trucking Company to pre- pare the (1) income statement and (2) statement of retained earnings for the year ended December 31. The Retained Earnings account balance was $155,000 at December 31 of the prior year.

Exercise 3-11 Preparing financial statements P6

Account Title Debit Credit

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

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,000

Accumulated depreciation—Trucks . . . . . . . . . . . . . . $ 36,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . 58,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Trucking fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 130,000

Depreciation expense—Trucks . . . . . . . . . . . . . . . . . 23,500

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,000

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . 8,000

Repairs expense—Trucks . . . . . . . . . . . . . . . . . . . . . . 12,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $410,000 $410,000

128 Chapter 3 Adjusting Accounts for Financial Statements

Use the following information to compute profit margin for each separate company a through e. Which of the five companies is the most profitable according to the profit margin ratio? Interpret the profit margin ratio for company c.

Exercise 3-13 Computing and interpreting profit margin

A1 Net Income Net Sales Net Income Net Sales

a. $ 4,361 $ 44,500 d. $65,646 $1,458,800 b. 97,706 398,800 e. 80,132 435,500 c. 111,281 257,000

Ricardo Construction began operations on December 1. In setting up its accounting procedures, the com- pany decided to debit expense accounts when it prepays its expenses and to credit revenue accounts when customers pay for services in advance. Prepare journal entries for items a through d and the adjusting en- tries as of its December 31 period-end for items e through g. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Interest Receivable; Supplies; Prepaid Insurance; Unearned Remodeling Fees; Remodeling Fees Earned; Supplies Expense; Insurance Expense; and Interest Expense. a. Supplies are purchased on December 1 for $2,000 cash. b. The company prepaid its insurance premiums for $1,540 cash on December 2. c. On December 15, the company receives an advance payment of $13,000 cash from a customer for re-

modeling work. d. On December 28, the company receives $3,700 cash from another customer for remodeling work to be

performed in January. e. A physical count on December 31 indicates that the company has $1,840 of supplies available. f. An analysis of insurance policies in effect on December 31 shows that $340 of insurance coverage had

expired. g. As of December 31, only one remodeling project has been worked on and completed. The $5,570 fee

for this project had been received in advance and recorded as remodeling fees earned.

Check (f ) Cr. Insurance Expense, $1,200

(g) Dr. Remodeling Fees Earned, $11,130

Exercise 3-15A Adjusting for prepaids recorded as expenses and unearned revenues recorded as revenues

P9

Use the information in the adjusted trial balance reported in Exercise 3-11 to prepare Wilson Trucking Company’s classified balance sheet as of December 31.

Exercise 3-12 Preparing a classified balance sheet C3

Calculate the current ratio for each of the following companies (round the ratio to two decimals). Identify the company with the strongest liquidity position. (These companies are competitors in the same industry.)

Current Assets Current Liabilities

Edison . . . . . . . . . . $ 79,040 $ 32,000 MAXT . . . . . . . . . . . 104,880 76,000

Chatter . . . . . . . . . 45,080 49,000

TRU . . . . . . . . . . . . 85,680 81,600

Gleeson . . . . . . . . . 61,000 100,000

Exercise 3-14 Computing and analyzing the current ratio

A2

1. Enter the accounts in proper order and enter their balances in the correct Debit or Credit column of the Unadjusted Trial Balance columns of the 10-column work sheet.

The following data are taken from the unadjusted trial balance of the Westcott Company at December 31. Each account carries a normal balance. Set up a 10-column work sheet to answer the requirements.

Exercise 3-16B Preparing unadjusted and adjusted trial balances, including the adjustments

P10 Accounts Payable . . . . . . . . . . . . . . . . . . . . $ 6 Prepaid Insurance . . . . . . $18 Retained Earnings . . . . . . . . . . . . $32

Accounts Receivable . . . . . . . . . . . . . . . . . 12 Revenue . . . . . . . . . . . . . . 75 Dividends . . . . . . . . . . . . . . . . . . . 6

Accumulated Depreciation—Equip . . . . . . . 15 Salaries Expense . . . . . . . 18 Unearned Revenue . . . . . . . . . . . 12

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Supplies . . . . . . . . . . . . . . 24 Utilities Expense . . . . . . . . . . . . . 12

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 39 Common Stock . . . . . . . . 10

[continued on next page]

Chapter 3 Adjusting Accounts for Financial Statements 129

2. Use the following adjustment information to complete the Adjustments columns of the work sheet from part 1.

a. Depreciation on equipment, $3 d. Supplies available at December 31, $15 b. Accrued salaries, $6 e. Expired insurance, $15 c. The $12 of unearned revenue has been earned 3. Extend the balances in the Adjusted Trial Balance columns of the work sheet to the proper financial

statement columns. Compute totals for those columns, including net income.

PROBLEM SET A

Problem 3-1A Identifying adjusting entries with explanations

P1 P2 P3 P4

For journal entries 1 through 12, enter the letter of the explanation that most closely describes it in the space beside each entry. You can use letters more than once. A. To record receipt of unearned revenue. B. To record this period’s earning of prior

unearned revenue. C. To record payment of an accrued expense. D. To record receipt of an accrued revenue.

E. To record an accrued expense. F. To record an accrued revenue. G. To record this period’s use of a prepaid expense. H. To record payment of a prepaid expense. I. To record this period’s depreciation expense.

______ 1. Interest Expense . . . . . . . . . . . . . . . 1,000 Interest Payable . . . . . . . . . . . 1,000

______ 2. Depreciation Expense . . . . . . . . . . 4,000 Accumulated Depreciation . . 4,000

______ 3. Unearned Professional Fees . . . . . 3,000 Professional Fees Earned . . . 3,000

______ 4. Insurance Expense . . . . . . . . . . . . . 4,200 Prepaid Insurance . . . . . . . . . 4,200

______ 5. Salaries Payable . . . . . . . . . . . . . . . 1,400 Cash . . . . . . . . . . . . . . . . . . . . 1,400

______ 6. Prepaid Rent . . . . . . . . . . . . . . . . . . 4,500 Cash . . . . . . . . . . . . . . . . . . . . 4,500

______ 7. Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Salaries Payable . . . . . . . . . . . . . . . . . . . . 6,000

______ 8. Interest Receivable . . . . . . . . . . . . . . . . . . . . . . 5,000 Interest Revenue . . . . . . . . . . . . . . . . . . . 5,000

______ 9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Accounts Receivable (from consulting) . . 9,000

______ 10. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 Unearned Professional Fees . . . . . . . . . . 7,500

______ 11. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Interest Receivable . . . . . . . . . . . . . . . . . . 2,000

______ 12. Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . 2,000

The following two events occurred for Trey Co. on October 31, the end of its fiscal year. a. Trey rents a building from its owner for $2,800 per month. By a prearrangement, the company de-

layed paying October’s rent until November 5. On this date, the company paid the rent for both October and November.

b. Trey rents space in a building it owns to a tenant for $850 per month. By prearrangement, the tenant delayed paying the October rent until November 8. On this date, the tenant paid the rent for both October and November.

Required

1. Prepare adjusting entries that the company must record for these events as of October 31. 2. Assuming Trey does not use reversing entries, prepare journal entries to record Trey’s payment of rent

on November 5 and the collection of the tenant’s rent on November 8. 3. Assuming that the company uses reversing entries, prepare reversing entries on November 1 and the

journal entries to record Trey’s payment of rent on November 5 and the collection of the tenant’s rent on November 8.

Exercise 3-17C Preparing reversing entries

P11

Arnez Company’s annual accounting period ends on December 31, 2019. The following information con- cerns the adjusting entries to be recorded as of that date. Entries can draw from the following partial chart of accounts: Cash; Rent Receivable; Office Supplies; Prepaid Insurance; Building; Accumulated Depreciation—Building; Salaries Payable; Unearned Rent; Rent Earned; Salaries Expense; Office Supplies Expense; Insurance Expense; and Depreciation Expense—Building.

Problem 3-2A Preparing adjusting and subsequent journal entries

P1 P2 P3 P4

[continued on next page]

130 Chapter 3 Adjusting Accounts for Financial Statements

Wells Technical Institute (WTI), a school owned by Tristana Wells, provides training to individuals who pay tuition directly to the school. WTI also offers training to groups in off-site locations. Its unadjusted trial balance as of December 31 follows, along with descriptions of items a through h that require adjust- ing entries on December 31.

Additional Information

a. An analysis of WTI’s insurance policies shows that $2,400 of coverage has expired. b. An inventory count shows that teaching supplies costing $2,800 are available at year-end. c. Annual depreciation on the equipment is $13,200. d. Annual depreciation on the professional library is $7,200. e. On September 1, WTI agreed to do five courses for a client for $2,500 each. Two courses will start

immediately and finish before the end of the year. Three courses will not begin until next year. The client paid $12,500 cash in advance for all five courses on September 1, and WTI credited Unearned Training Fees.

f. On October 15, WTI agreed to teach a four-month class (beginning immediately) for an executive with payment due at the end of the class. At December 31, $7,500 of the tuition has been earned by WTI.

g. WTI’s two employees are paid weekly. As of the end of the year, two days’ salaries have accrued at the rate of $100 per day for each employee.

h. The balance in the Prepaid Rent account represents rent for December.

Problem 3-3A Preparing adjusting entries, adjusted trial balance, and financial statements

P1 P2 P3 P4 P5 P6

Policy Date of Purchase Months of Coverage Cost

A . . . . . . April 1, 2017 24 $14,400

B . . . . . . April 1, 2018 36 12,960

C . . . . . . August 1, 2019 12 2,400

c. The company has 15 employees, who earn a total of $1,960 in salaries each working day. They are paid each Monday for their work in the five-day workweek ending on the previous Friday. Assume that December 31, 2019, is a Tuesday, and all 15 employees worked the first two days of that week. Because New Year’s Day is a paid holiday, they will be paid salaries for five full days on Monday, January 6, 2020.

d. The company purchased a building on January 1, 2019. It cost $960,000 and is expected to have a $45,000 salvage value at the end of its predicted 30-year life. Annual depreciation is $30,500.

e. Since the company is not large enough to occupy the entire building it owns, it rented space to a ten- ant at $3,000 per month, starting on November 1, 2019. The rent was paid on time on November 1, and the amount received was credited to the Rent Earned account. However, the tenant has not paid the December rent. The company has worked out an agreement with the tenant, who has promised to pay both December and January rent in full on January 15. The tenant has agreed not to fall behind again.

f. On November 1, the company rented space to another tenant for $2,800 per month. The tenant paid five months’ rent in advance on that date. The payment was recorded with a credit to the Unearned Rent account.

Required

1. Use the information to prepare adjusting entries as of December 31, 2019. 2. Prepare journal entries to record the first subsequent cash transaction in 2020 for parts c and e.

Check (1b) Dr. Insurance Expense, $7,120 (1d) Dr. Depreciation Expense, $30,500

a. The Office Supplies account started the year with a $4,000 balance. During 2019, the company pur- chased supplies for $13,400, which was added to the Office Supplies account. The inventory of sup- plies available at December 31, 2019, totaled $2,554.

b. An analysis of the company’s insurance policies provided the following facts. The total premium for each policy was paid in full (for all months) at the purchase date, and the Prepaid Insurance account was debited for the full cost. (Year-end adjusting entries for Prepaid Insurance were properly recorded in all prior years.)

Chapter 3 Adjusting Accounts for Financial Statements 131

WELLS TECHNICAL INSTITUTE Unadjusted Trial Balance

December 31

Cash Accounts receivable Teaching supplies Prepaid insurance Prepaid rent Professional library Accumulated depreciation—Professional library Equipment Accumulated depreciation—Equipment Accounts payable Salaries payable Unearned training fees

Tuition fees earned Training fees earned Depreciation expense—Professional library Depreciation expense—Equipment Salaries expense Insurance expense Rent expense Teaching supplies expense Advertising expense Utilities expense Totals

Common stock Retained earnings 80,000

10,000

Dividends

Debit $ 34,000

0 8,000

12,000 3,000

35,000

80,000

50,000

0 0

50,000 0

33,000 0

6,000 6,400

$317,400

Credit

$317,400

$ 10,000

15,000 26,000

0 12,500

123,900 40,000

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. 2. Prepare the necessary adjusting journal entries for items a through h and post them to the T-accounts.

Assume that adjusting entries are made only at year-end. 3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. 4. Prepare Wells Technical Institute’s income statement and statement of retained earnings for the year

and prepare its balance sheet as of December 31. The Retained Earnings account balance was $80,000 on December 31 of the prior year.

Check (2e) Cr. Training Fees Earned, $5,000 (2f) Cr. Tuition Fees Earned, $7,500 (3) Adj. trial balance totals, $345,700 (4) Net income, $49,600

The adjusted trial balance for Chiara Company as of December 31 follows. Problem 3-4A Preparing financial statements from the adjusted trial balance

P6

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 Notes receivable (due in 90 days) . . . . . . . . . . . . . . . . . . . . . . 168,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Automobiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000 Accumulated depreciation—Automobiles . . . . . . . . . . . . . . . . $ 50,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,000 Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . 18,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 Unearned fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235,800 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000

[continued on next page]

132 Chapter 3 Adjusting Accounts for Financial Statements

Required

Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31; (b) the statement of retained earnings for the year ended December 31 [Note: Retained Earnings at December 31 of the prior year was $235,800]; and (c) the balance sheet as of December 31.

Check Total assets, $600,000

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484,000 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Depreciation expense—Automobiles . . . . . . . . . . . . . . . . . . . . 26,000 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . 18,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188,000 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 Repairs expense—Automobiles . . . . . . . . . . . . . . . . . . . . . . . . 24,800 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,134,800 $1,134,800

[continued from previous page]

On April 1, Jiro Nozomi created a new travel agency, Adventure Travel. The following transactions occurred during the company’s first month.

Apr. 1 Nozomi invested $30,000 cash and computer equipment worth $20,000 in the company in exchange for common stock.

2 The company rented furnished office space by paying $1,800 cash for the first month’s (April) rent.

3 The company purchased $1,000 of office supplies for cash. 10 The company paid $2,400 cash for the premium on a 12-month insurance policy. Coverage

begins on April 11. 14 The company paid $1,600 cash for two weeks’ salaries earned by employees. 24 The company collected $8,000 cash for commissions earned. 28 The company paid $1,600 cash for two weeks’ salaries earned by employees. 29 The company paid $350 cash for minor repairs to the company’s computer. 30 The company paid $750 cash for this month’s telephone bill. 30 The company paid $1,500 cash in dividends.

The company’s chart of accounts follows.

Problem 3-5A Applying the accounting cycle

P1 P2 P3 P4 P5 P6 P7 P8

Required

1. Use the balance column format to set up each ledger account listed in its chart of accounts. 2. Prepare journal entries to record the transactions for April and post them to the ledger accounts. The

company records prepaid and unearned items in balance sheet accounts. 3. Prepare an unadjusted trial balance as of April 30. 4. Use the following information to journalize and post adjusting entries for the month: a. Prepaid insurance of $133 has expired this month. b. At the end of the month, $600 of office supplies are still available. c. This month’s depreciation on the computer equipment is $500. d. Employees earned $420 of unpaid and unrecorded salaries as of month-end. e. The company earned $1,750 of commissions that are not yet billed at month-end. 5. Prepare the adjusted trial balance as of April 30. Prepare the income statement and the statement of

retained earnings for the month of April and the balance sheet at April 30. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

Check (3) Unadj. trial balance totals, $58,000

(4a) Dr. Insurance Expense, $133

(5) Net income, $2,197; Total assets, $51,117

101 Cash 106 Accounts Receivable 124 Office Supplies 128 Prepaid Insurance 167 Computer Equipment 168 Accumulated Depreciation—Computer Equip . 209 Salaries Payable

307 Common Stock 318 Retained Earnings 319 Dividends 405 Commissions Earned 612 Depreciation Expense — Computer Equip . 622 Salaries Expense 637 Insurance Expense

640 Rent Expense 650 Office Supplies Expense 684 Repairs Expense 688 Telephone Expense 901 Income Summary

(7) P-C trial balance totals, $51,617

Chapter 3 Adjusting Accounts for Financial Statements 133

The adjusted trial balance for Tybalt Construction as of December 31, 2019, follows. O. Tybalt invested $5,000 cash in the business in exchange for common stock during year 2019. The December 31, 2018, credit balance of the Retained Earnings account was $121,400.

Problem 3-6A Preparing closing entries and financial statements

P6 P7Adjusted Trial Balance December 31, 2019

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 104 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 168 Accumulated depreciation—Equipment . . . . . . . . . . . . . $ 20,000 173 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 174 Accumulated depreciation—Building . . . . . . . . . . . . . . . 50,000 183 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,500 203 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 208 Rent payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 213 Property taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . 900 233 Unearned professional fees . . . . . . . . . . . . . . . . . . . . . . . 7,500 244 Current portion of long-term note payable . . . . . . . . . . . 7,000 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121,400 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 401 Professional fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 97,000 406 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 407 Dividends earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 409 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,100 606 Depreciation expense—Building . . . . . . . . . . . . . . . . . . . 11,000 612 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . 6,000 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 633 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,400 652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,400 682 Postage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200 683 Property taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 684 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,900 688 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200 690 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $411,900 $411,900

Required

1. Prepare the income statement and the statement of retained earnings for calendar-year 2019 and the classified balance sheet at December 31, 2019.

2. Prepare the necessary closing entries at December 31, 2019.

Check (1) Total assets (12/31/2019), $218,100; Net income, $4,300

In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classifica- tion. If the item should not appear on the balance sheet, enter a Z in the blank. A. Current assets B. Long-term investments C. Plant assets

Problem 3-7A Determining balance sheet classifications

C3 D. Intangible assets E. Current liabilities

F. Long-term liabilities G. Equity

1. Long-term investment in stock 2. Depreciation expense—Building 3. Prepaid rent (2 months of rent) 4. Interest receivable 5. Taxes payable (due in 5 weeks) 6. Automobiles 7. Notes payable (due in 3 years) 8. Accounts payable 9. Cash 10. Common stock

11. Unearned services revenue 12. Accumulated depreciation—Trucks 13. Prepaid insurance (expires in 5 months) 14. Buildings 15. Store supplies 16. Office equipment 17. Land (used in operations) 18. Repairs expense 19. Office supplies 20. Current portion of long-term note payable

134 Chapter 3 Adjusting Accounts for Financial Statements

PROBLEM SET B

Problem 3-1B Identifying adjusting entries with explanations

P1 P2 P3 P4

For each of the following journal entries 1 through 12, enter the letter of the explanation that most closely describes it in the space beside each entry. You can use letters more than once. A. To record payment of a prepaid expense. B. To record this period’s use of a prepaid expense. C. To record this period’s depreciation expense. D. To record receipt of unearned revenue. E. To record this period’s earning of prior

unearned revenue.

F. To record an accrued expense. G. To record payment of an accrued expense. H. To record an accrued revenue. I. To record receipt of accrued revenue.

______ 1. Interest Receivable . . . . . . . . . . . . . 3,500 Interest Revenue . . . . . . . . . . 3,500

______ 2. Salaries Payable . . . . . . . . . . . . . . . 9,000 Cash . . . . . . . . . . . . . . . . . . . . 9,000

______ 3. Depreciation Expense . . . . . . . . . . 8,000 Accumulated Depreciation . . 8,000

______ 4. Cash . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Unearned Professional Fees . 9,000

______ 5. Insurance Expense . . . . . . . . . . . . . 4,000 Prepaid Insurance . . . . . . . . . 4,000

______ 6. Interest Expense . . . . . . . . . . . . . . . 5,000 Interest Payable . . . . . . . . . . . 5,000

______ 7. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accounts Receivable (from services) . . . . 1,500

______ 8. Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Salaries Payable . . . . . . . . . . . . . . . . . . . . 7,000

______ 9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Interest Receivable . . . . . . . . . . . . . . . . . . 1,000

______ 10. Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

______ 11. Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . 7,500

______ 12. Unearned Professional Fees . . . . . . . . . . . . . . . 6,000 Professional Fees Earned . . . . . . . . . . . . . 6,000

Problem 3-2B Preparing adjusting and subsequent journal entries

P1 P2 P3 P4

Natsu Company’s annual accounting period ends on October 31, 2019. The following information con- cerns the adjusting entries that need to be recorded as of that date. Entries can draw from the following partial chart of accounts: Cash; Rent Receivable; Office Supplies; Prepaid Insurance; Building; Accumulated Depreciation—Building; Salaries Payable; Unearned Rent; Rent Earned; Salaries Expense; Office Supplies Expense; Insurance Expense; and Depreciation Expense—Building. a. The Office Supplies account started the fiscal year with a $600 balance. During the fiscal year, the

company purchased supplies for $4,570, which was added to the Office Supplies account. The sup- plies available at October 31, 2019, totaled $800.

b. An analysis of the company’s insurance policies provided the following facts. The total premium for each policy was paid in full (for all months) at the purchase date, and the Prepaid Insurance account was debited for the full cost. (Year-end adjusting entries for Prepaid Insurance were properly recorded in all prior fiscal years.)

Policy Date of Purchase Months of Coverage Cost

A . . . . . . April 1, 2018 24 $6,000 B . . . . . . April 1, 2019 36 7,200 C . . . . . . August 1, 2019 12 1,320

c. The company has four employees, who earn a total of $1,000 for each workday. They are paid each Monday for their work in the five-day workweek ending on the previous Friday. Assume that October 31, 2019, is a Monday, and all four employees worked the first day of that week. They will be paid salaries for five full days on Monday, November 7, 2019.

d. The company purchased a building on November 1, 2016, that cost $175,000 and is expected to have a $40,000 salvage value at the end of its predicted 25-year life. Annual depreciation is $5,400.

e. Because the company does not occupy the entire building it owns, it rented space to a tenant at $1,000 per month, starting on September 1, 2019. The rent was paid on time on September 1, and the amount received was credited to the Rent Earned account. However, the October rent has not been paid. The company has worked out an agreement with the tenant, who has promised to pay both October and November rent in full on November 15. The tenant has agreed not to fall behind again.

f. On September 1, the company rented space to another tenant for $725 per month. The tenant paid five months’ rent in advance on that date. The payment was recorded with a credit to the Unearned Rent account.

Required

1. Use the information to prepare adjusting entries as of October 31, 2019. 2. Prepare journal entries to record the first subsequent cash transaction in November 2019 for parts c and e.

Check (1b) Dr. Insurance Expense, $4,730 (1d) Dr. Depreciation Expense, $5,400

Chapter 3 Adjusting Accounts for Financial Statements 135

Following is the unadjusted trial balance for Alonzo Institute as of December 31. The Institute provides one-on-one training to individuals who pay tuition directly to the business and offers extension training to groups in off-site locations. Shown after the trial balance are items a through h that require adjusting entries as of December 31.

Problem 3-3B Preparing adjusting entries, adjusted trial balance, and financial statements

P1 P2 P3 P4 P5 P6 ALONZO INSTITUTE

Unadjusted Trial Balance December 31

Cash Accounts receivable Teaching supplies Prepaid insurance Prepaid rent Professional library Accumulated depreciation—Professional library Equipment Accumulated depreciation—Equipment Accounts payable Salaries payable Unearned training fees Common stock

Tuition fees earned Training fees earned Depreciation expense—Professional library Depreciation expense—Equipment Salaries expense Insurance expense Rent expense Teaching supplies expense Advertising expense Utilities expense Totals

0

0 0

0

$ 60,000 0

70,000 19,000 3,800

12,000

40,000

20,000Dividends

44,200

29,600

19,000 13,400

$331,000

Debit

$331,000

$ 2,500

20,000 11,200

0 28,600 11,000

129,200 68,000

Credit

Retained earnings 60,500

Additional Information

a. An analysis of the Institute’s insurance policies shows that $9,500 of coverage has expired. b. An inventory count shows that teaching supplies costing $20,000 are available at year-end. c. Annual depreciation on the equipment is $5,000. d. Annual depreciation on the professional library is $2,400. e. On November 1, the Institute agreed to do a special two-month course (starting immediately) for

a client. The contract calls for a $14,300 monthly fee, and the client paid the two months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited.

f. On October 15, the Institute agreed to teach a four-month class (beginning immediately) to an execu- tive with payment due at the end of the class. At December 31, $5,750 of the tuition has been earned by the Institute.

g. The Institute’s only employee is paid weekly. As of the end of the year, three days’ salaries have accrued at the rate of $150 per day.

h. The balance in the Prepaid Rent account represents rent for December.

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. 2. Prepare the necessary adjusting journal entries for items a through h, and post them to the T-accounts.

Assume that adjusting entries are made only at year-end. 3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. 4. Prepare the company’s income statement and statement of retained earnings for the year, and prepare its

balance sheet as of December 31. The Retained Earnings account balance was $60,500 on December 31 of the prior year.

Check (2e) Cr. Training Fees Earned, $28,600 (2f ) Cr. Tuition Fees Earned, $5,750 (3) Adj. trial balance totals, $344,600 (4) Net income, $54,200

136 Chapter 3 Adjusting Accounts for Financial Statements

Problem 3-4B Preparing financial statements from adjusted trial balance

P6

The adjusted trial balance for Speedy Courier as of December 31 follows.

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Notes receivable (due in 90 days) . . . . . . . . . . . . . . . . . 210,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000 Accumulated depreciation—Trucks . . . . . . . . . . . . . . . . $ 58,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 Accumulated depreciation—Equipment . . . . . . . . . . . . . 200,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Unearned delivery fees . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Delivery fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . 611,800 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Depreciation expense—Trucks . . . . . . . . . . . . . . . . . . . . 29,000 Depreciation expense—Equipment . . . . . . . . . . . . . . . . 48,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,000 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 31,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,200 Repairs expense—Trucks . . . . . . . . . . . . . . . . . . . . . . . . 35,600 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,530,800 $1,530,800

Required

Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31; (b) the statement of retained earnings for the year ended December 31 [Note: Retained Earnings at Dec. 31 of the prior year was $110,000]; and (c) the balance sheet as of December 31.

Check Total assets, $663,000

101 Cash 307 Common Stock 640 Rent Expense 106 Accounts Receivable 318 Retained Earnings 650 Office Supplies Expense 124 Office Supplies 319 Dividends 684 Repairs Expense 128 Prepaid Insurance 401 Storage Fees Earned 688 Telephone Expense 173 Buildings 606 Depreciation Expense—Buildings 901 Income Summary 174 Accumulated Depreciation—Buildings 622 Salaries Expense 209 Salaries Payable 637 Insurance Expense

On July 1, Lula Plume created a new self-storage business, Safe Storage Co. The following transactions occurred during the company’s first month.

July 1 Plume invested $30,000 cash and buildings worth $150,000 in the company in exchange for common stock.

2 The company rented equipment by paying $2,000 cash for the first month’s (July) rent. 5 The company purchased $2,400 of office supplies for cash. 10 The company paid $7,200 cash for the premium on a 12-month insurance policy. Coverage

begins on July 11. 14 The company paid an employee $1,000 cash for two weeks’ salary earned. 24 The company collected $9,800 cash for storage fees from customers. 28 The company paid $1,000 cash for two weeks’ salary earned by an employee. 29 The company paid $950 cash for minor repairs to a leaking roof. 30 The company paid $400 cash for this month’s telephone bill. 31 The company paid $2,000 cash in dividends.

The company’s chart of accounts follows.

Problem 3-5B Applying the accounting cycle

P1 P2 P3 P4 P5 P6 P7 P8

Chapter 3 Adjusting Accounts for Financial Statements 137

Required

1. Use the balance column format to set up each ledger account listed in its chart of accounts. 2. Prepare journal entries to record the transactions for July and post them to the ledger accounts. Record

prepaid and unearned items in balance sheet accounts. 3. Prepare an unadjusted trial balance as of July 31. 4. Use the following information to journalize and post adjusting entries for the month: a. Prepaid insurance of $400 has expired this month. b. At the end of the month, $1,525 of office supplies are still available. c. This month’s depreciation on the buildings is $1,500. d. An employee earned $100 of unpaid and unrecorded salary as of month-end. e. The company earned $1,150 of storage fees that are not yet billed at month-end. 5. Prepare the adjusted trial balance as of July 31. Prepare the income statement and the statement of

retained earnings for the month of July and the balance sheet at July 31. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

Check (3) Unadj. trial balance totals, $189,800

(4a) Dr. Insurance Expense, $400

(5) Net income, $2,725; Total assets, $180,825

(7) P-C trial balance totals, $182,325

The adjusted trial balance for Anara Co. as of December 31, 2019, follows. P. Anara invested $40,000 cash in the business in exchange for common stock during year 2019. The December 31, 2018, credit bal- ance of the Retained Earnings account was $52,800.

Problem 3-6B Preparing closing entries and financial statements

P6 P7 Adjusted Trial Balance December 31, 2019

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,400 104 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . 11,200 126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 168 Accumulated depreciation—Equipment . . . . . . . . . . . . . $ 4,000 173 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 174 Accumulated depreciation—Building . . . . . . . . . . . . . . . 10,000 183 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 203 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 208 Rent payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,280 213 Property taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,330 233 Unearned professional fees . . . . . . . . . . . . . . . . . . . . . . . 750 244 Current portion of long-term notes payable . . . . . . . . . . 8,400 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . 31,600 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,800 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 401 Professional fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 59,600 406 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 407 Dividends earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 409 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320 606 Depreciation expense—Building . . . . . . . . . . . . . . . . . . . 2,000 612 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . 1,000 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500 633 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,525 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 682 Postage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410 683 Property taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . 4,825 684 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679 688 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521 690 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,920 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $224,230 $224,230

138 Chapter 3 Adjusting Accounts for Financial Statements

SERIAL PROBLEM Business Solutions

P1 P2 P3 P4 P5 P6 P7 P8

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 3 After the success of the company’s first two months, Santana Rey continues to operate Business Solutions. (Transactions for the first two months are described in the Chapter 2 serial problem.) The November 30, 2019, unadjusted trial balance of Business Solutions (reflecting its transactions for October and November of 2019) follows.

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $38,264 106 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,618 126 Computer supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,545 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,220 131 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300 163 Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 164 Accumulated depreciation—Office equipment . . . . . . . . . . . . . . . . . . $ 0 167 Computer equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 168 Accumulated depreciation—Computer equipment . . . . . . . . . . . . . . 0 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 236 Unearned computer services revenue . . . . . . . . . . . . . . . . . . . . . . . . 0 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600 403 Computer services revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,659 612 Depreciation expense—Office equipment . . . . . . . . . . . . . . . . . . . . . 0 613 Depreciation expense—Computer equipment . . . . . . . . . . . . . . . . . . 0 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 652 Computer supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 655 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,728 676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $98,659 $98,659

Required

1. Prepare the income statement and the statement of retained earnings for calendar-year 2019 and the classified balance sheet at December 31, 2019.

2. Prepare the necessary closing entries at December 31, 2019.

Check (1) Total assets (12/31/2019), $164,700; Net income, $28,890

In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classifica- tion. If the item should not appear on the balance sheet, enter a Z in the blank. A. Current assets D. Intangible assets F. Long-term liabilities B. Long-term investments E. Current liabilities G. Equity C. Plant assets

Problem 3-7B Determining balance sheet classifications

C3

1. Commissions earned 2. Interest receivable 3. Long-term investment in stock 4. Prepaid insurance (4 months of rent) 5. Machinery 6. Notes payable (due in 15 years) 7. Copyrights 8. Current portion of long-term

note payable 9. Accumulated depreciation—Trucks 10. Office equipment

11. Rent receivable 12. Salaries payable 13. Income taxes payable

(due in 11 weeks) 14. Common stock 15. Office supplies 16. Interest payable 17. Rent revenue 18. Notes receivable (due in 120 days) 19. Land (used in operations) 20. Depreciation expense—Trucks

©Alexander Image/Shutterstock

Chapter 3 Adjusting Accounts for Financial Statements 139

Business Solutions had the following transactions and events in December 2019.

Dec. 2 Paid $1,025 cash to Hillside Mall for Business Solutions’s share of mall advertising costs. 3 Paid $500 cash for minor repairs to the company’s computer. 4 Received $3,950 cash from Alex’s Engineering Co. for the receivable from November. 10 Paid cash to Lyn Addie for six days of work at the rate of $125 per day. 14 Notified by Alex’s Engineering Co. that Business Solutions’s bid of $7,000 on a proposed proj-

ect has been accepted. Alex’s paid a $1,500 cash advance to Business Solutions. 15 Purchased $1,100 of computer supplies on credit from Harris Office Products. 16 Sent a reminder to Gomez Co. to pay the fee for services recorded on November 8. 20 Completed a project for Liu Corporation and received $5,625 cash. 22–26 Took the week off for the holidays. 28 Received $3,000 cash from Gomez Co. on its receivable. 29 Reimbursed S. Rey for business automobile mileage (600 miles at $0.32 per mile). 31 The company paid $1,500 cash in dividends.

The following additional facts are collected for use in making adjusting entries prior to preparing financial statements for the company’s first three months. a. The December 31 inventory count of computer supplies shows $580 still available. b. Three months have expired since the 12-month insurance premium was paid in advance. c. As of December 31, Lyn Addie has not been paid for four days of work at $125 per day. d. The computer system, acquired on October 1, is expected to have a four-year life with no salvage value. e. The office equipment, acquired on October 1, is expected to have a five-year life with no salvage value. f. Three of the four months’ prepaid rent have expired.

Required

1. Prepare journal entries to record each of the December transactions and events for Business Solutions. Post those entries to the accounts in the ledger.

2. Prepare adjusting entries to reflect a through f. Post those entries to the accounts in the ledger. 3. Prepare an adjusted trial balance as of December 31, 2019. 4. Prepare an income statement for the three months ended December 31, 2019. 5. Prepare a statement of retained earnings for the three months ended December 31, 2019. 6. Prepare a balance sheet as of December 31, 2019. 7. Record and post the necessary closing entries as of December 31, 2019. 8. Prepare a post-closing trial balance as of December 31, 2019.

Check (3) Adjusted trial balance totals, $109,034

(6) Total assets, $83,460

(8) Post-closing trial balance totals, $85,110

The General Ledger tool in Connect allows students to immediately see the financial statements as of a specific date. Each of the following questions begins with an unadjusted trial balance. Using transactions from the following assignment, prepare the necessary adjustments and determine the impact each adjust- ment has on net income. The financial statements are automatically populated.

GL 3-1 Based on the FastForward illustration in this chapter

Using transactions from the following assignments, prepare the necessary adjustments, create the finan- cial statements, and determine the impact each adjustment has on net income.

GL 3-2 Based on Problem 3-3A

GL 3-3 Extension of Problem 2-1A

GL 3-4 Extension of Problem 2-2A

GL 3-5 Based on Serial Problem SP 3

GENERAL LEDGER PROBLEM

GL

COMPANY ANALYSIS A1 P7

Accounting Analysis

AA 3-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Compute Apple’s profit margin for fiscal years ended (a) September 30, 2017, and (b) September 24, 2016. 2. Is the change in Apple’s profit margin favorable or unfavorable? 3. In 2017, did Apple’s profit margin outperform or underperform the industry (assumed) average of 12%? 4. For the fiscal year ended September 30, 2017, what is the balance of its Income Summary account

before it is closed? APPLE

140 Chapter 3 Adjusting Accounts for Financial Statements

GLOBAL ANALYSIS A1

APPLE Samsung

GOOGLE

AA 3-3 Key comparative figures for Samsung, Apple, and Google follow.

Required

1. Compute profit margin for Samsung, Apple, and Google. 2. Which company has the highest profit margin?

In millions Samsung Apple Google

Net income . . . . . . . . . . . W 42,186,747 $ 48,351 $ 12,662

Net sales . . . . . . . . . . . . 239,575,376 229,234 110,855

Required

1. Compute profit margins for (a) Apple and (b) Google for the two years of data reported above. 2. In the current year, which company is more successful on the basis of profit margin? 3. Compute current ratios for (a) Apple and (b) Google for the two years reported above. 4. In the current year, which company has the better ability to pay short-term obligations according to the

current ratio?

AA 3-2 Key figures for the recent two years of both Apple and Google follow.

Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Net income . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 $ 12,662 $ 19,478

Net sales . . . . . . . . . . . . . . . . . . . 229,234 215,639 110,855 90,272

Current assets . . . . . . . . . . . . . . . 128,645 106,869 124,308 105,408

Current liabilities . . . . . . . . . . . . . 100,814 79,006 24,183 16,756

COMPARATIVE ANALYSIS A1 A2

APPLE GOOGLE

ETHICS CHALLENGE P4 P6

BTN 3-1 On January 20, 2019, Tamira Nelson, the accountant for Picton Enterprises, is feeling pressure to complete the annual financial statements. The company president has said he needs up-to-date financial statements to share with the bank on January 21 at a dinner meeting that has been called to discuss Picton’s obtaining loan financing for a special building project. Tamira knows that she will not be able to gather all the needed information in the next 24 hours to prepare the entire set of adjusting entries. Those entries must be posted before the financial statements accurately portray the company’s performance and financial position for the fiscal period ended December 31, 2018. Tamira ultimately decides to estimate several expense accruals at the last minute. When deciding on estimates for the expenses, she uses low estimates because she does not want to make the financial statements look worse than they are. Tamira finishes the financial statements before the deadline and gives them to the president without mentioning that several account balances are estimates that she provided.

Required

1. Identify several courses of action that Tamira could have taken instead of the one she took. 2. If you were in Tamira’s situation, what would you have done? Briefly justify your response.

Beyond the Numbers

BTN 3-2 One of your classmates states that a company’s books should be ongoing and therefore not closed until that business is terminated. Write a half-page memo to this classmate explaining the concept of the closing process by drawing analogies between (1) a scoreboard for an athletic event and the revenue and expense accounts of a business or (2) a sports team’s record book and the retained earnings account. Hint: Think about what would happen if the scoreboard were not cleared before the start of a new game.

COMMUNICATING IN PRACTICE P7 P8

Chapter 3 Adjusting Accounts for Financial Statements 141

BTN 3-4 Four types of adjustments are described in the chapter: (1) prepaid expenses, (2) unearned revenues, (3) accrued expenses, and (4) accrued revenues.

Required

1. Form learning teams of four (or more) members. Each team member must select one of the four adjustments as an area of expertise (each team must have at least one expert in each area).

2. Form expert teams from the individuals who have selected the same area of expertise. Expert teams are to discuss and write a report that each expert will present to his or her learning team addressing the following: a. Description of the adjustment and why it’s necessary. b. Example of a transaction or event, with dates and amounts, that requires adjustment. c. Adjusting entry(ies) for the example in requirement b. d. Status of the affected account(s) before and after the adjustment in requirement c. e. Effects on financial statements of not making the adjustment.

3. Each expert should return to his or her learning team. In rotation, each member should present his or her expert team’s report to the learning team. Team discussion is encouraged.

TEAMWORK IN ACTION P1 P2 P3 P4

BTN 3-3 Access EDGAR online (SEC.gov) and locate the 10-K report of The Gap, Inc. (ticker: GPS), filed on March 20, 2017. Review its financial statements reported for the year ended January 28, 2017, to answer the following questions.

Required

1. What are Gap’s main brands? 2. When is Gap’s fiscal year-end? 3. What is Gap’s net sales for the period ended January 28, 2017? 4. What is Gap’s net income for the period ended January 28, 2017? 5. Compute Gap’s profit margin for the year ended January 28, 2017. 6. Do you believe Gap’s decision to use a year-end of late January or early February relates to its natural

business year? Explain.

TAKING IT TO THE NET A1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

BTN 3-5 Review this chapter’s opening feature involving Evan and Bobby and Snapchat. 1. Explain how a classified balance sheet can help Evan and Bobby know what bills are due when and

whether they have the resources to pay those bills. 2. Why is it important for Evan and Bobby to match costs and revenues in a specific time period? How

do closing entries help them in this regard? 3. What objectives are met when Evan and Bobby apply closing procedures each fiscal year-end?

ENTREPRENEURIAL DECISION C3 P7

BTN 3-6 Select a company that you can visit in person or interview on the telephone. Call ahead to the company to arrange a time when you can interview an employee (preferably an accountant) who helps prepare the annual financial statements. Inquire about the following aspects of its accounting cycle: 1. Does the company prepare interim financial statements? What time period(s) is used for interim

statements? 2. Does the company use the cash or accrual basis of accounting? 3. Does the company use a work sheet in preparing financial statements? Why or why not? 4. Does the company use a spreadsheet program? If so, which software program is used? 5. How long does it take after the end of its reporting period to complete annual statements?

HITTING THE ROAD C1 C2

Learning Objectives

CONCEPTUAL C1 Describe merchandising activities and

identify income components for a merchandising company.

C2 Identify and explain the inventory asset and cost flows of a merchandising company.

ANALYTICAL A1 Compute the acid-test ratio and explain

its use to assess liquidity.

A2 Compute the gross margin ratio and explain its use to assess profitability.

P5 Appendix 4A—Record and compare merchandising transactions using both periodic and perpetual inventory systems.

P6 Appendix 4B—Prepare adjustments for discounts, returns, and allowances per revenue recognition rules.

P7 Appendix 4C—Record and compare merchandising transactions using the gross method and net method.

PROCEDURAL P1 Analyze and record transactions for

merchandise purchases using a perpetual system.

P2 Analyze and record transactions for merchandise sales using a perpetual system.

P3 Prepare adjustments and close accounts for a merchandising company.

P4 Define and prepare multiple-step and single-step income statements.

Chapter Preview

4 Accounting for Merchandising Operations

MERCHANDISING PURCHASES

P1 Accounting for: Purchases discounts

Purchases returns and allowances

Transportation costs

MERCHANDISING SALES

P2 Accounting for: Sales of merchandise

Sales discounts

Sales returns and allowances

MERCHANDISING ACTIVITIES

C1 Income and inventory for merchandisers

C2 Operating cycle Inventory cost flows

NTK 4-1 NTK 4-2 NTK 4-3

MERCHANDISER REPORTING

P3 Adjusting and closing P4 Multiple-step and

single-step income statements

A1 Acid-test analysis A2 Gross margin analysis

NTK 4-4, 4-5

143

“Understand what matters”—Maxine Clark

Bear Up

ST. LOUIS—“When I graduated from college,” explains Maxine Clark, “I felt the retail world had lost its spark. I wanted to be more creative.” Maxine was determined to start a business that would be different. Then she went shopping with the young daughter of a friend. “When we couldn’t find anything new, Katie picked up a Beanie Baby and said we could make one,” recalls Maxine. “Her words gave me the idea to create a company that would allow people to create their own customized stuffed animals.” Build-A-Bear Workshop (BuildaBear.com) was born!

“I did some research and began putting together a plan,” says Maxine. The Build-A-Bear Workshops were an instant success.

As her company grew, Maxine says accounting data on her merchandising operations fell short. “We can’t give up!” was her view. In response, Maxine set up an accounting system to mea- sure, track, summarize, and report on merchandising transac- tions, especially purchases.

Maxine computerized the accounting system, prepared monthly financial statements per store, developed annual bud- gets, and tracked all bank accounts and payables.

Build-A-Bear’s successful use of accounting data has made Maxine a self-made woman. She insists, however, it is not about

the financial rewards. “We’re a family business,” explains Maxine. “It’s important to set an example for children by being a company that does good things and cares about the well-being of others.”

Sources: Build-A-Bear website, January 2019; Fortune, March 2012; LEADERS, April 2011; CSRwire, August 2008

©Monty Brinton/CBS/Getty Images

Previous chapters covered accounting for service companies. A merchandising company’s activities differ from those of a service company. Merchandise refers to products, also called goods, that a company buys to resell. A merchandiser earns net income by buying and selling merchandise. Merchandisers are wholesalers or retailers. A wholesaler buys products from manufacturers and sells them to retailers. A retailer buys products from manufacturers or wholesalers and sells them to consumers.

Reporting Income for a Merchandiser Net income for a merchandiser equals revenues from selling merchandise minus both the cost of merchandise sold and other expenses—see Exhibit 4.1. Revenue from selling merchandise is called sales, and the expense of buying and preparing merchandise is called cost of goods sold. (Some service companies use the term sales instead of revenues; cost of goods sold is also called cost of sales.)

MERCHANDISING ACTIVITIES C1 Describe merchandising activities and identify income components for a merchandising company.

EqualsMinusEqualsMinus Expenses

Net income

Net sales

Merchandiser

Expenses Net

income Revenues

Service Company

Minus Equals

Gross profit

Cost of goods sold

EXHIBIT 4.1 Computing Income for a Merchandising Company versus a Service Company

Point: SuperValu and SYSCO are wholesalers. Target and Walmart are retailers.

144 Chapter 4 Accounting for Merchandising Operations

EXHIBIT 4.2 Income Statement for a Service Company and a Merchandising Company

LIBERTY TAX Income Statement ($ millions)

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $174

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12

Service Company Merchandising Company

NORDSTROM INC. Income Statement ($ millions)

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,757

Cost of goods sold . . . . . . . . . . . . . . . . . . 9,440 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . 5,317 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,963

Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 354

Reporting Inventory for a Merchandiser A merchandiser’s balance sheet has a current asset called merchandise inventory, an item not on a service company’s balance sheet. Merchandise inventory, or simply inventory, refers to products that a company owns and intends to sell. Inventory cost includes the cost to buy the goods, ship them to the store, and make them ready for sale.

Operating Cycle for a Merchandiser Exhibit 4.3 shows an operating cycle for a merchandiser with credit sales. The cycle moves from (a) cash purchases of merchandise to (b) inventory for sale to (c) credit sales to (d) accounts receivable to (e) receipt of cash. The length of an operating cycle differs across the types of businesses. Department stores often have operating cycles of two to five months. Operating cycles for grocery stores are usually from two to eight weeks. Companies try to keep their operating cycles short because assets tied up in inventory and receivables are not productive. Cash sales shorten operating cycles.

Inventory Systems Exhibit 4.4 shows that a company’s merchandise available for sale consists of what it begins with (beginning inventory) and what it purchases (net purchases). The merchandise available for sale is either sold (cost of goods sold) or kept for future sales (ending inventory).

Companies account for inventory in one of two ways: perpetual system or periodic system. Perpetual inventory system updates account-

ing records for each purchase and each sale of inventory.

Periodic inventory system updates account- ing records for purchases and sales of inven- tory only at the end of a period.

Technology has dramatically increased the use of the perpetual system. It gives managers immediate access to information on sales and inventory levels, which allows them to strategi- cally react and increase profit. (Some compa-

nies use a hybrid system where the perpetual system is used for tracking units available and the periodic system is used to compute cost of sales.)

C2 Identify and explain the inventory asset and cost flows of a merchandising company.

Cash

(b) Merchandise inventory

(d) Accounts receivable

(a) Purchases

(e ) C

as h

co lle

ctio n

(c) Credit sale s

54 6

1

W9797 Cherry Rd. Antigo, WI 54409

See reverse for terms of sale and returns.

Net of Discount $490

Invoice Date Number

11/2/17 4657-2

P.O. Date Salesperson Terms Freight Ship

Subtotal 500

500

Shipping Tax

Total

7

6 Freight terms Goods7 Total invoice amount8 Net amount9

1 32 54Seller Invoice date Purchaser Order date Credit termsKey:

INVOICE

CH015 SD099

Toddler–Challenger X7 Boys/Girls–Speed Demon

1 1

150 350

150 350

10/30/17 #141 2/10, n/30 FOB Destination Via FedEx

Model No. Description Quantity Price Amount

8

SOLD TO

9

Z-Mart

Tom Novak, Purchasing Agent

10 Michigan Street

Chicago

Illinois Zip

3 Firm Name

Attention of

Address

City

State 605212

EXHIBIT 4.3 Merchandiser’s Operating Cycle

Merchandise Inventory

Beg. inventory # Net purchases #

Merchandise avail. for sale # COGS #

End. inventory #

Beginning inventory

Net purchases

= Merchandise available for sale

Cost of goods sold

Ending inventory

+

+

EXHIBIT 4.4 Merchandiser’s Cost Flow for a Single Time Period

Point: Merchandise avail. for sale: MAS = EI + COGS,

which can be rewritten as MAS − EI = COGS, or MAS − COGS = EI.

The income statements for a service company, Liberty Tax, and for a merchandiser, Nordstrom, are in Exhibit 4.2. We see that the merchandiser, Nordstrom, reports cost of goods sold, which is not reported by the service company. The merchandiser also reports gross profit, or gross margin, which is net sales minus cost of goods sold.

Chapter 4 Accounting for Merchandising Operations 145

Use the following information (in random order) from a merchandising company and from a service com- pany to complete the requirements. Hint: Not all information may be necessary for the solutions.

C1 C2

Merchandise Accounts and Computations

NEED-TO-KNOW 4-1

1. For the merchandiser only, compute (a) goods available for sale, (b) cost of goods sold, and (c) gross profit. 2. Compute net income for each company.

SaveCo Merchandiser

Supplies . . . . . . . . . . . . . $ 10 Beginning inventory . . . 100 Ending inventory . . . . . . 50

Expenses . . . . . . . $ 20 Net purchases . . . 80 Net sales . . . . . . . 190

Hi-Tech Services

Expenses . . . . . $170 Revenues . . . . . 200 Cash . . . . . . . . . 10

Prepaid rent . . . . . . . . $25 Accounts payable . . . 35 Supplies . . . . . . . . . . . 65

Solution

1. a. Computation of goods available for sale (SaveCo).

b. Computation of cost of goods sold (SaveCo).

c. Computation of gross profit (SaveCo).

2. Computation of net income for each company.

SaveCo Merchandiser

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $190 Less: Cost of goods sold (from part 1b) . . . . . . . . . . 130 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Less: Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40

Hi-Tech Services

Revenues . . . . . . . . . . . . . . . . . . . . . . $200

Less: Expenses . . . . . . . . . . . . . . . . . 170 Net income . . . . . . . . . . . . . . . . . . . . $ 30 Do More: QS 4-3, E 4-1, E 4-2

Beginning inventory . . . . . . . . . . $100 Plus: Net purchases . . . . . . . . . . 80 Goods available for sale . . . . . . $180

Beginning inventory . . . . . . . . . . $100 Plus: Net purchases . . . . . . . . . . 80 Goods available for sale . . . . . . 180 Less: Ending inventory . . . . . . . . 50 Cost of goods sold . . . . . . . . . . . $130

Net sales . . . . . . . . . . . . . . . . . . $190 Less: Cost of goods sold (from part b) . . . . . . . . . 130 Gross profit . . . . . . . . . . . . . . . . $ 60

This section explains how we record purchases under different purchase terms.

Purchases without Cash Discounts Z-Mart records a $500 cash purchase of merchandise on November 2 as follows.

ACCOUNTING FOR MERCHANDISE PURCHASES P1 Analyze and record transactions for merchandise purchases using a perpetual system.

Assets = Liabilities + Equity +500 −500

Nov . 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Purchased goods for cash.

If these goods are instead purchased on credit, and no discounts are offered for early payment, Z-Mart makes the same entry except that Accounts Payable is credited instead of Cash.

Point: Costs recorded in Merchandise Inventory are called inventoriable costs.

Trade Discounts When a manufacturer or wholesaler prepares a catalog of items for sale, each item has a list price, or catalog price. However, an item’s selling price equals list price minus a percent called a trade discount. A wholesaler buying in large quantities gets a larger discount than a retailer buying in small quantities. A buyer re- cords the net amount of list price minus trade discount. If a supplier of Z-Mart lists an item at $625 and gives Z-Mart a 20% trade discount, Z-Mart’s purchase price is $500, computed as $625 − (20% × $625). ■

Decision Insight

Point: Trade discounts are not journalized; purchases are recorded based on the invoice amount.

Purchases with Cash Discounts The purchase of goods on credit requires credit terms. Credit terms include the amounts and timing of payments from a buyer to a seller. To demonstrate, when sellers require payment within 10 days after the end of the month (EOM) of the invoice date, credit terms are “n∕10

146 Chapter 4 Accounting for Merchandising Operations

EOM.” When sellers require payment within 30 days after the invoice date, credit terms are “n∕30,” meaning net 30 days.

Credit Terms Exhibit 4.5 explains credit terms. The amount of time allowed before full pay- ment is due is the credit period. Sellers can grant a cash discount to encourage buyers to pay earlier. A buyer views a cash discount as a purchases discount. A seller views a cash discount as a sales discount. Any cash discounts are described on the invoice. For example, credit terms of “2∕10, n∕60” mean that full payment is due within a 60-day credit period, but the buyer can deduct 2% of the invoice amount if payment is made within 10 days of the invoice date. This reduced payment is only for the discount period.

Amount Due

Due: Invoice priceDue: Invoice price minus discount

Discount period

Credit period

Invoice date

Credit Terms

Time

EXHIBIT 4.5 Credit Terms

Invoice On November 2, Z-Mart purchases $500 of merchandise on credit with terms of 2∕10, n∕30. The invoice for this purchase is shown in Exhibit 4.6. This is a purchase invoice for Z-Mart (buyer) and a sales invoice for Trex (seller). The amount recorded for merchandise in- ventory includes its purchase cost, shipping fees, taxes, and any other costs necessary to make it ready for sale.

54 6

1

W9797 Cherry Rd. Antigo, WI 54409

See reverse for terms of sale and returns.

Net of Discount $490

Invoice Date Number

11/2/18 4657-2 2

P.O. Date Salesperson Terms Freight Ship

Subtotal 500

500

Shipping Tax

Total

7

INVOICE

CH015 SD099

Toddler–Challenger X7 Boys/Girls–Speed Demon

1 1

150 350

150 350

10/30/18 #141 2/10, n/30 FOB Destination Via FedEx

Model No. Description Quantity Price Amount

8

Firm Name SOLD TO

Attention of

Address

City

State Zip

Tom Novak, Purchasing Agent

10 Michigan Street

Z-Mart

Chicago

Illinois 60521

3

6 Freight terms

Goods7

Total invoice amount8

Net amount9

1 Seller

2 Invoice date

3 Purchaser

5

4 Order date

Credit terms

Key:

9

EXHIBIT 4.6 Invoice

Point: The invoice date sets the discount and credit periods.

Gross Method Z-Mart purchases $500 of merchandise on credit terms of 2∕10, n∕30. The November 2 invoice offers a 2% discount if paid within 10 days; if not, Z-Mart must pay the full amount within 30 days. The buyer has two options. Pay within discount period (Nov. 2 through Nov. 12): Due = $490.

or Pay after discount period (Nov. 13 through Dec. 2): Due = $500.

The $490 equals the $500 invoice minus $10 discount (computed as $500 × 2%).

Chapter 4 Accounting for Merchandising Operations 147

On the purchase date, we do not know if payment will occur within the discount period. The gross method records the purchase at its gross (full) invoice amount. For Z-Mart, the purchase of $500 of merchandise with terms of 2∕10, n∕30 is recorded at $500. The gross method is used here because it is (1) used more in practice, (2) easier to apply, and (3) less costly.

Purchases on Credit Z-Mart’s entry to record the November 2 purchase of $500 of merchandise on credit follows. (For recording, it can help to add the name to the payable, such as Accounts Payable—Trex.)

Payment within Discount Period Good cash management means that invoices are not paid until the last day of the discount or credit period. This is because the buyer can use that money until payment is required. If Z-Mart pays the amount due on (or before) November 12, the entry is

Nov . 2 500

Bal . 490

Nov . 12 10

Merchandise Inventory

Nov . 12 490

Cash

Nov . 12 500 Nov . 2 500

Bal . 0

Accounts Payable

The Merchandise Inventory account equals the $490 net cost of purchases after these entries, and the Accounts Payable account has a zero balance.

Payment after Discount Period If the invoice is paid after November 12, the dis- count is lost. If Z-Mart pays the gross (full) amount due on December 2 (the n∕30 due date), the entry is

Point: Appendix 4A repeats jour- nal entries a through g using the periodic system.

Purchases with Returns and Allowances Purchases returns are merchandise a buyer purchases but then returns. Purchases allowances refer to a seller granting a price reduction (allowance) to a buyer of defective or unacceptable merchandise.

Purchases Allowances On November 5, Z-Mart (buyer) agrees to a $30 allowance from Trex for defective merchandise (assume allowance is $30 whether paid within the discount period or not). Z-Mart’s entry to update Merchandise Inventory and record the allowance follows. Z-Mart’s allowance for defective merchandise reduces its account payable to the seller. If cash is refunded, Cash is debited instead of Accounts Payable.

Point: When a buyer returns or takes an allowance on merchan- dise, the buyer issues a debit memorandum. This informs the seller of a debit made to the seller’s account payable in the buyer’s records.

(a) Nov . 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Purchased goods, terms 2∕10, n∕30.

Assets = Liabilities + Equity +500 +500

(b1) Nov . 12 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490

Paid for goods within discount period. *$500 × (100% − 2%)

Assets = Liabilities + Equity −490 −500 − 10

(b2) Dec . 2 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Paid for goods outside discount period.

Assets = Liabilities + Equity −500 −500

(c1) Nov . 5 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Allowance for defective goods.

Assets = Liabilities + Equity −30 −30

Purchases Returns Returns of inventory are recorded at the amount charged for that inventory. On June 1, Z-Mart purchases $250 of merchandise with terms 2∕10, n∕60—see en- tries below. On June 3, Z-Mart returns $50 of those goods. When Z-Mart pays on June 11, it

148 Chapter 4 Accounting for Merchandising Operations

takes the 2% discount only on the $200 remaining balance ($250 − $50). When goods are re- turned, a buyer takes a discount on only the remaining balance. This means the discount is $4 (computed as $200 × 2%) and the cash payment is $196 (computed as $200 − $4).

Point: Credit terms apply to both partial and full payments.

Assets = Liabilities + Equity +250 +250

Assets = Liabilities + Equity −50 −50

Assets = Liabilities + Equity −196 −200 − 4

     June 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Purchased goods, terms 2∕10, n∕60. (c2) June 3 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Returned goods to seller.

       June 11 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

Paid for $200 of goods less $4 discount.

These T-accounts show the final $196 in inventory, the zero balance in Accounts Payable, and the $196 cash payment.

Example: If on June 20, Z-Mart returns all goods paid for on June 11, the entry is Cash . . . . . . . . . . . . . . . . . . . . 196 Merchandise Inventory . . . 196

Jun . 1 250

Bal . 196

Jun . 3 50 Jun . 11 4

Merchandise Inventory

Jun . 3 50 Jun . 11 200

Jun . 1 250

Bal . 0

Accounts Payable

Jun . 11 196

Cash

Purchases and Transportation Costs The buyer and seller must agree on who is responsible for paying freight (shipping) costs and who has the risk of loss during transit. This is the same as asking at what point ownership trans- fers from the seller to the buyer. The point of transfer is called the FOB (free on board) point.

Exhibit 4.7 covers two alternative points of transfer.

1. FOB shipping point means the buyer accepts ownership when the goods depart the seller’s place of business. The buyer pays shipping costs and has the risk of loss in transit. The goods are part of the buyer’s inventory when they are in transit because ownership has transferred to the buyer. 1-800-Flowers.com, a floral merchandiser, uses FOB shipping point.

2. FOB destination means ownership of goods transfers to the buyer when the goods arrive at the buyer’s place of business. The seller pays shipping charges and has the risk of loss in transit. The seller does not record revenue until the goods arrive at the destination.

©Michael DeYoung/Blend Images

Point: When the party not respon- sible for shipping pays shipping cost, it either bills the other party responsible or adjusts its account payable or account receivable with the other party. Freight pay- ments are not applied in comput- ing discounts.

Destination

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

Goods in transit Shipping point

Seller Buyer

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . . #

EXHIBIT 4.7 Ownership Transfer and Transportation Costs

What’s Your Policy? Return policies are a competitive advantage for businesses. REI offers a 1-year return policy on nearly every product it sells. Amazon picks up returned items at your door. On the other hand, some stores like Best Buy allow only 14 days to return products. ■

Decision Insight

Chapter 4 Accounting for Merchandising Operations 149

When a buyer is responsible for paying transportation costs, the payment is made to a carrier or directly to the seller. The cost principle requires that transportation costs of a buyer (often called transportation-in or freight-in) be part of the cost of merchandise inventory. Z-Mart’s entry to record a $75 freight charge from UPS for merchandise purchased FOB shipping point is

Point: If we place an order online and receive free shipping, we have terms FOB destination.

(d) Nov . 24 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Paid freight costs on goods.

Assets = Liabilities + Equity +75 −75

When a seller is responsible for paying shipping costs, it records these costs in a Delivery Expense account. Delivery expense, also called transportation-out or freight-out, is reported as a selling expense in the seller’s income statement.

Itemized Costs of Purchases In summary, purchases are recorded as debits to Merchandise Inventory (or Inventory). Purchases discounts, returns, and allowances are credited to (subtracted from) Merchandise Inventory. Transportation-in is debited (added) to Merchandise Inventory. Z-Mart’s itemized costs of merchandise purchases for the year are in Exhibit 4.8.

The accounting system described here does not provide separate records (accounts) for total purchases, total pur- chases discounts, total purchases returns and allowances, and total transportation-in. Many companies collect this information in supple- mentary records to evaluate these costs. Supplementary records, or supplemental records, refer to information outside the usual ledger accounts.

Point: INcoming freight costs are charged to INventory. When inventory EXits, freight costs are charged to EXpense.

Itemized Costs of Merchandise Purchases

Invoice cost of merchandise purchases . . . . . . . . . $ 235,800

Less: Purchases discounts received . . . . . . . . . . . . (4,200)

Purchases returns and allowances . . . . . . . . . (1,500)

Add: Costs of transportation-in . . . . . . . . . . . . . . . .       2,300

Total net cost of merchandise purchases . . . . . . $232,400

EXHIBIT 4.8 Itemized Costs of Merchandise Purchases

Point: Some companies have separate accounts for purchases discounts, returns and allowances, and transportation-in. These accounts are then transferred to Merchandise Inventory at period- end. This is a hybrid system of perpetual and periodic. That is, Merchandise Inventory is updated on a perpetual basis but only for purchases and cost of goods sold.

Payables Manager As a new accounts payable manager, you are being trained by the outgoing manager. She explains that the system prepares checks for amounts net of favorable cash discounts, and the checks are dated the last day of the discount period. She tells you that checks are not mailed until five days later, adding that “the company gets free use of cash for an extra five days, and our department looks better.” Do you continue this policy? ■ Answer: One point of view is that the late payment policy is unethical. A deliberate plan to make late payments means the company lies when it pretends to make payment within the discount period. Another view is that the late payment policy is acceptable. Some believe attempts to take discounts through late payments are accepted as “price negotiation.”

Decision Ethics

Prepare journal entries to record each of the following purchases transactions of a merchandising com- pany. Assume a perpetual inventory system using the gross method for recording purchases.

Oct. 1 Purchased $1,000 of goods. Terms of the sale are 4∕10, n∕30, and FOB shipping point; the in- voice is dated October 1.

3 Paid $30 cash for freight charges from UPS for the October 1 purchase. 7 Returned $50 of the $1,000 of goods from the October 1 purchase and received full credit. 11 Paid the amount due from the October 1 purchase (less the return on October 7). 31 Assume the October 11 payment was never made. Instead, payment of the amount due, less the

return on October 7, occurred on October 31.

Solution

P1 Merchandise Purchases

NEED-TO-KNOW 4-2

Oct . 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Purchased goods, terms 4∕10, n∕30. Oct . 3 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Paid freight on purchases FOB shipping point.

[continued on next page]

150 Chapter 4 Accounting for Merchandising Operations

The perpetual accounting system requires that each sales transaction for a merchandiser, whether for cash or on credit, has two entries: one for revenue and one for cost.

1. Revenue received (and asset increased) from the customer. 2. Cost of goods sold incurred (and asset decreased) to the customer.

Sales without Cash Discounts Revenue Side: Inflow of Assets Z-Mart sold $1,000 of merchandise on credit terms n∕60 on November 12. The revenue part of this transaction is recorded as follows. This entry shows an increase in Z-Mart’s assets in the form of accounts receivable. It also shows the in- crease in revenue (Sales). If the sale is for cash, debit Cash instead of Accounts Receivable.

Oct . 7 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Returned goods.

Oct . 11 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Merchandise Inventory* . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Cash† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 912

Paid for goods within discount period. *$950 × 4% †$950 − ($950 × 4%)

Oct . 31 Accounts Payable‡ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Paid for goods outside discount period. ‡$1,000 − $50

[continued from previous page]

Do More: QS 4-5, QS 4-6, QS 4-7, E 4-3, E 4-5

Merchandising companies must account for sales, sales discounts, sales returns and allowances, and cost of goods sold. Z-Mart has these items in its gross profit computation—see Exhibit 4.9. This shows that customers paid $314,700 for merchandise that cost Z-Mart $230,400, yielding a gross profit of $84,300.

ACCOUNTING FOR MERCHANDISE SALES P2 Analyze and record transac- tions for merchandise sales using a perpetual system.

EXHIBIT 4.9 Gross Profit Computation

Computation of Gross Profit

Net sales (net of discounts, returns, and allowances) . . . . . . . . . . . . $314,700

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 84,300

Cost Side: Outflow of Assets The cost side of each sale requires that Merchandise Inventory decrease by that item’s cost. The cost of the merchandise Z-Mart sold on November 12 is $300, and the entry to record the cost part of this transaction follows.

Point: Gross profit on Nov. 12 sale:

Net sales . . . . . . . . . . . . . $1,000 Cost of goods sold . . . . . . 300 Gross profit . . . . . . . . . . . $ 700

Assets = Liabilities + Equity +1,000 +1,000

Nov . 12 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold goods on credit.

Assets = Liabilities + Equity −300 −300

Nov . 12 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record cost of Nov. 12 sale.

Chapter 4 Accounting for Merchandising Operations 151

Sales with Cash Discounts Offering discounts on credit sales benefits a seller through earlier cash receipts and reduced col- lection efforts. We use the gross method, which records sales at the full amount and records sales discounts if, and when, they are taken. The gross method requires a period-end adjusting entry to estimate future sales discounts. (The net method records sales at the net amount, which assumes all discounts are taken. This method requires an adjusting entry to estimate future dis- counts lost. See Appendix 4C.)

Sales on Credit Z-Mart makes a credit sale for $1,000 on November 12 with terms of 2∕10, n∕45 (cost of the merchandise sold is $300). The entries to record this sale follow.

Future Demands Large merchandising companies, such as Amazon, bombard suppliers with demands. These in- clude discounts for bar coding and technology support systems and fines for shipping errors. Merchandisers’ goals are to reduce inventories, shorten lead times, and eliminate errors. Colleges offer programs in supply chain manage- ment and logistics to train future employees to help merchandisers meet such goals. ■

Decision Insight

©Polaris/Newscom

Assets = Liabilities + Equity +1,000 +1,000

Assets = Liabilities + Equity −300 −300

Nov . 12 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold goods, terms 2∕10, n∕45. Nov . 12 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record cost of Nov. 12 sale.

Buyer Pays within Discount Period One option is for the buyer to pay $980 within the 10-day discount period ending November 22. The $20 sales discount is computed as $1,000 × 2%. If the customer pays on (or before) November 22, Z-Mart records the cash receipt as follows. Sales Discounts is a contra revenue account, meaning the Sales Discounts account is subtracted from the Sales account when computing net sales. The Sales Discounts account has a normal debit balance because it is subtracted from Sales, which has a normal credit balance.

Point: Net sales is the amount received from the customer.

Sales . . . . . . . . . . . . . . . . . $1,000 Sales discounts . . . . . . . . (20 ) Net sales . . . . . . . . . . . . . $ 980

Buyer Pays after Discount Period The customer’s second option is to wait 45 days until December 27 (or at least until after the discount period) and then pay $1,000. Z-Mart records that cash receipt as

Sales with Returns and Allowances If a customer is unhappy with a purchase, many sellers allow the customer to either return the merchandise for a full refund (sales return) or keep the merchandise along with a partial refund (sales allowance). Most sellers can reliably estimate returns and allowances (abbreviated R&A).

Buyer Returns Goods—Revenue Side When a buyer returns goods, it impacts the seller’s revenue and cost sides. When a return occurs, the seller debits Sales Returns and

Assets = Liabilities + Equity + 980 −20 −1,000

Nov . 22 Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 980

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment on Nov. 12 sale less discount. *$1,000 − ($1,000 × 2%)

Assets = Liabilities + Equity +1,000 −1,000

Dec . 27 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment on Nov. 12 sale after discount period.

152 Chapter 4 Accounting for Merchandising Operations

Buyer Returns Goods—Cost Side When a return occurs, the seller must reduce the cost of sales. Continuing the example where the returned items sold for $15 and cost $9, the cost-side entry depends on whether the goods are defective.

Returned Goods Not Defective. If the merchandise returned is not defective and can be resold, there is a cost-side entry. The seller adds the cost of the returned goods back to inven- tory and reduces cost of goods sold as follows. This entry reverses the cost-side entry of November 12 for only $9 of goods returned.

(e1) Nov . 26 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Goods returned from Nov. 12 sale.

Assets = Liabilities + Equity −15 −15

Allowances, a contra revenue account to Sales. Assume that a customer returns merchandise on November 26 that sold for $15 and cost $9; the revenue-side returns entry is

Assets = Liabilities + Equity +9 +9

(e2) Nov . 26 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Returned goods are added back to inventory.

If the seller has already collected cash for the sale, the seller could give the price reduction in cash. For example, instead of crediting the buyer’s Accounts Receivable in the entry above, the seller can credit Cash for $10.

Point: When a seller accepts returns or grants an allowance, the seller issues a credit memo- randum. This informs the buyer of a credit made to the buyer’s account in the seller’s records.

Prepare journal entries to record each of the following sales transactions of a merchandising company. Assume a perpetual inventory system and use of the gross method (beginning inventory equals $9,000).

June 1 Sold 50 units of merchandise to a customer for $150 per unit under credit terms of 2∕10, n∕30, FOB shipping point, and the invoice is dated June 1. The 50 units of merchandise had cost $100 per unit.

7 The customer returns 2 units purchased on June 1 because those units did not fit its needs. The seller restores those units to its inventory (as they are not defective) and credits Accounts Re- ceivable from the customer.

11 The seller receives the balance due from the June 1 sale to the customer less returns and allowances. 14 The customer discovers that 10 units have minor damage but keeps them because the seller

sends a $50 cash payment allowance to compensate.

Merchandise Sales

NEED-TO-KNOW 4-3

P2

Buyer Granted Allowances If a buyer is not satisfied with the goods, the seller might offer a price reduction for the buyer to keep the goods. There is no cost-side entry in this case as the inventory is not returned. On the revenue side, the seller debits Sales Returns and Allowances and credits Cash or Accounts Receivable depending on what’s agreed. Assume that $40 of mer- chandise previously sold is defective. The seller gives a price reduction and credits the buyer’s accounts receivable for $10. The seller records this allowance as follows.

Returned Goods Are Defective. If the merchandise returned is defective, the returned inventory is recorded at its estimated value, not its cost. The following entry assumes the returned goods costing $9 are defective and are worth $2.

Nov . 26 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Loss from Defective Merchandise . . . . . . . . . . . . . . . . . . . . . . . 7

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Returned defective goods to inventory and record loss.

Assets = Liabilities + Equity +2 −7 +9

(f ) Nov . 24 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 10 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Sales allowance granted.

Assets = Liabilities + Equity −10 −10

Chapter 4 Accounting for Merchandising Operations 153

June 1 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Sold goods. 50 units × $150 June 1 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Cost of sale. 50 units × $100 June 7 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 300

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Returns accepted. 2 units × $150 June 7 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Returns added to inventory. 2 units × $100 June 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,056

Sales Discounts* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,200

Received payment. *($7,500 − $300) × 2% June 14 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 50

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Recorded allowance on goods. Do More: QS 4-8, E 4-4,

E 4-6, E 4-7

Exhibit 4.10 shows the flow of merchandising costs during a period and where these costs are reported at period-end. Specifically, beginning inventory plus the net cost of purchases is the merchandise available for sale. As inventory is sold, its cost is recorded in cost of goods sold on the income statement; what remains is ending inventory on the balance sheet. A period’s ending inventory is the next period’s beginning inventory.

ADJUSTING AND CLOSING FOR MERCHANDISERS

Solution

Beginning inventory

From supplier

Net purchases

Ending inventory

Period 2Period 1

Cost of goods sold

Merchandise available for sale

To Income Statement

To Balance Sheet

Beginning inventory

From supplier

Net purchases

Ending inventory

Cost of goods sold

Merchandise available for sale

To Income Statement

To Balance Sheet

EXHIBIT 4.10 Merchandising Cost Flow in the Accounting Cycle

Adjusting Entries for Merchandisers Each of the steps in the accounting cycle described in the prior chapter applies to a merchan- diser. We expand upon three steps of the accounting cycle for a merchandiser—adjustments, statement preparation, and closing.

Inventory Shrinkage—Adjusting Entry A merchandiser using a perpetual inven- tory system makes an adjustment to Merchandise Inventory for any loss of merchandise, includ- ing theft and deterioration. Shrinkage is the loss of inventory, and it is computed by comparing a physical count of inventory with recorded amounts.

P3 Prepare adjustments and close accounts for a mer- chandising company.

154 Chapter 4 Accounting for Merchandising Operations

Z-Mart’s Merchandise Inventory account at the end of the year has a balance of $21,250, but a physical count shows only $21,000 of inventory exists. The adjusting entry to record this $250 shrinkage is

Dec . 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Adjust for $250 shrinkage.

Assets = Liabilities + Equity −250 −250

Sales Discounts, Returns, and Allowances—Adjusting Entries Revenue recognition rules require sales to be reported at the amount expected to be received. This means that period-end adjusting entries are commonly made for Expected sales discounts. Expected returns and allowances (revenue side). Expected returns and allowances (cost side).

These three adjustments produce three new accounts: Allowance for Sales Discounts, Sales Refund Payable, and Inventory Returns Estimated. Appendix 4B covers these accounts and the adjusting entries.

Preparing Financial Statements The financial statements of a merchandiser are similar to those for a service company described in prior chapters. The income statement mainly differs by the addition of cost of goods sold and gross profit. Net sales is affected by discounts, returns and allowances, and some additional expenses such as delivery expense and loss from defective merchandise. The balance sheet dif- fers by the addition of merchandise inventory as part of current assets. (Appendix 4B explains inventory returns estimated as part of current assets and sales refund payable as part of current liabilities.) The statement of retained earnings is unchanged.

Closing Entries for Merchandisers Closing entries are similar for service companies and merchandising companies. The difference is that we close some new temporary accounts that come from merchandising activities. Z-Mart has temporary accounts unique to merchandisers: Sales (of goods), Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. The third and fourth closing entries are identical for a mer- chandiser and a service company. The differences are in red in the closing entries of Exhibit 4.11.

EXHIBIT 4.11 Closing Entries for a Merchandiser

Step 1: Close Credit Balances in Temporary Accounts to Income Summary.

Step 2: Close Debit Balances in Temporary Accounts to Income Summary.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,100 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . 2,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,700 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,800 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,300 Close debit balances in temporary accounts.

Step 3: Close Income Summary.

Dec . 31 Income Summary . . . . . . 12,900 Retained Earnings . . 12,900

Step 4: Close Dividends.

Dec . 31 Retained Earnings . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . 4,000

Dec . 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Close credit balances in temporary accounts.

Chapter 4 Accounting for Merchandising Operations 155

Sales, having a normal credit balance, is debited in step 1. Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold, having normal debit balances, are credited in step 2.

Summary of Merchandising Entries Exhibit 4.12 summarizes the adjusting and closing entries of a merchandiser (using a perpetual inventory system).

EXHIBIT 4.12 Summary of Key Merchandising Entries (using perpetual system and gross method)

Merchandising Transactions Merchandising Entries Dr. Cr.

Purchasing merchandise for Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . # resale . Cash or Accounts Payable . . . . . . . . . . . . . . #

Paying freight costs on Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . # purchases; FOB shipping point . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Paying within discount period . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Merchandise Inventory . . . . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Paying outside discount period . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Recording purchases returns or Cash or Accounts Payable . . . . . . . . . . . . . . . . . . . # allowances . Merchandise Inventory . . . . . . . . . . . . . . . . . #

Selling merchandise . Cash or Accounts Receivable . . . . . . . . . . . . . . . . # Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . . . . #

Receiving payment within Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period . Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . # Accounts Receivable . . . . . . . . . . . . . . . . . . #

Sales Receiving payment outside Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period . Accounts Receivable . . . . . . . . . . . . . . . . . . #

Receiving sales returns Sales Returns and Allowances . . . . . . . . . . . . . . . # of nondefective inventory . Cash or Accounts Receivable . . . . . . . . . . . #

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . #

Recognizing sales allowances . Sales Returns and Allowances . . . . . . . . . . . . . . . # Cash or Accounts Receivable . . . . . . . . . . . #

Paying freight costs on sales; Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . # FOB destination . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjustment for shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . # (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . . . . . . # larger than physical inventory) .

Period-end adjustment for Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . # Adjusting expected sales discounts .* Allowance for Sales Discounts . . . . . . . . . . . #

Period-end adjustment for expected Sales Returns and Allowances . . . . . . . . . . . . . . . # returns—both revenue side and Sales Refund Payable . . . . . . . . . . . . . . . . . . # cost side .* Inventory Returns Estimated . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . #

Closing temporary accounts Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # with credit balances . Income Summary . . . . . . . . . . . . . . . . . . . . . #

Closing temporary accounts Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . # Closing with debit balances . Sales Returns and Allowances . . . . . . . . . . . # Sales Discounts . . . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . # Delivery Expense . . . . . . . . . . . . . . . . . . . . . # “Other Expenses” . . . . . . . . . . . . . . . . . . . . . #

Merchandise Inventory

Beginning inventory Purchases Pur. returns Freight-in (FOB shp pt) Pur. allowances Pur. discounts Shrinkage

Goods avail. for sale Customer returns COGS

Ending inventory

* Period-end adjustments depend on unadjusted balances, which can reverse the debit and credit in the adjusting entries shown; these three entries are covered in Appendix 4B.

156 Chapter 4 Accounting for Merchandising Operations

A merchandising company’s ledger on May 31, its fiscal year-end, includes the following accounts that have normal balances (it uses the perpetual inventory system). A physical count of its May 31 year-end inventory reveals that the cost of the merchandise inventory still available is $656. (a) Prepare the entry to record any inventory shrinkage. (b) Prepare the four closing entries as of May 31.

Recording Shrinkage and Closing Entries

NEED-TO-KNOW 4-4

P3

Solution

This section covers two income statement formats: multiple-step and single-step. The classified balance sheet of a merchandiser also is covered.

Multiple-Step Income Statement A multiple-step income statement details net sales and expenses and reports subtotals for various types of items. Exhibit 4.13 shows a multiple-step income statement. The statement has three main parts: (1) gross profit, which is net sales minus cost of goods sold; (2) income from operations, which is gross profit minus operating expenses; and (3) net income, which is income from operations plus or minus nonoperating items.

Operating expenses are separated into two sections. Selling expenses are the expenses of advertising merchandise, making sales, and delivering goods to customers. General and admin- istrative expenses support a company’s overall operations and include expenses related to accounting, human resources, and finance. Expenses are allocated between sections when they contribute to more than one. Z-Mart allocates rent expense of $9,000 from its store building between two sections: $8,100 to selling expense and $900 to general and administrative expenses.

Nonoperating activities consist of other expenses, revenues, losses, and gains that are un related to a company’s operations. Other revenues and gains commonly include interest revenue, divi- dend revenue, rent revenue, and gains from asset disposals. Other expenses and losses commonly include interest expense, losses from asset disposals, and casualty losses. When there are no reportable nonoperating activities, its income from operations is simply labeled net income.

MORE ON FINANCIAL STATEMENT FORMATS P4 Define and prepare multiple-step and single- step income statements.

Example: Sometimes interest rev- enue and interest expense are netted and reported on the in- come statement as Interest, net.

Do More: QS 4-9, QS 4-10, E 4-10, E 4-12, P 4-4

May 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Adjust for shrinkage ($756 − $656).

a.

May 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Close temporary accounts with credit balances.

May 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 250 Cost of Goods Sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Other Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . 300 Close temporary accounts with debit balances.

*$2,100 (Unadj. bal.) + $100 (Shrinkage)

May 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Close Income Summary account.

May 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Close Dividends account.

b.

Merchandise inventory . . . . $ 756 Sales . . . . . . . . . . . . . . . . . . . . . $4,300 Depreciation expense . . . . . . . . . $400 Common stock . . . . . . . . . . . 1,000 Sales discounts . . . . . . . . . . . . . 50 Salaries expense . . . . . . . . . . . . . 600 Retained earnings . . . . . . . . 1,300 Other operating expenses . . . . 300 Sales returns and allowances . . . 250 Dividends . . . . . . . . . . . . . . . 150 Cost of goods sold . . . . . . . . . . 2,100

Chapter 4 Accounting for Merchandising Operations 157

Single-Step Income Statement A single-step income statement is shown in Exhibit 4.14. It lists cost of goods sold as another expense and shows only one subtotal for total expenses. Expenses are grouped into few, if any, categories. Many companies use formats that combine features of both single- and multiple-step statements. Management chooses the format that best informs users.

Z-MART Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000

Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,300

Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . 2,000 6,300

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314,700

Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,300 Operating expenses

Selling expenses

Depreciation expense—Store equipment . . . . . . . . . . . . . . 3,000

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500

Rent expense—Selling space . . . . . . . . . . . . . . . . . . . . . . . . 8,100

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,300

Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,100

General and administrative expenses

Depreciation expense—Office equipment . . . . . . . . . . . . . 700

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,300

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Rent expense—Office space . . . . . . . . . . . . . . . . . . . . . . . . 900

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Total general and administrative expenses . . . . . . . . . . . . . 29,300

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,400

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 Other revenues and gains (expenses and losses)

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Gain on sale of building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,500)

Total other revenues and gains (expenses and losses) . . . . . . 2,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

Nonoperating activities computation

Income from operations computation

Gross profit computation

Beginning inventory. . . . . . $ 19,000 Net cost of purchases . . . . 232,400 Goods available for sale . . . 251,400 Less ending inventory . . . . 21,000 Cost of goods sold . . . . . . . $230,400

*Cost of goods sold:

EXHIBIT 4.13 Multiple-Step Income Statement

EXHIBIT 4.14 Single-Step Income Statement

Z-MART Income Statement

For Year Ended December 31, 2019

Revenues Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $314,700

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Gain on sale of building . . . . . . . . . . . . . . . . . . . . . . 2,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318,200

Expenses Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . $230,400

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,100

General and administrative expenses . . . . . . . . . . . 29,300

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303,300

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900 Point: Net income is identical under the single-step and multiple-step formats.

Point: Z-Mart did not have any nonoperating activities. Exhibit 4.13 includes some for illustrative purposes.

158 Chapter 4 Accounting for Merchandising Operations

Classified Balance Sheet The classified balance sheet reports merchandise inventory as a current asset, usually after accounts receivable, according to how quickly they can be converted to cash. Inventory is converted less quickly to cash than accounts receivable because inventory first must be sold before cash can be received. Exhibit 4.15 shows the current asset section of Z-Mart’s classified balance sheet (other sections are similar to the previous chapter).

Z-MART Balance Sheet (partial)

December 31, 2019

Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,200 Accounts receivable . . . . . . . . . . . . . 11,200 Merchandise inventory . . . . . . . . . 21,000 Office supplies . . . . . . . . . . . . . . . . . 550 Store supplies . . . . . . . . . . . . . . . . . . 250 Prepaid insurance . . . . . . . . . . . . . . . 300 Total current assets . . . . . . . . . . . . . $41,500

EXHIBIT 4.15 Classified Balance Sheet (partial) of a Merchandiser

Shenanigans Accurate invoices are important to both sellers and buyers. Merchandisers use invoices to make sure they receive full payment for products provided. To achieve this, controls are set up. Still, failures occur. A survey reports that 30% of employees in sales and marketing witnessed false or misleading invoices sent to customers. Another 29% observed employees violating contract terms with customers (KPMG). ■

Ethical Risk

Taret’s adjusted trial balance on April 30, its fiscal year-end, is shown here (accounts in random order). (a) Prepare a multiple-step income statement that begins with gross sales and includes separate categories for net sales, cost of goods sold, selling expenses, and gen- eral and administrative expenses. (b) Prepare a single-step income statement that begins with net sales and includes these expense cat- egories: cost of goods sold, selling expenses, and general and administrative expenses.

Multiple- and Single-Step Income Statements

NEED-TO-KNOW 4-5

P4

Solution

a. Multiple-step income statement.

TARET Income Statement

For Year Ended April 30

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,500 Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $260 Sales returns and allowances . . . . . . . . . . . . . . . . . . . . 240 500 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Operating expenses Selling expenses Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 450 Rent expense—Selling space . . . . . . . . . . . . . . . . . . . . . 400 Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 30 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 900 General and administrative expenses Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 420 Rent expense—Office space . . . . . . . . . . . . . . . . . . . . . 72 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 8 Total general and administrative expenses . . . . . . . . . 500 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,100

TARET Income Statement

For Year Ended April 30

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 Expenses Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $6,500 Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 General and administrative expenses . . . . . . . . . . . 500 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,100

b. Single-step income statement.

Adjusted Trial Balance Debit Credit

Merchandise inventory . . . . . . . . . . . . . . . . . . . $ 800 Other (noninventory) assets . . . . . . . . . . . . . . . 2,600 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 400 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 1,700 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . 260 Sales returns and allowances . . . . . . . . . . . . . 240 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 6,500 Sales salaries expense . . . . . . . . . . . . . . . . . . . 450 Rent expense—Selling space . . . . . . . . . . . . . . 400 Store supplies expense . . . . . . . . . . . . . . . . . . 30 Advertising expense . . . . . . . . . . . . . . . . . . . . 20 Office salaries expense . . . . . . . . . . . . . . . . . . 420 Rent expense—Office space . . . . . . . . . . . . . . 72 Office supplies expense . . . . . . . . . . . . . . . . . 8 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,100 $12,100

Do More: QS 4-11, E 4-11, E 4-15, P 4-3

Chapter 4 Accounting for Merchandising Operations 159

Acid-Test and Gross Margin Ratios Decision Analysis

Acid-Test Ratio One measure of a merchandiser’s ability to pay its current liabilities (referred to as its liquidity) is the acid- test ratio. The acid-test ratio, also called quick ratio, is defined as quick assets (cash, short-term invest- ments, and current receivables) divided by current liabilities—see Exhibit 4.16. It differs from the current ratio by excluding less liquid current assets such as inventory and prepaid expenses that take longer to be converted to cash.

Exhibit 4.17 shows both the acid-test and current ratios of Nike and Under Armour for three recent years. Nike’s acid-test ratio implies that it has enough quick assets to cover current liabilities. It is also on par with its competitor, Under Armour. Nike’s current ratio suggests it has more than enough current assets to cover current liabilities. Analysts might argue that Nike could invest some current assets in more productive assets. An acid-test ratio less than 1.0 means that current liabilities exceed quick assets. A rule of thumb is that the acid-test ratio should have a value near, or higher than, 1.0. Less than 1.0 raises liquid- ity concerns unless a company can get enough cash from sales or if liabilities are not due until late in the next period.

A1 Compute the acid-test ratio and explain its use to as- sess liquidity.

Acid-test ratio = Cash and cash equivalents + Short-term investments + Current receivables

Current liabilities

EXHIBIT 4.16 Acid-Test (Quick) Ratio

Company $ millions Current Year 1 Year Ago 2 Years Ago

Nike Total quick assets . . . . . . . . . . . . . . $ 9,856 $ 8,698 $ 9,282 Total current assets . . . . . . . . . . . . . $16,061 $15,025 $15,587

Total current liabilities . . . . . . . . . . . $ 5,474 $ 5,358 $ 6,332

Acid-test ratio . . . . . . . . . . . . . . . . . 1.8 1.6 1.5 Current ratio . . . . . . . . . . . . . . . . . . 2.9 2.8 2.5 Under Armour Acid-test ratio . . . . . . . . . . . . . . . . . 0 .9 1 .3 1 .2 Current ratio . . . . . . . . . . . . . . . . . . 2 .2 2 .9 3 .1

EXHIBIT 4.17 Acid-Test and Current Ratios for two competitors

Gross Margin Ratio Without enough gross profit, a merchandiser can fail. The gross margin ratio helps understand this link. It differs from the profit margin ratio in that it excludes all costs except cost of goods sold. The gross margin ratio (or gross profit ratio) is defined as gross margin (net sales minus cost of goods sold) divided by net sales—see Exhibit 4.18.

Supplier A retailer requests to purchase supplies on credit from your company. You have no prior experience with this retailer. The retailer’s current ratio is 2.1, its acid-test ratio is 0.5, and inventory makes up most of its current assets. Do you extend credit? ■ Answer: A current ratio of 2.1 suggests sufficient current assets to cover current liabilities. An acid-test ratio of 0.5 suggests, however, that quick assets can cover only about one-half of current liabilities. The retailer depends on money from sales of inventory to pay current liabilities. If sales decline, the likelihood that this retailer will default on its payments increases. You probably do not extend credit.

Decision Maker

Point: Successful use of a just-in- time inventory system can narrow the gap between the acid-test ratio and the current ratio.

A2 Compute the gross margin ratio and explain its use to assess profitability.

EXHIBIT 4.18 Gross Margin RatioGross margin ratio =

Net sales − Cost of goods sold Net sales

Exhibit 4.19 shows the gross margin ratio of Nike for three recent years. For Nike, each $1 of sales in the current year yielded about 44.6¢ in gross margin to cover all expenses and still produce a net income. This 44.6¢ margin is down from 46.2¢ in the prior year. This decrease is unfavorable.

$ millions Current Year 1 Year Ago 2 Years Ago

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,312 $14,971 $14,067

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $34,350 $32,376 $30,601

Gross margin ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44.6% 46.2% 46.0%

EXHIBIT 4.19 Nike’s Gross Margin Ratio

160 Chapter 4 Accounting for Merchandising Operations

Use the following adjusted trial balance and additional information to complete the requirements.

COMPREHENSIVE 1

Single- and Multiple-Step Income Statements, Closing Entries, and Analysis Using Acid-Test and Gross Margin

NEED-TO-KNOW 4-6 KC ANTIQUES

Adjusted Trial Balance December 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Merchandise inventory (ending) . . . . . . . . . . . . . . . 60,000

Store supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,600

Accumulated depreciation—Equipment . . . . . . . . . $ 16,600

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Sales returns and allowances . . . . . . . . . . . . . . . . . 6,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Depreciation expense—Store equipment . . . . . . . 4,100

Depreciation expense—Office equipment . . . . . . . 1,600

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . 30,000

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . 34,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent expense—Selling space . . . . . . . . . . . . . . . . . . 16,800

Rent expense—Office space . . . . . . . . . . . . . . . . . . 7,200

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . 5,750

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . 31,400

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $449,850 $449,850

160 Chapter 4 Accounting for Merchandising Operations

Financial Officer Your company has a 36% gross margin ratio and a 17% net profit margin ratio. Industry averages are 44% for gross margin and 16% for net profit margin. Do these comparative results concern you? ■ Answer: Your company’s net profit margin is about equal to the industry average. However, gross margin shows that your company is paying far more in cost of goods sold or receiving far less in sales price than competitors. You should try to find the problem with cost of goods sold, sales, or both.

Decision Maker

KC Antiques’s supplementary records for the year reveal the following itemized costs for merchandising activities.

Invoice cost of merchandise purchases . . . . . . . $150,000

Purchases discounts received . . . . . . . . . . . . . . . 2,500 Purchases returns and allowances . . . . . . . . . . . $2,700

Cost of transportation-in . . . . . . . . . . . . . . . . . . . 5,000

Required

1. Use the supplementary records to compute the total cost of merchandise purchases for the year. 2. Prepare a multiple-step income statement for the year. (Beginning inventory was $70,100.) 3. Prepare a single-step income statement for the year. 4. Prepare closing entries for KC Antiques at December 31. 5. Compute the acid-test ratio and the gross margin ratio. Explain the meaning of each ratio and interpret

them for KC Antiques.

Chapter 4 Accounting for Merchandising Operations 161

PLANNING THE SOLUTION Compute the total cost of merchandise purchases for the year. To prepare the multiple-step statement, first compute net sales. Then, to compute cost of goods sold,

add the net cost of merchandise purchases for the year to beginning inventory and subtract the cost of ending inventory. Subtract cost of goods sold from net sales to get gross profit. Then classify expenses as selling expenses or general and administrative expenses.

To prepare the single-step income statement, begin with net sales. Then list and subtract the expenses. The first closing entry debits all temporary accounts with credit balances and opens the Income

Summary account. The second closing entry credits all temporary accounts with debit balances. The third entry closes the Income Summary account to the Retained Earnings account, and the fourth entry closes the Dividends account to the Retained Earnings account.

Identify the quick assets on the adjusted trial balance. Compute the acid-test ratio by dividing quick assets by current liabilities. Compute the gross margin ratio by dividing gross profit by net sales.

SOLUTION 1.

Invoice cost of merchandise purchases . . . . . . . . . . . . $150,000

Less: Purchases discounts received . . . . . . . . . . . . . . . 2,500

Purchases returns and allowances . . . . . . . . . . . 2,700

Add: Cost of transportation-in . . . . . . . . . . . . . . . . . . . . 5,000

Total cost of merchandise purchases . . . . . . . . . . . . . . $149,800

2. Multiple-step income statement. 3. Single-step income statement.

KC ANTIQUES Income Statement

For Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,250

Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Sales returns and allowances . . . . . . . . . . . . . . 6,000 11,000

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,250

Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,350

Expenses

Selling expenses

Depreciation expense—Store equipment . . . . . 4,100

Sales salaries expense . . . . . . . . . . . . . . . . . . . . 30,000

Rent expense—Selling space . . . . . . . . . . . . . . . 16,800

Store supplies expense . . . . . . . . . . . . . . . . . . . 5,750

Advertising expense . . . . . . . . . . . . . . . . . . . . . . 31,400

Total selling expenses . . . . . . . . . . . . . . . . . . . . . 88,050

General and administrative expenses

Depreciation expense—Office equipment . . . . . 1,600

Office salaries expense . . . . . . . . . . . . . . . . . . . . 34,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent expense—Office space . . . . . . . . . . . . . . . . 7,200

Total general and administrative expenses . . . . 53,800

Total operating expenses . . . . . . . . . . . . . . . . . . . . 141,850

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,500

*Cost of goods sold also can be directly computed: Beginning merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . $ 70,100 Total cost of merchandise purchases (from part 1) . . . . . . . . . . 149,800 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219,900 Ending merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,900

Tax expense for a corporation appears immediately before Net income in its own category .

KC ANTIQUES Income Statement

For Year Ended December 31

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $332,250

Expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . . $159,900

Selling expenses . . . . . . . . . . . . . . . . . . . . 88,050

General and administrative expenses . . . 53,800

Total expenses . . . . . . . . . . . . . . . . . . . . . . 301,750

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,500

162 Chapter 4 Accounting for Merchandising Operations

5. Acid-test ratio = (Cash and equivalents + Short-term investments + Current receivables)∕ Current liabilities

= (Cash + Accounts receivable)∕(Accounts payable + Salaries payable)

= ($7,000 + $13,000)∕($9,000 + $2,000) = $20,000∕$11,000 = 1.82 Gross margin ratio = Gross profit∕Net sales = $172,350∕$332,250 = 0.52 (or 52%)

KC Antiques has a healthy acid-test ratio of 1.82. This means it has $1.82 in liquid assets to sat- isfy each $1.00 in current liabilities. The gross margin of 0.52 shows that KC Antiques spends 48¢ ($1.00 − $0.52) of every dollar of net sales on the costs of acquiring the merchandise it sells. This leaves 52¢ of every dollar of net sales to cover other expenses incurred in the business and to provide a net profit.

4. Dec . 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Close credit balances in temporary accounts.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312,750

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . 6,000

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Depreciation Expense—Store Equipment . . . . . . . . . . . . 4,100

Depreciation Expense—Office Equipment . . . . . . . . . . . 1,600

Sales Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Office Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent Expense—Selling Space . . . . . . . . . . . . . . . . . . . . . . 16,800

Rent Expense—Office Space . . . . . . . . . . . . . . . . . . . . . . 7,200

Store Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 5,750

Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,400

Close debit balances in temporary accounts.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500

Close Income Summary account.

Dec . 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Close Dividends account.

Prepare journal entries for the following transactions for both the seller (BMX) and buyer (Sanuk).

May 4 BMX sold $1,500 of merchandise on account to Sanuk, terms FOB shipping point, n∕45, in- voice dated May 4. The cost of the merchandise was $900.

6 Sanuk paid transportation charges of $30 on the May 4 purchase from BMX. 8 BMX sold $1,000 of merchandise on account to Sanuk, terms FOB destination, n∕15, in-

voice dated May 8. The cost of the merchandise was $700. This sale permitted returns for 30 days.

10 BMX paid transportation costs of $50 for delivery of merchandise sold to Sanuk on May 8. 16 BMX issued Sanuk a $200 credit memorandum for merchandise returned. The merchan-

dise was purchased by Sanuk on account on May 8. The cost of the merchandise returned was $140.

18 BMX received payment from Sanuk for the May 8 purchase. 21 BMX sold $2,400 of merchandise on account to Sanuk, terms FOB shipping point, 2∕10,

n∕EOM. The cost of the merchandise was $1,440. This sale permitted returns for 90 days. 31 BMX received payment from Sanuk for the May 21 purchase, less discount.

COMPREHENSIVE 2

Recording Merchandising Transactions—Both Seller and Buyer

NEED-TO-KNOW 4-7

Chapter 4 Accounting for Merchandising Operations 163

Solution BMX (Seller) Sanuk (Buyer)

May 4 Accounts Receivable—Sanuk . . . . . . . . . . 1,500 Merchandise Inventory . . . . . . . . . . . . . . 1,500

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accounts Payable—BMX . . . . . . . . . 1,500

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 900

Merchandise Inventory . . . . . . . . . . . 900

6 No entry . Merchandise Inventory . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 30

8 Accounts Receivable—Sanuk . . . . . . . . . . 1,000 Merchandise Inventory . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Accounts Payable—BMX . . . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . . . . . . . . 700

Merchandise Inventory . . . . . . . . . . . 700

10 Delivery Expense . . . . . . . . . . . . . . . . . . . . 50 No entry .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 50

16 Sales Returns & Allowances . . . . . . . . . . . 200 Accounts Payable—BMX . . . . . . . . . . . . . 200

Accounts Receivable—Sanuk . . . . . . 200 Merchandise Inventory . . . . . . . . . . 200

Merchandise Inventory . . . . . . . . . . . . . . . 140

Cost of Goods Sold . . . . . . . . . . . . . . 140

18 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Accounts Payable—BMX . . . . . . . . . . . . . 800

Accounts Receivable—Sanuk . . . . . . 800 Cash . . . . . . . . . . . . . . . . . . . . . . . . . 800

21 Accounts Receivable—Sanuk . . . . . . . . . . . 2,400 Merchandise Inventory . . . . . . . . . . . . . . 2,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 2,400 Accounts Payable—BMX . . . . . . . . . 2,400

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 1,440

Merchandise Inventory . . . . . . . . . . . 1,440

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,352 Accounts Payable—BMX . . . . . . . . . . . . . 2,400

Sales Discounts . . . . . . . . . . . . . . . . . . . . . 48 Merchandise Inventory . . . . . . . . . . 48

Accounts Receivable—Sanuk . . . . . . 2,400 Cash . . . . . . . . . . . . . . . . . . . . . . . . . 2,352

APPENDIX

Periodic Inventory System 4A A periodic inventory system requires updating the inventory account only at the end of a period. During the period, the Merchandise Inventory balance remains unchanged and cost of merchandise is recorded in a temporary Purchases account. When a company sells merchandise, it records revenue but not the cost of the goods sold. At the end of the period, it takes a physical count of inventory to get ending inventory. The cost of goods sold is then computed as cost of merchandise available for sale minus ending inventory.

Recording Merchandise Purchases Under a periodic system, the purchases, purchases returns and allowances, purchases discounts, and transportation-in transactions are recorded in separate temporary accounts. At period-end, each of these temporary accounts is closed, which updates the Merchandise Inventory account. To demonstrate, journal entries under the periodic inventory system are shown for the most common transactions (codes a through d link these transactions to those in the chap- ter). For comparison, perpetual system journal entries are shown to the right of each periodic entry. Differences are highlighted.

Credit Purchases with Cash Discounts The periodic system uses a temporary Purchases account that accumulates the cost of all purchase transactions during each period. The Purchases account has a normal debit balance, as it increases the cost of merchandise available for sale. Z-Mart’s November 2 entry to record the purchase of merchandise for $500 on credit with terms of 2∕10, n∕30 is

P5 Record and compare merchandising transactions using both periodic and perpetual inventory systems.

(a) Periodic Perpetual

Purchases . . . . . . . . . . . . . . . . . . 500 Merchandise Inventory . . . . . . . . . . . 500

Accounts Payable . . . . . . . 500 Accounts Payable . . . . . . . . . . . 500

164 Chapter 4 Accounting for Merchandising Operations

Payment of Purchases The periodic system uses a temporary Purchases Discounts account that accumu- lates discounts taken during the period. If payment for transaction a is made within the discount period, the entry is

Purchases Allowances The buyer and seller agree to a $30 purchases allowance for defective goods (whether paid within the discount period or not). In the periodic system, the temporary Purchases Returns and Allowances account accumulates the cost of all returns and allowances during a period. The buyer records the $30 allowance as

If payment for transaction a is made after the discount period expires, the entry is

(b1) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 500

Purchases Discounts* . . . . . 10 Merchandise Inventory* . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490 *$500 × 2% *$500 × 2%

(b2) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

(c1) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 30 Accounts Payable . . . . . . . . . . . . . . . . 30

Purchases Returns and Allowances . . . . . . . . . . 30 Merchandise Inventory . . . . . . . 30

(c2) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 50 Accounts Payable . . . . . . . . . . . . . . . . 50

Purchases Returns and Allowances . . . . . . . . . . 50 Merchandise Inventory . . . . . . . 50

(d) Periodic Perpetual

Transportation-In . . . . . . . . . . . . 75 Merchandise Inventory . . . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . . . . 75

Purchases Returns The buyer returns $50 of merchandise within the discount period. The entry is

Point: Purchases Discounts and Purchases Returns and Allowances are contra purchases accounts and have normal credit balances, as they both decrease the cost of merchandise available for sale.

Transportation-In The buyer paid a $75 freight charge to transport goods with terms FOB destination. In the periodic system, this cost is recorded in a temporary Transportation-In account, which has a normal debit balance as it increases the cost of merchandise available for sale.

Recording Merchandise Sales Journal entries under the periodic system are shown for the most common transactions (codes e through h link these transactions to those in the chapter). Perpetual system entries are shown to the right of each periodic entry. Differences are highlighted.

Credit Sales and Receipt of Payments Both the periodic and perpetual systems record sales entries simi- larly, using the gross method. The same holds for entries related to payment of receivables from sales both during and after the discount period. However, under the periodic system, the cost of goods sold is not recorded at the time of each sale (whereas it is under the perpetual system). The entry to record $1,000 in credit sales (costing $300) is

Periodic Perpetual

Accounts Receivable . . . . . . . . . . 1,000 Accounts Receivable . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . 1,000 Sales . . . . . . . . . . . . . . . . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . . . . . 300

No cost-side entry . . . . . . . Merchandise Inventory . . . . . . . 300

Chapter 4 Accounting for Merchandising Operations 165

Returns Received by Seller A customer returned merchandise for a cash refund. The goods sell for $15 and cost $9. (Recall: The periodic system records only the revenue effect, not the cost effect, for sales transactions.) The entry for the seller to take back the return is

Allowances Granted by Seller The seller gives a price reduction and credits the buyer’s accounts receivable for $10. The entry is identical under the periodic and perpetual systems. The seller records this allowance as

Recording Adjusting Entries Shrinkage—Adjusting Entry Adjusting (and closing) entries for the two systems are in Exhibit 4A.1. The $250 shrinkage is only recorded under the perpetual system—see entry z in Exhibit 4A.1. Shrinkage in cost of goods is unknown using a periodic system because inventory is not continually updated and therefore cannot be compared to the physical count.

Periodic Perpetual

(f ) Sales Returns and Allowances . . . . 10 Sales Returns and Allowances . . . . . . 10 Accounts Receivable . . . . . . . 10 Accounts Receivable . . . . . . . . . 10

Periodic Perpetual

(e1) Sales Returns and Allowances . . . . 15 Sales Returns and Allowances . . . . . . 15 Cash . . . . . . . . . . . . . . . . . . . . 15 Cash . . . . . . . . . . . . . . . . . . . . . . 15

(e2) Merchandise Inventory . . . . . . . . . . . 9 No entry . . . . . . . . . . . . . . . . . Cost of Goods Sold . . . . . . . . . . 9

EXHIBIT 4A.1 Comparison of Adjusting and Closing Entries— Periodic and Perpetual

Periodic Perpetual Adjusting Entries Adjusting Entries

(z) None Cost of Goods Sold . . . . . . . . . . . . . . 250 Merchandise Inventory . . . . . . 250

(g) Sales Discounts . . . . . . . . . . . . . . . . 50 Sales Discounts . . . . . . . . . . . . . . . . . 50 Allowance for Sales Discounts 50 Allowance for Sales Discounts . . 50

(h1) Sales Returns and Allowances . . . . 900 Sales Returns and Allowances . . . . . . 900 Sales Refund Payable . . . . . . . 900 Sales Refund Payable . . . . . . . . 900

(h2) Inventory Returns Estimated . . . . . . 300 Inventory Returns Estimated . . . . . . . 300 Purchases . . . . . . . . . . . . . . . . 300 Cost of Goods Sold . . . . . . . . . . 300

Entries in gray are covered in Appendix 4B. Entries in gray are covered in Appendix 4B.

Periodic Perpetual Closing Entries Closing Entries

(1) Sales . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Merchandise Inventory (ending) 21,000 Purchases Discounts . . . . . . . . . . 4,200 Purchases Returns and Allowances 1,500 Income Summary . . . . . . . . . . 347,700 Income Summary . . . . . . . . . . . 321,000

(2) Income Summary . . . . . . . . . . . . . . 334,800 Income Summary . . . . . . . . . . . . . . . . 308,100 Sales Discounts . . . . . . . . . . . 4,300 Sales Discounts . . . . . . . . . . . . 4,300 Sales Returns and Allowances 2,000 Sales Returns and Allowances . . 2,000 Merch. Inven. (beginning) . . . 19,000 Purchases . . . . . . . . . . . . . . . 235,800 Cost of Goods Sold . . . . . . . . . 230,400 Transportation-In . . . . . . . . . 2,300 Depreciation Expense . . . . . . 3,700 Depreciation Expense . . . . . . . 3,700 Salaries Expense . . . . . . . . . . 43,800 Salaries Expense . . . . . . . . . . . 43,800 Insurance Expense . . . . . . . . 600 Insurance Expense . . . . . . . . . . 600 Rent Expense . . . . . . . . . . . . . 9,000 Rent Expense . . . . . . . . . . . . . . 9,000 Supplies Expense . . . . . . . . . 3,000 Supplies Expense . . . . . . . . . . . 3,000 Advertising Expense . . . . . . . 11,300 Advertising Expense . . . . . . . . . 11,300

(3) Income Summary . . . . . . . . . . . . . . 12,900 Income Summary . . . . . . . . . . . . . . . . 12,900 Retained Earnings . . . . . . . . . 12,900 Retained Earnings . . . . . . . . . . . 12,900

(4) Retained Earnings . . . . . . . . . . . . . 4,000 Retained Earnings . . . . . . . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . . . . . . . 4,000

166 Chapter 4 Accounting for Merchandising Operations

Expected Sales Discounts—Adjusting Entry Both the periodic and perpetual methods make a period-end adjusting entry under the gross method to estimate the $50 sales discounts arising from current-period sales that are likely to be taken in future periods. Z-Mart made the period-end adjusting entry g in Exhibit 4A.1 for expected sales discounts.

Expected Returns and Allowances—Adjusting Entry Both the periodic and perpetual inventory systems estimate returns and allowances arising from current-period sales that will occur in future periods. The adjusting entry for both systems is identical for the sales side, but slightly different for the cost side. The period-end entries h1 and h2 in Exhibit 4A.1 are used to record the updates to expected sales refunds of $900 and the cost side of $300. Under both systems, the seller sets up a Sales Refund Payable account, which is a current liability reflecting the amount expected to be refunded to customers, and an Inventory Returns Estimated account, which is a current asset reflecting the inventory estimated to be returned.

Recording Closing Entries Periodic and perpetual inventory systems have slight differ- ences in closing entries. The period-end Merchandise Inventory balance (unadjusted) is $19,000 under the periodic system. Because the periodic system does not update the Merchandise Inventory balance during the period, the $19,000 amount is the beginning inventory. A physical count of inventory taken at the end of the period reveals $21,000 of merchandise available. The adjusting and closing entries for the two systems are in Exhibit 4A.1. Recording the periodic inventory balance is a two-step process. The ending inventory balance of $21,000 is entered by debiting the inventory account in the first closing entry. The beginning inventory balance of $19,000 is deleted by crediting the inventory account in the second closing entry.1 By updating Merchandise Inventory and closing Purchases, Purchases Discounts, Purchases Returns and Allowances, and Transportation-In, the periodic system transfers the cost of sales amount to Income Summary. Review the periodic side of Exhibit 4A.1 and see that the red items affect Income Summary as follows.

1This approach is called the closing entry method. An alternative approach, referred to as the adjusting entry method, would not make any entries to Merchandise Inventory in the closing entries of Exhibit 4A.1, but instead would make two adjusting entries. Using Z-Mart data, the two adjusting entries would be (1) Dr. Income Summary and Cr. Merchandise Inventory for $19,000 each and (2) Dr. Merchandise Inventory and Cr. Income Summary for $21,000 each. The first entry removes the beginning balance of Merchandise Inventory, and the second entry records the actual ending balance.

Credit to Income Summary in the first closing entry includes amounts from

Merchandise inventory (ending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  21,000

Purchases discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200

Purchases returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Debit to Income Summary in the second closing entry includes amounts from

Merchandise inventory (beginning) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (19,000)

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (235,800)

Transportation-in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,300)

Net effect on Income Summary (net debit = cost of goods sold) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(230,400)

This $230,400 effect on Income Summary is the cost of goods sold amount (which is equal to cost of goods sold reported in a perpetual inventory system). The periodic system transfers cost of goods sold to the Income Summary account but without using a Cost of Goods Sold account. Also, the periodic system does not separately measure shrinkage. Instead, it computes cost of goods available for sale, subtracts the cost of ending inventory, and defines the difference as cost of goods sold, which includes shrinkage.

Preparing Financial Statements The financial statements of a merchandiser using the periodic system are similar to those for a service company described in prior chapters. The income statement mainly differs by the inclusion of cost of goods sold and gross profit—of course, net sales is affected by dis- counts, returns, and allowances. The cost of goods sold section under the periodic system follows. The balance sheet mainly differs by the inclusion of merchandise inventory, inventory returns estimated, allowance for sales discounts, and sales refund payable. Visit the Additional Student Resource section of the Connect ebook to view sample chart of accounts for periodic and perpetual systems.

Calculation of Cost of Goods Sold

Beginning inventory . . . . . . . . . . . . . . . . . . . $ 19,000

Net cost of purchases . . . . . . . . . . . . . . . . . . 232,400

Cost of goods available for sale . . . . . . . . . 251,400

Less ending inventory . . . . . . . . . . . . . . . . . 21,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . $230,400

Chapter 4 Accounting for Merchandising Operations 167

APPENDIX

Adjusting Entries under New Revenue Recognition Rules 4B

Expected Sales Discounts—Adjusting Entry New revenue recognition rules require sales to be reported at the amount expected to be received. This means that a period-end adjusting entry is made to estimate sales discounts for current-period sales that are expected to be taken in future periods. To demonstrate, assume Z-Mart has the following unadjusted balances.

P6 Prepare adjustments for discounts, returns, and allowances per revenue recognition rules.

Accounts Receivable . . . . . . . . . . $11,250 Allowance for Sales Discounts . . . . . . . . . . $0

Of the $11,250 of receivables, $2,500 of them are within the 2% discount period for which we expect buy- ers to take $50 in future-period discounts (computed as $2,500 × 2%) arising from this period’s sales. The adjusting entry for the $50 update to Allowance for Sales Discounts is

Allow. for Sales Discounts

Beg . bal . 0 Req . adj . 50

Est . bal . 50

Allowance for Sales Discounts is a contra asset account and is reported on the balance sheet as a reduc- tion to the Accounts Receivable asset account. The Allowance for Sales Discounts account has a normal credit balance because it reduces Accounts Receivable, which has a normal debit balance. This adjusting entry results in both accounts receivable and sales being reported at expected amounts.*

Expected Returns and Allowances—Adjusting Entries To avoid overstatement of sales and cost of sales, sellers estimate sales returns and allowances in the period of the sale. Estimating returns and allowances requires companies to maintain the following two balance sheet accounts that are set up with adjusting entries. Two adjusting entries are made: one for the revenue side and one for the cost side.

Current Asset→Inventory Returns Estimated Current Liability→Sales Refund Payable

Balance Sheet—partial

Accounts receivable . . . . . . . . . . . . . . . . $11,250 Less allowance for sales discounts . . . . 50 Accounts receivable, net . . . . . . . . . . . . $11,200

Income Statement—partial

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000 Less sales discounts, returns & allowances . . . . . 6,300 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $314,700

*Next Period Adjustment The Allowance for Sales Discounts balance remains unchanged during a period except for the period-end adjusting entry. At next period-end, assume that Z-Mart computes an $80 balance for the Allowance for Sales Discounts. Using our three-step adjusting process we get: Step 1: Current bal. is $50 credit in Allowance for Sales Discounts. Step 2: Current bal. should be $80 credit in Allowance for Sales Discounts. Step 3: Record entry to get from step 1 to step 2. Sales Discounts . . . . . . . . . . . . . . . . . . 30 Allowance for Sales Discounts. . . . . 30

Revenue Side for Expected R&A When returns and allowances are expected, a seller sets up a Sales Refund Payable account, which is a current liability showing the amount expected to be refunded to customers. Assume that on December 31 the company estimates future sales refunds to be $1,200. Assume also that the unadjusted balance in Sales Refund Payable is a $300 credit. The adjusting entry for the $900 update to Sales Refund Payable follows. The Sales Refund Payable account is updated only during the adjusting entry process. Its balance remains unchanged during the period when actual returns and allowances are recorded.

Assets = Liabilities + Equity −50 −50

(g) Dec . 31 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Allowance for Sales Discounts . . . . . . . . . . . . . . . . . . . . . 50 Adjustment for future discounts.

Assets = Liabilities + Equity +900 −900

Sales Refund Payable

Beg . bal . 300 Req . adj . 900

Est . bal . 1,200

(h1) Dec . 31 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 900 Sales Refund Payable . . . . . . . . . . . . . . . . . . . . . . . . . . 900 Expected refund of sales.*

*This entry uses our three-step adjusting process: Step 1: Current bal. is $300 credit for Sales Refund Payable. Step 2: Current bal. should be $1,200 credit for Sales Refund Payable. Step 3: Record entry to get from step 1 to step 2.

168 Chapter 4 Accounting for Merchandising Operations

Cost Side for Expected R&A On the cost side, some inventory is expected to be returned, which means that cost of goods sold recorded at the time of sale is overstated due to expected returns. A seller sets up an Inventory Returns Estimated account, which is a current asset showing the inventory estimated to be returned. Extending the example above, assume that the company estimates future inventory returns to be $500 (which is the cost side of the $1,200 expected returns and allowances above). Assume also that the (beginning) unadjusted balance in Inventory Returns Estimated is a $200 debit. The adjusting entry for the $300 update to expected returns follows. The Inventory Returns Estimated account is updated only during the adjusting entry process. Its balance remains unchanged during the period when actual returns and allowances are recorded.

Point: If estimates of returns and allowances prove too high or too low, we adjust future estimates accordingly.

Assets = Liabilities + Equity +300 +300

Inventory Returns Est.

Beg . bal . 200 Req . adj . 300

Est . bal . 500

(h2) Dec . 31 Inventory Returns Estimated . . . . . . . . . . . . . . . . . . . . . . . . . 300 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Expected return of inventory.*

*This entry uses our three-step adjusting process: Step 1: Current bal. is $200 debit for Inventory Returns Estimated. Step 2: Current bal. should be $500 debit for Inventory Returns Estimated. Step 3: Record entry to get from step 1 to step 2.

At the current year-end, a company shows the following unadjusted balances for selected accounts.

P6

Estimating Discounts, Returns, and Allowances

NEED-TO-KNOW 4-8 Allowance for Sales Discounts . . . . . . . . . . . . . . $  75 credit Sales Discounts . . . . . . . . . . . . . . . . . . . . . . $1,850 debit Sales Refund Payable . . . . . . . . . . . . . . . . . . . . . 800 credit Sales Returns and Allowances . . . . . . . . . . 4,825 debit Inventory Returns Estimated . . . . . . . . . . . . . . . 450 debit Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 9,875 debit

a. After an analysis of future sales discounts, the company estimates that the Allowance for Sales Discounts account should have a $275 credit balance. Prepare the current year-end adjusting journal entry for future sales discounts.

b. After an analysis of future sales returns and allowances, the company estimates that the Sales Refund Payable account should have an $870 credit balance (revenue side).

c. After an analysis of future inventory returns, the company estimates that the Inventory Returns Estimated account should have a $500 debit balance (cost side).

Solution

Dec . 31 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Allowance for Sales Discounts . . . . . . . . . . . . . . . . . . . . . 200 Adjustment for future discounts. $275 Cr. − $75 Cr. Dec . 31 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 70 Sales Refund Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Adjustment for future sales refund. $870 Cr. − $800 Cr. Dec . 31 Inventory Returns Estimated . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Adjustment for future inventory returns. $500 Dr. − $450 Dr.

Do More: QS 4-19, QS 4-20, E 4-20, E 4-21, E 4-22

APPENDIX

Net Method for Merchandising4C The net method records an invoice at its net amount (net of any cash discount). The gross method, cov- ered earlier in the chapter, initially records an invoice at its gross (full) amount. This appendix records merchandising transactions using the net method. Differences with the gross method are highlighted. When invoices are recorded at net amounts, any cash discounts are deducted from the balance of the Merchandise Inventory account when initially recorded. This assumes that all cash discounts will be taken. If any discounts are later lost, they are recorded in a Discounts Lost expense account reported on the income statement.

P7 Record and compare merchandising transactions using the gross method and net method.

Chapter 4 Accounting for Merchandising Operations 169

If the invoice is paid on (or before) November 12 within the discount period, it records Gross Method—Perpetual Net Method—Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Merchandise Inventory . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490

Gross Method—Perpetual Net Method—Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490 Discounts Lost* . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

*For simplicity, we record Discounts Lost on the payment date.

Cost of Goods Sold . . . . . . . . . . . 200 Cost of Goods Sold . . . . . . . . . . . . . . . 200

Merchandise Inventory . . . 200 Merchandise Inventory . . . . . . . 200

Gross Method—Perpetual Net Method—Perpetual

Accounts Receivable . . . . . . . . . . 500 Accounts Receivable . . . . . . . . . . . . . . 490 Sales . . . . . . . . . . . . . . . . . . 500 Sales . . . . . . . . . . . . . . . . . . . . . . 490

If the invoice is paid after the discount period, it records

Gross Method—Perpetual Net Method—Perpetual

Merchandise Inventory . . . . . . . . 500 Merchandise Inventory . . . . . . . . . . . . 490

Accounts Payable . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . 490

SALES—Perpetual A company sells merchandise on November 2 at a $500 invoice price ($490 net) with terms of 2∕10, n∕30. The goods cost $200. Its November 2 entries are

If cash is received on (or before) November 12 within the discount period, it records Gross Method—Perpetual Net Method—Perpetual

Cash . . . . . . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 490

Sales Discounts . . . . . . . . . . . . . . 10

Accounts Receivable . . . . . 500 Accounts Receivable . . . . . . . . . 490

Perpetual Inventory System PURCHASES—Perpetual A company purchases merchandise on November 2 at a $500 invoice price ($490 net) with terms of 2∕10, n∕30. Its November 2 entries under the gross and net methods are

If cash is received after the discount period, it records Gross Method—Perpetual Net Method—Perpetual

Cash . . . . . . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Interest Revenue . . . . . . . . . . . . 10

Accounts Receivable . . . . . 500 Accounts Receivable . . . . . . . . . 490

Periodic Inventory System PURCHASES—Periodic Under the periodic system, the balance of the Merchandise Inventory account remains unchanged during the period and is updated at period-end. During the period, three accounts are used to record purchases of inventory: Purchases; Purchases Discounts; and Purchases Returns and Allowances. The entries below are identical to the perpetual system except that Merchandise Inventory is substituted for each of the three purchases accounts. To demonstrate, we apply the periodic system to purchases transactions. On November 2, a buyer pur- chases goods ($500 gross; $490 net) with terms of 2∕10, n∕30. Its November 2 entries under the gross and net methods are

Gross Method—Periodic Net Method—Periodic

Purchases . . . . . . . . . . . . . . . . . . 500 Purchases . . . . . . . . . . . . . . . . . . . . . . 490 Accounts Payable . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . 490

170 Chapter 4 Accounting for Merchandising Operations

If the invoice is paid on (or before) November 12 within the discount period, it records

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Purchases Discounts . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Discounts Lost . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

If the invoice is paid after the discount period, it records

SALES—Periodic For sales transactions, the perpetual and periodic entries are identical except that under the periodic system the cost-side entries are not made at the time of each sale nor for any subsequent returns. Instead, the cost of goods sold is computed at period-end based on a physical count of inventory. This entry is shown in Exhibit 4A.1.

APPENDIX

Work Sheet—Perpetual System4D This appendix along with assignments is available online.

MERCHANDISING ACTIVITIES Merchandise: Goods a company buys to resell. Cost of goods sold: Costs of merchandise sold. Gross profit (gross margin): Net sales minus cost of goods sold. Computing net income (service company vs. merchandiser):

EqualsMinusEqualsMinus Expenses Netincome

Net sales

Merchandiser

Expenses NetincomeRevenues

Service Company Minus Equals

Gross profit

Cost of goods sold

Inventory: Costs of merchandise owned, but not yet sold. It is a current asset on the balance sheet. Merchandise Cost Flows:

Net purchases

Merchandise available for sale

Cost of goods sold

Ending inventory

Beginning inventory

Perpetual inventory system: Updates accounting records for each pur- chase and each sale of inventory. Periodic inventory system: Updates accounting records for purchases and sales of inventory only at the end of a period.

Summary: Cheat Sheet

MERCHANDISING PURCHASES Cash discount: A purchases discount on the price paid by the buyer; or, a sales discount on amount received for the seller. Credit terms example: “2/10, n/60” means full payment is due within 60 days, but the buyer can deduct 2% of the invoice amount if payment is made within 10 days. Gross method: Initially record purchases at gross (full) invoice amounts. Purchasing Merchandise for Resale Entries:

Transportation Costs and Ownership Transfer Rules:

Purchasing merchandise Merchandise Inventory . . . . . . . . 500 on credit Accounts Payable . . . . . . . . 500

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . . #

Paying within discount period Accounts Payable . . . . . . . . . . . . 500 (Inventory reduced by Merchandise Inventory . . . 10 discount taken) Cash . . . . . . . . . . . . . . . . . . 490

Paying outside discount Accounts Payable . . . . . . . . . . . . 500 period Cash . . . . . . . . . . . . . . . . . . 500

Recording purchases Cash or Accounts Payable . . . . . 30 returns or allowances Merchandise Inventory . . . 30

Chapter 4 Accounting for Merchandising Operations 171

MERCHANDISING SALES

Sales Discounts: A contra revenue account, meaning Sales Discounts is subtracted from Sales when computing net sales.

If goods are defective, Inventory is debited for estimated value. A loss is recorded for the difference between cost of merchandise and estimated value.

MERCHANDISER REPORTING Inventory shrinkage: An adjusting entry to account for the loss of inven- tory due to theft or deterioration. It is computed by comparing a physical count of inventory with recorded amounts.

Steps 3 and 4: Same entries as those for service companies. Multiple-step income statement: Three parts: (1) gross profit; (2) income from operations, which is gross profit minus operating expenses; and (3) net income, which is income from operations plus or minus nonoperating items. Operating expenses: Separated into selling expenses and general & administrative expenses. Selling expenses: Expenses of advertising merchandise, making sales, and delivering goods to customers. General & administrative expenses: Expenses that support a company’s overall operations, including accounting and human resources. Nonoperating activities: Consist of expenses, revenues, losses, and gains that are unrelated to a company’s main operations. Multiple-Step Income Statement Example

Closing Entries: Differences between merchandisers and service companies in red.

Step 1: Close Credit Balances Sales . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 in Temporary Accounts to Income Summary . . . . . . . . . . . . . 321,000 Income Summary

Adjustment for shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . 250 (occurs when recorded amount Merchandise Inventory . . . . . . . . . 250 larger than physical inventory)

Acid-test ratio (159) Allowance for Sales Discounts (167) Cash discount (146) Cost of goods sold (143) Credit memorandum (152) Credit period (146) Credit terms (145) Debit memorandum (147) Discount period (146)

Discounts Lost (168) EOM (145) FOB (148) General and administrative expenses (156) Gross margin (144) Gross margin ratio (159) Gross method (147, 168) Gross profit (144) Inventory (144)

Inventory Returns Estimated (166) List price (145) Merchandise (143) Merchandise inventory (144) Merchandiser (143) Multiple-step income statement (156) Net method (151, 168) Periodic inventory system (144) Perpetual inventory system (144)

Key Terms

Step 2: Close Debit Balances Income Summary . . . . . . . . . . . . . . . 308,100 in Temporary Accounts to Sales Discounts . . . . . . . . . . . . . 4,300 Income Summary Sales Returns and Allowances . . 2,000 Cost of Goods Sold . . . . . . . . . . . 230,400 Other Expenses . . . . . . . . . . . . . . 71,400

Selling merchandise Accounts Receivable . . . . . . . . . . 1,000 on credit Sales . . . . . . . . . . . . . . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . 300 Merchandise Inventory . . . . . 300

Receiving payment within Cash . . . . . . . . . . . . . . . . . . . . . . . 980 discount period Sales Discounts . . . . . . . . . . . . . . 20 Accounts Receivable . . . . . . . 1,000

Receiving payment outside Cash . . . . . . . . . . . . . . . . . . . . . . . 1,000 discount period Accounts Receivable . . . . . . . 1,000

Customer Merchandise Returns Entries:

Receiving sales returns of Sales Returns and Allowances . . 15 nondefective inventory Cash or Accounts Receivable 15

Merchandise Inventory . . . . . . . . 9 Cost of Goods Sold . . . . . . . . . 9

Receiving sales returns of Merchandise Inventory . . . . . . . . . . . 2 defective inventory Loss from Defective Merchandise . . . 7

Cost of Goods Sold . . . . . . . . . . . . 9

Recognizing sales Sales Returns and Allowances . . 10 allowances Cash or Accounts Receivable 10

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000 Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,300 Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . 2,000 6,300 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314,700 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,300 Operating Expenses Selling expenses† General and administrative expenses† Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 71,400 Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 Total other revenues and gains (expenses and losses) . . . . 2,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

†Must list all individual expenses and amounts—see Exhibit 4.13 (not done here for brevity).

Single-Step Income Statement Example

Revenues Total revenues* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $318,200 Expenses Total expenses* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303,300 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

*Must list all individual items and amounts—see Exhibit 4.14 (not done here for brevity).

Sales allowance: A price reduction agreed to with the buyer if they are unsatisfied with the goods.

172 Chapter 4 Accounting for Merchandising Operations

Purchases discount (146) Retailer (143) Sales discount (146) Sales Refund Payable (166)

Sales Returns and Allowances (151) Selling expenses (156) Shrinkage (153) Single-step income statement (157)

Supplementary records (149) Trade discount (145) Wholesaler (143)

Multiple Choice Quiz

1. A company has $550,000 in net sales and $193,000 in gross profit. This means its cost of goods sold equals a. $743,000. c. $357,000. e. $(193,000). b. $550,000. d. $193,000.

2. A company purchased $4,500 of merchandise on May 1 with terms of 2∕10, n∕30. On May 6, it returned $250 of that merchandise. On May 8, it paid the balance owed for merchandise, taking any discount it is entitled to. The cash paid on May 8 is a. $4,500. c. $4,160. e. $4,410. b. $4,250. d. $4,165.

3. A company has cash sales of $75,000, credit sales of $320,000, sales returns and allowances of $13,700, and sales discounts of $6,000. Its net sales equal

a. $395,000. c. $300,300. e. $414,700. b. $375,300. d. $339,700.

4. A company’s quick assets are $37,500, its current assets are $80,000, and its current liabilities are $50,000. Its acid-test ratio equals a. 1.600. c. 0.625. e. 0.469. b. 0.750. d. 1.333.

5. A company’s net sales are $675,000, its cost of goods sold is $459,000, and its net income is $74,250. Its gross margin ratio equals a. 32%. c. 47%. e. 34%. b. 68%. d. 11%.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; Gross profit = $550,000 − $193,000 = $357,000 2. d; ($4,500 − $250) × (100% − 2%) = $4,165 3. b; Net sales = $75,000 + $320,000 − $13,700 − $6,000 = $375,300

4. b; Acid-test ratio = $37,500∕$50,000 = 0.75 5. a; Gross margin ratio = ($675,000 − $459,000)∕$675,000 = 32%

A(B,C) Superscript letter A, B, or C denotes assignments based on Appendix 4A, 4B, or 4C.

Icon denotes assignments that involve decision making.

1. What items appear in financial statements of merchan- dising companies but not in the statements of service companies?

2. In comparing the accounts of a merchandising company with those of a service company, what additional accounts would the merchandising company likely use, assuming it employs a perpetual inventory system?

3. Explain how a business can earn a positive gross profit on its sales and still have a net loss.

4. Why do companies offer a cash discount? 5. How does a company that uses a perpetual inventory system

determine the amount of inventory shrinkage? 6. Distinguish between cash discounts and trade discounts for

purchases. Is the amount of a trade discount on purchased merchandise recorded in the accounts?

7. What is the difference between a sales discount and a pur- chases discount?

8. Why would a company’s manager be concerned about the quantity of its purchases returns if its suppliers allow unlimited returns?

Discussion Questions

9. Does the sender (maker) of a debit memorandum record a debit or a credit in the recipient’s account? What entry (debit or credit) does the recipient record?

10. What is the difference between the single-step and multiple- step income statement formats?

11. Refer to Apple’s balance sheet and income statement in Appendix A. What does the com- pany title its inventory account? Does the company present a detailed calculation of its cost of goods sold?

12. Refer to Google’s income statement in Appendix A. What title does it use for cost of goods sold?

13. Refer to Samsung’s income statement in Appendix A. What does Samsung title its cost of goods sold account?

14. Refer to Samsung’s income statement in Appendix A. Does its income statement report a gross profit figure? If yes, what is the amount?

15. Buyers negotiate purchase contracts with suppliers. What type of shipping terms should a buyer attempt to negotiate to minimize freight-in costs?

APPLE

Samsung

Samsung

GOOGLE

Chapter 4 Accounting for Merchandising Operations 173

QUICK STUDY

QS 4-1 Applying merchandising terms

C1 P1

Enter the letter for each term in the blank space beside the definition that it most closely matches. A. Sales discount D. FOB destination G. Merchandise inventory B. Credit period E. FOB shipping point H. Purchases discount C. Discount period F. Gross profit

1. Goods a company owns and expects to sell to its customers. 2. Time period that can pass before a customer’s full payment is due. 3. Seller’s description of a cash discount granted to buyers in return for early payment. 4. Ownership of goods is transferred when the seller delivers goods to the carrier. 5. Purchaser’s description of a cash discount received from a supplier of goods. 6. Difference between net sales and the cost of goods sold. 7. Time period in which a cash discount is available. 8. Ownership of goods is transferred when delivered to the buyer’s place of business.

Costs of $5,000 were incurred to acquire goods and make them ready for sale. The goods were shipped to the buyer (FOB shipping point) for a cost of $200. Additional necessary costs of $400 were incurred to acquire the goods. No other incentives or discounts were available. What is the buyer’s total cost of mer- chandise inventory? a. $5,000 b. $5,200 c. $5,400 d. $5,600

QS 4-2 Identifying inventory costs

C2

Use the following information (in random order) from a merchandising company and from a service com- pany. Hint: Not all information may be necessary for the solutions. a. For the merchandiser only, compute (1) goods available for sale, (2) cost of goods sold, and (3) gross profit. b. Compute net income for each company.

QS 4-3 Merchandise accounts and computations

C2

Kleiner Merchandising Company

Accumulated depreciation . . . $ 700 Expenses . . . . . . . . $1,450

Beginning inventory . . . . . . . . 5,000 Net purchases . . . . 3,900

Ending inventory . . . . . . . . . . . 1,700 Net sales . . . . . . . . 9,500

Krug Service Company

Expenses . . . . . . . . . . . . $12,500 Prepaid rent . . . . . . . . $ 800

Revenues . . . . . . . . . . . . 14,000 Accounts payable . . . . 200

Cash . . . . . . . . . . . . . . . . 700 Equipment . . . . . . . . . . 1,300

Compute the amount to be paid for each of the four separate invoices assuming that all invoices are paid within the discount period.

Merchandise (gross) Terms Merchandise (gross) Terms a. $5,000 2∕10, n∕60 c. $75,000 1∕10, n∕30 b. $20,000 1∕15, EOM d. $10,000 3∕15, n∕45

QS 4-4 Computing net invoice amounts

P1

Prepare journal entries to record each of the following transactions of a merchandising company. The company uses a perpetual inventory system and the gross method.

Nov. 5 Purchased 600 units of product at a cost of $10 per unit. Terms of the sale are 2∕10, n∕60; the invoice is dated November 5.

7 Returned 25 defective units from the November 5 purchase and received full credit. 15 Paid the amount due from the November 5 purchase, minus the return on November 7.

QS 4-5 Recording purchases, returns, and discounts taken

P1

Prepare journal entries to record each of the following transactions. The company records purchases using the gross method and a perpetual inventory system.

Aug. 1 Purchased merchandise with an invoice price of $60,000 and credit terms of 3∕10, n∕30. 11 Paid supplier the amount owed from the August 1 purchase.

QS 4-6 Recording purchases and discounts taken

P1

Prepare journal entries to record each of the following transactions. The company records purchases using the gross method and a perpetual inventory system.

Sep. 15 Purchased merchandise with an invoice price of $35,000 and credit terms of 2∕5, n∕15. 29 Paid supplier the amount owed on the September 15 purchase.

QS 4-7 Recording purchases and discounts missed

P1

174 Chapter 4 Accounting for Merchandising Operations

QS 4-8 Recording sales, returns, and discounts taken

P2

Prepare journal entries to record each of the following sales transactions of a merchandising company. The company uses a perpetual inventory system and the gross method.

Apr. 1 Sold merchandise for $3,000, with credit terms n∕30; invoice dated April 1. The cost of the merchandise is $1,800.

4 The customer in the April 1 sale returned $300 of merchandise for full credit. The merchandise, which had cost $180, is returned to inventory.

8 Sold merchandise for $1,000, with credit terms of 1∕10, n∕30; invoice dated April 8. Cost of the merchandise is $700.

11 Received payment for the amount due from the April 1 sale less the return on April 4.

QS 4-10 Closing entries P3

Refer to QS 4-9 and prepare journal entries to close the balances in temporary revenue and expense ac- counts. Remember to consider the entry for shrinkage from QS 4-9.

QS 4-11 Multiple-step income statement

P4

For each item below, indicate whether the statement describes a multiple-step income statement or a single-step income statement. a. Multiple-step income statement b. Single-step income statement

1. Commonly reports detailed computations of net sales and other costs and expenses. 2. Statement limited to two main categories (revenues and expenses). 3. Reports gross profit on a separate line. 4. Separates income from operations from the other revenues and gains.

QS 4-9 Accounting for shrinkage— perpetual system

P3

Nix’It Company’s ledger on July 31, its fiscal year-end, includes the following selected accounts that have normal balances (Nix’It uses the perpetual inventory system).

Merchandise inventory . . . . . . . . . . $ 37,800 Sales returns and allowances . . . . . . . . $ 6,500

Retained earnings . . . . . . . . . . . . . . 115,300 Cost of goods sold . . . . . . . . . . . . . . . . . 105,000

Dividends . . . . . . . . . . . . . . . . . . . . . 7,000 Depreciation expense . . . . . . . . . . . . . . 10,300

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 160,200 Salaries expense . . . . . . . . . . . . . . . . . . 32,500

Sales discounts . . . . . . . . . . . . . . . . 4,700 Miscellaneous expenses . . . . . . . . . . . . 5,000

A physical count of its July 31 year-end inventory discloses that the cost of the merchandise inventory still available is $35,900. Prepare the entry to record any inventory shrinkage.

Sales discounts . . . . . . . . . . . . . . . . . . . . $ 750 Office supplies expense . . . . . . . . . . . . . . . $ 500

Office salaries expense . . . . . . . . . . . . . 2,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . 9,000

Rent expense—Office space . . . . . . . . . 1,500 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Advertising expense . . . . . . . . . . . . . . . . 500 Insurance expense . . . . . . . . . . . . . . . . . . . 1,000

Sales returns and allowances . . . . . . . . 250 Sales staff salaries . . . . . . . . . . . . . . . . . . . 2,500

QS 4-12 Preparing a multiple-step income statement

P4

Save-the-Earth Co. reports the following income statement accounts for the year ended December 31. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Categorize the following accounts as sell- ing expenses: Sales Staff Salaries and Advertising Expense. Categorize the remaining expenses as general and administrative.

Buildings . . . . . . . . . . . . . . . . . . . . . . . . $25,000 Notes payable (due in 7 years) . . . . . . . . . . $30,000

Accounts receivable . . . . . . . . . . . . . . . 2,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . 1,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . 10,000

Merchandise inventory . . . . . . . . . . . . . 7,000 Retained earnings . . . . . . . . . . . . . . . . . . . . 6,000

Accounts payable . . . . . . . . . . . . . . . . . 5,000 Wages payable . . . . . . . . . . . . . . . . . . . . . . . 3,000

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

QS 4-13 Preparing a classified balance sheet for a merchandiser

P4

Clear Water Co. reports the following balance sheet accounts as of December 31. Prepare a classified bal- ance sheet.

Chapter 4 Accounting for Merchandising Operations 175

Compute net sales, gross profit, and the gross margin ratio for each of the four separate companies. Interpret the gross margin ratio for Carrier.

Carrier Lennox Trane York

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 $550,000 $38,700 $255,700

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . 5,000 17,500 600 4,800

Sales returns and allowances . . . . . . . . . . . . 20,000 6,000 5,100 900

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 79,750 329,589 24,453 126,500

QS 4-15 Computing and analyzing gross margin ratio

A2

Identify whether each description best applies to a periodic or a perpetual inventory system. a. Updates the inventory account only at period-end. b. Requires an adjusting entry to record inventory shrinkage. c. Returns immediately affect the account balance of Merchandise Inventory. d. Records cost of goods sold each time a sales transaction occurs. e. Provides more timely information to managers.

QS 4-16A Contrasting periodic and perpetual systems

P5

Refer to QS 4-5 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the gross method and a periodic inventory system.

QS 4-17A Recording purchases, returns, and discounts— periodic & gross methods P5

Refer to QS 4-8 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the gross method and a periodic inventory system.

QS 4-18A Recording sales, returns, and discounts—periodic & gross methods P5

ProBuilder has the following June 30 fiscal-year-end unadjusted balances: Allowance for Sales Discounts, $0; and Accounts Receivable, $10,000. Of the $10,000 of receivables, $2,000 are within a 3% discount period, meaning that it expects buyers to take $60 in future discounts arising from this period’s sales. a. Prepare the June 30 fiscal-year-end adjusting journal entry for future sales discounts. b. Assume the same facts above and that there is a $10 fiscal-year-end unadjusted credit balance in the

Allowance for Sales Discounts. Prepare the June 30 fiscal-year-end adjusting journal entry for future sales discounts.

QS 4-19B Recording estimates of future discounts

P6

QS 4-20B Recording estimates of future returns

P6

ProBuilder reports merchandise sales of $50,000 and cost of merchandise sales of $20,000 in its first year of operations ending June 30. It makes fiscal-year-end adjusting entries for estimated future returns and allowances equal to 2% of sales, or $1,000, and 2% of cost of sales, or $400. a. Prepare the June 30 fiscal-year-end adjusting journal entry for future returns and allowances related to sales. b. Prepare the June 30 fiscal-year-end adjusting journal entry for future returns and allowances related to

cost of sales.

QS 4-21C Recording purchases, returns, and discounts—net & perpetual methods P7

Refer to QS 4-5 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the net method and a perpetual inventory system.

QS 4-22C Recording sales, returns, and discounts—net & perpetual methods P7

Refer to QS 4-8 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the net method and a perpetual inventory system.

Use the following information on current assets and current liabilities to compute and interpret the acid- test ratio. Explain what the acid-test ratio of a company measures.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,490 Prepaid expenses . . . . . . . . . . . . . . . . . . . $ 700

Accounts receivable . . . . . . . . . . . . . . . 2,800 Accounts payable . . . . . . . . . . . . . . . . . . . 5,750

Inventory . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Other current liabilities . . . . . . . . . . . . . . . 850

QS 4-14 Computing and interpreting acid-test ratio

A1

176 Chapter 4 Accounting for Merchandising Operations

QS 4-23 Sales transactions

P2

Prepare journal entries to record each of the following sales transactions of EcoMart Merchandising. EcoMart uses a perpetual inventory system and the gross method. Oct. 1 Sold fair trade merchandise for $1,500, with credit terms n∕30, invoice dated October 1. The

cost of the merchandise is $900. 6 The customer in the October 1 sale returned $150 of fair trade merchandise for full credit. The

merchandise, which had cost $90, is returned to inventory. 9 Sold recycled leather merchandise for $700, with credit terms of 1∕10, n∕30, invoice dated

October 9. Cost of the merchandise is $450. 11 Received payment for the amount due from the October 1 sale less the return on October 6.

Exercise 4-2 Operating cycle for merchandiser

C2

The operating cycle of a merchandiser with credit sales includes the following five activities. Starting with merchandise acquisition, identify the chronological order of these five activities.

a. Prepare merchandise for sale. d. Purchase merchandise. b. Collect cash from customers on account. e. Monitor and service accounts receivable. c. Make credit sales to customers.

Exercise 4-4 Recording sales, sales returns, and sales allowances

P2

Allied Merchandisers was organized on May 1. Macy Co. is a major customer (buyer) of Allied (seller) products. Prepare journal entries to record the following transactions for Allied assuming it uses a per- petual inventory system and the gross method. May 3 Allied made its first and only purchase of inventory for the period on May 3 for 2,000 units at a

price of $10 cash per unit (for a total cost of $20,000). 5 Allied sold 1,500 of the units in inventory for $14 per unit (invoice total: $21,000) to Macy Co.

under credit terms 2∕10, n∕60. The goods cost Allied $15,000. 7 Macy returns 125 units because they did not fit the customer’s needs (invoice amount: $1,750).

Allied restores the units, which cost $1,250, to its inventory. 8 Macy discovers that 200 units are scuffed but are still of use and, therefore, keeps the units.

Allied gives a price reduction (allowance) and credits Macy’s accounts receivable for $300 to compensate for the damage.

15 Allied receives payment from Macy for the amount owed on the May 5 purchase; payment is net of returns, allowances, and any cash discount.

Exercise 4-3 Recording purchases, purchases returns, and purchases allowances

P1

Prepare journal entries to record the following transactions for a retail store. The company uses a perpet- ual inventory system and the gross method. Apr. 2 Purchased $4,600 of merchandise from Lyon Company with credit terms of 2∕15, n∕60, invoice

dated April 2, and FOB shipping point. 3 Paid $300 cash for shipping charges on the April 2 purchase. 4 Returned to Lyon Company unacceptable merchandise that had an invoice price of $600. 17 Sent a check to Lyon Company for the April 2 purchase, net of the discount and the returned mer-

chandise. 18 Purchased $8,500 of merchandise from Frist Corp. with credit terms of 1∕10, n∕30, invoice

dated April 18, and FOB destination. 21 After negotiations over scuffed merchandise, received from Frist a $500 allowance toward the

$8,500 owed on the April 18 purchase. 28 Sent check to Frist paying for the April 18 purchase, net of the allowance and the discount.

Check Apr. 28, Cr. Cash, $7,920

EXERCISES

Exercise 4-1 Computing revenues, expenses, and income

C1 C2

Fill in the blanks in the following separate income statements a through e. Identify any negative amount by putting it in parentheses.

a b c d e

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $62,000 $43,500 $46,000 $ ? $25,600 Cost of goods sold Merchandise inventory (beginning) . . . . . . . . . . . . . . . . 8,000 17,050 7,500 8,000 4,560 Total cost of merchandise purchases . . . . . . . . . . . . . . 38,000 ? ? 32,000 6,600 Merchandise inventory (ending) . . . . . . . . . . . . . . . . . . ? (3,000) (9,000) (6,600) ? Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,050 16,000 ? ? 7,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? ? 3,750 45,600 ? Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,650 12,150 3,600 6,000 Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ? $16,850 $  (8,400) $42,000 $ ?

Chapter 4 Accounting for Merchandising Operations 177

Exercise 4-5 Recording purchases, purchases returns, and purchases allowances P1

Refer to Exercise 4-4 and prepare journal entries for Macy Co. to record each of the May transactions. Macy is a retailer that uses the gross method and a perpetual inventory system; it purchases these units for resale.

Exercise 4-7 Recording sales, purchases, shipping, and returns—buyer and seller

P1 P2

Sydney Retailing (buyer) and Troy Wholesalers (seller) enter into the following transactions. Both Sydney and Troy use a perpetual inventory system and the gross method. May 11 Sydney accepts delivery of $40,000 of merchandise it purchases for resale from Troy: invoice

dated May 11, terms 3∕10, n∕90, FOB shipping point. The goods cost Troy $30,000. Sydney pays $345 cash to Express Shipping for delivery charges on the merchandise.

12 Sydney returns $1,400 of the $40,000 of goods to Troy, who receives them the same day and restores them to its inventory. The returned goods had cost Troy $1,050.

20 Sydney pays Troy for the amount owed. Troy receives the cash immediately. 1. Prepare journal entries that Sydney Retailing (buyer) records for these three transactions. 2. Prepare journal entries that Troy Wholesalers (seller) records for these three transactions.

Check (1) May 20, Cr. Cash, $37,442

Exercise 4-8 Inventory and cost of sales transactions in T-accounts

P1 P2

The following summarizes Tesla’s merchandising activities for the year. Set up T-accounts for Merchandise Inventory and for Cost of Goods Sold. Enter each line item into one of the two T-accounts and compute the T-account balances.

Check Ending Merch. Inventory, $20,000

Cost of merchandise sold to customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $196,000 Merchandise inventory, beginning-year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Cost of merchandise purchases, gross amount . . . . . . . . . . . . . . . . . . . . . . . . . 192,500 Shrinkage on merchandise as of year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Cost of transportation-in for merchandise purchases . . . . . . . . . . . . . . . . . . . . 2,900 Cost of merchandise returned by customers and restored to inventory . . . . . . 2,100 Discounts received from suppliers on merchandise purchases . . . . . . . . . . . . . 1,700 Returns to and allowances from suppliers on merchandise purchases . . . . . . 4,000

Exercise 4-9 Recording purchases, sales, returns, and shipping

P1 P2

Prepare journal entries for the following merchandising transactions of Dollar Store assuming it uses a perpetual inventory system and the gross method. Nov. 1 Dollar Store purchases merchandise for $1,500 on terms of 2∕5, n∕30, FOB shipping point,

invoice dated November 1. 5 Dollar Store pays cash for the November 1 purchase. 7 Dollar Store discovers and returns $200 of defective merchandise purchased on November 1,

and paid for on November 5, for a cash refund. 10 Dollar Store pays $90 cash for transportation costs for the November 1 purchase. 13 Dollar Store sells merchandise for $1,600 with terms n∕30. The cost of the merchandise is $800. 16 Merchandise is returned to the Dollar Store from the November 13 transaction. The returned items

are priced at $160 and cost $80; the items were not damaged and were returned to inventory.

Exercise 4-6 Recording sales, purchases, and cash discounts—buyer and seller

P1 P2

Santa Fe Retailing purchased merchandise “as is” (with no returns) from Mesa Wholesalers with credit terms of 3∕10, n∕60 and an invoice price of $24,000. The merchandise had cost Mesa $16,000. Assume that both buyer and seller use a perpetual inventory system and the gross method. 1. Prepare entries that the buyer records for the (a) purchase, (b) cash payment within the discount

period, and (c) cash payment after the discount period. 2. Prepare entries that the seller records for the (a) sale, (b) cash collection within the discount period,

and (c) cash collection after the discount period.

Exercise 4-10 Preparing adjusting and closing entries for a merchandiser

P3

The following list includes selected permanent accounts and all of the temporary accounts from the December 31 unadjusted trial balance of Emiko Co., a business owned by Kumi Emiko. Use these account balances along with the additional information to journalize (a) adjusting entries and (b) closing entries. Emiko Co. uses a perpetual inventory system.

[continued on next page]

Debit Credit

Merchandise inventory . . . . . . . . . . $30,000 Prepaid selling expenses . . . . . . . . . 5,600 Dividends . . . . . . . . . . . . . . . . . . . . . 33,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . $529,000 Sales returns and allowances . . . . . 17,500 Sales discounts . . . . . . . . . . . . . . . . . 5,000

Debit Credit

Cost of goods sold . . . . . . . . . . $212,000 Sales salaries expense . . . . . . . 48,000 Utilities expense . . . . . . . . . . . . 15,000 Selling expenses . . . . . . . . . . . . 36,000 Administrative expenses . . . . . 105,000

178 Chapter 4 Accounting for Merchandising Operations

Exercise 4-11 Computing net sales for multiple-step income statement

P4

A company reports the following sales-related information. Compute and prepare the net sales portion only of this company’s multiple-step income statement.

Sales, gross . . . . . . . . . . . . . . . . $200,000 Sales returns and allowances . . . . . . . . . . . . $16,000 Sales discounts . . . . . . . . . . . . . 4,000 Sales salaries expense . . . . . . . . . . . . . . . . . 10,000

Additional Information

Accrued and unpaid sales salaries amount to $1,700. Prepaid selling expenses of $3,000 have expired. A physical count of year-end merchandise inventory is taken to determine shrinkage and shows $28,700 of goods still available.

Check Dr. $84,500 to close Income Summary

Exercise 4-12 Impacts of inventory error on key accounts

P3

A retailer completed a physical count of ending merchandise inventory. When counting inventory, employ- ees did not include $3,000 of incoming goods shipped by a supplier on December 31 under FOB shipping point. These goods had been recorded in Merchandise Inventory, but they were not included in the physical count because they were in transit. This means shrinkage was incorrectly overstated by $3,000.

Compute the amount of overstatement or understatement for each of the following amounts for this period. a. Ending inventory b. Total assets c. Net income d. Total equity

Exercise 4-13 Physical count error and profits A2

Refer to the information in Exercise 4-12 and indicate whether the failure to include in-transit inventory as part of the physical count results in an overstatement, understatement, or no effect on the following ratios. a. Gross margin ratio b. Profit margin ratio c. Acid-test ratio d. Current ratio

Exercise 4-14 Computing and analyzing acid-test and current ratios

A1

Compute the current ratio and acid-test ratio for each of the following separate cases. (Round ratios to two decimals.) Which company is in the best position to meet short-term obligations? Explain.

Camaro GTO Torino

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000 $      110 $1,000 Short-term investments . . . . . . . . . . . . 50 0 580 Current receivables . . . . . . . . . . . . . . . 350 470 700 Inventory . . . . . . . . . . . . . . . . . . . . . . . . 2,600 2,420 4,230 Prepaid expenses . . . . . . . . . . . . . . . . . 200 500 900 Total current assets . . . . . . . . . . . . . . . $5,200 $3,500 $7,410

Current liabilities . . . . . . . . . . . . . . . . . . $2,000 $1,000 $3,800

Exercise 4-15 Preparing a multiple-step income statement

P4

Fit-for-Life Foods reports the following income statement accounts for the year ended December 31. Prepare a multiple-step income statement that includes separate categories for net sales; cost of goods sold; selling expenses; general and administrative expenses; and other revenues, gains, expenses, and losses. Categorize the following accounts as selling expenses: Sales Staff Wages, Rent Expense—Selling Space, TV Advertising Expense, and Sales Commission Expense. Categorize the remaining expenses as general and administrative.

Gain on sale of equipment . . . . . . . . . . . . $ 6,250 Depreciation expense—Office copier . . . . . . . . . . . $ 500 Office supplies expense . . . . . . . . . . . . . . 700 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Insurance expense . . . . . . . . . . . . . . . . . . 1,300 Sales returns and allowances . . . . . . . . . . . . . . . . . 4,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 TV advertising expense . . . . . . . . . . . . . . . . . . . . . . 2,000 Office salaries expense . . . . . . . . . . . . . . 32,500 Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 750 Rent expense—Selling space . . . . . . . . . . 10,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Sales staff wages . . . . . . . . . . . . . . . . . . . 23,000 Sales commission expense . . . . . . . . . . . . . . . . . . . 13,000

Exercise 4-16 Preparing a classified balance sheet for a merchandiser

P4

Adams Co. reports the following balance sheet accounts as of December 31. Prepare a classified balance sheet.

Salaries payable . . . . . . . . . . . . . . . . . . . . $ 6,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 Notes payable (due in 9 years) . . . . . . . . . . . . . . . . 30,000 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . 7,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Merchandise inventory . . . . . . . . . . . . . . . 14,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Accounts payable . . . . . . . . . . . . . . . . . . . 10,000 Accumulated depreciation—Building . . . . . . . . . . . 5,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . 3,000 Mortgages payable (due in 5 years) . . . . . . . . . . . . 12,000 Accounts receivable . . . . . . . . . . . . . . . . . 4,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Common stock . . . . . . . . . . . . . . . . . . . . . 10,000

Chapter 4 Accounting for Merchandising Operations 179

Exercise 4-17A Recording purchases, returns, and allowances— periodic P5

Refer to Exercise 4-3 and prepare journal entries to record each of the merchandising transactions assum- ing that the buyer uses the periodic inventory system and the gross method.

Exercise 4-18A Recording sales, purchases, and discounts: buyer and seller—periodic P5

Refer to Exercise 4-6 and prepare journal entries to record each of the merchandising transactions assum- ing that the periodic inventory system and the gross method are used by both the buyer and the seller.

Exercise 4-19A Recording sales, purchases, shipping, and returns: buyer and seller—periodic P5

Refer to Exercise 4-7 and prepare journal entries to record each of the merchandising transactions assum- ing that the periodic inventory system and the gross method are used by both the buyer and the seller.

Exercise 4-20B Recording estimates of future discounts

P6

Med Labs has the following December 31 year-end unadjusted balances: Allowance for Sales Discounts, $0; and Accounts Receivable, $5,000. Of the $5,000 of receivables, $1,000 are within a 2% discount pe- riod, meaning that it expects buyers to take $20 in future-period discounts arising from this period’s sales. a. Prepare the December 31 year-end adjusting journal entry for future sales discounts. b. Assume the same facts above and that there is a $5 year-end unadjusted credit balance in Allowance for

Sales Discounts. Prepare the December 31 year-end adjusting journal entry for future sales discounts. c. Is Allowance for Sales Discounts a contra asset or a contra liability account?

Exercise 4-21B Recording estimates of future returns

P6

Chico Company allows its customers to return merchandise within 30 days of purchase. ∙ At December 31, the end of its first year of operations, Chico estimates future-period merchandise

returns of $60,000 (cost of $22,500) related to its current-year sales. ∙ A few days later, on January 3, a customer returns merchandise with a selling price of $2,000 for a cash

refund; the returned merchandise cost $750 and is returned to inventory as it is not defective. a. Prepare the December 31 year-end adjusting journal entry for estimated future sales returns and allow-

ances (revenue side). b. Prepare the December 31 year-end adjusting journal entry for estimated future inventory returns and

allowances (cost side). c. Prepare the January 3 journal entries to record the merchandise returned.

Exercise 4-22B Recording estimates of future returns

P6

Lopez Company reports unadjusted first-year merchandise sales of $100,000 and cost of merchandise sales of $30,000. a. Compute gross profit (using the unadjusted numbers above). b. The company expects future returns and allowances equal to 5% of sales and 5% of cost of sales. 1. Prepare the year-end adjusting entry to record the sales expected to be refunded. 2. Prepare the year-end adjusting entry to record the cost side of sales returns and allowances. 3. Recompute gross profit using the adjusted numbers from parts 1 and 2. c. Is Sales Refund Payable an asset, liability, or equity account? d. Is Inventory Returns Estimated an asset, liability, or equity account?

Exercise 4-23C Recording sales, purchases, shipping, and returns: buyer and seller—perpetual and net method P7

Refer to Exercise 4-7 and prepare journal entries to record each of the merchandising transactions assum- ing that the perpetual inventory system and the net method are used by both the buyer and the seller.

Exercise 4-24C Recording purchases, sales, returns, and discounts: buyer and seller—perpetual and both net & gross methods

P7

Piere Imports uses the perpetual system in accounting for merchandise inventory and had the following transactions during the month of October. Prepare entries to record these transactions assuming that Piere Imports records invoices (a) at gross amounts and (b) at net amounts.

Oct. 2 Purchased merchandise at a $3,000 price ($2,940 net), invoice dated October 2, terms 2∕10, n∕30. 10 Returned $500 ($490 net) of merchandise purchased on October 2 and debited its account pay-

able for that amount. 17 Purchased merchandise at a $5,400 price ($5,292 net), invoice dated October 17, terms 2∕10, n∕30. 27 Paid for the merchandise purchased on October 17, less the discount. 31 Paid for the merchandise purchased on October 2.

180 Chapter 4 Accounting for Merchandising Operations

Exercise 4-25 Purchasing transactions

P1

Prepare journal entries to record the following transactions of Recycled Fashion retail store. Recycled Fashion uses a perpetual inventory system and the gross method. Mar. 3 Purchased $1,150 of merchandise made from recycled material from GreenWorld Company

with credit terms of 2∕15, n∕60, invoice dated March 3, and FOB shipping point. 4 Paid $75 cash for shipping charges on the March 3 purchase. 5 Returned to GreenWorld unacceptable merchandise that had an invoice price of $150. 18 Paid GreenWorld for the March 3 purchase, net of the discount and the returned merchandise. 19 Purchased $425 of fair trade merchandise from PeopleFirst Corp. with credit terms of 1∕10,

n∕30, invoice dated March 19, and FOB destination. 21 After negotiations, received from PeopleFirst a $25 allowance (for scuffed merchandise) toward

the $425 owed on the March 19 purchase. 29 Sent check to PeopleFirst paying for the March 19 purchase, net of the allowance and the discount.

PROBLEM SET A

Problem 4-1A Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Cabela’s, which uses the perpetual inventory system and the gross method. Hint: It will help to identify each receivable and pay- able; for example, record the purchase on July 1 in Accounts Payable—Boden. July 1 Purchased merchandise from Boden Company for $6,000 under credit terms of 1∕15, n∕30,

FOB shipping point, invoice dated July 1. 2 Sold merchandise to Creek Co. for $900 under credit terms of 2∕10, n∕60, FOB shipping point,

invoice dated July 2. The merchandise had cost $500. 3 Paid $125 cash for freight charges on the purchase of July 1. 8 Sold merchandise that had cost $1,300 for $1,700 cash. 9 Purchased merchandise from Leight Co. for $2,200 under credit terms of 2∕15, n∕60, FOB

destination, invoice dated July 9. 11 Returned $200 of merchandise purchased on July 9 from Leight Co. and debited its account

payable for that amount. 12 Received the balance due from Creek Co. for the invoice dated July 2, net of the discount. 16 Paid the balance due to Boden Company within the discount period. 19 Sold merchandise that cost $800 to Art Co. for $1,200 under credit terms of 2∕15, n∕60, FOB

shipping point, invoice dated July 19. 21 Gave a price reduction (allowance) of $100 to Art Co. for merchandise sold on July 19 and

credited Art’s accounts receivable for that amount. 24 Paid Leight Co. the balance due, net of discount. 30 Received the balance due from Art Co. for the invoice dated July 19, net of discount. 31 Sold merchandise that cost $4,800 to Creek Co. for $7,000 under credit terms of 2∕10, n∕60,

FOB shipping point, invoice dated July 31.

July 24, Cr. Cash, $1,960 July 30, Dr. Cash, $1,078

Check July 12, Dr. Cash, $882 July 16, Cr. Cash, $5,940

Problem 4-2A Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Lowe’s, which uses the per- petual inventory system and the gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on August 1 in Accounts Payable—Aron. Aug. 1 Purchased merchandise from Aron Company for $7,500 under credit terms of 1∕10, n∕30, FOB

destination, invoice dated August 1. 5 Sold merchandise to Baird Corp. for $5,200 under credit terms of 2∕10, n∕60, FOB destination,

invoice dated August 5. The merchandise had cost $4,000. 8 Purchased merchandise from Waters Corporation for $5,400 under credit terms of 1∕10, n∕45,

FOB shipping point, invoice dated August 8. 9 Paid $125 cash for shipping charges related to the August 5 sale to Baird Corp. 10 Baird returned merchandise from the August 5 sale that had cost Lowe’s $400 and was sold for

$600. The merchandise was restored to inventory. 12 After negotiations with Waters Corporation concerning problems with the purchases on

August 8, Lowe’s received a price reduction from Waters of $400 off the $5,400 of goods pur- chased. Lowe’s debited accounts payable for $400.

14 At Aron’s request, Lowe’s paid $200 cash for freight charges on the August 1 purchase, reduc- ing the amount owed (accounts payable) to Aron.

15 Received balance due from Baird Corp. for the August 5 sale less the return on August 10. 18 Paid the amount due Waters Corporation for the August 8 purchase less the price allowance

from August 12.

Check Aug. 9, Dr. Delivery Expense, $125

Aug. 18, Cr. Cash, $4,950

[continued on next page]

Chapter 4 Accounting for Merchandising Operations 181

19 Sold merchandise to Tux Co. for $4,800 under credit terms of n∕10, FOB shipping point, in- voice dated August 19. The merchandise had cost $2,400.

22 Tux requested a price reduction on the August 19 sale because the merchandise did not meet specifications. Lowe’s gave a price reduction (allowance) of $500 to Tux and credited Tux’s accounts receivable for that amount.

29 Received Tux’s cash payment for the amount due from the August 19 sale less the price allow- ance from August 22.

30 Paid Aron Company the amount due from the August 1 purchase.

Aug. 29, Dr. Cash, $4,300

Problem 4-3A Computing merchandising amounts and formatting income statements

C2 P4

Valley Company’s adjusted trial balance on August 31, its fiscal year-end, follows. It categorizes the fol- lowing accounts as selling expenses: Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Debit Credit

Merchandise inventory (ending) . . . . . . . . . . $ 41,000 Other (noninventory) assets . . . . . . . . . . . . . 130,400 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 25,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . 94,550 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,600 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . 2,250 Sales returns and allowances . . . . . . . . . . . . 12,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 74,500 Sales salaries expense . . . . . . . . . . . . . . . . . . 32,000 Rent expense—Selling space . . . . . . . . . . . . . 8,000 Store supplies expense . . . . . . . . . . . . . . . . . 1,500 Advertising expense . . . . . . . . . . . . . . . . . . . . 13,000 Office salaries expense . . . . . . . . . . . . . . . . . 28,500 Rent expense—Office space . . . . . . . . . . . . . 3,600 Office supplies expense . . . . . . . . . . . . . . . . . 400 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $355,150 $355,150

Beginning merchandise inventory was $25,400. Supplementary records of merchandising activities for the year ended August 31 reveal the following itemized costs.

Invoice cost of merchandise purchases . . . . . . . . . $92,000 Purchases returns and allowances . . . . . . . . . . $ 4,500

Purchases discounts received . . . . . . . . . . . . . . . . . 2,000 Costs of transportation-in . . . . . . . . . . . . . . . . . 4,600

Required

1. Compute the company’s net sales for the year. 2. Compute the company’s total cost of merchandise purchased for the year. 3. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods

sold, selling expenses, and general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold, sell-

ing expenses, and general and administrative expenses.

Check (2) $90,100

(3) Gross profit, $136,850; Net income, $49,850

(4) Total expenses, $161,500

Use the data for Valley Company in Problem 4-3A to complete the following requirement.

Required

Prepare closing entries as of August 31 (the perpetual inventory system is used).

Problem 4-4A Preparing closing entries and interpreting information about discounts and returns C2 P3

The following unadjusted trial balance is prepared at fiscal year-end for Nelson Company. Nelson Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses: Depreciation Expense—Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Problem 4-5A Preparing adjusting entries and income statements; computing gross margin, acid-test, and current ratios

A1 A2 P3 P4

182 Chapter 4 Accounting for Merchandising Operations

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment Accumulated depreciation—Store equipment Accounts payable Common stock Retained earnings

Dividends Sales

1,000 12,500 5,800 2,400

42,900

2,200

2,000 2,200

$

$

NELSON COMPANY Unadjusted Trial Balance

January 31 Debit Credit

169,200

15,250 10,000 5,000

27,000

111,950

$

Cost of goods sold Depreciation expense—Store equipment

Sales salaries expense O�ce salaries expense Insurance expense Rent expense—Selling space

Rent expense—O�ce space Store supplies expense

Advertising expense

Totals

38,400 0

17,500 17,500

0 7,500

7,500 0

9,800

169,200 $

Sales discounts Sales returns and allowances

Required

1. Prepare adjusting journal entries to reflect each of the following: a. Store supplies still available at fiscal year-end amount to $1,750. b. Expired insurance, an administrative expense, is $1,400 for the fiscal year. c. Depreciation expense on store equipment, a selling expense, is $1,525 for the fiscal year. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $10,900

of inventory is still available at fiscal year-end. 2. Prepare a multiple-step income statement for the year ended January 31 that begins with gross sales

and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses.

3. Prepare a single-step income statement for the year ended January 31. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of January 31. (Round ratios to

two decimals.)

Check (2) Gross profit, $67,750

(3) Total expenses, $106,775; Net income, $975

PROBLEM SET B

Problem 4-1B Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of IKEA, which uses the per- petual inventory system and gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on May 2 in Accounts Payable—Havel.

May 2 Purchased merchandise from Havel Co. for $10,000 under credit terms of 1∕15, n∕30, FOB shipping point, invoice dated May 2.

4 Sold merchandise to Rath Co. for $11,000 under credit terms of 2∕10, n∕60, FOB shipping point, invoice dated May 4. The merchandise had cost $5,600.

5 Paid $250 cash for freight charges on the purchase of May 2. 9 Sold merchandise that had cost $2,000 for $2,500 cash. 10 Purchased merchandise from Duke Co. for $3,650 under credit terms of 2∕15, n∕60, FOB des-

tination, invoice dated May 10. 12 Returned $650 of merchandise purchased on May 10 from Duke Co. and debited its account

payable for that amount. 14 Received the balance due from Rath Co. for the invoice dated May 4, net of the discount. 17 Paid the balance due to Havel Co. within the discount period.

Check May 14, Dr. Cash, $10,780 May 17, Cr. Cash, $9,900

[continued on next page]

Chapter 4 Accounting for Merchandising Operations 183

Problem 4-2B Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Menards, which applies the perpetual inventory system and gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on July 3 in Accounts Payable—OLB.

July 3 Purchased merchandise from OLB Corp. for $15,000 under credit terms of 1∕10, n∕30, FOB destination, invoice dated July 3.

7 Sold merchandise to Brill Co. for $11,500 under credit terms of 2∕10, n∕60, FOB destination, invoice dated July 7. The merchandise had cost $7,750.

10 Purchased merchandise from Rupert Co. for $14,200 under credit terms of 1∕10, n∕45, FOB shipping point, invoice dated July 10.

11 Paid $300 cash for shipping charges related to the July 7 sale to Brill Co. 12 Brill returned merchandise from the July 7 sale that had cost Menards $1,450 and been sold for

$2,000. The merchandise was restored to inventory. 14 After negotiations with Rupert Co. concerning problems with the merchandise purchased on

July 10, Menards received a price reduction from Rupert of $1,200. Menards debited accounts payable for $1,200.

15 At OLB’s request, Menards paid $200 cash for freight charges on the July 3 purchase, reducing the amount owed (accounts payable) to OLB.

17 Received balance due from Brill Co. for the July 7 sale less the return on July 12. 20 Paid the amount due Rupert Co. for the July 10 purchase less the price reduction granted on July 14. 21 Sold merchandise to Brown for $11,000 under credit terms of 1∕10, n∕30, FOB shipping point,

invoice dated July 21. The merchandise had cost $7,000. 24 Brown requested a price reduction on the July 21 sale because the merchandise did not meet

specifications. Menards gave a price reduction (allowance) of $1,000 to Brown and credited Brown’s accounts receivable for that amount.

30 Received Brown’s cash payment for the amount due from the July 21 sale less the price allow- ance from July 24.

31 Paid OLB Corp. the amount due from the July 3 purchase.

Check July 17, Dr. Cash, $9,310

July 30, Dr. Cash, $9,900

July 31, Cr. Cash, $14,800

May 30, Dr. Cash, $2,450

20 Sold merchandise that cost $1,450 to Tamer Co. for $2,800 under credit terms of 2∕15, n∕60, FOB shipping point, invoice dated May 20.

22 Gave a price reduction (allowance) of $300 to Tamer Co. for merchandise sold on May 20 and credited Tamer’s accounts receivable for that amount.

25 Paid Duke Co. the balance due, net of the discount. 30 Received the balance due from Tamer Co. for the invoice dated May 20, net of discount and

allowance. 31 Sold merchandise that cost $3,600 to Rath Co. for $7,200 under credit terms of 2∕10, n∕60,

FOB shipping point, invoice dated May 31.

Problem 4-3B Computing merchandising amounts and formatting income statements

C1 C2 P4

Barkley Company’s adjusted trial balance on March 31, its fiscal year-end, follows. It categorizes the fol- lowing accounts as selling expenses: Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Debit Credit

Merchandise inventory (ending) . . . . . . . . . . $ 56,500 Other (noninventory) assets . . . . . . . . . . . . . . 202,600 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,500 Common stock . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . 154,425 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,650 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . 5,875 Sales returns and allowances . . . . . . . . . . . . 20,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 115,600 Sales salaries expense . . . . . . . . . . . . . . . . . . 44,500 Rent expense—Selling space . . . . . . . . . . . . . 16,000 Store supplies expense . . . . . . . . . . . . . . . . . 3,850 Advertising expense . . . . . . . . . . . . . . . . . . . . 26,000 Office salaries expense . . . . . . . . . . . . . . . . . 40,750 Rent expense—Office space . . . . . . . . . . . . . 3,800 Office supplies expense . . . . . . . . . . . . . . . . . 1,100 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $539,575 $539,575

184 Chapter 4 Accounting for Merchandising Operations

Beginning merchandise inventory was $37,500. Supplementary records of merchandising activities for the year ended March 31 reveal the following itemized costs.

Invoice cost of merchandise purchases . . . . . . . . . $138,500 Purchases returns and allowances . . . . . . . . . . . . $6,700

Purchases discounts received . . . . . . . . . . . . . . . . . 2,950 Costs of transportation-in . . . . . . . . . . . . . . . . . . . 5,750

Required

1. Compute the company’s net sales for the year. 2. Compute the company’s total cost of merchandise purchased for the year. 3. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods

sold, selling expenses, and general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold, sell-

ing expenses, and general and administrative expenses.

Check (2) $134,600

(3) Gross profit, $191,175; Net income, $55,175

(4) Total expenses, $251,600

Problem 4-4B Preparing closing entries and interpreting information about discounts and returns C2 P3

Use the data for Barkley Company in Problem 4-3B to complete the following requirement.

Required

Prepare closing entries as of March 31 (the perpetual inventory system is used).

Problem 4-5B Preparing adjusting entries and income statements; computing gross margin, acid-test, and current ratios

P3 P4 A1 A2

The following unadjusted trial balance is prepared at fiscal year-end for Foster Products Company. Foster Products Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses: Depreciation Expense—Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment Accumulated depreciation—Store equipment Accounts payable Common stock

Dividends Sales

7,400 24,000

9,700 6,600

81,800

2,000

1,000 5,000

$

FOSTER PRODUCTS COMPANY Unadjusted Trial Balance

October 31 Debit Credit

$320,100

32,000 18,000 3,000

Retained earnings 40,000

227,100

$

Cost of goods sold Depreciation expense—Store equipment

Sales salaries expense O�ce salaries expense Insurance expense Rent expense—Selling space

Rent expense—O�ce space Store supplies expense Advertising expense

Totals

75,800 0

31,500 31,500

0 13,000

13,000 0

17,800

$320,100

Sales discounts Sales returns and allowances

Required

1. Prepare adjusting journal entries to reflect each of the following: a. Store supplies still available at fiscal year-end amount to $3,700. b. Expired insurance, an administrative expense, is $2,800 for the fiscal year. [continued on next page]

Chapter 4 Accounting for Merchandising Operations 185

Check (2) Gross profit, $142,600

(3) Total expenses, $197,100; Net income, $24,000

SERIAL PROBLEM Business Solutions

P1 P2 P3 P4

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 4 Santana Rey created Business Solutions on October 1, 2019. The company has been successful, and its list of customers has grown. To accommodate the growth, the accounting system is modified to set up separate accounts for each customer. The following chart of accounts includes the account number used for each account and any balance as of December 31, 2019. Santana Rey decided to add a fourth digit with a decimal point to the 106 account number that had been used for the single Accounts Receivable account. This change allows the company to continue using the existing chart of accounts.

c. Depreciation expense on store equipment, a selling expense, is $3,000 for the fiscal year. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $21,300

of inventory is still available at fiscal year-end. 2. Prepare a multiple-step income statement for the year ended October 31 that begins with gross sales

and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses.

3. Prepare a single-step income statement for the year ended October 31. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of October 31. (Round ratios to

two decimals.)

No. Account Title Dr. Cr.

210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    500

236 Unearned computer services revenue . . . . . . . . . . . . . . 1,500

307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,000

318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,360

319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0

403 Computer services revenue . . . . . . . . . . . . . . . . . . . . . . 0

413 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

414 Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . 0

415 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

502 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

612 Depreciation expense—Office equipment . . . . . . . . . . . 0

613 Depreciation expense—Computer equipment . . . . . . . . 0

623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

652 Computer supplies expense . . . . . . . . . . . . . . . . . . . . . . 0

655 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . 0

684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . . . . 0

No. Account Title Dr. Cr.

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $48,372

106 .1 Alex’s Engineering Co . . . . . . . . . . . . . . . 0

106 .2 Wildcat Services . . . . . . . . . . . . . . . . . . . 0

106 .3 Easy Leasing . . . . . . . . . . . . . . . . . . . . . . 0

106 .4 IFM Co . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

106 .5 Liu Corp . . . . . . . . . . . . . . . . . . . . . . . . . . 0

106 .6 Gomez Co . . . . . . . . . . . . . . . . . . . . . . . . 2,668

106 .7 Delta Co . . . . . . . . . . . . . . . . . . . . . . . . . . 0

106 .8 KC, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

106 .9 Dream, Inc . . . . . . . . . . . . . . . . . . . . . . . . 0

119 Merchandise inventory . . . . . . . . . . . . . . 0

126 Computer supplies . . . . . . . . . . . . . . . . . 580

128 Prepaid insurance . . . . . . . . . . . . . . . . . 1,665

131 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . 825

163 Office equipment . . . . . . . . . . . . . . . . . . 8,000

164 Accumulated depreciation— Office equipment . . . . . . . . . . . . . . . . $ 400

167 Computer equipment . . . . . . . . . . . . . . . 20,000

168 Accumulated depreciation— Computer equipment . . . . . . . . . . . . . 1,250

201 Accounts payable . . . . . . . . . . . . . . . . . . 1,100

In response to requests from customers, S. Rey will begin selling computer software. The company will extend credit terms of 1∕10, n∕30, FOB shipping point, to all customers who purchase this merchandise. However, no cash discount is available on consulting fees. Additional accounts (Nos. 119, 413, 414, 415, and 502) are added to its general ledger to accommodate the company’s new merchandising activities. Its transactions for January through March follow.

Jan. 4 The company paid cash to Lyn Addie for five days’ work at the rate of $125 per day. Four of the five days relate to wages payable that were accrued in the prior year.

5 Santana Rey invested an additional $25,000 cash in the company in exchange for more common stock.

7 The company purchased $5,800 of merchandise from Kansas Corp. with terms of 1∕10, n∕30, FOB shipping point, invoice dated January 7.

9 The company received $2,668 cash from Gomez Co. as full payment on its account. 11 The company completed a five-day project for Alex’s Engineering Co. and billed it $5,500,

which is the total price of $7,000 less the advance payment of $1,500. The company debited Unearned Computer Services Revenue for $1,500.

©Alexander Image/Shutterstock

186 Chapter 4 Accounting for Merchandising Operations

13 The company sold merchandise with a retail value of $5,200 and a cost of $3,560 to Liu Corp., invoice dated January 13.

15 The company paid $600 cash for freight charges on the merchandise purchased on January 7. 16 The company received $4,000 cash from Delta Co. for computer services provided. 17 The company paid Kansas Corp. for the invoice dated January 7, net of the discount. 20 The company gave a price reduction (allowance) of $500 to Liu Corp. and credited Liu’s ac-

counts receivable for that amount. 22 The company received the balance due from Liu Corp., net of the discount and the allowance. 24 The company returned defective merchandise to Kansas Corp. and accepted a credit against

future purchases (debited accounts payable). The defective merchandise invoice cost, net of the discount, was $496.

26 The company purchased $9,000 of merchandise from Kansas Corp. with terms of 1∕10, n∕30, FOB destination, invoice dated January 26.

26 The company sold merchandise with a $4,640 cost for $5,800 on credit to KC, Inc., invoice dated January 26.

31 The company paid cash to Lyn Addie for 10 days’ work at $125 per day. Feb. 1 The company paid $2,475 cash to Hillside Mall for another three months’ rent in advance. 3 The company paid Kansas Corp. for the balance due, net of the cash discount, less the $496

credit from merchandise returned on January 24. 5 The company paid $600 cash to Facebook for an advertisement to appear on February 5 only. 11 The company received the balance due from Alex’s Engineering Co. for fees billed on January 11. 15 The company paid a $4,800 cash dividend. 23 The company sold merchandise with a $2,660 cost for $3,220 on credit to Delta Co., invoice

dated February 23. 26 The company paid cash to Lyn Addie for eight days’ work at $125 per day. 27 The company reimbursed Santana Rey $192 cash for business automobile mileage. The com-

pany recorded the reimbursement as “Mileage Expense.” Mar. 8 The company purchased $2,730 of computer supplies from Harris Office Products on credit

with terms of n∕30, FOB destination, invoice dated March 8. 9 The company received the balance due from Delta Co. for merchandise sold on February 23. 11 The company paid $960 cash for minor repairs to the company’s computer. 16 The company received $5,260 cash from Dream, Inc., for computing services provided. 19 The company paid the full amount due of $3,830 to Harris Office Products, consisting of

amounts created on December 15 (of $1,100) and March 8. 24 The company billed Easy Leasing for $9,047 of computing services provided. 25 The company sold merchandise with a $2,002 cost for $2,800 on credit to Wildcat Services,

invoice dated March 25. 30 The company sold merchandise with a $1,048 cost for $2,220 on credit to IFM Company, in-

voice dated March 30. 31 The company reimbursed Santana Rey $128 cash for business automobile mileage. The com-

pany recorded the reimbursement as “Mileage Expense.”

The following additional facts are available for preparing adjustments on March 31 prior to financial state- ment preparation. a. The March 31 amount of computer supplies still available totals $2,005. b. Prepaid insurance coverage of $555 expired during this three-month period. c. Lyn Addie has not been paid for seven days of work at the rate of $125 per day. d. Prepaid rent of $2,475 expired during this three-month period. e. Depreciation on the computer equipment for January 1 through March 31 is $1,250. f. Depreciation on the office equipment for January 1 through March 31 is $400. g. The March 31 amount of merchandise inventory still available totals $704.

Required

1. Prepare journal entries to record each of the January through March transactions. 2. Post the journal entries in part 1 to the accounts in the company’s general ledger. Note: Begin with the

ledger’s post-closing adjusted balances as of December 31, 2019. 3. Prepare a 6-column work sheet (similar to the one shown in Exhibit 3.13) that includes the unadjusted

trial balance, the March 31 adjustments (a) through (g), and the adjusted trial balance. Do not prepare closing entries and do not journalize the adjustments or post them to the ledger.

Check (2) Ending balances at March 31: Cash, $68,057; Sales, $19,240 (3) Unadj. TB totals, $151,557; Adj. TB totals, $154,082

[continued on next page]

Chapter 4 Accounting for Merchandising Operations 187

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so that the accounting professional can focus on the impacts of each transaction on the various financial reports. The following General Ledger questions highlight the operating cycle of a merchandising com- pany. In each case, the trial balance is automatically updated from the journal entries recorded.

GL 4-1 Based on Problem 4-1A GL 4-3 Based on Problem 4-5A

GL 4-2 Based on Problem 4-2A

GL

4. Prepare an income statement (from the adjusted trial balance in part 3) for the three months ended March 31, 2020. (a) Use a single-step format. List all expenses without differentiating between selling expenses and general and administrative expenses. (b) Use a multiple-step format that begins with gross sales (service revenues plus gross product sales) and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Categorize the follow- ing accounts as selling expenses: Wages Expense, Mileage Expense, and Advertising Expense. Categorize the remaining expenses as general and administrative.

5. Prepare a statement of retained earnings (from the adjusted trial balance in part 3) for the three months ended March 31, 2020.

6. Prepare a classified balance sheet (from the adjusted trial balance) as of March 31, 2020. (6) Total assets, $120,268

COMPANY ANALYSIS A1

Accounting Analysis

AA 4-1 Refer to Apple’s financial statements in Appendix A to answer the following.

Required

1. Assume that the amounts reported for inventories and cost of sales reflect items purchased in a form ready for resale. Compute the net cost of goods purchased for the year ended September 30, 2017.

2. Compute the current ratio and acid-test ratio as of September 30, 2017, and September 24, 2016. 3. Does Apple’s 2017 current ratio outperform or underperform the (assumed) industry average of 1.5? 4. Does Apple’s 2017 acid-test ratio outperform or underperform the (assumed) industry average of 1.0?

APPLE

AA 4-2 Key comparative figures for Apple and Google follow.

Required

1. Compute the amount of gross margin and the gross margin ratio for the two years shown for each of these companies.

2. Which company earns more in gross margin for each dollar of net sales for the current year? 3. Do (a) Apple’s and (b) Google’s current-year gross margins underperform or outperform the industry

(assumed) average of 35.0%? 4. Are (a) Apple’s and (b) Google’s current-year gross margins on a favorable or unfavorable trend?

Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Net sales . . . . . . . . . . . . . . . $229,234 $215,639 $110,855 $90,272

Cost of sales . . . . . . . . . . . . . 141,048 131,376 45,583 35,138

COMPARATIVE ANALYSIS A2

APPLE GOOGLE

AA 4-3 Key comparative figures for Samsung, Apple, and Google follow.

In millions Net Sales Cost of Sales

Samsung . . . . . . . . . . . . . . W239,575,376 W129,290,661

Apple . . . . . . . . . . . . . . . . . $ 229,234 $ 141,048

Google . . . . . . . . . . . . . . . . $ 110,855 $ 45,583

GLOBAL ANALYSIS A2 P4

APPLE GOOGLE Samsung

(4) Net income, $18,833

188 Chapter 4 Accounting for Merchandising Operations

ETHICS CHALLENGE C1 P2

BTN 4-1 Amy Martin is a student who plans to attend approximately four professional events a year at her college. Each event necessitates a financial outlay of $100 to $200 for a new suit and accessories. After incurring a major hit to her savings for the first event, Amy developed a different approach. She buys the suit on credit the week before the event, wears it to the event, and returns it the next week to the store for a full refund on her charge card.

Required

1. Comment on the ethics exhibited by Amy and possible consequences of her actions. 2. How does the merchandising company account for the suits that Amy returns?

Beyond the Numbers

Required

1. Compute the gross margin ratio for each of the three companies. 2. Is Samsung’s gross margin ratio better or worse than (a) Apple’s ratio? (b) Google’s? 3. Do (a) Apple, (b) Google, and (c) Samsung use single-step or multiple-step income statements?

BTN 4-2 You are the financial officer for Music Plus, a retailer that sells goods for home entertainment needs. The business owner, Vic Velakturi, recently reviewed the annual financial statements you prepared and sent you an e-mail stating that he thinks you overstated net income. He explains that although he has invested a great deal in security, he is sure shoplifting and other forms of inventory shrinkage have occurred, but he does not see any deduction for shrinkage on the income statement. The store uses a per- petual inventory system.

Required

Prepare a brief memorandum that responds to the owner’s concerns.

COMMUNICATING IN PRACTICE C2 P3 P5

BTN 4-3 Access the SEC’s EDGAR database (SEC.gov) and obtain the March 21, 2017, filing of its fiscal 2017 10-K report (for year ended January 28, 2017) for J. Crew Group, Inc. (ticker: JCG).

Required

Prepare a table that reports the gross margin ratios for J. Crew using the revenues and cost of goods sold data from J. Crew’s income statement for each of its most recent three years. Analyze and comment on the trend in its gross margin ratio.

TAKING IT TO THE NET C1 A2

BTN 4-4 Official Brands’s general ledger and supplementary records at the end of its current period reveal the following.

TEAMWORK IN ACTION C1 C2

Sales, gross . . . . . . . . . . . . . . . . . . . . $600,000 Merchandise inventory (beginning of period) . . . . . . . $ 98,000

Sales returns & allowances . . . . . . . . 20,000 Invoice cost of merchandise purchases . . . . . . . . . . . . 360,000

Sales discounts . . . . . . . . . . . . . . . . . 13,000 Purchases discounts received . . . . . . . . . . . . . . . . . . . 9,000

Cost of transportation-in . . . . . . . . . . 22,000 Purchases returns and allowances . . . . . . . . . . . . . . . . 11,000

Operating expenses . . . . . . . . . . . . . 50,000 Merchandise inventory (end of period) . . . . . . . . . . . . 84,000

Required

1. Each member of the team is to assume responsibility for computing one of the following items. You are not to duplicate your teammates’ work. Get any necessary amounts to compute your item from the appropriate teammate. Each member is to explain his or her computation to the team in preparation for reporting to the class.

a. Net sales d. Gross profit b. Total cost of merchandise purchases e. Net income c. Cost of goods sold 2. Check your net income with the instructor. If correct, proceed to step 3. 3. Assume that a physical inventory count finds that actual ending inventory is $76,000. Discuss how this

affects previously computed amounts in step 1.

Point: In teams of four, assign the same student a and e. Rotate teams for reporting on a different computation and the analysis in step 3.

Chapter 4 Accounting for Merchandising Operations 189

BTN 4-5 Refer to the opening feature about Build-A-Bear Workshop and its founder Maxine Clark. Assume the business reports current annual sales at approximately $1 million and prepares the following income statement.

ENTREPRENEURIAL DECISION C1 C2 P1

BUILD-A-BEAR WORKSHOP Income Statement

For Year Ended January 31, 2018

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610,000

Expenses (other than cost of sales) . . . . . . . . . . . . . 200,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      190,000

Assume the business sells to individuals and retailers, ranging from small shops to large chains. Assume that they currently offer credit terms of 1∕15, n∕60, and ship FOB destination. To improve their cash flow, they are considering changing credit terms to 3∕10, n∕30. In addition, they propose to change shipping terms to FOB shipping point. They expect that the increase in discount rate will increase net sales by 9%, but the gross margin ratio (and ratio of cost of sales divided by net sales) is expected to remain unchanged. They also expect that delivery expenses will be zero under this proposal; thus, expenses other than cost of sales are expected to increase only 6%.

Required

1. Prepare a forecasted income statement for the year ended January 31, 2019, based on the proposal. 2. Based on the forecasted income statement alone (from your part 1 solution), do you recommend that

the business implement the new sales policies? Explain. 3. What else should the business consider before deciding whether to implement the new policies?

Explain.

BTN 4-6 Arrange an interview (in person or by phone) with the manager of a retail shop in a mall or in the downtown area of your community. Explain to the manager that you are a student studying merchan- dising activities and the accounting for sales returns and sales allowances. Ask the manager what the store policy is regarding returns. Also find out if sales allowances are ever negotiated with customers. Inquire whether management perceives that customers are abusing return policies and what actions management takes to counter potential abuses. Be prepared to discuss your findings in class.

HITTING THE ROAD C1 P2

Point: This activity complements the Ethics Challenge assignment.

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Learning Objectives

CONCEPTUAL C1 Identify the items making up

merchandise inventory.

C2 Identify the costs of merchandise inventory.

ANALYTICAL A1 Analyze the effects of inventory

methods for both financial and tax reporting.

P2 Compute the lower of cost or market amount of inventory.

P3 Appendix 5A—Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average.

P4 Appendix 5B—Apply both the retail inventory and gross profit methods to estimate inventory.

A2 Analyze the effects of inventory errors on current and future financial statements.

A3 Assess inventory management using both inventory turnover and days’ sales in inventory.

PROCEDURAL P1 Compute inventory in a perpetual

system using the methods of specific identification, FIFO, LIFO, and weighted average.

Chapter Preview

5 Inventories and Cost of Sales

NTK 5-3, 5-4

INVENTORY VALUATION, ERRORS, AND ANALYSIS

P2 Lower of cost or market A2 Effects of inventory errors A3 Inventory management P3 Appendix: Periodic system P4 Appendix: Inventory

estimation

NTK 5-1

INVENTORY BASICS

C1 Determining inventory items C2 Determining inventory costs

Control of inventory

Physical count

NTK 5-2

INVENTORY COSTING

P1 Cost flow assumptions: Specific identification

First-in, first-out

Last-in, first-out

Weighted average

A1 Effects on financial statements

191

“Show guests you care”—Danny Meyer

Shake It Up

NEW YORK—Danny Meyer opened his first Shake Shack (ShakeShack.com) restaurant in Madison Square Park. The first Shake Shack was a hot dog stand! While much has changed since the first Shack, Danny’s commitment to high-quality ingre- dients has not.

“We call it fine-casual,” explains Danny. “Shake Shack . . . is proving that people don’t want to go backwards in terms of how their food was sourced, how it was cooked.”

Managing this “modern-day roadside burger stand” was not easy. Danny’s Shack grew from “$5,000 worth of hamburgers” to “$30,000-plus” of hamburgers per day. Danny needed an accounting system to track everything.

“The thinking back then was, to have a successful restaurant, the owner had to be there 24/7,” says Danny. To expand Shake Shack, that had to change. Danny put in an inventory system for each of his Shacks. “Great companies,” insists Danny, “figured [inventory] out.”

To ensure fresh sourced ingredients were available at the Shacks, Danny set up an inventory tracking system. He pre- pared and read inventory reports and applied inventory man- agement tools. His inventory system tracks all transactions, and he regularly reviews accounting data in making key decisions.

“You need to get your ducks in a line,” asserts Danny. This means that Shake Shack must successfully manage its inven- tory, even as growth continues.

To be successful, Danny insists that “the numbers add up.” Once your financial house is in order, explains Danny, “you need to take more risk.” He adds, “The best start-ups are businesses that find a unique way to solve problems for people—sometimes problems that people didn’t even know they had.”

Sources: Shake Shack website, January 2019; Fool.com, December 2016; Eater.com, September 2016; Inc.com, May 2015

©Monica Schipper/NYCWFF/Getty Images

Determining Inventory Items Merchandise inventory includes all goods that a company owns and holds for sale. This is true regardless of where the goods are located when inventory is counted. Special atten- tion is directed at goods in transit, goods on consignment, and goods that are damaged or obsolete.

Goods in Transit Does a buyer’s inventory include goods in transit from a supplier? If ownership has passed to the buyer, the goods are included in the buyer’s inventory. We deter- mine this by reviewing shipping terms. FOB shipping point—goods are included in buyer’s inventory once they are shipped. FOB destination—goods are included in buyer’s inventory after arrival at their destination.

Goods on Consignment Goods on consignment are goods shipped by the owner, called the consignor, to another party, the consignee. A consignee sells goods for the owner. The consignor owns the consigned goods and reports them in its inventory. For example, Upper Deck pays sports celebrities such as Russell Wilson of the Seattle Seahawks to sign memorabilia, which are offered to card shops on consignment. Upper Deck, the consignor, reports these items in its inventory until sold. The consignee never reports consigned goods in inventory.

Goods Damaged or Obsolete Damaged, obsolete (out-of-date), and deteriorated goods are not reported in inventory if they cannot be sold. If these goods can be sold at a

INVENTORY BASICS

C1 Identify the items making up merchandise inventory.

192 Chapter 5 Inventories and Cost of Sales

Eyes in the Sky One of the largest builders, Homex, was accused of faking the construction and sale of 100,000 homes. How were they caught? When the SEC used satellite imagery to confirm the existence of homes, they found nothing but bare soil. SEC 2017-60 ■

Ethical Risk

©Aleksandar Georgiev/Getty Images

Determining Inventory Costs Merchandise inventory includes costs to bring an item to a salable condition and location. Inventory costs include invoice cost minus any discount, plus any other costs. Other costs include shipping, storage, import duties, and insurance. The expense recognition principle says that inventory costs are expensed as cost of goods sold when inventory is sold.

Internal Controls and Taking a Physical Count Events can cause the Inventory account balance to be different than the actual inventory avail- able. Such events include theft, loss, damage, and errors. Thus, nearly all companies take a physical count of inventory at least once each year. This physical count is used to adjust the Inventory account balance to the actual inventory available.

C2 Identify the costs of merchandise inventory.

Fraud: Auditors observe employ- ees as they count inventory. Auditors also take their own count to ensure accuracy.

In Control A company applies internal controls when taking a physical count of inventory that usually include the following to minimize fraud and to increase reliability.

• Prenumbered inventory tickets are distributed to counters—each ticket must be accounted for. • Counters of inventory are assigned and do not include those responsible for inventory. • Counters confirm the existence, amount, and condition of inventory. • A second count is taken by a different counter. • A manager confirms all inventories are ticketed once, and only once. ■

Decision Insight

Point: The Inventory account has subsidiary ledgers that contain a separate record (units and costs) for each separate product.

1. A master carver of wooden birds operates her business out of a garage. At the end of the current period, the carver has 17 units (carvings) in her garage, 3 of which were damaged by water and cannot be sold. She also has another 5 units in her truck, ready to deliver per a customer order, terms FOB destination, and another 11 units out on consignment at retail stores. How many units does she include in the busi- ness’s period-end inventory?

2. A distributor of artistic iron-based fixtures acquires a piece for $1,000, terms FOB shipping point. Additional costs in obtaining it and offering it for sale include $150 for transportation-in, $300 for import duties, $100 for insurance during shipment, $200 for advertising, a $50 voluntary gratuity to the delivery person, $75 for enhanced store lighting, and $250 for sales staff salaries. For computing inventory, what cost is assigned to this artistic piece?

Solutions

1. 2.

Inventory Items and Costs

NEED-TO-KNOW 5-1

C1 C2

Do More: QS 5-1, QS 5-2, QS 5-23, E 5-1, E 5-2

Units in ending inventory

Units in storage . . . . . . . . . . . . . . . . . . . . . . . . . 17 units

Less damaged (unsalable) units . . . . . . . . . . . . (3)

Plus units in transit . . . . . . . . . . . . . . . . . . . . . . 5

Plus units on consignment . . . . . . . . . . . . . . . . 11

Total units in ending inventory . . . . . . . . . . . . . 30 units

Merchandise cost . . . . . . . . . . . . . . . . $1,000

Plus:

Transportation-in . . . . . . . . . . . . . . 150

Import duties . . . . . . . . . . . . . . . . . 300

Insurance . . . . . . . . . . . . . . . . . . . . 100

Total inventory cost . . . . . . . . . . . . . . . $1,550

lower price, they are included in inventory at net realizable value. Net realizable value is sales price minus the cost of making the sale. A loss is recorded when the damage or obso- lescence occurs.

Chapter 5 Inventories and Cost of Sales 193

INVENTORY COSTING UNDER A PERPETUAL SYSTEM

*Includes specific identification.

FIFO 48%

LIFO 28%

Weighted Average 20%

Other* 4%

EXHIBIT 5.1 Frequency in Use of Inventory Methods

When identical items are purchased at different costs, we must decide which amounts to record in cost of goods sold and which amounts remain in inventory. Four methods are used to assign costs to inventory and to cost of goods sold: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted average. Exhibit 5.1 shows the frequency in use of these methods.

Each method has a pattern for how costs flow through inventory. The cost flow assumption does not have to match the actual physical flow of goods. For example, Kroger’s grocery chain sells food first-in, first-out, meaning they sell the oldest food in inventory first. However, Kroger can use last-in, first-out to assign costs to food sold. With the exception of specific identifica- tion, the physical flow and cost flow do not have to be the same.

Inventory Cost Flow Assumptions To show inventory cost flow assumptions, assume that three identical units are purchased separately at the following three dates and costs: May 1 at $45, May 3 at $65, and May 6 at $70. One unit is then sold on May 7 for $100. Exhibit 5.2 shows the flow of costs to either cost of goods sold on the income statement or inventory reported on the balance sheet for FIFO, LIFO, and weighted average.

Point: Cost of goods sold is abbre- viated COGS.

$180 3

= $60 each

2. Last-in, first-out (LIFO) Costs flow in the reverse

order incurred.

3. Weighted average Costs flow at an average

of costs available.

1. First-in, first-out (FIFO) Costs flow in the order

incurred.

× 2× 1

Income Statement Net sales.................... $100 Cost of goods sold.. 45 Gross profit................ $ 55

Balance Sheet Inventory.................... $135

Income Statement Net sales.................... $100 Cost of goods sold.. 70 Gross profit................ $ 30

Balance Sheet Inventory.................... $1 10

Income Statement Net sales.................... $100 Cost of goods sold.. 60 Gross profit................ $ 40

Balance Sheet Inventory.................... $120

$65 May 3

$45 May 1 G

o o d s

s o l d

G o o d s

s o l d

G o o d s

s o l d

G o o d s

l e f t

G o o d s

l e f t

G o o d s

l e f t

$70 May 6

$65 May 3

$45 May 1

$70 May 6

$70 May 6

$65 May 3

$45 May 1

EXHIBIT 5.2 Cost Flow Assumptions

(1) FIFO assumes costs flow in the order incurred. The unit purchased on May 1 for $45 is the earliest cost incurred—it is sent to cost of goods sold on the income statement first. The remaining two units ($65 and $70) are reported in inventory on the balance sheet.

(2) LIFO assumes costs flow in the reverse order incurred. The unit purchased on May 6 for $70 is the most recent cost incurred—it is sent to cost of goods sold on the income statement. The remaining two units ($45 and $65) are reported in inventory on the balance sheet.

(3) Weighted average assumes costs flow at an average of the costs available. The units available at the May 7 sale average $60 in cost, computed as ($45 + $65 + $70)/3. One unit’s $60 average cost is sent to cost of goods sold on the income statement. The remaining two units’ average costs are reported in inventory at $120 on the balance sheet.

Cost flow assumptions impact gross profit and inventory numbers. Exhibit 5.2 shows that gross profit ranges from $30 to $55 due to the cost flow assumption.

Point: Recall inventory cost flow.

+

= Merchandise available for sale

Cost of goods sold

Net purchases

Beginning inventory

Ending inventory

+

The following sections on inventory costing use the perpetual system. Appendix 5A uses the periodic system. An instructor can choose to cover either one or both systems. If the perpetual system is skipped, then read Appendix 5A and return to the “Valuing Inventory at LCM and the Effects of Inventory Errors” section.

194 Chapter 5 Inventories and Cost of Sales

Inventory Costing Illustration This section demonstrates inventory costing methods. We use information from Trekking, a sporting goods store. Among its products, Trekking sells one type of mountain bike whose sales are directed at resorts that provide inexpensive bikes for guest use. We use Trekking’s data from August. Its mountain bike (unit) inventory at the beginning of August and its purchases and sales during August are in Exhibit 5.3. It ends August with 12 bikes in inventory.

P1 Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average.

EXHIBIT 5.3 Purchases and Sales of Goods

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Aug . 1 Beginning inventory . . . . . . . 10 units @ $ 91 = $ 910 10 units Aug . 3 Purchases . . . . . . . . . . . . . . . 15 units @ $106 = $ 1,590 25 units Aug . 14 Sales . . . . . . . . . . . . . . . . . . . 20 units @ $130 5 units

Aug . 17 Purchases . . . . . . . . . . . . . . . 20 units @ $115 = $ 2,300 25 units Aug . 28 Purchases . . . . . . . . . . . . . . . 10 units @ $119 = $ 1,190 35 units Aug . 30 Sales . . . . . . . . . . . . . . . . . . . 23 units @ $150 12 units Totals . . . . . . . . . . . . . . . . . . 55 units $5,990 43 units

Units available for sale Goods available for sale Units sold Units left

Trekking uses the perpetual inventory system, which means that its Merchandise Inventory account is updated for each purchase and sale of inventory. (Appendix 5A describes the assign- ment of costs to inventory using a periodic system.) Regardless of what inventory method is used, cost of goods available for sale must be allocated between cost of goods sold and ending inventory.

Specific Identification When each item in inventory can be matched with a specific purchase and invoice, we can use specific identification or SI to assign costs. We also need sales records that identify exactly which items were sold and when. Trekking’s internal documents show the following specific unit sales.

August 14 Sold 8 bikes costing $91 each and 12 bikes costing $106 each. Total cost = $2,000. August 30 Sold 2 bikes costing $91 each, 3 bikes costing $106 each, 15 bikes costing $115

each, and 3 bikes costing $119 each. Total cost = $2,582.

Exhibit 5.4 begins with the $5,990 in total units available for sale. For the 20 units sold on August 14, the total cost of sales is $2,000. Next, for the 23 units sold on August 30, the total cost of sales is $2,582. The total cost of sales for the period is $4,582. We then subtract this $4,582 in cost of goods sold from the $5,990 in cost of goods available to get $1,408 in ending inventory.

EXHIBIT 5.4 Specific Identification Computations

Total cost of 55 units available for sale (from Exhibit 5 .3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,990

Cost of goods sold Aug . 14 (8 @ $91) + (12 @ $106) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000 Aug . 30 (2 @ $91) + (3 @ $106) + (15 @ $115) + (3 @ $119) . . . . . . . . . . . . . . . . . . 2,582 4,582 Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,408

Merchandise Inventory (SI)

Aug. 1 910 Aug. 3 1,590 Aug. 14 2,000 Aug. 17 2,300 Aug. 28 1,190 Aug. 30 2,582

Aug. 31 1,408

Trekking’s cost of goods sold reported on the income statement is $4,582, and ending inventory reported on the balance sheet is $1,408. The following graphic shows this flow of costs.

Point: Specific identification is common for custom-made inven- tory. Examples include jewelers and fashion designers.

LAST BoughtFIRST Bought

SI Inventory $1,408

SI COGS $4,582

©Michael DeYoung/Blend Images

Chapter 5 Inventories and Cost of Sales 195

First-In, First-Out First-in, first-out (FIFO) assumes that inventory items are sold in the order acquired. When sales occur, the costs of the earliest units acquired are charged to cost of goods sold. This leaves the costs from the most recent purchases in ending inventory.

Exhibit 5.5 starts with beginning inventory of 10 bikes at $91 each.

August 3 Purchased 15 bikes costing $106 each for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500.

August 14 Sold 20 bikes—applying FIFO, the first 10 sold cost $91 each and the next 10 sold cost $106 each, for a total cost of $1,970. This leaves 5 bikes costing $106 each, or $530, in inventory.

August 17 Purchased 20 bikes costing $115 each, and on August 28, purchased another 10 bikes costing $119 each, for a total of 35 bikes costing $4,020 in inventory.

August 30 Sold 23 bikes—applying FIFO, the first 5 bikes sold cost $106 each and the next 18 sold cost $115 each, for a total of $2,600. This leaves 12 bikes costing $1,420 in ending inventory.

Point: “Goods Purchased” column is identical for all methods.

Trekking’s cost of goods sold reported on its income statement is $4,570 ($1,970 + $2,600), and its ending inventory reported on the balance sheet is $1,420.

LAST BoughtFIRST Bought

FIFO COGS $4,570 FIFO Inventory $1,420

EXHIBIT 5.5 FIFO Computations— Perpetual System

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 = $ 910

Aug. 3 15 @ $106 = $1,590 10 @ $ 91 15 @ $106

= $ 2,500

Aug. 14 10 @ $ 91 = $ 910 10 @ $106 = $1,060

= $1,970 5 @ $106 = $ 530

Aug. 17 20 @ $115 = $2,300 5 @ $106 20 @ $115

= $ 2,830

Aug. 28 10 @ $119 = $1,190 5 @ $106 20 @ $115 = $ 4,020 10 @ $119

Aug. 30 5 @ $106 = $ 530 2 @ $115 18 @ $115 = $2,070

= $2,600 10 @ $119

= $1,420

$4,570

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

⎧ ⎨ ⎩

Merchandise Inventory (FIFO)

Aug. 1 910 Aug. 3 1,590 Aug. 14 1,970 Aug. 17 2,300 Aug. 28 1,190 Aug. 30 2,600

Aug. 31 1,420

Last-In, First-Out Last-in, first-out (LIFO) assumes that the most recent purchases are sold first. These more recent costs are charged to the goods sold, and the costs of the earliest purchases are assigned to inventory.

Point: By assigning costs from the most recent purchases to cost of goods sold, LIFO comes closest to matching current costs of goods sold with revenues.

196 Chapter 5 Inventories and Cost of Sales

Exhibit 5.6 starts with beginning inventory of 10 bikes at $91 each.

August 3 Purchased 15 bikes costing $106 each for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500.

August 14 Sold 20 bikes—applying LIFO, the first 15 sold are from the most recent purchase costing $106 each, and the next 5 sold are from the next most recent purchase costing $91 each, for a total of $2,045. This leaves 5 bikes costing $91 each, or $455, in inventory.

August 17 Purchased 20 bikes costing $115 each, and on August 28, purchased another 10 bikes costing $119 each, for a total of 35 bikes costing $3,945 in inventory.

August 30 Sold 23 bikes—applying LIFO, the first 10 bikes sold are from the most recent purchase costing $119 each, and the next 13 sold are from the next most recent purchase costing $115 each, for a total of $2,685. This leaves 12 bikes costing $1,260 in ending inventory.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 = $ 910

Aug. 3 15 @ $106 = $1,590 10 @ $ 91 15 @ $106

= $ 2,500

Aug. 14 15 @ $106 = $1,590 5 @ $ 91 = $ 455

= $2,045 5 @ $ 91 = $ 455

Aug. 17 20 @ $115 = $2,300 5 @ $ 91 20 @ $115

= $ 2,755

Aug. 28 10 @ $119 = $1,190 5 @ $ 91 20 @ $115 = $ 3,945 10 @ $119

Aug. 30 10 @ $119 = $1,190 5 @ $ 91 13 @ $115 = $1,495

= $2,685 7 @ $115

= $1,260

$4,730

EXHIBIT 5.6 LIFO Computations— Perpetual System

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

⎧ ⎨ ⎩

Trekking’s cost of goods sold reported on the income statement is $4,730 ($2,045 + $2,685), and its ending inventory reported on the balance sheet is $1,260.

Merchandise Inventory (LIFO)

Aug. 1 910 Aug. 3 1,590 Aug. 14 2,045 Aug. 17 2,300 Aug. 28 1,190 Aug. 30 2,685

Aug. 31 1,260

LAST Bought*LIFO perpetual applied at each sale date.FIRST Bought

LIFO Inventory $1,260

*LIFO COGS $4,730

Weighted Average Weighted average or WA (also called average cost) requires that we use the weighted average cost per unit of inventory at the time of each sale.

Weighted average cost per unit at time of each sale =

Cost of goods available for sale (at each sale) Number of units available for sale (at each sale)

Exhibit 5.7 starts with beginning inventory of 10 bikes at $91 each.

August 3 Purchased 15 bikes costing $106 each for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500. The average cost per bike for that inventory is $100, computed as $2,500/(10 bikes + 15 bikes).

Chapter 5 Inventories and Cost of Sales 197

August 14 Sold 20 bikes—applying WA, the 20 sold are assigned the $100 average cost, for a total of $2,000. This leaves 5 bikes with an average cost of $100 each, or $500, in inventory.

August 17 Purchased 20 bikes costing $2,300, and on August 28, purchased another 10 bikes costing $1,190, for a total of 35 bikes costing $3,990 in inventory at August 28. The average cost per bike for the August 28 inventory is $114, computed as $3,990/35 bikes.

August 30 Sold 23 bikes—applying WA, the 23 sold are assigned the $114 average cost, for a total of $2,622. This leaves 12 bikes costing $1,368 in ending inventory.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug . 1 Beginning balance 10 @ $ 91 = $ 910 (10 @ $ 91 per unit)

Aug . 3 15 @ $106 = $1,590 10 @ $ 91 15 @ $106

= $ 2,500 (25 @ $100 per unit)a

Aug . 14 20 @ $100 = $2,000 5 @ $100 = $ 500 ( 5 @ $100 per unit)b

Aug . 17 20 @ $115 = $2,300 5 @ $100 20 @ $115

= $ 2,800 (25 @ $112 per unit)c

Aug . 28 10 @ $119 = $1,190 25 @ $112 10 @ $119

= $ 3,990 (35 @ $114 per unit)d

Aug . 30 23 @ $114 = $2,622 12 @ $114 = $1,368 (12 @ $114 per unit)e

$4,622

a$100 per unit = ($2,500 inventory balance ÷ 25 units in inventory). b$100 per unit = ($500 inventory balance ÷ 5 units in inventory). c$112 per unit = ($2,800 inventory balance ÷ 25 units in inventory).

d$114 per unit = ($3,990 inventory balance ÷ 35 units in inventory). e$114 per unit = ($1,368 inventory balance ÷ 12 units in inventory).

EXHIBIT 5.7 Weighted Average Computations—Perpetual System

Merchandise Inventory (WA)

Aug. 1 910 Aug. 3 1,590 Aug. 14 2,000 Aug. 17 2,300 Aug. 28 1,190 Aug. 30 2,622

Aug. 31 1,368

Trekking’s cost of goods sold reported on the income statement is $4,622 ($2,000 + $2,622), and its ending inventory reported on the balance sheet is $1,368.

LAST BoughtFIRST Bought

WA COGS $4,622WA Inventory $1,368

Point: WA perpetual applied at each sale date.

Kickbacks and Invoice Fraud Inventory safeguards include restricted access, use of authorized requisitions, and security measures. Proper accounting includes matching inventory received with purchase order terms and quality requirements, preventing misstatements, and controlling access to records. A study reports that 35% of employees in purchasing and procurement observed improper kickbacks or gifts from suppliers. ■

Ethical Risk

Financial Statement Effects of Costing Methods When purchase prices do not change, each inventory costing method assigns the same cost amounts to inventory and to cost of goods sold. When purchase prices are different, the methods assign different cost amounts. We show these differences in Exhibit 5.8 using Trekking’s data.

Rising Costs When purchase costs regularly rise, as in Trekking’s case, the following occurs. FIFO reports the lowest cost of goods sold—yielding the highest gross profit and net income. LIFO reports the highest cost of goods sold—yielding the lowest gross profit and net income. Weighted average yields results between FIFO and LIFO.

A1 Analyze the effects of inventory methods for both financial and tax reporting.

198 Chapter 5 Inventories and Cost of Sales

Falling Costs When costs regularly decline, the reverse occurs for FIFO and LIFO. FIFO gives the highest cost of goods sold—yielding the lowest gross profit and income. LIFO gives the lowest cost of goods sold—yielding the highest gross profit and income.

Method Advantages Each method offers advantages. FIFO—inventory on the balance sheet approximates its current cost; it also follows the actual

flow of goods for most businesses. LIFO—cost of goods sold on the income statement approximates its current cost; it also bet-

ter matches current costs with revenues. Weighted average—smooths out erratic changes in costs. Specific identification—matches the costs of items with the revenues they generate.

Tax Effects of Costing Methods Inventory costs affect net income and have potential tax effects. Exhibit 5.8 shows that Trekking gains a temporary tax advantage by using LIFO because it has less income to be taxed. Many companies use LIFO for this reason. The IRS requires that when LIFO is used for tax reporting, it also must be used for financial reporting—called LIFO conformity rule.

Point: LIFO inventory is often less than the inventory’s replacement cost because LIFO inventory is valued using the oldest inventory purchase costs.

Trekking Company Specific Weighted For Month Ended August 31 Identification FIFO LIFO Average

Income Statement Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,050 $ 6,050 $ 6,050 $ 6,050

Cost of goods sold . . . . . . . . . . . . . . . . . . 4,582 4,570 4,730 4,622 Gross profit . . . . . . . . . . . . . . . . . . . . . . 1,468 1,480 1,320 1,428

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 450 450 450 450

Income before taxes . . . . . . . . . . . . . . . . . 1,018 1,030 870 978

Income tax expense (30%) . . . . . . . . . . . . 305 309 261 293

Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 713 $   721 $   609 $ 685

Balance Sheet Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . $1,408 $1,420 $1,260 $1,368

EXHIBIT 5.8 Financial Statement Effects of Inventory Costing Methods

Inventory Manager Your compensation as inventory manager includes a bonus plan based on gross profit. Your superior asks your opinion on changing the inventory costing method from FIFO to LIFO. As costs are expected to continue to rise, your superior predicts that LIFO would match higher current costs against sales, thereby lowering taxable income (and gross profit). What do you recommend? ■ Answer: It seems your company can save (or at least postpone) taxes by switching to LIFO, but the switch is likely to reduce bonus money that you believe you have earned and deserve. Your best decision is to tell your superior about the tax savings with LIFO. You should discuss your bonus plan and how this is likely to hurt you unfairly.

Decision Ethics

A company reported the following December purchase and sales data for its only product.

Perpetual SI, FIFO, LIFO, and WA

NEED-TO-KNOW 5-2

P1

Date Activities Units Acquired at Cost Units Sold at Retail

Dec . 1 Beginning inventory . . . . . . . . . . . . . . 5 units @ $3 .00 = $ 15 .00 Dec . 8 Purchase . . . . . . . . . . . . . . . . . . . . . . . 10 units @ $4 .50 = 45 .00 Dec . 9 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 units @ $7 .00

Dec . 19 Purchase . . . . . . . . . . . . . . . . . . . . . . . 13 units @ $5 .00 = 65 .00 Dec . 24 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 units @ $8 .00

Dec . 30 Purchase . . . . . . . . . . . . . . . . . . . . . . . 8 units @ $5 .30 = 42 .40 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 units $167 .40 26 units

The company uses a perpetual inventory system. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) FIFO, (c) LIFO, and (d) weighted average. (Round per unit costs and inventory amounts to cents.)

Chapter 5 Inventories and Cost of Sales 199

For specific identification, ending inventory consists of 10 units, where 8 are from the December 30 purchase and 2 are from the December 8 purchase. Specific unit sales follow.

Dec. 9 Sold 2 units costing $3.00 each and 6 units costing $4.50 each. Total cost = $33.00. Dec. 24 Sold 3 units costing $3.00 each, 2 units costing $4.50 each, and 13 units costing $5.00

each. Total cost = $83.00.

Solutions

a. Specific identification: Ending inventory—eight units from December 30 purchase and two units from December 8 purchase.

b. FIFO—Perpetual.

Date Goods Purchased Cost of Goods Sold Inventory Balance

12/1 5 @ $3 .00 = $15 .00

12/8 10 @ $4 .50 5 @ $3 .00

10 @ $4 .50 = $60 .00

12/9 5 @ $3 .00 7 @ $4 .50 = $31 .50

3 @ $4 .50 = $ 28 .50

12/19 13 @ $5 .00 7 @ $4 .50

13 @ $5 .00 = $96 .50

12/24 7 @ $4 .50

11 @ $5 .00 = $ 86 .50 2 @ $5 .00 = $10 .00

12/30 8 @ $5 .30 2 @ $5 .00

$115 .00

8 @ $5 .30 = $52 .40

Merchandise Inventory (FIFO)

Beg. inventory 15.00 Dec. 8 45.00 Dec. 9 28.50 Dec. 19 65.00 Dec. 24 86.50 Dec. 30 42.40

End. inventory 52.40

Ending Cost of Specific Identification Inventory Goods Sold

(8 × $5 .30) + (2 × $4 .50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $51 .40 (5 × $3 .00) + (8 × $4 .50) + (13 × $5 .00) + (0 × $5 .30) or $167 .40 [Total Goods Available] − $51 .40 [Ending Inventory] . . . . . . . . . . . . $116 .00

Merchandise Inventory (SI)

Beg. inventory 15.00 Dec. 8 45.00 Dec. 9 33.00 Dec. 19 65.00 Dec. 24 83.00 Dec. 30 42.40

End. inventory 51.40

OR “short-cut” FIFO—Perpetual.

Ending Cost of FIFO Inventory Goods Sold

(8 × $5 .30) + (2 × $5 .00) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52 .40 (5 × $3 .00) + (10 × $4 .50) + (11 × $5 .00) or $167 .40 [Total Goods Available] − $52 .40 [Ending Inventory] . . . . . . . . . . . . $115 .00

c. LIFO—Perpetual.

Merchandise Inventory (LIFO)

Beg. inventory 15.00 Dec. 8 45.00 Dec. 9 36.00 Dec. 19 65.00 Dec. 24 83.00 Dec. 30 42.40

End. inventory 48.40

Date Goods Purchased Cost of Goods Sold Inventory Balance

12/1 5 @ $3 .00 = $15 .00

12/8 10 @ $4 .50 5 @ $3 .00

10 @ $4 .50 = $60 .00

12/9 5 @ $3 .00

8 @ $4 .50 = $ 36 .00

2 @ $4 .50 = $24 .00

12/19 13 @ $5 .00 5 @ $3 .00

2 @ $4 .50 = $89 .00 13 @ $5 .00

12/24 13 @ $5 .00

2 @ $4 .50 = $ 83 .00 2 @ $3 .00 = $ 6 .00 3 @ $3 .00

12/30 8 @ $5 .30 2 @ $3 .00

$119 .00

8 @ $5 .30 = $48 .40

200 Chapter 5 Inventories and Cost of Sales

Merchandise Inventory (WA)

Beg. inventory 15.00 Dec. 8 45.00 Dec. 9 32.00 Dec. 19 65.00 Dec. 24 83.70 Dec. 30 42.40

End. inventory 51.70

Date Goods Purchased Cost of Goods Sold Inventory Balance

12/1 5 @ $3 .00 = $15 .00 (5 @ $3 .00 per unit)

12/8 10 @ $4 .50 5 @ $3 .00

10 @ $4 .50 = $60 .00

($60 .00∕15 units = $4 .00 avg . cost)

12/9 8 @ $4 .00 = $ 32 .00 7 @ $4 .00 = $28 .00 (7 @ $4 .00 per unit)

12/19 13 @ $5 .00 7 @ $4 .00

13 @ $5 .00 = $93 .00

($93 .00∕20 units = $4 .65 avg . cost)

12/24 18 @ $4 .65 = $ 83 .70 2 @ $4 .65 = $ 9 .30 (2 @ $4 .65 per unit)

12/30 8 @ $5 .30 2 @ $4 .65

$115 .70

8 @ $5 .30 = $51 .70

($51 .70∕10 units = $5 .17 avg . cost)

Do More: QS 5-3, QS 5-4, QS 5-5, QS 5-6, QS 5-10, QS 5-11, QS 5-12, E 5-3

d. Weighted Average—Perpetual.

VALUING INVENTORY AT LCM AND THE EFFECTS OF INVENTORY ERRORS This section covers how market value and inventory errors impact financial statements.

Lower of Cost or Market After companies apply one of four costing methods (FIFO, LIFO, weighted average, or spe- cific identification), inventory is reviewed to ensure it is reported at the lower of cost or market (LCM).

Computing the Lower of Cost or Market Market in the term LCM is replace- ment cost for LIFO, but net realizable value for the other three methods—advanced courses cover specifics. A decline in market value means a loss of value in inventory. When market value is lower than cost of inventory, a loss is recorded. When market value is higher than cost of inventory, no adjustment is made.

LCM is applied in one of three ways: (1) to each individual item separately, (2) to major cat- egories of items, or (3) to the whole of inventory. With the increasing use of technology and inventory tracking, companies increasingly apply LCM to each individual item separately. Accordingly, we show that method only; advanced courses cover other methods. To demonstrate LCM, we apply it to the ending inventory of a motorsports retailer in Exhibit 5.9.

P2 Compute the lower of cost or market amount of inventory.

Point: LCM applied to each individual item always yields the lowest inventory.

Per Unit Inventory Total Total LCM Applied Items Units Cost Market Cost Market to Items

Roadster . . . . . . . . . . . . . 20 $8,500 $7,000 $170,000 $140,000 $   140,000

Sprint . . . . . . . . . . . . . . . 10 5,000 6,000 50,000 60,000 50,000

Totals . . . . . . . . . . . . . . . $220,000 $190,000

EXHIBIT 5.9 Lower of Cost or Market Computations

The amount of $190,000 is lower than the $220,000 recorded cost .

$140,000 is the lower of $170,000 or $140,000 .

For Roadster, $140,000 is the lower of the $170,000 cost and the $140,000 market. For Sprint, $50,000 is the lower of the $50,000 cost and the $60,000 market. This yields a $190,000 reported inventory, computed from $140,000 for Roadster plus $50,000 for Sprint.

Recording the Lower of Cost or Market Inventory is adjusted downward when total “LCM applied to items” is less than total cost of inventory. To demonstrate, if LCM is

Chapter 5 Inventories and Cost of Sales 201

applied in Exhibit 5.9, the Merchandise Inventory account must be adjusted from the $220,000 recorded cost down to the $190,000 LCM amount as follows.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . 30,000 Adjust inventory cost to market.

Financial Statement Effects of Inventory Errors An inventory error causes misstatements in cost of goods sold, gross profit, net income, current assets, and equity. It also causes misstatements in the next period’s statements because ending inventory of one period is the beginning inventory of the next. As we consider financial state- ment effects, we recall the following inventory relation.

A2 Analyze the effects of inventory errors on current and future financial statements.

Beginning inventory

Net purchases

Ending inventory

Cost of goods sold+ – =

Income Statement Effects Exhibit 5.10 shows the effects of inventory errors in the current and next period’s income statements. Row 1, Year 1. Understating ending inventory overstates cost of goods sold. This is because

we subtract a smaller ending inventory in computing cost of goods sold. A higher cost of goods sold yields a lower income.

Row 1, Year 2. Understated ending inventory for Year 1 becomes an understated beginning in- ventory for Year 2. If beginning inventory is understated, cost of goods sold is understated (be- cause we are starting with a smaller amount). A lower cost of goods sold yields a higher income.

Row 2, Year 1. Overstating ending inventory understates cost of goods sold. A lower cost of goods sold yields a higher income.

Row 2, Year 2. Overstated ending inventory for Year 1 becomes an overstated beginning in- ventory for Year 2. If beginning inventory is overstated, cost of goods sold is overstated. A higher cost of goods sold yields a lower income.

LCM Method

NEED-TO-KNOW 5-3

P2

A company has the following products in its ending inventory, along with cost and market values. (a) Compute the lower of cost or market for its inventory when applied separately to each product. (b) If the market amount is less than the recorded cost of the inventory, then record the December 31 LCM adjustment to the Merchandise Inventory account.

Do More: QS 5-19, E 5-10

b. Dec . 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Adjust inventory cost to market ($11,000 − $10,000).

Units Cost per Unit Market per Unit

Road bikes . . . . . . . . . . . . . . 5 $1,000 $800 Mountain bikes . . . . . . . . . . . 4 500 600 Town bikes . . . . . . . . . . . . . . 10 400 450

Solution

a. Cost Market Total Total Inventory Items Units per Unit per Unit Cost Market LCM Items

Road bikes . . . . . . . . . . . . . . . . . . 5 $1,000 $800 $ 5,000 $4,000 $ 4,000 Mountain bikes . . . . . . . . . . . . . . . 4 500 600 2,000 2,400 2,000 Town bikes . . . . . . . . . . . . . . . . . . 10 400 450 4,000 4,500 4,000 Totals . . . . . . . . . . . . . . . . . . . . . . . $11,000 $ 10,000

LCM applied to each product . . . . $10,000

202 Chapter 5 Inventories and Cost of Sales

EXHIBIT 5.10 Effects of Inventory Errors on the Income Statement

Year 1 Year 2

Ending Inventory Cost of Goods Sold Net Income Cost of Goods Sold Net Income

Understated  . . . . . . . . . . . Overstated  Understated  Understated  Overstated 

Overstated  . . . . . . . . . . . . . Understated  Overstated  Overstated  Understated 

Inventory Error Example Consider an inventory error for a company with $100,000 in sales for each of Year 1, Year 2, and Year 3. If this company has a steady $20,000 inventory level and makes $60,000 in purchases in each year, its cost of goods sold is $60,000 and its gross profit is $40,000.

Year 1 Understated Inventory: Year 1 Impact Assume the company makes an error in comput- ing its Year 1 ending inventory and reports $16,000 instead of the correct amount of $20,000. The effects of this error are in Exhibit 5.11. The $4,000 understatement of Year 1 ending inven- tory causes a $4,000 overstatement in Year 1 cost of goods sold and a $4,000 understatement in both gross profit and net income for Year 1.

Correct income is $30,000 for each year .

Income Statements Year 1 Year 2 Year 3

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000 $100,000

Cost of goods sold

Beginning inventory . . . . . . . . . . . . $20,000 $16,000* $20,000 Cost of goods purchased . . . . . . . . 60,000 60,000 60,000

Goods available for sale . . . . . . . . 80,000 76,000 80,000

Ending inventory . . . . . . . . . . . . . . 16,000* 20,000 20,000 Cost of goods sold . . . . . . . . . . . . . 64,000† 56,000† 60,000 Gross profit . . . . . . . . . . . . . . . . . . . . . 36,000 44,000 40,000

Expenses . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000 10,000

Net income . . . . . . . . . . . . . . . . . . . . . $ 26,000 $ 34,000 $ 30,000

*Correct amount is $20,000. †Correct amount is $60,000.

EXHIBIT 5.11 Effects of Inventory Errors on Three Periods’ Income Statements

Year 1 Understated Inventory: Year 2 Impact The Year 1 understated ending inventory becomes the Year 2 understated beginning inventory. This error causes an understatement in Year 2 cost of goods sold and a $4,000 overstatement in both gross profit and net income for Year 2.

Year 1 Understated Inventory: Year 3 Impact The Year 1 ending inventory error affects only that period and the next. It does not affect Year 3 results or any period thereafter.

Balance Sheet Effects Understating ending inventory understates both current and total assets. An understatement in ending inventory also yields an understatement in equity

because of the understatement in net income. Exhibit 5.12 shows the effects of inventory errors on the current period’s balance sheet amounts.

Example: If Year 1 ending inventory in Exhibit 5.11 is overstated by $3,000, cost of goods sold is understated by $3,000 in Year 1 and overstated by $3,000 in Year 2. Net income is overstated in Year 1 and understated in Year 2. Assets and equity are overstated in Year 1.

EXHIBIT 5.12 Effects of Inventory Errors on Current Period’s Balance Sheet

Ending Inventory Assets Equity

Understated . . . . Understated Understated

Overstated . . . . . Overstated Overstated

A company had $10,000 of sales, and it purchased merchandise costing $7,000 in each of Year 1, Year 2, and Year 3. It also maintained a $2,000 physical inventory from the beginning to the end of that three-year period. In accounting for inventory, it made an error at the end of Year 1 that caused its Year 1 ending inventory to appear on its statements as $1,600 rather than the correct $2,000. (a) Determine the correct amount of the company’s gross profit in each of Year 1, Year 2, and Year 3. (b) Prepare comparative in- come statements as in Exhibit 5.11 to show the effect of this error on the company’s cost of goods sold and gross profit for each of Year 1, Year 2, and Year 3.

Solution

a. Correct gross profit = $10,000 − $7,000 = $3,000 (for each year). b. Cost of goods sold and gross profit figures follow.

Effects of Inventory Errors

NEED-TO-KNOW 5-4

A2

Chapter 5 Inventories and Cost of Sales 203

Do More: QS 5-20, E 5-12

Year 1 Year 2 Year 3

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 $10,000 $10,000

Cost of goods sold

Beginning inventory . . . . . . . . . . . . $2,000 $1,600 $2,000 Cost of purchases . . . . . . . . . . . . . 7,000 7,000 7,000

Goods available for sale . . . . . . . . 9,000 8,600 9,000

Ending inventory . . . . . . . . . . . . . . 1,600 2,000 2,000 Cost of goods sold . . . . . . . . . . . . . 7,400 6,600 7,000 Gross profit . . . . . . . . . . . . . . . . . . . . . $ 2,600 $ 3,400 $ 3,000

Combined income for the 3 years is $9,000 ($2,600 + $3,400 + $3,000), which is correct, meaning the inventory error is “self-correcting” (even though individual years’ inventory amounts are in error).

Inventory Turnover and Days’ Sales in Inventory Decision Analysis

Inventory Turnover Inventory turnover, also called merchandise inventory turnover, is defined in Exhibit 5.13. Inventory turnover tells how many times a company turns over (sells) its inventory in a period. It is used to assess whether management is doing a good job controlling the amount of inventory. A low ratio means the com- pany may have more inventory than it needs. A very high ratio means inventory might be too low. This can cause lost sales if customers must back-order merchandise. Inventory turnover has no simple rule except to say a high ratio is preferable if inventory is adequate to meet demand.

EXHIBIT 5.13 Inventory TurnoverInventory turnover =

Cost of goods sold Average inventory

Days’ Sales in Inventory Days’ sales in inventory is a ratio that shows how much inventory is available in terms of the number of days’ sales. It can be interpreted as the number of days one can sell from existing inventory if no new items are purchased. This ratio reveals the buffer against out-of-stock inventory and is useful in evaluating how quickly inventory is being sold. It is defined in Exhibit 5.14. Days’ sales in inventory uses ending inventory, whereas inventory turnover uses average inventory.

Point: Low inventory turnover can reveal obsolescence.

Point: Inventory turnover is higher and days’ sales in inventory is lower for industries such as foods.

A3 Assess inventory management using both inventory turnover and days’ sales in inventory.

EXHIBIT 5.14 Days’ Sales in InventoryDays’ sales in inventory =

Ending inventory Cost of goods sold

× 365

Analysis of Inventory Management Merchandisers must plan and control inventory purchases and sales. Costco’s inventory at the end of the current year was $9,834 million. This inventory was 57% of its current assets and 27% of its total assets. We apply the analysis tools in this section to Costco and Walmart, as shown in Exhibit 5.15.

EXHIBIT 5.15 Inventory Turnover and Days’ Sales in Inventory for Costco and Walmart

Costco’s current year inventory turnover of 11.9 times means that it turns over its inventory 11.9 times per year. Costco’s inventory turnover exceeded Walmart’s turnover in each of the last three years. This is a positive for Costco, as we prefer inventory turnover to be high provided inventory is not out of stock and the company is not losing customers. Days’ sales in inventory of 32.1 days means that Costco is carrying 32.1 days of sales in inventory. This inventory buffer seems sufficient. As long as Costco is not at risk of running out of stock, it prefers its assets not be tied up in inventory.

Point: Take care when comparing turnover ratios across companies that use different costing meth- ods (such as FIFO and LIFO).

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Costco Cost of goods sold . . . . . . . . . . . . . . $111,882 $102,901 $101,065 Ending inventory . . . . . . . . . . . . . . . . $ 9,834 $ 8,969 $ 8,908

Inventory turnover . . . . . . . . . . . . . 11.9 times 11.5 times 11.6 times Days’ sales in inventory . . . . . . . . . 32.1 days 31.8 days 32.2 days Walmart Inventory turnover . . . . . . . . . . . . . . 8 .3 times 8 .1 times 8 .1 times Days’ sales in inventory . . . . . . . . . . 43 .5 days 45 .0 days 45 .1 days

Craig Company buys and sells one product. Its beginning inventory, purchases, and sales during calendar- year 2019 follow.

COMPREHENSIVE 1

NEED-TO-KNOW 5-5

Perpetual Method: Computing Inventory Using LIFO, FIFO, WA, and SI; Financial Statement Impacts; and Inventory Errors

204 Chapter 5 Inventories and Cost of Sales

Entrepreneur Your retail store has an inventory turnover of 5.0 and a days’ sales in inventory of 73 days. The indus- try norm for inventory turnover is 4.4 and for days’ sales in inventory is 74 days. What is your assessment of inventory management? ■ Answer: Your inventory turnover is higher than the norm, whereas days’ sales in inventory approximates the norm. Because your turnover is already 14% better than average, you should probably direct attention to days’ sales in inventory. You should see if you can reduce the level of inventory while maintaining service to customers. Given your higher turnover, you should be able to hold less inventory.

Decision Maker

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Jan . 1 Beg . inventory . . . . . . . . . . . 400 units @ $14 = $ 5,600 400 units Jan . 15 Sale . . . . . . . . . . . . . . . . . . . 200 units @ $30 200 units Mar . 10 Purchase . . . . . . . . . . . . . . . 200 units @ $15 = $ 3,000 400 units Apr . 1 Sale . . . . . . . . . . . . . . . . . . . 200 units @ $30 200 units May 9 Purchase . . . . . . . . . . . . . . . 300 units @ $16 = $ 4,800 500 units Sep . 22 Purchase . . . . . . . . . . . . . . . 250 units @ $20 = $ 5,000 750 units Nov . 1 Sale . . . . . . . . . . . . . . . . . . . 300 units @ $35 450 units Nov . 28 Purchase . . . . . . . . . . . . . . . 100 units @ $21 = $ 2,100 550 units Totals . . . . . . . . . . . . . . . . . . 1,250 units $20,500 700 units

Additional tracking data for specific identification: (1) January 15 sale—200 units @ $14, (2) April 1 sale—200 units @ $15, and (3) November 1 sale—200 units @ $14 and 100 units @ $20.

Required

1. Compute the cost of goods available for sale. 2. Apply the four methods of inventory costing (FIFO, LIFO, weighted average, and specific identifica-

tion) to compute ending inventory and cost of goods sold under each method using the perpetual system. 3. Compute gross profit earned by the company for each of the four costing methods in part 2. Also,

report the inventory amount reported on the balance sheet for each of the four methods. 4. In preparing financial statements for year 2019, the financial officer was instructed to use FIFO but

failed to do so and instead computed cost of goods sold according to LIFO, which led to a $1,400 over- statement in cost of goods sold from using LIFO. Determine the impact on year 2019’s income from the error. Also determine the effect of this error on year 2020’s income. Assume no income taxes.

5. Management wants a report that shows how changing from FIFO to another method would change net income. Prepare a table showing (1) the cost of goods sold amount under each of the four methods, (2) the amount by which each cost of goods sold total is different from the FIFO cost of goods sold, and (3) the effect on net income if another method is used instead of FIFO.

PLANNING THE SOLUTION Compute cost of goods available for sale by multiplying the units of beginning inventory and each

purchase by their unit costs to determine the total cost of goods available for sale. Prepare a perpetual FIFO table starting with beginning inventory and showing how inventory changes

after each purchase and after each sale (see Exhibit 5.5). Prepare a perpetual LIFO table starting with beginning inventory and showing how inventory changes

after each purchase and after each sale (see Exhibit 5.6). Make a table of purchases and sales recalculating the average cost of inventory prior to each sale to

arrive at the weighted average cost of ending inventory. Total the average costs associated with each sale to determine cost of goods sold (see Exhibit 5.7).

Prepare a table showing the computation of cost of goods sold and ending inventory using the specific identification method (see Exhibit 5.4).

Compare the year-end 2019 inventory amounts under FIFO and LIFO to determine the misstatement of year 2019 income that results from using LIFO. The errors for years 2019 and 2020 are equal in amount but opposite in effect.

Create a table showing cost of goods sold under each method and how net income would differ from FIFO net income if an alternate method were adopted.

Chapter 5 Inventories and Cost of Sales 205

SOLUTION 1. Cost of goods available for sale (this amount is the same for all methods).

Date Units Unit Cost Cost

Jan . 1 Beg . inventory . . . . . . . . . . . . . 400 $14 $ 5,600

Mar . 10 Purchase . . . . . . . . . . . . . . . . . 200 15 3,000

May 9 Purchase . . . . . . . . . . . . . . . . . 300 16 4,800

Sep . 22 Purchase . . . . . . . . . . . . . . . . . 250 20 5,000

Nov . 28 Purchase . . . . . . . . . . . . . . . . . 100 21 2,100

Total goods available for sale . . . . . . . . . . . . 1,250 $20,500

2a. FIFO perpetual method.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan . 1 Beginning balance 400 @ $14 = $ 5,600

Jan . 15 200 @ $14 = $2,800 200 @ $14 = $ 2,800

Mar . 10 200 @ $15 = $3,000 200 @ $14 = $ 5,800

200 @ $15

Apr . 1 200 @ $14 = $2,800 200 @ $15 = $ 3,000

May 9 300 @ $16 = $4,800 200 @ $15 = $ 7,800

300 @ $16

Sep . 22 250 @ $20 = $5,000 200 @ $15 300 @ $16 = $ 12,800 250 @ $20

Nov . 1 200 @ $15 = $3,000 200 @ $16 = $ 8,200

100 @ $16 = $1,600 250 @ $20

Nov . 28 100 @ $21 = $2,100 200 @ $16 250 @ $20 = $10,300 100 @ $21

Total cost of goods sold $10,200 ⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

Note: In a classroom situation, once we compute cost of goods available for sale, we can compute the amount for either cost of goods sold or ending inventory—it is a matter of preference. In practice, the costs of items sold are identified as sales are made and immediately transferred from the Inventory account to the Cost of Goods Sold account. The previous solution showing the line-by-line approach illustrates actual ap- plication in practice. The following alternate solutions illustrate that, once the concepts are understood, other solution approaches are available. Although this is only shown for FIFO, it could be shown for all methods.

Alternate Methods to Compute FIFO Perpetual Numbers

Cost of goods available for sale (from part 1) . . . . . $ 20,500

Ending inventory*

Nov . 28 Purchase (100 @ $21) . . . . . . . . . . . $2,100

Sep . 22 Purchase (250 @ $20) . . . . . . . . . . . 5,000

May 9 Purchase (200 @ $16) . . . . . . . . . . . 3,200

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,300 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . $10,200

* FIFO assumes that the earlier costs are the first to flow out; thus, we determine ending inventory by assigning the most recent costs to the remaining items.

[FIFO Alternate No . 1: Computing ending inventory first] [FIFO Alternate No . 2: Computing cost of goods sold first]

Cost of goods available for sale (from part 1) . . . . . . . . $ 20,500

Cost of goods sold Jan . 15 Sold (200 @ $14) . . . . . . . . . . . . . . . . . $2,800

Apr . 1 Sold (200 @ $14) . . . . . . . . . . . . . . . . . 2,800

Nov . 1 Sold (200 @ $15 and 100 @ $16) . . . . 4,600 10,200 Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,300

206 Chapter 5 Inventories and Cost of Sales

2b. LIFO perpetual method.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan . 1 Beginning balance 400 @ $14 = $ 5,600

Jan . 15 200 @ $14 = $2,800 200 @ $14 = $ 2,800

Mar . 10 200 @ $15 = $3,000 200 @ $14 = $ 5,800

200 @ $15

Apr . 1 200 @ $15 = $3,000 200 @ $14 = $ 2,800

May 9 300 @ $16 = $4,800 200 @ $14 = $ 7,600

300 @ $16

Sep . 22 250 @ $20 = $5,000 200 @ $14 300 @ $16 = $12,600 250 @ $20

Nov . 1 250 @ $20 = $5,000 200 @ $14 = $ 6,800

50 @ $16 = $ 800 250 @ $16

Nov . 28 100 @ $21 = $2,100 200 @ $14 250 @ $16 = $ 8,900 100 @ $21

Total cost of goods sold $11,600

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

2c. Weighted average perpetual method.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan . 1 Beginning balance 400 @ $14 .00 = $     5,600 ($5,600/400 units = $14 .00 avg . cost)

Jan . 15 200 @ $14 .00 = $ 2,800 200 @ $14 .00 = $    2,800

Mar . 10 200 @ $15 .00 = $3,000 200 @ $14 .00 = $     5,800

200 @ $15 .00

($5,800/400 units = $14 .50 avg . cost)

Apr . 1 200 @ $14 .50 = $ 2,900 200 @ $14 .50 = $    2,900

May 9 300 @ $16 .00 = $4,800 200 @ $14 .50 = $    7,700

300 @ $16 .00

($7,700/500 units = $15 .40 avg . cost)

Sep . 22 250 @ $20 .00 = $5,000 500 @ $15 .40 250 @ $20 .00

= $ 12,700

($12,700/750 units = $16 .93† avg . cost)

Nov . 1 300 @ $16 .93 = $ 5,079 450 @ $16 .93 = $ 7,618 .50

Nov . 28 100 @ $21 .00 = $2,100 450 @ $16 .93 = $9,718.50

100 @ $21 .00

($9,718 .50/550 units = $17 .67 avg . cost)

Total cost of goods sold* $10,779

*Cost of goods sold ($10,779) plus ending inventory ($9,718.50) is $2.50 less †Rounded to 2 decimal places. than the cost of goods available for sale ($20,500) due to rounding.

Chapter 5 Inventories and Cost of Sales 207

2d. Specific identification method.

Cost of goods available for sale (from part 1) . . . . . . . . . . . . . . . $ 20,500

Ending inventory*

May 9 Purchase (300 @ $16) . . . . . . . . . . . . . . . . . . . . . $4,800

Sep . 22 Purchase (150 @ $20) . . . . . . . . . . . . . . . . . . . . . 3,000

Nov . 28 Purchase (100 @ $21) . . . . . . . . . . . . . . . . . . . . . 2,100

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,600

*The additional tracking data provided are used to identify the items in ending inventory.

3.

Weighted Specific FIFO LIFO Average Identification

Income Statement Sales* . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,500 $22,500 $ 22,500 $22,500

Cost of goods sold . . . . . . . . . . . . . . . . 10,200 11,600 10,779 10,600 Gross profit . . . . . . . . . . . . . . . . . . . . . $ 12,300 $10,900 $ 11,721 $11,900

Balance Sheet Inventory . . . . . . . . . . . . . . . . . . . . . . . . $10,300 $ 8,900 $9,718.50 $ 9,900

*Sales = (200 units × $30) + (200 units × $30) + (300 units × $35) = $22,500

4. Mistakenly using LIFO when FIFO should have been used overstates cost of goods sold in year 2019 by $1,400, which is the difference between the FIFO and LIFO amounts of ending inventory. It under- states income in 2019 by $1,400. In year 2020, income is overstated by $1,400 because of the under- statement in beginning inventory.

5. Analysis of the effects of alternative inventory methods.

Difference from Effect on Net FIFO Cost of Income If Adopted Cost of Goods Sold Goods Sold Instead of FIFO

FIFO . . . . . . . . . . . . . . . . . . . . . . . . $10,200 — —

LIFO . . . . . . . . . . . . . . . . . . . . . . . . 11,600 +$1,400 $1,400 lower Weighted average . . . . . . . . . . . . 10,779 + 579 579 lower Specific identification . . . . . . . . . . 10,600 + 400 400 lower

Craig Company buys and sells one product. Its beginning inventory, purchases, and sales during calendar- year 2019 follow.

COMPREHENSIVE 2

NEED-TO-KNOW 5-6

Periodic Method: Computing Inventory Using LIFO, FIFO, WA, and SI; Financial Statement Impacts; and Inventory Errors

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Jan . 1 Beg . inventory . . . . . . . . . . . 400 units @ $14 = $  5,600 400 units Jan . 15 Sale . . . . . . . . . . . . . . . . . . . 200 units @ $30 200 units

Mar . 10 Purchase . . . . . . . . . . . . . . . 200 units @ $15 = $  3,000 400 units Apr . 1 Sale . . . . . . . . . . . . . . . . . . . 200 units @ $30 200 units

May 9 Purchase . . . . . . . . . . . . . . . 300 units @ $16 = $  4,800 500 units Sep . 22 Purchase . . . . . . . . . . . . . . . 250 units @ $20 = $  5,000 750 units Nov . 1 Sale . . . . . . . . . . . . . . . . . . . 300 units @ $35 450 units

Nov . 28 Purchase . . . . . . . . . . . . . . . 100 units @ $21 = $  2,100 550 units Totals . . . . . . . . . . . . . . . . . . 1,250 units $20,500 700 units

Additional tracking data for specific identification: (1) January 15 sale—200 units @ $14, (2) April 1 sale—200 units @ $15, and (3) November 1 sale—200 units @ $14 and 100 units @ $20.

208 Chapter 5 Inventories and Cost of Sales

Required

1. Compute the cost of goods available for sale. 2. Apply the four methods of inventory costing (FIFO, LIFO, weighted average, and specific iden-

tification) to compute ending inventory and cost of goods sold under each method using the periodic system.

3. Compute gross profit earned by the company for each of the four costing methods in part 2. Also, report the inventory amount reported on the balance sheet for each of the four methods.

4. In preparing financial statements for year 2019, the financial officer was instructed to use FIFO but failed to do so and instead computed cost of goods sold according to LIFO. Determine the impact of the error on year 2019’s income. Also determine the effect of this error on year 2020’s income. Assume no income taxes.

PLANNING THE SOLUTION Compute cost of goods available for sale by multiplying the units of beginning inventory and each

purchase by their unit costs to determine the total cost of goods available for sale. Prepare a periodic FIFO computation starting with cost of units available and subtracting FIFO ending

inventory amounts to obtain FIFO cost of goods sold (see Exhibit 5A.3). Prepare a periodic LIFO computation starting with cost of units available and subtracting LIFO ending

inventory amounts to obtain LIFO cost of goods sold (see Exhibit 5A.4). Compute weighted average ending inventory and cost of goods sold using the three-step process illus-

trated in Exhibits 5A.5a and 5A.5b. Prepare a table showing the computation of cost of goods sold and ending inventory using the specific

identification method (see Exhibit 5A.2). Compare the year-end 2019 inventory amounts under FIFO and LIFO to determine the misstatement of

year 2019 income that results from using LIFO. The errors for years 2019 and 2020 are equal in amount but opposite in effect.

SOLUTION 1. Cost of goods available for sale (this amount is the same for all methods).

Date Units Unit Cost Cost

Jan . 1 Beg . inventory . . . . . . . . . . . . . 400 $14 $ 5,600

Mar . 10 Purchase . . . . . . . . . . . . . . . . . 200 15 3,000

May 9 Purchase . . . . . . . . . . . . . . . . . 300 16 4,800

Sep . 22 Purchase . . . . . . . . . . . . . . . . . 250 20 5,000

Nov . 28 Purchase . . . . . . . . . . . . . . . . . 100 21 2,100

Total goods available for sale . . . . . . . . . . . . 1,250 $20,500

2a. FIFO periodic method.

Cost of goods available for sale (from part 1) . . . . $ 20,500

Ending inventory*

Nov . 28 Purchase (100 @ $21) . . . . . . . . . . $2,100

Sep . 22 Purchase (250 @ $20) . . . . . . . . . . 5,000

May 9 Purchase (200 @ $16) . . . . . . . . . . 3,200

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 10,300 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . $10,200

* FIFO assumes that the earlier costs are the first to flow out; thus, we determine ending inventory by assigning the most recent costs to the remaining items.

2b. LIFO periodic method.

Cost of goods available for sale (from part 1) . . . . $ 20,500

Ending inventory†

Jan . 1 Beg . inventory (400 @ $14) . . . $5,600

Mar . 10 Purchase (150 @ $15) . . . . . . . . 2,250

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 7,850 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . $12,650

† LIFO assumes that the most recent (newest) costs are the first to flow out; thus, we determine ending inventory by assigning the earliest (oldest) costs to the remaining items.

Chapter 5 Inventories and Cost of Sales 209

2c. Weighted average periodic method.

Step 1: 400 units @ $14 = $ 5,600 200 units @ $15 =  3,000 300 units @ $16 = 4,800 250 units @ $20 = 5,000 100 units @ $21 = 2,100 1,250 units $20,500

Step 2: $20,500/1,250 units = $16.40 weighted average cost per unit Step 3: Total cost of 1,250 units available for sale . . . . . . . . . . . . . . $ 20,500 Less ending inventory priced on a weighted average cost basis: 550 units at $16 .40 each . . . . . . . . . . . . . . . . . . . 9,020 Cost of goods sold (700 units at $16.40 each) . . . . . . . . . $11,480

2d. Specific identification method.

Cost of goods available for sale (from part 1) . . . $  20,500 Ending inventory* May 9 Purchase (300 @ $16) . . . . . . . $4,800 Sep . 22 Purchase (150 @ $20) . . . . . . . 3,000 Nov . 28 Purchase (100 @ $21) . . . . . . . 2,100 Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . 9,900 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . $10,600

*The additional tracking data provided are used to identify the items in ending inventory.

3.

Weighted Specific FIFO LIFO Average Identification

Income Statement Sales* . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,500 $22,500 $ 22,500 $22,500

Cost of goods sold . . . . . . . . . . . . . . . . 10,200 12,650 11,480 10,600 Gross profit . . . . . . . . . . . . . . . . . . . . . $ 12,300 $ 9,850 $ 11,020 $11,900

Balance Sheet Inventory . . . . . . . . . . . . . . . . . . . . . . . . $10,300 $  7,850 $ 9,020 $   9,900

*Sales = (200 units × $30) + (200 units × $30) + (300 units × $35) = $22,500

4. Mistakenly using LIFO, when FIFO should have been used, overstates cost of goods sold in year 2019 by $2,450, which is the difference between the FIFO and LIFO amounts of ending inventory. It under- states income in 2019 by $2,450. In year 2020, income is overstated by $2,450 because of the under- statement in beginning inventory.

APPENDIX

Inventory Costing under a Periodic System 5A This section demonstrates inventory costing methods. We use information from Trekking, a sporting goods store. Among its many products, Trekking sells one type of mountain bike whose sales are directed at resorts that provide inexpensive bikes for guest use. We use Trekking’s data from August. Its mountain bike (unit) inventory at the beginning of August and its purchases and sales during August are shown in Exhibit 5A.1. It ends August with 12 bikes remaining in inventory.

P3 Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average.

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Aug . 1 Beginning inventory . . . . . . . 10 units @ $ 91 = $ 910 10 units Aug . 3 Purchases . . . . . . . . . . . . . . . 15 units @ $106 = $ 1,590 25 units Aug . 14 Sales . . . . . . . . . . . . . . . . . . . 20 units @ $130 5 units

Aug . 17 Purchases . . . . . . . . . . . . . . . 20 units @ $115 = $ 2,300 25 units Aug . 28 Purchases . . . . . . . . . . . . . . . 10 units @ $119 = $ 1,190 35 units Aug . 30 Sales . . . . . . . . . . . . . . . . . . . 23 units @ $150 12 units Totals . . . . . . . . . . . . . . . . . . 55 units $5,990 43 units

Units available for sale Goods available for sale Units sold Units left

EXHIBIT 5A.1 Purchases and Sales of Goods

210 Chapter 5 Inventories and Cost of Sales

Trekking uses the periodic inventory system, which means that its Merchandise Inventory account is updated at the end of each period (monthly for Trekking) to reflect purchases and sales. Regardless of what inventory method is used, cost of goods available for sale must be allocated between cost of goods sold and ending inventory. (Many companies use the periodic system for tracking costs [not so much for sales]. Reasons include the use of standard costs by some companies and dollar-value LIFO by others. Also, the methods of specific identification and FIFO, used by a majority of companies, give the same result under the periodic and the perpetual systems.)

Specific Identification When each item in inventory can be matched with a specific purchase and invoice, we can use specific identification or SI to assign costs. We also need sales records that iden- tify exactly which items were sold and when. Trekking’s internal documents show the following specific unit sales.

August 14 Sold 8 bikes costing $91 each and 12 bikes costing $106 each. Total cost = $2,000. August 30 Sold 2 bikes costing $91 each, 3 bikes costing $106 each, 15 bikes costing $115 each, and

3 bikes costing $119 each. Total cost = $2,582.

Exhibit 5A.2 begins with the $5,990 in total units available for sale. For the 20 units sold on August 14, the total cost of sales is $2,000. Next, for the 23 units sold on August 30, the total cost of sales is $2,582. The total cost of sales for the period is $4,582. We then subtract this $4,582 in cost of goods sold from the $5,990 in cost of goods available to get $1,408 in ending inventory.

EXHIBIT 5A.2 Specific Identification Computations

Total cost of 55 units available for sale (from Exhibit 5A .1) . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,990

Cost of goods sold Aug . 14 (8 @ $91) + (12 @ $106) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000 Aug . 30 (2 @ $91) + (3 @ $106) + (15 @ $115) + (3 @ $119) . . . . . . . . . . . . . . . . . . 2,582 4,582 Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,408

Trekking’s cost of goods sold reported on the income statement is $4,582, and ending inventory re- ported on the balance sheet is $1,408. The following graphic shows these cost flows.

Point: Specific identification is common for custom-made inven- tory. Examples include jewelers and fashion designers.

LAST BoughtFIRST Bought

SI Inventory $1,408

SI COGS $4,582

Point: SI yields identical results un- der both periodic and perpetual.

First-In, First-Out First-in, first-out (FIFO) assumes that inventory items are sold in the order acquired. When sales occur, the costs of the earliest units acquired are charged to cost of goods sold. This leaves the costs from the most recent purchases in ending inventory. Exhibit 5A.3 starts with $5,990 in total units available for sale. Applying FIFO, the 12 units in ending inventory are reported at the cost of the most recent 12 purchases. Reviewing purchases in reverse order, we assign costs to the 12 bikes in ending inventory as follows: $119 cost to 10 bikes and $115 cost to 2 bikes. This yields $1,420 in ending inventory. We subtract this $1,420 in ending inventory from $5,990 in cost of goods available to get $4,570 in cost of goods sold.

Point: For FIFO, COGS and ending inventory are the same for peri- odic and perpetual.

Chapter 5 Inventories and Cost of Sales 211

Last-In, First-Out Last-in, first-out (LIFO) assumes that the most recent purchases are sold first. These more recent costs are charged to goods sold, and the costs of the earliest purchases are assigned to inventory. Exhibit 5A.4 starts with $5,990 in total units available for sale. Applying LIFO, the 12 units in ending inventory are reported at the cost of the earliest 12 purchases. Reviewing the earliest purchases in order, we assign costs to the 12 bikes in ending inventory as follows: $91 cost to 10 bikes and $106 cost to 2 bikes. This yields $1,122 in ending inventory. We subtract this $1,122 in ending inventory from $5,990 in cost of goods available to get $4,868 in cost of goods sold.

Point: By assigning costs from the most recent purchases to cost of goods sold, LIFO comes closest to matching current costs of goods sold with revenues.

LAST BoughtFIRST Bought

FIFO COGS $4,570 FIFO Inventory $1,420

Total cost of 55 units available for sale (from Exhibit 5A .1) . . . . . . . . . . . . . . $ 5,990

Less ending inventory priced using FIFO

10 units from August 28 purchase at $119 each . . . . . . . . . . . . . . . . . . . . $1,190

2 units from August 17 purchase at $115 each . . . . . . . . . . . . . . . . . . . . . 230

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,420 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,570

Exhibit 5A .1 shows that the 12 units in ending inventory consist of 10 units from the latest purchase on Aug . 28 and 2 units from the next latest purchase on Aug . 17 .

EXHIBIT 5A.3 FIFO Computations— Periodic System

Trekking’s ending inventory reported on the balance sheet is $1,420, and its cost of goods sold re- ported on the income statement is $4,570.

Trekking’s ending inventory reported on the balance sheet is $1,122, and its cost of goods sold re- ported on the income statement is $4,868.

LAST BoughtFIRST Bought

LIFO Inventory $1,122

LIFO COGS $4,868

Total cost of 55 units available for sale (from Exhibit 5A .1) . . . . . . . . . . . . . . . $ 5,990

Less ending inventory priced using LIFO

10 units in beginning inventory at $91 each . . . . . . . . . . . . . . . . . . . . . . . . $910

2 units from August 3 purchase at $106 each . . . . . . . . . . . . . . . . . . . . . . . 212

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,122 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,868

EXHIBIT 5A.4 LIFO Computations— Periodic System

Exhibit 5A .1 shows that the 12 units in ending inventory consist of 10 units from the earliest purchase (beg . inv .) and 2 units from the next earliest purchase on Aug . 3 .

Weighted Average Weighted average or WA (also called average cost) requires that we use the average cost per unit of inventory at the end of the period. Weighted average cost per unit equals the cost

212 Chapter 5 Inventories and Cost of Sales

Trekking’s ending inventory reported on the balance sheet is $1,307, and its cost of goods sold reported on the income statement is $4,683.

EXHIBIT 5A.5a Weighted Average Cost per Unit

Step 1: 10 units @ $ 91 = $       910 15 units @ $106 = 1,590 20 units @ $115 = 2,300 10 units @ $119 = 1,190 55 $5,990

Step 2: $5,990/55 units = $108.91 weighted average cost per unit

EXHIBIT 5A.5b Weighted Average Computations—Periodic

Step 3: Total cost of 55 units available for sale (from Exhibit 5A .1) . . . . . . . . . . . . . . . $ 5,990 Less ending inventory priced on a weighted average cost basis: 12 units at $108 .91 each (from Exhibit 5A .5a) . . . . . . . . . . . . . . . . 1,307 Cost of goods sold (43 units at $108.91 each) . . . . . . . . . . . . . . . . . . . . . . . $4,683

Step 3 uses the weighted average cost per unit to assign costs to ending inventory and to cost of goods sold, as shown in Exhibit 5A.5b.

of goods available for sale divided by the units available. The weighted average method has three steps. The first two steps are shown in Exhibit 5A.5a. Step 1 in Exhibit 5A.5a multiplies the per unit cost for beginning inventory and each purchase by the number of units (from Exhibit 5A.1). Step 2 adds these amounts and divides by the total number of units available for sale to find the weighted average cost per unit.

LAST BoughtFIRST Bought

WA Inventory $1,307

WA COGS $4,683

Financial Statement Effects of Costing Methods When purchase prices do not change, each inventory costing method assigns the same cost amounts to inventory and to cost of goods sold. When purchase prices are different, the methods assign different cost amounts. We show these dif- ferences in Exhibit 5A.6 using Trekking’s data.

Rising Costs When purchase costs regularly rise, as in Trekking’s case, the following occurs.

FIFO reports the lowest cost of goods sold—yielding the highest gross profit and net income. LIFO reports the highest cost of goods sold—yielding the lowest gross profit and net income. Weighted average yields results between FIFO and LIFO.

EXHIBIT 5A.6 Financial Statement Effects of Inventory Costing Methods

Trekking Company Specific Weighted For Month Ended August 31 Identification FIFO LIFO Average

Income Statement Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,050 $ 6,050 $ 6,050 $ 6,050

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 4,582 4,570 4,868 4,683 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . 1,468 1,480 1,182 1,367

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 450 450 450

Income before taxes . . . . . . . . . . . . . . . . . . . . 1,018 1,030 732 917

Income tax expense (30%) . . . . . . . . . . . . . . . 305 309 220 275

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $   713 $   721 $   512 $   642 Balance Sheet Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,408 $1,420 $1,122 $1,307

Chapter 5 Inventories and Cost of Sales 213

Falling Costs When costs regularly decline, the reverse occurs for FIFO and LIFO. FIFO gives the highest cost of goods sold—yielding the lowest gross profit and income. LIFO gives the lowest cost of goods sold—yielding the highest gross profit and income.

Method Advantages Each method offers advantages.

FIFO—inventory on the balance sheet approximates its current cost; it also follows the actual flow of goods for most businesses.

LIFO—cost of goods sold on the income statement approximates its current cost; it also better matches current costs with revenues.

Weighted average—smooths out erratic changes in costs. Specific identification—matches the costs of items with the revenues they generate.

Point: LIFO inventory is often less than the inventory’s replacement cost because LIFO inventory is valued using the oldest inventory purchase costs.

Periodic SI, FIFO, LIFO, and WA

NEED-TO-KNOW 5-7

P3

A company reported the following December purchases and sales data for its only product.

The company uses a periodic inventory system. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) FIFO, (c) LIFO, and (d) weighted average. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 10 units, where 8 are from the December 30 purchase and 2 are from the December 8 purchase.

Solutions

a. Specific identification: Ending inventory—eight units from December 30 purchase and two units from December 8 purchase.

Date Activities Units Acquired at Cost Units Sold at Retail

Dec . 1 Beginning inventory . . . . . . . . . . . . . . 5 units @ $3 .00 = $ 15 .00 Dec . 8 Purchase . . . . . . . . . . . . . . . . . . . . . . . 10 units @ $4 .50 = 45 .00 Dec . 9 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 units @ $7 .00

Dec . 19 Purchase . . . . . . . . . . . . . . . . . . . . . . . 13 units @ $5 .00 = 65 .00 Dec . 24 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 units @ $8 .00

Dec . 30 Purchase . . . . . . . . . . . . . . . . . . . . . . . 8 units @ $5 .30 = 42 .40 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 units $167 .40 26 units

b. FIFO—Periodic.

c. LIFO—Periodic.

Ending Cost of Specific Identification Inventory Goods Sold

(8 × $5 .30) + (2 × $4 .50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $51 .40 (5 × $3 .00) + (8 × $4 .50) + (13 × $5 .00) + (0 × $5 .30) or $167 .40 [Total Goods Available] − $51 .40 [Ending Inventory] . . . . . . . . . . . . . . . . . . $116 .00

Ending Cost of FIFO Inventory Goods Sold

(8 × $5 .30) + (2 × $5 .00) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52 .40 (5 × $3 .00) + (10 × $4 .50) + (11 × $5 .00) or $167 .40 [Total Goods Available] − $52 .40 [Ending Inventory] . . . . . . . . . . . . . . . . . $115 .00

Ending Cost of LIFO Inventory Goods Sold

(5 × $3 .00) + (5 × $4 .50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $37 .50 (8 × $5 .30) + (13 × $5 .00) + (5 × $4 .50) or $167 .40 [Total Goods Available] − $37 .50 [Ending Inventory] . . . . . . . . . . . . . . . . . $129 .90

214 Chapter 5 Inventories and Cost of Sales

d. WA—Periodic.

Ending Cost of WA Inventory Goods Sold

10 × $4 .65 (computed from $167 .40/36) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $46 .50 26 × $4 .65 (computed from $167 .40/36) or $167 .40 [Total Goods Available] − $46 .50 [Ending Inventory] . . . . . . . . . . . . . . . . . $120 .90

Do More: QS 5-7, QS 5-8, QS 5-9, QS 5-14, QS 5-15, QS 5-16, QS 5-17, E 5-5

APPENDIX

Inventory Estimation Methods5B Inventory sometimes is estimated for two reasons. First, companies often report interim financial state- ments (financial statements prepared for periods of less than one year), but they only annually take a physi- cal count of inventory. Second, companies may require an inventory estimate if some casualty such as fire or flood makes taking a physical count impossible. Estimates are usually only required for companies that use the periodic system. Companies using a perpetual system would presumably have updated inventory data. This appendix describes two methods to estimate inventory.

Retail Inventory Method To avoid the time-consuming process of taking a physical inven- tory, some companies use the retail inventory method to estimate cost of goods sold and ending inventory. The retail inventory method uses a three-step process to estimate ending inventory. We need to know the amount of inventory a company had at the beginning of the period in both cost and retail amounts. We

already explained how to com- pute the cost of inventory. The retail amount of inventory is measured using selling prices of inventory items. We also need to know the net amount of goods purchased (minus returns, allow- ances, and discounts) in the pe- riod, both at cost and at retail. The amount of net sales at retail also is needed. The process is shown in Exhibit 5B.1.

The reasoning behind the re- tail inventory method is that if we can get a good estimate of the cost-to-retail ratio, we can multiply ending inventory at re- tail by this ratio to estimate end-

ing inventory at cost. Exhibit 5B.2 shows how these steps are applied to estimate ending inventory. First, we find that $100,000 of goods (at retail selling prices) were available for sale. A total of $70,000 of these

P4 Apply both the retail inventory and gross profit methods to estimate inventory.

Step 2

Step 1

Step 3

Goods available for sale at retail

Net sales at retail

Ending inventory at retail

Goods available for sale at cost

Goods available for sale at retail

Cost-to- retail ratio

Ending inventory at retail

Cost-to- retail ratio

Estimated ending inventory

at cost ×

÷

=

=

=

EXHIBIT 5B.1 Retail Inventory Method of Inventory Estimation

EXHIBIT 5B.2 Estimated Inventory Using the Retail Inventory Method

At Cost At Retail

Goods available for sale

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  20,500 $  34,500

Cost of goods purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,500 65,500

Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 100,000

Step 1: Deduct net sales at retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 Ending inventory at retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000

Step 2: Cost-to-retail ratio: ($60,000 ÷ $100,000) = 60%

Step 3: Estimated ending inventory at cost ($30,000 × 60%) . . . . . . . . . . . . . . . . . . $18,000

Chapter 5 Inventories and Cost of Sales 215

goods were sold, leaving $30,000 (retail value) of merchandise in ending inventory. Second, the cost of these goods is 60% of the $100,000 retail value. Third, because cost for these goods is 60% of retail, the estimated cost of ending inventory is $18,000.

Gross Profit Method The gross profit method estimates the cost of ending inventory by applying the gross profit ratio to net sales (at retail). This type of estimate often is used when inventory is destroyed, lost, or stolen. This method uses the historical rela- tion between cost of goods sold and net sales to estimate the pro- portion of cost of goods sold making up current sales. This cost of goods sold estimate is then subtracted from cost of goods available for sale to esti- mate the ending inventory at cost. These two steps are shown in Exhibit 5B.3. To demonstrate, assume that a company’s inventory is destroyed by fire in March. When the fire oc- curs, the company’s accounts show the following balances for January through March: Net Sales, $30,000; Beginning Inventory, $12,000 (at January 1); and Cost of Goods Purchased, $20,500. If this company’s gross profit ratio is 30%, then 30% of each net sales dollar is gross profit and 70% is cost of goods sold. We show in Exhibit 5B.4 how this 70% is used to estimate lost inventory of $11,500.

Step 2

Step 1 Net sales at retail

1.0 – Gross profit ratio

Estimated cost of

goods sold

Goods available for sale at cost

Estimated cost of

goods sold

Estimated ending

inventory at cost

×

=

=

EXHIBIT 5B.3 Gross Profit Method of Inventory Estimation

EXHIBIT 5B.4 Estimated Inventory Using the Gross Profit Method

Goods available for sale

Beginning inventory, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000

Cost of goods purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,500

Goods available for sale (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,500

Net sales at retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Step 1: Estimated cost of goods sold ($30,000 × 70%) . . . . . . . . . . . . . . . . . (21,000) × 0 .70 Step 2: Estimated March inventory at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,500

Using the retail method and the following data, estimate the cost of ending inventory.

Retail Inventory Estimation

NEED-TO-KNOW 5-8

Solution

Estimated ending inventory (at cost) is $327,000. It is computed as follows.

Step 1: ($530,000 + $335,000) − $320,000 = $545,000

Step 2: $324,000 + $195,000 $530,000 + $335,000

= 60%

Step 3: $545,000 × 60% = $327,000

P4

Cost Retail

Beginning inventory . . . . . . . . . . . . . . . . . $324,000 $530,000

Cost of goods purchased . . . . . . . . . . . . . 195,000 335,000

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Do More: QS 5-22, E 5-16, E 5-17, P 5-9

INVENTORY BASICS FOB shipping point: Goods are included in buyer’s inventory once they are shipped. FOB destination: Goods are included in buyer’s inventory after arrival at their destination.

Summary: Cheat Sheet

Consignee: Never reports consigned goods in inventory; stays in consign- or’s inventory until sold. Merchandise inventory: Includes any necessary costs to make an item ready for sale. Examples—shipping, storage, import fees, and insurance.

216 Chapter 5 Inventories and Cost of Sales

INVENTORY COSTING FIFO: Earliest units purchased are the first to be reported as cost of goods sold. LIFO: Latest units purchased are the first to be reported as cost of goods sold. Weighted average: The weighted average cost per unit (formula below) of inventory at the time of each sale is reported as cost of goods sold.

Cost of goods available for sale (at each sale) Number of units available for sale (at each sale)

Specific identification: Each unit is assigned a cost, and when that unit is sold, its cost is reported as cost of goods sold.

Financial Statement Effects Rising Costs—FIFO reports lowest cost of goods sold and highest net income. LIFO reports highest cost of goods sold and lowest income. Weighted average reports results in between LIFO and FIFO. Falling Costs—FIFO reports highest cost of goods sold and lowest net income. LIFO reports lowest cost of goods sold and highest income.

INVENTORY VALUATION, ERRORS, & ANALYSIS Lower of cost or market (LCM): When market value of inventory is lower than its cost, a loss is recorded. When market value is higher than cost of inventory, no adjustment is made. LCM Example (applied to individual items separately)

LCM Journal Entry: To get from $220,000 reported inventory to the $190,000 LCM inventory, make the following entry.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Merchandise Inventory . . . . . . . . . . . . . . . . . 30,000

Effects of Overstated or Understated Inventory for Income Statement

Year 1 Year 2

Ending Inventory Cost of Goods Sold Net Income Cost of Goods Sold Net Income

Understated  Overstated  Understated  Understated  Overstated 

Overstated  Understated  Overstated  Overstated  Understated 

Effects of Overstated or Understated Inventory for Balance Sheet

Ending Inventory Assets Equity

Understated . . . . Understated Understated

Overstated . . . . . Overstated Overstated

Average cost (196, 211) Consignee (191) Consignor (191) Days’ sales in inventory (203) First-in, first-out (FIFO) (195, 210)

Gross profit method (215) Interim financial statements (214) Inventory turnover (203) Last-in, first-out (LIFO) (195, 211) Lower of cost or market (LCM) (200)

Net realizable value (192) Retail inventory method (214) Specific identification (SI) (194, 210) Weighted average (WA) (196, 211)

Key Terms

Multiple Choice Quiz

Use the following information from Marvel Company for the month of July to answer questions 1 through 4.

1. Perpetual: Assume that Marvel uses a perpetual FIFO inven- tory system. What is the dollar value of its ending inventory? a. $2,940 c. $2,625 e. $2,705 b. $2,685 d. $2,852

2. Perpetual: Assume that Marvel uses a perpetual LIFO inven- tory system. What is the dollar value of its ending inventory? a. $2,940 c. $2,625 e. $2,705 b. $2,685 d. $2,852

July 1 Beginning inventory . . . . . . . . . . . . 75 units @ $25 each

July 3 Purchase . . . . . . . . . . . . . . . . . . . . . 348 units @ $27 each

July 8 Sale . . . . . . . . . . . . . . . . . . . . . . . . . 300 units

July 15 Purchase . . . . . . . . . . . . . . . . . . . . . 257 units @ $28 each

July 23 Sale . . . . . . . . . . . . . . . . . . . . . . . . . 275 units

$180 3

= $60 each

2. Last-in, first-out (LIFO) Costs flow in the reverse

order incurred.

3. Weighted average Costs flow at an average

of costs available.

1. First-in, first-out (FIFO) Costs flow in the order

incurred.

× 2× 1

Income Statement Net sales.................... $100 Cost of goods sold.. 45 Gross profit................ $ 55

Balance Sheet Inventory.................... $135

Income Statement Net sales.................... $100 Cost of goods sold.. 70 Gross profit................ $ 30

Balance Sheet Inventory.................... $1 10

Income Statement Net sales.................... $100 Cost of goods sold.. 60 Gross profit................ $ 40

Balance Sheet Inventory..................... $120

$65 May 3

$45 May 1 G

o o d s

s o l d

G o o d s

s o l d

G o o d s

s o l d

G o o d s

l e f t

G o o d s

l e f t

G o o d s

l e f t

$70 May 6

$65 May 3

$45 May 1

$70 May 6

$70 May 6

$65 May 3

$45 May 1

Cost Flow Assumptions Example

Per Unit Inventory Total Total LCM Applied Items Units Cost Market Cost Market to Items

Roadster 20 $8,500 $7,000 $170,000 $140,000 $  140,000

Sprint 10 5,000 6,000 50,000 60,000 50,000

Totals $220,000 $190,000

Roadster: $140,000 is the lower of the $170,000 cost and $140,000 market. Sprint: $50,000 is the lower of the $50,000 cost and $60,000 market. LCM: Results in a $190,000 reported inventory.

Chapter 5 Inventories and Cost of Sales 217

3. Perpetual and Periodic: Assume that Marvel uses a spe- cific identification inventory system. Its ending inventory consists of 20 units from beginning inventory, 40 units from the July 3 purchase, and 45 units from the July 15 purchase. What is the dollar value of its ending inventory? a. $2,940 c. $2,625 e. $2,840 b. $2,685 d. $2,852

4.A Periodic: Assume that Marvel uses a periodic FIFO inven- tory system. What is the dollar value of its ending inventory? a. $2,940 c. $2,625 e. $2,705 b. $2,685 d. $2,852

5.A Periodic: A company reports the following beginning in- ventory and purchases, and it ends the period with 30 units in inventory.

i) Compute ending inventory using the FIFO periodic system.

a. $400 b. $1,460 c. $1,360 d. $300 ii) Compute cost of goods sold using the LIFO periodic

system. a. $400 b. $1,460 c. $1,360 d. $300 6. A company has cost of goods sold of $85,000 and ending

inventory of $18,000. Its days’ sales in inventory equals a. 49.32 days. c. 4.72 days. e. 1,723.61 days. b. 0.21 day. d. 77.29 days.

Beginning inventory . . . . . . . . . 100 units at $10 cost per unit Purchase 1 . . . . . . . . . . . . . . . . 40 units at $12 cost per unit Purchase 2 . . . . . . . . . . . . . . . . 20 units at $14 cost per unit

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a; FIFO perpetual

2. b; LIFO perpetual

3. e; Specific identification (perpetual and periodic are identical for specific identification)—Ending inventory computation follows.

4. a; FIFO periodic. Ending inventory computation: 105 units @ $28 each = $2,940. (Hint: FIFO periodic inventory computation is identical to the FIFO perpetual inventory computation.)

5. i) a; FIFO periodic inventory = (20 × $14) + (10 × $12) = $400 ii) b; LIFO periodic cost of goods sold = (20 × $14) + (40 × $12)

+ (70 × $10) = $1,460 6. d; Days’ sales in inventory = (Ending inventory/Cost of goods sold)

× 365 = ($18,000∕$85,000) × 365 = 77.29 days

Date Goods Purchased Cost of Goods Sold Inventory Balance

July 1 75 units @ $25 = $ 1,875 July 3 348 units @ $27 = $9,396 75 units @ $25 348 units @ $27

= $11,271

July 8 75 units @ $25 123 units @ $27 = $ 3,321 225 units @ $27

= $ 7,950

July 15 257 units @ $28 = $7,196 123 units @ $27 257 units @ $28

= $10,517

July 23 123 units @ $27 105 units @ $28 = $ 2,940 152 units @ $28

= $ 7,577

$15,527

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎪ ⎨ ⎪ ⎩

Date Goods Purchased Cost of Goods Sold Inventory Balance

July 1 75 units @ $25 = $ 1,875 July 3 348 units @ $27 = $9,396 75 units @ $25 348 units @ $27

= $ 11,271

July 8 300 units @ $27 = $ 8,100 75 units @ $25 48 units @ $27

= $ 3,171

July 15 257 units @ $28 = $7,196 75 units @ $25 48 units @ $27

257 units @ $28 = $10,367

July 23 257 units @ $28 75 units @ $25

18 units @ $27 = $ 7,682

30 units @ $27 = $ 2,685

$15,782

⎧ ⎨ ⎩

⎧ ⎨ ⎩

⎧ ⎨ ⎩

20 units @ $25 $ 500

40 units @ $27 1,080

45 units @ $28 1,260

105 units $2,840

218 Chapter 5 Inventories and Cost of Sales

A(B) Superscript letter A or B denotes assignments based on Appendix 5A or 5B.

Icon denotes assignments that involve decision making.

1. Describe how costs flow from inventory to cost of goods sold for the following methods: (a) FIFO and (b) LIFO.

2. Where is the amount of merchandise inventory disclosed in the financial statements?

3. If costs are declining, will the LIFO or FIFO method of inventory valuation yield the lower cost of goods sold? Why?

4. If inventory errors are said to correct themselves, why are accounting users concerned when such errors are made?

5. Explain the following statement: “Inventory errors correct themselves.”

6. What is the meaning of market as it is used in determining the lower of cost or market for inventory?

7. What factors contribute to (or cause) inventory shrinkage?

8.B When preparing interim financial statements, what two methods can companies utilize to estimate cost of goods sold and ending inventory?

9. Refer to Apple’s financial statements in Appendix A. On September 30, 2017, what percent of current assets is represented by inventory?

10. Refer to Apple’s financial statements in Appendix A and compute its cost of goods available for sale for the year ended September 30, 2017.

11. Refer to Samsung’s financial statements in Appendix A. Compute its cost of goods available for sale for the year ended December 31, 2017.

12. Refer to Samsung’s financial statements in Appendix A. What percent of its cur- rent assets is inventory as of December 31, 2017 and 2016?

Discussion Questions

APPLE

APPLE

Samsung

Samsung

QUICK STUDY

QS 5-1 Inventory ownership

C1

Homestead Crafts, a distributor of handmade gifts, operates out of owner Emma Finn’s house. At the end of the current period, Emma looks over her inventory and finds that she has

∙ 1,300 units (products) in her basement, 20 of which were damaged by water and cannot be sold. ∙ 350 units in her van, ready to deliver per a customer order, terms FOB destination. ∙ 80 units out on consignment to a friend who owns a retail store.

How many units should Emma include in her company’s period-end inventory?

A car dealer acquires a used car for $14,000, with terms FOB shipping point. Compute total inventory costs assigned to the used car if additional costs include

∙ $250 for transportation-in. ∙ $150 for advertising. ∙ $300 for shipping insurance. ∙ $1,250 for sales staff salaries. ∙ $900 for car import duties. ∙ $180 for trimming shrubs.

QS 5-2 Inventory costs

C2

Wattan Company reports beginning inventory of 10 units at $60 each. Every week for four weeks it pur- chases an additional 10 units at respective costs of $61, $62, $65, and $70 per unit for weeks 1 through 4. Compute the cost of goods available for sale and the units available for sale for this four-week period. Assume that no sales occur during those four weeks.

QS 5-3 Computing goods available for sale P1

A company reports the following beginning inventory and two purchases for the month of January. On January 26, the company sells 350 units. Ending inventory at January 31 totals 150 units.

QS 5-4 Perpetual: Inventory costing with FIFO

P1 Units Unit Cost

Beginning inventory on January 1 . . . . . . . . . . . . . 320 $3 .00

Purchase on January 9 . . . . . . . . . . . . . . . . . . . . . . 80 3 .20

Purchase on January 25 . . . . . . . . . . . . . . . . . . . . . 100 3 .34

Required

Assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

Chapter 5 Inventories and Cost of Sales 219

Refer to the information in QS 5-4 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on LIFO. (Round per unit costs and inventory amounts to cents.)

QS 5-5 Perpetual: Inventory costing with LIFO P1

Refer to the information in QS 5-10 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the LIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-11 Perpetual: Inventory costing with LIFO P1

Refer to the information in QS 5-4 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

QS 5-6 Perpetual: Inventory costing with weighted average P1

Refer to the information in QS 5-4 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

QS 5-9A Periodic: Inventory costing with weighted average P3

Refer to the information in QS 5-4 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-7A Periodic: Inventory costing with FIFO P3

Refer to the information in QS 5-4 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the LIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-8A Periodic: Inventory costing with LIFO P3

Trey Monson starts a merchandising business on December 1 and enters into the following three inventory purchases. Also, on December 15, Monson sells 15 units for $20 each.

QS 5-10 Perpetual: Assigning costs with FIFO

P1Purchases on December 7 . . . . . . 10 units @ $ 6 .00 cost Purchases on December 14 . . . . . 20 units @ $12 .00 cost

Purchases on December 21 . . . . . 15 units @ $14 .00 cost

Required

Monson uses a perpetual inventory system. Determine the costs assigned to the December 31 ending in- ventory based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

Refer to the information in QS 5-10 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

QS 5-12 Perpetual: Inventory costing with weighted average P1

Refer to the information in QS 5-10 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on specific identification. Of the units sold, eight are from the December 7 purchase and seven are from the December 14 purchase. (Round per unit costs and inventory amounts to cents.)

QS 5-13 Perpetual: Inventory costing with specific identification P1

Refer to the information in QS 5-10 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-14A Periodic: Inventory costing with FIFO P3

Refer to the information in QS 5-10 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the LIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-15A Periodic: Inventory costing with LIFO P3

220 Chapter 5 Inventories and Cost of Sales

Refer to the information in QS 5-10 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

QS 5-16A Periodic: Inventory costing with weighted average P3

Refer to the information in QS 5-10 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on specific identification. Of the units sold, eight are from the December 7 purchase and seven are from the December 14 purchase. (Round per unit costs and inventory amounts to cents.)

QS 5-17A Periodic: Inventory costing with specific identification P3

Endor Company begins the year with $140,000 of goods in inventory. At year-end, the amount in inven- tory has increased to $180,000. Cost of goods sold for the year is $1,200,000. Compute Endor’s inventory turnover and days’ sales in inventory. Assume there are 365 days in the year.

QS 5-21 Analyzing inventory A3

Ames Trading Co. has the following products in its ending inventory. Compute lower of cost or market for inventory applied separately to each product.

QS 5-19 Applying LCM to inventories

P2 Product Quantity Cost per Unit Market per Unit

Mountain bikes . . . . . . . . . . . 11 $600 $550

Skateboards . . . . . . . . . . . . . 13 350 425

Gliders . . . . . . . . . . . . . . . . . . 26 800 700

Identify the inventory costing method (SI, FIFO, LIFO, or WA) best described by each of the following separate statements. Assume a period of increasing costs.

1. Results in the highest cost of goods sold. 2. Yields the highest net income. 3. Has the lowest tax expense because of reporting the lowest net income. 4. Better matches current costs with revenues. 5. Precisely matches the costs of items with the revenues they generate.

QS 5-18 Contrasting inventory costing methods

A1

In taking a physical inventory at the end of Year 1, Grant Company forgot to count certain units and un- derstated ending inventory by $10,000. Determine how this error affects each of the following. a. Year 1 cost of goods sold c. Year 2 cost of goods sold b. Year 1 net income d. Year 2 net income

QS 5-20 Inventory errors

A2

Confucius Bookstore’s inventory is destroyed by a fire on September 5. The following data for the current year are available from the accounting records. Estimate the cost of the inventory destroyed.

QS 5-22B Estimating inventories— gross profit method

P4 Beginning inventory, Jan . 1 . . . . . . . . . . . . . . . . . . . . . . $190,000 Jan . 1 through Sept . 5 purchases (net) . . . . . . . . . . . . . $352,000

Jan . 1 through Sept . 5 sales (net) . . . . . . . . . . . . . . . . . $685,000

Current year’s estimated gross profit rate . . . . . . . . . . 44%

A solar panel dealer acquires a used panel for $9,000, with terms FOB shipping point. Compute total in- ventory costs assigned to the used panel if additional costs include

∙ $1,500 for sales staff salaries. ∙ $135 for shipping insurance. ∙ $280 for transportation-in by train. ∙ $550 for used panel restoration. ∙ $110 for online advertising. ∙ $300 for lawn care.

QS 5-23 Inventory costs

C2

EXERCISES

Exercise 5-1 Inventory ownership C1

1. At year-end, Barr Co. had shipped $12,500 of merchandise FOB destination to Lee Co. Which com- pany should include the $12,500 of merchandise in transit as part of its year-end inventory?

2. Parris Company has shipped $20,000 of goods to Harlow Co., and Harlow Co. has arranged to sell the goods for Parris. Identify the consignor and the consignee. Which company should include any unsold goods as part of its inventory?

Chapter 5 Inventories and Cost of Sales 221

Walberg Associates, antique dealers, purchased goods for $75,000. Terms of the purchase were FOB ship- ping point, and the cost of transporting the goods to Walberg Associates’s warehouse was $2,400. Walberg Associates insured the shipment at a cost of $300. Prior to putting the goods up for sale, they cleaned and refurbished them at a cost of $980. Determine the cost of inventory.

Exercise 5-2 Inventory costs

C2

Laker Company reported the following January purchases and sales data for its only product. Exercise 5-3 Perpetual: Inventory costing methods

P1 Date Activities Units Acquired at Cost Units Sold at Retail

Jan . 1 Beginning inventory . . . . . . . . . . . . 140 units @ $6 .00 = $ 840 Jan . 10 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 100 units @ $15

Jan . 20 Purchase . . . . . . . . . . . . . . . . . . . . . 60 units @ $5 .00 = 300 Jan . 25 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 80 units @ $15

Jan . 30 Purchase . . . . . . . . . . . . . . . . . . . . . 180 units @ $4 .50 = 810 Totals . . . . . . . . . . . . . . . . . . . . . . . . 380 units $1,950 180 units

Required

The company uses a perpetual inventory system. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d) LIFO. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 200 units, where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning inventory.

Check Ending inventory: LIFO, $930; WA, $918

Use the data in Exercise 5-3 to prepare comparative income statements for the month of January for Laker Company similar to those shown in Exhibit 5.8 for the four inventory methods. Assume expenses are $1,250 and the applicable income tax rate is 40%. (Round amounts to cents.) 1. Which method yields the highest net income? 2. Does net income using weighted average fall above, between, or below that using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest net income?

Exercise 5-4 Perpetual: Income effects of inventory methods

A1

Refer to the information in Exercise 5-3 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d) LIFO. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 200 units, where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning inventory.

Exercise 5-5A Periodic: Inventory costing

P3

Use the data and results from Exercise 5-5 to prepare comparative income statements for the month of January for the company similar to those shown in Exhibit 5.8 for the four inventory methods. Assume expenses are $1,250 and the applicable income tax rate is 40%. (Round amounts to cents.)

Required

1. Which method yields the highest net income? 2. Does net income using weighted average fall above, between, or below that using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest net income?

Exercise 5-6A Periodic: Income effects of inventory methods

P3 A1

Hemming Co. reported the following current-year purchases and sales for its only product. Exercise 5-7 Perpetual: Inventory costing methods—FIFO and LIFO

P1

Date Activities Units Acquired at Cost Units Sold at Retail

Jan . 1 Beginning inventory . . . . . . . . . . . . 200 units @ $10 = $ 2,000 Jan . 10 Sales . . . . . . . . . . . . . . . . . . . . . . . . 150 units @ $40

Mar . 14 Purchase . . . . . . . . . . . . . . . . . . . . 350 units @ $15 = 5,250 Mar . 15 Sales . . . . . . . . . . . . . . . . . . . . . . . . 300 units @ $40

July 30 Purchase . . . . . . . . . . . . . . . . . . . . 450 units @ $20 = 9,000 Oct . 5 Sales . . . . . . . . . . . . . . . . . . . . . . . . 430 units @ $40

Oct . 26 Purchase . . . . . . . . . . . . . . . . . . . . 100 units @ $25 = 2,500 Totals . . . . . . . . . . . . . . . . . . . . . . . 1,100 units $18,750 880 units

222 Chapter 5 Inventories and Cost of Sales

Required

Hemming uses a perpetual inventory system. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. (c) Compute the gross margin for each method. (Round amounts to cents.)

Check Ending inventory: LIFO, $4,150

Refer to the information in Exercise 5-7. Ending inventory consists of 45 units from the March 14 purchase, 75 units from the July 30 purchase, and all 100 units from the October 26 purchase. Using the specific iden- tification method, compute (a) the cost of goods sold and (b) the gross profit. (Round amounts to cents.)

Exercise 5-8 Specific identification P1

Refer to the information in Exercise 5-7 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. (c) Compute the gross margin for each method.

Exercise 5-9A Periodic: Inventory costing P3

Martinez Company’s ending inventory includes the following items. Compute the lower of cost or market for ending inventory applied separately to each product.

Exercise 5-10 Lower of cost or market

P2 Product Units Cost per Unit Market per Unit

Helmets . . . . . . . . . . 24 $50 $54

Bats . . . . . . . . . . . . . 17 78 72

Shoes . . . . . . . . . . . . 38 95 91

Uniforms . . . . . . . . . 42 36 36 Check LCM = $7,394

Vibrant Company had $850,000 of sales in each of Year 1, Year 2, and Year 3, and it purchased merchan- dise costing $500,000 in each of those years. It also maintained a $250,000 physical inventory from the beginning to the end of that three-year period. In accounting for inventory, it made an error at the end of Year 1 that caused its Year 1 ending inventory to appear on its statements as $230,000 rather than the correct $250,000. 1. Determine the correct amount of the company’s gross profit in each of Year 1, Year 2, and Year 3. 2. Prepare comparative income statements as in Exhibit 5.11 to show the effect of this error on the com-

pany’s cost of goods sold and gross profit for each of Year 1, Year 2, and Year 3.

Exercise 5-12 Analyzing inventory errors

A2

Cruz Company uses LIFO for inventory costing and reports the following financial data. It also recom- puted inventory and cost of goods sold using FIFO for comparison purposes.

Exercise 5-11 Comparing LIFO numbers to FIFO numbers; ratio analysis

A1 A3 Year 2 Year 1

LIFO inventory . . . . . . . . . . . . . . . . . . . . . . . . $160 $110

LIFO cost of goods sold . . . . . . . . . . . . . . . . 740 680

FIFO inventory . . . . . . . . . . . . . . . . . . . . . . . . 240 110

FIFO cost of goods sold . . . . . . . . . . . . . . . . 660 645

Current assets (using LIFO) . . . . . . . . . . . . . 220 180

Current assets (using FIFO) . . . . . . . . . . . . . . 300 180

Current liabilities . . . . . . . . . . . . . . . . . . . . . . 200 170

1. Compute its current ratio, inventory turnover, and days’ sales in inventory for Year 2 using (a) LIFO numbers and (b) FIFO numbers. (Round answers to one decimal.)

2. Comment on and interpret the results of part 1.

Check (1) FIFO: Current ratio, 1.5; Inventory turnover, 3.8 times

Use the following information for Palmer Co. to compute inventory turnover for Year 3 and Year 2, and its days’ sales in inventory at December 31, Year 3 and Year 2. (Round answers to one decimal.) Comment on Palmer’s efficiency in using its assets to increase sales from Year 2 to Year 3.

Exercise 5-13 Inventory turnover and days’ sales in inventory

A3 Year 3 Year 2 Year 1

Cost of goods sold . . . . . . . . . . . . $643,825 $426,650 $391,300

Ending inventory . . . . . . . . . . . . . . 97,400 87,750 92,500

Chapter 5 Inventories and Cost of Sales 223

Lopez Company reported the following current-year data for its only product. The company uses a peri- odic inventory system, and its ending inventory consists of 150 units—50 from each of the last three pur- chases. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d) LIFO. (Round per unit costs and inventory amounts to cents.) (e) Which method yields the highest net income?

Exercise 5-14A Periodic: Cost flow assumptions

P3

Jan . 1 Beginning inventory . . . . . . . . . . . 96 units @ $2 .00 = $ 192 Mar . 7 Purchase . . . . . . . . . . . . . . . . . . . . 220 units @ $2 .25 = 495 July 28 Purchase . . . . . . . . . . . . . . . . . . . . 544 units @ $2 .50 = 1,360 Oct . 3 Purchase . . . . . . . . . . . . . . . . . . . . 480 units @ $2 .80 = 1,344 Dec . 19 Purchase . . . . . . . . . . . . . . . . . . . . 160 units @ $2 .90 = 464 Totals . . . . . . . . . . . . . . . . . . . . . . . 1,500 units $3,855 Check Inventory; LIFO,

$313.50; FIFO, $435.00

Flora’s Gifts reported the following current-month data for its only product. The company uses a periodic inventory system, and its ending inventory consists of 60 units—50 units from the January 6 purchase and 10 units from the January 25 purchase. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d) LIFO. (Round per unit costs and inventory amounts to cents.) (e) Which method yields the lowest net income?

Exercise 5-15A Periodic: Cost flow assumptions

P3

Jan . 1 Beginning inventory . . . . . . . . . . . 138 units @ $3 .00 = $ 414 Jan . 6 Purchase . . . . . . . . . . . . . . . . . . . . 300 units @ $2 .80 = 840 Jan . 17 Purchase . . . . . . . . . . . . . . . . . . . . 540 units @ $2 .30 = 1,242 Jan . 25 Purchase . . . . . . . . . . . . . . . . . . . . 22 units @ $2 .00 = 44 Totals . . . . . . . . . . . . . . . . . . . . . . . 1,000 units $2,540 Check Inventory: LIFO,

$180.00; FIFO, $131.40

Dakota Company had net sales (at retail) of $260,000. The following additional information is available from its records. Use the retail inventory method to estimate Dakota’s year-end inventory at cost.

Exercise 5-16B Estimating ending inventory—retail method

P4 At Cost At Retail

Beginning inventory . . . . . . . . . . . . . . . . $ 63,800 $128,400

Cost of goods purchased . . . . . . . . . . . . 115,060 196,800 Check End. inventory at cost, $35,860

On January 1, JKR Shop had $225,000 of beginning inventory at cost. In the first quarter of the year, it purchased $795,000 of merchandise, returned $11,550, and paid freight charges of $18,800 on purchased merchandise, terms FOB shipping point. The company’s gross profit averages 30%, and the store had $1,000,000 of net sales (at retail) in the first quarter of the year.

Use the gross profit method to estimate its cost of inventory at the end of the first quarter.

Exercise 5-17B Estimating ending inventory—gross profit method P4

Required

The company uses a perpetual inventory system. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. (c) Compute the gross margin for each method.

Tree Seedlings has the following current-year purchases and sales for its only product. Exercise 5-18 Perpetual inventory costing

P1Date Activities Units Acquired at Cost Units Sold at Retail

Jan . 1 Beginning inventory . . . . . . . . . . . 40 units @ $2 = $ 80 Jan . 3 Sales . . . . . . . . . . . . . . . . . . . . . . . 30 units @ $8

Feb . 14 Purchase . . . . . . . . . . . . . . . . . . . . 70 units @ $3 = $210 Feb . 15 Sales . . . . . . . . . . . . . . . . . . . . . . . 60 units @ $8

June 30 Purchase . . . . . . . . . . . . . . . . . . . . 90 units @ $4 = $360 Nov . 6 Sales . . . . . . . . . . . . . . . . . . . . . . . 86 units @ $8

Nov . 19 Purchase . . . . . . . . . . . . . . . . . . . . 20 units @ $5 = $100 Totals . . . . . . . . . . . . . . . . . . . . . . 220 units $750 176 units

224 Chapter 5 Inventories and Cost of Sales

Refer to the information in Exercise 5-18 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. (c) Compute the gross margin for each method.

Exercise 5-19A Periodic inventory costing

P3

PROBLEM SET A

Problem 5-1A Perpetual: Alternative cost flows

P1

Warnerwoods Company uses a perpetual inventory system. It entered into the following purchases and sales transactions for March. (For specific identification, the March 9 sale consisted of 80 units from beginning inventory and 340 units from the March 5 purchase; the March 29 sale consisted of 40 units from the March 18 purchase and 120 units from the March 25 purchase.)

Date Activities Units Acquired at Cost Units Sold at Retail

Mar . 1 Beginning inventory . . . . . . . . . . . . . 100 units @ $50 .00 per unit

Mar . 5 Purchase . . . . . . . . . . . . . . . . . . . . . . 400 units @ $55 .00 per unit

Mar . 9 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 420 units @ $85 .00 per unit

Mar . 18 Purchase . . . . . . . . . . . . . . . . . . . . . . 120 units @ $60 .00 per unit

Mar . 25 Purchase . . . . . . . . . . . . . . . . . . . . . . 200 units @ $62 .00 per unit

Mar . 29 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 160 units @ $95 .00 per unit

Totals . . . . . . . . . . . . . . . . . . . . . . . . . 820 units 580 units

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Check (3) Ending inventory: FIFO, $14,800; LIFO, $13,680; WA, $14,352 (4) LIFO gross profit, $17,980

Refer to the information in Problem 5-1A and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Problem 5-2AA Periodic: Alternative cost flows

P3

Montoure Company uses a perpetual inventory system. It entered into the following calendar-year pur- chases and sales transactions. (For specific identification, units sold consist of 600 units from beginning inventory, 300 from the February 10 purchase, 200 from the March 13 purchase, 50 from the August 21 purchase, and 250 from the September 5 purchase.)

Problem 5-3A Perpetual: Alternative cost flows

P1

Date Activities Units Acquired at Cost Units Sold at Retail

Jan . 1 Beginning inventory . . . . . . . . . . . . . 600 units @ $45 .00 per unit

Feb . 10 Purchase . . . . . . . . . . . . . . . . . . . . . . 400 units @ $42 .00 per unit

Mar . 13 Purchase . . . . . . . . . . . . . . . . . . . . . . 200 units @ $27 .00 per unit

Mar . 15 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 800 units @ $75 .00 per unit

Aug . 21 Purchase . . . . . . . . . . . . . . . . . . . . . . 100 units @ $50 .00 per unit

Sep . 5 Purchase . . . . . . . . . . . . . . . . . . . . . . 500 units @ $46 .00 per unit

Sep . 10 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 600 units @ $75 .00 per unit

Totals . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 units 1,400 units

Chapter 5 Inventories and Cost of Sales 225

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. The company’s manager earns a bonus based on a percent of gross profit. Which method of inventory costing produces the highest bonus for the manager?

Check (3) Ending inventory: FIFO, $18,400; LIFO, $18,000; WA, $17,760 (4) LIFO gross profit, $45,800

Refer to the information in Problem 5-3A and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. The company’s manager earns a bonus based on a percentage of gross profit. Which method of inven- tory costing produces the highest bonus for the manager?

Problem 5-4AA Periodic: Alternative cost flows

P3

A physical inventory of Liverpool Company taken at December 31 reveals the following. Problem 5-5A Lower of cost or market

P2 Car audio equipment

Security equipment

Binocular equipment

Speakers Stereos Amplifiers Subwoofers

Alarms

Locks Cameras

Stabilizers Tripods

Units Cost per UnitItem Market per Unit

345 260 326 204

480

291 212

185 170

$ 90 1 1 1 86 52

150

93 310

70 97

$ 98 100 95 41

125

84 322

84 105

Required

1. Compute the lower of cost or market for the inventory applied separately to each item. 2. If the market amount is less than the recorded cost of the inventory, then record the LCM adjustment

to the Merchandise Inventory account.

Check (1) $273,054

Navajo Company’s financial statements show the following. The company recently discovered that in making physical counts of inventory, it had made the following errors: Year 1 ending inventory is under- stated by $56,000 and Year 2 ending inventory is overstated by $20,000.

Problem 5-6A Analysis of inventory errors

A2

For Year Ended December 31 Year 1 Year 2 Year 3

(a) Cost of goods sold . . . . . . . . . . . . . . . . . . . $ 615,000 $ 957,000 $ 780,000

(b) Net income . . . . . . . . . . . . . . . . . . . . . . . . . 230,000 285,000 241,000

(c) Total current assets . . . . . . . . . . . . . . . . . . 1,255,000 1,365,000 1,200,000

(d) Total equity . . . . . . . . . . . . . . . . . . . . . . . . . 1,387,000 1,530,000 1,242,000

226 Chapter 5 Inventories and Cost of Sales

2. What is the total error in combined net income for the three-year period resulting from the inventory errors? Explain.

Required

1. For each key financial statement figure—(a), (b), (c), and (d) above—prepare a table similar to the following to show the adjustments necessary to correct the reported amounts.

Figure: Year 1 Year 2 Year 3

Reported amount . . . . . . . . . . . . . . . . . . . . . . . . .

Adjustments for: Year 1 error . . . . . . . . . . . . . . . . . .

Year 2 error . . . . . . . . . . . . . . . . . .

Corrected amount . . . . . . . . . . . . . . . . . . . . . . . . .

Check (1) Corrected net income: Year 1, $286,000; Year 2, $209,000; Year 3, $261,000

Seminole Co. began the year with 23,000 units of product in its January 1 inventory costing $15 each. It made four purchases of its product during the year as follows. The company uses a periodic inventory system. On December 31, a physical count reveals that 40,000 units of its product remain in inventory.

Problem 5-7AA Periodic: Alternative cost flows P3

Mar . 7 . . . . . . . . . . . 30,000 units @ $18 .00 each

May 25 . . . . . . . . . . . 39,000 units @ $20 .00 each

Aug . 1 . . . . . . . . . . . 23,000 units @ $25 .00 each

Nov . 10 . . . . . . . . . . . 35,000 units @ $26 .00 each

Required

1. Compute the number and total cost of the units available for sale during the year. 2. Compute the amounts assigned to ending inventory and the cost of goods sold using (a) FIFO,

(b) LIFO, and (c) weighted average. (Round all amounts to cents.)

Check (2) Cost of goods sold: FIFO, $2,115,000; LIFO, $2,499,000; WA, $2,310,000

QP Corp. sold 4,000 units of its product at $50 per unit during the year and incurred operating expenses of $5 per unit in selling the units. It began the year with 700 units in inventory and made successive pur- chases of its product as follows.

Problem 5-8AA Periodic: Income comparisons and cost flows

A1 P3 Jan . 1 Beginning inventory . . . . . . . . . . . . 700 units @ $18 .00 per unit

Feb . 20 Purchase . . . . . . . . . . . . . . . . . . . . 1,700 units @ $19 .00 per unit

May 16 Purchase . . . . . . . . . . . . . . . . . . . . 800 units @ $20 .00 per unit

Oct . 3 Purchase . . . . . . . . . . . . . . . . . . . . 500 units @ $21 .00 per unit

Dec . 11 Purchase . . . . . . . . . . . . . . . . . . . . 2,300 units @ $22 .00 per unit

Total . . . . . . . . . . . . . . . . . . . . . . . . 6,000 units

Required

1. Prepare comparative income statements similar to Exhibit 5.8 for the three inventory costing methods of FIFO, LIFO, and weighted average. (Round all amounts to cents.) Include a detailed cost of goods sold section as part of each statement. The company uses a periodic inventory system, and its income tax rate is 40%.

2. How would the financial results from using the three alternative inventory costing methods change if the company had been experiencing declining costs in its purchases of inventory?

3. What advantages and disadvantages are offered by using (a) LIFO and (b) FIFO? Assume the continu- ing trend of increasing costs.

Check (1) Net income: FIFO, $61,200; LIFO, $57,180; WA, $59,196

The records of Alaska Company provide the following information for the year ended December 31.Problem 5-9AB Retail inventory method

P4 At Cost At Retail

Beginning inventory, January 1 . . . . . . . . . . . $ 469,010 $ 928,950

Cost of goods purchased . . . . . . . . . . . . . . . . 3,376,050 6,381,050

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,595,800

Sales returns . . . . . . . . . . . . . . . . . . . . . . . . . . 42,800

Required

1. Use the retail inventory method to estimate the company’s year-end inventory at cost. 2. A year-end physical inventory at retail prices yields a total inventory of $1,686,900. Prepare a calcula-

tion showing the company’s loss from shrinkage at cost and at retail.

Check (1) Inventory, $924,182 cost (2) Inventory shortage at cost, $36,873

Chapter 5 Inventories and Cost of Sales 227

Wayward Company wants to prepare interim financial statements for the first quarter. The company wishes to avoid making a physical count of inventory. Wayward’s gross profit rate averages 34%. The fol- lowing information for the first quarter is available from its records.

Problem 5-10AB Gross profit method P4

Beginning inventory, January 1 . . . . . . . . . . . $ 302,580

Cost of goods purchased . . . . . . . . . . . . . . . . 941,040

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,211,160

Sales returns . . . . . . . . . . . . . . . . . . . . . . . . . . 8,410

Required

Use the gross profit method to estimate the company’s first-quarter ending inventory. Check Estimated ending inventory, $449,805

PROBLEM SET B

Problem 5-1B Perpetual: Alternative cost flows

P1

Ming Company uses a perpetual inventory system. It entered into the following purchases and sales trans- actions for April. (For specific identification, the April 9 sale consisted of 8 units from beginning inven- tory and 27 units from the April 6 purchase; the April 30 sale consisted of 12 units from beginning inventory, 3 units from the April 6 purchase, and 10 units from the April 25 purchase.)

Date Activities Units Acquired at Cost Units Sold at Retail

Apr . 1 Beginning inventory . . . . . . . . . . . . . 20 units @ $3,000 .00 per unit

Apr . 6 Purchase . . . . . . . . . . . . . . . . . . . . . . 30 units @ $3,500 .00 per unit

Apr . 9 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 35 units @ $12,000 .00 per unit

Apr . 17 Purchase . . . . . . . . . . . . . . . . . . . . . . 5 units @ $4,500 .00 per unit

Apr . 25 Purchase . . . . . . . . . . . . . . . . . . . . . . 10 units @ $4,800 .00 per unit

Apr . 30 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 25 units @ $14,000 .00 per unit

Total . . . . . . . . . . . . . . . . . . . . . . . . . . 65 units 60 units

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Check (3) Ending inventory: FIFO, $24,000; LIFO, $15,000; WA, $20,000 (4) LIFO gross profit, $549,500

Refer to the information in Problem 5-1B and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Problem 5-2BA Periodic: Alternative cost flows

P3

Aloha Company uses a perpetual inventory system. It entered into the following calendar-year purchases and sales transactions. (For specific identification, the May 9 sale consisted of 80 units from beginning inventory and 100 units from the May 6 purchase; the May 30 sale consisted of 200 units from the May 6 purchase and 100 units from the May 25 purchase.)

Problem 5-3B Perpetual: Alternative cost flows

P1

Date Activities Units Acquired at Cost Units Sold at Retail

May 1 Beginning inventory . . . . . . . . . . . . . 150 units @ $300 .00 per unit

May 6 Purchase . . . . . . . . . . . . . . . . . . . . . . 350 units @ $350 .00 per unit

May 9 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 180 units @ $1,200 .00 per unit

May 17 Purchase . . . . . . . . . . . . . . . . . . . . . . 80 units @ $450 .00 per unit

May 25 Purchase . . . . . . . . . . . . . . . . . . . . . . 100 units @ $458 .00 per unit

May 30 Sales . . . . . . . . . . . . . . . . . . . . . . . . . 300 units @ $1,400 .00 per unit

Total . . . . . . . . . . . . . . . . . . . . . . . . . . 680 units 480 units

228 Chapter 5 Inventories and Cost of Sales

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. If the company’s manager earns a bonus based on a percent of gross profit, which method of inventory costing will the manager likely prefer?

Check (3) Ending inventory: FIFO, $88,800; LIFO, $62,500; WA, $75,600 (4) LIFO gross profit, $449,200

Refer to the information in Problem 5-3B and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. If the company’s manager earns a bonus based on a percentage of gross profit, which method of inven- tory costing will the manager likely prefer?

Problem 5-4BA Periodic: Alternative cost flows

P3

A physical inventory of Office Necessities Company taken at December 31 reveals the following.Problem 5-5B Lower of cost or market

P2

Required

1. Compute the lower of cost or market for the inventory applied separately to each item. 2. If the market amount is less than the recorded cost of the inventory, then record the LCM adjustment

to the Merchandise Inventory account.

Check (1) $580,054

O�ce furniture

Filing cabinets

O�ce equipment

Desks Chairs Mats Bookshelves

Two-drawer Four-drawer Lateral

Copiers Projectors

Phones

536 395 687 421

1 14 298

75

370 475

$261 227

49 93

81 135 104

168 317

$305 256

43 82

70 122 118

200 288

302 125 1 17

Units Cost per UnitItem Market per Unit

For Year Ended December 31 Year 1 Year 2 Year 3

(a) Cost of goods sold . . . . . . . . . . . . . . . . . . . . $207,200 $213,800 $197,030

(b) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 175,800 212,270 184,910

(c) Total current assets . . . . . . . . . . . . . . . . . . . . 276,000 277,500 272,950

(d) Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . 314,000 315,000 346,000

Hallam Company’s financial statements show the following. The company recently discovered that in making physical counts of inventory, it had made the following errors: Year 1 ending inventory is over- stated by $18,000 and Year 2 ending inventory is understated by $26,000.

Problem 5-6B Analysis of inventory errors

A2

Chapter 5 Inventories and Cost of Sales 229

2. What is the total error in combined net income for the three-year period resulting from the inventory errors? Explain.

Required

1. For each key financial statement figure—(a), (b), (c), and (d) above—prepare a table similar to the following to show the adjustments necessary to correct the reported amounts.

Figure: Year 1 Year 2 Year 3

Reported amount . . . . . . . . . . . . . . . . . . . . . . . . .

Adjustments for: Year 1 error . . . . . . . . . . . . . . . . . .

Year 2 error . . . . . . . . . . . . . . . . . .

Corrected amount . . . . . . . . . . . . . . . . . . . . . . . . .

Check (1) Corrected net income: Year 1, $157,800; Year 2, $256,270; Year 3, $158,910

Seneca Co. began the year with 6,500 units of product in its January 1 inventory costing $35 each. It made four purchases of its product during the year as follows. The company uses a periodic inventory system. On December 31, a physical count reveals that 8,500 units of its product remain in inventory.

Problem 5-7BA Periodic: Alternative cost flows

P3 July 9 . . . . . . . . . . . . 11,000 units @ $29 each

Nov . 21 . . . . . . . . . . . . 7,600 units @ $27 each

Jan . 4 . . . . . . . . . . . . 11,500 units @ $33 each

May 18 . . . . . . . . . . . . 13,400 units @ $32 each

Required

1. Compute the number and total cost of the units available for sale during the year. 2. Compute the amounts assigned to ending inventory and the cost of goods sold using (a) FIFO,

(b) LIFO, and (c) weighted average. (Round all amounts to cents.)

Check (2) Cost of goods sold: FIFO, $1,328,700; LIFO, $1,266,500; WA, $1,294,800

Shepard Company sold 4,000 units of its product at $100 per unit during the year and incurred operating expenses of $15 per unit in selling the units. It began the year with 840 units in inventory and made suc- cessive purchases of its product as follows.

Problem 5-8BA Periodic: Income comparisons and cost flows

A1 P3 Jan . 1 Beginning inventory . . . . . . . . . . . . . 840 units @ $58 per unit

Apr . 2 Purchase . . . . . . . . . . . . . . . . . . . . . . 600 units @ $59 per unit

June 14 Purchase . . . . . . . . . . . . . . . . . . . . . . 1,205 units @ $61 per unit

Aug . 29 Purchase . . . . . . . . . . . . . . . . . . . . . . 700 units @ $64 per unit

Nov . 18 Purchase . . . . . . . . . . . . . . . . . . . . . . 1,655 units @ $65 per unit

Total . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 units

Required

1. Prepare comparative income statements similar to Exhibit 5.8 for the three inventory costing methods of FIFO, LIFO, and weighted average. (Round all amounts to cents.) Include a detailed cost of goods sold sec- tion as part of each statement. The company uses a periodic inventory system, and its income tax rate is 40%.

2. How would the financial results from using the three alternative inventory costing methods change if the company had been experiencing decreasing prices in its purchases of inventory?

3. What advantages and disadvantages are offered by using (a) LIFO and (b) FIFO? Assume the continu- ing trend of increasing costs.

Check (1) Net income: LIFO, $52,896; FIFO, $57,000; WA, $55,200

Problem 5-9BB Retail inventory method

P4

The records of Macklin Co. provide the following information for the year ended December 31.

At Cost At Retail

Beginning inventory, January 1 . . . . . . . . . . . $ 90,022 $115,610

Cost of goods purchased . . . . . . . . . . . . . . . . 502,250 761,830

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 782,300

Sales returns . . . . . . . . . . . . . . . . . . . . . . . . . . 3,460

Required

1. Use the retail inventory method to estimate the company’s year-end inventory. 2. A year-end physical inventory at retail prices yields a total inventory of $80,450. Prepare a calculation

showing the company’s loss from shrinkage at cost and at retail.

Check (1) Inventory, $66,555 cost (2) Inventory shortage at cost, $12,251.25

230 Chapter 5 Inventories and Cost of Sales

Otingo Equipment Co. wants to prepare interim financial statements for the first quarter. The company wishes to avoid making a physical count of inventory. Otingo’s gross profit rate averages 35%. The follow- ing information for the first quarter is available from its records.

Problem 5-10BB Gross profit method

P4

Beginning inventory, January 1 . . . . . . . . . . . $ 802,880

Cost of goods purchased . . . . . . . . . . . . . . . . 2,209,636

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,760,260

Sales returns . . . . . . . . . . . . . . . . . . . . . . . . . . 79,300

Required

Use the gross profit method to estimate the company’s first-quarter ending inventory. Check Est. ending inventory, $619,892

SERIAL PROBLEM Business Solutions

A3 P2

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 5 Part A

Santana Rey of Business Solutions is evaluating her inventory to determine whether it must be adjusted based on lower of cost or market rules. Business Solutions has three different types of software in its inventory, and the following information is available for each.

Inventory Items Units Cost per Unit Market per Unit

Office productivity . . . . . . . . . . . 3 $ 76 $ 74

Desktop publishing . . . . . . . . . . . 2 103 100

Accounting . . . . . . . . . . . . . . . . . 3 90 96

Required

Compute the lower of cost or market for ending inventory assuming Rey applies the lower of cost or mar- ket rule to each product in inventory. Must Rey adjust the reported inventory value? Explain.

Part B

Selected accounts and balances for the three months ended March 31, 2020, for Business Solutions follow.

Beginning inventory, January 1 . . . . . . . . . . . $ 0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 14,052

Ending inventory, March 31 . . . . . . . . . . . . . . 704

Required

1. Compute inventory turnover and days’ sales in inventory for the three months ended March 31, 2020. 2. Assess the company’s performance if competitors average 15 times for inventory turnover and 25 days

for days’ sales in inventory.

©Alexander Image/Shutterstock

COMPANY ANALYSIS C2 A3

Accounting Analysis

AA 5-1 Use Apple’s financial statements in Appendix A to answer the following.

Required

1. What amount of inventories did Apple report as a current asset (a) on September 30, 2017? (b) On September 24, 2016?

2. Inventories make up what percent of total assets (a) on September 30, 2017? (b) On September 24, 2016? 3. Assuming Apple has enough inventory to meet demand, does Apple prefer inventory to be a lower or

higher percentage of total assets? 4. Compute (a) inventory turnover for fiscal year ended September 30, 2017, and (b) days’ sales in inven-

tory as of September 30, 2017.

APPLE

Chapter 5 Inventories and Cost of Sales 231

AA 5-2 Comparative figures for Apple and Google follow.

Required

1. Compute inventory turnover for each company for the most recent two years shown. 2. Compute days’ sales in inventory for each company for the three years shown. 3. In the current year, does (a) Apple’s and (b) Google’s inventory turnover underperform or outperform

the industry (assumed) average of 15?

Apple Google

Current One Year Two Years Current One Year Two Years $ millions Year Prior Prior Year Prior Prior

Inventory . . . . . . . . . . . . . . $ 4,855 $ 2,132 $ 2,349 $ 749 $ 268 $ 491

Cost of sales . . . . . . . . . . . 141,048 131,376 140,089 45,583 35,138 28,164

COMPARATIVE ANALYSIS A3

APPLE

Required

1. Compute Samsung’s (a) inventory turnover and (b) days’ sales in inventory for the most recent two years.

2. Is Samsung’s inventory turnover on a favorable or unfavorable trend? 3. In the current year, does Samsung’s inventory turnover underperform or outperform the industry

(assumed) average of 15?

AA 5-3 Key figures for Samsung follow.

₩ millions Current Year One Year Prior Two Years Prior

Inventory . . . . . . . . . . . . . . ₩ 24,983,355 ₩ 18,353,503 ₩ 18,811,794

Cost of sales . . . . . . . . . . . 129,290,661 120,277,715 123,482,118

GLOBAL ANALYSIS A3

Samsung

ETHICS CHALLENGE A1

BTN 5-1 Golf Challenge Corp. is a retail sports store carrying golf apparel and equipment. The store is at the end of its second year of operation and is struggling. A major problem is that its cost of inventory has continually increased in the past two years. In the first year of operations, the store assigned inventory costs using LIFO. A loan agreement the store has with its bank, its prime source of financing, requires the store to maintain a certain profit margin and current ratio. The store’s owner is currently looking over Golf Challenge’s preliminary financial statements for its second year. The numbers are not favorable. The only way the store can meet the financial ratios agreed on with the bank is to change from LIFO to FIFO. The store originally decided on LIFO because of its tax advantages. The owner recalculates ending inventory using FIFO and submits those numbers and statements to the loan officer for the required bank review. The owner thankfully reflects on the available latitude in choosing the inventory costing method.

Required

1. How does Golf Challenge’s use of FIFO improve its net profit margin and current ratio? 2. Is the action by Golf Challenge’s owner ethical? Explain.

Beyond the Numbers

BTN 5-2 You are a financial adviser with a client in the wholesale produce business that just completed its first year of operations. Due to weather conditions, the cost of acquiring produce to resell has escalated during the latter part of this period. Your client, Javonte Gish, mentions that because her business sells perishable goods, she has striven to maintain a FIFO flow of goods. Although sales are good, the increas- ing cost of inventory has put the business in a tight cash position. Gish has expressed concern regarding the ability of the business to meet income tax obligations.

Required

Prepare a memorandum that identifies, explains, and justifies the inventory method you recommend that Ms. Gish adopt.

COMMUNICATING IN PRACTICE A1

GOOGLE

232 Chapter 5 Inventories and Cost of Sales

BTN 5-3 Access the September 30, 2017, 10-K report for Apple, Inc. (ticker: AAPL), filed on November 3, 2017, from the EDGAR filings at SEC.gov.

Required

1. What products are manufactured by Apple? 2. What inventory method does Apple use? Hint: See Note 1 to its financial statements. 3. Compute its gross margin and gross margin ratio for the 2017 fiscal year. Comment on your

computations—assume an industry average of 40% for the gross margin ratio. 4. Compute its inventory turnover and days’ sales in inventory for the year ended September 30, 2017.

Comment on your computations—assume an industry average of 15 for inventory turnover and 9 for days’ sales in inventory.

TAKING IT TO THE NET A3

BTN 5-4 Each team member has the responsibility to become an expert on an inventory method. This expertise will be used to facilitate teammates’ understanding of the concepts relevant to that method. 1. Each learning team member should select an area for expertise by choosing one of the following

inventory methods: specific identification, LIFO, FIFO, or weighted average. 2. Form expert teams made up of students who have selected the same area of expertise. The instructor

will identify where each expert team will meet. 3. Using the following data, each expert team must collaborate to develop a presentation that illustrates

the relevant concepts and procedures for its inventory method. Each team member must write the pre- sentation in a format that can be shown to the learning team.

Data

The company uses a perpetual inventory system. It had the following beginning inventory and current- year purchases of its product.

TEAMWORK IN ACTION A1 P1

Point: Step 1 allows four choices or areas for expertise. Larger teams will have some duplication of choice, but the specific identification method should not be duplicated.

Jan . 1 Beginning inventory . . . . . . . . . . . 50 units @ $100 = $ 5,000 Jan . 14 Purchase . . . . . . . . . . . . . . . . . . . . 150 units @ $120 = 18,000 Apr . 30 Purchase . . . . . . . . . . . . . . . . . . . . 200 units @ $150 = 30,000 Sep . 26 Purchase . . . . . . . . . . . . . . . . . . . . 300 units @ $200 = 60,000

Jan . 10 30 units . . . . . . . . . . specific cost: 30 @ $100

Feb . 15 100 units . . . . . . . . . . specific cost: 100 @ $120

Oct . 5 350 units . . . . . . . . . . specific cost: 100 @ $150 and 250 @ $200

The company transacted sales on the following dates at a $350 per unit sales price.

Concepts and Procedures to Illustrate in Expert Presentation

a. Identify and compute the costs to assign to the units sold. (Round per unit costs to three decimals.) b. Identify and compute the costs to assign to the units in ending inventory. (Round inventory bal-

ances to the dollar.) c. How likely is it that this inventory costing method will reflect the actual physical flow of goods?

How relevant is that factor in determining whether this is an acceptable method to use? d. What is the impact of this method versus others in determining net income and income taxes? e. How closely does the ending inventory amount reflect replacement cost? 4. Re-form learning teams. In rotation, each expert is to present to the team the presentation developed in

part 3. Experts are to encourage and respond to questions.

BTN 5-5 Review the chapter’s opening feature highlighting Danny Meyer and Shake Shack. Assume that the business consistently maintains an inventory level of $30,000, meaning that its average and ending inventory levels are the same. Also assume its annual cost of sales is $120,000. To cut costs, the business proposes to slash inventory to a constant level of $15,000 with no impact on cost of sales. The business plans to work with suppliers to get quicker deliveries and to order smaller quantities more often.

ENTREPRENEURIAL DECISION A3

APPLE

Chapter 5 Inventories and Cost of Sales 233

Required

1. Compute the company’s inventory turnover and its days’ sales in inventory under (a) current condi- tions and (b) proposed conditions.

2. Evaluate and comment on the merits of the proposal given your analysis for part 1. Identify any con- cerns you might have about the proposal.

BTN 5-6 Visit four retail stores with another classmate. In each store, identify whether the store uses a bar coding system to help manage its inventory. Try to find at least one store that does not use bar coding. If a store does not use bar coding, ask the store’s manager or clerk whether he or she knows which type of inventory method the store employs. Create a table that shows columns for the name of store visited, type of merchandise sold, use or nonuse of bar coding, and the inventory method used if bar coding is not employed. You also might inquire as to what the store’s inventory turnover is and how often physical inventory is taken.

HITTING THE ROAD C1 C2

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Define internal control and identify its

purpose and principles.

C2 Define cash and cash equivalents and explain how to report them.

ANALYTICAL A1 Compute the days’ sales uncollected

ratio and use it to assess liquidity.

P3 Prepare a bank reconciliation.

P4 Appendix 6A—Describe use of documentation and verification to control cash payments.

PROCEDURAL P1 Apply internal control to cash receipts

and payments.

P2 Explain and record petty cash fund transactions.

Chapter Preview

6 Cash, Fraud, and Internal Control

NTK 6-3, 6-4

TOOLS OF CONTROL AND ANALYSIS

P2 Control of petty cash P3 Bank reconciliation as a

control tool

A1 Assessing liquidity

NTK 6-1

FRAUD AND INTERNAL CONTROL

C1 Purpose and principles of controls

Technology and controls

Limitations of controls

NTK 6-2

CONTROL OF CASH

C2 Definition and reporting of cash

P1 Control of cash receipts and cash payments

235

“Take the risks”—Sheila Marcelo

Taking Care of Business

WALTHAM, MA—Sheila Marcelo was in college when her first child was born. “We had to scramble for child care throughout our college years,” recalls Sheila. “It was harder than it should have been.”

The struggle to find child care led Sheila to start Care.com (Care.com). Care.com matches caregivers with families online.

A key part of Care.com’s business is its internal control sys- tems. Sheila explains that controls are important to Care.com’s future, to the integrity of its systems, and to the trust of its mem- bers. Her controls extend to monitoring transactions and safe- guarding its assets and members.

Sheila insists that controls raise productivity, cut expenses, reduce fraud, and enhance the member experience. “People fear finance [and accounting] courses,” admits Sheila. “[But] if you want to be an entrepreneur,” declares Sheila, “don’t under- estimate the value of skills learned in those classes.”

Sheila offers two suggestions for pursuing a business. First, “don’t worry about how you’re being perceived . . . about fitting into the mold.” Second, “to grow in leadership, you have to be a

narcissist.” Adds Sheila, “Focus on yourself, understand your- self, take time for yourself. It will make you a better leader.”

Sources: Care.com website, January 2019; EAK, October 2016; Business Insider, March 2014; Boston Globe, August 2014; Bloomberg, September 2012

©Jin Lee/Bloomberg/Getty Images

Purpose of Internal Control Managers or owners of small businesses often control the entire operation. They know if the business is actually receiving the assets and services it paid for. Most companies, however, can- not maintain personal supervision and must rely on internal controls.

Internal Control System Managers use an internal control system to monitor and control business activities. An internal control system is policies and procedures used to Protect assets. Promote efficient operations. Ensure reliable accounting. Uphold company policies.

Managers use internal control systems to prevent avoidable losses, plan operations, and monitor company and employee performance. For example, internal controls for UnitedHealth Group protect patient records and privacy.

Sarbanes-Oxley Act (SOX) Sarbanes-Oxley Act (SOX) requires managers and audi- tors of companies whose stock is traded on an exchange (called public companies) to document and verify internal controls. Following are some of the requirements. The company must have effective internal controls. Auditors must evaluate internal controls. Violators receive harsh penalties—up to 25 years in prison with fines. Auditors’ work is overseen by the Public Company Accounting Oversight Board (PCAOB).

Committee of Sponsoring Organizations (COSO) Committee of Sponsoring Organizations (COSO) lists five ingredients of internal control that add to the quality of accounting information. Control environment—company structure, ethics, and integrity for internal control. Risk assessment—identify, analyze, and manage risk factors. Control activities—policies and procedures to reduce risk of loss. Information & communication—reports to internal and external parties. Monitoring—regular review of internal control effectiveness.

FRAUD AND INTERNAL CONTROL C1 Define internal control and identify its purpose and principles.

©Wright Studio/Shutterstock

Information &CommunicationControl Activities

Monitoring

Control Environment

Risk Assessment

236 Chapter 6 Cash, Fraud, and Internal Control

Principles of Internal Control Internal control varies from company to company, but internal control principles apply to all companies. The principles of internal control are to

1. Establish responsibilities. 2. Maintain adequate records. 3. Insure assets and bond key employees. 4. Separate recordkeeping from custody of assets. 5. Divide responsibility for related transactions. 6. Apply technological controls. 7. Perform regular and independent reviews.

Establish Responsibilities Responsibility for a task should be clearly established and assigned to one person. When a problem occurs in a company where responsibility is not estab- lished, determining who is at fault is difficult. For example, if two salesclerks share the same cash register and cash is missing, neither clerk can be held accountable. To prevent this prob- lem, a company can use separate cash drawers for each clerk.

Maintain Adequate Records Good recordkeeping helps protect assets and helps managers monitor company activities. When there are detailed records of equipment, for ex- ample, items are unlikely to be lost or stolen without detection. Similarly, transactions are less likely to be entered in wrong accounts if a chart of accounts is used. Preprinted forms are also part of good internal control. When sales slips are properly designed, employees can record information efficiently with fewer errors. When sales slips are prenumbered, each slip is the responsibility of one salesperson, preventing the salesperson from stealing cash by making a sale and destroying the sales slip. Computerized point-of-sale systems achieve the same control results.

Insure Assets and Bond Key Employees Assets should be insured against losses, and employees handling lots of cash and easily transferable as- sets should be bonded. An employee is bonded when a company purchases an insurance policy, or a bond, against theft by that employee. Bonding discour- ages theft because bonded employees know the bonding company will pursue reported theft.

Separate Recordkeeping from Custody of Assets A person who controls or has access to an asset must not have access to that asset’s account- ing records. This principle reduces the risk of theft or waste of an asset because the person with control over it knows that another person keeps its records. Also, a recordkeeper who does not have access to the asset has no reason to falsify re- cords. This means that to steal an asset and hide the theft from the records, two or

more people must collude—or agree in secret to commit the fraud.

Divide Responsibility for Related Transactions Responsibility for a transac- tion should be divided between two or more individuals or departments. This ensures the work of one person acts as a check on the other to prevent fraud and errors. This principle, called separation of duties, does not mean duplication of work. For example, when a company orders inventory, the task should be split among several employees. One employee submits a request to purchase inventory, a second employee approves the request, a third employee makes the payment, and a fourth employee records the transaction.

Apply Technological Controls Cash registers, time clocks, and ID scanners are ex- amples of devices that can improve internal control. A cash register with a locked-in tape or electronic file makes a record of each cash sale. A time clock records the exact hours worked by an employee. ID scanners limit access to authorized individuals.

Point: Many companies have a mandatory vacation policy for em- ployees who handle cash. When another employee must cover for the one on vacation, it is more difficult to hide cash frauds.

A control system is only as strong as its weakest link

Courtesy of Commercial Collection Agency Association of the Commercial Law League of America

Point: ACFE estimates that employee fraud costs more than $150,000 per incident.

Chapter 6 Cash, Fraud, and Internal Control 237

Perform Regular and Independent Reviews Regular reviews of internal con- trols help ensure that procedures are followed. These reviews are preferably done by auditors not directly involved in the activities. Auditors evaluate the efficiency and effectiveness of internal controls. Many companies pay for audits by independent auditors. These auditors test the com- pany’s financial records and evaluate the effectiveness of internal controls.

Entrepreneur As owner of a start-up surfboard company, you hire a systems analyst. The analyst sees that your company employs only two workers. She says that as owner you must serve as a compensating control. What does the analyst mean? ■ Answer: Transaction authorization, recording, and asset custody are ideally handled by three employees. Many small busi- nesses do not employ three workers. In such cases, an owner must make sure that the lack of separation of duties does not result in fraud.

Decision Maker

Technology, Fraud, and Internal Control Principles of internal control are relevant no matter what the technological state of the account- ing system, from manual to fully automated. Technology allows us quicker access to informa- tion and improves managers’ abilities to monitor and control business activities. This section describes technological impacts we must be alert to.

Reduced Processing Errors Technology reduces, but does not eliminate, errors in processing information. Less human involvement can cause data entry errors to go undiscov- ered. Also, errors in software can produce consistent but inaccurate processing of transactions.

More Extensive Testing of Records When accounting records are kept manually, only small samples of data are usually checked for accuracy. When data are accessible using technology, large samples or even the entire database can be tested quickly.

New Evidence of Processing Technology makes it possible to record additional transaction details not possible with manual systems. For example, a system can record who made the entry, the date and time, the source of the entry, and so on. This means that internal control depends more on the design and operation of the information system and less on the analysis of its resulting documents.

Separation of Duties A company with few employees risks losing separation of duties. For example, the person who designs the information system should not operate it. The company also must separate control over programs and files from the activities related to cash receipts and payments. For example, a computer operator should not control check-writing activities.

Increased E-Commerce Amazon and eBay are examples of successful e-commerce companies. All e-commerce transactions involve at least three risks: (1) credit card number theft, (2) computer viruses, and (3) impersonation or identity theft. Companies use technologi- cal internal controls to combat these risks.

Point: Internal control failure reduces confidence in financial statements.

Point: To assess a company’s in- ternal controls, review the audi- tor’s report, management report on controls (if available), manage- ment discussion and analysis, and financial press.

Butterfingers Internal control failures can cost a company and its customers millions. Amazon learned the hard way when its web services failed. This failure led hundreds of websites to slow down. Reports say this failure cost compa- nies in the S&P 500 index $150 million. The culprit? A typo in Amazon’s code. ■

Decision Insight

Limitations of Internal Control Internal controls have limitations from (1) human error or fraud and (2) the cost-benefit principle.

Human error occurs from carelessness, misjudgment, or confusion. Human fraud is inten- tionally defeating internal controls, such as management override, for personal gain. Human fraud is driven by the triple threat of fraud. Opportunity—internal control weaknesses in a business. Pressure—financial, family, and societal stresses to succeed. Rationalization—employees justifying fraudulent behavior.

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Rationalization

Financial Pressure

©EpicStockMedia/iStockphoto/ Getty Images

238 Chapter 6 Cash, Fraud, and Internal Control

The cost-benefit principle says that the costs of internal controls must not exceed their ben- efits. Analysis of costs and benefits considers all factors, including morale. For example, most companies have a legal right to read employees’ e-mails but rarely do unless there is evidence of potential harm.

Hacker’s Guide to Cyberspace Pharming Viruses attached to e-mails and websites monitor keystrokes; when you sign on to financial websites, it steals your passwords.

Phishing Hackers send e-mails to you posing as banks; you are asked for infor- mation using fake websites where they steal your passwords and personal data.

Wi-Phishing Cybercrooks set up wireless networks hoping you will use them to connect to the web; passwords and data are stolen when you connect.

Bot-Networking Hackers send out spam and viruses from your PC.

Typo-Squatting Hackers set up websites with addresses similar to legit businesses; when you make a typo and hit their sites, they infect your PC.

Identify each of the following as a (a) purpose of an internal control system, (b) principle of internal control, or (c) limitation of internal control.

1. Protect assets 2. Establish responsibilities 3. Human error 4. Maintain adequate records 5. Apply technological controls 6. Ensure reliable accounting 7. Insure assets and bond key employees

Internal Controls

NEED-TO-KNOW 6-1

C1 8. Human fraud 9. Separate recordkeeping from custody of assets 10. Divide responsibility for related transactions 11. Cost-benefit principle 12. Promote efficient operations 13. Perform regular and independent reviews 14. Uphold company policies

Solution

1. a 2. b 3. c 4. b 5. b 6. a 7. b 8. c 9. b 10. b 11. c 12. a 13. b 14. a Do More: QS 6-1, E 6-1, E 6-2,

E 6-3, P 6-1

Cash is easily hidden and moved. Internal controls protect cash and meet three guidelines.

1. Handling cash is separate from recordkeeping of cash. 2. Cash receipts are promptly deposited in a bank. 3. Cash payments are made by check or electronic funds transfer (EFT).

The first guideline applies separation of duties to minimize errors and fraud. When duties are separated, two or more people must collude to steal cash and hide this action. The second guide- line uses immediate deposits of all cash receipts to produce an independent record of the cash received. It also reduces the chance of cash theft (or loss). The third guideline uses payments by check to develop an independent record of cash payments. It also reduces the risk of cash theft (or loss).

Cash, Cash Equivalents, and Liquidity Liquidity refers to a company’s ability to pay for its current liabilities. Cash and similar assets are called liquid assets because they can be readily used to pay for liabilities.

CONTROL OF CASH C2 Define cash and cash equivalents and explain how to report them.

Chapter 6 Cash, Fraud, and Internal Control 239

Cash includes currency, coins, and deposits in bank accounts. Cash also includes items that can be deposited in these accounts such as customer checks, cashier’s checks, certified checks, and money orders. Cash equivalents are short-term, highly liquid investment assets meeting two criteria: (1) readily convertible to a known cash amount and (2) close enough to their due date so that their market value will not greatly change. Only investments within three months of their due date usually meet these criteria. Cash equivalents are short-term investments such as U.S. Treasury bills. Most companies combine cash equivalents with cash on the balance sheet.

Cash Management A common reason companies fail is inability to manage cash. Companies must plan both cash receipts and cash payments. Goals of cash management are to

1. Plan cash receipts to meet cash payments when due. 2. Keep a minimum level of cash necessary to operate.

The treasurer is responsible for cash management. Effective cash management involves apply- ing the following cash management strategies.

Encourage collection of receivables. The quicker customers and others pay the company, the quicker it can use the money. Some companies offer discounts for quicker payments.

Delay payment of liabilities. The more delayed a company is in paying others, the more time it has to use the money. Companies regularly wait to pay bills until the last day allowed.

Keep only necessary assets. Acquiring expensive and rarely used assets can cause cash short- ages. Some companies lease warehouses or rent equipment to avoid large up-front payments.

Plan expenditures. Companies must look at seasonal and business cycles to plan expendi- tures when money is available.

Invest excess cash. Excess cash earns no return and should be invested in productive assets like factories. Excess cash from seasonal cycles can be placed in a short-term investment for interest.

Control of Cash Receipts Internal control of cash receipts ensures that cash received is properly recorded and deposited. Cash receipts arise from transactions such as cash sales, collections of customer accounts, receipts of interest, bank loans, sales of assets, and owner investments. This section explains internal control over two types of cash receipts: over-the-counter and by mail.

Over-the-Counter Cash Receipts Over-the-counter cash sales should be recorded on a cash register after each sale, and customers should get a receipt. Cash registers should hold a permanent, locked-in record of each transaction. The register is often linked with the account- ing system. Less advanced registers record each transaction on a paper tape or electronic file locked inside the register.

Custody over cash should be separate from recordkeeping. The clerk who has access to cash in the register should not have access to its record. At the end of the clerk’s work period, the clerk should count the cash in the register, record the amount, and turn over the cash and record to the company cashier. The cashier, like the clerk, has access to the cash but should not have access to accounting records (or the register tape or file). A third employee, often a supervisor, compares the record of total register transactions with the cash receipts reported by the cashier. This record is used for a journal entry recording over- the-counter cash receipts. The third employee has access to the records for cash but not to the actual cash. The clerk and the cashier have access to cash but not to the accounting

P1 Apply internal control to cash receipts and payments.

Point: The most liquid assets are usually reported first on a balance sheet; the least liquid assets are reported last.

Point: Companies invest idle cash in cash equivalents to increase income.

Point: Many businesses have signs that read: If you receive no receipt, your purchase is free! This helps ensure that clerks ring up all transactions on registers.

240 Chapter 6 Cash, Fraud, and Internal Control

records. None of them can make a mistake or steal cash without the difference being noticed (see the following diagram).

CashCash

Register Sheet

NameDateSer.No Rank Signature

FastForward Los Angeles

Deposit

Paid in by _______________ ________________________ Credit account of C & L Computer LTD ________________________

Date _______ Notes _______ Coin _______

$

9821 0058 478211006

Paid in by ____________ _____________________ Credit accoount of C & L Commputer LTD _____________________

9821 00058 478211000

$

$

Supervisor reads register data, prepares register sheet (and keeps copy), and sends

both to company cashier.

Cashier prepares cash records, deposit slip, and

journal entry.

Sales Department Cashier Department

Cash

Cash sheets Received from..................................

Amount dollar ....................................

Authorized Signature

Cash sheets Received from..................................

Amount dollar ....................................

Authorised Signature

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Caash ssheetss Receiveed from..................................

AAAAAAAAmAmAmAmmountAmountAmmountmountmountA d lld lld lldolladollarr ....................................

Authorised Signature

Register Sheet

NameDateSer.No Rank Signature

Clerk rings up cash sales on register; clerk prepares cash count sheet (and keeps copy) and sends to

company cashier along with the cash.

Cash Over and Short One or more customers can be given too much or too little change. This means that at the end of a work period, the cash in a cash register might not equal the record of cash receipts. This difference is reported in the Cash Over and Short account, also called Cash Short and Over, which is an income statement account recording the income effects of cash overages and cash shortages. If a cash register’s record shows $550 but the count of cash in the register is $555, the entry to record cash sales and its overage is

Alternatively, if a cash register’s record shows $625 but the count of cash in the register is $621, the entry to record cash sales and its shortage is

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550

Record cash sales and a cash overage.

Assets = Liabilities + Equity +555 + 5 +550

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625

Record cash sales and a cash shortage.

Assets = Liabilities + Equity +621 − 4 +625

Because customers are more likely to dispute being shortchanged than being given too much change, the Cash Over and Short account usually has a debit balance. A debit balance reflects an expense. It is reported on the income statement as part of selling, general, and administrative expenses. (Because the amount is usually small, it is often reported as part of miscellaneous expenses—or as part of miscellaneous revenues if it has a credit balance.)

Cash Receipts by Mail Two people are assigned the task of opening the mail. In this case, theft of cash receipts by mail requires collusion between these two employees. The person(s) opening the mail enters a list (in triplicate) of money received. This list has each sender’s name, the amount, and an explanation of why the money was sent. The first copy is sent with the money to the cashier. A second copy is sent to the recordkeeper. A third copy is kept by the person(s) who opened the mail. The cashier deposits the money in a bank, and the recordkeeper records the amounts received.

Chapter 6 Cash, Fraud, and Internal Control 241

This process is good internal control because the bank’s record of cash deposited must agree with the records from each of the three. If the mail person(s) does not report all receipts cor- rectly, customers will question their account balances. If the cashier does not deposit all the cash, the bank balance does not agree with the recordkeeper’s cash balance. The recordkeeper does not have access to cash and has no opportunity to steal cash. This system makes errors and fraud highly unlikely. The exception is employee collusion.

Cash Register Insight Walmart uses a network of information links with its point-of-sale cash registers to coordi- nate sales, purchases, and distribution. Its stores ring up tens of thousands of separate sales on heavy days. By using cash register information, the company can fix pricing mistakes quickly and capitalize on sales trends. ■

Decision Insight

Control of Cash Payments Control of cash payments is important as most large thefts occur from payment of fictitious invoices. One key to controlling cash payments is to require all payments to be made by check. The only exception is small payments made from petty cash. Another key is to deny access to accounting records to anyone other than the owner who has the authority to sign checks. A small-business owner often signs checks and knows that the items being paid for are actually received. Large businesses cannot maintain personal supervision and must rely on internal con- trols described here, including the voucher system and petty cash system.

Cash Budget Projected cash receipts and cash payments are summarized in a cash bud- get. If there is enough cash for operations, companies wish to minimize the cash they hold be- cause of its risk of theft and its low return versus other assets.

Voucher System of Control A voucher system is a set of procedures and approvals designed to control cash payments and the acceptance of liabilities that consist of Verifying, approving, and recording liabilities for cash payment. Issuing checks for payment of verified, approved, and recorded liabilities.

A voucher system’s control over cash payments begins when a company incurs a liability that will result in cash payment. The system only allows authorized departments and individuals to incur liabilities and limits the type of liabilities. In a large retail store, for example, only a pur- chasing department is authorized to incur liabilities for inventory. Purchasing, receiving, and paying for merchandise are divided among several departments (or individuals). These depart- ments include the one requesting the purchase, the purchasing department, the receiving department, and the accounting department.

To coordinate and control responsibilities of these departments, a company uses several dif- ferent business documents. Exhibit 6.1 shows how documents are accumulated in a voucher, which is an internal document (or file) used to collect information to control cash payments and to ensure that a transaction is properly recorded. This specific example begins with a purchase requisition and ends with issuing a check.

A voucher system should be applied to all payments (except those using petty cash). When a company receives a monthly telephone bill, it should review the charges, prepare a voucher (file), and insert the bill. This transaction is then recorded. If the amount is due, a check is issued. If not, the voucher is filed for payment on its due date. Without records, an employee could collude with a supplier to get more than one payment, payment for excessive amounts, or payment for goods and services not received. A voucher system helps prevent such frauds.

Point: A purchase requisition is a request to purchase merchandise.

Cash Fraud The Association of Certified Fraud Examiners (ACFE) reports that 87% of fraud is from asset theft. Of those asset thefts, a few stand out—in both frequency and median loss. Namely, cash is most frequently stolen through billing (22%) and theft (20%), followed by expense reimbursements (14%), skimming (12%), check tampering (11%), and payroll (9%). Interestingly, the average loss per incident is greatest for check tampering ($158,000) and billing ($100,000). Source: “Report to the Nations,” ACFE. ■

Ethical Risk

©Amble Design/Shutterstock

242 Chapter 6 Cash, Fraud, and Internal Control

Petty Cash System of Control To avoid writing checks for small amounts, a com- pany sets up a petty cash system. Petty cash payments are small payments for items such as shipping fees, minor repairs, and low-cost supplies.

Operating a Petty Cash Fund A petty cash fund requires estimating the amount of small payments to be made during a short period such as a week or month. A check is then drawn by the company cashier for an amount slightly in excess of this estimate. The check is cashed and given to an employee called the petty cashier or petty cash custodian. The petty cashier keeps this cash safe, makes payments from the fund, and keeps records of it in a secure petty cashbox.

When a cash payment is made, the person receiving payment signs a prenumbered petty cash receipt, also called petty cash ticket—see Exhibit 6.2. The petty cash receipt is then placed in the petty cashbox with the remaining money. Under this system, the total of all receipts plus the remaining cash equals the total fund amount. A $100 petty cash fund, for example, contains any combination of cash and petty cash receipts that totals $100 (examples are $80 cash plus $20 in receipts, or $10 cash plus $90 in receipts).

The petty cash fund is reimbursed when it is nearing zero and at the end of an accounting period. The petty cashier sorts the paid receipts by the type of expense or account and then totals the receipts. The petty cashier gives all paid receipts to the company cashier, who stamps all receipts paid so they cannot be reused, files them for recordkeeping, and gives the petty cashier a check. When this check is cashed and the money placed in the cashbox, the total money in the cashbox is restored to its original amount. The fund is now ready for a new cycle of petty cash payments.

Point: Companies use surprise petty cash counts for verification.

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No. 119CheckZ-Mart November 12

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Request purchase of the follo wing item(s):

Model No. Descr iption

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Quantity Price Amount

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Purchase Order

Purchase Requisition

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9

8

EXHIBIT 6.1 Document Flow in a Voucher System

Which of the following statements are true regarding the control of cash receipts and cash payments? 1. Over-the-counter cash sales should be recorded on a cash register after each sale. 2. Custody over cash should be separate from the recordkeeping of cash. 3. For control of cash receipts that arrive through the mail, two people should be present for opening

that mail. 4. One key to controlling cash payments is to require that no expenditures be made by check;

instead, all expenditures should be made from petty cash. 5. A voucher system of control should be applied only to purchases of inventory and never to other

expenditures.

Solution

1. True 2. True 3. True 4. False 5. False

Control of Cash Receipts and Payments

NEED-TO-KNOW 6-2

P1 C2

Do More: QS 6-2, QS 6-4, QS 6-5, E 6-4, E 6-5, E 6-6,

E 6-7

P2 Explain and record petty cash fund transactions.

For

Date

Charge to Amount Approved by

Received by

EXHIBIT 6.2 Petty Cash Receipt

Chapter 6 Cash, Fraud, and Internal Control 243

Illustrating a Petty Cash Fund Assume Z-Mart sets up a petty cash fund on November 1. A $75 check is drawn, cashed, and the proceeds given to the petty cashier. The entry to record the setup of this petty cash fund is

After the petty cash fund is established, the Petty Cash account is not debited or credited again unless the amount of the fund is changed.

Next, assume that Z-Mart’s petty cashier makes several November payments from petty cash. On November 27, after making a $46.50 cash payment for tile cleaning, only $3.70 cash remains in the fund. The petty cashier then summarizes and totals the petty cash receipts as shown in Exhibit 6.3.

The petty cash payments report and all receipts are given to the company cashier in exchange for a $71.30 check to reimburse the fund. The petty cashier cashes the check and puts the $71.30 cash in the petty cashbox. The company records this reimbursement as follows. A petty cash fund is usually reimbursed at the end of an accounting period so that expenses are recorded in the proper period, even if the fund is not low on money.

EXHIBIT 6.3 Petty Cash Payments Report

Petty Cash Payments Report

Miscellaneous Expense Nov . 27 Tile cleaning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 46 .50

Merchandise Inventory (transportation-in) Nov . 5 Transport of merchandise purchased . . . . . . . . . . . . . . . . . . 15 .05

Delivery Expense Nov . 18 Customer’s package delivered . . . . . . . . . . . . . . . . . . . . . . . 5 .00

Office Supplies Expense Nov . 15 Purchase of office supplies immediately used . . . . . . . . . . . 4 .75

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $71.30

Point: This report also can include receipt number and names of those who approved and received cash payment (see Need-to-Know 6-3).

Increasing or Decreasing a Petty Cash Fund A decision to increase or decrease a petty cash fund is often made when reimbursing it. Assume Z-Mart decides to increase its petty cash fund from $75 to $100 on November 27 when it reimburses the fund. The entries required are to (1) reimburse the fund as usual (see the preceding November 27 entry) and (2) increase the fund amount as follows.

Nov . 1 Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Establish a petty cash fund.

Assets = Liabilities + Equity +75 −75

Nov . 27 Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 .50

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 .05

Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 .00

Office Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 .75

Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 .30

Reimburse petty cash. *$75 fund bal. − $3.70 cash remaining.

Assets = Liabilities + Equity −71.30 −46.50 +15.05 − 5.00 − 4.75

Instead, if it decreases the petty cash fund from $75 to $55 on November 27, the entry is

Nov . 27 Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Increase petty cash fund from $75 to $100.

Nov . 27 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Decrease petty cash fund from $75 to $55.

244 Chapter 6 Cash, Fraud, and Internal Control

Event Petty Cash Cash Expenses

Set up fund . . . . . . . . Dr . Cr . —

Reimburse fund . . . . . — Cr . Dr .

Increase fund . . . . . . Dr . Cr . —

Decrease fund . . . . . . Cr . Dr . —

Summary of Petty Cash Accounting Cash Over and Short Sometimes a petty cashier fails to get a receipt for payment or overpays for the amount due. When this occurs and the fund is later reimbursed, the petty cash payments report plus the cash remaining will not equal the fund bal- ance. This mistake causes the fund to be short. This shortage is recorded as an ex- pense in the reimbursing entry with a debit to the Cash Over and Short account. (An overage in the petty cash fund is recorded with a credit to Cash Over and Short in the reimbursing entry.)

Following is the June 1 entry to reimburse a $200 petty cash fund when its payments report shows $178 in miscellaneous expenses and only $15 cash remains.

$200 Petty Cash Fund

$15 Cash $7 Short $178 Receipts

For

Date

Charge to Amount

PETTY CASH RECEIPT Z-Mart No. 9

Approved by

Received by

June 1 Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

Reimburse petty cash. *$200 fund bal. − $15 cash remaining.

Get Clued In There are clues to fraudulent activities. Clues from accounting include (1) an increase in customer refunds—could be fake, (2) missing documents—could be used for fraud, (3) differences between bank deposits and cash receipts—could be cash embezzled, and (4) delayed recording—could reflect fraudulent records. Clues from employees include (1) lifestyle change—could be embezzlement, (2) too close with suppliers—could signal fraudulent transactions, and (3) refusal to leave job, even for vacations—could conceal fraudulent activities. ■

Ethical Risk

Bacardi Company established a $150 petty cash fund with Eminem as the petty cashier. When the fund balance reached $19 cash, Eminem prepared a petty cash payments report, which follows.

Petty Cash System

NEED-TO-KNOW 6-3

P2 Petty Cash Payments Report Receipt No. Account Charged Approved by Received by

12 Delivery Expense . . . . . . . . . . . . . . . . $ 29 Eminem A . Smirnoff

13 Merchandise Inventory . . . . . . . . . . . 18 Eminem J . Daniels

15 (Omitted) . . . . . . . . . . . . . . . . . . . . . . . 32 Eminem C . Carlsberg

16 Miscellaneous Expense . . . . . . . . . . . 41 (Omitted) J . Walker

Total . . . . . . . . . . . . . . . . . . . . . . . . . . $120

Required

1. Identify four internal control weaknesses from the petty cash payments report. 2. Prepare general journal entries to record a. Establishment of the petty cash fund. b. Reimbursement of the fund. (Assume for this part only that petty cash Receipt No. 15 was issued

for miscellaneous expenses.) 3. What is the Petty Cash account balance immediately before reimbursement? After reimbursement?

Solution

1. Four internal control weaknesses that are apparent from the payments report include a. Petty cash Receipt No. 14 is missing. This raises questions about the petty cashier’s management of

the fund. b. The $19 cash balance means that $131 has been withdrawn ($150 − $19 = $131). However, the

total amount of the petty cash receipts is only $120 ($29 + $18 + $32 + $41). The fund is $11 short of cash ($131 − $120 = $11). Management should investigate.

c. The petty cashier (Eminem) did not sign petty cash Receipt No. 16. This could have been a mistake on his part or he might not have authorized the payment.

d. Petty cash Receipt No. 15 does not say which account to charge. Management should check with C. Carlsberg and the petty cashier (Eminem) about the transaction. Without further information, debit Miscellaneous Expense.

Chapter 6 Cash, Fraud, and Internal Control 245

2. Petty cash general journal entries. a. Entry to establish the petty cash fund. b. Entry to reimburse the fund.

Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 18

Miscellaneous Expense ($41 + $32) . . . . . . . . . . . 73 Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . 11

Cash ($150 fund bal . − $19 cash rem .) . . . . . 131

3. The Petty Cash account balance always equals its fund balance, in this case $150. This account balance does not change unless the fund is increased or decreased.

Do More: QS 6-6, E 6-8, E 6-9, E 6-10, P 6-2, P 6-3

Basic Bank Services Banks safeguard cash and provide detailed records of cash transactions. They provide services and documents that help control cash, which is the focus of this section.

Bank Account, Deposit, and Check A bank account is used to deposit money for safekeeping and helps control withdrawals. Persons authorized to write checks on the account must sign a signature card, which the bank uses to verify signatures.

Each bank deposit has a deposit ticket, which lists items such as currency, coins, and checks deposited along with amounts. The bank gives the customer a receipt as proof of the deposit. Exhibit 6.4 shows a deposit ticket.

Point: Firms often have multiple bank accounts for different needs and for specific transactions such as payroll.

BANKING ACTIVITIES AS CONTROLS

C H

EC KS

L IS

T S

IN G

LY D

O LL

A RS

C EN

TS

1 14

-2 87

/ 9 39

90 50

2 82

-7 59

/ 3 39

82 80

3 4 5 6 7 8 9 10 11 12 13 14

TO TA

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T H

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76 -9

07 / 9

19 30

20

20 3

50

DEPOSIT TICKET

.......................................... (Memo)

USE OTHER SIDE FOR ADDITIONAL LISTINGS. BE SURE EACH ITEM IS PROPERLY ENDORSED.

Date ...................... 20 ......... CURRENCY

TOTAL

NET DEPOSIT

36 October 2

Deposit checks

19

203 240

240

50

50 00

00

CASH COIN

LIST CHECKS SINGLY

TOTAL FROM OTHER SIDE

Front Back

901 Main Street Hillcrest, NY 11749

EXHIBIT 6.4 Deposit Ticket

To withdraw money, the depositor can use a check, which is a document telling the bank to pay a specified amount to a designated recipient. A check involves three parties: a maker who signs the check, a payee who is the recipient, and a bank (or payer) on which the check is drawn. The bank provides the depositor the checks. Exhibit 6.5 shows one type of check. It has an optional remittance advice explaining the payment. The memo line is used for an explanation.

Electronic Funds Transfer Electronic funds transfer (EFT) is the electronic trans- fer of cash from one party to another. Companies are increasingly using EFT because of its convenience and low cost. Payroll, rent, utilities, insurance, and interest payments are usually done by EFT. The bank statement lists cash withdrawals by EFT with the checks and other deductions. Cash receipts by EFT are listed with deposits and other additions.

246 Chapter 6 Cash, Fraud, and Internal Control

Bank Statement Usually once a month, the bank sends a bank statement showing the account activity. Different banks use different formats for their bank statements, but all of them include the following.

1. Beginning-of-period account balance. 2. Checks and other debits decreasing the account during the period. 3. Deposits and other credits increasing the account during the period. 4. End-of-period account balance.

Exhibit 6.6 shows one type of bank statement. Part A of Exhibit 6.6 summarizes changes in the account. B lists paid checks along with other debits. C lists deposits and credits to the account.

Canceled checks are checks the bank has paid and deducted from the customer’s account. We say such checks cleared the bank. Other usual deductions on a bank statement include (1) bank

Point: Good control is to send a copy of the bank statement directly to a party without access to cash or recordkeeping.

Pay to the order of

Date Description Gross Amount Deductions Net Amount

VideoBuster Company, Hillcrest, NY

Detach this portion before cashing

$

........................ 20 .......

Dollars

Memo

99-DT/101

No. 438CheckMaker

Payee

Payer

Remittance Advice

901 Main Street Hillcrest, NY 11749

Hillcrest Lighting

Lighting design, Invoice No. 4658

October 3

375.

$375.00 $375.0010-3-19

19

Three Hundred and Seventy-Five Dollars and

Store Lighting Design

EXHIBIT 6.5 Check with Remittance Advice

VideoBuster Company 901 Main Street Hillcrest, NY 11749

October 31, 2019 Statement Date

494 504 2 Account Number

Previous Balance

Symbols: CM–Credit Memo DM–Debit Memo

EC–Error Correction IN–Interest Earned

NSF–Non-Su�cient Funds EFT–Electronic Funds Transfer

SC–Service Charge OD–Overdraft

Checks and Debits Deposits and Credits

Total Checks and Debits Total Deposits and Credits Current Balance

1,610

Date Oct. 3 Oct. 12 Oct. 14 Oct. 16 Oct. 23 Oct. 25

Oct. 2 Oct. 15 Oct. 16 Oct. 23 Oct. 31

240 No. Amount Date Amount

723 1,163 2,050

121 375 100 EFT

122 70 485 CM 330

123 25 EFT 8 IN125 15

127 185

20 NSF 10 DM

23 DM

CB

A

Bank Statement Member FDIC

Oct. 26

EXHIBIT 6.6 Bank Statement

Bank’s Liability to VideoBuster

Sep. 30 bal. 1,610 CRs 1,163 DRs 723

Oct. 31 bal. 2,050

Point: Debit memos (DM) from the bank produce credits on the depositor’s books. Credit memos (CM) from the bank produce debits on the depositor’s books.

Forms of Check Fraud (CkFraud.org)

•   Forged signatures—legitimate  checks with fake payer signature

•   Forged endorsements—stolen check  that is endorsed and cashed by someone other than the payee

•   Counterfeit checks—fraudulent  checks with fake payer signature

•   Altered checks—legitimate check  altered (such as changed payee or amount) to benefit perpetrator

•   Check kiting—deposit check from  one bank account (without sufficient funds) into a second bank account

Chapter 6 Cash, Fraud, and Internal Control 247

service fees, (2) checks deposited that are uncollectible, (3) corrections of previous errors, (4) withdrawals through automated teller machines (ATMs), and (5) payments arranged in advance by a depositor. A debit memorandum notifies a depositor of a deduction.

Increases to the depositor’s account include amounts the bank collects on behalf of the depositor and the corrections of previous errors. A credit memorandum notifies the depositor of all increases. Banks that pay interest on checking accounts credit interest earned to the depos- itor’s account each period. In Exhibit 6.6, the bank credits $8 of interest to the account.

Bank Reconciliation The balance of a checking account on the bank statement rarely equals the depositor’s book bal- ance (from its records). This is due to information that one party has that the other does not. We must therefore verify the accuracy of both the depositor’s records and the bank’s records. To do this, we prepare a bank reconciliation to explain differences between the checking account bal- ance in the depositor’s records and the balance on the bank statement. The following explains bank and book adjustments.

Bank Balance Adjustments + Deposits in transit (or outstanding deposits). Deposits in transit are deposits made and

recorded in the depositor’s books but not yet listed on the bank statement. For example, companies can make deposits (in the night depository) after the bank is closed. If such a deposit occurred on a bank statement date, it would not appear on this period’s statement. The bank would record such a deposit on the next business day, and it would appear on the next period’s bank statement. Deposits mailed to the bank near the end of a period also can be in transit and not listed on the bank statement.

− Outstanding checks. Outstanding checks are checks written by the depositor, subtracted on the depositor’s books, and sent to the payees but not yet turned in for payment at the bank statement date.

± Bank errors. Any errors made by the bank are accounted for in the reconciliation. To find errors, we (a) compare deposits on the bank statement with deposits in the accounting records and (b) compare canceled checks on the bank statement with checks recorded in the accounting records.

Book Balance Adjustments + Interest earned and unrecorded cash receipts. Banks sometimes collect notes for

depositors. Banks also receive electronic funds transfers to the depositor’s account. When a bank collects an item, it is added to the depositor’s account, less any service fee. The bank statement also includes any interest earned.

− Bank fees and NSF checks. A company sometimes deposits another party’s check that is uncollectible. This check is called a nonsufficient funds (NSF) check. The bank initially credits (increases) the depositor’s account for the check. When the check is uncollectible, the bank debits (reduces) the depositor’s account for that check. The bank may charge the depositor a fee for processing an uncollectible check. Other bank charges include printing new checks and service fees.

± Book errors. Any errors made by the depositor in the company books are accounted for in the reconciliation. To find errors, we use the same procedures described in the “Bank errors” section above.

Adjustments Summary Following is a summary of bank and book adjustments. Each of these items has already been recorded by either the bank or the company, but not both.

Point: Books refer to accounting records.

Point: The person preparing the bank reconciliation should not be responsible for processing cash receipts, managing checks, or maintaining cash records.

Point: Your checking account is a liability from the bank’s perspec- tive (but an asset from yours). When you make a deposit, they “credit your account.” Credits in- crease the bank’s liability to you. When you write a check or use your debit card, the bank de- creases its liability to you; they “debit your account.” Debits de- crease the bank’s liability to you.

P3 Prepare a bank reconciliation.

Point: Businesses with few employees often allow record- keepers to both write checks and keep the general ledger. If this is done, the owner must do the bank reconciliation.

Bank Balance Adjustments

Add deposits in transit .

Subtract outstanding checks .

Add or subtract corrections of bank errors .

Book Balance Adjustments

Add interest earned and unrecorded cash receipts .

Subtract bank fees and NSF checks .

Add or subtract corrections of book errors .

248 Chapter 6 Cash, Fraud, and Internal Control

Bank Reconciliation Demonstration In preparing the bank reconciliation, refer to Exhibit 6.7 and steps 1 through 8 .

1 Enter VideoBuster’s bank balance of $2,050 taken from the bank statement. 2 Add any unrecorded deposits and bank errors that understate the bank balance to the bank

balance. VideoBuster’s $145 deposit in the bank’s night depository on October 31 is not listed on its bank statement.

3 Subtract any outstanding checks and bank errors that overstate the bank balance from the bank balance. VideoBuster’s comparison of canceled checks with its books shows two checks outstanding: No. 124 for $150 and No. 126 for $200.

4 Compute the adjusted bank balance. 5 Enter VideoBuster’s cash account book balance of $1,405 taken from its accounting records. 6 Add any unrecorded cash receipts, interest earned, and errors understating the book balance

to the book balance. VideoBuster’s bank statement shows the bank collected a note receiv- able and increased VideoBuster’s account for $485. The bank statement also shows $8 for interest earned that was not yet recorded on the books.

7 Subtract any unrecorded bank fees, NSF checks, and errors overstating the book balance from the book balance. Deductions on VideoBuster’s bank statement that are not yet recorded include (a) a $23 charge for check printing and (b) an NSF check for $30. (The NSF check is dated October 16 and was in the book balance.)

8 Compute the adjusted book balance.

Verify that the two adjusted balances from steps 4 and 8 are equal (reconciled).

Point: Outstanding checks are identified by comparing canceled checks on the bank statement with checks recorded. This in- cludes identifying any outstand- ing checks listed on the previous period’s bank reconciliation that are not included in the canceled checks on this period’s bank statement.

VIDEOBUSTER Bank Reconciliation October 31, 2019

1 Bank statement balance . . . . . . . . . . . $ 2,050 5 Book balance . . . . . . . . . . . . . . . . . . . . . $ 1,405

2 Add 6 Add

Deposit of Oct . 31 in transit . . . . . . 145 Collected note . . . . . . . . . . . . . . . . . $485

2,195 Interest earned . . . . . . . . . . . . . . . . . 8 493

3 Deduct 1,898

Outstanding checks 7 Deduct

No . 124 . . . . . . . . . . . . . . . . . . . . $150 Check printing charge . . . . . . . . . . . 23

No . 126 . . . . . . . . . . . . . . . . . . . . 200 350 NSF check . . . . . . . . . . . . . . . . . . . . . 30 53

4 Adjusted bank balance . . . . . . . . . . . $1,845 8 Adjusted book balance . . . . . . . . . . . . $1,845

Balances are equal (reconciled)

EXHIBIT 6.7 Bank Reconciliation

Adjusting Entries from a Bank Reconciliation A bank reconciliation often finds unrecorded items that need recording by the company. In VideoBuster’s reconciliation, the adjusted balance of $1,845 is the correct balance as of October 31. But the company’s account- ing records show a $1,405 balance. We make adjusting entries so that the book balance equals the adjusted balance. Only items impacting the book balance need entries. Exhibit 6.7 shows that four entries are required.

Collection of Note The first entry is to record collection of a note receivable by the bank.

Interest Earned The second entry records interest earned.

Oct . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

Record note collected by bank.

Assets = Liabilities + Equity +485 −485

Oct . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Record interest earned in checking account.

Assets = Liabilities + Equity +8 +8

Chapter 6 Cash, Fraud, and Internal Control 249

Check Printing The third entry records expenses for the check printing charge.

NSF Check The fourth entry records the NSF check that is returned as uncollectible. The check was from T. Woods in payment of his account. The bank deducted $30 total from VideoBuster’s account. This means the entry must reverse the effects of the original entry when the check was received.

Point: The company will try to col- lect the $30 from the customer.

Assets = Liabilities + Equity −23 −23

Oct . 31 Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Check printing charge.

Assets = Liabilities + Equity +30 −30

Oct . 31 Accounts Receivable—T . Woods . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Charge Woods’s account for $30 NSF check.

After these four entries are recorded, the book balance of cash is adjusted to the correct amount of $1,845 (the adjusted book balance). The Cash T-account to the side shows the computation, where entries match the steps in Exhibit 6.7.

Point: Need-to-Know 6-4 shows an adjusting entry for an error correction.

Cash

Unadj . bal . 1,405 6 485 7 23 6 8 7 30

Adj . bal . 1,845

Cause for Alarm The Association of Certified Fraud Examiners (ACFE) reports that the primary factor contributing to fraud is the lack of internal controls (30%), followed by the override of existing controls (19%), lack of management review (18%), poor tone at the top (10%), and lack of competent oversight (8%). These findings highlight the impor- tance of internal controls over cash. Source: “Report to the Nations,” ACFE. ■

Ethical Risk

©Redpixel.pl/Shutterstock

The following information is available to reconcile Gucci’s book balance of cash with its bank statement cash balance as of December 31. a. The December 31 cash balance according to the accounting records is $1,610, and the bank statement

cash balance for that date is $1,900. b. Gucci’s December 31 daily cash receipts of $800 were placed in the bank’s night depository on

December 31 but do not appear on the December 31 bank statement. c. Gucci’s comparison of canceled checks with its books shows three checks outstanding: No. 6242 for

$200, No. 6273 for $400, and No. 6282 for $100. d. When the December checks are compared with entries in the accounting records, it is found that Check

No. 6267 had been correctly drawn (taken from the bank) for $340 to pay for office supplies but was erroneously entered in the accounting records as $430.

e. The bank statement shows the bank collected a note receivable and increased Gucci’s account for $470. Gucci had not recorded this transaction before receiving the statement.

f. The bank statement included an NSF check for $150 received from Prada Inc. in payment of its account. It also included a $20 charge for check printing. Gucci had not recorded these transactions before receiving the statement.

Required

1. Prepare the bank reconciliation for this company as of December 31. 2. Prepare the journal entries to make Gucci’s book balance of cash equal to the reconciled cash balance

as of December 31.

Bank Reconciliation

NEED-TO-KNOW 6-4

P3

250 Chapter 6 Cash, Fraud, and Internal Control

Solutions

Part 1

GUCCI Bank Reconciliation

December 31

Bank statement balance . . . . . . . . . . . . $1,900 Book balance . . . . . . . . . . . . . . $1,610

Add Add

Deposit of Dec . 31 . . . . . . . . . . . . . . 800 Error (Ck . 6267) . . . . . . . . . . $ 90

2,700 Collected note . . . . . . . . . . . 470 560

2,170

Deduct Deduct

Outstanding Checks No . 6242 . . . . $200 NSF check . . . . . . . . . . . . . . 150

6273 . . . . 400 Printing fee . . . . . . . . . . . . . . 20

6282 . . . . 100 700 170

Adjusted bank balance . . . . . . . . . . . . . $2,000 Adjusted book balance . . . . . . $2,000

Part 2

Dec . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

Office Supplies . . . . . . . . . . . . . . . . 90

Correct an entry error.

Dec . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470

Notes Receivable . . . . . . . . . . . . . . 470

Record note collection.

Dec . 31 Accounts Receivable—Prada Inc . . . . . . . 150

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 150

Charge account for NSF check.

Dec . 31 Miscellaneous Expenses . . . . . . . . . . . . . 20

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 20

Record check printing charge.

Do More: QS 6-7, QS 6-8, QS 6-9, E 6-11, E 6-12, E 6-13,

E 6-14, P 6-4, P 6-5

Days’ Sales UncollectedDecision Analysis

One measure of how quickly a company can convert its accounts receivable into cash is the days’ sales uncollected, also called days’ sales in receivables, which is defined in Exhibit 6.8.A1

Compute the days’ sales uncollected ratio and use it to assess liquidity.

Days’ sales uncollected = Accounts receivable

Net sales × 365EXHIBIT 6.8

Days’ Sales Uncollected

We use days’ sales uncollected to estimate how much time is likely to pass before the current amount of accounts receivable is received in cash. It is used to determine if cash is being collected quickly enough to pay upcoming obligations. Days’ sales uncollected are shown for Starbucks and Jack in the Box in Exhibit 6.9.

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Starbucks Accounts receivable . . . . . . . . . . . . . . . . . . . . $ 870 $ 769 $ 719 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22,387 $21,316 $19,163

Days’ sales uncollected . . . . . . . . . . . . . . . . 14.2 days 13.2 days 13.7 days Jack in the Box Accounts receivable . . . . . . . . . . . . . . . . . . . . $ 69 $ 73 $ 48 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,554 $ 1,599 $ 1,540

Days’ sales uncollected . . . . . . . . . . . . . . . . 16.2 days 16.7 days 11.4 days

EXHIBIT 6.9 Analysis Using Days’ Sales Uncollected

Days’ sales uncollected for Starbucks is 14.2 days for the current year, computed as ($870/$22,387) × 365 days. This means it takes 14.2 days to collect cash from ending accounts receivable. This number reflects one or more of the following factors: a company’s ability to collect receivables, customer financial health, customer payment strategies, and discount terms. To further assess Starbucks, we compare it to Jack in the Box. We see that Starbucks’s 14.2 days’ sales uncollected is better than Jack in the Box’s 16.2 days’ sales

Chapter 6 Cash, Fraud, and Internal Control 251

uncollected for the current year. Starbucks took less time to collect its receivables. The less time money is tied up in receivables, the better.

Sales Representative The sales staff are told to help reduce days’ sales uncollected for cash management purposes. What can you, a salesperson, do to reduce days’ sales uncollected? ■ Answer: A salesperson can (1) push cash sales over credit, (2) identify customers most delayed in their payments and require earlier payments or cash sales, and (3) eliminate credit sales to customers that never pay.

Decision Maker

Prepare a bank reconciliation for Jamboree Enterprises for the month ended November 30. The following information is available as of November 30. a. On November 30, the company’s book balance of cash is $16,380, but its bank statement shows a

$38,520 balance. b. Checks No. 2024 for $4,810 and No. 2026 for $5,000 are outstanding. c. In comparing the canceled checks on the bank statement with the entries in the accounting records, it

is found that Check No. 2025 in payment of rent is correctly drawn (taken from the bank) for $1,000 but is erroneously entered in the accounting records as $880.

d. The November 30 deposit of $17,150 was placed in the night depository after banking hours on that date, and this amount does not appear on the bank statement.

e. In reviewing the bank statement, a check written by Jumbo Enterprises in the amount of $160 was erroneously drawn against Jamboree’s account.

f. The bank statement says that the bank collected a $30,000 note and $900 of interest was earned. These transactions were not recorded by Jamboree prior to receiving the statement.

g. The bank statement lists a $1,100 NSF check received from a customer, Marilyn Welch. Jamboree had not recorded the return of this check before receiving the statement.

h. Bank service charges for November total $40. These charges were not recorded by Jamboree before receiving the statement.

PLANNING THE SOLUTION Set up a bank reconciliation (as in Exhibit 6.7). Examine each item a through h to determine whether it affects the book or the bank balance and

whether it should be added or subtracted. After all items are analyzed, complete the reconciliation and arrive at a reconciled balance between the

bank side and the book side. For each reconciling item on the book side, prepare an adjusting entry. Additions to the book side

require an adjusting entry that debits Cash. Deductions on the book side require an adjusting entry that credits Cash.

SOLUTION

COMPREHENSIVE

Preparing Bank Reconciliation and Adjusting Entries

NEED-TO-KNOW 6-5

JAMBOREE ENTERPRISES Bank Reconciliation

November 30

Bank statement balance . . . . . . . . $ 38,520 Book balance . . . . . . . . . . . . . . . . . $ 16,380

Add Add

Deposit of Nov . 30 . . . . . . . . . . $17,150 Collection of note . . . . . . . . . . . $30,000

Bank error (Jumbo) . . . . . . . . . 160 17,310 Interest earned . . . . . . . . . . . . . 900 30,900

55,830 47,280

Deduct Deduct

Outstanding checks NSF check (M . Welch) . . . . . . . . 1,100

No . 2024 . . . . . . . . . . . . . . . . 4,810 Recording error (No . 2025) . . . 120

No . 2026 . . . . . . . . . . . . . . . . 5,000 9,810 Service charge . . . . . . . . . . . . . 40 1,260

Adjusted bank balance . . . . . . . . $46,020 Adjusted book balance . . . . . . . . $46,020

PURCHASE REQUISITION

For Purchasing Department use only: Order Date P.O. No.

Z-Mart

Request purchase of the following item(s):

No. 917

10-30-19 P98

Date Preferred Vendor

Reason for Request Replenish inventory Approval for Request

DESCRIPTION

Boys/Girls –Speed Demon 1

QUANTITY

Toddler –Challenger X7 1

MODEL NO.

CH 015

SD 099

Date Preferred Vendor Trex

October 28, 2019From Sporting Goods Department

To Purchasing Department

EXHIBIT 6A.1 Purchase Requisition

252 Chapter 6 Cash, Fraud, and Internal Control

Nov . 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Notes Receivable . . . . . . . . . . . . . . . . 30,000

Record collection of note.

Nov . 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Interest Revenue . . . . . . . . . . . . . . . . . 900

Record collection of revenue.

Nov . 30 Accounts Receivable—M . Welch . . . . . . . . . 1,100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100

Reinstate account due from an NSF check.

Nov . 30 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . 120

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Correct recording error on Check No. 2025.

Nov . 30 Miscellaneous Expenses . . . . . . . . . . . . . . . 40

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Record bank service charges.

Required Adjusting Entries for Jamboree

APPENDIX

Documentation and Verification6A This appendix covers the documents of a voucher system of control.

Purchase Requisition Department managers are usually not allowed to place orders directly with suppliers for control purposes. Instead, a department manager must inform the purchasing depart- ment of its needs by preparing and signing a purchase requisition, which lists the merchandise requested to be purchased—see Exhibit 6A.1. Two copies of the purchase requisition are sent to the purchasing department, which then sends one copy to the accounting department. When the accounting department receives a purchase requisition, it creates and maintains a voucher for this transaction. The requesting department keeps a third copy.

P4 Describe use of documentation and verification to control cash payments.

Purchase Order A purchase order is a document the purchasing department uses to place an order with a vendor (seller or supplier). A purchase order authorizes a vendor to ship merchandise at the stated price and terms—see Exhibit 6A.2. When the purchasing department receives a purchase requisi- tion, it prepares at least five copies of a purchase order. The copies are distributed as follows: copy 1 to the vendor as a purchase request to ship merchandise; copy 2, along with a copy of the purchase requisition, to the accounting department, where it is entered in the voucher and used in approving payment of the invoice; copy 3 to the requesting department to inform its manager of the purchase; copy 4 to the receiving department without order quantity so it can compare with goods received and provide an independent count of goods received; and copy 5 kept on file by the purchasing department.

Invoice An invoice is an itemized statement of goods prepared by the vendor listing the customer’s name, items sold, sales prices, and terms of sale. An invoice is also a bill sent to the buyer from the supplier. From the vendor’s point of view, it is a sales invoice. The buyer, or vendee, treats it as a purchase

Point: This appendix shows one example of a common voucher system design, but not the only design.

Chapter 6 Cash, Fraud, and Internal Control 253

invoice. The invoice is sent to the buyer’s accounting department, where it is placed in the voucher. (Refer back to Exhibit 4.6, which shows Z-Mart’s purchase invoice.)

Receiving Report Many companies have a receiving department to receive all merchandise and purchased assets. When each shipment arrives, this receiving department counts the goods and checks them for damage and agreement with the purchase order. It then prepares four or more copies of a receiv- ing report, which is used within the company to notify that ordered goods have been received and to describe the quantities and condition of the goods. One copy is sent to accounting and placed in the voucher. Copies also are sent to the requesting department and the purchasing department to notify them that the goods have arrived. The receiving department keeps a copy in its files.

Invoice Approval When a receiving report arrives, the accounting department should have cop- ies of the following documents in the voucher: purchase requisition, purchase order, and invoice. With the information in these documents, the accounting department can record the purchase and approve its pay- ment. In approving an invoice for payment, it checks and compares information across all documents. To verify this information and to ensure that no step is missing, it often uses an invoice approval, also called check authorization—see Exhibit 6A.3. An invoice approval is a checklist of steps necessary for approving an invoice for recording and payment. It is a separate document either filed in the voucher or preprinted (or stamped) on the voucher.

PURCHASE ORDERZ-Mart 10 Michigan Street

Chicago, Illinois 60521 No. P98

To: Trex W9797 Cherry Road Antigo, Wisconsin 54409

Date 10-30-19

2/15, n/30

FOB Destination As soon as possibleShip by

Terms Request shipment of the following item(s):

All shipments and invoices must include purchase order number.

ORDERED BY

Model No. Description

Boys/Girls –Speed Demon 1

Quantity Price Amount

350 350

CH 015

SD 099

Toddler –Challenger X7 1 150 150

Point: Shipping terms and credit terms are shown on the purchase order.

EXHIBIT 6A.2 Purchase Order

INVOICE APPROVAL

Purchase requisition

Purchase order

Receiving report

Invoice:

Price

Calculations

Terms

Approved for payment

917

P98

R85

4657

10-28-19TZ

JW

SK

JK

JK

JK

BC

10-30-19

11-03-19

11-12-19

11-12-19

11-12-19

11-12-19

BY DATEDOCUMENT

EXHIBIT 6A.3 Invoice Approval

As each step in the checklist is approved, the person initials the invoice approval and records the cur- rent date. Final approval means the following steps have occurred.

1. Requisition check: Items on invoice are requested per purchase requisition. 2. Purchase order check: Items on invoice are ordered per purchase order. 3. Receiving report check: Items on invoice are received per receiving report. 4. Invoice check: Price: Invoice prices are as agreed with the vendor. Calculations: Invoice has no mathematical errors. Terms: Terms are as agreed with the vendor.

Voucher Once an invoice has been checked and approved, the voucher is complete. A complete voucher is a record summarizing a transaction. Once the voucher certifies a transaction, it authorizes record- ing an obligation. A voucher also contains approval for paying the obligation on an appropriate date.

Point: Recording a purchase is initiated by an invoice approval, not an invoice. An invoice ap- proval verifies that the amount is consistent with that requested, ordered, and received. This con- trols and verifies purchases and related liabilities.

Point: Auditors, when auditing inventory, check a sampling of purchases by reviewing the purchase order, receiving report, and invoice.

254 Chapter 6 Cash, Fraud, and Internal Control

Completion of a voucher usually requires a person to enter certain information on both the inside and outside of the voucher. Typical information required on the inside of a voucher is on the left-hand side of Exhibit 6A.4, and that for the outside is on the right-hand side. This information is taken from the invoice and the supporting documents filed in the voucher. A complete voucher is sent to an authorized individual (often called an auditor). This person performs a final review, approves the accounts and amounts for debiting (called the accounting distribution), and authorizes recording of the voucher.

Chicago, Illinois

Date

For the following: (attach all invoices and supporting documents)

Oct. 28, 2019 Trex

Voucher No. 4657

Pay to AntigoCity WisconsinState

TERMS TERMS

Nov. 2, 2019 2/15, n/30 Invoice No. 4657 Less discount

Net amount payable

500 10 490

Payment approved

Auditor

Z-Mart

DATE OF INVOICE INVOICE NUMBER AND OTHER DETAILS

Inside Voucher No. 4657

November 12, 2019Due Date TrexPay to

AntigoCity WisconsinState

500 Summary of charges: Total charges Discount Net payment

10 490

Record of payment: Paid Check No.

Accounting Distribution ACCOUNT DEBITED

Merch. Inventory Store Supplies O�ce Supplies Sales Salaries Other

Total Vouch. Pay. Cr.

500

500

AMOUNT

Outside

EXHIBIT 6A.4 A Voucher

After a voucher is approved and recorded (in a journal called a voucher register), it is filed by its due date. A check is then sent on the payment date from the cashier, the voucher is marked “paid,” and the voucher is sent to the accounting department and recorded (in a journal called the check register). The person issuing checks relies on the approved voucher and its signed supporting documents as proof that an obligation has been incurred and must be paid. The purchase requisition and purchase order confirm the purchase was authorized. The receiving report shows that items have been received, and the invoice ap- proval form verifies that the invoice has been checked for errors. There is little chance for error and even less chance for fraud without collusion unless all the documents and signatures are forged.

FRAUD AND INTERNAL CONTROL Principles of Internal Control Establish responsibilities: Responsibility for a task should be assigned to one person. If responsibility is not established, determining who is at fault is difficult. Maintain adequate records: Good recordkeeping helps protect assets and helps managers monitor company activities. Insure assets and bond key employees: Assets should be insured, and employees handling cash and easily transferable assets should be bonded. Separate recordkeeping from custody of assets: An employee who has access to an asset must not have access to that asset’s accounting records. Divide responsibility for related transactions: Responsibility for a trans- action should be divided between two or more individuals or departments. One person’s work is a check on the others to prevent errors. This is not duplication of work. Apply technological controls: Use technology such as ID scanners to pro- tect assets and improve control. Perform regular and independent reviews: Regular reviews of internal controls should be performed by outside reviewers, preferably auditors.

CONTROL OF CASH Cash account: Includes currency, coins, checks, and deposits in bank accounts. Cash equivalents: Short-term, liquid investment assets meeting two crite- ria: (1) convertible to a known cash amount and (2) close to their due date, usually within 3 months. An example is a U.S. Treasury bill. Cash management strategies: (a) Encourage early collection of receiv- ables, (b) delay payment of liabilities, (c) keep only necessary assets, (d) plan expenditures, and (e) invest excess cash.

Summary: Cheat Sheet

Over-the-Counter Cash Receipt Control Procedures ∙ Sales are recorded on a cash register after each sale, and customers are

given a receipt. ∙ Cash registers hold a locked-in record of each transaction and often are

linked with the accounting system. ∙ Custody over cash is separate from recordkeeping. The clerk who has

access to cash in the register cannot access accounting records. The recordkeeper cannot access the cash.

Cash Over and Short Journal Entries

Cash Receipts by Mail Control Procedures ∙ Two people are tasked with opening mail. Theft of cash would require

collusion between these two employees. ∙ A list (in triplicate) is kept of each sender’s name, the amount, and an

explanation of why money was sent. The first copy is sent with the money to the cashier. A second copy is sent to the recordkeeper. The employees who opened the mail keep the third copy. The cashier depos- its the money in a bank, and the recordkeeper records amounts received.

∙ No employee has access to both accounting records and cash.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . 5 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550

If cash received is more than recorded cash sales:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625

If cash received is less than recorded cash sales:

Chapter 6 Cash, Fraud, and Internal Control 255

Cash Payment Control Procedures ∙ Require all payments to be made by check or EFT. The only exception is

small payments made from petty cash. ∙ Deny access to records to employees who can sign checks (other than the

owner). Voucher system: Set of procedures to control cash payments. Applied to all payments.

TOOLS OF CONTROL AND ANALYSIS Petty cash: System of control used for small payments.

Canceled checks: Checks the bank has paid and deducted from the cus- tomer’s account. Bank reconciliation adjustments:

Entry to set up a petty cash fund:

Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Increasing a petty cash fund (after reimbursement):

Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Decreasing a petty cash fund (after reimbursement):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Adjusting Entries from Bank Reconciliation—Examples Collection of note:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

Interest earned:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Bank fees:

Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 23

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

NSF checks:

Accounts receivable–Name . . . . . . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Petty cash fund has unexplained shortage:

Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 178

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

Reimburse and record expenses for petty cash:

Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 46 .50

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 .05

Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 .00

Office Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 4 .75

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 .30

Bank Balance Adjustments

Add deposits in transit . Subtract outstanding checks . Add or subtract corrections of bank errors .

Book Balance Adjustments

Add interest earned and unrecorded cash receipts . Subtract bank fees and NSF checks . Add or subtract corrections of book errors .

Bank reconciliation (247) Bank statement (246) Canceled checks (246) Cash (239) Cash equivalents (239) Cash Over and Short (240) Check (245) Check register (254) Committee of Sponsoring

Organizations (COSO) (235) Credit memorandum (247) Days’ sales uncollected (250)

Debit memorandum (247) Deposit ticket (245) Deposits in transit (247) Electronic funds transfer (EFT) (245) Internal control system (235) Invoice (252) Invoice approval (253) Liquid assets (238) Liquidity (238) Outstanding checks (247) Petty cash (242) Principles of internal control (236)

Purchase order (252) Purchase requisition (252) Receiving report (253) Sarbanes-Oxley Act (SOX) (235) Signature card (245) Vendee (252) Vendor (252) Voucher (241) Voucher register (254) Voucher system (241)

Key Terms

Multiple Choice Quiz

1. The following information is available for Hapley Co. ∙ November 30 bank statement shows a $1,895 balance. ∙ The general ledger shows a $1,742 balance at November 30. ∙ A $795 deposit placed in the bank’s night depository on

November 30 does not appear on the November 30 bank statement.

∙ Outstanding checks amount to $638 at November 30. ∙ A customer’s $320 note was collected by the bank and

deposited in Hapley’s account in November.

∙ A bank service charge of $10 is deducted by the bank and appears on the November 30 bank statement.

How will the customer’s note appear on Hapley’s November 30 bank reconciliation? a. $320 appears as an addition to the book balance of cash. b. $320 appears as a deduction from the book balance of cash. c. $320 appears as an addition to the bank balance of cash. d. $320 appears as a deduction from the bank balance of cash. e. $335 appears as an addition to the bank balance of cash.

256 Chapter 6 Cash, Fraud, and Internal Control

2. Using the information from question 1, what is the reconciled balance on Hapley’s November 30 bank reconciliation? a. $2,052 c. $1,742 e. $1,184 b. $1,895 d. $2,201

3. A company needs to replenish its $500 petty cash fund. Its petty cashbox has $75 cash and petty cash receipts of $420. The journal entry to replenish the fund includes a. A debit to Cash for $75. b. A credit to Cash for $75.

c. A credit to Petty Cash for $420. d. A credit to Cash Over and Short for $5. e. A debit to Cash Over and Short for $5.

4. A company had net sales of $84,000 and accounts receiv- able of $6,720. Its days’ sales uncollected is a. 3.2 days. c. 230.0 days. e. 12.5 days. b. 18.4 days. d. 29.2 days.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a; recognizes cash collection of note by bank. 2. a; the bank reconciliation follows.

3. e; The entry follows.

Bank Reconciliation November 30

Balance per bank statement . . . . $1,895

Add: Deposit in transit . . . . . . . . . 795

Deduct: Outstanding checks . . . . (638)

Reconciled balance . . . . . . . . . . . $2,052

Balance per books . . . . . . . . $1,742

Add: Note collected . . . . . . . 320

Deduct: Service charge . . . . (10)

Reconciled balance . . . . . . . $2,052

Debits to expenses (or assets) . . . . . . . . . . 420

Cash Over and Short . . . . . . . . . . . . . . . . . . 5

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 425

4. d; ($6,720∕$84,000) × 365 = 29.2 days

A Superscript letter A denotes assignments based on Appendix 6A.

Icon denotes assignments that involve decision making.

1. List the seven broad principles of internal control. 2. Internal control procedures are important in every busi-

ness, but at what stage in the development of a business do they become especially critical?

3. Why should responsibility for related transactions be divided among different departments or individuals?

4. Why should the person who keeps the records of an as- set not be the person responsible for its custody?

5. When a store purchases merchandise, why are individ- ual departments not allowed to directly deal with suppliers?

6. What are the limitations of internal controls? 7. Which of the following assets—inventory, building, accounts

receivable, or cash—is most liquid? Which is least liquid? 8. What is a petty cash receipt? Who should sign it? 9. Why should cash receipts be deposited on the day of receipt? 10. Apple’s statement of cash flows in Appendix A

describes changes in cash and cash equivalents for the year ended September 30, 2017. What total amount

is provided (used) by investing activities? What amount is provided (used) by financing activities?

11. Refer to Google’s financial statements in Appendix A. Identify Google’s net earn- ings (income) for the year ended December 31, 2017. Is its net earnings equal to the change in cash and cash equiva- lents for the year? Explain the difference between net earn- ings and the change in cash and cash equivalents.

12. Refer to Samsung’s balance sheet in Appendix A. How does its cash (titled “Cash and cash equivalents”) compare with its other cur- rent assets (in both amount and percent) as of December 31, 2017? Compare and assess its cash at December 31, 2017, with its cash at December 31, 2016.

13. Samsung’s statement of cash flows in Appendix A reports the change in cash and equivalents for the year ended December 31, 2017. Identify the cash generated (or used) by operating activities, by investing activities, and by financing activities.

Discussion Questions

APPLE

Samsung

Samsung

GOOGLE

QUICK STUDY

QS 6-1 Internal control objectives

C1

Indicate which statements are true and which are false. 1. Separation of recordkeeping for assets from the custody over assets helps reduce fraud. 2. The primary objective of internal control procedures is to safeguard the business against theft

from government agencies. 3. Internal control procedures should be designed to protect assets from waste and theft. 4. Separating the responsibility for a transaction between two or more individuals or departments

will not help prevent someone from creating a fictitious invoice and paying the money to himself.

Chapter 6 Cash, Fraud, and Internal Control 257

Choose from the following list of terms and phrases to best complete the following statements. a. Cash c. Outstanding check e. Cash over and short b. Cash equivalents d. Liquidity f. Voucher system

1. The category includes currency, coins, and deposits in bank accounts. 2. The term refers to a company’s ability to pay for its current liabilities. 3. The category includes short-term, highly liquid investment assets that are readily con-

vertible to a known cash amount and sufficiently close to their due dates so that their market value will not greatly change.

QS 6-3 Cash and equivalents

C2

1. Brooks Agency set up a petty cash fund for $150. At the end of the current period, the fund contained $28 and had the following receipts: entertainment, $70; postage, $30; and printing, $22. Prepare jour- nal entries to record (a) establishment of the fund and (b) reimbursement of the fund at the end of the current period.

2. Identify the two events from the following that cause a Petty Cash account to be credited in a journal entry.

a. Fund amount is being reduced. c. Fund is being eliminated. b. Fund amount is being increased. d. Fund is being established.

QS 6-6 Petty cash accounting

P2

Nolan Company’s Cash account shows a $22,352 debit balance and its bank statement shows $21,332 on deposit at the close of business on June 30. Prepare a bank reconciliation using the following information. a. Outstanding checks as of June 30 total $3,713. b. The June 30 bank statement lists $41 in bank service charges; the company has not yet recorded the

cost of these services.

QS 6-8 Bank reconciliation

P3

Record the journal entry for Sales and for Cash Over and Short for each of the following separate situations. a. The cash register’s record shows $420 of cash sales, but the count of cash in the register is $430. b. The cash register’s record shows $980 of cash sales, but the count of cash in the register is $972.

QS 6-5 Cash Over and Short

P1

Identify each of the following statements as either true or false. a. A guideline for safeguarding cash is that all cash receipts be deposited monthly or yearly. b. A voucher system of control is a control system exclusively for cash receipts. c. A guideline for safeguarding cash is to separate the duties of those who have custody of cash from

those who keep cash records. d. Separation of duties eliminates the possibility of collusion to steal an asset and hide the theft from

the records.

QS 6-4 Internal control for cash

P1

COSO lists five components of internal control: control environment, risk assessment, control activities, information and communication, and monitoring. Indicate the COSO component that matches with each of the following internal control activities.

a. Independent review of controls c. Reporting of control effectiveness b. Executives’ strong ethics d. Analyses of fraud risk factors

QS 6-2 COSO internal control components

C1

For a through g, indicate whether its amount (1) affects the bank or book side of a bank reconciliation, (2) is an addition or a subtraction in a bank reconciliation, and (3) requires an adjusting journal entry.

QS 6-7 Bank reconciliation

P3 Bank or Book Side Add or Subtract Adj. Entry or Not

a . Interest on cash balance . . . . . . . . . . . . . . . . .

b . Bank service charges . . . . . . . . . . . . . . . . . . .

c . Minimum balance bank fee . . . . . . . . . . . . . .

d . Outstanding checks . . . . . . . . . . . . . . . . . . . .

e . Collection of note by bank . . . . . . . . . . . . . . .

f . NSF checks . . . . . . . . . . . . . . . . . . . . . . . . . . .

g . Outstanding deposits . . . . . . . . . . . . . . . . . . .

[continued on next page]

258 Chapter 6 Cash, Fraud, and Internal Control

c. In reviewing the bank statement, a $90 check written by the company was mistakenly recorded in the company’s books as $99.

d. June 30 cash receipts of $4,724 were placed in the bank’s night depository after banking hours and were not recorded on the June 30 bank statement.

e. The bank statement included a $23 credit for interest earned on the company’s cash in the bank. The company has not yet recorded interest earned.

Organic Food Co.’s Cash account shows a $5,500 debit balance and its bank statement shows $5,160 on de- posit at the close of business on August 31. Prepare a bank reconciliation using the following information. a. August 31 cash receipts of $1,240 were placed in the bank’s night depository after banking hours and

were not recorded on the August 31 bank statement. b. The bank statement shows a $120 NSF check from a customer; the company has not yet recorded this

NSF check. c. Outstanding checks as of August 31 total $1,120. d. In reviewing the bank statement, an $80 check written by Organic Fruits was mistakenly drawn against

Organic Food’s account. e. The August 31 bank statement lists $20 in bank service charges; the company has not yet recorded the

cost of these services.

QS 6-9 Bank reconciliation

P3

Management uses a voucher system to help control and monitor cash payments. Which one or more of the four documents listed below are prepared as part of a voucher system of control?

a. Purchase order b. Outstanding check c. Invoice d. Voucher

QS 6-11A Documents in a voucher system P4

EXERCISES

Exercise 6-1 Analyzing internal control

C1

Identify the internal control principle that was violated in each of the following separate situations. a. The recordkeeper left town after the owner discovered a large sum of money had disappeared. An au-

dit found that the recordkeeper had written and signed several checks made payable to his fiancée and recorded the checks as salaries expense.

b. An employee was put in charge of handling cash. That employee later stole cash from the business. The company incurred an uninsured loss of $184,000.

c. There is $500 in cash missing from a cash register drawer. Three salesclerks shared the cash register drawer, so the owner cannot determine who is at fault.

Whole Fruits Market took the following actions to improve internal controls. For each of the following actions, identify the internal control principle the company followed. a. Prohibit the recordkeeper from having control over cash. b. Purchased an insurance (bonding) policy against losses from theft by a cashier. c. Each cashier is designated a specific cash drawer and is solely responsible for cash in that drawer. d. Detailed records of inventory are kept to ensure items lost or stolen do not go unnoticed. e. Digital time clocks are used to register which employees are at work at what times. f. External auditors are regularly hired to evaluate internal controls.

Exercise 6-2 Applying internal control principles

C1

Year 2 Year 1

Accounts receivable . . . . . . . . . . . . $  100,000 $   85,000

Net sales . . . . . . . . . . . . . . . . . . . . . 2,500,000 2,000,000

The following annual account balances are from Armour Sports at December 31.QS 6-10 Days’ sales uncollected

A1

a. What is the change in the number of days’ sales uncollected between Year 1 and Year 2? (Round the number of days to one decimal.)

b. From the analysis in part a, is the company’s collection of receivables improving?

Chapter 6 Cash, Fraud, and Internal Control 259

Determine whether each procedure described below is an internal control strength or weakness; then iden- tify the internal control principle violated or followed for each procedure. 1. The same employee requests, records, and makes payment for purchases of inventory. 2. The company saves money by having employees involved in operations perform the only review of

internal controls. 3. Time is saved by not updating records for use of supplies. 4. The recordkeeper is not allowed to write checks or initiate EFTs. 5. Each salesclerk is in charge of her own cash drawer.

Exercise 6-3 Internal control strengths and weaknesses

C1

Determine whether each policy below is good or bad cash management; then identify the cash manage- ment strategy violated or followed for each policy. 1. Bills are paid as soon as they are received. 2. Cash receipts and cash payments are regularly planned and reviewed. 3. Excess cash is put in checking accounts, earning no interest income. 4. Customers are regularly allowed to pay after due dates without concern. 5. Rarely used equipment is rented rather than purchased.

Exercise 6-4 Cash management strategies

C2

Determine whether each cash receipts procedure is an internal control strength or weakness. 1. If a salesclerk makes an error in recording a cash sale, she can access the register’s electronic record to

correct the transaction. 2. All sales transactions, even those for less than $1, are recorded on a cash register. 3. Two employees are tasked with opening mail that contains cash receipts. 4. One of the two employees tasked with opening mail is also the recordkeeper for the business. 5. The supervisor has access to both cash and the accounting records. 6. Receipts are given to customers only for sales that are above $20.

Exercise 6-6 Control of cash receipts

P1

Determine whether each cash payment procedure is an internal control strength or weakness. 1. A voucher system is used for all payments of liabilities. 2. The owner of a small business has authority to write and sign checks. 3. When the owner is out of town, the recordkeeper is in charge of signing checks. 4. To save time, all departments are allowed to incur liabilities. 5. Payments over $100 are made by check. 6. Requesting and receiving merchandise are handled by the same department.

Exercise 6-7 Voucher system and control of cash payments

P1

Specter Co. combines cash and cash equivalents on the balance sheet. Using the following information, determine the amount reported on the year-end balance sheet for cash and cash equivalents. ∙ $3,000 cash deposit in checking account. ∙ $200, 3-year loan to an employee. ∙ $20,000 bond investment due in 20 years. ∙ $1,000 of currency and coins. ∙ $5,000 U.S. Treasury bill due in 1 month. ∙ $500 of accounts receivable.

Exercise 6-5 Cash and cash equivalents

C2

Waupaca Company establishes a $350 petty cash fund on September 9. On September 30, the fund shows $104 in cash along with receipts for the following expenditures: transportation-in, $40; postage expenses, $123; and miscellaneous expenses, $80. The petty cashier could not account for a $3 shortage in the fund. The company uses the perpetual system in accounting for merchandise inventory. Prepare (1) the September 9 entry to establish the fund, (2) the September 30 entry to reimburse the fund, and (3) an October 1 entry to increase the fund to $400.

Exercise 6-8 Petty cash fund with a shortage P2

Check (2) Cr. Cash, $246 and (3) Cr. Cash, $50

EcoMart establishes a $1,050 petty cash fund on May 2. On May 30, the fund shows $326 in cash along with receipts for the following expenditures: transportation-in, $120; postage expenses, $369; and miscel- laneous expenses, $240. The petty cashier could not account for a $5 overage in the fund. The company uses the perpetual system in accounting for merchandise inventory. Prepare the (1) May 2 entry to establish the fund, (2) May 30 entry to reimburse the fund [Hint: Credit Cash Over and Short for $5 and credit Cash for $724], and (3) June 1 entry to increase the fund to $1,200.

Exercise 6-9 Petty cash fund with an overage

P2

260 Chapter 6 Cash, Fraud, and Internal Control

Palmona Co. establishes a $200 petty cash fund on January 1. On January 8, the fund shows $38 in cash along with receipts for the following expenditures: postage, $74; transportation-in, $29; delivery expenses, $16; and miscellaneous expenses, $43. Palmona uses the perpetual system in accounting for merchandise inventory. Prepare journal entries to (1) establish the fund on January 1, (2) reimburse it on January 8, and (3) both reimburse the fund and increase it to $450 on January 8, assuming no entry in part 2. Hint: Make two separate entries for part 3.

Exercise 6-10 Petty cash fund accounting

P2

Check (3) Cr. Cash, $162 & $250

Indicate whether each item should be added to or deducted from the book or bank balance and whether it should or should not appear on the September 30 reconciliation. For items that add or deduct from the book balance column, place a Dr. or Cr. after the “Add” or “Deduct” to show the accounting impact on Cash. 1. NSF check from a customer is shown on the bank statement but not yet recorded by the company. 2. Interest earned on the September cash balance in the bank is not yet recorded by the company. 3. Deposit made on September 5 and processed by the bank on September 6. 4. Checks written by another depositor but mistakenly charged against this company’s account. 5. Bank service charge for September is not yet recorded by the company. 6. Checks outstanding on August 31 that cleared the bank in September. 7. Check written against the company’s account and cleared by the bank; erroneously not recorded by

the company’s recordkeeper. 8. A note receivable is collected by the bank for the company, but it is not yet recorded by the company. 9. Checks written and mailed to payees on October 2. 10. Checks written by the company and mailed to payees on September 30. 11. Night deposit made on September 30 after the bank closed. 12. Bank fees for check printing are not yet recorded by the company.

Prepare a table with the following headings for a monthly bank reconciliation dated September 30.Exercise 6-11 Bank reconciliation and adjusting entries

P3 Shown or Not Shown Item Bank Balance Book Balance on Reconciliation

Add or Subtract Add or Subtract Dr . or Cr . Shown or Not Shown

Del Gato Clinic’s Cash account shows an $11,589 debit balance and its bank statement shows $10,555 on deposit at the close of business on June 30. Prepare its bank reconciliation using the following information. a. Outstanding checks as of June 30 total $1,829. b. The June 30 bank statement lists a $16 bank service charge. c. Check No. 919, listed with the canceled checks, was correctly drawn for $467 in payment of a utility

bill on June 15. Del Gato Clinic mistakenly recorded it with a debit to Utilities Expense and a credit to Cash in the amount of $476.

d. The June 30 cash receipts of $2,856 were placed in the bank’s night depository after banking hours and were not recorded on the June 30 bank statement.

Exercise 6-12 Bank reconciliation

P3

Check Reconciled bal., $11,582

Prepare the adjusting journal entries that Del Gato Clinic must record as a result of preparing the bank reconciliation in Exercise 6-12.

Exercise 6-13 Adjusting entries from bank reconciliation P3

Wright Company’s Cash account shows a $27,500 debit balance and its bank statement shows $25,800 on deposit at the close of business on May 31. Prepare its bank reconciliation using the following information. a. The May 31 bank statement lists $100 in bank service charges; the company has not yet recorded the

cost of these services. b. Outstanding checks as of May 31 total $5,600. c. May 31 cash receipts of $6,200 were placed in the bank’s night depository after banking hours and

were not recorded on the May 31 bank statement. d. In reviewing the bank statement, a $400 check written by Smith Company was mistakenly drawn

against Wright’s account. e. The bank statement shows a $600 NSF check from a customer; the company has not yet recorded this

NSF check.

Exercise 6-14 Bank reconciliation

P3

Check Reconciled bal., $26,800

Chapter 6 Cash, Fraud, and Internal Control 261

Barga Co.’s net sales for Year 1 and Year 2 are $730,000 and $1,095,000, respectively. Its year-end bal- ances of accounts receivable follow: Year 1, $65,000; and Year 2, $123,000. a. Compute its days’ sales uncollected at the end of each year. Round the number of days to one decimal. b. Did days’ sales uncollected improve or worsen in Year 2 versus Year 1?

Exercise 6-15 Liquid assets and accounts receivable A1

Match each document in a voucher system with its description. Document 1. Purchase requisition 2. Purchase order 3. Invoice 4. Receiving report 5. Invoice approval 6. Voucher

Exercise 6-16A Documents in a voucher system

P4

Description A. An itemized statement of goods prepared by the vendor listing the cus-

tomer’s name, items sold, sales prices, and terms of sale. B. An internal file used to store documents and information to control

cash payments and to ensure that a transaction is properly authorized and recorded.

C. A document used to place an order with a vendor that authorizes the vendor to ship ordered merchandise at the stated price and terms.

D. A checklist of steps necessary for the approval of an invoice for record- ing and payment; also known as a check authorization.

E. A document used by department managers to inform the purchasing department to place an order with a vendor.

F. A document used to notify the appropriate persons that ordered goods have arrived, including a description of the quantities and condition of goods.

PROBLEM SET A

Problem 6-1A Analyzing internal control

C1

Following are five separate cases involving internal control issues. a. Chi Han receives all incoming customer cash receipts for her employer and posts the customer pay-

ments to their respective accounts. b. At Tico Company, Julia and Trevor alternate lunch hours. Julia is the petty cash custodian, but if some-

one needs petty cash when she is at lunch, Trevor fills in as custodian. c. Nori Nozumi posts all patient charges and payments at the Hopeville Medical Clinic. Each night Nori

backs up the computerized accounting system but does not password lock her computer. d. Ben Shales prides himself on hiring quality workers who require little supervision. As office manager,

Ben gives his employees full discretion over their tasks and for years has seen no reason to perform independent reviews of their work.

e. Carla Farah’s manager has told her to reduce costs. Carla decides to raise the deductible on the plant’s property insurance from $5,000 to $10,000. This cuts the property insurance premium in half. In a related move, she decides that bonding the plant’s employees is a waste of money because the company has not experienced any losses due to employee theft. Carla saves the entire amount of the bonding insurance premium by dropping the bonding insurance.

Required

1. For each case, identify the principle(s) of internal control that is violated. 2. Recommend what should be done to adhere to principles of internal control in each case.

Kiona Co. set up a petty cash fund for payments of small amounts. The following transactions involving the petty cash fund occurred in May (the last month of the company’s fiscal year).

May 1 Prepared a company check for $300 to establish the petty cash fund. 15 Prepared a company check to replenish the fund for the following expenditures made since May 1. a. Paid $88 for janitorial expenses. b. Paid $53.68 for miscellaneous expenses. c. Paid postage expenses of $53.50. d. Paid $47.15 to Facebook for advertising expense. e. Counted $62.15 remaining in the petty cashbox. 16 Prepared a company check for $200 to increase the fund to $500.

Problem 6-2A Establishing, reimbursing, and adjusting petty cash

P2

[continued on next page]

262 Chapter 6 Cash, Fraud, and Internal Control

31 The petty cashier reports that $288.20 cash remains in the fund. A company check is drawn to replenish the fund for the following expenditures made since May 15.

f. Paid postage expenses of $147.36. g. Reimbursed the office manager for mileage expense, $23.50. h. Paid $34.75 in delivery expense for products to a customer, terms FOB destination. 31 The company decides that the May 16 increase in the fund was too large. It reduces the fund by

$100, leaving a total of $400.

Required

Prepare journal entries to establish the fund on May 1, to replenish it on May 15 and on May 31, and to reflect any increase or decrease in the fund balance on May 16 and May 31.

Check Cr. to Cash: May 15, $237.85; May 16, $200.00

Problem 6-3A Establishing, reimbursing, and increasing petty cash

P2

Nakashima Gallery had the following petty cash transactions in February of the current year. Nakashima uses the perpetual system to account for merchandise inventory.

Feb. 2 Wrote a $400 check to establish a petty cash fund. 5 Purchased paper for the copier for $14.15 that is immediately used. 9 Paid $32.50 shipping charges (transportation-in) on merchandise purchased for resale, terms

FOB shipping point. These costs are added to merchandise inventory. 12 Paid $7.95 postage to deliver a contract to a client. 14 Reimbursed Adina Sharon, the manager, $68 for mileage on her car. 20 Purchased office paper for $67.77 that is immediately used. 23 Paid a courier $20 to deliver merchandise sold to a customer, terms FOB destination. 25 Paid $13.10 shipping charges (transportation-in) on merchandise purchased for resale, terms

FOB shipping point. These costs are added to merchandise inventory. 27 Paid $54 for postage expenses. 28 The fund had $120.42 remaining in the petty cashbox. Sorted the petty cash receipts by ac-

counts affected and exchanged them for a check to reimburse the fund for expenditures. 28 The petty cash fund amount is increased by $100 to a total of $500.

Required

1. Prepare the journal entry to establish the petty cash fund. 2. Prepare a petty cash payments report for February with these categories: delivery expense, mileage

expense, postage expense, merchandise inventory (for transportation-in), and office supplies expense. 3. Prepare the journal entries for part 2 to both (a) reimburse and (b) increase the fund amount.

Check Cash credit: (3a) $279.58; (3b) $100.00

Check (1) Reconciled balance, $34,602; (2) Cr. Notes Receivable, $8,000

The following information is available to reconcile Branch Company’s book balance of cash with its bank statement cash balance as of July 31. a. On July 31, the company’s Cash account has a $27,497 debit balance, but its July bank statement

shows a $27,233 cash balance. b. Check No. 3031 for $1,482, Check No. 3065 for $382, and Check No. 3069 for $2,281 are outstanding

checks as of July 31. c. Check No. 3056 for July rent expense was correctly written and drawn for $1,270 but was erroneously

entered in the accounting records as $1,250. d. The July bank statement shows the bank collected $7,955 cash on a note for Branch. Branch had not

recorded this event before receiving the statement. e. The bank statement shows an $805 NSF check. The check had been received from a customer, Evan

Shaw. Branch has not yet recorded this check as NSF. f. The July statement shows a $25 bank service charge. It has not yet been recorded in miscellaneous

expenses because no previous notification had been received. g. Branch’s July 31 daily cash receipts of $11,514 were placed in the bank’s night depository on that date

but do not appear on the July 31 bank statement.

Required

1. Prepare the bank reconciliation for this company as of July 31. 2. Prepare the journal entries necessary to make the company’s book balance of cash equal to the recon-

ciled cash balance as of July 31.

Problem 6-4A Preparing a bank reconciliation and recording adjustments

P3

Chapter 6 Cash, Fraud, and Internal Control 263

Chavez Company most recently reconciled its bank statement and book balances of cash on August 31 and it reported two checks outstanding, No. 5888 for $1,028 and No. 5893 for $494. Check No. 5893 was still outstanding as of September 30. The following information is available for its September 30 reconciliation.

Problem 6-5A Preparing a bank reconciliation and recording adjustments

P3From the September 30 Bank Statement

16,800 9,617 11,270 18,453

PREVIOUS BALANCE TOTAL CHECKS AND DEBITS TOTAL DEPOSITS AND CREDITS CURRENT BALANCE

Date Sep. 3 Sep. 4 Sep. 7 Sep. 17 Sep. 20 Sep. 22 Sep. 22 Sep. 28 Sep. 29

CHECKS AND DEBITS DEPOSITS AND CREDITS

Sep. 5 Sep. 12 Sep. 21 Sep. 25 Sep. 30 Sep. 30

5888 1,103 No. Amount Date Amount

5902 2,226 5901 4,093

5905 12 IN 2,351

5903 1,485 CM 5904 5907 5909

1,028 719

1,824

937 399

2,090 213

1,807

600 NSF

From Chavez Company’s Accounting Records

Cash Receipts Deposited

Date Cash Debit

Sep . 5 1,103

12 2,226

21 4,093

25 2,351

30 1,682

11,455 Cash Acct. No. 101

Date Explanation PR Debit Credit Balance

Aug . 31 Balance 15,278

Sep . 30 Total receipts R12 11,455 26,733

30 Total payments D23 9,329 17,404

Cash Payments

Check No. Cash Credit

5901 1,824

5902 719

5903 399

5904 2,060

5905 937

5906 982

5907 213

5908 388

5909 1,807

9,329

Additional Information (a) Check No. 5904 is correctly drawn for $2,090 to pay for computer equip- ment; however, the recordkeeper misread the amount and entered it in the accounting records with a debit to Computer Equipment and a credit to Cash of $2,060. (b) The NSF check shown in the statement was originally received from a customer, S. Nilson, in payment of her account. Its return has not yet been recorded by the company. (c) The credit memorandum (CM) is from the collection of a $1,485 note for Chavez Company by the bank. The collection is not yet recorded.

Required

1. Prepare the September 30 bank reconciliation for this company. 2. Prepare journal entries to adjust the book balance of cash to the reconciled balance.

Check (1) Reconciled balance, $18,271; (2) Cr. Notes Receivable, $1,485

PROBLEM SET B

Problem 6-1B Analyzing internal control

C1

Following are five separate cases involving internal control issues. a. Tywin Company keeps very poor records of its equipment. Instead, the company asserts its employees

are honest and would never steal from the company. b. Marker Theater has a computerized order-taking system for its tickets. The system is backed up once a year. c. Sutton Company has two employees handling acquisitions of inventory. One employee places pur-

chase orders and pays vendors. The second employee receives the merchandise.

264 Chapter 6 Cash, Fraud, and Internal Control

d. The owner of Super Pharmacy uses a check software/printer to prepare checks, making it difficult for anyone to alter the amount of a check. The check software/printer, which is not password protected, is on the owner’s desk in an office that contains company checks and is normally unlocked.

e. To ensure the company retreat would not be cut, the manager of Lavina Company decided to save money by canceling the external audit of internal controls.

Required

1. For each case, identify the principle(s) of internal control that is violated. 2. Recommend what should be done to adhere to principles of internal control in each case.

Moya Co. establishes a petty cash fund for payments of small amounts. The following transactions involv- ing the petty cash fund occurred in January (the last month of the company’s fiscal year).

Jan. 3 A company check for $150 is written and made payable to the petty cashier to establish the petty cash fund.

14 A company check is written to replenish the fund for the following expenditures made since January 3.

a. Purchased office supplies for $14.29 that are immediately used. b. Paid $19.60 COD shipping charges on merchandise purchased for resale, terms FOB

shipping point. Moya uses the perpetual system to account for inventory. c. Paid $38.57 to All-Tech for repairs expense to a computer. d. Paid $12.82 for items classified as miscellaneous expenses. e. Counted $62.28 remaining in the petty cashbox. 15 Prepared a company check for $50 to increase the fund to $200. 31 The petty cashier reports that $17.35 remains in the fund. A company check is written to replen-

ish the fund for the following expenditures made since January 14. f. Paid $50 to The Smart Shopper in advertising expense for January’s newsletter. g. Paid $48.19 for postage expenses. h. Paid $78 to Smooth Delivery for delivery expense of merchandise, terms FOB destination. 31 The company decides that the January 15 increase in the fund was too little. It increases the

fund by another $50.

Required

Prepare journal entries (in dollars and cents) to establish the fund on January 3, to replenish it on January 14 and January 31, and to reflect any increase or decrease in the fund balance on January 15 and 31.

Problem 6-2B Establishing, reimbursing, and adjusting petty cash

P2

Check Cr. to Cash: Jan. 14, $87.72; Jan. 31 (total), $232.65

Blues Music Center had the following petty cash transactions in March of the current year. Blues uses the perpetual system to account for merchandise inventory.

Mar. 5 Wrote a $250 check to establish a petty cash fund. 6 Paid $12.50 shipping charges (transportation-in) on merchandise purchased for resale, terms

FOB shipping point. These costs are added to merchandise inventory. 11 Paid $10.75 in delivery expense on merchandise sold to a customer, terms FOB destination. 12 Purchased office file folders for $14.13 that are immediately used. 14 Reimbursed Bob Geldof, the manager, $11.65 for office supplies purchased and used. 18 Purchased office printer paper for $20.54 that is immediately used. 27 Paid $45.10 shipping charges (transportation-in) on merchandise purchased for resale, terms

FOB shipping point. These costs are added to merchandise inventory. 28 Paid postage expense of $18. 30 Reimbursed Geldof $56.80 for mileage expense. 31 Cash of $61.53 remained in the fund. Sorted the petty cash receipts by accounts affected and

exchanged them for a check to reimburse the fund for expenditures. 31 The petty cash fund amount is increased by $50 to a total of $300.

Required

1. Prepare the journal entry to establish the petty cash fund. 2. Prepare a petty cash payments report for March with these categories: delivery expense, mileage

expense, postage expense, merchandise inventory (for transportation-in), and office supplies expense. 3. Prepare the journal entries for part 2 to both (a) reimburse and (b) increase the fund amount.

Problem 6-3B Establishing, reimbursing, and increasing petty cash

P2

Check (2) Total expenses, $189.47 (3a & 3b) Total Cr. to Cash, $238.47

Chapter 6 Cash, Fraud, and Internal Control 265

The following information is available to reconcile Severino Co.’s book balance of cash with its bank statement cash balance as of December 31. a. The December 31 cash balance according to the accounting records is $32,878.30, and the bank state-

ment cash balance for that date is $46,822.40. b. Check No. 1242 for $410.40, Check No. 1273 for $4,589.30, and Check No. 1282 for $400 are out-

standing checks as of December 31. c. Check No. 1267 had been correctly drawn for $3,456 to pay for office supplies but was erroneously

entered in the accounting records as $3,465. d. The bank statement shows a $762.50 NSF check received from a customer, Titus Industries, in pay-

ment of its account. The statement also shows a $99 bank fee in miscellaneous expenses for check printing. Severino had not yet recorded these transactions.

e. The bank statement shows that the bank collected $18,980 cash on a note receivable for the company. Severino did not record this transaction before receiving the statement.

f. Severino’s December 31 daily cash receipts of $9,583.10 were placed in the bank’s night depository on that date but do not appear on the December 31 bank statement.

Required

1. Prepare the bank reconciliation for this company as of December 31. 2. Prepare the journal entries necessary to make the company’s book balance of cash equal to the recon-

ciled cash balance as of December 31.

Check (1) Reconciled balance, $51,005.80; (2) Cr. Notes Receivable, $18,980.00

Problem 6-4B Preparing a bank reconciliation and recording adjustments

P3

Shamara Systems most recently reconciled its bank balance on April 30 and reported two checks outstand- ing at that time, No. 1771 for $781 and No. 1780 for $1,425.90. Check No. 1780 was still outstanding as of May 31. The following information is available for its May 31 reconciliation.

Problem 6-5B Preparing a bank reconciliation and recording adjustments

P3 From the May 31 Bank Statement

PREVIOUS BALANCE TOTAL CHECKS AND DEBITS TOTAL DEPOSITS AND CREDITS CURRENT BALANCE

CHECKS AND DEBITS DEPOSITS AND CREDITS

18,290.70

Date May 1 May 2 May 4 May 11 May 18 May 25 May 26 May 29 May 31

May 4 May 14 May 22 May 25 May 26

1771 No. Amount Date Amount

13,094.80 16,566.80 21,762.70

1783 1782 1784

1787 1785 1788

2,438.00 2,898.00 1,801.80

2,079.00 7,350.00 CM

781.00 382.50

1,285.50

431.80 NSF 8,032.50

63.90 654.00

14.00 SC

1,449.60

From Shamara Systems’s Accounting Records

Cash Acct. No. 101

Date Explanation PR Debit Credit Balance

Apr . 30 Balance 16,083 .80

May 31 Total receipts R7 11,944 .10 28,027 .90

31 Total payments D8 12,850 .60 15,177 .30

Cash Receipts Deposited

Date Cash Debit

May 4 2,438 .00

14 2,898 .00

22 1,801 .80

26 2,079 .00

31 2,727 .30

11,944 .10

Cash Payments

Check No. Cash Credit

1782 1,285 .50

1783 382 .50

1784 1,449 .60

1785 63 .90

1786 353 .10

1787 8,032 .50

1788 644 .00

1789 639 .50

12,850 .60

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266 Chapter 6 Cash, Fraud, and Internal Control

Additional Information (a) Check No. 1788 is correctly drawn for $654 to pay for May utilities; how- ever, the recordkeeper misread the amount and entered it in the accounting records with a debit to Utilities Expense and a credit to Cash for $644. The bank paid and deducted the correct amount. (b) The NSF check shown in the statement was originally received from a customer, W. Sox, in payment of her account. The company has not yet recorded its return. (c) The credit memorandum (CM) is from a $7,350 note that the bank collected for the company. The collection has not yet been recorded.

Required

1. Prepare the May 31 bank reconciliation for Shamara Systems. 2. Prepare journal entries to adjust the book balance of cash to the reconciled balance.

Check (1) Reconciled balance, $22,071.50; (2) Cr. Notes Receivable, $7,350.00

SERIAL PROBLEM Business Solutions

P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 6 Santana Rey receives the March bank statement for Business Solutions on April 11, 2020. The March 31 bank statement shows an ending cash balance of $67,566. The general ledger Cash account, No. 101, shows an ending cash balance per books of $68,057 as of March 31 (prior to any reconciliation). A comparison of the bank statement with the general ledger Cash account, No. 101, reveals the following. a. The bank erroneously cleared a $500 check against the company account in March that S. Rey did not

issue. The check was actually issued by Business Systems. b. On March 25, the bank statement lists a $50 charge for a safety deposit box. Santana has not yet re-

corded this expense. c. On March 26, the bank statement lists a $102 charge for printed checks that Business Solutions or-

dered from the bank. Santana has not yet recorded this expense. d. On March 31, the bank statement lists $33 interest earned on Business Solutions’s checking account

for the month of March. Santana has not yet recorded this revenue. e. S. Rey notices that the check she issued for $128 on March 31, 2020, has not yet cleared the bank. f. S. Rey verifies that all deposits made in March do appear on the March bank statement.

Required

1. Prepare a bank reconciliation for Business Solutions for the month ended March 31, 2020. 2. Prepare any necessary adjusting entries. Use Miscellaneous Expenses, No. 677, for any bank charges.

Use Interest Revenue, No. 404, for any interest earned on the checking account for March.

Check (1) Adj. bank bal., $67,938

©Alexander Image/Shutterstock

The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so that the financial professional can focus on the impacts of each transaction on the various financial reports.

GL 6-1 General Ledger assignment GL 6-1, based on Problem 6-2A, focuses on transactions related to the petty cash fund and highlights the impact each transaction has on net income, if any. Prepare the jour- nal entries related to the petty cash fund and assess the impact of each transaction on the company’s net income, if any.

GENERAL LEDGER PROBLEM

GL

COMPANY ANALYSIS C2 A1

Accounting Analysis

AA 6-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Identify the total amount of cash and cash equivalents for fiscal years ended (a) September 30, 2017,

and (b) September 24, 2016. 2. Compute cash and cash equivalents as a percent (rounded to one decimal) of total current assets, total

current liabilities, total shareholders’ equity, and total assets at fiscal year-end for both 2017 and 2016.APPLE

Chapter 6 Cash, Fraud, and Internal Control 267

ETHICS CHALLENGE C1

BTN 6-1 Harriet Knox, Ralph Patton, and Marcia Diamond work for a family physician, Dr. Gwen Conrad, who is in private practice. Dr. Conrad is knowledgeable about office management practices and has segregated the cash receipt duties as follows. Knox opens the mail and prepares a triplicate list of money received. She sends one copy of the list to Patton, the cashier, who deposits the receipts daily in the bank. Diamond, the recordkeeper, receives a copy of the list and posts payments to patients’ accounts. About once a month the office clerks have an expensive lunch they pay for as follows. First, Patton

Beyond the Numbers

3. Compute the percent change (rounded to one decimal) between the beginning and ending year amounts of cash and cash equivalents for fiscal years ended (a) September 30, 2017, and (b) September 24, 2016.

4. Compute the days’ sales uncollected (rounded to one decimal) as of (a) September 30, 2017, and (b) September 24, 2016.

5. Does Apple’s collection of receivables show a favorable or unfavorable change?

AA 6-3 Key figures for Samsung follow. GLOBAL ANALYSIS C2 A1

W millions Current Year Prior Year

Cash . . . . . . . . . . . . . . . . . . . . . . . . . W 30,545,130 W 32,111,442

Accounts receivable . . . . . . . . . . . . 31,804,956 27,800,408

Current assets . . . . . . . . . . . . . . . . . 146,982,464 141,429,704

Total assets . . . . . . . . . . . . . . . . . . . 301,752,090 262,174,324

Current liabilities . . . . . . . . . . . . . . . 67,175,114 54,704,095

Shareholders’ equity . . . . . . . . . . . 214,491,428 192,963,033

Net sales . . . . . . . . . . . . . . . . . . . . . 239,575,376 201,866,745

Required

1. Compute cash and cash equivalents as a percent (rounded to one decimal) of total current assets, total assets, total current liabilities, and total shareholders’ equity for both years.

2. Compute the percentage change (rounded to one decimal) between the current year and prior year cash balances.

3. Compute the days’ sales uncollected (rounded to one decimal) at the end of both the (a) current year and (b) prior year.

4. Does Samsung’s collection of receivables show a favorable or unfavorable change?

Samsung

Required

1. Compute days’ sales uncollected (rounded to one decimal) for (a) Apple and (b) Google for the current and prior years.

2. Which company had more success collecting receivables?

AA 6-2 Key comparative figures for Apple and Google follow. COMPARATIVE ANALYSIS A1

APPLE GOOGLE

Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Accounts receivable . . . . . . . . . . . . $ 17,874 $ 15,754 $ 18,336 $14,137

Net sales . . . . . . . . . . . . . . . . . . . . . 229,234 215,639 110,855 90,272

268 Chapter 6 Cash, Fraud, and Internal Control

endorses a patient’s check in Dr. Conrad’s name and cashes it at the bank. Knox then destroys the remit- tance advice accompanying the check. Finally, Diamond posts payment to the customer’s account as a miscellaneous credit. The three justify their actions by their relatively low pay and knowledge that Dr. Conrad will likely never miss the money.

Required

1. Who is the best person in Dr. Conrad’s office to reconcile the bank statement? 2. Would a bank reconciliation uncover this office fraud? 3. What are some procedures to detect this type of fraud? 4. Suggest additional internal controls that Dr. Conrad could implement.

BTN 6-2 Assume you are a business consultant. The owner of a company sends you an e-mail expressing concern that the company is not taking advantage of its discounts offered by vendors. The company cur- rently uses the gross method of recording purchases. The owner is considering a review of all invoices and payments from the previous period. Due to the volume of purchases, however, the owner recognizes that this is time-consuming and costly. The owner seeks your advice about monitoring purchase discounts in the future. Provide a response in memorandum form. Hint: It will help to review the recording of purchase discounts in Appendix 4C.

COMMUNICATING IN PRACTICE P4

BTN 6-3 Visit the Association of Certified Fraud Examiners website and open the “2016 Report to the Nations” (s3-us-west-2.amazonaws.com/acfepublic/2016-report-to-the-nations.pdf). Read the two- page Executive Summary and fill in the following blanks. 1. The median loss for all cases in our study was , with of cases causing losses of

$1 million or more. 2. The typical organization loses of revenues in a given year as a result of fraud. 3. The median duration—the amount of time from when the fraud commenced until it was detected—for

the fraud cases reported to us was . 4. Asset misappropriation was by far the most common form of occupational fraud, occurring in more

than of cases, but causing the smallest median loss of . 5. Financial statement fraud was on the other end of the spectrum, occurring in less than 10% of cases

but causing a median loss of . Corruption cases fell in the middle, with of cases and a median loss of .

6. The most common detection method in our study was (39.1% of cases). 7. Approximately of the cases reported to us targeted privately held or publicly owned compa-

nies. These for-profit organizations suffered the largest median losses among the types of organiza- tions analyzed, at and , respectively.

TAKING IT TO THE NET C1 P1

BTN 6-4 Organize the class into teams. Each team must prepare a list of 10 internal controls a con- sumer could observe in a typical retail department store. When called upon, the team’s spokesperson must be prepared to share controls identified by the team that have not been shared by another team’s spokesperson.

TEAMWORK IN ACTION C1

Chapter 6 Cash, Fraud, and Internal Control 269

BTN 6-5 Review the opening feature of this chapter that highlights Sheila Marcelo and her company Care.com. Her company plans to open a kiosk in the Ferry Building in San Francisco to sell Care.com shirts, hats, and other merchandise. Other retail outlets and expansion plans may be in the works.

Required

1. List the seven principles of internal control and explain how a retail outlet might implement each of the principles in its store.

2. Do you believe that a retail outlet will need to add controls to the business as it expands? Explain.

ENTREPRENEURIAL DECISION C1 P1

BTN 6-6 Visit an area of your college that serves the student community with either products or services. Some examples are food services, libraries, and bookstores. Identify and describe between four and eight internal controls being implemented.

HITTING THE ROAD C1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Describe accounts receivable and how

they occur and are recorded.

C2 Describe a note receivable, the computation of its maturity date, and the recording of its existence.

C3 Explain how receivables can be converted to cash before maturity.

P2 Apply the allowance method to accounts receivable.

P3 Estimate uncollectibles based on sales and accounts receivable.

P4 Record the honoring and dishonoring of a note and adjustments for interest.

ANALYTICAL A1 Compute accounts receivable turnover

and use it to help assess financial condition.

PROCEDURAL P1 Apply the direct write-off method to

accounts receivable.

Chapter Preview

7 Accounting for Receivables

NTK 7-4

ESTIMATING BAD DEBTS

P3 Percent of sales Percent of receivables

Aging of receivables

NTK 7-5

NOTES RECEIVABLE

C2 Maturity and interest

P4 Accounting for notes

C3 Selling and pledging

A1 Receivable turnover

NTK 7-3

ALLOWANCE METHOD

P2 Recording bad debts

Writing off bad debts

Recovery of bad debts

VALUING RECEIVABLES

C1 Sales on credit Sales on store card

Sales on bank card

Sales on installment

NTK 7-2

DIRECT WRITE- OFF METHOD

P1 Recording bad debts

Recovery of bad debts

When to use direct write-off

NTK 7-1

271

“Taking initiative pays off”—Sheryl Sandberg

At Face Value

MENLO PARK, CA—Many know the story of how Mark Zuckerberg started Facebook (Facebook.com) in his college dorm room. How Facebook went from a “cool website” to a profitable company is less well known.

It began at a Christmas party when Sheryl Sandberg met Mark. “We talked for probably an hour by the door,” recalls Mark. After much convincing, Sheryl joined Facebook as its chief op- erating officer.

Sheryl began by reviewing Facebook’s financial statements and was alarmed by the lack of revenue and receivables. “There was this open question,” explains Sheryl. “Could we make money . . . ever?” She organized a meeting where ideas such as charging a subscription fee and inserting ads were pro- posed.

As we now know, Facebook committed to an ad-focused model. The strategy was a huge success, and revenues and receivables soared. Sheryl then moved to her next challenge: managing accounts receivable.

Sheryl and Mark saw that decisions on credit sales and ex- tending credit were impacting income. To combat risk of loss, credit is extended to customers who make timely payments.

Sheryl and Mark also look at cash inflow patterns to estimate uncollectibles and minimize bad debts.

Sheryl enjoys Facebook’s success, but her passion is “mission-based.” She explains: “I believe strongly in what Facebook’s doing. That’s why I get up and go to work every day.”

Sources: Facebook website, January 2019; BSR.org, April 2016; McKinsey, April 2013; New Yorker, July 2011

©Kim White/Bloomberg/Getty Images

A receivable is an amount due from another party. The two most common receivables are accounts receivable and notes receivable. Other receivables include interest receivable, rent receivable, tax refund receivable, and receivables from employees.

Accounts receivable are amounts due from customers for credit sales. Exhibit 7.1 shows amounts of receivables and their percent of total assets for some well-known companies.

VALUING ACCOUNTS RECEIVABLE C1 Describe accounts receivable and how they occur and are recorded.

Percent of Total Assets 0% 2% 4% 6% 8% 10% 12% 14% 16%

Abercrombie & Fitch 4.1%

$3,011 mil.John Deere

Callaway Golf 16.0%

Pfizer 4.8%

5.2%

$93 mil.

$8,225 mil.

$128 mil.

EXHIBIT 7.1 Accounts Receivable for Selected Companies

Sales on Credit Credit sales are recorded by increasing (debiting) Accounts Receivable. The general ledger has a single Accounts Receivable account (called a control account). A com- pany uses a separate account for each customer to track how much that customer purchases, has already paid, and still owes. A supplementary record has a separate account for each customer and is called the accounts receivable ledger (or accounts receivable subsidiary ledger).

Exhibit 7.2 shows the relation between the Accounts Receivable account in the general led- ger and its customer accounts in the accounts receivable ledger for TechCom, a small whole- saler. TechCom’s accounts receivable reports a $3,000 ending balance for June 30. TechCom has two credit customers: CompStore and RDA Electronics. Its schedule of accounts receivable shows that the $3,000 balance of the Accounts Receivable account in the general ledger equals the total of its two customers’ balances in the accounts receivable ledger.

272 Chapter 7 Accounting for Receivables

To see how to record accounts receivable from credit sales, we look at two transactions between TechCom and its credit customers—see Exhibit 7.3. The first is a credit sale of $950 to CompStore. The second is a collection of $720 from RDA Electronics from a prior credit sale.

General Ledger

Date June 30

Debit

3,0003,0003,000

PR Accounts Receivable

Accounts Receivable Ledger

Date June 30

Debit Balance

1,0001,0001,000

PR RDA Electronics

Date June 30

Debit Credit Balance

2,0002,0002,000

PR CompStore

RDA Electronics……………… $1,000 CompStore……………………… 2,000

TechCom Schedule of Accounts Receivable

Credit Balance Credit

Total………………………………… $3,000

EXHIBIT 7.2 General Ledger and the Accounts Receivable Ledger (before July 1 transactions)

Assets = Liabilities + Equity +950 +950

Assets = Liabilities + Equity +720 −720

EXHIBIT 7.3 Accounts Receivable Transactions

July 1 Accounts Receivable—CompStore . . . . . . . . . . . . . . . . . . . . . . 950

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Record credit sales.*

July 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720

Accounts Receivable—RDA Electronics . . . . . . . . . . . . . . 720

Record collection of credit sales.

* We omit the entry to Dr. Cost of Sales and Cr. Inventory to focus on sales and receivables; no sales returns and allowances are expected.

Exhibit 7.4 shows the general ledger and the accounts receivable ledger after recording the two July 1 transactions. The general ledger shows the effects of the sale, the collection, and the resulting balance of $3,230. These transactions are also shown in the individual customer accounts: RDA Electronics’s ending balance is $280 and CompStore’s ending balance is $2,950. The $3,230 total of customer accounts equals the balance of the Accounts Receivable account in the general ledger.

General Ledger

Date

June 30 July 1 July 1

Debit Credit Balance

3,000 3,950 3,230

3,000 3,950 3,230

3,000 950

720

PR Accounts Receivable

Accounts Receivable Ledger

Date

June 30 July 1

Debit Credit Balance

1,0001,0001,000 720 280

PR RDA Electronics

Date

June 30 July 1

Debit Credit Balance

2,0002,000 2,9502,950

2,000 950

PR CompStore

TechCom Schedule of Accounts Receivable

RDA Electronics……………… $ 280 CompStore……………………… 2,950

Total………………………………… $3,230

EXHIBIT 7.4 General Ledger and the Accounts Receivable Ledger (after July 1 transactions)

Sales on Store Credit Cards Like TechCom, many large retailers such as Home Depot sell on credit. Many also have their own credit cards to grant credit to approved custom- ers and to earn interest on any balance past due. The entries in this case are the same as those for TechCom except for added interest revenue as follows.

Assets = Liabilities + Equity +1,000 +1,000

Assets = Liabilities + Equity +15 +15

Nov . 1 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Record sales on store credit card.

Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Interest of $15 earned on store card sales past due.

Chapter 7 Accounting for Receivables 273

Sales on Bank Credit Cards Most companies allow customers to pay using bank (or third-party) credit cards, such as Visa, Mastercard, or American Express, and debit cards. Sellers allow customers to use credit cards and debit cards for several reasons. First, the seller does not have to decide who gets credit and how much. Second, the seller avoids the risk of customers not paying (this risk is transferred to the card company). Third, the seller typically receives cash from the card company sooner than had it granted credit directly to customers. Fourth, more credit options for customers can lead to more sales.

The seller pays a fee when a card is used by the customer, often ranging from 1% to 5% of card sales. This fee reduces the cash received by the seller. If TechCom has $100 of credit card sales with a 4% fee, the entry follows. Some sellers report Credit Card Expense in the income statement as a discount subtracted from sales to get net sales. Other sellers report it as a selling expense or an administrative expense. In this text, we report credit card expense as a selling expense.

Point: JCPenney reported third- party credit card costs exceeding $10 million.

©Science Photo Library/Image Source

Assets = Liabilities + Equity +96 +100 −4

July 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

Credit Card Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Record credit card sales less a 4% credit card expense.*

*We omit the entry to Dr. Cost of Sales and Cr. Inventory to focus on credit card expense.

Sales on Installment Many companies allow their credit customers to make periodic payments over several months. For example, Harley-Davidson reports more than $2 billion in installment receivables. The seller reports such assets as installment accounts (or finance) re- ceivable, which are amounts owed by customers from credit sales for which payment is required in periodic amounts. Most installment receivables require interest payments, and they can be either current or noncurrent assets depending on the time of repayment.

Credit or Debit? A credit card is authorization by the card company of a line of credit for the buyer—hence, the term credit card. A buyer’s debit card purchase reduces the buyer’s Cash account balance at the card company, which is often a bank. Because the buyer’s Cash account balance is a liability (with a credit balance) for the card com- pany to the buyer, the card company would debit that account for a buyer’s purchase—hence, the term debit card. ■

Decision Insight

Entrepreneur As a small retailer, you are considering allowing customers to use credit cards. Until now, your store accepted only cash. What analysis do you use to decide? ■ Answer: This analysis must weigh benefits versus costs. The main benefit is the potential to increase sales by attracting customers who prefer credit cards. The main cost is the fee charged by the credit card company. We must estimate the expected increase in sales from allowing credit cards and then subtract (1) normal costs and expenses and (2) card fees from the expected sales increase. If analysis shows an increase in profit, the store should probably accept credit cards.

Decision Maker

©PhotoAlto

A small retailer accepts credit cards and has its own store credit card. Prepare journal entries to record the following transactions for the retailer. (The retailer uses the perpetual inventory system.)

Jan. 2 Sold merchandise for $1,000 (that had cost $600) and accepted the customer’s AA Bank Card. AA charges a 5% fee.

6 Sold merchandise for $400 (that had cost $300) and accepted the customer’s VIZA Card. VIZA charges a 3% fee.

31 Recognized the $75 interest revenue earned on its store credit card for January.

C1 Credit Card Sales

NEED-TO-KNOW 7-1

Solution

Jan . 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Credit Card Expense* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Record credit card sales less 5% fee. *($1,000 × 0.05) Jan . 2 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Record cost of sales.

Jan . 6 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388

Credit Card Expense† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Record credit card sales less 3% fee. †($400 × 0.03) Jan . 6 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record cost of sales.

Jan . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Record interest earned from store credit card.Do More: QS 7-1, E 7-2, E 7-3

274 Chapter 7 Accounting for Receivables

When a company directly grants credit to customers, it expects some customers will not pay what they promised. The accounts of these customers are uncollectible accounts, or bad debts. Uncollectible accounts are an expense of selling on credit. Why do companies sell on credit if they expect uncollectible accounts? The answer is that companies believe that granting credit will increase total sales enough to offset bad debts. Companies use two methods for uncollect- ible accounts: (1) direct write-off method and (2) allowance method.

Recording and Writing Off Bad Debts The direct write-off method records the loss from an uncollectible account receivable when it is determined to be uncollectible. No at- tempt is made to predict bad debts expense. If TechCom determines on January 23 that it cannot collect $520 owed by its customer J. Kent, it records the loss as follows. The debit in this entry charges the uncollectible amount directly to the current period’s Bad Debts Expense account. The credit removes its balance from the Accounts Receivable account.

Point: Managers realize that some credit sales will be uncollectible, but which credit sales is unknown.

DIRECT WRITE-OFF METHOD P1 Apply the direct write-off method to accounts receivable.

Jan . 23 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Write off an uncollectible account.

Assets = Liabilities + Equity −520 −520

Mar . 11 Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Reinstate account previously written off.

Mar . 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Record full payment of account.

Assets = Liabilities + Equity +520 +520

Assets = Liabilities + Equity +520 −520

Recovering a Bad Debt Sometimes an account written off is later collected. If the ac- count of J. Kent that was written off directly to Bad Debts Expense is later collected in full, then we record two entries.

Point: Recovery of a bad debt always requires two journal entries.

Assessing the Direct Write-Off Method Many publicly traded companies and thousands of privately held companies use the direct write-off method; they include

Chapter 7 Accounting for Receivables 275

Rand Medical Billing, Gateway Distributors, First Industrial Realty, New Frontier Energy, Globalink, Solar3D, and Sub Surface Waste Management. The following disclosure by Pharma-Bio Serv is the usual justification: Bad debts are mainly accounted for using the direct write-off method . . . this method approximates that of the allowance method.

Companies weigh at least two concepts when considering use of the direct write-off method. (1) Expense recognition requires expenses be reported in the same period as the sales they helped produce. The direct write-off method usually does not best match sales and expenses because bad debts expense is not recorded until an account becomes uncollectible, which often occurs in a period after the credit sale. (2) The materiality constraint permits use of the direct write-off method when its results are similar to using the allowance method. Otherwise, compa- nies must use the allowance method.

Direct write-off method

Advantages: •  Simple •  No estimates needed

Disadvantages: •   Receivables and income

temporarily overstated •   Bad debts expense often not

matched with sales

A retailer uses the direct write-off method. Record the following transactions.

Feb. 14 The retailer determines that it cannot collect $400 of its accounts receivable from a customer named ZZZ Company.

Apr. 1 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its recov- ery of this bad debt.

Solution

P1

Entries under Direct Write-Off Method

NEED-TO-KNOW 7-2

Do More: QS 7-2, QS 7-3, E 7-4

Feb . 14 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Write off an account.

Apr . 1 Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Reinstate an account previously written off.

Apr . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Record cash received on account.

The allowance method for bad debts matches the estimated loss from uncollectible accounts receivable against the sales they helped produce. We use estimated losses because when sales occur, sellers do not know which customers will not pay. This means that at the end of each period, the allowance method requires an estimate of the total bad debts expected from that period’s sales. This method has two advantages over the direct write-off method: (1) It records estimated bad debts expense in the period when the related sales are recorded and (2) it reports accounts receivable on the balance sheet at the estimated amount to be collected.

Recording Bad Debts Expense The allowance method estimates bad debts expense at the end of each accounting period and records it with an adjusting entry. TechCom had credit sales of $300,000 in its first year of operations. At the end of the first year, $20,000 of credit sales were uncollected. Based on the experience of similar businesses, TechCom estimates that $1,500 of its accounts receiv- able is uncollectible and makes the following adjusting entry.

ALLOWANCE METHOD P2 Apply the allowance method to accounts receivable.

Method Bad Debts Expense Recorded . . .

Direct write-off. . . In future, when accounts are uncollectible. Allowance . . . . . . . Currently, using estimated uncollectibles.

Assets = Liabilities + Equity −1,500 −1,500

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 1,500

Record estimated bad debts.

276 Chapter 7 Accounting for Receivables

The estimated Bad Debts Expense of $1,500 is reported on the income statement (as either a selling expense or an administrative expense). The Allowance for Doubtful Accounts is a con- tra asset account. TechCom’s account balances for Accounts Receivable and the Allowance for Doubtful Accounts follow.

Allowance method

Advantages: •   Receivables fairly stated •   Bad debts expense matched 

with sales •   Writing off bad debt does not affect 

net receivables or income

Disadvantages: •   Estimates needed

Dec . 31 20,000

Accounts Receivable

Dec . 31 1,500

Allowance for Doubtful Accounts

Current assets

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 Less allowance for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . . 1,500 $18,500

Current assets

Accounts receivable (net of $1,500 doubtful accounts) . . . . . . . . . . $18,500

The Allowance for Doubtful Accounts credit balance of $1,500 reduces accounts receivable to its realizable value, which is the amount expected to be received. Although credit customers owe $20,000 to TechCom, only $18,500 is expected from customers. (TechCom still bills its customers for $20,000.) In the balance sheet, the Allowance for Doubtful Accounts is subtracted from Accounts Receivable and is often reported as follows.

Sometimes the Allowance for Doubtful Accounts is not reported separately as follows.

Writing Off a Bad Debt When specific accounts become uncollectible, they are writ- ten off against the Allowance for Doubtful Accounts. TechCom decides that J. Kent’s $520 ac- count is uncollectible and makes the following entry to write it off.

Jan . 23 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Write off an uncollectible account.

Assets = Liabilities + Equity +520 −520

This entry removes $520 from the Accounts Receivable account (and the subsidiary ledger). The general ledger accounts appear as follows.

Point: Bad Debts Expense is not debited in the write-off because it was recorded in the period when sales occurred.

The write-off does not affect the realizable value of accounts receivable; see Exhibit 7.5. Nei- ther total assets nor net income is affected by the write-off of a specific account. Instead, both assets and net income are affected in the period when bad debts expense is predicted and recorded with an adjusting entry.

Point: In posting a write-off, the Explanation column shows the reason for this credit so it is not misinterpreted as payment in full.

EXHIBIT 7.5 Realizable Value before and after Write-Off of a Bad Debt

Before Write-Off After Write-Off

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 19,480

Less allowance for doubtful accounts . . . . . . . . . . 1,500 980

Realizable value of accounts receivable . . . . . . $18,500 $18,500

Dec . 31 20,000 Jan . 23 520

Accounts Receivable

Jan . 23 520 Dec . 31 1,500

Allowance for Doubtful Accounts

Chapter 7 Accounting for Receivables 277

Recovering a Bad Debt If an account that was written off is later collected, two en- tries are made. The first is to reverse the write-off and reinstate the customer’s account. The second is to record the collection of the reinstated account. If on March 11 Kent pays in full his account previously written off, the entries are

Exhibit 7.6 portrays the allowance method. It shows the creation of the allowance for future write-offs—adding to a cookie jar. It also shows the decrease of the allowance through write- offs—taking cookies from the jar.

A dj

us tin

g en

tr ie

s Adjusting entries add to allowance

for doubtful accounts. Allowance for

doubtful accounts

Write-o�s

Allowance for doubtful accounts

Bad debt write-o�s subtract from allowance for doubtful accounts.

Increase Allowance Decrease Allowance

Bad Debts Expense… # Allow. for Doubtful Accts… #

Allow. for Doubtful Accts… # Accts Receivable—J.Kent… #

EXHIBIT 7.6 Increases and Decreases to the Allowance for Doubtful Accounts

Assets = Liabilities + Equity +520 −520

Assets = Liabilities + Equity +520 −520

Mar . 11 Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 520

Reinstate account previously written off.

Mar . 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Record full payment of account.

Kent paid the entire amount previously written off, but sometimes a customer pays only a por- tion. If we believe this customer will later pay in full, we return the entire amount owed to accounts receivable (in the first entry only). If we expect no further collection, we return only the amount paid.

A retailer uses the allowance method. Record the following transactions.

Dec. 31 The retailer estimates $3,000 of its accounts receivable are uncollectible at its year-end. Feb. 14 The retailer determines that it cannot collect $400 of its accounts receivable from a customer

named ZZZ Company. Apr. 1 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its

recovery of this bad debt.

Solution

P2

Entries under Allowance Method

NEED-TO-KNOW 7-3

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 3,000

Record estimated bad debts.

Feb . 14 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Write off an account.

Apr . 1 Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 400

Reinstate an account previously written off.

Apr . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Record cash received on account. Do More: QS 7-4, QS 7-5, E 7-5

278 Chapter 7 Accounting for Receivables

Bad debts expense is estimated under the allowance method. This section covers methods for estimating bad debts expense.

Percent of Sales Method The percent of sales method, or income statement method, assumes that a percent of credit sales for the period is uncollectible. For example, Musicland has credit sales of $400,000 in 2019. Music land estimates 0.6% of credit sales to be uncollectible. This means Musicland expects $2,400 of bad debts expense from its sales ($400,000 × 0.006) and makes the following adjusting entry.

Point: Focus on credit sales because cash sales do not produce bad debts.

ESTIMATING BAD DEBTS P3 Estimate uncollectibles based on sales and accounts receivable.

Allowance for Doubtful Accounts, a balance sheet account, is not closed at period end. Unless a company is in its first period of operations, its Allowance for Doubtful Accounts balance rarely equals the Bad Debts Expense balance. (When computing bad debts expense as a percent of sales, managers monitor and adjust the percent so it is not too high or too low.)

Percent of Receivables Method The percent of accounts receivable method, also called a balance sheet method, assumes that a percent of a company’s receivables is uncollectible. This percent is based on experience and economic trends. Total receivables is multiplied by this percent to get the estimated uncollect- ible amount as reported in the balance sheet as Allowance for Doubtful Accounts.

Assume Musicland has $50,000 of accounts receivable on December 31, 2019. It estimates 5% of its receivables is uncollectible. This means that after the adjusting entry is posted, we want the Allowance for Doubtful Accounts to show a $2,500 credit balance (5% of $50,000). Musicland’s beginning balance is $2,200 on December 31, 2018—see Exhibit 7.7.

Point: When using the percent of sales method for estimating uncollectibles, and because the “Unadj. bal.” in Bad Debts Expense is always $0, the adjusting entry amount always equals the % of sales.

Dec . 31* Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 2,400

Record estimated bad debts.

*The adjusting entry applies our three-step adjusting entry process: Step 1: Current balance for Bad Debts Expense is $0 debit (as the expense account was closed in prior period). Step 2: Current balance for Bad Debts Expense should be $2,400 debit. Step 3: Record entry to get from step 1 to step 2.

Assets = Liabilities + Equity −2,400 −2,400

Bad Debts Expense

Unadj. bal. 0 Adj. (% sales) 2,400

Est. bal. 2,400

During 2019, accounts of customers are written off on July 10 and November 20. The account has a $200 credit balance before the December 31, 2019, adjustment. The adjusting entry to give the allowance account the estimated $2,500 balance is

Assets = Liabilities + Equity −2,300 −2,300

Dec . 31* Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 2,300 Record estimated bad debts.

*The adjusting entry applies our three-step adjusting entry process: Step 1: Current balance for Allowance account is $200 credit. Step 2: Current balance for Allowance account should be $2,500 credit. Step 3: Record entry to get from step 1 to step 2.

EXHIBIT 7.7 Allowance for Doubtful Accounts after Bad Debts Adjusting Entry

Prior-year estimate of allowance for

doubtful accounts

Adjusting entry

Current-year estimate of allowance for doubtful accounts

Current-year write-o�s

Dec. 31, 2018, bal. 2,200

Dec. 31, 2019, bal.

Dec. 31 adjustment

2,500

July 10

Nov. 20

Unadjusted bal.

Allowance for Doubtful Accounts

200 2,300

1,500 500

Chapter 7 Accounting for Receivables 279

Aging of Receivables Method The aging of accounts receivable method, also called a balance sheet method, is applied like the percent of receivables method except that several percentages are used (versus one) to esti- mate the allowance. Each receivable is classified by how long it is past its due date. Then estimates of uncollectible amounts are made assuming that the longer an amount is past due, the more likely it is uncollectible. After the amounts are classified (or aged), experience is used to estimate the percent of each uncollectible class. These percents are multiplied by the amounts in each class to get the estimated balance of the Allowance for Doubtful Accounts. An example schedule is shown in Exhibit 7.8.

Exhibit 7.8 lists each customer’s balance assigned to one of five classes based on its days past due. The amounts in each class are totaled and multiplied by the estimated percent of uncollect- ible accounts for each class.

For the Ages Unlike wine, accounts receivable do not improve with age. The longer a receivable is past due, the less likely it is to be collected. An aging schedule uses this knowledge to estimate bad debts. The chart here is from a survey that reported estimates of bad debts for receivables grouped by how long they were past their due dates. Each company sets its own estimates based on its customers and its customers’ payment patterns. ■

Decision Insight

9–11

6–8

3–5

2

1

≥12

0% 100%

M on

th s

Pa st

D ue

82%

58%

43%

15%

27%

6% Bad Debts Percentage

Each receivable is grouped by how long it

is past its due date.

MUSICLAND Schedule of Accounts Receivable by Age

December 31, 2019

Customer

Carlie Abbott…………………… 5,890$ $

$ $ $ $ $

5,890

Jamie Allen…………………….. 710 710$

Chavez Andres……………… 10,500

Balicia Company…………… 2,800

Zem Services……………......

Total receivables………..

Percent uncollectible…….

Estimated uncollectible…

× 2% × 5% × 10% × 25% × 40%

21,000

$50,000

$ 2,270$ 2,270

$37,000

740 325 370 475 360

$6,500 $3,700

Texas Rawhide……………… 9,100 6,110 2,990

$1,900 900$

20,810 190

1,900$ $ 900

200$ 10,300

Totals Not Yet

Due

1 to 30 Days

Past Due

31 to 60 Days

Past Due

61 to 90 Days

Past Due

Over 90 Days Past Due

Each age group is multiplied by its estimated

bad debts percent.

Estimated bad debts for each group are totaled.

To explain, Musicland has $3,700 in accounts receivable that are 31 to 60 days past due. Management estimates 10% of the amounts in this class are uncollectible, or a total of $370 ($3,700 × 10%). Similar analysis is done for each class. The final total of $2,270 ($740 + $325 + $370 + $475 + $360) shown in the first column is the estimated balance for the Allowance for Doubtful Accounts. Exhibit 7.9 shows that because the allowance account has an unadjusted

EXHIBIT 7.9 Computation of the Required Adjustment for the Accounts Receivable Method

Unadjusted balance . . . . . . . . . . . . . . . $ 200 credit

Estimated balance . . . . . . . . . . . . . . . . . 2,270 credit

Required adjustment . . . . . . . . . . . . . $2,070 credit

Step 1: Current account balance equals

Step 2: Determine what account balance should be

Step 3: Make adjustment to get from step 1 to step 2

credit balance of $200, the required adjustment to the Allowance for Doubtful Accounts is $2,070. (We can use a T-account for this analysis as shown to the side.) This analysis yields the following end-of-period adjusting entry.

Allowance for Doubtful Accounts

Unadj. bal. 200 Req. adj. 2,070

Est. bal. 2,270

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,070 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 2,070 Record estimated bad debts.

Assets = Liabilities + Equity −2,070 −2,070

EXHIBIT 7.8 Aging of Accounts Receivable

280 Chapter 7 Accounting for Receivables

Unadjusted Debit Balance in the Allowance Account If the allowance account had an unad- justed debit balance of $500 (instead of the $200 credit balance), its required adjustment is computed as follows. (A T-account can be used for this analysis as shown to the side.)

Point: A debit balance implies that write-offs for that period exceed the total allowance.

Estimating Bad Debts—Summary of Methods Exhibit 7.10 summarizes the three estimation methods. The aging of accounts receivable method focuses on specific ac- counts and is usually the most reliable of the estimation methods.

Point: Credit approval is usually not assigned to the selling dept. because its goal is to increase sales, and it may approve custom- ers at the cost of increased bad debts.

The entry to record the end-of-period adjustment is

Allowance for Doubtful Accounts

Unadj. bal. 500 Req. adj. 2,770

Est. bal. 2,270

Unadjusted balance . . . . . . . . . . . . . . . $ 500 debit

Estimated balance . . . . . . . . . . . . . . . . . 2,270 credit

Required adjustment . . . . . . . . . . . . . $2,770 credit

Step 1: Current account balance equals

Step 2: Determine what account balance should be

Step 3: Make adjustment to get from step 1 to step 2

Current-year estimate of allowance for doubtful accounts Adjusting entry amount

Assets = Liabilities + Equity −2,770 −2,770

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,770 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 2,770 Record estimated bad debts.

Income Statement Focus [Emphasis on Matching]

Percent of Sales

Sales × Rate = Bad Debts Expense

Percent of Receivables Aging of Receivables

Balance Sheet Focus [Emphasis on Realizable Value]

Bad Debts Estimation

Allowance for Doubtful

Accounts × Rate = Accounts

Receivable

Allowance for Doubtful

Accounts

Accounts Receivable

(by Age)

Rates (by Age)

Adj. Entry Amt. = Percent of Sales Adj. Entry Amt. = Percent (or Aging) of Receivables − Unadj. bal. Cr. or + Unadj. bal. Dr.

or

or

EXHIBIT 7.10 Methods to Estimate Bad Debts under the Allowance Method

Labor Union One week prior to labor contract negotiations, financial statements are released showing no income growth. A 10% growth was predicted. Your analysis finds that the company increased its allowance for uncollectibles from 1.5% to 4.5% of receivables. Without this change, income would show a 9% growth. Does this analysis impact negotiations? ■ Answer: Yes, this information is likely to impact negotiations. The obvious question is why the company greatly increased this allow- ance. The large increase means a substantial increase in bad debts expense and a decrease in earnings. This change (coming prior to labor negotiations) also raises concerns because it reduces labor’s bargaining power. We want to ask management for documentation justifying this increase.

Decision Maker

©kali9/Getty Images

At its December 31 year-end, a company estimates uncollectible accounts using the allowance method. 1. It prepared the following aging of receivables analysis. (a) Estimate the balance of the Allowance for

Doubtful Accounts using the aging of accounts receivable method. (b) Prepare the adjusting entry to record bad debts expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $10 debit.

Estimating Bad Debts

NEED-TO-KNOW 7-4

P3

Days Past Due

Total 0 1 to 30 31 to 60 61 to 90 Over 90

Accounts receivable . . . . . . . . . . . . $2,600 $2,000 $300 $80 $100 $120

Percent uncollectible . . . . . . . . . . . 1% 2% 5% 7% 10%

Chapter 7 Accounting for Receivables 281

2. Refer to the data in part 1. (a) Estimate the balance of the Allowance for Doubtful Accounts assuming the company uses 2% of total accounts receivable to estimate uncollectibles instead of the aging of receiv- ables method in part 1. (b) Prepare the adjusting entry to record bad debts expense using the estimate from part 2a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $4 credit.

3. Refer to the data in part 1. (a) Estimate the balance of the uncollectibles assuming the company uses 0.5% of annual credit sales (annual credit sales were $10,000). (b) Prepare the adjusting entry to record bad debts expense using the estimate from part 3a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $4 credit.

Solutions

1a. Computation of the estimated balance of the allowance for uncollectibles.

Do More: QS 7-7, QS 7-8, QS 7-9, E 7-6, E 7-7, E 7-8,

E 7-9, E 7-10, E 7-11

2a. Computation of the estimated balance of the allowance for uncollectibles.

3a. Computation of the estimated balance of the bad debts expense.

$2,600 × 0.02 = $52 credit

3b. Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . 50

Record estimated bad debts.

$10,000 × 0.005 = $50 credit

Bad Debts Expense

Unadj. Dec. 31 0 Adj. Dec. 31 50

Est. bal. Dec. 31 50

Allowance for Doubtful Accounts

Unadj. Dec. 31 10 Adj. Dec. 31 59

Est. bal. Dec. 31 49

1b. Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . 59

Record estimated bad debts.*

*Unadjusted balance . . . . . . . . . . . . $10 debit Estimated balance . . . . . . . . . . . . . 49 credit Required adjustment . . . . . . . . . . . $59 credit

Step 1: Current account balance equals Step 2: Determine what account balance should be Step 3: Make adjustment to get from step 1 to step 2

Allowance for Doubtful Accounts

Unadj. Dec. 31 4 Adj. Dec. 31 48

Est. bal. Dec. 31 52

2b. Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . 48

Record estimated bad debts.*

Step 1: Current account balance equals Step 2: Determine what account balance should be Step 3: Make adjustment to get from step 1 to step 2

*Unadjusted balance . . . . . . . . . . . . $ 4 credit Estimated balance . . . . . . . . . . . . . 52 credit Required adjustment . . . . . . . . . . . $48 credit

NOTES RECEIVABLE C2 Describe a note receivable, the computation of its maturity date, and the recording of its existence.

A promissory note is a written promise to pay a specified amount, usually with interest, either on demand or at a stated future date. Promissory notes are used in many transactions, including paying for products and services and lending and borrowing money. Sellers sometimes ask for a note to replace an account receivable when a customer requests more time to pay a past-due account. Sellers prefer notes when the credit period is long and when the receivable is for a large amount. If a lawsuit is needed to collect from a customer, a note is the customer’s written prom- ise to pay the debt, its amount, and its terms.

Not due . . . . . . . . . . $2,000 × 0 .01 = $20 1 to 30 . . . . . . . . . . 300 × 0 .02 = 6 31 to 60 . . . . . . . . . . 80 × 0 .05 = 4 61 to 90 . . . . . . . . . . 100 × 0 .07 = 7 Over 90 . . . . . . . . . . 120 × 0 .10 = 12 $49 credit

282 Chapter 7 Accounting for Receivables

Exhibit 7.11 shows a promissory note dated July 10, 2019. For this note, Julia Browne prom- ises to pay TechCom or to its order a specified amount ($1,000), called the principal of a note, at a stated future date (October 8, 2019). As the one who signed the note and promised to pay it, Browne is the maker of the note. As the person to whom the note is payable, TechCom is the payee of the note. To Browne, the note is a liability called a note payable. To TechCom, the same note is an asset called a note receivable. This note’s interest rate is 12%, as written on the note. Interest is the charge for using the money until its due date. To a borrower, interest is an expense. To a lender, it is revenue.

Principal

Date of note Due date

Payee

Interest rate

Maker

Promissory Note Amount: ............

...................... after date ........................... promise to pay to the order of

$1,000 Date: ....................July 10, 2019

Ninety days I

12% First National Bank of Los Angeles, CA

TechCom Company Los Angeles, CA

One thousand and no/100 ---------------------------------------------------- Dollars for value received with interest at the annual rate of .......... payable at ............................................................

EXHIBIT 7.11 Promissory Note

Computing Maturity and Interest This section covers a note’s maturity date, period covered, and interest computation.

Maturity Date and Period The maturity date of a note is the day the note (principal and interest) must be repaid. The period of a note is the time from the note’s (contract) date to its maturity date. Many notes mature in less than a full year, and the period they cover is often ex- pressed in days. As an example, a five-day note dated June 15 matures and is due on June 20. A 90-day note dated July 10 matures on October 8. This count is shown in Exhibit 7.12. The period of a note is sometimes expressed in months or years. When months are used, the note is payable in the month of its maturity on the same day of the month as its original date. A nine-month note dated July 10, for example, is payable on April 10. The same rule applies when years are used.

Point: When counting days, omit the day a note is issued, but count the due date.

EXHIBIT 7.12 Maturity Date Computation

Days in July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Minus the date of the note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Days remaining in July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Add days in August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Add days in September . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Days to equal 90 days, or maturity date of October 8 . . . . . . . 8 Period of the note in days . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

July 11–31

Aug . 1–31

Sep . 1–30

Oct . 1–8

July 10

21 days +31 days +30 days +8 days

90-day note Oct. 8

July 11–31

Aug. 1–31

Sep. 1–30

Oct. 1–8

Interest Computation Interest is the cost of borrowing money for the borrower and the profit from lending money for the lender. Unless otherwise stated, the rate of interest on a note is the rate charged for the use of principal for one year (annual rate). The formula for com- puting interest on a note is in Exhibit 7.13.

Point: Excel for maturity date.

A B

1 Note date 10-Jul

2 # of days 90

3 Maturity

=B1+B2 = 8-Oct

EXHIBIT 7.13 Computation of Interest Formula

Principal Annual Time expressed of the note × interest rate × in fraction of year = Interest

To simplify interest computations, a year is commonly treated as having 360 days (called the banker’s rule and widely used in business transactions). We treat a year as having 360 days

Chapter 7 Accounting for Receivables 283

for interest computations in examples and assignments. Using the promissory note in Exhibit 7.11, where we have a 90-day, 12%, $1,000 note, the total interest follows.

$1,000 × 12% × 90 360

= $1,000 × 0.12 × 0.25 = $30

Recording Notes Receivable Notes receivable are usually recorded in a single Notes Receivable account to simplify record- keeping. To show how we record receipt of a note, we use the $1,000, 90-day, 12% promissory note in Exhibit 7.11. TechCom received this note at the time of a product sale to Julia Browne. This is recorded as

Point: If the banker’s rule is not used, interest is $29.589041. The banker’s rule yields $30, which is easier to account for than $29.589041.

Point: Maturity value of a note equals principal plus interest earned.

When a seller accepts a note from an overdue customer to grant a time extension on a past-due account receivable, it often will collect part of the past-due balance in cash. Assume that Tech- Com agreed to accept $232 in cash along with a $600, 60-day, 15% note from Jo Cook to settle her $832 past-due account. TechCom makes the following entry.

July 10* Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold goods in exchange for a 90-day, 12% note.

*We omit the entry to Dr. Cost of Sales and Cr. Inventory to focus on sales and receivables.

Assets = Liabilities + Equity +1,000 +1,000

Oct . 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Accounts Receivable—J . Cook . . . . . . . . . . . . . . . . . . . . . 832

Received cash and note to settle account.

Assets = Liabilities + Equity +232 +600 −832

Valuing and Settling Notes Recording an Honored Note The principal and interest of a note are due on its ma- turity date. The maker of the note usually honors the note and pays it in full. When J. Cook pays the note above on its due date, TechCom records it as follows. Interest revenue, or interest earned, is reported on the income statement.

Recording a Dishonored Note When a note’s maker does not pay at maturity, the note is dishonored. Dishonoring a note does not mean the maker no longer has to pay. The payee still tries to collect. How do companies report this? The balance of the Notes Receivable ac- count should only include notes that have not matured. When a note is dishonored, we remove the amount of this note from Notes Receivable and charge it back to an account receivable from its maker. Assume that J. Cook dishonors the note at maturity. The following records the dis- honoring of the note.

P4 Record the honoring and dishonoring of a note and adjustments for interest.

Charging a dishonored note to accounts receivable does two things. First, it removes the note from the Notes Receivable account and records the dishonored note in the maker’s account. Second, if the maker of the dishonored note asks for credit in the future, his or her account will show the dishonored note.

Dec . 4 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Collect note with interest of $600 × 15% × 60∕360.

Assets = Liabilities + Equity +615 +15 −600

Dec . 4 Accounts Receivable—J . Cook . . . . . . . . . . . . . . . . . . . . . . . . . 615

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Charge account of J. Cook for a dishonored note and interest of $600 × 15% × 60∕360.

Assets = Liabilities + Equity +615 +15 −600

284 Chapter 7 Accounting for Receivables

Recording End-of-Period Interest Adjustment When notes receivable are out- standing at period-end, any accrued interest is recorded. Assume on December 16 TechCom accepts a $3,000, 60-day, 12% note from a customer. When TechCom’s accounting period ends on December 31, $15 of interest has accrued on this note ($3,000 × 12% × 15/360). The follow- ing adjusting entry records this revenue.

Total interest on the 60-day note is $60 ($3,000 × 12% × 60/360). The $15 credit to Interest Receivable is the collection of interest accrued from the December 31 entry. The $45 interest revenue is from holding the note from January 1 to February 14.

Interest revenue is on the income statement, and interest receivable is on the balance sheet as a current asset. When the December 16 note is collected on February 14, TechCom’s entry to record the cash receipt is

Dec . 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Record accrued interest earned.

Assets = Liabilities + Equity +15 +15

Assets = Liabilities + Equity +3,060 +45 −15 −3,000

Feb . 14 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,060

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Received payment of note and its interest.

Ace Company purchases $1,400 of merchandise from Zitco on December 16. Zitco accepts Ace’s $1,400, 90-day, 12% note as payment. Zitco’s accounting period ends on December 31. a. Prepare entries for Zitco on December 16 and December 31. b. Prepare Zitco’s March 16 entry if Ace dishonors the note. c. Instead of the facts in part b, prepare Zitco’s March 16 entry if Ace honors the note. d. Assume the facts in part b (Ace dishonors the note). Then, on March 31, Zitco writes off the receivable

from Ace Company. Prepare that write-off entry assuming that Zitco uses the allowance method.

Solution

a.

C2 P4

Honoring and Dishonoring Notes

NEED-TO-KNOW 7-5

Mar . 16 Accounts Receivable—Ace . . . . . . . . . . . . . . . . . . . . . . . . . 1,442

Interest Revenue ($1,400 × 12% × 75∕360) . . . . . . 35 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Notes Receivable—Ace . . . . . . . . . . . . . . . . . . . . . . . 1,400

b.

Dec . 16 Note Receivable—Ace . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Dec . 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Interest Revenue ($1,400 × 12% × 15∕360) . . . . . . 7

Mar . 16 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,442

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Notes Receivable—Ace . . . . . . . . . . . . . . . . . . . . . . . 1,400

c.

Mar . 31 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . 1,442

Accounts Receivable—Ace . . . . . . . . . . . . . . . . . . . . . 1,442

d.Do More: QS 7-10, QS 7-11, QS 7-12, QS 7-13, E 7-12,

E 7-13, E 7-14, E 7-15

Chapter 7 Accounting for Receivables 285

Disposal of Receivables Companies convert receivables to cash before they are due if they need cash or do not want to deal with collecting receivables. This is usually done by (1) selling them or (2) using them as security for a loan.

Selling Receivables A company can sell its receivables to a finance company or bank. The buyer, called a factor, acquires ownership of the receivables and receives cash when they come due. The seller is charged a factoring fee. By incurring a factoring fee, the seller gets cash earlier and can pass the risk of bad debts to the factor. The seller also avoids costs of billing and accounting for receivables. If TechCom sells $20,000 of its accounts receivable and is charged a 4% factoring fee, it records this sale as follows.

C3 Explain how receivables can be converted to cash before maturity.

Point: A seller of receivables al- ways receives less cash than the amount of receivables sold due to factoring fees.

Pledging Receivables A company can borrow money by pledging its receivables as se- curity for the loan. If the borrower defaults on (does not pay) the loan, the lender is paid from the cash receipts of the receivables. The borrower discloses pledging receivables in financial state- ment footnotes. If TechCom borrows $35,000 and pledges its receivables as security, it records

Assets = Liabilities + Equity +19,200 −800 −20,000

Aug . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

Factoring Fee Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Sold accounts receivable for cash less 4% fee.

Aug . 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Borrow with a note secured by pledging receivables.

Assets = Liabilities + Equity +35,000 +35,000

©Rawpixel.com/Shutterstock

Analyst/Auditor You are reviewing accounts receivable. Over the past five years, the allowance account as a per- centage of gross accounts receivable shows a steady downward trend. What does this finding suggest? ■ Answer: The downward trend means the company is reducing the relative amount charged to bad debts expense each year. This could be to increase net income. Alternatively, collections may have improved and fewer bad debts are justified.

Decision Maker

Accounts Receivable Turnover Decision Analysis

Accounts receivable turnover helps assess the quality and liquidity of receivables. Quality of receivables is the likelihood of collection without loss. Liquidity of receivables is the speed of collection. Accounts receivable turnover measures how often, on average, receivables are collected during the period and is defined in Exhibit 7.14.

A1 Compute accounts receivable turnover and use it to help assess financial condition.

EXHIBIT 7.14 Accounts Receivable Turnover

Accounts receivable turnover = Net sales

Average accounts receivable, net

The denominator is the average accounts receivable, net balance, computed as (Beginning balance + Ending balance) ÷ 2. TechCom has an accounts receivable turnover of 5.1. This means its average accounts receivable balance is converted into cash 5.1 times during the period, which is pictured here.

Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.

5.1 times per year

54321

Accounts receivable turnover shows how well management is doing in granting credit to customers. A high turnover suggests that management should consider using less strict credit terms to increase sales. A low turnover suggests management should consider more strict credit terms and more aggressive collec- tion efforts to avoid having assets tied up in accounts receivable.

Clayco Company completes the following transactions during the year.

July 14 Writes off a $750 account receivable arising from a sale to Briggs Company that dates to 10 months ago. (Clayco Company uses the allowance method.)

30 Clayco Company receives a $1,000, 90-day, 10% note in exchange for merchandise sold to Sumrell Company (the merchandise cost $600).

Aug. 15 Receives $2,000 cash plus a $10,000 note from JT Co. in exchange for merchandise that sells for $12,000 (its cost is $8,000). The note is dated August 15, bears 12% interest, and matures in 120 days.

Nov. 1 Completes a $200 credit card sale with a 4% fee (the cost of sales is $150). The cash is trans- ferred immediately from the credit card company.

3 Sumrell Company refuses to pay the note that was due to Clayco Company on October 28. Pre- pare the journal entry to charge the dishonored note plus accrued interest to Sumrell Company’s accounts receivable.

5 Completes a $500 credit card sale with a 5% fee (the cost of sales is $300). The cash is trans- ferred immediately from the credit card company.

15 Receives the full amount of $750 from Briggs Company that was previously written off on July 14. Record the bad debts recovery.

Dec. 13 Receives payment of principal plus interest from JT for the August 15 note.

Required

1. Prepare Clayco Company’s journal entries to record these transactions. 2. Prepare a year-end adjusting journal entry as of December 31 for each separate situation. a. Bad debts are estimated to be $20,400 by aging accounts receivable. The unadjusted balance of the

Allowance for Doubtful Accounts is a $1,000 debit. b. Alternatively, assume that bad debts are estimated using the percent of sales method. The Allowance

for Doubtful Accounts had a $1,000 debit balance before adjustment, and the company estimates bad debts to be 1% of its credit sales of $2,000,000.

PLANNING THE SOLUTION Examine each transaction to determine the accounts affected, and then record the entries. For the year-end adjustment, record the bad debts expense for the two approaches.

COMPREHENSIVE

Recording Accounts and Notes Receivable Transactions; Estimating Bad Debts

NEED-TO-KNOW 7-6

286 Chapter 7 Accounting for Receivables

Exhibit 7.15 shows accounts receivable turnover for Visa and Mastercard.

EXHIBIT 7.15 Analysis Using Accounts Receivable Turnover

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Visa Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,358 $15,082 $13,880 Average accounts receivable, net . . . . . . . . . . . $ 1,087 $ 944 $ 835

Accounts receivable turnover . . . . . . . . . . . . . 16.9 16.0 16.6 Mastercard Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,497 $10,776 $ 9,667 Average accounts receivable, net . . . . . . . . . . . $ 1,693 $ 1,248 $ 1,094

Accounts receivable turnover . . . . . . . . . . . . . 7.4 8.6 8.8

Visa’s current year turnover is 16.9, computed as $18,358/$1,087 ($ millions). This means that Visa’s average accounts receivable balance was converted into cash 16.9 times in the current year. Its turnover slightly increased in the current year (16.9) compared with one year ago (16.0). Visa’s turnover also exceeds that for Mastercard in each of these three years. Both Visa and Mastercard seem to be doing an adequate job of managing receivables.

Family Physician Your medical practice is barely profitable, so you hire an analyst. The analyst says, “Accounts receivable turnover is too low. Tighter credit policies are recommended along with discontinuing service to those most delayed in payments.” What actions do you take? ■ Answer: Both suggestions are probably financially wise recommendations, but we may be troubled by eliminating services to those less able to pay. One alternative is to follow the recommendations but start a care program directed at patients less able to pay for services. This allows you to continue services to patients less able to pay and to discontinue services to patients able but unwilling to pay.

Decision Maker

Chapter 7 Accounting for Receivables 287

SOLUTION 1.

July 14 Allowance for Doubtful Accounts . . . . . . . . 750

Accounts Receivable—Briggs Co . . . . . 750

Wrote off an uncollectible account.

July 30 Notes Receivable—Sumrell Co . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold merchandise for a 90-day, 10% note.

July 30 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 600

Merchandise Inventory . . . . . . . . . . . . 600

Record the cost of July 30 sale.

Aug . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Notes Receivable—JT Co . . . . . . . . . . . . . . . 10,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Sold merchandise for $2,000 cash and $10,000 note.

Aug . 15 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 8,000

Merchandise Inventory . . . . . . . . . . . . 8,000

Record the cost of Aug. 15 sale.

Nov . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

Credit Card Expense . . . . . . . . . . . . . . . . . . 8

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Record credit card sale less a 4% credit card expense.

Nov . 1 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 150

Merchandise Inventory . . . . . . . . . . . . 150

Record the cost of Nov. 1 sale.

Nov . 3 Accounts Receivable—Sumrell Co . . . . . . . . 1,025

Interest Revenue . . . . . . . . . . . . . . . . . 25

Notes Receivable—Sumrell Co . . . . . . 1,000

Charge account of Sumrell Co. for a $1,000 dishonored note and interest of $1,000 × 10% × 90/360.

Nov . 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475

Credit Card Expense . . . . . . . . . . . . . . . . . . 25

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Record credit card sale less a 5% credit card expense.

Nov . 5 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . 300

Record the cost of Nov. 5 sale.

Nov . 15 Accounts Receivable—Briggs Co . . . . . . . . . 750

Allowance for Doubtful Accounts . . . . 750

Reinstate account of Briggs Co. previously written off.

Nov . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750

Accounts Receivable—Briggs Co . . . . 750

Cash received in full payment of account.

Dec . 13 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,400

Interest Revenue . . . . . . . . . . . . . . . . . 400

Note Receivable—JT Co . . . . . . . . . . . 10,000

Collect note with interest of $10,000 × 12% × 120/360.

2a. Aging of accounts receivable method.

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 21,400

Adjust allowance account from a $1,000 debit balance to a $20,400 credit balance.

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 20,000

Record bad debts expense as 1% × $2,000,000 of credit sales.

2b. Percent of sales method. (For the income statement approach, which requires estimating bad debts as a percent of sales or credit sales, the Allowance for Doubtful Accounts balance is not considered when making the adjusting entry.)

VALUING RECEIVABLES Accounts Receivable: Amounts due from customers for credit sales.

Store credit card interest revenue:

Sales using bank credit card: Accounts Receivable—CompStore . . . . . . . . . . . . . . . . . 950

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720

Accounts Receivable—RDA Electronics . . . . . . . . . 720

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

Credit Card Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Summary: Cheat Sheet

Credit sales and later collection:

288 Chapter 7 Accounting for Receivables

DIRECT WRITE-OFF METHOD Direct write-off method: Record bad debt expense when an account is determined to be uncollectible.

ESTIMATING BAD DEBTS When using the allowance method, we often use one of the following methods to estimate bad debts. ∙ Percent of sales: Uses a percent of credit sales for the period to estimate

bad debts. ∙ Percent of accounts receivable: Uses a percent of accounts receivable

to estimate bad debts. ∙ Aging of accounts receivable: Applies several percentages to accounts

receivable to estimate bad debts.

NOTES RECEIVABLE Note receivable: A promise to pay a specified amount of money at a future date. Principal of a note: Amount promised to be repaid. Maturity date: Day the note must be repaid.

Pledging of receivables: Borrowing money by pledging receivables as security for a loan. Borrower discloses pledging in notes to financial statement.

ALLOWANCE METHOD Allowance method: Matches estimated loss from uncollectible accounts receivable against the sales they helped produce.

Allowance for Doubtful Accounts: A contra asset account that reduces accounts receivable.

Bad debt is later recovered under allowance method:

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 520

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . 520

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . 520

Bad debt later recovered under direct method:

Income Statement Focus [Emphasis on Matching]

Percent of Sales Percent of Receivables Aging of Receivables

Balance Sheet Focus [Emphasis on Realizable Value]

Bad Debts Estimation

Allowance for Doubtful

Accounts × Rate = AccountsReceivable

Allowance for Doubtful

Accounts

Accounts Receivable

(by Age)

Rates (by Age)

=× Sales × Rate = Bad Debts Expense

Adj. Entry Amt. = Percent of Sales Adj. Entry Amt. = Percent (or Aging) of Receivables − Unadj. bal. Cr. or + Unadj. bal. Dr.

or

or

Note receivable from sales:

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accrue interest on note receivable:

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Note receivable and cash in exchange for accounts receivable:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Accounts Receivable—J . Cook . . . . . . . . . . . . . . . . 832

Note is honored; cash received in full (with interest):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Note is dishonored; receivable and interest recorded:

Accounts Receivable—J . Cook . . . . . . . . . . . . . . . . . . . . . 615

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Factoring (selling) receivables: Accounts receivable are sold to a bank and the seller is charged a factoring fee.

Note is honored; when note term runs over two periods:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,060

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . 15

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . 520

Writing off a bad debt under direct method:

Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 1,500

Estimating bad debts:

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . 520

Writing off a bad debt under allowance method:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

Factoring Fee Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Sale of receivables for cash with a charged factor fee:

Principal Annual Time expressed of the note × interest rate × in fraction of year = Interest

Interest formula (year assumed to have 360 days):

Chapter 7 Accounting for Receivables 289

Icon denotes assignments that involve decision making.

1. How do sellers benefit from allowing their customers to use credit cards?

2. Why does the direct write-off method of accounting for bad debts usually fail to match revenues and expenses?

3. Explain the accounting constraint of materiality. 4. Why might a business prefer a note receivable to an account

receivable? 5. Explain why writing off a bad debt against the Allowance

for Doubtful Accounts does not reduce the estimated realiz- able value of a company’s accounts receivable.

6. Why does the Bad Debts Expense account usually not have the same adjusted balance as the Allowance for Doubtful Accounts?

7. Refer to the financial statements and notes of Apple in Appendix A. In its presentation of accounts receivable on the balance sheet, how does it title accounts receivable? What does it report for its allowance as of September 30, 2017?

8. Refer to the balance sheet of Google in Appendix A. Does it use the direct write-off

Discussion Questions

APPLE

GOOGLE

Accounts receivable (271) Accounts receivable turnover (285) Aging of accounts receivable (279) Allowance for Doubtful Accounts (276) Allowance method (275)

Bad debts (274) Direct write-off method (274) Interest (282) Maker of the note (282) Maturity date of a note (282)

Payee of the note (282) Principal of a note (282) Promissory note (or note) (281) Realizable value (276)

Key Terms

Multiple Choice Quiz

1. A company’s Accounts Receivable balance at its December 31 year-end is $125,650, and its Allowance for Doubtful Accounts has a credit balance of $328 before year-end ad- justment. Its net sales are $572,300. It estimates that 4% of outstanding accounts receivable are uncollectible. What amount of bad debts expense is recorded at December 31? a. $5,354 c. $5,026 e. $34,338 b. $328 d. $4,698

2. A company’s Accounts Receivable balance at its December 31 year-end is $489,300, and its Allowance for Doubtful Accounts has a debit balance of $554 before year-end ad- justment. Its net sales are $1,300,000. It estimates that 6% of outstanding accounts receivable are uncollectible. What amount of bad debts expense is recorded at December 31? a. $29,912 c. $78,000 e. $554 b. $28,804 d. $29,358

3. Total interest to be earned on a $7,500, 5%, 90-day note is a. $93.75. c. $1,125.00. e. $125.00. b. $375.00. d. $31.25.

4. A company receives a $9,000, 8%, 60-day note. The matu- rity value of the note is a. $120. c. $9,120. e. $9,720. b. $9,000. d. $720.

5. A company has net sales of $489,600 and average accounts receivable of $40,800. What is its accounts receivable turn- over? a. 0.08 c. 1,341.00 e. 111.78 b. 30.41 d. 12.00

ANSWERS TO MULTIPLE CHOICE QUIZ

1. d; Desired balance in Allowance for Doubtful Accounts = $ 5,026 cr. ($125,650 × 0.04)

Current balance in Allowance for Doubtful Accounts = (328) cr. Bad debts expense to be recorded = $ 4,698 2. a; Desired balance in Allowance for Doubtful Accounts = $ 29,358 cr.

($489,300 × 0.06) Current balance in Allowance for Doubtful Accounts = 554 dr. Bad debts expense to be recorded = $29,912

3. a; $7,500 × 0.05 × 90∕360 = $93.75 4. c; Principal amount . . . . . . . . $9,000 Interest accrued . . . . . . . . . 120 ($9,000 × 0.08 × 60∕360) Maturity value . . . . . . . . . . $9,120 5. d; $489,600∕$40,800 = 12

290 Chapter 7 Accounting for Receivables

method or allowance method in accounting for its accounts receivable? What is the realizable value of its receivables balance as of December 31, 2017?

9. Refer to the financial statements of Samsung in Appendix A. What is the amount of Samsung’s accounts receivable, titled as

“Trade receivables,” on its December 31, 2017, balance sheet?

10. Refer to the December 31, 2017, financial statements of Samsung in Appendix A. Does Samsung report its accounts receivable, titled as “Trade receivables,” as a current or noncurrent asset?

Samsung Samsung

QUICK STUDY

QS 7-1 Credit card sales

C1

Prepare journal entries for the following credit card sales transactions (the company uses the perpetual inventory system). 1. Sold $20,000 of merchandise, which cost $15,000, on Mastercard credit cards. Mastercard charges a

5% fee. 2. Sold $5,000 of merchandise, which cost $3,000, on an assortment of bank credit cards. These cards

charge a 4% fee.

QS 7-2 Direct write-off method

P1

Solstice Company determines on October 1 that it cannot collect $50,000 of its accounts receivable from its customer, P. Moore. Apply the direct write-off method to record this loss as of October 1.

QS 7-3 Recovering a bad debt

P1

Solstice Company determines on October 1 that it cannot collect $50,000 of its accounts receivable from its customer, P. Moore. It uses the direct write-off method to record this loss as of October 1. On October 30, P. Moore unexpectedly pays his account in full to Solstice Company. Record Solstice’s entries for recovery of this bad debt.

QS 7-4 Distinguishing between allowance method and direct write-off method

P1 P2

Indicate whether each statement best describes the allowance (A) method or the direct write-off (DW) method.

1. Does not predict bad debts expense. 2. Accounts receivable on the balance sheet is reported at net realizable value. 3. The write-off of a specific account does not affect net income. 4. When an account is written off, the debit is to Bad Debts Expense. 5. Usually does not best match sales and expenses because bad debts expense is not recorded

until an account becomes uncollectible, which usually occurs in a period after the credit sale. 6. Estimates bad debts expense related to the sales recorded in that period.

QS 7-5 Allowance method for bad debts

P2

Gomez Corp. uses the allowance method to account for uncollectibles. On January 31, it wrote off an $800 account of a customer, C. Green. On March 9, it receives a $300 payment from Green. 1. Prepare the journal entry for January 31. 2. Prepare the journal entries for March 9; assume no additional money is expected from Green.

QS 7-6 Reporting allowance for doubtful accounts

P2

On December 31 of Swift Co.’s first year, $50,000 of accounts receivable is not yet collected. Swift esti- mates that $2,000 of its accounts receivable is uncollectible and recorded the year-end adjusting entry. 1. Compute the realizable value of accounts receivable reported on Swift’s year-end balance sheet. 2. On January 1 of Swift’s second year, it writes off a customer’s account for $300. Compute the realiz-

able value of accounts receivable on January 1 after the write-off.

QS 7-7 Percent of accounts receivable method

P3

Warner Company’s year-end unadjusted trial balance shows accounts receivable of $99,000, allowance for doubtful accounts of $600 (credit), and sales of $280,000. Uncollectibles are estimated to be 1.5% of ac- counts receivable. 1. Prepare the December 31 year-end adjusting entry for uncollectibles. 2. What amount would have been used in the year-end adjusting entry if the allowance account had a

year-end unadjusted debit balance of $300?

Chapter 7 Accounting for Receivables 291

Warner Company’s year-end unadjusted trial balance shows accounts receivable of $99,000, allowance for doubtful accounts of $600 (credit), and sales of $140,000. Uncollectibles are estimated to be 1% of sales. Prepare the December 31 year-end adjusting entry for uncollectibles.

QS 7-8 Percent of sales method

P3

On August 2, Jun Co. receives a $6,000, 90-day, 12% note from customer Ryan Albany as payment on his $6,000 account receivable. (1) Compute the maturity date for this note. (2) Prepare Jun’s journal entry for August 2.

QS 7-11 Note receivable

C2

On August 2, Jun Co. receives a $6,000, 90-day, 12% note from customer Ryan Albany as payment on his $6,000 account receivable. Prepare Jun’s journal entry assuming the note is honored by the customer on October 31 of that same year.

QS 7-12 Note receivable honored

P4

On December 1, Daw Co. accepts a $10,000, 45-day, 6% note from a customer. (1) Prepare the year-end adjusting entry to record accrued interest revenue on December 31. (2) Prepare the entry required on the note’s maturity date assuming it is honored.

QS 7-13 Note receivable interest and maturity P4

Record the sale by Balus Company of $125,000 in accounts receivable on May 1. Balus is charged a 2.5% factoring fee.

QS 7-14 Factoring receivables C3

Net Zero Products, a wholesaler of sustainable raw materials, prepares the following aging of receivables analysis. (1) Estimate the balance of the Allowance for Doubtful Accounts using the aging of accounts receivable method. (2) Prepare the adjusting entry to record bad debts expense assuming the unadjusted balance in the Allowance for Doubtful Accounts is a $1,000 credit.

QS 7-9 Aging of receivables method

P3

Days Past Due

Total 0 1 to 30 31 to 60 61 to 90 Over 90

Accounts receivable . . . . . . . . . . . . $115,200 $80,000 $18,000 $7,200 $4,000 $6,000

Percent uncollectible . . . . . . . . . . . 1% 3% 5% 8% 11%

Determine the maturity date and compute interest for each note. QS 7-10 Computing note interest and maturity date

C2 Note Contract Date Principal Interest Rate Period of Note (Term)

1 . . . . . . . . . . . . . March 1 $10,000 6% 60 days

2 . . . . . . . . . . . . . May 15 15,000 8 90 days

3 . . . . . . . . . . . . . October 20 8,000 4 45 days

Selected accounts from Fair Trader Co.’s adjusted trial balance for the year ended December 31 follow. Prepare its income statement.

QS 7-15 Preparing an income statement

P2 P4 C3Factoring fees . . . . . . . . . . . . . . . . . . . . . . . . . . $ 300 Interest revenue . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . 4,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . 22,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Supplies expense . . . . . . . . . . . . . . . . . . . . . . 200

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Bad debt expense . . . . . . . . . . . . . . . . . . . . . 1,000

Selected accounts from Bennett Co.’s adjusted trial balance for the year ended December 31 follow. Prepare a classified balance sheet. Note: Allowance for doubtful accounts is subtracted from accounts re- ceivable on the company’s balance sheet.

QS 7-16 Preparing a balance sheet

P2 P4 C3

Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . $2,500

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . 10,000 Allowance for doubtful accounts . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Notes payable (due in 10 years) . . . . . . . . . . 6,000

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 Notes receivable (due in 4 years) . . . . . . . . . 4,000

292 Chapter 7 Accounting for Receivables

QS 7-17 Accounts receivable turnover

A1

The following data are for Ruggers Company. Compute and interpret its accounts receivable turnover for the current year (competitors average a turnover of 7.5).

Current Year 1 Year Ago

Accounts receivable, net . . . . . . . . . . . . $153,400 $138,500

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . 861,105 910,600

Exercise 7-2 Accounting for credit card sales

C1

Levine Company uses the perpetual inventory system. Prepare journal entries to record the following credit card transactions of Levine Company.

Apr. 8 Sold merchandise for $8,400 (that had cost $6,000) and accepted the customer’s Suntrust Bank Card. Suntrust charges a 4% fee.

12 Sold merchandise for $5,600 (that had cost $3,500) and accepted the customer’s Continental Card. Continental charges a 2.5% fee.

Exercise 7-3 Sales on store credit card

C1

Z-Mart uses the perpetual inventory system and has its own credit card. Z-Mart charges a per-month inter- est fee for any unpaid balance on its store credit card at each month-end.

Apr. 30 Z-Mart sold merchandise for $1,000 (that had cost $650) and accepted the customer’s Z-Mart store credit card.

May 31 Z-Mart recorded $4 of interest earned from its store credit card as of this month-end.

Exercise 7-4 Direct write-off method

P1

Dexter Company uses the direct write-off method. Prepare journal entries to record the following transactions.

Mar. 11 Dexter determines that it cannot collect $45,000 of its accounts receivable from Leer Co. 29 Leer Co. unexpectedly pays its account in full to Dexter Company. Dexter records its recovery

of this bad debt.

Exercise 7-5 Writing off receivables

P2

On January 1, Wei Company begins the accounting period with a $30,000 credit balance in Allowance for Doubtful Accounts. a. On February 1, the company determined that $6,800 in customer accounts was uncollectible; specifically,

$900 for Oakley Co. and $5,900 for Brookes Co. Prepare the journal entry to write off those two accounts. b. On June 5, the company unexpectedly received a $900 payment on a customer account, Oakley

Company, that had previously been written off in part a. Prepare the entries to reinstate the account and record the cash received.

EXERCISES

Exercise 7-1 Accounts receivable subsidiary ledger; schedule of accounts receivable

C1

Vail Company recorded the following transactions during November.

1. Open a general ledger having T-accounts for Accounts Receivable, Sales, and Sales Returns and Allowances. Also open an accounts receivable subsidiary ledger having a T-account for each of its three customers. Post these entries to both the general ledger and the accounts receivable ledger.

2. Prepare a schedule of accounts receivable (see Exhibit 7.4) and compare its total with the balance of the Accounts Receivable controlling account as of November 30.

Check Accounts Receivable ending balance, $9,301

Nov . 5 Accounts Receivable—Ski Shop . . . . . . . . . . . . . . . . . . . . . . . . 4,615

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,615

10  Accounts Receivable—Welcome Enterprises . . . . . . . . . . . . . . 1,350

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,350

13 Accounts Receivable—Zia Natara . . . . . . . . . . . . . . . . . . . . . . . 832

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 832

21 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 209

Accounts Receivable—Zia Natara . . . . . . . . . . . . . . . . . . 209

30 Accounts Receivable—Ski Shop . . . . . . . . . . . . . . . . . . . . . . . . 2,713

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,713

Chapter 7 Accounting for Receivables 293

Exercise 7-6 Percent of sales method; write-off

P3

At year-end (December 31), Chan Company estimates its bad debts as 1% of its annual credit sales of $487,500. Chan records its bad debts expense for that estimate. On the following February 1, Chan de- cides that the $580 account of P. Park is uncollectible and writes it off as a bad debt. On June 5, Park un- expectedly pays the amount previously written off. Prepare Chan’s journal entries to record the transactions of December 31, February 1, and June 5.

Exercise 7-7 Percent of accounts receivable method

P3

Mazie Supply Co. uses the percent of accounts receivable method. On December 31, it has outstanding accounts receivable of $55,000, and it estimates that 2% will be uncollectible. Prepare the year-end adjusting entry to record bad debts expense under the assumption that the Allowance for Doubtful Accounts has (a) a $415 credit balance before the adjustment and (b) a $291 debit balance before the adjustment.

Exercise 7-8 Aging of receivables method

P3

Daley Company prepared the following aging of receivables analysis at December 31.

Days Past Due

Total 0 1 to 30 31 to 60 61 to 90 Over 90

Accounts receivable . . . . . . . . . . . . $570,000 $396,000 $90,000 $36,000 $18,000 $30,000

Percent uncollectible . . . . . . . . . . . 1% 2% 5% 7% 10%

a. Estimate the balance of the Allowance for Doubtful Accounts using aging of accounts receivable. b. Prepare the adjusting entry to record bad debts expense using the estimate from part a. Assume the

unadjusted balance in the Allowance for Doubtful Accounts is a $3,600 credit. c. Prepare the adjusting entry to record bad debts expense using the estimate from part a. Assume the

unadjusted balance in the Allowance for Doubtful Accounts is a $100 debit.

Exercise 7-11 Estimating bad debts

P3

At December 31, Folgeys Coffee Company reports the following results for its calendar year.

Cash sales . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000 Credit sales . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Exercise 7-9 Percent of receivables method

P3

Refer to the information in Exercise 7-8 to complete the following requirements. a. Estimate the balance of the Allowance for Doubtful Accounts assuming the company uses 4.5% of

total accounts receivable to estimate uncollectibles, instead of the aging of receivables method. b. Prepare the adjusting entry to record bad debts expense using the estimate from part a. Assume the

unadjusted balance in the Allowance for Doubtful Accounts is a $12,000 credit. c. Prepare the adjusting entry to record bad debts expense using the estimate from part a. Assume the

unadjusted balance in the Allowance for Doubtful Accounts is a $1,000 debit.

Exercise 7-10 Aging of receivables schedule

P3

Following is a list of credit customers along with their amounts owed and the days past due at December 31. Following that list are five classifications of accounts receivable and estimated bad debts percent for each class. 1. Create an aging of accounts receivable schedule similar to Exhibit 7.8 and calculate the estimated bal-

ance for the Allowance for Doubtful Accounts. 2. Assuming an unadjusted credit balance of $100, record the required adjustment to the Allowance for

Doubtful Accounts.

Customer Accounts Receivable Days Past Due

BCC Company

Lannister Co.

Mike Properties

Ted Reeves

Jen Ste�ens

$4,000

1,000

5,000

500

2,000

12

0

107

72

35

Days Past Due 0 1 to 30 31 to 60 61 to 90 Over 90

Percent uncollectible . . . . . . . . . 1% 3% 5% 8% 12%

294 Chapter 7 Accounting for Receivables

Its year-end unadjusted trial balance includes the following items.

Accounts receivable . . . . . . . . . . . $125,000 debit Allowance for doubtful accounts . . . . . $5,000 debit

1. Prepare the adjusting entry to record bad debts expense assuming uncollectibles are estimated to be 3% of credit sales.

2. Prepare the adjusting entry to record bad debts expense assuming uncollectibles are estimated to be 1% of total sales.

3. Prepare the adjusting entry to record bad debts expense assuming uncollectibles are estimated to be 6% of year-end accounts receivable.

Check Dr. Bad Debts Expense: (1) $9,000

(3) $12,500

Exercise 7-12 Notes receivable transactions C2

Prepare journal entries for the following transactions of Danica Company.

Dec. 13 Accepted a $9,500, 45-day, 8% note in granting Miranda Lee a time extension on her past-due account receivable.

31 Prepared an adjusting entry to record the accrued interest on the Lee note.Check Dec. 31, Cr. Interest Revenue, $38

Prepare journal entries to record transactions for Vitalo Company.

Nov. 1 Accepted a $6,000, 180-day, 8% note from Kelly White in granting a time extension on her past-due account receivable.

Dec. 31 Adjusted the year-end accounts for the accrued interest earned on the White note. Apr. 30 White honored her note when presented for payment.

Exercise 7-14 Honoring a note

P4

Prepare journal entries to record the following transactions of Ridge Company.

Mar. 21 Accepted a $9,500, 180-day, 8% note from Tamara Jackson in granting a time extension on her past-due account receivable.

Sep. 17 Jackson dishonored her note. Dec. 31 After trying several times to collect, Ridge Company wrote off Jackson’s account against the

Allowance for Doubtful Accounts.

Exercise 7-15 Dishonoring a note

P4

On November 30, Petrov Co. has $128,700 of accounts receivable and uses the perpetual inventory sys- tem. (1) Prepare journal entries to record the following transactions. (2) Which transaction would most likely require a note to the financial statements?

Dec. 4 Sold $7,245 of merchandise (that had cost $5,000) to customers on credit, terms n/30. 9 Sold $20,000 of accounts receivable to Main Bank. Main charges a 4% factoring fee. 17 Received $5,859 cash from customers in payment on their accounts. 27 Borrowed $10,000 cash from Main Bank, pledging $12,500 of accounts receivable as security

for the loan.

Exercise 7-16 Selling and pledging accounts receivable

C3

Refer to the information in Exercise 7-12 and prepare the journal entries for the following year for Danica Company.

Jan. 27 Received Lee’s payment for principal and interest on the note dated December 13. Mar. 3 Accepted a $5,000, 10%, 90-day note in granting a time extension on the past-due account

receivable of Tomas Company. 17 Accepted a $2,000, 30-day, 9% note in granting H. Cheng a time extension on his past-due

account receivable. Apr. 16 Cheng dishonored his note. May 1 Wrote off the Cheng account against the Allowance for Doubtful Accounts. June 1 Received the Tomas payment for principal and interest on the note dated March 3.

Check Jan. 27, Dr. Cash, $9,595

June 1, Dr. Cash, $5,125

Exercise 7-13 Notes receivable transactions P4

The following information is from the annual financial statements of Raheem Company. (1) Compute its accounts receivable turnover for Year 2 and Year 3. (2) Assuming its competitor has a turnover of 11, is Raheem performing better or worse at collecting receivables than its competitor?

Exercise 7-17 Accounts receivable turnover

A1 Year 3 Year 2 Year 1

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,140 $335,280 $388,000

Accounts receivable, net (year-end) . . . . . . . . . . . . . 44,800 41,400 34,800

Chapter 7 Accounting for Receivables 295

PROBLEM SET A

Problem 7-1A Sales on account and credit card sales

C1

Mayfair Co. completed the following transactions and uses a perpetual inventory system.

June 4 Sold $650 of merchandise on credit (that had cost $400) to Natara Morris, terms n∕15. 5 Sold $6,900 of merchandise (that had cost $4,200) to customers who used their Zisa cards. Zisa

charges a 3% fee. 6 Sold $5,850 of merchandise (that had cost $3,800) to customers who used their Access cards.

Access charges a 2% fee. 8 Sold $4,350 of merchandise (that had cost $2,900) to customers who used their Access cards.

Access charges a 2% fee. 13 Wrote off the account of Abigail McKee against the Allowance for Doubtful Accounts. The

$429 balance in McKee’s account was from a credit sale last year. 18 Received Morris’s check in full payment for the June 4 purchase.

Required

Prepare journal entries to record the preceding transactions and events.

Check June 18, Dr. Cash, $650

Problem 7-2A Estimating and reporting bad debts

P2 P3

Required

1. Prepare the adjusting entry to record bad debts under each separate assumption. a. Bad debts are estimated to be 1.5% of credit sales. b. Bad debts are estimated to be 1% of total sales. c. An aging analysis estimates that 5% of year-end accounts receivable are uncollectible. 2. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31

balance sheet given the facts in part 1a. 3. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31

balance sheet given the facts in part 1c.

Check Bad Debts Expense: (1a) $85,230, (1c) $80,085

At December 31, Hawke Company reports the following results for its calendar year.

In addition, its unadjusted trial balance includes the following items.

Cash sales . . . . . . . . . . . . . . . . . . . $1,905,000 Credit sales . . . . . . . . . . . . . . . . . . . . . . $5,682,000

Accounts receivable . . . . . . . . . . . $1,270,100 debit Allowance for doubtful accounts . . . . . $16,580 debit

On December 31, Jarden Co.’s Allowance for Doubtful Accounts has an unadjusted credit balance of $14,500. Jarden prepares a schedule of its December 31 accounts receivable by age.

Problem 7-3A Aging accounts receivable and accounting for bad debts

P2 P31 2

3

4

5

6

7

A B C Age of

Accounts Receivable Expected Percent

Uncollectible Accounts

Receivable

Not yet due 1 to 30 days past due

31 to 60 days past due

61 to 90 days past due

Over 90 days past due

1.25% 2.00

6.50

32.75

68.00

$830,000 254,000

86,000

38,000

12,000

Required

1. Compute the required balance of the Allowance for Doubtful Accounts at December 31 using an aging of accounts receivable.

2. Prepare the adjusting entry to record bad debts expense at December 31.

Analysis Component

3. On June 30 of the next year, Jarden concludes that a customer’s $4,750 receivable is uncollectible and the account is written off. Does this write-off directly affect Jarden’s net income?

Check (2) Dr. Bad Debts Expense, $27,150

296 Chapter 7 Accounting for Receivables

Liang Company began operations in Year 1. During its first two years, the company completed a number of transactions involving sales on credit, accounts receivable collections, and bad debts. These transac- tions are summarized as follows.

Year 1

a. Sold $1,345,434 of merchandise (that had cost $975,000) on credit, terms n∕30. b. Wrote off $18,300 of uncollectible accounts receivable. c. Received $669,200 cash in payment of accounts receivable. d. In adjusting the accounts on December 31, the company estimated that 1.5% of accounts receivable

would be uncollectible.

Year 2

e. Sold $1,525,634 of merchandise on credit (that had cost $1,250,000), terms n∕30. f. Wrote off $27,800 of uncollectible accounts receivable. g. Received $1,204,600 cash in payment of accounts receivable. h. In adjusting the accounts on December 31, the company estimated that 1.5% of accounts receivable

would be uncollectible.

Required

Prepare journal entries to record Liang’s summarized transactions and its year-end adjustments to record bad debts expense. (The company uses the perpetual inventory system, and it applies the allowance method for its accounts receivable. Round to the nearest dollar.)

Check (d) Dr. Bad Debts Expense, $28,169

(h) Dr. Bad Debts Expense, $32,199

Problem 7-4A Accounts receivable transactions and bad debts adjustments

C1 P2 P3

The following transactions are from Ohlm Company.

Year 1

Dec. 16 Accepted a $10,800, 60-day, 8% note in granting Danny Todd a time extension on his past-due account receivable.

31 Made an adjusting entry to record the accrued interest on the Todd note.

Year 2

Feb. 14 Received Todd’s payment of principal and interest on the note dated December 16. Mar. 2 Accepted a $6,100, 8%, 90-day note in granting a time extension on the past-due account re-

ceivable from Midnight Co. 17 Accepted a $2,400, 30-day, 7% note in granting Ava Privet a time extension on her past-due

account receivable. Apr. 16 Privet dishonored her note. May 31 Midnight Co. dishonored its note. Aug. 7 Accepted a $7,440, 90-day, 10% note in granting a time extension on the past-due account re-

ceivable of Mulan Co. Sep. 3 Accepted a $2,100, 60-day, 10% note in granting Noah Carson a time extension on his past-due

account receivable. Nov. 2 Received payment of principal plus interest from Carson for the September 3 note. Nov. 5 Received payment of principal plus interest from Mulan for the August 7 note. Dec. 1 Wrote off the Privet account against the Allowance for Doubtful Accounts.

Required

1. Prepare journal entries to record these transactions and events.

Analysis Component

2. If Ohlm pledged its receivables as security for a loan from the bank, where on the financial statements does it disclose this pledge of receivables?

Check Feb. 14, Cr. Interest Revenue, $108

May 31, Cr. Interest Revenue, $122

Nov. 2, Cr. Interest Revenue, $35

Problem 7-5A Analyzing and journalizing notes receivable transactions

C2 C3 P4

Chapter 7 Accounting for Receivables 297

PROBLEM SET B

Problem 7-1B Sales on account and credit card sales C1

Archer Co. completed the following transactions and uses a perpetual inventory system.

Aug. 4 Sold $3,700 of merchandise on credit (that had cost $2,000) to McKenzie Carpenter, terms n∕10.

10 Sold $5,200 of merchandise (that had cost $2,800) to customers who used their Commerce Bank credit cards. Commerce charges a 3% fee.

11 Sold $1,250 of merchandise (that had cost $900) to customers who used their Goldman cards. Goldman charges a 2% fee.

14 Received Carpenter’s check in full payment for the August 4 purchase. 15 Sold $3,250 of merchandise (that had cost $1,758) to customers who used their Goldman cards.

Goldman charges a 2% fee. 22 Wrote off the account of Craw Co. against the Allowance for Doubtful Accounts. The $498 bal-

ance in Craw Co.’s account was from a credit sale last year.

Required

Prepare journal entries to record the preceding transactions and events.

Check Aug. 14, Dr. Cash, $3,700

Problem 7-2B Estimating and reporting bad debts

P2 P3

Required

1. Prepare the adjusting entry to record bad debts under each separate assumption. a. Bad debts are estimated to be 2.5% of credit sales. b. Bad debts are estimated to be 1.5% of total sales. c. An aging analysis estimates that 6% of year-end accounts receivable are uncollectible. 2. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31

balance sheet given the facts in part 1a. 3. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31

balance sheet given the facts in part 1c.

Check Dr. Bad Debts Expense: (1b) $35,505, (1c) $27,000

At December 31, Ingleton Company reports the following results for the year.

In addition, its unadjusted trial balance includes the following items.

Cash sales . . . . . . . . . . . . . . . . . . . $1,025,000 Credit sales . . . . . . . . . . . . . . . . . . . . . . $1,342,000

Accounts receivable . . . . . . . . . . . $575,000 debit Allowance for doubtful accounts . . . . . $7,500 credit

At December 31, Hovak Co.’s Allowance for Doubtful Accounts has an unadjusted debit balance of $3,400. Hovak prepares a schedule of its December 31 accounts receivable by age.

Problem 7-3B Aging accounts receivable and accounting for bad debts

P2 P3

Required

1. Compute the required balance of the Allowance for Doubtful Accounts at December 31 using an aging of accounts receivable.

2. Prepare the adjusting entry to record bad debts expense at December 31.

Analysis Component

3. On July 31 of the following year, Hovak concludes that a customer’s $3,455 receivable is uncollectible and the account is written off. Does this write-off directly affect Hovak’s net income?

Check (2) Dr. Bad Debts Expense, $31,390

Not yet due

1 to 30 days past due

31 to 60 days past due

61 to 90 days past due

Over 90 days past due

Age of Accounts Receivable

Expected Percent Uncollectible

Accounts Receivable

$396,400

277,800

48,000

6,600

2,800

2.0%

4.0

8.5

39.0

82.0

1

2

3

4

5

6

7

A B C

298 Chapter 7 Accounting for Receivables

Sherman Co. began operations in Year 1. During its first two years, the company completed several trans- actions involving sales on credit, accounts receivable collections, and bad debts. These transactions are summarized as follows.

Year 1

a. Sold $685,350 of merchandise on credit (that had cost $500,000), terms n∕30. b. Received $482,300 cash in payment of accounts receivable. c. Wrote off $9,350 of uncollectible accounts receivable. d. In adjusting the accounts on December 31, the company estimated that 1% of accounts receivable

would be uncollectible.

Year 2

e. Sold $870,220 of merchandise on credit (that had cost $650,000), terms n∕30. f. Received $990,800 cash in payment of accounts receivable. g. Wrote off $11,090 of uncollectible accounts receivable. h. In adjusting the accounts on December 31, the company estimated that 1% of accounts receivable

would be uncollectible.

Required

Prepare journal entries to record Sherman’s summarized transactions and its year-end adjusting entries to record bad debts expense. (The company uses the perpetual inventory system, and it applies the allowance method for its accounts receivable.)

Check (d) Dr. Bad Debts Expense, $11,287

(h) Dr. Bad Debts Expense, $9,773

Problem 7-4B Accounts receivable transactions and bad debts adjustments

C1 P2 P3

The following transactions are from Springer Company.

Year 1

Nov. 1 Accepted a $4,800, 90-day, 8% note in granting Steve Julian a time extension on his past-due account receivable.

Dec. 31 Made an adjusting entry to record the accrued interest on the Julian note.

Year 2

Jan. 30 Received Julian’s payment for principal and interest on the note dated November 1. Feb. 28 Accepted a $12,600, 30-day, 8% note in granting a time extension on the past-due account

receivable from King Co. Mar. 1 Accepted a $6,200, 60-day, 12% note in granting Myron Shelley a time extension on his

past-due account receivable. 30 The King Co. dishonored its note. Apr. 30 Received payment of principal plus interest from M. Shelley for the March 1 note. June 15 Accepted a $2,000, 72-day, 8% note in granting a time extension on the past-due account

receivable of Ryder Solon. 21 Accepted a $9,500, 90-day, 8% note in granting J. Felton a time extension on his past-due

account receivable. Aug. 26 Received payment of principal plus interest from R. Solon for the June 15 note. Sep. 19 Received payment of principal plus interest from J. Felton for the June 21 note. Nov. 30 Wrote off King’s account against the Allowance for Doubtful Accounts.

Required

1. Prepare journal entries to record these transactions and events.

Analysis Component

2. If Springer pledged its receivables as security for a loan from the bank, where on the financial state- ments does it disclose this pledge of receivables?

Check Jan. 30, Cr. Interest Revenue, $32

Apr. 30, Cr. Interest Revenue, $124

Sep. 19, Cr. Interest Revenue, $190

Problem 7-5B Analyzing and journalizing notes receivable transactions

C2 C3 P4

SERIAL PROBLEM Business Solutions

P1 P2

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 7 Santana Rey, owner of Business Solutions, realizes that she needs to begin accounting for bad debts expense. Assume that Business Solutions has total revenues of $44,000 during the first three months of 2020 and that the Accounts Receivable balance on March 31, 2020, is $22,867.

Chapter 7 Accounting for Receivables 299

Required

1. Prepare the adjusting entry to record bad debts expense on March 31, 2020, under each separate assumption. There is a zero unadjusted balance in the Allowance for Doubtful Accounts at March 31.

a. Bad debts are estimated to be 1% of total revenues. b. Bad debts are estimated to be 2% of accounts receivable. (Round to the dollar.) 2. Assume that Business Solutions’s Accounts Receivable balance at June 30, 2020, is $20,250 and that

one account of $100 has been written off against the Allowance for Doubtful Accounts since March 31, 2020. If Rey uses the method in part 1b, what adjusting journal entry is made to recognize bad debts expense on June 30, 2020?

3. Should Rey consider adopting the direct write-off method of accounting for bad debts expense rather than one of the allowance methods considered in part 1? Explain. ©Alexander Image/Shutterstock

Check (2) Dr. Bad Debts Expense, $48

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in accounting so that the financial professional can focus on the impacts of each transaction on various financial reports and perfor- mance measures.

GL 7-1 General Ledger assignment GL 7-1, based on Problem 7-5A, focuses on transactions related to accounts and notes receivable and highlights the impact each transaction has on interest revenue.

GL

COMPANY ANALYSIS A1

Accounting Analysis

AA 7-1 Use Apple’s financial statements in Appendix A to answer the following. 1. What is the amount of Apple’s accounts receivable as of September 30, 2017? 2. Compute Apple’s accounts receivable turnover as of September 30, 2017. 3. How long does it take, on average, for the company to collect receivables for the fiscal year ended

September 30, 2017? 4. Apple’s most liquid assets include (a) cash and cash equivalents, (b) short-term marketable securities,

(c) accounts receivable, and (d ) inventory. Compute the percentage that these liquid assets (in total) make up of current liabilities as of September 30, 2017, and as of September 24, 2016.

5. Did Apple’s liquid assets as a percentage of current liabilities improve or worsen as of its fiscal 2017 year-end compared to its fiscal 2016 year-end?

APPLE

AA 7-2 Comparative figures for Apple and Google follow.

Apple Google

Current One Year Two Years Current One Year Two Years $ millions Year Prior Prior Year Prior Prior

Accounts receivable, net . . $ 17,874 $ 15,754 $ 16,849 $ 18,336 $14,137 $11,556

Net sales . . . . . . . . . . . . . . . 229,234 215,639 233,715 110,855 90,272 74,989

COMPARATIVE ANALYSIS A1 P2

APPLE GOOGLE

Required

1. Compute the accounts receivable turnover for (a) Apple and (b) Google for each of the two most recent years using the data shown.

2. Compute how many days, on average, it takes to collect receivables for the two most recent years for (a) Apple and (b) Google.

3. Which company more quickly collects its accounts receivable in the current year?

Hint: Average collection period equals 365 divided by the accounts receivable turnover.

300 Chapter 7 Accounting for Receivables

1. Compute its accounts receivable turnover for the current year. 2. How long does it take on average for Samsung to collect receivables in the current year? 3. In the current year, does Samsung’s accounts receivable turnover underperform or outperform the in-

dustry (assumed) average of 7?

AA 7-3 Key figures for Samsung follow.

₩ millions Current Year One Year Prior Two Years Prior

Accounts receivable, net . . . . . . . . . . . . ₩ 27,695,995 ₩ 24,279,211 ₩ 25,168,026

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239,575,376 201,866,745 200,653,482

GLOBAL ANALYSIS C1 A1

Samsung

ETHICS CHALLENGE P2 P3

BTN 7-1 Anton Blair is the manager of a medium-size company. A few years ago, Blair persuaded the owner to base a part of his compensation on the net income the company earns each year. Each December he estimates year-end financial figures in anticipation of the bonus he will receive. If the bonus is not as high as he would like, he offers several recommendations to the accountant for year-end adjustments. One of his favorite recommendations is for the controller to reduce the estimate of doubtful accounts.

Required

1. What effect does lowering the estimate for doubtful accounts have on the income statement and bal- ance sheet?

2. Do you believe Blair’s recommendation to adjust the allowance for doubtful accounts is within his rights as manager, or do you believe this action is an ethics violation? Justify your response.

3. What type of internal control(s) might be useful for this company in overseeing the manager’s recom- mendations for accounting changes?

Beyond the Numbers

BTN 7-2 As the accountant for Pure-Air Distributing, you attend a sales managers’ meeting devoted to a discussion of credit policies. At the meeting, you report that bad debts expense is estimated to be $59,000 and accounts receivable at year-end amount to $1,750,000 less a $43,000 allowance for doubtful accounts. Sid Omar, a sales manager, expresses confusion over why bad debts expense and the allowance for doubt- ful accounts are different amounts. Write a one-page memorandum to him explaining why a difference in bad debts expense and the allowance for doubtful accounts is not unusual. The company estimates bad debts expense as 2% of sales.

COMMUNICATING IN PRACTICE P2 P3

BTN 7-3 Access eBay’s February 6, 2017, filing of its 10-K report for the year ended December 31, 2016, at SEC.gov.

Required

1. What is the amount of eBay’s net accounts receivable at December 31, 2016, and at December 31, 2015?

2. “Financial Statement Schedule II” of its 10-K report lists eBay’s allowance for doubtful accounts (including authorized credits). For the two years ended December 31, 2016 and 2015, identify its allowance for doubtful accounts (including authorized credits), and then compute it as a percent of gross accounts receivable.

3. Do you believe that these percentages are reasonable based on what you know about eBay? Explain.

TAKING IT TO THE NET C1 P3

BTN 7-4 Each member of a team is to participate in estimating uncollectibles using the aging schedule and percents shown in Problem 7-3A. The division of labor is up to the team. Your goal is to accurately complete this task as soon as possible. After estimating uncollectibles, check your estimate with the instructor. If the estimate is correct, the team then should prepare the adjusting entry and the presentation of accounts receivable (net) for the December 31 year-end balance sheet.

TEAMWORK IN ACTION P2 P3

Chapter 7 Accounting for Receivables 301

BTN 7-5 Sheryl Sandberg and Mark Zuckerberg of Facebook are introduced in the chapter’s opening feature. Assume that they are considering two options.

Plan A. Facebook would begin selling access to a premium version of its website. The new online cus- tomers would use their credit cards. The company has the capability of selling the premium service with no additional investment in hardware or software. Annual credit sales are expected to increase by $250,000.

Costs associated with Plan A: Additional wages related to these new sales are $135,500; credit card fees will be 4.75% of sales; and additional recordkeeping costs will be 6% of sales. Premium service sales will reduce advertising revenues for Facebook by $8,750 annually because some customers will now only use the premium service.

Plan B. The company would begin selling Facebook merchandise. It would make additional annual credit sales of $500,000.

Costs associated with Plan B: Cost of these new sales is $375,000; additional recordkeeping and ship- ping costs will be 4% of sales; and uncollectible accounts will be 6.2% of sales.

Required

1. Compute the additional annual net income or loss expected under (a) Plan A and (b) Plan B. 2. Should the company pursue either plan? Discuss both the financial and nonfinancial factors relevant

to this decision.

Check (1b) Additional net income, $74,000

ENTREPRENEURIAL DECISION C1

BTN 7-6 Many commercials include comments similar to the following: “We accept VISA” or “We do not accept American Express.” Conduct your own research by contacting at least five companies via interviews, phone calls, or the Internet to determine the reason(s) companies discriminate in their use of credit cards. Collect information on the fees charged by the different cards for the companies contacted. (The instructor can assign this as a team activity.)

HITTING THE ROAD C1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Compute the cost of plant assets.

C2 Explain depreciation for partial years and changes in estimates.

C3 Distinguish between revenue and capital expenditures, and account for them.

P2 Account for asset disposal through discarding or selling an asset.

P3 Account for natural resource assets and their depletion.

P4 Account for intangible assets.

P5 Appendix 8A—Account for asset exchanges.

ANALYTICAL A1 Compute total asset turnover and apply

it to analyze a company’s use of assets.

PROCEDURAL P1 Compute and record depreciation using

the straight-line, units-of-production, and declining-balance methods.

Chapter Preview

8 Accounting for Long-Term Assets

NTK 8-5

INTANGIBLE ASSETS

P4 Cost determination Amortization

Types of intangibles

A1 Analyze asset usage

NTK 8-1, 8-2, 8-3

PLANT ASSETS

C1 Cost determination P1 Depreciation C2 Partial years and changes

in estimates

C3 Additional expenditures P2 Disposal

NTK 8-4

NATURAL RESOURCES

P3 Cost determination Depletion

Presentation

Plant assets tied into extracting resources

303

“Strive to surpass yourself”—Deb Carey

Crafting the Dream

NEW GLARUS, WI—Deb Carey told her husband Dan, “I could start a brewery and you could work for me.” A few days later, she recalls, “We were bidding on equipment from a brew pub.” Dan reminded her, “But we don’t have any money.” Deb declared, “I’m going to sell the house!” Soon, she says, New Glarus Brewing (NewGlarusBrewing.com) was up and running.

“In that first year,” explains Deb, “we had no money, and we were working from 5 a.m. to midnight.” Deb focused on the busi- ness. She stresses that long-term assets in the brewery such as brew houses, packaging lines, and fermentation cellars are ex- pensive but key to success. Financing that equipment, buildings, and other assets, she says, is not easy.

A constant challenge for Deb and Dan is maintaining the right kind and amount of assets to meet business demands and be profitable. “Machinery cannot be divorced from the process,” insists Dan. “You have to work with the strengths and weak- nesses of your machinery.”

Deb explains that success depends on monitoring and control- ling the types and costs of long-term assets. Each of her tangible and intangible assets commands Deb’s attention. She accounts for, manages, and focuses on recovering all costs of those acquisitions.

Their company is on a roll—employing nearly 150 workers, offering unique products such as Spotted Cow, and generating over 250,000 barrels. Adds Deb, running a company “is like having a big family.”

Sources: New Glarus Brewing website, January 2019; Wisconsin State Journal, July 2011; NBC 26 Green Bay, February 2018; Daily Dose, October 2017

©Casper Hedberg/Bloomberg/Getty Images

Plant assets are tangible assets used in a company’s operations that have a useful life of more than one accounting period. Plant assets are also called plant and equipment; property, plant and equipment (PP&E); or fixed assets. Exhibit 8.1 shows plant assets as a percentage of total assets for several companies.

Plant assets are set apart from other assets by two important features. First, plant assets are used in opera- tions. A computer purchased to resell is reported on the balance sheet as inventory. If the same computer is used in operations, it is a plant asset. Another example is land held for expansion, which is reported as a long-term investment. Instead, if this land holds a factory used in operations, the land is a plant asset.

The second important feature is that plant assets have useful lives extending over more than one accounting period. This makes plant assets dif- ferent from current assets such as supplies that are normally used up within one period.

Exhibit 8.2 shows four issues in accounting for plant assets: (1) computing the costs of plant assets, (2) allocating the costs of plant assets, (3) accounting for subsequent expenditures to plant assets, and (4) recording the disposal of plant assets. The following sections discuss these issues.

Section 1—Plant Assets

As a Percentage of Total Assets 0% 20% 40% 60% 80%

McDonald's

eBay 6%$1,516 mil.

Boston Beer 66%$408 mil.

Walmart 57%$114,178 mil.

$21,258 mil. 69%

EXHIBIT 8.1 Plant Assets of Selected Companies

Point: Capital-intensive refers to companies with large amounts of plant assets.

Acquisition 1. Compute cost.

Disposal 4. Record disposal.

2. Allocate cost to periods benefited. 3. Account for subsequent expenditures.

Use

Decline in asset book value over its useful life

For Sale

EXHIBIT 8.2 Issues in Accounting for Plant Assets

304 Chapter 8 Accounting for Long-Term Assets

C1 Compute the cost of plant assets.

Plant assets are recorded at cost when acquired. Cost includes all expenditures necessary to get an asset in place and ready for use. The cost of a machine, for example, includes its invoice cost minus any discount, plus necessary shipping, assembling, installing, and testing costs. Exam- ples are the costs of building a base for a machine, installing electrical hookups, and testing the asset before using it in operations.

To be recorded as part of the cost of a plant asset, an expenditure must be normal, reasonable, and necessary in preparing it for its intended use. If an asset is damaged during unpacking, the repairs are not added to its cost. Instead, they are charged to an expense account. Costs to mod- ify or customize a new plant asset are added to the asset’s cost. This section explains how to determine the cost of plant assets for its four major classes.

Machinery and Equipment The costs of machinery and equipment consist of all costs normal and necessary to purchase them and prepare them for their intended use. These include the purchase price, taxes, transpor- tation charges, insurance while in transit, and the installing, assembling, and testing of the machinery and equipment.

Buildings A Building account consists of the costs of purchasing or constructing a building that is used in operations. A purchased building’s costs include its purchase price, taxes, title fees, and lawyer fees. Its costs also include all expenditures to ready it for its intended use, including necessary repairs or renovations. When a company constructs a building or any plant asset for its own use, its costs include materials and labor plus indirect overhead cost. Overhead includes heat, lighting, power, and depreciation on machinery used to construct the asset. Costs of construction also include design fees, building permits, and insurance during construction. However, costs such as insurance to cover the asset after it is being used are operating expenses.

Land Improvements Land improvements are additions to land and have limited useful lives. Examples are parking lots, driveways, walkways, fences, and lighting systems. Land improvements include costs nec- essary to make those improvements ready for their intended use.

Land Land is the earth’s surface and has an indefinite (unlimited) life. Land includes costs necessary to make it ready for its intended use. When land is purchased for a building site, its cost includes the total amount paid for the land, including real estate commissions, title insurance fees, legal fees, and any accrued property taxes paid by the purchaser. Payments for surveying, clearing, grading, and draining also are included in the cost of land. Other costs include government assessments, whether incurred at the time of purchase or later, for items such as public roads, sewers, and sidewalks. These assessments are included because they permanently add to the land’s value (and are not depreciated as they are not the company’s responsibility). Land pur- chased as a building site can include unwanted structures. The cost of removing those struc- tures, less amounts recovered through sale of salvaged materials, is charged to the Land account.

Assume Starbucks paid $167,000 cash to acquire land for a coffee shop. This land had an old service garage that was removed at a net cost of $13,000 ($15,000 in costs less $2,000 pro- ceeds from salvaged materials). Additional closing costs total $10,000, consisting of brokerage fees ($8,000), legal fees ($1,500), and title costs ($500). The cost of this land to Starbucks is $190,000 and is computed as shown in Exhibit 8.3.

Point: Entry for cash purchase of land improvements: Land Improvements . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . #

COST DETERMINATION

©Syda Productions/Shutterstock

Chapter 8 Accounting for Long-Term Assets 305

Lump-Sum Purchase Plant assets sometimes are purchased as a group in a single transaction for a lump-sum price. This transaction is called a lump-sum purchase, or group, bulk, or basket purchase. When this occurs, we allocate the cost to the assets acquired based on their relative market (or appraised) values. Assume CarMax paid $90,000 cash to acquire a group of items consisting of a building appraised at $60,000 and land appraised at $40,000. The $90,000 cost is allocated based on appraised values as shown in Exhibit 8.4. The entry to record the lump-sum purchase also is shown in Exhibit 8.4.

EXHIBIT 8.3 Computing and Recording Cost of Land

Cash price of land . . . . . . . . . . . . . . . . . . . . . $  167,000

Net cost of garage removal . . . . . . . . . . . . . 13,000

Closing costs . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Cost of land . . . . . . . . . . . . . . . . . . . . . . . . . $190,000

Land . . . . . . . . . . . . . . . . . . . . . . 190,000

Cash . . . . . . . . . . . . . . . . . 190,000

Record purchase of land.

Entry for cash purchase of land:

Appraised Value Percent of Total Apportioned Cost

Building . . . $ 60,000 60% ($60,000/$100,000) $54,000 ($90,000 × 60%) Land . . . . . 40,000 40 ($40,000/$100,000) 36,000 ($90,000 × 40%) Totals . . . . $100,000 100% $ 90,000

EXHIBIT 8.4 Computing and Recording Costs in a Lump-Sum Purchase

Building . . . . . . . . . . . . . . 54,000

Land . . . . . . . . . . . . . . . . 36,000

Cash . . . . . . . . . . . . 90,000

Record costs of plant assets.

Entry for lump-sum cash purchase:

Depreciation is the process of allocating the cost of a plant asset to expense while it is in use. Depreciation does not measure the decline in the asset’s market value or its physical deteriora- tion. This section covers computing depreciation.

Factors in Computing Depreciation Factors that determine depreciation are (1) cost, (2) salvage value, and (3) useful life.

Cost The cost of a plant asset consists of all necessary and reasonable expenditures to ac- quire it and to prepare it for its intended use.

Salvage Value The salvage value, also called residual value or scrap value, is an esti- mate of the asset’s value at the end of its useful life. This is the amount the owner expects to receive from disposing of the asset at the end of its useful life. If the asset is expected to be traded in on a new asset, its salvage value is the expected trade-in value.

Useful Life The useful life of a plant asset is the length of time it is used in a company’s operations. Useful life, or service life, might not be as long as the asset’s total productive life. For example, the productive life of a computer can be eight years or more. Some companies, however, trade in old computers for new ones every two years. In this case, these computers

Point: If we expect disposal costs, the salvage value equals the ex- pected amount from disposal less any disposal costs.

DEPRECIATION

P1 Compute and record depreciation using the straight-line, units-of- production, and declining- balance methods.

Point: Useful life and salvage value are estimates.

Compute the recorded cost of a new machine given the following payments related to its purchase: gross purchase price, $700,000; sales tax, $49,000; purchase discount taken, $21,000; freight cost—terms FOB shipping point, $3,500; normal assembly costs, $3,000; cost of necessary machine platform, $2,500; and cost of parts used in maintaining machine, $4,200.

Solution

$737,000 = $700,000 + $49,000 − $21,000 + $3,500 + $3,000 + $2,500

Cost Determination

NEED-TO-KNOW 8-1

C1

Do More: QS 8-1, QS 8-2, E 8-1, E 8-2, E 8-3

306 Chapter 8 Accounting for Long-Term Assets

have a two-year useful life. The useful life of a plant asset is impacted by inadequacy and obso- lescence. Inadequacy is the inability of a plant asset to meet its demands. Obsolescence is the process of becoming outdated and no longer used.

Sweet Life The useful life of plant assets is different for each company. Hershey Foods and Tootsie Roll are com- petitors and apply similar manufacturing processes, but their equipment’s life expectancies are different. Hershey depreciates equipment over 3 to 15 years, but Tootsie Roll depreciates them over 5 to 20 years. Such differences impact financial statements. ■

Decision Insight

Depreciation Methods Depreciation methods are used to allocate a plant asset’s cost over its useful life. The most fre- quently used method is the straight-line method. The units-of-production and double-declining methods are also commonly used. We explain all three methods. Computations in this section use information about a machine used by Reebok and Adidas to inspect athletic shoes before packaging. Data for this machine are in Exhibit 8.5.

©Fuse/Getty Images

EXHIBIT 8.5 Data for Inspection Machine

Cost . . . . . . . . . . . . . . . . . . $10,000

Salvage value . . . . . . . . . . 1,000

Depreciable cost . . . . . . . . $ 9,000

Useful life:

Accounting periods . . . . . . . . 5 years

Units inspected . . . . . . . . . . . 36,000 shoes

Straight-Line Method Straight-line depreciation charges the same amount to each period of the asset’s useful life. A two-step process is used. We first compute the depreciable cost of the asset, also called cost to be depreciated. It is computed as asset total cost minus salvage value. Second, depreciable cost is divided by the number of accounting periods in the asset’s useful life. The computation for the inspection machine is in Exhibit 8.6.

EXHIBIT 8.6 Straight-Line Depreciation Formula and Example

Cost – Salvage value Useful life in periods

= =$10,000 – $1,000 $1,800 per year 5 years

If this machine is purchased on December 31, 2018, and used during its predicted useful life of five years, the straight-line method allocates equal depreciation to each of the years 2019 through 2023. We make the following adjusting entry at the end of each of the five years to record straight-line depreciation.

Point: Excel for SLN.

A B

1 Cost $10,000

2 Salvage $1,000

3 Life 5

4 SLN depr.

=SLN(B1,B2,B3) = $1,800

The $1,800 Depreciation Expense is reported on the income statement. The $1,800 Accumu- lated Depreciation is a contra asset account to the Machinery account on the balance sheet. The left graph in Exhibit 8.7 shows the $1,800 per year expense reported in each of the five years. The right graph shows the Machinery account balance (net) on each of the six December 31 balance sheets.

Dec . 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Accumulated Depreciation—Machinery . . . . . . . . . . . . . 1,800

Record annual depreciation.

Assets = Liabilities + Equity −1,800 −1,800

Chapter 8 Accounting for Long-Term Assets 307

Depreciation Expense (on Income Statement)

2018 20232019 2020 2021 2022

$1,800

600

1,200

Year-End Book Value (on Balance Sheet)

20232018 2019 2020 2021 2022

$10,000

2,000

6,000$ 1,8

00

$1 ,80

0

$1 ,80

0

$1 ,80

0

$1 ,80

0

$1 0,0

00

$8 ,20

0

$6 ,40

0

$4 ,60

0

$2 ,80

0

$1 ,00

0

EXHIBIT 8.7 Financial Statement Effects of Straight-Line Depreciation

The net balance sheet amount is the asset book value, or book value, and is computed as the asset’s total cost minus accumulated depreciation. For example, at the end of Year 2 (December 31, 2020), its book value is $6,400, which is $10,000 minus $3,600 (2 years × $1,800), and is reported in the balance sheet as follows.

Book value = Cost − Accumulated depreciation

We also can compute the straight-line depreciation rate, which is 100% divided by the num- ber of periods in the asset’s useful life. For the inspection machine, this rate is 20% (100% ÷ 5 years, or 20% per period). We use this rate, along with other information, to compute the machine’s straight-line depreciation schedule shown in Exhibit 8.8. This exhibit shows (1) straight-line depreciation is the same each period, (2) accumulated depreciation is the total of current and prior periods’ depreciation expense, and (3) book value declines each period until it equals salvage value.

Machinery . . . . . . . . . . . . . . . . . . . . $10,000

Less accumulated depreciation . . . 3,600 $6,400 Machinery (net of $3,600 accumulated depreciation) . . . $6,400Book value

OR

Point: Once an asset’s book value equals its salvage value, depreciation stops.

Example: If salvage value of the machine is $2,500, what is the annual depreciation? Answer: ($10,000 − $2,500)/ 5 years = $1,500 per year

EXHIBIT 8.8 Straight-Line Depreciation Schedule

Depreciation for the Period End of Period

Annual Depreciable Depreciation Depreciation Accumulated Book Period Cost* Rate Expense Depreciation Value†

2018 — — — — $10,000

2019 $9,000 20% $1,800 $1,800 8,200 2020 9,000 20 1,800 3,600 6,400 2021 9,000 20 1,800 5,400 4,600 2022 9,000 20 1,800 7,200 2,800 2023 9,000 20 1,800 9,000 1,000 $9,000

*$10,000 − $1,000. †Book value is total cost minus accumulated depreciation.

$10,000 cost − $1,000 salvage

Salvage value is not depreciated .

Units-of-Production Method The use of some plant assets varies greatly from one period to the next. For example, a builder might use a piece of equipment for a month and then not use it again for several months. When equipment use varies from period to period, the units-of-production depreciation method can better match expenses with revenues. Units- of-production depreciation charges a varying amount for each period depending on an asset’s usage.

A two-step process is used. We first compute depreciation per unit as the asset’s total cost minus salvage value and then divide by the total units expected to be produced during its useful life. Units of production can be expressed in product or other units such as hours used or miles driven. The second step is to compute depreciation for the period by multiply- ing the units produced in the period by the depreciation per unit. The computation for the machine described in Exhibit 8.5 is in Exhibit 8.9. Note: 7,000 shoes are inspected and sold in its first year.

308 Chapter 8 Accounting for Long-Term Assets

EXHIBIT 8.10 Units-of-Production Depreciation Schedule

Depreciation for the Period End of Period

Annual Number of Depreciation per Depreciation Accumulated Book Period Units Unit Expense Depreciation Value

2018 — — — — $10,000

2019 7,000 $0 .25 $1,750 $1,750 8,250 2020 8,000 0 .25 2,000 3,750 6,250 2021 9,000 0 .25 2,250 6,000 4,000 2022 7,000 0 .25 1,750 7,750 2,250 2023 5,000 0 .25 1,250 9,000 1,000 36,000 units $9,000$10,000 cost − $1,000 salvage Salvage value is not depreciated .

EXHIBIT 8.11 Double-Declining-Balance Depreciation Formula*

Straight-line rate = 100% ÷ Useful life = 100% ÷ 5 years = 20%

Double-declining-balance rate = 2 × Straight-line rate = 2 × 20% = 40%

Depreciation expense = Double-declining-balance rate × Beginning-period book value 40% × $10,000 = $4,000 (for 2019)

Step 1

Step 2

Step 3

*In simple form: DDB depreciation = (2 × Beginning-period book value)∕Useful life.

$0.25 per shoe × 7,000 shoes = $1,750 Depreciation expense = Depreciation per unit × Units produced in period

Depreciation per unit = Cost – Salvage valueStep 1

Step 2

Total units of production = $10,000 – $1,000

36,000 shoes = $0.25 per shoe EXHIBIT 8.9 Units-of-Production Depreciation Formula and Example

Using data on the number of units inspected (shoes produced) by the machine, we compute the units-of-production depreciation schedule in Exhibit 8.10. For example, depreciation for the first year is $1,750 (7,000 shoes at $0.25 per shoe). Depreciation for the second year is $2,000 (8,000 shoes at $0.25 per shoe). Exhibit 8.10 shows (1) depreciation expense depends on unit output, (2) accumulated depreciation is the total of current and prior periods’ depreciation expense, and (3) book value declines each period until it equals salvage value.

Example: Refer to Exhibit 8.10. If the number of shoes inspected in 2023 is 5,500, what is depreciation for 2023? Answer: $1,250 (never depreci- ate below salvage value)

Declining-Balance Method An accelerated depreciation method has more depre- ciation in the early years and less depreciation in later years. The most common accelerated method is the declining-balance method, which uses a depreciation rate that is a multiple of the straight-line rate. A common depreciation rate is double the straight-line rate. This is called double-declining-balance (DDB). This is done in three steps.

1. Compute the asset’s straight-line depreciation rate. 2. Double the straight-line rate. 3. Compute depreciation by multiplying this rate by the asset’s beginning-period book value.

Let’s return to the machine in Exhibit 8.5 and use double-declining-balance to compute depreciation. Exhibit 8.11 shows the first-year depreciation computation. The three steps are (1) divide 100% by five years to get the straight-line rate of 20%, or 1/5, per year; (2) double this 20% rate to get the declining-balance rate of 40%, or 2/5, per year; and (3) compute depreciation as 40%, or 2/5, multiplied by the beginning-period book value.

SL rate = 100%

Useful life

DDB rate = 200%

Useful life

Point: Excel for DDB.

A B

1 Cost $10,000

2 Salvage $1,000

3 Life 5

4 DDB depr.

5 1

6 2

7 etc.

=DDB(B1,B2,B3,A5) = $4,000

=DDB(B1,B2,B3,A6) = $2,400

Chapter 8 Accounting for Long-Term Assets 309

The double-declining-balance depreciation schedule is in Exhibit 8.12. The schedule follows the formula except for year 2023, when depreciation is $296. This $296 is not equal to 40% × $1,296, or $518.40. If we had used the $518.40 for depreciation in 2023, the ending book value would equal $777.60, which is less than the $1,000 salvage value. Instead, the $296 is computed as $1,296 book value minus $1,000 salvage value (for the year when DDB depreciation cuts into salvage value).

Units CostItem Market Straight-LinePeriod Double-Declining-Balance

2020 2021 2022 2023

Totals

2019

1,800 1,800 1,800

$9,000

1,800 $1,800

Units-of-Production

2,250 1,750 1,250

$9,000

2,000 $1,750

1,440

2,400 $4,000

864 296

$9,000

EXHIBIT 8.13 Depreciation Expense for the Different Methods

Depreciation for Tax Reporting Many companies use accelerated depreciation in computing taxable income. Reporting higher depreciation expense in the early years of an as- set’s life reduces the company’s taxable income in those years and increases it in later years. The goal is to postpone its tax payments. The U.S. tax law has rules for depreciating assets. These rules include the Modified Accelerated Cost Recovery System (MACRS), which allows straight-line depreciation for some assets but requires accelerated depreciation for most kinds of assets. MACRS is not acceptable for financial reporting because it does not consider an asset’s useful life or salvage value.

Partial-Year Depreciation When an asset is purchased or sold at a time other than the beginning or end of an accounting period, depreciation is recorded for part of that period.

Mid-Period Asset Purchase Assume that the machine in Exhibit 8.5 is purchased and placed in service on October 1, 2018, and the annual accounting period ends on December 31. Because this machine is used for three months in 2018, the calendar-year income statement reports depreciation for those three months. Using straight-line depreciation, we compute three months’ depreciation of $450 as follows.

$10,000 − $1,000 5 years

× 3 12

= $450

Most Popular Methods

Declining-balance, 4%

Units-of-production, 5%

Straight-line, 85%

Accelerated and other, 6%

C2 Explain depreciation for partial years and changes in estimates.

EXHIBIT 8.12 Double-Declining-Balance Depreciation Schedule

Depreciation for the Period End of Period

Annual Beginning-of- Depreciation Depreciation Accumulated Book Period Period Book Value Rate Expense Depreciation Value

2018 — — — — $10,000

2019 $10,000 40% $4,000 $4,000 6,000 2020 6,000 40 2,400 6,400 3,600 2021 3,600 40 1,440 7,840 2,160 2022 2,160 40 864 8,704 1,296 2023 1,296 40 296* 9,000 1,000 $9,000

*Year 2023 depreciation is $1,296 − $1,000 = $296 (never depreciate book value below salvage value).

Salvage value is not depreciated .

$10,000 cost − $1,000 salvage

Comparing Depreciation Methods Exhibit 8.13 shows depreciation for each year under the three methods. While depreciation per period differs, total depreciation of $9,000 is the same over the useful life.

Example: What is the DDB depreciation in year 2022 if salvage value is $2,000? Answer: $2,160 − $2,000 = $160

310 Chapter 8 Accounting for Long-Term Assets

Mid-Period Asset Sale Assume that the machine above is sold on June 1, 2023. Depreciation is recorded in 2023 for the period January 1 through June 1 as follows.

$10,000 − $1,000 5 years

× 5 12

= $750

Change in Estimates Depreciation is based on estimates of salvage value and useful life. If our estimate of an asset’s useful life and/or salvage value changes, what should we do? The answer is to use the new esti- mate to compute depreciation for current and future periods. Revising an estimate of the useful life or salvage value of a plant asset is called a change in an accounting estimate and only affects current and future financial statements. We do not go back and restate (change) prior years’ statements. This applies to all depreciation methods.

Let’s return to the machine in Exhibit 8.8 using straight-line depreciation. At the beginning of this asset’s third year, its book value is $6,400. Assume that at the beginning of its third year, the estimated number of years remaining in its useful life changes from three to four years and its estimate of salvage value changes from $1,000 to $400. Depreciation for each of the four remaining years is computed as in Exhibit 8.14.

Impairment Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . 50

Record impairment of equipment.

Controller You are the controller for a struggling wingsuit company. Depreciation is its largest expense. Competitors depreciate equipment over three years. The company president tells you to revise useful lives of equipment from three to six years. What should you do? ■ Answer: The president’s instructions may be an honest and reasonable prediction of the future. However, you might confront the president if you believe the aim is only to increase income.

Decision Ethics

Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The manager estimates the machine will produce 1,000 units of product during its life. It actually produces the following units: 200 in Year 1, 400 in Year 2, 300 in Year 3, 80 in Year 4, and 30 in Year 5. The total units produced by the end of Year 5 exceed the original estimate—this difference was not predicted. (The machine must not be depreciated below its estimated salvage value.) Compute depreciation expense for each year and total depreciation for all years combined under straight-line, units-of- production, and double-declining-balance.

Part 2. In early January, a company acquires equipment for $3,800. The company estimates this equip- ment has a useful life of three years and a salvage value of $200. On January 1 of the third year, the com- pany changes its estimates to a total four-year useful life and zero salvage value. Using the straight-line method, what is depreciation expense for the third year?

Depreciation Computations

NEED-TO-KNOW 8-2

C2 P1

EXHIBIT 8.14 Computing Revised Straight-Line Depreciation

Book value − Revised salvage value Revised remaining useful life

= $6,400 − $400

4 years = $1,500 per year

Reporting Depreciation Some companies, such as O’Reilly Auto, report both the cost and accumulated depreciation of plant assets on the balance sheet. Apple and many other companies show plant assets on one line with the net amount of cost minus accumulated depreciation. When this is done, accumu- lated depreciation is disclosed in a note—see Appendix A for Apple.

Impairment When there is a permanent decline in the fair value of an asset relative to its book value, the company writes down the asset to this fair value. This is called an asset impairment. Assume equipment has a book value of $800 and a fair (market) value of $750, and this $50 decline in value meets the impairment test (details are in advanced courses). The impairment entry is

Annual Original Revised Period Depreciation Depreciation

2018 — — 2019 $1,800 $1,800 2020 1,800 1,800 2021 1,800 1,500 2022 1,800 1,500 2023 1,800 1,500 2024 — 1,500

$9,000 $9,600

©Cultura Creative/Alamy Stock Photo

Point: Assets purchased on days 1 through 15 of a month are usually recorded as purchased on the 1st of that month. Assets purchased on days 16 to month- end are recorded as if purchased on the 1st of the next month. The same applies to asset sales.

Chapter 8 Accounting for Long-Term Assets 311

Solution—Part 1

Year Straight-Linea Units-of-Productionb Double-Declining-Balancec

1 . . . . . . . . . . . . . . . $ 4,000 $ 4,000 $ 8,800

2 . . . . . . . . . . . . . . . 4,000 8,000 5,280

3 . . . . . . . . . . . . . . . 4,000 6,000 3,168

4 . . . . . . . . . . . . . . . 4,000 1,600 1,901

5 . . . . . . . . . . . . . . . 4,000 400 851

Totals . . . . . . . . . . . $20,000 $20,000 $20,000

aStraight-line: Cost per year = ($22,000 − $2,000)∕5 years = $4,000 per year bUnits-of-production: Cost per unit = ($22,000 − $2,000)∕1,000 units = $20 per unit

Year Units Depreciation per Unit Depreciation Accum. Deprec. Book Value

1 . . . . . . . . . . . . . . . . . . 200 $20 $ 4,000 $ 4,000 $18,000

2 . . . . . . . . . . . . . . . . . . 400 20 8,000 12,000 10,000

3 . . . . . . . . . . . . . . . . . . 300 20 6,000 18,000 4,000

4 . . . . . . . . . . . . . . . . . . 80 20 1,600 19,600 2,400

5 . . . . . . . . . . . . . . . . . . 30 20 400* 20,000* 2,000

Total . . . . . . . . . . . . . . . $20,000

* 30 × $20 = $600; however, $600 would make accumulated depreciation exceed the $20,000 total depreciable cost. This means we take only enough depreciation in Year 5, or $400, to decrease book value to the asset’s $2,000 salvage value (never lower).

cDouble-declining-balance: (100%∕5) × 2 = 40% depreciation rate

Annual Ending Book Value Depreciation Accumulated ($22,000 cost less Beginning (40% of Depreciation accumulated Year Book Value book value) at Year-End depreciation)

1 . . . . . . . . $22,000 $ 8,800 $ 8,800 $13,200

2 . . . . . . . . 13,200 5,280 14,080 7,920

3 . . . . . . . . 7,920 3,168 17,248 4,752

4 . . . . . . . . 4,752 1,901* 19,149 2,851

5 . . . . . . . . 2,851 851† 20,000 2,000

Total . . . . . $20,000

*Rounded to the nearest dollar. † Set depreciation in Year 5 to reduce book value to the $2,000 salvage value; namely, instead of $1,140 ($2,851 × 40%), we use the maximum of $851 ($2,851 − $2,000).

Solution—Part 2

($3,800 − $200)∕3 years = $1,200 (original depreciation per year)

$1,200 × 2 years = $2,400 (accumulated depreciation at date of change in estimate)

($3,800 − $2,400)∕2 years = $700 (revised depreciation)

Do More: QS 8-3 through QS 8-8, E 8-4

through E 8-13

Plant assets require maintenance, repairs, and improvements. We must decide whether to expense or capitalize these expenditures (to capitalize is to increase the asset account).

Revenue expenditures, also called income statement expenditures, are costs that do not materially increase the plant asset’s life or capabilities. They are recorded as expenses on the current-period income statement.

Capital expenditures, also called balance sheet expenditures, are costs of plant assets that provide benefits for longer than the current period. They increase the asset on the balance sheet.

ADDITIONAL EXPENDITURES C3 Distinguish between revenue and capital expenditures, and account for them.

312 Chapter 8 Accounting for Long-Term Assets

Ordinary Repairs Ordinary repairs are expenditures to keep an asset in good operating condition. Ordinary repairs do not extend an asset’s useful life or increase its productivity beyond original expecta- tions. Examples are normal costs of cleaning, lubricating, changing oil, and replacing small parts of a machine. Ordinary repairs are revenue expenditures. This means their costs are reported as expenses on the current-period income statement. Following this rule, Brunswick reports that “maintenance and repair costs are expensed as incurred.” If Brunswick’s current- year repair costs are $9,500, it makes the following entry.

Example: Assume a firm owns a web server. Identify each cost as a revenue or capital expenditure: (1) purchase price, (2) necessary wiring, (3) platform for operation, (4) circuits to increase capacity, (5) monthly cleaning, (6) repair of a faulty switch, and (7) replace- ment of a worn fan. Answer: Capital expenditures: 1, 2, 3, 4; Revenue expenditures: 5, 6, 7.

Additional Expenditures Examples Expense Timing Entry

Ordinary repairs • Cleaning • Lubricating Expensed currently Repairs Expense. . . . . # • Adjusting • Repainting Cash . . . . . . . . . . . . . #

Betterments and • Replacing main parts Expensed in future Asset (such as Equip.) # extraordinary repairs • Major asset expansions Cash . . . . . . . . . . . . . #

Betterments and Extraordinary Repairs Betterments and extraordinary repairs are capital expenditures.

Betterments (Improvements) Betterments, or improvements, are expenditures that make a plant asset more efficient or productive. A betterment often involves adding a component to an asset or replacing an old com- ponent with a better one and does not always increase useful life. An example is replacing manual controls on a

machine with automatic controls. One special type of betterment is an addition, such as adding a new dock to a warehouse. Because a betterment benefits future periods, it is debited to the as- set account as a capital expenditure. The new book value (less salvage value) is then depreciated over the asset’s remaining useful life. Assume a company pays $8,000 for a machine with an eight-year useful life and no salvage value. After three years and $3,000 of depreciation, it adds an automated control system to the machine at a cost of $1,800. The cost of the betterment is added to the Machinery account with the following entry.

Assets = Liabilities + Equity −9,500 −9,500

Dec . 31 Repairs Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Record ordinary repairs of equipment.

Assets = Liabilities + Equity +1,800 −1,800

Jan . 2 Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Record installation of automated system.

After this entry, the remaining cost to be depreciated is $6,800, computed as $8,000 − $3,000 + $1,800. Depreciation for the remaining five years is $1,360 per year, computed as $6,800∕5 years.

Extraordinary Repairs (Replacements) Extraordinary repairs are expenditures that extend the asset’s useful life beyond its original estimate. Their costs are debited to the asset account.

Point: Both extraordinary repairs and betterments require revising future depreciation.

To the Moon and Back SpaceX made history when it relaunched a used Falcon 9 rocket. This was the first time an orbital rocket was launched into space a second time. SpaceX made extraordinary repairs to the rocket to make this relaunch possible. However, these repairs were considerably less costly than building a new rocket for tens of millions of dollars. ■

Decision Insight

Source: NASA/Tony Gray and Kevin O’Connell

Disposal of plant assets occurs in one of three ways: discarding, sale, or exchange. Discarding and selling are covered here; Appendix 8A covers exchanges. The steps for disposing plant assets are in Exhibit 8.15.

DISPOSALS OF PLANT ASSETS

Chapter 8 Accounting for Long-Term Assets 313

Discarding Plant Assets A plant asset is discarded when it is no longer useful to the company and it has no market value. Assume that a machine costing $9,000 with accumulated depreciation of $9,000 is discarded. When accumulated depreciation equals the asset’s cost, it is said to be fully depreciated (zero book value). The entry to record the discarding of this asset is

EXHIBIT 8.15 Accounting for Disposals of Plant Assets

1 . Record depreciation up to the date of disposal—this also updates Accumulated Depreciation .

2 . Record the removal of the disposed asset’s account balances—including its accumulated depreciation .

3 . Record any cash (and/or other assets) received or paid in the disposal .

4 . Record any gain or loss—equal to the value of any assets received minus the disposed asset’s book value .

This entry reflects all four steps of Exhibit 8.15. Step 1 is unnecessary because the machine is fully depreciated. Step 2 is reflected in the debit to Accumulated Depreciation and credit to Machinery. Because no other asset is involved, step 3 is irrelevant. Finally, because book value is zero and no other asset is involved, no gain or loss is recorded in step 4.

How do we account for discarding an asset that is not fully depreciated or one whose depre- ciation is not up-to-date? To answer this, consider equipment costing $8,000 with accumulated depreciation of $6,000 on December 31 of the prior fiscal year-end. This equipment is being depreciated by $1,000 per year using the straight-line method over eight years with zero salvage. On July 1 of the current year it is discarded. Step 1 is to bring depreciation up-to-date.

Point: Recording depreciation expense up-to-date gives an up-to-date book value for determining gain or loss.

Steps 2 through 4 of Exhibit 8.15 are reflected in the second (and final) entry.

This loss is computed by comparing the equipment’s $1,500 book value ($8,000 − $6,000 − $500) with the zero net cash proceeds. The loss is reported in the Other Expenses and Losses section of the income statement. Discarding an asset can sometimes require a cash payment that would increase the loss.

Selling Plant Assets To demonstrate selling plant assets, consider BTO’s March 31 sale of equipment that cost $16,000 and has accumulated depreciation of $12,000 at December 31 of the prior year- end. Annual depreciation on this equipment is $4,000 using straight-line. Step 1 of this sale is to record depreciation expense and update accumulated depreciation to March 31 of the current year.

June 5 Accumulated Depreciation—Machinery . . . . . . . . . . . . . . . . . 9,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Discarding of fully depreciated machinery.

Assets = Liabilities + Equity +9,000 −9,000

July 1 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Accumulated Depreciation—Equipment . . . . . . . . . . . . . 500

Record 6 months’ depreciation ($1,000 × 6∕12).

Assets = Liabilities + Equity −500 −500

July 1 Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . . 6,500

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Discard equipment with a $1,500 book value.

Assets = Liabilities + Equity +6,500 −1,500 −8,000

Mar . 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . 1,000

Record 3 months’ depreciation ($4,000 × 3∕12).

Assets = Liabilities + Equity −1,000 −1,000

P2 Account for asset disposal through discarding or selling an asset.

314 Chapter 8 Accounting for Long-Term Assets

Steps 2 through 4 need one final entry that depends on the amount received from the sale. We cover three different possibilities.

Sale at Book Value If BTO receives $3,000 cash, an amount equal to the equipment’s book value as of March 31 (book value = $16,000 − $12,000 − $1,000), no gain or loss is re- corded. The entry is

Sale price = Book value → No gain or loss

Sale above Book Value If BTO receives $7,000, an amount that is $4,000 above the equipment’s $3,000 book value as of March 31, a gain is recorded. The entry is

Sale price > Book value → Gain

Sale below Book Value If BTO receives $2,500, an amount that is $500 below the equipment’s $3,000 book value as of March 31, a loss is recorded. The entry is

Sale price < Book value → Loss

Mar . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . 13,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Record sale of equipment for no gain or loss.

Assets = Liabilities + Equity +3,000 +13,000 −16,000

Mar . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . 13,000

Gain on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . 4,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Record sale of equipment for a $4,000 gain.

Assets = Liabilities + Equity +7,000 +4,000 +13,000 −16,000

Mar . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . . . . . 500

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . 13,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Record sale of equipment for a $500 loss.

Assets = Liabilities + Equity +2,500 −500 +13,000 −16,000

Part 1. A company pays $1,000 for equipment expected to last four years and have a $200 salvage value. Prepare journal entries to record the following costs related to the equipment. a. During the second year of the equipment’s life, $400 cash is paid for a new component expected to

materially increase the equipment’s productivity. b. During the third year, $250 cash is paid for normal repairs necessary to keep the equipment in good

working order. c. During the fourth year, $500 is paid for repairs expected to increase the useful life of the equipment

from four to five years.

Part 2. A company owns a machine that cost $500 and has accumulated depreciation of $400. Prepare the entry to record the disposal of the machine on January 2 in each separate situation. a. The company disposed of the machine, receiving nothing in return. b. The company sold the machine for $80 cash. c. The company sold the machine for $100 cash. d. The company sold the machine for $110 cash.

Solution—Part 1

a.

Additional Expenditures and Asset Disposals

NEED-TO-KNOW 8-3

C3 P2

Year 2 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Record betterment.

b. Year 3 Repairs Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Record ordinary repairs.

Chapter 8 Accounting for Long-Term Assets 315

Solution—Part 2 (Note: Book value of machine = $500 − $400 = $100)

a. Disposed of at no value.

c. Year 4 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Record extraordinary repairs.

Jan . 2 Loss on Disposal of Machine . . . . . . . . . . . . 100

Accumulated Depreciation—Machine . . . . . 400

Machine . . . . . . . . . . . . . . . . . . . . . . . . 500

Record disposal of machine.

Jan . 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Loss on Sale of Machine . . . . . . . . . . . . . . . 20

Accumulated Depreciation—Machine . . . . . 400

Machine . . . . . . . . . . . . . . . . . . . . . . . . 500

Record sale of machine below book value.

b. Sold for $80 cash.

Jan . 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Accumulated Depreciation—Machine . . . . . 400

Machine . . . . . . . . . . . . . . . . . . . . . . . . 500

Record sale of machine at book value.

c. Sold for $100 cash.

Jan . 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Accumulated Depreciation—Machine . . . . . 400

Gain on Sale of Machine . . . . . . . . . . . 10

Machine . . . . . . . . . . . . . . . . . . . . . . . . 500

Record sale of machine above book value.

d. Sold for $110 cash.

Do More: QS 8-9, QS 8-10, E 8-14, E 8-15, E 8-16,

E 8-17

Natural resources are assets that are physically consumed when used. Examples are standing timber, mineral deposits, and oil and gas fields. These assets are soon-to-be inventories of raw materials after cutting, mining, or pumping. Until that conversion happens, they are reported as noncurrent assets under either plant assets or their own category using titles such as Timber- lands, Mineral deposits, or Oil reserves.

Cost Determination and Depletion Natural resources are recorded at cost, which includes all expenditures necessary to acquire the resource and prepare it for use. Depletion is the process of allocating the cost of a natural resource to the period when it is consumed. Natural resources are reported on the balance sheet at cost minus accumulated depletion. The depletion expense per period is usually based on units extracted from cutting, mining, or pumping. This is similar to units-of-production depreciation.

To demonstrate, consider a mineral deposit with an estimated 250,000 tons of available ore. It is purchased for $500,000, and we expect zero salvage value. The depletion charge per ton of ore mined is $2, computed as $500,000 ÷ 250,000 tons. If 85,000 tons are mined and sold in the first year, the depletion charge for that year is $170,000. These computations are in Exhibit 8.16.

Section 2—Natural Resources P3 Account for natural resource assets and their depletion.

Depletion expense for the first year is recorded as follows.

Depletion expense = Depletion per unit × Units extracted and sold in period = $2 × 85,000 = $170,000

Depletion per unit = Cost – Salvage value

Total units of capacity =

$500,000 – $0 250,000 tons

= $2 per tonStep 1

Step 2

EXHIBIT 8.16 Depletion Formula and Example

Dec . 31 Depletion Expense—Mineral Deposit . . . . . . . . . . . . . . . . . . . . 170,000

Accumulated Depletion—Mineral Deposit . . . . . . . . . . . . 170,000

Record depletion of the mineral deposit.

Assets = Liabilities + Equity −170,000 −170,000

316 Chapter 8 Accounting for Long-Term Assets

The period-end balance sheet reports the mineral deposit as shown in Exhibit 8.17.

Mineral deposit . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000

Less accumulated depletion . . . . . . . . . . . . . . 170,000 $330,000

EXHIBIT 8.17 Balance Sheet Presentation of Natural Resources

Because all 85,000 tons of the mined ore are sold during the year, the entire $170,000 of depletion is reported on the income statement. If some of the ore remains unsold at year-end, the depletion related to the unsold ore is carried forward on the balance sheet and reported as Ore Inventory, a current asset. Altering our example, assume that of the 85,000 tons mined the first year, only 70,000 tons are sold. We record depletion of $140,000 (70,000 tons × $2 depletion per unit) and the remaining ore inventory of $30,000 (15,000 tons × $2 depletion per unit) as follows.

Dec . 31 Depletion Expense—Mineral Deposit . . . . . . . . . . . . . . . . . . . 140,000

Ore Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Accumulated Depletion—Mineral Deposit . . . . . . . . . . . 170,000

Record depletion and inventory of mineral deposit.

Assets = Liabilities + Equity −170,000 −140,000 +30,000

Plant Assets Tied into Extracting Mining, cutting, or pumping natural resources requires machinery, equipment, and buildings. When the usefulness of these plant assets is directly related to the depletion of a natural resource, their costs are depreciated using the units-of-production method in proportion to the depletion of the natural resource. For example, if a machine is permanently installed in a mine and 10% of the ore is mined and sold in the period, then 10% of the machine’s cost (minus any salvage value) is depreciated. The same procedure is used when a machine is abandoned once resources are extracted. If the machine will be used at another site when extraction is complete, it is depre- ciated over its own useful life.

Lost Cause Long-term assets must be safeguarded against theft, misuse, and damage. Controls include use of secu- rity tags, monitoring of rights infringements, and approvals of asset disposals. A study reports that 43% of employees in operations and services witnessed the wasting, mismanaging, or abusing of assets in the past year (KPMG). ■

Ethical Risk

©GIRODJL/Shutterstock

A company acquires a zinc mine at a cost of $750,000 on January 1. At that same time, it incurs additional costs of $100,000 to access the mine, which is estimated to hold 200,000 tons of zinc. The estimated value of the land after the zinc is removed is $50,000. 1. Prepare the January 1 entry(ies) to record the cost of the zinc mine. 2. Prepare the December 31 year-end adjusting entry if 50,000 tons of zinc are mined, but only 40,000

tons are sold the first year.

Solution

1.

Depletion Accounting

NEED-TO-KNOW 8-4

P3

2. Depletion per unit = ($750,000 + $100,000 − $50,000)/200,000 tons = $4.00 per ton

Do More: QS 8-11, E 8-18, P 8-7

Jan . 1 Zinc Mine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 850,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 850,000 Record cost of zinc mine.

Dec . 31 Depletion Expense—Zinc Mine . . . . . . . . . . . . . . . . . . . . . . 160,000 Zinc Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Accumulated Depletion—Zinc Mine . . . . . . . . . . . . . . 200,000 Record depletion of zinc mine (50,000 × $4.00).

Chapter 8 Accounting for Long-Term Assets 317

Intangible assets are nonphysical assets used in operations that give companies long-term rights or competitive advantages. Examples are patents, copyrights, licenses, leaseholds, franchises, and trademarks. Lack of physical substance does not always mean an intangible asset. For example, notes and accounts receivable lack physical substance but are not intangi- bles. This section covers common types of intangible assets.

Cost Determination and Amortization An intangible asset is recorded at cost when purchased. Intangibles can have limited lives or indefinite lives. If an intangible has a limited life, its cost is expensed over its estimated use- ful life using amortization. If an intangible asset has an indefinite life—meaning that no legal, competitive, economic, or other factors limit its useful life—it is not amortized. (If an intangible with an indefinite life is later judged to have a limited life, it is amortized over that limited life.)

Amortization of intangible assets is similar to depreciation. However, only the straight-line method is used for amortizing intangibles unless the company can show that another method is preferred. Amortization is recorded in a contra account, Accumulated Amortization. The acqui- sition cost of intangible assets is disclosed along with the accumulated amortization. The dis- posal of an intangible asset involves removing its book value, recording any other asset(s) received or given up, and recognizing any gain or loss for the difference.

Many intangibles have limited lives due to laws, contracts, or other reasons. Examples are patents, copyrights, and leaseholds. The cost of intangible assets is amortized over the periods expected to benefit from their use, but this period cannot be longer than the assets’ legal existence. Other intangibles such as trademarks and trade names have indefinite lives and are not amortized. An intangible asset that is not amortized is tested annually for impairment—if necessary, an impairment loss is recorded. (Details are in advanced courses.)

Intangible assets are often in a separate section of the balance sheet immediately after plant assets. For example, Nike follows this approach in reporting nearly $300 million of intangible assets in its balance sheet, plus $140 million in goodwill. Companies usually disclose their amortization periods for intangibles. The remainder of our discussion focuses on accounting for specific types of intangible assets.

Types of Intangibles Patents The federal government grants patents to encourage the invention of new technology and processes. A patent is an exclusive right granted to its owner to manufacture and sell a pat- ented item or to use a process for 20 years. When patent rights are purchased, the cost to acquire the rights is debited to an account called Patents. If the owner engages in lawsuits to successfully defend a patent, the cost of lawsuits is debited to the Patents account; if the defense is unsuccess- ful, the book value of the patent is expensed. However, the costs of research and development leading to a new patent are expensed when incurred.

A patent’s cost is amortized over its estimated useful life (not to exceed 20 years). If we purchase a patent costing $25,000 with a useful life of 10 years, we make the following adjusting entry at the end of each of the 10 years to amortize one-tenth of its cost. The $2,500 debit to Amortization Expense is on the income statement as a cost of the patented product or service. The Accumulated Amortization—Patents account is a contra asset account to Patents.

Section 3—Intangible Assets P4 Account for intangible assets.

©Michael DeYoung/Blend Images

Dec . 31 Amortization Expense—Patents . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Accumulated Amortization—Patents . . . . . . . . . . . . . . . . 2,500

Amortize patent costs over its useful life.

Assets = Liabilities + Equity −2,500 −2,500

318 Chapter 8 Accounting for Long-Term Assets

Copyrights A copyright gives its owner the exclusive right to publish and sell a musical, literary, or artistic work during the life of the creator plus 70 years, although the useful life of most copyrights is much shorter. The costs of a copyright are amortized over its useful life. The only identifiable cost of many copyrights is the fee paid to the Copyright Office. Identifiable costs of a copyright are capitalized (recorded in an asset account) and amortized by debiting an account called Amortization Expense—Copyrights.

Franchises and Licenses Franchises and licenses are rights that a company or gov- ernment grants an entity to sell a product or service under specified conditions. Many organiza- tions grant franchise and license rights—Anytime Fitness, Firehouse Subs, and Major League Baseball are just a few examples. The costs of franchises and licenses are debited to a Franchises and Licenses asset account and are amortized over the life of the agreement. If an agreement is for an indefinite time, those costs are not amortized.

Trademarks and Trade Names A trademark or trade (brand) name is a sym- bol, name, phrase, or jingle identified with a company, product, or service. Examples are Nike Swoosh, Big Mac, Coca-Cola, and Corvette. Ownership and exclusive right to use a trademark or trade name often are granted to the company that used it first. Ownership is best established by registering a trademark or trade name with the government’s Patent Office. The cost of developing, maintaining, or enhancing the value of a trademark or trade name (such as advertising) is charged to expense when incurred. If a trademark or trade name is purchased, however, its cost is debited to an asset account and then amortized over its expected life. If the company plans to renew indefinitely its right to the trademark or trade name, the cost is not amortized.

Goodwill Goodwill is the amount by which a company’s value exceeds the value of its in- dividual assets and liabilities. This implies that the company as a whole has certain valuable attributes not measured in assets and liabilities. These can include superior management, skilled workforce, good supplier or customer relations, quality products or services, good location, or other competitive advantages.

Goodwill is only recorded when an entire company or business segment is purchased. Purchased goodwill is computed as purchase price of the company minus the market value of net assets (excluding goodwill). Google paid $1.19 billion to acquire YouTube; about $1.13 of the $1.19 billion was for goodwill. Goodwill is recorded as an asset, and it is not amortized. Instead, goodwill is annually tested for impairment. (Details are in advanced courses.)

Right-of-Use Asset (Lease) Property is rented under a contract called a lease. The property’s owner, called the lessor, grants the lease. The one who secures the right to possess and use the property is called the lessee. A leasehold is the rights the lessor grants to the lessee under the terms of the lease.

Lease or Buy Some advantages of leasing an asset versus buying it are that Little or no up-front payment is normally required (making it more affordable). Lease terms often allow exchanges to trade up on leased assets (reducing obsolescence).

Lease Accounting For noncurrent leases, the lessee records a “Right-of-Use Asset” and “Lease Liability” equal to the value of lease payments. At each period-end, the lessee records amortization with a debit to Amortization Expense and a credit to Accumulated Amortization— Right-of-Use Asset.

Leasehold Improvements A lessee sometimes pays for improvements to the leased property such as partitions, painting, and storefronts. These improvements are called leasehold improvements, and the lessee debits these costs to a Leasehold Improvements account. The lessee amortizes these costs over the life of the lease or the life of the improvements, whichever

Point: McDonald’s “golden arches” are one of the world’s most valuable trademarks, yet this asset is not on McDonald’s balance sheet.

Point: Amortization of goodwill is different for financial accounting and tax accounting. The IRS requires the amortization of goodwill over 15 years.

Example: Assume goodwill has a book value of $500, an implied fair value of $475, and this $25 decline in value meets the impair- ment test. The impairment entry is Impairment Loss . . . . . . . . . . 25 Goodwill . . . . . . . . . . . . . . 25

Point: At lease start: Right-of-Use Asset . . . . . . . # Lease Liability . . . . . . . . . #

At each period-end: Amortization Expense . . . . # Acc Amor—RoU Asset . . . #

Point: A Leasehold account im- plies existence of future benefits that the lessee controls because of a prepayment. It also meets the definition of an asset.

Chapter 8 Accounting for Long-Term Assets 319

is shorter. The amortization entry debits Amortization Expense—Leasehold Improvements and credits Accumulated Amortization—Leasehold Improvements.

Other Intangibles There are other types of intangible assets such as software, non- compete covenants, customer lists, and so forth. Accounting for them is the same as for other intangibles.

Research and Development Research and development costs are expenditures to discover new products, new processes, or knowledge. Creating patents, copyrights, and innova- tive products and services requires research and development costs. The costs of research and development are expensed when incurred because it is difficult to predict the future benefits from research and development. GAAP does not include them as intangible assets.

Free Mickey The Walt Disney Company successfully lobbied Congress to extend copyright protection from the life of the creator plus 50 years to the life of the creator plus 70 years. This extension allows the company to protect its characters for 20 additional years before the right to use them enters the public domain. Mickey Mouse is now pro- tected by copyright law until 2023. The law is officially termed the Copyright Term Extension Act (CTEA), but it is also known as the Mickey Mouse Protection Act. ■

Decision Insight

©Yoshikazu Tsuno/AFP/Getty Images

Part 1. A publisher purchases the copyright on a book for $1,000 on January 1 of this year. The copyright lasts five more years. The company plans to sell prints for seven years. Prepare entries to record the pur- chase of the copyright on January 1 and its annual amortization on December 31.

Part 2. On January 3 of this year, a retailer pays $9,000 to modernize its store. Improvements include lighting, partitions, and a sound system. These improvements are estimated to yield benefits for five years. The retailer leases its store and has three years remaining on its lease. Prepare the entry to record (a) the cost of modernization and (b) amortization at the end of this year.

Part 3. On January 6 of this year, a company pays $6,000 for a patent with a remaining 12-year legal life to produce a supplement expected to be marketable for 3 years. Prepare entries to record its acquisition and the December 31 amortization entry.

Solution—Part 1

P4

Accounting for Intangibles

NEED-TO-KNOW 8-5

Jan . 1 Copyright . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Record purchase of copyright.

Dec . 31 Amortization Expense—Copyright . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Accumulated Amortization—Copyright . . . . . . . . . . . . . . . . . . . . 200

Record amortization of copyright ($1,000/5 years).

Solution—Part 2

a. Jan . 3 Leasehold Improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Record leasehold improvements.

b. Dec . 31 Amortization Expense—Leasehold Improvements . . . . . . . . . . . . . . . 3,000 Accumulated Amortization—Leasehold Improvements . . . . . . . 3,000

Record amortization of leasehold over remaining lease life.*

*Amortization = $9,000∕3-year lease term = $3,000 per year.

320 Chapter 8 Accounting for Long-Term Assets

Total Asset TurnoverDecision Analysis

One important measure of a company’s ability to use its assets efficiently and effectively is total asset turnover, defined in Exhibit 8.18.

A1 Compute total asset turn- over and apply it to analyze a company’s use of assets.

Net sales is net amounts earned from the sale of products and services. Average total assets is (Current period-end total assets + Prior period-end total assets)/2. A higher total asset turnover means a company is generating more net sales for each dollar of assets. Management is evaluated on efficient and effective use of total assets by looking at total asset turnover. Let’s look at total asset turnover in Exhibit 8.19 for two competing companies: Starbucks and Jack in the Box.

EXHIBIT 8.18 Total Asset Turnover Total asset turnover =

Net sales Average total assets

To show how we use total asset turnover, let’s look at Starbucks. We express Starbucks’s use of assets in generating net sales by saying “it turned its assets over 1.56 times during the current year.” This means that each $1.00 of assets produced $1.56 of net sales.

Is a total asset turnover of 1.56 good or bad? All companies want a high total asset turnover. Interpreting the total asset turnover requires an understanding of company operations. Some operations are capital- intensive, meaning that a relatively large amount is invested in plant assets to generate sales. This results in a lower total asset turnover. Other companies’ operations are labor-intensive, meaning that they gener- ate sales using people instead of assets. In that case, we expect a higher total asset turnover. Starbucks’s turnover is higher than that for Jack in the Box. However, Starbucks’s total asset turnover decreased over the last three years. To maintain a strong total asset turnover, Starbucks must grow sales at a rate equal to, or higher than, its total asset growth.

Environmentalist A paper manufacturer claims it cannot afford more environmental controls. It points to its low total asset turnover of 1.9 and argues that it cannot compete with companies whose total asset turnover is much higher. Examples cited are food stores (5.5) and auto dealers (3.8). How do you respond? ■ Answer: The paper manufacturer’s com- parison of its total asset turnover with food stores and auto dealers is misdirected. You need to collect data from competitors in the paper industry to show that a 1.9 total asset turnover is about the norm for this industry.

Decision Maker

Do More: QS 8-12, QS 8-13, E 8-19, E 8-20

Jan . 6 Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Record purchase of patent.

Dec . 31 Amortization Expense* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Accumulated Amortization—Patents . . . . . . . . . . . . . . . . . . . . . . 2,000

Record amortization of patent. *$6,000/3 years = $2,000

Solution—Part 3

EXHIBIT 8.19 Analysis Using Total Asset Turnover

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Starbucks Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22,387 $21,316 $19,163 Average total assets . . . . . . . . . . . . . . . . . . . . $14,339 $13,364 $11,585 Total asset turnover . . . . . . . . . . . . . . . . . . . 1.56 1.60 1.65 Jack in the Box Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,554 $1,599 $1,540 Average total assets . . . . . . . . . . . . . . . . . . . . $1,289 $1,326 $1,287 Total asset turnover . . . . . . . . . . . . . . . . . . . 1.21 1.21 1.20

Chapter 8 Accounting for Long-Term Assets 321

Required

1. Allocate the total $600,000 purchase cost among the separate assets. 2. Compute the 2018 (six months) and 2019 depreciation expense for each asset, and compute the company’s

total depreciation expense for both years. The machinery produced 700 units in 2018 and 1,800 units in 2019. 3. On the last day of calendar-year 2020, Tulsa discarded equipment that had been on its books for five

years. The equipment’s original cost was $12,000 (estimated life of five years) and its salvage value was $2,000. No depreciation had been recorded for the fifth year when the disposal occurred. Journalize the fifth year of depreciation (straight-line method) and the asset’s disposal.

4. At the beginning of year 2020, Tulsa purchased a patent for $100,000 cash. The company estimated the patent’s useful life to be 10 years. Journalize the patent acquisition and its amortization for the year 2020.

5. Late in the year 2020, Tulsa acquired an ore deposit for $600,000 cash. It added roads and built mine shafts for an additional cost of $80,000. Salvage value of the mine is estimated to be $20,000. The company estimated 330,000 tons of available ore. In year 2020, Tulsa mined and sold 10,000 tons of ore. Journalize the mine’s acquisition and its first year’s depletion.

6.A (This question applies to this chapter’s Appendix coverage.) On the first day of 2020, Tulsa exchanged the machinery that was acquired on July 1, 2018, along with $5,000 cash for machinery with a $210,000 market value. Journalize the exchange of these assets assuming the exchange has commercial substance. (Refer to background information in parts 1 and 2.)

PLANNING THE SOLUTION Complete a three-column table showing the following amounts for each asset: appraised value, percent

of total value, and apportioned cost. Using allocated costs, compute depreciation for 2018 (only one-half year) and 2019 (full year) for each

asset. Summarize those computations in a table showing total depreciation for each year. Depreciation must be recorded up-to-date before discarding an asset. Calculate and record depreciation

expense for the fifth year using the straight-line method. Record the loss on the disposal as well as the removal of the discarded asset and its accumulated depreciation.

Record the patent (an intangible asset) at its purchase price. Use straight-line amortization over its use- ful life to calculate amortization expense.

Record the ore deposit (a natural resource asset) at its cost, including any added costs to ready the mine for use. Calculate depletion per ton using the depletion formula. Multiply the depletion per ton by the amount of tons mined and sold to calculate depletion expense for the year.

Gains and losses on asset exchanges that have commercial substance are recognized. Make a journal entry to add the acquired machinery and remove the old machinery, along with its accumulated depre- ciation, and to record the cash given in the exchange.

SOLUTION 1. Allocation of the total cost of $600,000 among the separate assets.

Appraised Percent of Asset Value Total Value Apportioned Cost

Land . . . . . . . . . . . . . . . . . . . . . . . . $160,000 20% $120,000 ($600,000 × 20%) Land improvements . . . . . . . . . . . 80,000 10 60,000 ($600,000 × 10%) Building . . . . . . . . . . . . . . . . . . . . . 320,000 40 240,000 ($600,000 × 40%) Machinery . . . . . . . . . . . . . . . . . . . 240,000 30 180,000 ($600,000 × 30%) Total . . . . . . . . . . . . . . . . . . . . . . . . $800,000 100% $ 600,000

On July 1, 2018, Tulsa Company pays $600,000 to acquire a fully equipped factory. The purchase includes the following assets and information.

COMPREHENSIVE

Acquisition, Cost Allocation, and Disposal of Tangible and Intangible Assets

NEED-TO-KNOW 8-6

Asset Appraised Value Salvage Value Useful Life Depreciation Method

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 Not depreciated Land improvements . . . . . . . . . . . . . . . 80,000 $ 0 10 years Straight-line Building . . . . . . . . . . . . . . . . . . . . . . . . . 320,000 100,000 10 years Double-declining-balance Machinery . . . . . . . . . . . . . . . . . . . . . . . 240,000 20,000 10,000 units Units-of-production Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000

322 Chapter 8 Accounting for Long-Term Assets

2. Depreciation for each asset. (Land is not depreciated.)

Land Improvements Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000

Salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

Depreciable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000

Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 years

Annual depreciation expense ($60,000∕10 years) . . . . . . . . . . . . . . . . $ 6,000 2018 depreciation ($6,000 × 6∕12) . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 2019 depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000

Building Straight-line rate = 100%∕10 years = 10% Double-declining-balance rate = 10% × 2 = 20% 2018 depreciation ($240,000 × 20% × 6∕12) . . . . . . . . . . . . . . . . . . $ 24,000 2019 depreciation [($240,000 − $24,000) × 20%] . . . . . . . . . . . . . . . $ 43,200

Machinery Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $180,000

Salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Depreciable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000

Total expected units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 units

Depreciation per unit ($160,000∕10,000 units) . . . . . . . . . . . . . . . . . . $ 16 2018 depreciation ($16 × 700 units) . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,200 2019 depreciation ($16 × 1,800 units) . . . . . . . . . . . . . . . . . . . . . . . . $ 28,800

Total depreciation expense for each year.

3. Record the depreciation up-to-date on the discarded asset.

Record the removal of the discarded asset and its loss on disposal.

2018 2019

Land improvements . . . . . . . . . . . $ 3,000 $ 6,000

Building . . . . . . . . . . . . . . . . . . . . . 24,000 43,200

Machinery . . . . . . . . . . . . . . . . . . . 11,200 28,800

Total . . . . . . . . . . . . . . . . . . . . . . . . $38,200 $78,000

Depreciation Expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Record depreciation on date of disposal: ($12,000 − $2,000)∕5.

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Record the discarding of equipment with a $2,000 book value.

Amortization Expense—Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Accumulated Amortization—Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Record amortization expense: $100,000∕10 years = $10,000.

Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Record patent acquisition.

4.

Chapter 8 Accounting for Long-Term Assets 323

Depletion Expense—Ore Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accumulated Depletion—Ore Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Record depletion expense: ($680,000 − $20,000)∕330,000 tons = $2 per ton. 10,000 tons mined and sold × $2 = $20,000 depletion.

Ore Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680,000

Record ore deposit acquisition and its related costs.

5.

6.A Record the asset exchange: The book value on the exchange date is $180,000 (cost) − $40,000 (accu- mulated depreciation). The book value of the machinery given up in the exchange ($140,000) plus the $5,000 cash paid is less than the $210,000 value of the machine acquired. The entry to record this ex- change of assets that has commercial substance and recognizes the $65,000 gain ($210,000 − $140,000 − $5,000) is

Machinery (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

Accumulated Depreciation—Machinery (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Machinery (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Gain on Exchange of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Record exchange with commercial substance of old equipment plus cash for new equipment.

APPENDIX

Exchanging Plant Assets 8A Many plant assets such as machinery, automobiles, and equipment are exchanged for newer assets. In a typical exchange of plant assets, a trade-in allowance is received on the old asset and the balance is paid in cash. Accounting for the exchange of assets depends on whether the transaction has commercial sub- stance. An exchange has commercial substance if the company’s future cash flows change as a result of the exchange of one asset for another asset. If an asset exchange has commercial substance, a gain or loss is recorded based on the difference between the book value of the asset(s) given up and the market value of the asset(s) received. Because most exchanges have commercial substance, we cover gains and losses for only that situation. Advanced courses cover exchanges without commercial substance.

Exchange with Commercial Substance: A Loss A company acquires $42,000 in new equipment. In exchange, the company pays $33,000 cash and trades in old equipment. The old equipment originally cost $36,000 and has accumulated depreciation of $20,000, which implies a $16,000 book value at the time of exchange. This exchange has commercial substance and the old equipment has a trade-in allowance of $9,000. This exchange yields a loss as computed in the middle (Loss) columns of Exhibit 8A.1; the loss is computed as Asset received − Assets given = $42,000 − $49,000 = $(7,000). We also can compute the loss as Trade-in allowance − Book value of assets given = $9,000 − $16,000 = $(7,000).

P5 Account for asset exchanges.

EXHIBIT 8A.1 Computing Gain or Loss on Asset Exchange with Commercial Substance

Asset Exchange Has Commercial Substance Loss Gain

Market value of asset received . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,000 $42,000

Book value of assets given:

Equipment ($36,000 − $20,000) . . . . . . . . . . . . . . . . . . . . . . . . $16,000 $16,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000 49,000 23,000 39,000

Gain (loss) on exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(7,000) $ 3,000

324 Chapter 8 Accounting for Long-Term Assets

A company acquires $45,000 in new web servers. In exchange, the company trades in old web servers along with a cash payment. The old servers originally cost $30,000 and had accumulated depreciation of $23,400 at the time of the trade. Prepare entries to record the trade under two different assumptions where (a) the exchange has commercial substance and the old servers have a trade-in allowance of $3,000 and (b) the exchange has commercial substance and the old servers have a trade-in allowance of $7,000.

Solution

Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Loss on Exchange of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Accumulated Depreciation—Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,400

Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Cash ($45,000 − $3,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Accumulated Depreciation—Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,400

Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Cash ($45,000 − $7,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000 Gain on Exchange of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Asset Exchange

NEED-TO-KNOW 8-7

P5

Do More: QS 8-16, E 8-23, E 8-24

a.

b.

The entry to record this asset exchange and the loss follows.

Exchange with Commercial Substance: A Gain Let’s assume the same facts as in the preceding asset exchange except that the company pays $23,000 cash, not $33,000, with the trade-in. This exchange has commercial substance and the old equipment has a trade-in allowance of $19,000. This exchange yields a gain as computed in the right-most (Gain) columns of Exhibit 8A.1; the gain is computed as Asset received − Assets given = $42,000 − $39,000 = $3,000. We also can compute the gain as Trade-in allow- ance − Book value of assets given = $19,000 − $16,000 = $3,000. The entry to record this asset exchange and the gain follows.

Jan . 3 Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000 Loss on Exchange of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Accumulated Depreciation—Equipment (old) . . . . . . . . . . . . . 20,000 Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

Record exchange (with commercial substance) of old equipment and cash for new equipment.

Assets = Liabilities + Equity +42,000 −7,000 +20,000 −36,000 −33,000

Point: “New” and “old” equipment are for illustration only. Both the debit and credit are to the same Equipment account.

Jan . 3 Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000 Accumulated Depreciation—Equipment (old) . . . . . . . . . . . . . 20,000 Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000

Gain on Exchange of Assets . . . . . . . . . . . . . . . . . . . . . . . 3,000

Record exchange (with commercial substance) of old equipment and cash for new equipment.

Assets = Liabilities + Equity +42,000 +3,000 +20,000 −36,000 −23,000

PLANT ASSETS Cost of plant assets: Normal, reasonable, and necessary costs in prepar- ing an asset for its intended use. If an asset is damaged during unpacking, the repairs are not added to its cost. Instead, they are charged to an expense account.

Summary: Cheat Sheet

Machinery and equipment: Cost includes purchase price, taxes, trans- portation, insurance while in transit, installation, assembly, and testing. Building: A purchased building’s costs include its purchase price, real estate fees, taxes, title fees, and attorney fees. A constructed building’s costs include construction costs and insurance during construction, but not insurance after it is completed.

Chapter 8 Accounting for Long-Term Assets 325

Depreciation expense = Depreciation per unit × Units produced in period

Depreciation per unit = Cost – Salvage valueStep 1

Step 2

Total units of production

Depreciation expense = Cost – Salvage value Useful life in periods

Land improvements: Additions to land that have limited useful lives. Examples are parking lots, driveways, and lights. Land: Has an indefinite (unlimited) life and costs include real estate com- missions, clearing, grading, and draining. Lump-sum purchase: Plant assets purchased as a group for a single lump- sum price. We allocate the cost to the assets acquired based on their rela- tive market (or appraised) values.

Depreciation: Process of allocating the cost of a plant asset to expense while it is in use. Salvage value: Estimate of the asset’s value at the end of its useful life. Useful life: Length of time a plant asset is to be used in operations.

Straight-line depreciation: Charges the same amount of depreciation expense in each period of the asset’s useful life.

Betterments (capital expenditure): Expenditures to make a plant asset more efficient or productive. Include upgrading components and adding additions onto plant assets. Extraordinary repairs (capital expenditure): Expenditures that extend the asset’s useful life beyond its original estimate.

Appraised Value Percent of Total Apportioned Cost

Building . . . $ 60,000 60% ($60,000/$100,000) $54,000 ($90,000 × 60%) Land . . . . . 40,000 40 ($40,000/$100,000) 36,000 ($90,000 × 40%) Totals . . . . . $100,000 100% $ 90,000

Building . . . . . . . . . . . . . . 54,000

Land . . . . . . . . . . . . . . . . 36,000

Cash . . . . . . . . . . . . 90,000

Record costs of plant assets.

Entry for lump-sum cash purchase:

Record depreciation expense:

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Accumulated Depreciation—“Asset Type” . . . . . . . 1,800

Straight-line depreciation formula:

Asset book value (or book value): Computed as the asset’s total cost minus accumulated depreciation. Units-of-production depreciation: Charges a varying amount for each period depending on an asset’s usage. Units-of-production formula:

Double-declining-balance depreciation: Charges more depreciation in early years and less depreciation in later years. Double-declining-balance formula:

Straight-line rate = 100% ÷ Useful life

Double-declining-balance rate = 2 × Straight-line rate

Depreciation expense = Double-declining-balance rate × Beginning-period book value

Step 1

Step 2

Step 3

Depletion expense = Depletion per unit × Units extracted and sold in period

Depletion per unit = Cost – Salvage value

Total units of capacityStep 1

Step 2

Change in an accounting estimate: For plant assets, it is changing the estimate of useful life or salvage value. It only affects current and future depreciation expense. Do not go back and change prior years’ depreciation.

Straight-line depreciation after change in accounting estimate:

Book value − Revised salvage value Revised remaining useful life

Impairment: Permanent decline in the fair value of an asset relative to its book value.

Impairment Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Accumulated Depreciation—Equipment . . . . . . . . 50

Ordinary repairs (revenue expenditure): Expenditures to keep an asset in good operating condition. They do not increase useful life or productiv- ity. Include cleaning, changing oil, and minor repairs.

Repairs Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Betterments and extraordinary repairs: These expenditures are “capitalized” by adding their costs to the plant asset.

“Plant Asset” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Before discarding, selling, or exchanging a plant asset: Must record depreciation up to that date.

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Accumulated Depreciation—Equipment . . . . . . . . 500

Discarding fully depreciated asset:

Accumulated Depreciation—Machinery . . . . . . . . . . . . . 9,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Discarding partially depreciated asset: Loss is the book value (Cost – Accumulated depreciation) of the asset when discarded.

Accumulated Depreciation—Equipment . . . . . . . . . . . . . 6,500

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Sale of asset at book value: If sale price = book value, no gain or loss.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . 13,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Sale of asset above book value: If sale price > book value → gain.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . 13,000

Gain on Disposal of Equipment . . . . . . . . . . . . . . . . 4,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Sale of asset below book value: If sale price < book value → loss.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . 500

Accumulated Depreciation—Equipment . . . . . . . . . . . . . 13,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

NATURAL RESOURCES Natural resources: Assets that are physically consumed when used. Examples are standing timber, mineral deposits, and oil and gas fields. Depletion: Process of allocating the cost of a natural resource. Depletion formula:

Depletion expense (when all units extracted are sold):

Depletion Expense—Mineral Deposit . . . . . . . . . . . . . . . 170,000

Accumulated Depletion—Mineral Deposit . . . . . . . 170,000

Depletion expense (when not all units extracted are sold):

Depletion Expense—Mineral Deposit . . . . . . . . . . . . . . . 140,000

Ore Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Accumulated Depletion—Mineral Deposit . . . . . . . 170,000

326 Chapter 8 Accounting for Long-Term Assets

INTANGIBLE ASSETS Intangible assets: Nonphysical assets (used in operations) that give com- panies long-term rights, privileges, or competitive advantages.

Patent: Exclusive right to manufacture and sell a patented item or to use a process for 20 years. Copyright: Exclusive right to publish and sell a musical, literary, or artis- tic work during the life of the creator plus 70 years.

Franchises or licenses: Rights to sell a product or service under specified conditions. Trademark or trade (brand) name: A symbol, name, phrase, or jingle identified with a company, product, or service. Goodwill: Amount by which a company’s value exceeds the value of its individual assets and liabilities (net assets). Goodwill is only recorded when an entire company or business segment is purchased. Not amortized, but tested for impairment. Right-of-use asset (lease): Rights the lessor grants to the lessee under terms of the lease. Leasehold improvements: Improvements to a leased (rented) property such as partitions, painting, and storefronts. The lessee amortizes these costs over the life of the lease or the life of the improvements, whichever is shorter.

Amortization: Intangible assets with limited useful lives require amorti- zation. It is similar to depreciation and uses the shorter of the legal life or useful life of the intangible for straight-line amortization.

Amortization Expense—Patents . . . . . . . . . . . . . . . . . . . . 2,500

Accumulated Amortization—Patents . . . . . . . . . . . 2,500

Accelerated depreciation method (308) Amortization (317) Asset book value (307) Betterments (312) Capital expenditures (311) Change in an accounting estimate (310) Copyright (318) Cost (304) Declining-balance method (308) Depletion (315) Depreciation (305) Extraordinary repairs (312) Franchises (318) Goodwill (318)

Impairment (310, 317) Inadequacy (306) Indefinite life (317) Intangible assets (317) Land improvements (304) Lease (318) Leasehold (318) Leasehold improvements (318) Lessee (318) Lessor (318) Licenses (318) Limited life (317) Modified Accelerated Cost Recovery

System (MACRS) (309)

Natural resources (315) Obsolescence (306) Ordinary repairs (312) Patent (317) Plant assets (303) Research and development costs (319) Revenue expenditures (311) Salvage value (305) Straight-line depreciation (306) Total asset turnover (320) Trademark or trade (brand) name (318) Units-of-production depreciation (307) Useful life (305)

Key Terms

Multiple Choice Quiz

1. A company paid $326,000 for property that included land, land improvements, and a building. The land was appraised at $175,000, the land improvements were appraised at $70,000, and the building was appraised at $105,000. What is the allocation of costs to the three assets? a. Land, $150,000; Land Improvements, $60,000; Building,

$90,000 b. Land, $163,000; Land Improvements, $65,200; Building,

$97,800 c. Land, $150,000; Land Improvements, $61,600; Building,

$92,400 d. Land, $159,000; Land Improvements, $65,200; Building,

$95,400 e. Land, $175,000; Land Improvements, $70,000; Building,

$105,000 2. A company purchased a truck for $35,000 on January 1,

2019. The truck is estimated to have a useful life of four years and a salvage value of $1,000. Assuming that the company uses straight-line depreciation, what is deprecia- tion expense for the year ended December 31, 2020? a. $8,750 c. $8,500 e. $25,500 b. $17,500 d. $17,000

3. A company purchased machinery for $10,800,000 on January 1, 2019. The machinery has a useful life of 10 years and an estimated salvage value of $800,000. What is depre- ciation expense for the year ended December 31, 2020, as- suming that the double-declining-balance method is used? a. $2,160,000 c. $1,728,000 e. $1,600,000 b. $3,888,000 d. $2,000,000

4. A company sold a machine that originally cost $250,000 for $120,000 when accumulated depreciation on the machine was $100,000. The gain or loss recorded on the sale of this machine is a. $0 gain or loss. d. $30,000 gain. b. $120,000 gain. e. $150,000 loss. c. $30,000 loss.

5. A company had average total assets of $500,000, gross sales of $575,000, and net sales of $550,000. The compa- ny’s total asset turnover is a. 1.15. d. 0.87. b. 1.10. e. 1.05. c. 0.91.

Chapter 8 Accounting for Long-Term Assets 327

A Superscript letter A denotes assignments based on Appendix 8A.

Icon denotes assignments that involve decision making.

1. What characteristics of a plant asset make it different from other assets?

2. What is the general rule for cost inclusion for plant assets? 3. What is different between land and land improvements? 4. Why is the cost of a lump-sum purchase allocated to the

individual assets acquired? 5. Does the balance in the Accumulated Depreciation—

Machinery account represent funds to replace the machin- ery when it wears out? If not, what does it represent?

6. Why is the Modified Accelerated Cost Recovery System not generally accepted for financial accounting purposes?

7. What is the difference between ordinary repairs and ex- traordinary repairs? How should each be recorded?

8. Identify events that might lead to disposal of a plant asset.

9. What is the process of allocating the cost of natural re- sources to expense as they are used?

10. Is the declining-balance method an acceptable way to com- pute depletion of natural resources? Explain.

11. What are the characteristics of an intangible asset? 12. What general procedures are applied in accounting for the

acquisition and potential cost allocation of intangible assets? 13. When do we know that a company has goodwill? When

can goodwill appear in a company’s balance sheet?

14. Assume that a company buys another business and pays for its goodwill. If the company plans to incur costs each year to maintain the value of the goodwill, must it also amortize this goodwill?

15. How is total asset turnover computed? Why would a financial statement user be interested in total asset turn- over?

16. On its recent balance sheet in Appendix A, Apple lists its plant assets as “Property, plant and equipment, net.” What does “net” mean in this title?

17. Refer to Google’s recent balance sheet in Appendix A. What is the book value of its total net property, plant, and equipment assets at December 31, 2017?

18. Refer to Samsung’s balance sheet in Appendix A. What does it title its plant assets? What is the book value of its plant assets at December 31, 2017?

19. Refer to Samsung’s December 31, 2017, balance sheet in Appendix A. What long- term assets discussed in this chapter are reported by the company?

20. Identify the main difference between (a) plant assets and current assets, (b) plant assets and inventory, and (c) plant assets and long-term investments.

Discussion Questions

APPLE

Samsung

Samsung

GOOGLE

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; 4. c;

Appraisal Total Value % Cost Allocated

Land . . . . . . . . . . . . . . . $175,000 50% $326,000 $163,000

Land improvements . . 70,000 20 326,000 65,200

Building . . . . . . . . . . . . 105,000 30 326,000 97,800

Totals . . . . . . . . . . . . . . $350,000 $326,000

2. c; ($35,000 − $1,000)∕4 years = $8,500 per year 3. c; 2019: $10,800,000 × (2 × 10%) = $2,160,000

2020: ($10,800,000 − $2,160,000) × (2 × 10%) = $1,728,000

Cost of machine . . . . . . . . . . . . . . . . . . . . $250,000

Accumulated depreciation . . . . . . . . . . . . 100,000

Book value . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Cash received . . . . . . . . . . . . . . . . . . . . . . 120,000

Loss on sale . . . . . . . . . . . . . . . . . . . . . . . $ 30,000

5. b; $550,000∕$500,000 = 1.10

QUICK STUDY

QS 8-1 Cost of plant assets

C1

Kegler Bowling buys scorekeeping equipment with an invoice cost of $190,000. The electrical work re- quired for the installation costs $20,000. Additional costs are $4,000 for delivery and $13,700 for sales tax. During the installation, the equipment was damaged and the cost of repair was $1,850.

What is the total recorded cost of the scorekeeping equipment?

328 Chapter 8 Accounting for Long-Term Assets

On January 1, the Matthews Band pays $65,800 for sound equipment. The band estimates it will use this equipment for four years and perform 200 concerts. It estimates that after four years it can sell the equip- ment for $2,000. During the first year, the band performs 45 concerts.

Compute the first-year depreciation using the straight-line method.

QS 8-3 Straight-line depreciation

P1

On January 1, the Matthews Band pays $65,800 for sound equipment. The band estimates it will use this equipment for four years and perform 200 concerts. It estimates that after four years it can sell the equip- ment for $2,000. During the first year, the band performs 45 concerts.

Compute the first-year depreciation using the units-of-production method.

QS 8-4 Units-of-production depreciation P1

A building is acquired on January 1 at a cost of $830,000 with an estimated useful life of eight years and salvage value of $75,000. Compute depreciation expense for the first three years using the double- declining-balance method.

QS 8-5 Double-declining-balance method P1

On January 1, the Matthews Band pays $65,800 for sound equipment. The band estimates it will use this equipment for four years and after four years it can sell the equipment for $2,000. Matthews Band uses straight-line depreciation but realizes at the start of the second year that this equipment will last only a total of three years. The salvage value is not changed.

Compute the revised depreciation for both the second and third years.

QS 8-7 Computing revised depreciation

C2

Equipment has a book value of $16,000 and a fair value of $14,750. The decline in value meets the im- pairment test. Prepare the entry to record this $1,250 impairment.

QS 8-8 Recording plant asset impairment C2

Garcia Co. owns equipment that cost $76,800, with accumulated depreciation of $40,800. Record the sale of the equipment under the following three separate cases assuming Garcia sells the equipment for (1) $47,000 cash, (2) $36,000 cash, and (3) $31,000 cash.

QS 8-10 Disposal of assets P2

Listed below are costs (or discounts) to purchase or construct new plant assets. (1) Indicate whether the costs should be expensed or capitalized (meaning they are included in the cost of the plant assets on the balance sheet). (2) For costs that should be capitalized, indicate in which category of plant assets (Equipment, Building, or Land) the related costs should be recorded on the balance sheet. Expensed or Asset Capitalized Category 1. Wages paid to train employees to use new equipment. 2. Invoice cost paid for new equipment. 3. Early payment discount taken on the purchase of new equipment. 4. Realtor commissions incurred on land purchased. 5. Property taxes on land incurred after it was purchased. 6. Costs of oil for the truck used to deliver new equipment. 7. Costs to lay foundation for a new building. 8. Insurance on a new building during its construction.

QS 8-2 Assigning costs to plant assets

C1

1. Classify the following as either a revenue expenditure (RE) or a capital expenditure (CE). a. Paid $40,000 cash to replace a motor on equipment that extends its useful life by four years. b. Paid $200 cash per truck for the cost of their annual tune-ups. c. Paid $175 for the monthly cost of replacement filters on an air-conditioning system. d. Completed an addition to a building for $225,000 cash.

2. Prepare the journal entries to record the four transactions from part 1.

QS 8-9 Revenue and capital expenditures

C3

On October 1, Organic Farming purchases wind turbines for $140,000. The wind turbines are expected to last six years, have a salvage value of $20,000, and be depreciated using the straight-line method. 1. Compute depreciation expense for the last three months of the first year. 2. Compute depreciation expense for the second year.

QS 8-6 Straight-line, partial-year depreciation C2

Chapter 8 Accounting for Long-Term Assets 329

QS 8-13 Intangible assets and amortization P4

On January 1 of this year, Diaz Boutique pays $105,000 to modernize its store. Improvements include new floors, ceilings, wiring, and wall coverings. These improvements are estimated to yield benefits for 10 years. Diaz leases (does not own) its store and has eight years remaining on the lease. Prepare the entry to record (1) the cost of modernization and (2) amortization at the end of this current year.

QS 8-11 Natural resources and depletion

P3

Perez Company acquires an ore mine at a cost of $1,400,000. It incurs additional costs of $400,000 to ac- cess the mine, which is estimated to hold 1,000,000 tons of ore. The estimated value of the land after the ore is removed is $200,000. 1. Prepare the entry(ies) to record the cost of the ore mine. 2. Prepare the year-end adjusting entry if 180,000 tons of ore are mined and sold the first year.

Exercise 8-2 Recording costs of assets

C1

Cala Manufacturing purchases land for $390,000 as part of its plans to build a new plant. The company pays $33,500 to tear down an old building on the lot and $47,000 to fill and level the lot. It also pays con- struction costs of $1,452,200 for the new building and $87,800 for lighting and paving a parking area. Prepare a single journal entry to record these costs incurred by Cala, all of which are paid in cash.

Exercise 8-3 Lump-sum purchase of plant assets C1

Rodriguez Company pays $395,380 for real estate with land, land improvements, and a building. Land is appraised at $157,040; land improvements are appraised at $58,890; and the building is appraised at $176,670. Allocate the total cost among the three assets and prepare the journal entry to record the purchase.

Exercise 8-4 Straight-line depreciation

P1

Ramirez Company installs a computerized manufacturing machine in its factory at the beginning of the year at a cost of $43,500. The machine’s useful life is estimated at 10 years, or 385,000 units of product, with a $5,000 salvage value. During its second year, the machine produces 32,500 units of product. Determine the machine’s second-year depreciation under the straight-line method.

Identify the following as intangible assets (IA), natural resources (NR), or some other asset (O). a. Oil well b. Trademark c. Leasehold

d. Gold mine e. Building f. Copyright

g. Franchise h. Coal mine i. Salt mine

QS 8-12 Classifying assets

P3 P4

QS 8-16A Asset exchange

P5

Caleb Co. owns a machine that had cost $42,400 with accumulated depreciation of $18,400. Caleb exchanges the machine for a newer model that has a market value of $52,000. 1. Record the exchange assuming Caleb paid $30,000 cash and the exchange has commercial substance. 2. Record the exchange assuming Caleb paid $22,000 cash and the exchange has commercial substance.

Aneko Company reports the following: net sales of $14,800 for Year 2 and $13,990 for Year 1; end-of-year total assets of $19,100 for Year 2 and $17,900 for Year 1. (1) Compute total asset turnover for Year 2. (2) Aneko’s competitor has a turnover of 2.0. Is Aneko performing better or worse than its competitor based on total asset turnover?

QS 8-15 Computing total asset turnover A1

EXERCISES

Exercise 8-1 Cost of plant assets

C1

Rizio Co. purchases a machine for $12,500, terms 2∕10, n∕60, FOB shipping point. Rizio paid within the discount period and took the $250 discount. Transportation costs of $360 were paid by Rizio. The machine required mounting and power connections costing $895. Another $475 is paid to assemble the machine, and $40 of materials are used to get it into operation. During installation, the machine was damaged and $180 worth of repairs were made. Compute the cost recorded for this machine.

QS 8-14 Preparing an income statement

P1 P3 P4

Selected accounts from Westeros Co.’s adjusted trial balance for the year ended December 31 follow. Prepare its income statement.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 Depreciation expense . . . . . . . . . . . . . . . . . . $ 5,000

Repairs expense . . . . . . . . . . . . . . . . . . . . . . . 500 Salaries expense . . . . . . . . . . . . . . . . . . . . . . 10,000

Depletion expense . . . . . . . . . . . . . . . . . . . . . 4,000 Amortization expense . . . . . . . . . . . . . . . . . . 2,000

330 Chapter 8 Accounting for Long-Term Assets

Ramirez Company installs a computerized manufacturing machine in its factory at the beginning of the year at a cost of $43,500. The machine’s useful life is estimated at 10 years, or 385,000 units of product, with a $5,000 salvage value. During its second year, the machine produces 32,500 units of product. Determine the machine’s second-year depreciation using the units-of-production method.

Exercise 8-5 Units-of-production depreciation P1

Ramirez Company installs a computerized manufacturing machine in its factory at the beginning of the year at a cost of $43,500. The machine’s useful life is estimated at 10 years, or 385,000 units of product, with a $5,000 salvage value. During its second year, the machine produces 32,500 units of product. Determine the machine’s second-year depreciation using the double-declining-balance method.

Exercise 8-6 Double-declining-balance depreciation P1

NewTech purchases computer equipment for $154,000 to use in operating activities for the next four years. It estimates the equipment’s salvage value at $25,000. Prepare a table showing depreciation and book value for each of the four years assuming straight-line depreciation.

Exercise 8-7 Straight-line depreciation

P1

On April 1, Cyclone Co. purchases a trencher for $280,000. The machine is expected to last five years and have a salvage value of $40,000. Compute depreciation expense at December 31 for both the first year and second year assuming the company uses the straight-line method.

Exercise 8-11 Straight-line, partial-year depreciation C2

NewTech purchases computer equipment for $154,000 to use in operating activities for the next four years. It estimates the equipment’s salvage value at $25,000. Prepare a table showing depreciation and book value for each of the four years assuming double-declining-balance depreciation.

Exercise 8-8 Double-declining-balance depreciation P1

On April 1, Cyclone Co. purchases a trencher for $280,000. The machine is expected to last five years and have a salvage value of $40,000. Compute depreciation expense at December 31 for both the first year and second year assuming the company uses the double-declining-balance method.

Exercise 8-12 Double-declining- balance, partial-year depreciation C2

Apex Fitness Club uses straight-line depreciation for a machine costing $23,860, with an estimated four- year life and a $2,400 salvage value. At the beginning of the third year, Apex determines that the machine has three more years of remaining useful life, after which it will have an estimated $2,000 salvage value. Compute (1) the machine’s book value at the end of its second year and (2) the amount of depreciation for each of the final three years given the revised estimates.

Exercise 8-13 Revising depreciation

C2

Check (2) $3,710

Oki Company pays $264,000 for equipment expected to last four years and have a $29,000 salvage value. Prepare journal entries to record the following costs related to the equipment. 1. Paid $22,000 cash for a new component that increased the equipment’s productivity. 2. Paid $6,250 cash for minor repairs necessary to keep the equipment working well. 3. Paid $14,870 cash for significant repairs to increase the useful life of the equipment from four to

seven years.

Exercise 8-14 Ordinary repairs, extraordinary repairs, and betterments

C3

Tory Enterprises pays $238,400 for equipment that will last five years and have a $43,600 salvage value. By using the equipment in its operations for five years, the company expects to earn $88,500 annually, after deducting all expenses except depreciation. Prepare a table showing income before depreciation, depreciation expense, and net (pretax) income for each year and for the total five-year period, assuming straight-line depreciation is used.

Exercise 8-9 Straight-line depreciation and income effects

P1

Tory Enterprises pays $238,400 for equipment that will last five years and have a $43,600 salvage value. By using the equipment in its operations for five years, the company expects to earn $88,500 annually, after deducting all expenses except depreciation. Prepare a table showing income before depreciation, depreciation expense, and net (pretax) income for each year and for the total five-year period, assuming double-declining-balance depreciation is used.

Exercise 8-10 Double-declining-balance depreciation P1

Check Year 3 NI, $54,170

Chapter 8 Accounting for Long-Term Assets 331

Exercise 8-16 Disposal of assets

P2

Diaz Company owns a machine that cost $250,000 and has accumulated depreciation of $182,000. Prepare the entry to record the disposal of the machine on January 1 in each separate situation. 1. The machine needed extensive repairs and was not worth repairing. Diaz disposed of the machine,

receiving nothing in return. 2. Diaz sold the machine for $35,000 cash. 3. Diaz sold the machine for $68,000 cash. 4. Diaz sold the machine for $80,000 cash.

Exercise 8-18 Depletion of natural resources

P3

Montana Mining Co. pays $3,721,000 for an ore deposit containing 1,525,000 tons. The company installs machinery in the mine costing $213,500. Both the ore and machinery will have no salvage value after the ore is completely mined. Montana mines and sells 166,200 tons of ore during the year. Prepare the year- end entries to record both the ore deposit depletion and the mining machinery depreciation. Mining machinery depreciation should be in proportion to the mine’s depletion.

Exercise 8-19 Amortization of intangible assets P4

Milano Gallery purchases the copyright on a painting for $418,000 on January 1. The copyright is good for 10 more years, after which the copyright will expire and anyone can make prints. The company plans to sell prints for 11 years. Prepare entries to record the purchase of the copyright on January 1 and its an- nual amortization on December 31.

Exercise 8-20 Goodwill

P4

Robinson Company purchased Franklin Company at a price of $2,500,000. The fair market value of the net assets purchased equals $1,800,000. 1. What is the amount of goodwill that Robinson records at the purchase date? 2. Does Robinson amortize goodwill at year-end for financial reporting purposes? If so, over how many

years is it amortized? 3. Robinson believes that its employees provide superior customer service, and through their efforts,

Robinson believes it has created $900,000 of goodwill. Should Robinson Company record this goodwill?

Exercise 8-17 Partial-year depreciation; disposal of plant asset

P2

Rayya Co. purchases a machine for $105,000 on January 1, 2019. Straight-line depreciation is taken each year for four years assuming a seven-year life and no salvage value. The machine is sold on July 1, 2023, during its fifth year of service. Prepare entries to record the partial year’s depreciation on July 1, 2023, and to record the sale under each separate situation. 1. The machine is sold for $45,500 cash. 2. The machine is sold for $25,000 cash.

Martinez Company owns a building that appears on its prior year-end balance sheet at its original $572,000 cost less $429,000 accumulated depreciation. The building is depreciated on a straight-line basis assuming a 20-year life and no salvage value. During the first week in January of the current calendar year, major structural repairs are completed on the building at a $68,350 cost. The repairs extend its useful life for 5 years beyond the 20 years originally estimated. 1. Determine the building’s age (plant asset age) as of the prior year-end balance sheet date. 2. Prepare the entry to record the cost of the structural repairs that are paid in cash. 3. Determine the book value of the building immediately after the repairs are recorded. 4. Prepare the entry to record the current calendar year’s depreciation.

Check (3) $211,350

Exercise 8-15 Extraordinary repairs; plant asset age

C3

Lok Co. reports net sales of $5,856,480 for Year 2 and $8,679,690 for Year 3. End-of-year balances for total assets are Year 1, $1,686,000; Year 2, $1,800,000; and Year 3, $1,982,000. (a) Compute Lok’s total asset turnover for Year 2 and Year 3. (b) Lok’s competitor has a turnover of 3.0. Is Lok performing better or worse than its competitor on the basis of total asset turnover?

Exercise 8-22 Evaluating efficient use of assets A1

Exercise 8-21 Preparing a balance sheet

P1 P3 P4

Selected accounts from Gregor Co.’s adjusted trial balance for the year ended December 31 follow. Prepare a classified balance sheet.

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Accounts payable… . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000

Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Accumulated depreciation—Equipment . . . . . . . . . 13,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Notes payable (due in 9 years) . . . . . . . . . . . . . . . . 11,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Accumulated depletion—Silver mine . . . . . . . . . . . . 3,000

Silver mine . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Accumulated amortization—Patents . . . . . . . . . . . . 1,000

332 Chapter 8 Accounting for Long-Term Assets

On January 2, Bering Co. disposes of a machine costing $44,000 with accumulated depreciation of $24,625. Prepare the entries to record the disposal under each separate situation. 1. The machine is sold for $18,250 cash. 2. The machine is traded in for a new machine having a $60,200 cash price. A $25,000 trade-in allowance

is received, and the balance is paid in cash. Assume the asset exchange has commercial substance. 3. The machine is traded in for a new machine having a $60,200 cash price. A $15,000 trade-in allowance

is received, and the balance is paid in cash. Assume the asset exchange has commercial substance.

Exercise 8-24A Recording plant asset disposals

P5

Check (3) Dr. Loss on Exchange, $4,375

Gilly Construction trades in an old tractor for a new tractor, receiving a $29,000 trade-in allowance and paying the remaining $83,000 in cash. The old tractor had cost $96,000 and had accumulated depreciation of $52,500. Answer the following questions assuming the exchange has commercial substance. 1. What is the book value of the old tractor at the time of exchange? 2. What is the loss on this asset exchange? 3. What amount should be recorded (debited) in the asset account for the new tractor?

Exercise 8-23A Exchanging assets

P5

Check (2) $14,500

PROBLEM SET A

Problem 8-1A Plant asset costs; depreciation methods

C1 P1

Timberly Construction makes a lump-sum purchase of several assets on January 1 at a total cash price of $900,000. The estimated market values of the purchased assets are building, $508,800; land, $297,600; land improvements, $28,800; and four vehicles, $124,800.

Required

1. Allocate the lump-sum purchase price to the separate assets purchased. Prepare the journal entry to record the purchase.

2. Compute the first-year depreciation expense on the building using the straight-line method, assuming a 15-year life and a $27,000 salvage value.

3. Compute the first-year depreciation expense on the land improvements assuming a five-year life and double-declining-balance depreciation.

Analysis Component

4. Compared to straight-line depreciation, does accelerated depreciation result in payment of less total taxes over the asset’s life?

Check (2) $30,000

(3) $10,800

Problem 8-2A Depreciation methods

P1

A machine costing $257,500 with a four-year life and an estimated $20,000 salvage value is installed in Luther Company’s factory on January 1. The factory manager estimates the machine will produce 475,000 units of product during its life. It actually produces the following units: 220,000 in Year 1, 124,600 in Year 2, 121,800 in Year 3, and 15,200 in Year 4. The total number of units produced by the end of Year 4 exceeds the original estimate—this difference was not predicted. Note: The machine cannot be depreci- ated below its estimated salvage value.

Required

Prepare a table with the following column headings and compute depreciation for each year (and total depreciation of all years combined) for the machine under each depreciation method.

Year Straight-Line Units-of-Production Double-Declining-Balance Check Year 4: units-of- production depreciation, $4,300; DDB depreciation, $12,187

Problem 8-3A Asset cost allocation; straight-line depreciation

C1 P1

On January 1, Mitzu Co. pays a lump-sum amount of $2,600,000 for land, Building 1, Building 2, and Land Improvements 1. Building 1 has no value and will be demolished. Building 2 will be an office and is appraised at $644,000, with a useful life of 20 years and a $60,000 salvage value. Land Improvements 1 is valued at $420,000 and is expected to last another 12 years with no salvage value. The land is valued at $1,736,000. The company also incurs the following additional costs.

Cost to demolish Building 1 . . . . . . . . . . . . . . . . . . $ 328,400 Cost of additional land grading . . . . . . . . . . . . . . . . . . . $175,400

Cost to construct Building 3, having a useful life Cost of new Land Improvements 2, having a 20-year of 25 years and a $392,000 salvage value . . . . 2,202,000 useful life and no salvage value . . . . . . . . . . . . . . . . 164,000

Chapter 8 Accounting for Long-Term Assets 333

Required

1. Prepare a table with the following column headings: Land, Building 2, Building 3, Land Improvements 1, and Land Improvements 2. Allocate the costs incurred by Mitzu to the appropriate columns and total each column.

2. Prepare a single journal entry to record all the incurred costs assuming they are paid in cash on January 1. 3. Using the straight-line method, prepare the December 31 adjusting entries to record depreciation for

the first year these assets were in use.

Check (1) Land costs, $2,115,800; Building 2 costs, $598,000

(3) Depr.—Land Improv. 1 and 2, $32,500 and $8,200

Problem 8-4A Computing and revising depreciation; revenue and capital expenditures

C1 C2 C3

Champion Contractors completed the following transactions involving equipment.

Year 1

Jan. 1 Paid $287,600 cash plus $11,500 in sales tax and $1,500 in transportation (FOB shipping point) for a new loader. The loader is estimated to have a four-year life and a $20,600 salvage value. Loader costs are recorded in the Equipment account.

3 Paid $4,800 to install air-conditioning in the loader to enable operations under harsher condi- tions. This increased the estimated salvage value of the loader by another $1,400.

Dec. 31 Recorded annual straight-line depreciation on the loader.

Year 2

Jan. 1 Paid $5,400 to overhaul the loader’s engine, which increased the loader’s estimated useful life by two years.

Feb. 17 Paid $820 for minor repairs to the loader after the operator backed it into a tree. Dec. 31 Recorded annual straight-line depreciation on the loader.

Required

Prepare journal entries to record these transactions and events.

Check Dec. 31, Year 1: Dr. Depr. Expense—Equip., $70,850

Dec. 31, Year 2: Dr. Depr. Expense—Equip., $43,590

Yoshi Company completed the following transactions and events involving its delivery trucks.

Year 1

Jan. 1 Paid $20,515 cash plus $1,485 in sales tax for a new delivery truck estimated to have a five-year life and a $2,000 salvage value. Delivery truck costs are recorded in the Trucks account.

Dec. 31 Recorded annual straight-line depreciation on the truck.

Year 2

Dec. 31 The truck’s estimated useful life was changed from five to four years, and the estimated salvage value was increased to $2,400. Recorded annual straight-line depreciation on the truck.

Year 3

Dec. 31 Recorded annual straight-line depreciation on the truck. 31 Sold the truck for $5,300 cash.

Required

Prepare journal entries to record these transactions and events.

Problem 8-5A Computing and revising depreciation; selling plant assets

C2 P1 P2

Check Dec. 31, Year 2: Dr. Depr. Expense—Trucks, $5,200

Dec. 31, Year 3: Dr. Loss on Disposal of Trucks, $2,300

Onslow Co. purchased a used machine for $178,000 cash on January 2. On January 3, Onslow paid $2,840 to wire electricity to the machine and an additional $1,160 to secure it in place. The machine will be used for six years and have a $14,000 salvage value. Straight-line depreciation is used. On December 31, at the end of its fifth year in operations, it is disposed of.

Required

1. Prepare journal entries to record the machine’s purchase and the costs to ready it for use. Cash is paid for all costs incurred.

2. Prepare journal entries to record depreciation of the machine at December 31 of (a) its first year of operations and (b) the year of its disposal.

3. Prepare journal entries to record the machine’s disposal under each separate situation: (a) it is sold for $15,000 cash; (b) it is sold for $50,000 cash; and (c) it is destroyed in a fire and the insurance company pays $30,000 cash to settle the loss claim.

Problem 8-6A Disposal of plant assets

C1 P1 P2

Check (2b) Depr. Exp., $28,000

(3c) Dr. Loss from Fire, $12,000

334 Chapter 8 Accounting for Long-Term Assets

Problem 8-7A Natural resources

P3

On July 23 of the current year, Dakota Mining Co. pays $4,715,000 for land estimated to contain 5,125,000 tons of recoverable ore. It installs and pays for machinery costing $410,000 on July 25. The company removes and sells 480,000 tons of ore during its first five months of operations ending on December 31. Depreciation of the machinery is in proportion to the mine’s depletion as the machinery will be abandoned after the ore is mined.

Required

Prepare entries to record (a) the purchase of the land, (b) the cost and installation of machinery, (c) the first five months’ depletion assuming the land has a net salvage value of zero after the ore is mined, and (d) the first five months’ depreciation on the machinery.

Analysis Component

(e) If the machine will be used at another site when extraction is complete, how would we depreciate this machine?

Check (c) Depletion, $441,600 (d) Depreciation, $38,400

Problem 8-8A Right-of-use lease asset

P4

On January 1, Falk Company signed a contract to lease space in a building for three years. The current value of the three lease payments is $270,000.

Required

Prepare entries for Falk to record (a) the lease asset and obligation at January 1 and (b) the $90,000 straight-line amortization at December 31 of the first year.

Nagy Company makes a lump-sum purchase of several assets on January 1 at a total cash price of $1,800,000. The estimated market values of the purchased assets are building, $890,000; land, $427,200; land improvements, $249,200; and five trucks, $213,600.

Required

1. Allocate the lump-sum purchase price to the separate assets purchased. Prepare the journal entry to record the purchase.

2. Compute the first-year depreciation expense on the building using the straight-line method, assuming a 12-year life and a $120,000 salvage value.

3. Compute the first-year depreciation expense on the land improvements assuming a 10-year life and double-declining-balance depreciation.

Analysis Component

4. Compared to straight-line depreciation, does accelerated depreciation result in payment of less total taxes over the asset’s life?

Check (2) $65,000

(3) $50,400

Problem 8-2B Depreciation methods

P1

On January 1, Manning Co. purchases and installs a new machine costing $324,000 with a five-year life and an estimated $30,000 salvage value. Management estimates the machine will produce 1,470,000 units of product during its life. Actual production of units is as follows: 355,600 in Year 1, 320,400 in Year 2, 317,000 in Year 3, 343,600 in Year 4, and 138,500 in Year 5. The total number of units produced by the end of Year 5 exceeds the original estimate—this difference was not predicted. Note: The machine cannot be depreciated below its estimated salvage value.

Required

Prepare a table with the following column headings and compute depreciation for each year (and total depreciation of all years combined) for the machine under each depreciation method.

Year Straight-Line Units-of-Production Double-Declining-Balance Check DDB Depreciation, Year 3, $46,656; U-of-P Depreciation, Year 4, $68,720

Problem 8-3B Asset cost allocation; straight-line depreciation

C1 P1

On January 1, ProTech Co. pays a lump-sum amount of $1,550,000 for land, Building A, Building B, and Land Improvements B. Building A has no value and will be demolished. Building B will be an office and is appraised at $482,800, with a useful life of 15 years and a $99,500 salvage value. Land Improvements B is valued at $142,000 and is expected to last another five years with no salvage value. The land is valued at $795,200. The company also incurs the following additional costs.

PROBLEM SET B

Problem 8-1B Plant asset costs; depreciation methods

C1 P1

Chapter 8 Accounting for Long-Term Assets 335

Cost to demolish Building A . . . . . . . . . . . . . . . . . . . $ 122,000 Cost of additional land grading . . . . . . . . . . . . . . . . . . . . . $174,500

Cost to construct Building C, having a useful life . . Cost of new Land Improvements C, having a 10-year of 20 years and a $258,000 salvage value . . . . . 1,458,000 useful life and no salvage value . . . . . . . . . . . . . . . . . . 103,500

Required

1. Prepare a table with the following column headings: Land, Building B, Building C, Land Improvements B, and Land Improvements C. Allocate the costs incurred by ProTech to the appropriate columns and total each column.

2. Prepare a single journal entry to record all incurred costs assuming they are paid in cash on January 1. 3. Using the straight-line method, prepare the December 31 adjusting entries to record depreciation for

the first year these assets were in use.

Check (1) Land costs, $1,164,500; Building B costs, $527,000

(3) Depr.—Land Improv. B and C, $31,000 and $10,350

Mercury Delivery Service completed the following transactions involving equipment.

Year 1

Jan. 1 Paid $25,860 cash plus $1,810 in sales tax for a new delivery van that was estimated to have a five-year life and a $3,670 salvage value. Van costs are recorded in the Equipment account.

3 Paid $1,850 to install sorting racks in the van for more accurate and quicker delivery of pack- ages. This increases the estimated salvage value of the van by another $230.

Dec. 31 Recorded annual straight-line depreciation on the van.

Year 2

Jan. 1 Paid $2,064 to overhaul the van’s engine, which increased the van’s useful life by two years. May 10 Paid $800 for minor repairs to the van after the driver backed it into a loading dock. Dec. 31 Recorded annual straight-line depreciation on the van.

Required

Prepare journal entries to record these transactions and events.

Problem 8-4B Computing and revising depreciation; revenue and capital expenditures

C1 C2 C3

Check Dec. 31, Year 1: Dr. Depr. Expense—Equip., $5,124

Dec. 31, Year 2: Dr. Depr. Expense—Equip., $3,760

York Instruments completed the following transactions and events involving its machinery.

Year 1

Jan. 1 Paid $107,800 cash plus $6,470 in sales tax for a new machine. The machine is estimated to have a six-year life and a $9,720 salvage value.

Dec. 31 Recorded annual straight-line depreciation on the machinery.

Year 2

Dec. 31 The machine’s estimated useful life was changed from six to four years, and the estimated salvage value was increased to $14,345. Recorded annual straight-line depreciation on the machinery.

Year 3

Dec. 31 Recorded annual straight-line depreciation on the machinery. 31 Sold the machine for $25,240 cash.

Required

Prepare journal entries to record these transactions and events.

Problem 8-5B Computing and revising depreciation; selling plant assets

C2 P1 P2

Check Dec. 31, Year 2: Dr. Depr. Expense— Machinery, $27,500

Dec. 31, Year 3: Dr. Loss on Disposal of Machinery, $16,605

On January 1, Walker purchased a used machine for $150,000. On January 4, Walker paid $3,510 to wire electricity to the machine and an additional $4,600 to secure it in place. The machine will be used for seven years and have an $18,110 salvage value. Straight-line depreciation is used. On December 31, at the end of its sixth year of use, the machine is disposed of.

Required

1. Prepare journal entries to record the machine’s purchase and the costs to ready it for use. Cash is paid for all costs incurred.

2. Prepare journal entries to record depreciation of the machine at December 31 of (a) its first year of operations and (b) the year of its disposal.

3. Prepare journal entries to record the machine’s disposal under each separate situation: (a) it is sold for $28,000 cash; (b) it is sold for $52,000 cash; and (c) it is destroyed in a fire and the insurance company pays $25,000 cash to settle the loss claim.

Check (2b) Depr. Exp., $20,000

(3c) Dr. Loss from Fire, $13,110

Problem 8-6B Disposal of plant assets

C1 P1 P2

336 Chapter 8 Accounting for Long-Term Assets

Problem 8-7B Natural resources

P3

On February 19 of the current year, Quartzite Co. pays $5,400,000 for land estimated to contain 4 million tons of recoverable ore. It installs and pays for machinery costing $400,000 on March 21. The company removes and sells 254,000 tons of ore during its first nine months of operations ending on December 31. Depreciation of the machinery is in proportion to the mine’s depletion as the machinery will be abandoned after the ore is mined.

Required

Prepare entries to record (a) the purchase of the land, (b) the cost and installation of the machinery, (c) the first nine months’ depletion assuming the land has a net salvage value of zero after the ore is mined, and (d) the first nine months’ depreciation on the machinery.

Analysis Component

(e) If the machine will be used at another site when extraction is complete, how would we depreciate this machine?

Check (c) Depletion, $342,900 (d) Depreciation, $25,400

Problem 8-8B Right-of-use lease asset

P4

On January 1, Mason Co. entered into a three-year lease on a building. The current value of the three lease payments is $60,000.

Required

Prepare entries for Mason to record (a) the lease asset and obligation at January 1 and (b) the $20,000 straight-line amortization at December 31 of the first year.

SERIAL PROBLEM Business Solutions

A1 P1

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 8 Selected ledger account balances for Business Solutions follow.

©Alexander Image/Shutterstock

For Three Months For Three Months Ended December 31, 2019 Ended March 31, 2020

Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000 $ 8,000

Accumulated depreciation—Office equipment . . . . . . . . 400 800

Computer equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 20,000

Accumulated depreciation—Computer equipment . . . . . 1,250 2,500

Total revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,284 44,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,460 120,268

Required

1. Assume that Business Solutions does not acquire additional office equipment or computer equipment in 2020. Compute amounts for the year ended December 31, 2020, for Depreciation Expense—Office Equipment and for Depreciation Expense—Computer Equipment (assume use of the straight-line method).

2. Given the assumptions in part 1, what is the book value of both the office equipment and the computer equipment as of December 31, 2020?

3. Compute the three-month total asset turnover for Business Solutions as of March 31, 2020. Use total revenue for the numerator and average the December 31, 2019, total assets and the March 31, 2020, total assets for the denominator. Interpret its total asset turnover if competitors average 2.5 for annual periods. (Round turnover to two decimals.)

Check (3) Three-month (annual) turnover = 0.43 (1.73 annual)

COMPANY ANALYSIS A1

Accounting Analysis

AA 8-1 Refer to Apple’s financial statements in Appendix A to answer the following. 1. What percent of the original cost of Apple’s Property, Plant and Equipment account remains to be

depreciated as of (a) September 30, 2017, and (b) September 24, 2016? Assume these assets have no salvage value and the entire account is depreciable. Hint: Accumulated Depreciation is listed under “Property, Plant and Equipment” in the notes to Apple’s financial statements in Appendix A.APPLE

Chapter 8 Accounting for Long-Term Assets 337

2. Much research and development is needed to create the next iPhone. Does Apple capitalize and amor- tize research and development costs over the life of the product, or are research and development costs expensed as incurred?

3. Compute Apple’s total asset turnover for the year ended (a) September 30, 2017, and (b) September 24, 2016. Assume total assets at September 26, 2015, are $290,345 ($ millions).

4. Using the results in part 3, is the change in Apple’s asset turnover favorable or unfavorable?

COMPARATIVE ANALYSIS A1

Required

1. Compute total asset turnover for the most recent two years for Apple and Google using the data shown. 2. In the current year, which company is more efficient in generating net sales given total assets? 3. Does each company’s asset turnover underperform or outperform the industry (assumed) asset turn-

over of 0.5 for (a) Apple and (b) Google?

AA 8-2 Comparative figures for Apple and Google follow.

Apple Google

Current One Year Two Years Current One Year Two Years $ millions Year Prior Prior Year Prior Prior

Total assets . . . . . . . . . . . . $375,319 $321,686 $290,345 $197,295 $167,497 $147,461

Net sales . . . . . . . . . . . . . . 229,234 215,639 233,715 110,855 90,272 74,989

APPLE GOOGLE

Required

1. Compute total asset turnover for the most recent two years for Samsung using the data shown. 2. Is the change in Samsung’s asset turnover favorable or unfavorable? 3. For the current year, is Samsung’s asset turnover better or worse than the asset turnover for (a) Apple

and (b) Google?

Samsung Apple Google

Current Prior Two Years Current Prior Current Prior In millions Year Year Prior Year Year Year Year

Total assets . . . W301,752,090 W262,174,324 W242,179,521 $375,319 $321,686 $197,295 $167,497

Net sales . . . . . 239,575,376 201,866,745 200,653,482 229,234 215,639 110,855 90,272

AA 8-3 Comparative figures for Samsung, Apple, and Google follow. GLOBAL ANALYSIS A1

Samsung APPLE GOOGLE

ETHICS CHALLENGE C1

BTN 8-1 Flo Choi owns a small business and manages its accounting. Her company just finished a year in which a large amount of borrowed funds was invested in a new building addition as well as in equip- ment and fixture additions. Choi’s banker requires her to submit semiannual financial statements so he can monitor the financial health of her business. He has warned her that if profit margins erode, he might raise the interest rate on the borrowed funds to reflect the increased loan risk from the bank’s point of view. Choi knows profit margin is likely to decline this year. As she prepares year-end adjusting entries, she decides to apply the following depreciation rule: All asset additions are considered to be in use on the first day of the following month. (The previous rule assumed assets are in use on the first day of the month nearest to the purchase date.)

Beyond the Numbers

338 Chapter 8 Accounting for Long-Term Assets

Required

1. Identify decisions that managers like Choi must make in applying depreciation methods. 2. Is Choi’s rule an ethical violation, or is it a legitimate decision in computing depreciation? 3. How will Choi’s new depreciation rule affect the profit margin of her business?

BTN 8-2 Teams are to select an industry, and each team member is to select a different company in that industry. Each team member is to acquire the financial statements (Form 10-K) of the company selected— see the company’s website or the SEC’s EDGAR database (SEC.gov). Use the financial statements to compute total asset turnover. Communicate with teammates via a meeting, e-mail, or telephone to discuss the meaning of this ratio, how different companies compare to each other, and the industry norm. The team must prepare a one-page report that describes the ratios for each company and identifies the conclu- sions reached during the team’s discussion.

COMMUNICATING IN PRACTICE A1

BTN 8-3 Access the Yahoo! (renamed as Altaba, ticker: AABA) 10-K report for the year ended December 31, 2016, filed on March 1, 2017, at SEC.gov.

Required

1. What amount of goodwill is reported on Yahoo!’s balance sheet? What percentage of total assets does its goodwill represent? Is goodwill a major asset for Yahoo!? Explain.

2. Compute the change in goodwill from December 31, 2015, to December 31, 2016. Comment on the change in goodwill over this period.

3. Locate Note 6 to its financial statements. What are the three categories of intangible assets that Yahoo! reports at December 31, 2016? What proportion of total assets do the intangibles represent?

4. What does Yahoo! indicate is the life of “Tradenames, trademarks, and domain names” according to its Note 6?

TAKING IT TO THE NET P4

BTN 8-4 Each team member is to become an expert on one depreciation method to facilitate teammates’ understanding of that method. Follow these procedures: a. Each team member is to select an area of expertise from one of the following depreciation methods:

straight-line, units-of-production, or double-declining-balance. b. Expert teams are to be formed from those who have selected the same area of expertise. The instructor

will identify the location where each expert team meets. c. Using the following data, expert teams are to collaborate and develop a presentation answering the

requirements. Expert team members must write the presentation in a format they can show to their learning teams.

Data and Requirements On January 8, 2017, Whitewater Riders purchases a van to transport rafters back to the point of departure at the conclusion of the rafting adventures they operate. The cost of the van is $44,000. It has an estimated salvage value of $2,000 and is expected to be used for four years and driven 60,000 miles. The van is driven 12,000 miles in 2017; 18,000 miles in 2018; 21,000 in 2019; and 10,000 in 2020. 1. Compute the annual depreciation expense for each year of the van’s estimated useful life. 2. Explain when and how annual depreciation is recorded. 3. Explain the impact on income of this depreciation method versus others over the van’s life. 4. Identify the van’s book value for each year of its life and illustrate the reporting of this amount for

any one year. d. Re-form original learning teams. In rotation, experts are to present to their teams the results from

part c. Experts are to encourage and respond to questions.

TEAMWORK IN ACTION P1

Point: This activity can follow an overview of each method. Step 1 allows for three areas of exper- tise. Larger teams will have some duplication of areas, but the straight-line choice should not be duplicated. Expert teams can use the book and consult with the instructor.

Chapter 8 Accounting for Long-Term Assets 339

BTN 8-5 Review the chapter’s opening feature involving Deb and Dan Carey and their company, New Glarus Brewing Company. Assume that the company currently has net sales of $8,000,000 and that it is planning an expansion that will increase net sales by $4,000,000. To accomplish this expansion, the com- pany must increase its average total assets from $2,500,000 to $3,000,000.

Required

1. Compute the company’s total asset turnover under (a) current conditions and (b) proposed conditions. 2. Evaluate and comment on the merits of the proposal given the analysis in part 1. Identify any concerns

we would express about the proposal.

ENTREPRENEURIAL DECISION A1

BTN 8-6 Team up with one or more classmates for this activity. Identify companies in your community or area that must account for at least one of the following assets: natural resource, patent, lease, leasehold improvement, copyright, trademark, or goodwill. You might find a company that has more than one type of asset. Once you identify a company with a specific asset, describe the accounting this company uses to allocate the cost of that asset to the periods that benefit from its use.

HITTING THE ROAD P3 P4

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Describe current and long-term liabilities

and their characteristics.

C2 Identify and describe known current liabilities.

C3 Explain how to account for contingent liabilities.

P3 Compute and record employer payroll expenses and liabilities.

P4 Account for estimated liabilities, including warranties and bonuses.

P5 Appendix 9A—Identify and describe the details of payroll reports, records, and procedures.

ANALYTICAL A1 Compute the times interest earned ratio

and use it to analyze liabilities.

PROCEDURAL P1 Prepare entries to account for short-term

notes payable.

P2 Compute and record employee payroll deductions and liabilities.

Chapter Preview

9 Accounting for Current Liabilities

PAYROLL LIABILITIES

P2 Employee payroll and deductions

P3 Employer payroll taxes

Multi-period liabilities

ESTIMATED LIABILITIES

P4 Reporting for: Health and pension

Vacation benefits

Bonus plans

Warranty liabilities

KNOWN LIABILITIES

C1 Reporting liabilities C2 Sales taxes payable

Unearned revenues

P1 Short-term notes

NTK 9-1 NTK 9-2 NTK 9-3

CONTINGENCIES AND ANALYSIS

C3 Accounting for contingencies:

Probable

Possible

Remote

A1 Times interest earned

NTK 9-4

341

“Good stuff doesn’t come easy”—Tim Westergren

Sounds Like a Winner!

OAKLAND, CA—“I was a senior in college,” recalls Tim Westergren, “when unbeknownst to me, I decided to become an entrepreneur.” Tim was playing in a band and considering ways to discover new music.

“I shared the idea with a former college classmate, Jon Kraft . . . and in a matter of weeks it went from ‘we have an idea’ to ‘we have a business plan and we’re pitching it.’” The business Tim and Jon built is now known as Pandora Media (Pandora.com), an Internet radio that plays music based on the listener’s preferences.

Tim and Jon started Pandora with financing help. However, within a year of starting the business, Tim and Jon ran out of money.

“We weren’t paying our employees,” admits Tim. “About 50 or 55 people worked without getting paid for over two years during that time.” To keep the business afloat, Tim and Jon learned about managing current liabilities for payroll, supplies, employee benefits, vacations, training, and taxes.

Tim and Jon insist that effective management of liabilities, especially payroll and employee benefits, is crucial for new businesses. Tim and Jon’s ability to juggle their current liabilities enabled them to “hang on” for those crucial first two years.

“Business is an execution game,” insists Tim, “not an inven- tion game.”

Tim encourages people to start a business doing some- thing they love. “If you’re doing it because you love it and because it has meaning for you,” proclaims Tim, “then you can’t really fail.”

Sources: Pandora website, January 2019; Billboard.com, March 2016; Fortune, June 2015; Washington Post, February 2015; GreenBiz, November 2012

©Jason Davis/Pandora Media/Getty Images

Characteristics of Liabilities This section discusses characteristics of liabilities and how liabilities are classified.

Defining Liabilities A liability is a probable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events. This definition includes three elements that are shown in Exhibit 9.1. No liability is reported when one or more of those elements are missing. For example, companies expect to pay wages in future years, but these future payments are not liabilities because no past event such as employee work resulted in a present obligation. Instead, liabilities are recorded when employees perform work and earn wages.

C1 Describe current and long-term liabilities and their characteristics.

KNOWN LIABILITIES

EXHIBIT 9.1 Characteristics of a Liability

Due to a past

transaction or event . . .

Past Present Future

company has a present obligation

. . . for future

payment of assets or services.

Supplies

Date:...............

Request purchase of the follo wing item(s):

Model No. Descr iption

Total

Quantity Price Amount

Payable

Point: Most liability accounts use payable or unearned in their titles.

Classifying Liabilities Liabilities are classified as either current or long term.

Current Liabilities Current liabilities, or short-term liabilities, are liabilities due within one year (or the company’s operating cycle if longer). Most are paid using current assets or by creating other current liabilities. Common examples are accounts payable, short-term notes

Point: For simplicity we assume an operating cycle of one year.

342 Chapter 9 Accounting for Current Liabilities

payable, wages payable, warranty liabilities, and taxes payable. Some liabilities do not have a fixed due date but instead are payable on the creditor’s demand. These are reported as current liabilities because of the possibility of payment in the near term.

Current liabilities differ across companies because they depend on the type of company oper- ations. For example, MGM Resorts reports casino outstanding chip liability. Harley-Davidson reports different current liabilities such as warranty, recall, and dealer incentive liabilities. Exhibit 9.2 shows current liabilities as a percentage of total liabilities for selected companies.

0% 20% 60%40% 80%

Six Flags 14%

Bowl America 58%

Apple 41%

100%

$3.3 mil.

$79,006 mil.

$316 mil.

Columbia Sportswear 84%$363 mil. EXHIBIT 9.2 Current Liabilities as a Percentage of Total Liabilities

Long-Term Liabilities Long-term liabilities are obligations due after one year (or the company’s operating cycle if longer). They include long-term notes payable, warranty liabili- ties, lease liabilities, and bonds payable. For example, Domino’s Pizza reports long-term liabil- ities of $2,196 million. A single liability can be divided between the current and noncurrent sections if a company expects to make payments toward it in both the short and long term. Domino’s reports long-term debt of $2,149 million and current portion of long-term debt of $39 million. The current portion is reported in current liabilities.

Uncertainty in Liabilities Accounting for liabilities involves answering three impor- tant questions: Whom to pay? When to pay? How much to pay? Answers are usually decided when a liability is incurred. For example, if a company has a $100 account payable to a firm, payable on March 15, the answers are clear. However, answers to one or more of these three questions are uncertain for some liabilities.

Uncertainty in Whom to Pay Liabilities can involve uncertainty in whom to pay. For ex- ample, a company can create a liability with a known amount when issuing a note that is pay- able to its holder. In this case, a specific amount is payable to the note’s holder at a specified date, but the company does not know who the holder is until that date. Despite this uncertainty, the company reports this liability on its balance sheet.

Uncertainty in When to Pay A company can have an obligation of a specific amount to a known creditor but not know when it must be paid. For example, a law firm can accept fees in advance from a client who plans to use the firm’s services in the future. This means that the firm has a liability that it settles by providing services at an unknown future date. Although this un- certainty exists, the law firm’s balance sheet must report this liability. These types of obligations are reported as current liabilities because they are likely to be settled in the short term.

Uncertainty in How Much to Pay A company can be aware of an obligation but not know how much it will be required to pay. For example, a company using electrical power is billed only after the meter has been read. This cost is incurred and the liability created before a bill is received. A liability to the power company is reported as an estimated amount if the balance sheet is prepared before a bill arrives.

Examples of Known Liabilities Known liabilities are measurable obligations arising from agreements, contracts, or laws. Known liabilities include accounts payable, notes payable, payroll obligations, sales taxes, and unearned revenues.

S M T W T F S

JANUARY 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

C2 Identify and describe known current liabilities.

Chapter 9 Accounting for Current Liabilities 343

Accounts Payable Accounts payable, or trade accounts payable, are amounts owed to suppliers for products or services purchased on credit. Accounts payable are a focus of the merchandising chapter.

Sales Taxes Payable Nearly all states and many cities levy taxes on retail sales. Sales taxes are shown as a percent of selling prices. The seller collects sales taxes from customers when sales occur and sends these collections to the government. Because sellers currently owe these collections to the govern- ment, this amount is a current liability. If Home Depot sells materials on August 31 for $6,000 cash that are subject to a 5% sales tax, the revenue portion of this transaction is recorded as fol- lows. Later, when Home Depot sends the $300 collected to the government, it debits Sales Taxes Payable and credits Cash.

Assets = Liabilities + Equity +6,300 +300 +6,000

Aug. 31 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,300

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Sales Taxes Payable ($6,000 × 0.05) . . . . . . . . . . . . . . . . . . . . 300 Record cash sales and 5% sales tax.*

*We also Dr. Cost of Sales and Cr. Inventory for cost of sales.

June 30 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Unearned Ticket Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Record sale of tickets for eight concerts.

Assets = Liabilities + Equity +5,000,000 +5,000,000

Oct. 31 Unearned Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000

Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000

Record concert revenues earned ($5,000,000 × 1∕8).

Assets = Liabilities + Equity −625,000 +625,000

Unearned Revenues Unearned revenues, or deferred revenues, are amounts received in advance from customers for future products or services. Unearned revenues arise with airline ticket sales, magazine sub- scriptions, construction projects, hotel reservations, gift card sales, and custom orders. Advance ticket sales for sporting events or concerts are other examples. If Selena Gomez sells $5 million in tickets for eight concerts, the entry is ©Dwphotos/Shutterstock

Point: To defer a revenue means to postpone recording a revenue collected in advance.

Unearned Ticket Revenue is reported as a current liability. As each concert is played, 1/8 of the liability is satisfied and 1/8 of the revenue is earned—this entry follows.

Short-Term Notes Payable A short-term note payable is a written promise to pay a specified amount on a stated future date within one year. Notes can be sold or transferred. Most notes payable bear interest. The written documentation with notes is helpful in resolving legal disputes. We describe two trans- actions that create notes payable.

Note Given to Extend Credit Period A company can replace an account payable with a note payable. A common example is a creditor that requires an interest-bearing note for an overdue account payable. Assume that on August 23, Brady asks to extend its past-due $600 account payable to McGraw. After negotiations, McGraw agrees to accept $100 cash and a 60-day, 12%, $500 note payable to replace the account payable. Brady records the following.

P1 Prepare entries to account for short-term notes payable.

Point: Note requirements: (1) un- conditional promise, (2) in writing, (3) specific amount, and (4) stated due date.

Assets = Liabilities + Equity −100 −600 +500

Aug. 23 Accounts Payable—McGraw. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Notes Payable—McGraw. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Sent cash and a note for payment on account.

344 Chapter 9 Accounting for Current Liabilities

Signing the note changes Brady’s debt from an account payable to a note payable. McGraw prefers the note payable over the account payable because it earns interest and it is written docu- mentation of the debt’s existence, term, and amount. When the note comes due, Brady pays the note and interest to McGraw and records this entry.

Interest expense is computed by multiplying the principal of the note ($500) by the annual interest rate (12%) for the fraction of the year the note is outstanding (60 days∕360 days).

Note Given to Borrow from Bank A bank requires a borrower to sign a note when making a loan. When the note comes due, the borrower repays the note with an amount larger than the amount borrowed. The difference between the amount borrowed and the amount repaid is in- terest. The amount borrowed is called principal or face value of the note. Assume that a company borrows $2,000 from a bank at 12% annual interest. The loan is made on September 30, 2019, and is due in 60 days. The note says: “I promise to pay $2,000 plus interest at 12% within 60 days after September 30.” The borrower records its receipt of cash and the new liability with this entry.

Point: Firms commonly compute interest using a 360-day year, called the banker’s rule.

Point: A loan is reported as an asset (receivable) on a bank’s balance sheet.

Point: Excel for accrued interest.

A B

1 Principal $500

2 Rate 12%

3 Issue date 8/23

4 Days 60

5 Accrued interest

=ACCRINTM(B3,B3+B4,B2,B1,2)=$10

Assets = Liabilities + Equity −510 −500 −10

Oct. 22 Notes Payable—McGraw . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

Paid note with interest ($500 × 12% × 60∕360).

When principal and interest are paid, the borrower records payment with this entry.

When Note Extends over Two Periods When a note is issued in one period but paid in the next, interest expense is recorded in each period based on the number of days the note extends over each period. Assume a company borrows $2,000 cash on December 16, 2019, at 12% annual interest. This 60-day note matures on February 14, 2020, and the company’s fis- cal year ends on December 31. This means 15 of the 60 days are in 2019 and 45 of the 60 days are in 2020. Interest for these two periods is: 12/16/2019 to 12/31/2019 = 15 days. Interest expense = $2,000 × 12% × 15/360 = $10. 01/01/2020 to 02/14/2020 = 45 days. Interest expense = $2,000 × 12% × 45/360 = $30.

The borrower records the 2019 expense with the following adjusting entry.

Point: Excel for accrued interest.

A B

1 Principal $2,000

2 Rate 12%

3 Issue date 9/30

4 Days 60

5 Accrued interest

=ACCRINTM(B3,B3+B4,B2,B1,2)=$40

Sep. 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Borrowed $2,000 cash with a 60-day, 12%, $2,000 note.

Assets = Liabilities + Equity +2,000 +2,000

Dec. 31, 2019 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Record accrued interest ($2,000 × 12% × 15∕360).

Assets = Liabilities + Equity +10 −10

Nov. 29 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,040

Paid note with interest ($2,000 × 12% × 60∕360). Assets = Liabilities + Equity −2,040 −2,000 −40

When this note is paid on February 14, the borrower records 45 days of interest expense in 2020 and removes the balances of the two liability accounts.

Feb. 14, 2020 Interest Expense* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,040

Paid note with interest. *$2,000 × 12% × 45∕360

Assets = Liabilities + Equity −2,040 −10 −30 −2,000

Chapter 9 Accounting for Current Liabilities 345

Debt to Pay Franchisors such as Pizza Hut and Papa John’s use notes to help entrepreneurs acquire their own franchises, including notes to pay for the franchise fee and equipment. Payments on these notes are usually collected monthly and often are secured by the franchisees’ assets. For example, a McDonald’s franchise can cost from under $200,000 to over $2 million, depending on the type selected. ■

Decision Insight

Part 1. A retailer sells merchandise for $500 cash on June 30 (cost of merchandise is $300). The retailer collects 7% sales tax. Record the entry for the $500 sale and its applicable sales tax. Also record the entry that shows the taxes collected being sent to the government on July 15.

Part 2. A ticket agency receives $40,000 cash in advance ticket sales for Haim’s upcoming four-date tour. Record the advance ticket sales on April 30. Record the revenue earned for the first concert date of May 15, assuming it represents one-fourth of the advance ticket sales.

Part 3. On November 25 of the current year, a company borrows $8,000 cash by signing a 90-day, 5% note payable with a face value of $8,000. (a) Compute the accrued interest payable on December 31 of the current year, (b) prepare the journal entry to record the accrued interest expense at December 31 of the current year, and (c) prepare the journal entry to record payment of the note at maturity.

Solution—Part 1

Accounting for Known Liabilities

NEED-TO-KNOW 9-1

C2 P1

Solution—Part 2

June 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Sales Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Record cash sales and 7% sales tax. June 30 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Record cost of June 30 sales. July 15 Sales Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Record sales taxes sent to govt.

Apr. 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Unearned Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Record sales in advance of concerts. May 15 Unearned Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Earned Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Record concert revenues earned ($40,000 × 1∕4).

Point: Maturity date is the day a note’s principal and interest are due. Maturity value is a note’s principal plus interest owed on its maturity date.

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Record accrued interest (5% × $8,000 × 36∕360).

b.

Solution—Part 3

a. Computation of interest payable at December 31: Days from November 25 to December 31 . . . . . . . . . . . . . . . . . . . . . . 36 days Accrued interest (5% × $8,000 × 36∕360) . . . . . . . . . . . . . . . . . . . . . $40

Feb. 23 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100 Record payment of note plus interest (5% × $8,000 × 90∕360 = $100 total interest) (5% × $8,000 × 54∕360 = $60 interest expense).

c.

Do More: QS 9-2, QS 9-3, QS 9-4, E 9-2, E 9-3, E 9-4

Point: Feb. 23 entry assumes no reversing entry was made.

Point: Accrued interest, 11/25–12/31.

A B

1 Principal $8,000

2 Rate 5%

3 Issue date 11/25

4 Days 36

5 Accrued interest

=ACCRINTM(B3,B3+B4,B2,B1,2)=$40

Point: Accrued Interest, 1/1–2/23.

A B

1 Principal $8,000

2 Rate 5%

3 Issue date 11/25

4 Days 54

5 Accrued interest

=ACCRINTM(B3,B3+B4,B2,B1,2)=$60

346 Chapter 9 Accounting for Current Liabilities

Payroll liabilities are from salaries and wages, employee benefits, and payroll taxes levied on the employer. For example, Boston Beer reports current payroll liabilities of more than $14 mil- lion from accrued “employee wages, benefits and reimbursements.”

EMPLOYEE Payroll and Deductions Gross pay is the total compensation an employee earns including wages, salaries, commissions, bonuses, and any compensation earned before deductions such as taxes. (Wages usually refer to payments to employees at an hourly rate. Salaries usually refer to payments to employees at a monthly or yearly rate.) Net pay, or take-home pay, is gross pay minus all deductions. Payroll deductions, or withholdings, are amounts withheld from an employee’s gross pay, either required or voluntary. Required deductions result from laws and include income taxes and Social Security taxes. Voluntary deductions, at an employee’s option, include pension and health contributions, health and life insurance premiums, union dues, and donations.

Exhibit 9.3 shows typical employee payroll deductions. The employer withholds payroll deductions from employees’ pay and sends this money to the designated group or government. The employer records payroll deductions as current liabilities until these amounts are sent. This section covers major payroll deductions.

P2 Compute and record employee payroll deductions and liabilities.

Point: Deductions at some compa- nies, such as those for insurance coverage, are “required” under labor contracts.

PAYROLL LIABILITIES

FICA Taxes (Social Security)

Gross Pay

Voluntary Deductions

FICA Taxes (Medicare)

State and Local Income Taxes

minus deductions

Net pay = Gross pay – Deductions

Net PayNet PayNet Pay

Federal Income Tax

EXHIBIT 9.3 Payroll Deductions

Employee FICA Taxes Employers withhold Federal Insurance Contributions Act (FICA) taxes from employees’ pay. Employers separate FICA taxes into two groups.

1. Social Security taxes—withholdings to cover retirement, disability, and survivorship. 2. Medicare taxes—withholdings to cover medical benefits.

Taxes for Social Security and Medicare are computed separately. For 2018, the amount with- held from each employee’s pay for Social Security tax is 6.2% of the first $128,400 the employee earns in the calendar year. The Medicare tax is 1.45% of all amounts the employee earns; there is no maximum limit to Medicare tax. A 0.9% Additional Medicare Tax is imposed on the high- income employee for pay usually in excess of $200,000 (this additional tax is not imposed on the employer, whereas the others are). Until the taxes are sent to the Internal Revenue Service (IRS), they are included in employers’ current liabilities. For any changes in rates or earnings levels, check IRS.gov or SSA.gov.

Employee Income Tax Most employers withhold federal income tax from each em- ployee’s paycheck. The amount withheld is computed using IRS tables. The amount depends on the employee’s income and the number of withholding allowances the employee claims. Allowances reduce taxes owed to the government. Employees can claim allowances for

Point: Sources of U.S. tax receipts: 50% Personal income tax 35% FICA and FUTA taxes 10% Corporate income tax 5% Other taxes

Chapter 9 Accounting for Current Liabilities 347

themselves and their dependents. Until the government is paid, withholdings are reported as a current liability on the employer’s balance sheet.

Employee Voluntary Deductions Voluntary deduction withholdings come from employee requests, contracts, unions, or other agreements. They include charitable giving, med- ical and life insurance premiums, pension contributions, and union dues. Until they are paid, voluntary withholdings are reported as part of employers’ current liabilities.

Employee Payroll Recording Employers accrue payroll expenses and liabilities at the end of each pay period. Assume that an employee earns a salary of $2,000 per month. At the end of January, the employer’s entry to accrue payroll expenses and liabilities for this employee is

Salaries Expense (debit) shows that the employee earns a gross salary of $2,000. The first five payables (credits) show the liabilities the employer owes on behalf of this employee to cover FICA taxes, income taxes, medical insurance, and union dues. The Salaries Payable account (credit) records the $1,524 net pay the employee receives from the $2,000 gross pay earned. The February 1 entry to record cash payment to this employee is

Jan. 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

FICA—Social Security Taxes Payable (6.2%) . . . . . . . . . . 124

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . . . . . . 29

Employee Federal Income Taxes Payable* . . . . . . . . . . . 213

Employee Medical Insurance Payable* . . . . . . . . . . . . . . 85

Employee Union Dues Payable* . . . . . . . . . . . . . . . . . . . 25

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

Record accrued payroll for January. *Amounts taken from employer’s accounting records.

Assets = Liabilities + Equity +124 −2,000 +29 +213 +85 +25 +1,524

Feb. 1 Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

Record payment of payroll.

EMPLOYER Payroll Taxes Employers must pay payroll taxes in addition to those required of employees. Employer taxes include FICA and unemployment taxes.

Employer FICA Tax Employers must pay FICA taxes on their payroll. For 2018, the employer must pay Social Security tax of 6.2% on the first $128,400 earned by each employee and 1.45% Medicare tax on all earnings of each employee. An employer’s tax is credited to the same FICA Taxes Payable accounts used to record the Social Security and Medicare taxes with- held from employees.

Employer Unemployment Taxes The federal government works with states in a joint federal and state unemployment insurance program. Each state has its own program. These programs provide unemployment benefits to qualified workers.

Federal Unemployment Tax Act (FUTA) Employers must pay a federal unemployment tax on wages and salaries earned by their employees. For the recent year, employers were required to pay FUTA taxes of as much as 6.0% of the first $7,000 earned by each employee. This federal tax can be reduced by a credit of up to 5.4% for taxes paid to a state program. As a result, the net federal unemployment tax is often 0.6%.

State Unemployment Tax Act (SUTA) All states fund their unemployment insurance pro- grams by placing a payroll tax on employers. (A few states require employees to make a contri- bution. In the book’s assignments, we assume this tax is only levied on the employer.) In most states, the base rate for SUTA taxes is 5.4% of the first $7,000 earned by each employee (the dollar level varies by state). This base rate is adjusted according to an employer’s merit rating.

P3 Compute and record employer payroll expenses and liabilities.

Point: A self-employed person must pay both the employee and employer FICA taxes.

348 Chapter 9 Accounting for Current Liabilities

The state assigns a merit rating based on a company’s stability in employing workers. A good rating reflects stability in employment and means an employer can pay less than the 5.4% base rate. A low rating means high turnover or seasonal hirings and layoffs.

Recording Employer Payroll Taxes Employer payroll taxes are an added expense beyond the wages and salaries earned by employees. These taxes are often recorded in an entry separate from the one recording payroll expenses and deductions. Assume that the $2,000 re- corded salaries expense from the previous example is earned by an employee whose earnings have not yet reached $5,000 for the year. This means the entire salaries expense for this period is subject to tax because year-to-date pay is under $7,000. Consequently, the FICA portion of the employer’s tax is $153, computed by multiplying both the 6.2% and 1.45% by the $2,000 gross pay. Assume that the federal unemployment tax rate is 0.6% and the state unemployment tax rate is 5.4%. This means state unemployment (SUTA) taxes are $108 (5.4% of the $2,000 gross pay) and federal unemployment (FUTA) taxes are $12 (0.6% of $2,000). The entry to record the employer’s payroll tax expense and related liabilities is

Internal Control of Payroll Internal controls are crucial for payroll because of a high risk of fraud and error. Exhibit 9.4 identifies and explains four key areas of payroll activities that we aim to separate and monitor.

Assets = Liabilities + Equity +124 −273 +29 +108 +12

Jan. 31 Payroll Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

FICA—Social Security Taxes Payable (6.2%) . . . . . . . . . . 124

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . . . . . . 29

State Unemployment Taxes Payable . . . . . . . . . . . . . . . . 108

Federal Unemployment Taxes Payable . . . . . . . . . . . . . . 12

Record employer payroll taxes.

NOW HIRING

Duty: Authorize, hire, and fire. Aim: Keep fake workers o payroll.

Duty: Verify tax rates and payroll amounts. Aim: Rates updated and amounts accurate.

Duty: Track and verify time worked. Aim: Paid for time worked only.

Duty: Sign and issue prenumbered checks. Aim: Checks valid, secured, and correct.

Employee Hiring Payroll Preparation Timekeeping Payroll PaymentEXHIBIT 9.4 Internal Controls in Four Key Areas of Payroll

Payroll Fraud Probably the greatest number of frauds involve payroll. Controls include proper approvals and pro- cesses for employee additions, deletions, and pay rate changes. A common fraud is a manager adding a fictitious employee to the payroll and then cashing the fictitious employee’s check. A study reports that 42% of employees in operations and service areas witnessed violations of employee wage, overtime, or benefit rules in the past year. Another 33% observed falsifying of time and expense reports (KPMG). ■

Ethical Risk

Ceridian Connection reports: 8.5% of fraud is tied to payroll; $72,000 is the median loss per payroll fraud; and 24 months is the median time to uncover pay- roll fraud.

Multi-Period Known Liabilities Many known liabilities extend over multiple periods. These often include unearned revenues and notes payable. For example, if Sports Illustrated sells a three-year digital magazine subscrip- tion, it records amounts received for this subscription in an Unearned Subscription Revenues account. Amounts in this account are liabilities, but are they current or long term? They are both. The portion of the Unearned Subscription Revenues account that will be fulfilled in the next year is reported as a current liability. The remaining portion is reported as a long-term liability.

Chapter 9 Accounting for Current Liabilities 349

The same analysis applies to notes payable. For example, a borrower reports a three-year note payable as a long-term liability in the first two years it is outstanding. In the third year, the bor- rower reclassifies this note as a current liability because it is due within one year. The current portion of long-term debt is that part of long-term debt due within one year. Long-term debt is reported under long-term liabilities, but the current portion due is reported under current liabil- ities. Assume that a $7,500 debt is paid in installments of $1,500 per year for five years. The $1,500 due within the year is reported as a current liability. No journal entry is necessary for this reclassification. Instead, we simply classify the amounts for debt as either current or long term when the balance sheet is prepared.

Point: Some accounting systems make an entry to transfer the cur- rent amount due out of Long-Term Debt and into the Current Portion of Long-Term Debt as follows:

Long-Term Debt . . . . . 1,500 Current Portion

of L-T Debt . . . . . 1,500

Summer Intern You take a summer job working as a windsurfing instructor. On your first payday, the owner slaps you on the back, gives you full payment in cash, winks, and adds: “No need to pay those high taxes, eh?” What action, if any, do you take? ■ Answer: You do not want to be an accomplice to unlawful payroll activities. Not paying federal and state taxes on wages is illegal and unethical. One action is to request payment by check. If this fails, you must consider quitting.

Decision Ethics

An estimated liability is a known obligation of an uncertain amount that can be reasonably estimated. Common examples are employee benefits such as pensions, health care, and vacation pay, and warranties offered by a seller.

Health and Pension Benefits Many companies provide employee benefits. An employer often pays all or part of medical, dental, life, and disability insurance. Many employers also contribute to pension plans, which are agreements by employers to provide benefits (payments) to employees after retirement. Many companies also provide medical care and insurance benefits to their retirees. Assume

ESTIMATED LIABILITIES P4 Account for estimated liabilities, including warranties and bonuses.

A company’s first weekly pay period of the year ends on January 8. Sales employees earned $30,000 and office employees earned $20,000 in salaries. The employees are to have withheld from their salaries FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $9,000 of federal in- come taxes, $2,000 of medical insurance deductions, and $1,000 of pension contributions. No employee earned more than $7,000 in the first pay period.

Part 1. Compute FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the jour- nal entry to record the company’s January 8 (employee) payroll expenses and liabilities.

Part 2. Prepare the journal entry to record the company’s (employer) payroll taxes resulting from the January 8 payroll. Its state unemployment tax rate is 5.4% on the first $7,000 paid to each employee. The federal unemployment tax rate is 0.6%.

Solution—Part 1 Solution—Part 2

Payroll Liabilities

NEED-TO-KNOW 9-2

P2 P3

Jan. 8 Sales Salaries Expense . . . . . . . . . . . . . . . . 30,000

Office Salaries Expense . . . . . . . . . . . . . . . . 20,000

FICA—Social Security Taxes Payable* 3,100

FICA—Medicare Taxes Payable† . . . . 725

Employee Fed. Income Taxes Payable 9,000

Employee Med. Insurance Payable . . 2,000

Employee Pensions Payable . . . . . . . 1,000

Salaries Payable . . . . . . . . . . . . . . . . . 34,175

Record payroll for period. *$50,000 × 6.2% = $3,100 †$50,000 × 1.45% = $725

Jan. 8 Payroll Taxes Expense . . . . . . . . . . . . . . . . . 6,825

FICA—Social Security Taxes Payable . 3,100

FICA—Medicare Taxes Payable . . . . . 725

State Unemployment Taxes Payable* 2,700

Federal Unemployment Taxes Payable† 300

Record employer payroll taxes. *$50,000 × 5.4% = $2,700 †$50,000 × 0.6% = $300

Do More: QS 9-5, QS 9-6, E 9-5, E 9-6, E 9-7, E 9-8, E 9-9

350 Chapter 9 Accounting for Current Liabilities

an employer agrees to (1) pay $8,000 for medical insurance and (2) contribute an additional 10% of the employees’ $120,000 gross salaries to a retirement program. The entry to record these accrued benefits is

Vacation Benefits Many employers offer paid vacation benefits, or paid absences. Vacation benefits are esti- mated and expensed in the period when employees earn them. Assume that salaried employ- ees earn 2 weeks’ paid vacation per year. The year-end adjusting entry to record $3,200 of accrued vacation benefits follows.

Point: An accrued expense is an unpaid expense and is also called an accrued liability.

Dec. 31 Employee Benefits Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Employee Medical Insurance Payable . . . . . . . . . . . . . . 8,000

Employee Retirement Program Payable . . . . . . . . . . . . . 12,000

Record costs of employee benefits.

Assets = Liabilities + Equity +8,000 −20,000 +12,000

Dec. 31 Vacation Benefits Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Vacation Benefits Payable . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Record vacation benefits accrued.

Assets = Liabilities + Equity +3,200 −3,200

Rest on One’s Laurels Major League Baseball was the first pro sport to set up a pension, originally up to $100 per month depending on years played. Many former players now take home six-figure pensions. Cal Ripken Jr.’s pension at age 62 is estimated at $180,000 per year (he played 21 seasons). The same applies to Ichiro Suzuki, who has played 17 seasons—see photo. The requirement is 43 games for a full pension and just one game for full medical benefits for life. ■

Decision Insight

©Imac/Alamy Stock Photo

Vacation Benefits Expense is an operating expense, and Vacation Benefits Payable is a current liability. When an employee takes a one-week vacation, the employer reduces (debits) Vacation Benefits Payable and credits Cash.

Bonus Plans Many companies offer bonuses to employees, and many of the bonuses depend on net income. Assume that an employer gives a bonus to its employees based on the company’s annual net income (to be equally shared by all). The year-end adjusting entry to record a $10,000 bonus is

Warranty Liabilities A warranty is a seller’s obligation to replace or fix a product (or service) that fails to perform as expected within a specified period. For example, new Ford cars are sold with a warranty covering parts for a specified period of time. The seller reports the expected warranty expense in the period

Jan. 20 Vacation Benefits Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Record vacation benefits taken.

Assets = Liabilities + Equity −400 −400

Assets = Liabilities + Equity +10,000 −10,000

Dec. 31 Employee Bonus Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Bonus Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Record expected bonus costs.

Chapter 9 Accounting for Current Liabilities 351

when revenue from the sale of the product or service is reported. The seller reports this warranty liability, even though the existence, amount, payee, and date of future payments are uncertain. This is because warranty costs are probable and the amount can be estimated using past experience.

Assume a dealer sells a car for $16,000 on December 1, 2019, with a one-year or 12,000-mile warranty covering parts. Experience shows that warranty expense is 4% of a car’s selling price, or $640 in this case ($16,000 × 4%). The dealer records the estimated expense and liability related to this sale with this entry.

1 YEAR WARRANTY

President SEAL MOTOR

Box: 25515 River Heights PO Newyork

EX CLUSIV

E

W

A RRANTY

1 YEAR

“ALL PARTS”

This entry alternatively could be made as part of end-of-period adjustments. Either way, the estimated warranty expense is reported on the 2019 income statement and the warranty liability on the 2019 balance sheet. Continuing this example, assume the customer brings the car in for warranty repairs on January 9, 2020. The dealer fixes the car by replacing parts costing $200. The entry to record the repair is

This entry reduces the balance of the Estimated Warranty Liability account, but no expense is recorded in 2020 for the repair. Warranty expense was previously recorded in 2019, the year the car was sold with the warranty. Finally, what happens if total warranty expenses are more or less than the estimated 4%, or $640? The answer is that management should monitor actual warranty expenses to see if a 4% rate is accurate. If not, the rate is changed for future periods.

Multi-Period Estimated Liabilities Estimated liabilities can be both current and long term. For example, pension liabilities to employees are long term to workers who will not retire within the next year. For employees who are retired or will retire within the next year, a portion of pension liabilities is current. Other examples include employee health benefits and warranties.

Dec. 1 Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640

Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . 640

Record estimated warranty expense.

Assets = Liabilities + Equity +640 −640

Jan. 9 Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Auto Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Record costs of warranty repairs.

Assets = Liabilities + Equity −200 −200

Promises, Promises When we purchase a new laptop at Best Buy, a sales clerk commonly asks: “Do you want the Geek Squad Protection Plan?” Best Buy earns about a 60% profit mar- gin on such warranty contracts, and those contracts are a large part of its profit—see table (BusinessWeek). ■

Decision Insight

Warranties as a percent of sales . . . . . . . . . . . . 4%

Warranties as a percent of operating profit . . . . 45%

Part 1. A company’s salaried employees earn two weeks’ vacation per year. The company estimated and must expense $9,000 of accrued vacation benefits for the year. (a) Prepare the year-end adjusting entry to record accrued vacation benefits. (b) Prepare the entry on May 1 of the next year when an employee takes a one-week vacation and is paid $450 cash for that week.

Part 2. For the current year ended December 31, a company has implemented an employee bonus pro- gram based on its net income, which employees share equally. Its bonus expense is $40,000. (a) Prepare the journal entry at December 31 of the current year to record the bonus due. (b) Prepare the journal entry at January 20 of the following year to record payment of that bonus to employees.

Part 3. On June 11 of the current year, a retailer sells a trimmer for $400 with a one-year warranty that covers parts. Warranty expense is estimated at 5% of sales. On March 24 of the next year, the trimmer is brought in for repairs covered under the warranty requiring $15 in materials taken from the Repair Parts Inventory. Prepare the (a) June 11 entry to record the trimmer sale—ignore the cost of sales part of this sales entry—and (b) March 24 entry to record warranty repairs.

Estimated Liabilities

NEED-TO-KNOW 9-3

P4

352 Chapter 9 Accounting for Current Liabilities

Solution—Part 1

Solution—Part 2

Solution—Part 3

June 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Record trimmer sales.

June 11 Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . 20

Record estimated warranty expense ($400 × 5%).

Mar. 24 Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Repair Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Record cost of warranty repairs.

b. Jan. 20 Bonus Payable . . . . . . . . . . . . . . . . 40,000 Cash . . . . . . . . . . . . . . . . . . . . 40,000

Record payment of bonus.

b. May 1 Vacation Benefits Payable . . . . . . . 450

Cash . . . . . . . . . . . . . . . . . . . . 450

Record vacation benefits taken.

Dec. 31 Employee Bonus Expense . . . . . . . . 40,000

Bonus Payable . . . . . . . . . . . . . 40,000

Record expected bonus costs.

a.

Dec. 31 Vacation Benefits Expense . . . . . . . . 9,000

Vacation Benefits Payable . . . . 9,000

Record vacation benefits accrued.

a.

Do More: QS 9-7, QS 9-8, QS 9-9, QS 9-10, E 9-10,

E 9-11, E 9-12, E 9-13

A contingent liability is a potential obligation that depends on a future event arising from a past transaction or event. An example is a pending lawsuit. Here, a past transaction or event leads to a lawsuit whose financial outcome depends on the result of the suit.

Accounting for Contingent Liabilities Accounting for contingent liabilities depends on the likelihood that a future event will occur and the ability to estimate the future amount owed if this event occurs. Three different possibilities are shown in Exhibit 9.5: record liability with a journal entry, disclose in notes to financial statements, or no disclosure.

CONTINGENT LIABILITIES C3 Explain how to account for contingent liabilities.

Nonestimable

Estimable

Possible

Remote

Probable

Contingent liability

Future event is Amount owed is Record liability

No disclosure

Disclose in notes

Est. Expense . . . . . # Est. Liability . . . #

EXHIBIT 9.5 Accounting for Contingent Liabilities

The conditions that determine each of these three possibilities follow.

1. Record liability. The future event is probable (likely) and the amount owed can be reasonably estimated. Examples are warranties, vacation pay, and income taxes.

2. Disclose in notes. The future event is reasonably possible (could occur). 3. No disclosure. The future event is remote (unlikely).

Point: A contingency is an if. Namely, if a future event occurs, then financial consequences are likely for the entity.

Chapter 9 Accounting for Current Liabilities 353

Applying Rules of Contingent Liabilities This section covers common contingent liabilities.

Potential Legal Claims Many companies are sued or at risk of being sued. The ac- counting issue is whether the defendant records a liability or discloses a contingent liability in its notes while a lawsuit is outstanding and not yet settled. The answer is that a potential claim is recorded only if payment for damages is probable and the amount can be reasonably esti- mated. If the potential claim cannot be reasonably estimated but is reasonably possible, it is disclosed. For example, Ford includes the following note in its annual report: “Various legal actions, proceedings, and claims are pending . . . arising out of alleged defects in our products.”

Debt Guarantees Sometimes a company guarantees the payment of debt owed by a sup- plier, customer, or another company. The guarantor usually discloses the guarantee in its finan- cial statement notes as a contingent liability. If it is probable that the debtor will default, the guarantor reports the guarantee as a liability. The Boston Celtics report a unique guarantee: “Contracts provide for guaranteed payments which must be paid even if the employee [player] is injured or terminated.”

Other Contingencies Other examples of contingencies include environmental dam- ages, possible tax assessments, insurance losses, and government investigations. Chevron, for example, reports that it “is subject to loss contingencies . . . related to environmental matters. . . . The amount of additional future costs are not fully determinable.” Many of Chevron’s contingen- cies are revealed only in notes.

Uncertainties That Are Not Contingencies All organizations face uncertainties from future events such as natural disasters and new tech- nologies. These uncertainties are not contingent liabilities because they are future events not arising from past transactions. Accordingly, they are not disclosed.

The following legal claims exist for a company. Identify the accounting treatment for each claim as either (a) a liability that is recorded or (b) an item described in notes to its financial statements. 1. The company (defendant) estimates that a pending lawsuit could result in damages of $500,000; it is

reasonably possible that the plaintiff will win the case. 2. The company faces a probable loss on a pending lawsuit; the amount is not reasonably estimable. 3. The company estimates environmental damages in a pending case at $900,000 with a high probability

of losing the case.

Solution

1. (b); reason—is reasonably estimated but not a probable loss. 2. (b); reason—probable loss but cannot be reasonably estimated. 3. (a); reason—can be reasonably estimated and loss is probable.

Contingent Liabilities

NEED-TO-KNOW 9-4

C3

Do More: QS 9-11, E 9-14

Times Interest Earned Ratio Decision Analysis

Interest expense is often called a fixed expense because it usually does not vary due to short-term changes in sales or other operating activities. While fixed expenses can be good when a company is growing, they create risk. The risk is that a company might be unable to pay fixed expenses if sales decline. Consider Diego Co.’s results for 2019 and two possible outcomes for year 2020 in Exhibit 9.6. Expenses excluding interest are expected to remain at 75% of sales. Expenses that change with sales volume are variable expenses. Interest expense is fixed at $60 per year.

A1 Compute the times interest earned ratio and use it to analyze liabilities.

The following transactions took place at Kern Co. during its recent calendar-year reporting period. a. In September, Kern sold $140,000 of merchandise covered by a 180-day warranty. Prior experience

shows that costs of the warranty equal 5% of sales. Compute September’s warranty expense and pre- pare the adjusting journal entry for the warranty liability as recorded at September 30. Also prepare the journal entry on October 8 to record a $300 cash payment to provide warranty service on an item sold in September.

b. On October 12, Kern replaced an overdue $10,000 account payable by paying $2,500 cash and signing a note for $7,500. The note matures in 90 days and has a 12% interest rate. Prepare the entries recorded on October 12, December 31, and January 10.

c. In late December, Kern is facing a product liability suit filed by an unhappy customer. Kern’s lawyer says it will probably suffer a loss from the lawsuit, but the amount is impossible to estimate.

d. Sally Bline works for Kern. For the pay period ended November 30, her gross earnings are $3,000. Bline has $800 deducted for federal income taxes and $200 for state income taxes from each paycheck. Additionally, a $35 premium for health insurance and a $10 donation to United Way are deducted. Bline pays FICA Social Security taxes at a rate of 6.2% and FICA Medicare taxes at a rate of 1.45%. She has not earned enough this year to be exempt from any FICA taxes. Journalize the accrual of sala- ries expense for Bline by Kern.

e. On November 1, Kern borrows $5,000 cash from a bank in return for a 60-day, 12%, $5,000 note. Record the note’s issuance on November 1 and its repayment with interest on December 31.

f.B (Part f covers Appendix 9B.) Kern has estimated and recorded its quarterly income tax payments. In reviewing its year-end tax adjustments, it identifies an additional $5,000 of income taxes expense that should be recorded. A portion of this additional expense, $1,000, is deferred to future years. Record this year-end income taxes expense adjusting entry.

g. For this calendar year, Kern’s net income is $1,000,000, its interest expense is $275,000, and its income taxes expense is $225,000. Compute Kern’s times interest earned ratio.

COMPREHENSIVE

Accounting for Current Liabilities Including Warranties, Notes, Contingencies, Payroll, and Income Taxes

NEED-TO-KNOW 9-5

354 Chapter 9 Accounting for Current Liabilities

The Sales Increase column of Exhibit 9.6 shows that Diego’s net income increases by 83% to $165 if sales increase by 50% to $900. The Sales Decrease column shows that net income decreases by 83% if sales decline by 50%. These results show that the amount of fixed interest expense affects a company’s risk of its ability to pay interest. One measure of “ability to pay” is the times interest earned ratio in Exhibit 9.7.

EXHIBIT 9.6 Actual and Projected Results

2020 Projections

$ millions 2019 Sales Increase Sales Decrease

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $600 $900 $300

Expenses (75% of sales) . . . . . . . . . . . 450 675 225

Income before interest . . . . . . . . . . . . 150 225 75

Interest expense (fixed) . . . . . . . . . . . 60 60 60

Net income. . . . . . . . . . . . . . . . . . . . . . $ 90 $165 $ 15

EXHIBIT 9.7 Times Interest Earned Times interest earned =

Income before interest expense and income taxes Interest expense

For 2019, Diego’s times interest earned is computed as $150/$60, or 2.5 times. This ratio means that Diego has low to moderate risk because its sales must decline sharply before it is unable to pay its interest expenses. If times interest earned falls below around 1.5, a company will likely be at risk of not being able to pay its liabilities.

$0 Sales Decrease Sales Flat Sales Increase

$100 1.0

0.0

5.0

4.0

7.0

6.0

Times Interest Earned

$200

$300

$400

$500

$600

$700

$800

$900

$ mil.

2.0

3.0

8.0

Net Income Times Interest EarnedSales

Entrepreneur You wish to invest in a franchise for either one of two national chains. Each franchise has an expected annual net income after interest and taxes of $100,000. Net income for the first franchise includes a regular fixed interest charge of $200,000. The fixed interest charge for the second franchise is $40,000. Which franchise is riskier to you if sales forecasts are not met? ■ Answer: Times interest earned for the first franchise is 1.5 [($100,000 + $200,000)/$200,000], whereas it is 3.5 for the second [($100,000 + $40,000)/$40,000]. This shows the first franchise is more at risk of incurring a loss if its sales decline.

Decision Maker

Chapter 9 Accounting for Current Liabilities 355

PLANNING THE SOLUTION For a, compute the warranty expense for September and record it with an estimated liability. Record

the October payment as a decrease in the liability. For b, eliminate the liability for the account payable and create the liability for the note payable.

Compute interest expense for the 80 days that the note is outstanding in the current year and record it as a liability. Record the payment of the note, being sure to include the interest for the 10 days in January.

For c, decide whether the company’s contingent liability needs to be disclosed or accrued (recorded) according to the two necessary criteria: probable loss and reasonably estimable.

For d, set up payable accounts for all items in Bline’s paycheck that require deductions. After all deduc- tions, credit the remaining amount to Salaries Payable.

For e, record the issuance of the note. Compute 60 days’ interest due. For f, determine how much of the income taxes expense is payable in the current year and how much

needs to be deferred (see Appendix 9B). For g, apply and compute times interest earned.

SOLUTION a. Warranty expense = 5% × $140,000 = $7,000

Sep. 30 Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . . 7,000

Record warranty expense for month.

Oct. 8 Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record cost of warranty service.

Oct. 12 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Paid $2,500 cash and gave a 90-day, 12% note to extend due date on the account.

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Accrue interest on note payable.

Jan. 10 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,725

Paid note with interest, including accrued interest payable.

b. Interest expense for current year = 12% × $7,500 × 80/360 = $200 Interest expense for following year = 12% × $7,500 × 10/360 = $25

c. Disclose the pending lawsuit in the financial statement notes. Although the loss is probable, no liability is accrued because the loss cannot be reasonably estimated.

d. Nov. 30 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000.00

FICA—Social Security Taxes Payable (6.2%) . . . . . . . . . . 186.00

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . . . . . . 43.50

Employee Federal Income Taxes Payable . . . . . . . . . . . 800.00

Employee State Income Taxes Payable . . . . . . . . . . . . . 200.00

Employee Medical Insurance Payable . . . . . . . . . . . . . . 35.00

Employee United Way Payable . . . . . . . . . . . . . . . . . . . . 10.00

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,725.50

Record Bline’s accrued payroll.

356 Chapter 9 Accounting for Current Liabilities

e. Nov. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Borrowed cash with a 60-day, 12% note.

Dec. 31 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100

Paid note with interest ($5,000 × 12% × 60∕360).

When the note and interest are paid 60 days later, Kern Co. records this entry.

g. Times interest earned = $1,000,000 + $275,000 + $225,000

$275,000 = 5.45 times

Dec. 31 Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Deferred Income Tax Liability . . . . . . . . . . . . . . . . . . . . . 1,000

Record added income taxes expense and the deferred tax liability.

f.B

APPENDIX

Payroll Reports, Records, and Procedures9A

This appendix focuses on payroll accounting reports, records, and procedures.

Payroll Reports Most employees and employers are required to pay local, state, and federal payroll taxes. Payroll expenses are liabilities to individual employees, to federal and state governments, and to other organizations such as insurance companies. Employers are required to prepare and submit reports explaining how they computed these payments.

Reporting FICA Taxes and Income Taxes The Federal Insurance Contributions Act (FICA) requires each employer to file an Internal Revenue Service (IRS) Form 941, the Employer’s Quarterly Federal Tax Return, within one month after the end of each calendar quarter. A sample Form 941 is shown in Exhibit 9A.1 for Phoenix Sales & Service, a landscape design company. Accounting information and soft- ware are helpful in tracking payroll transactions and reporting the accumulated information on Form 941. Specifically, the employer reports total wages subject to income tax withholding on line 2 of Form 941. (For simplicity, this appendix uses wages to refer to both wages and salaries.) The income tax withheld is reported on line 3. The combined amount of employee and employer FICA (Social Security) taxes for Phoenix Sales & Service is reported on line 5a (taxable Social Security wages, $36,599 × 12.4% = $4,538.28). The 12.4% is the sum of the Social Security tax withheld, computed as 6.2% tax withheld from the employee wages for the quarter, plus the 6.2% tax levied on the employer. The combined amount of employee Medicare wages is reported on line 5c. The 2.9% is the sum of 1.45% withheld from employee wages for the quarter plus 1.45% tax levied on the employer. Total FICA taxes are reported on line 5e and are added to the total income taxes withheld of $3,056.47 to yield a total of $8,656.12. For this year, assume that income up to $128,400 is subject to Social Security tax. There is no income limit on amounts subject to Medicare tax. Congress sets rates owed for Social Security tax (and it typically changes each year). Federal depository banks are authorized to accept deposits of amounts payable to the federal govern- ment. Deposit requirements depend on the amount of tax owed. For example, when the sum of FICA taxes plus the employee income taxes is less than $2,500 for a quarter, the taxes can be paid when Form 941 is filed.

Reporting FUTA Taxes and SUTA Taxes An employer’s federal unemployment taxes (FUTA) are reported on an annual basis by filing an Annual Federal Unemployment Tax Return, IRS Form 940. It must be mailed on or before January 31 following the end of each tax year. Ten more days are allowed if all required tax deposits are filed on a timely basis and the full amount of tax is paid on or before January 31. FUTA pay- ments are made quarterly to a federal depository bank if the total amount due exceeds $500. If $500 or less

Point: Deposits for federal payroll taxes must be made by electronic funds transfer (EFT).

P5 Identify and describe the details of payroll reports, records, and procedures.

Chapter 9 Accounting for Current Liabilities 357

3,079 11

2,049 77

3,527 24

8,656 12

enter the final date you paid wages .

If your business has closed or you stopped paying wages

Part 2: Tell us about your deposit schedule and tax liability for this quarter.

.

.

.

If you are unsure about whether you are a monthly schedule depositor or a semiweekly schedule depositor, see section 11 of Pub. 15.

16

17

18

Check one: Line 12 on this return is less than $2,500 or line 12 (line 10 if the prior quarter was the fourth quarter of last year) on the return for the prior quarter was less than $2,500, and you didn’t incur a $100,000 next-day deposit obligation during the current quarter. If line 12 (line 10 if the prior quarter was the fourth quarter of last year) for the prior quarter was less than $2,500 but line 12 on this reutrn is $100,000 or more, you must provide a record of your federal tax liability. If you are a monthly schedule depositor, complete the deposit schedule below; if you are a semiweekly schedule depositor, attach Schedule B (Form 941). Go to Part 3. You were a monthly schedule depositor for the entire quarter. Enter your tax liability for each month and total liability for the quarter, then go to Part 3.

.

Tax liability: Month 1

Month 2

Month 3

Total liability for quarter Total must equal line 12.

You were a semiweekly schedule depositor for any part of this quarter. Fill out Schedule B (Form 941): Report of Tax Liability for Semiweekly Schedule Depositors, and attach it to Form 941.

Check here, and

If you are a seasonal employer and you do not have to file a return for every quarter of the year

Do you want to allow an employee, a paid tax preparer, or another person to discuss this return with the IRS? See the instructions for details.

Yes. Designee’s name and phone number

Select a 5-digit Personal Identification Number (PIN) to use when talking to the IRS.

Part 3: Tell us about your business. If a question does NOT apply to your business, leave it blank.

Check here.

Part 4: May we speak with your third-party designee?

No.

Part 5: Sign here. You MUST complete both pages of Form 941 and SIGN it.

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Sign your name here

Print your name here Print your title here

Date Best daytime phone/ /

/ /enter the

If your bu

ll u

are ctio

17

18

eck

If you are

Do you wa instruction

Yes.

Part 3: Tell u

Part 4: May w

No.

Part 5: Sign

Under pe to the bes based on

Sign your name here

Date

Part 2: Tel

If you a see sec

16 Che

Department of the Treasury — Internal Revenue Service

(EIN) Employer identification number

Name (not your trade name)

Trade name (if any)

Address Suite or room number

State ZIP code

Report for this Quarter ... (Check one.)

1: January, February, March

2: April, May, June

3: July, August, September

4: October, November, December

941Form

Part 1: Answer these questions for this quarter.

1

4 5

5a

5b

5c

5d

10 11

12 Total taxes after adjustments and credits. Subtract line 11 from line 10

13

Number of employees who received wages, tips, or other compensation for the pay period including: Mar. 12 (Quarter 1), June 12 (Quarter 2), Sept. 12 (Quarter 3), Dec. 12 (Quarter 4)

2 Wages, tips, and other compensation

3 Total income tax withheld from wages, tips, and other compensation

If no wages, tips, and other compensation are subject to social security or Medicare tax Check and go to line 6. Taxable social security and Medicare wages and tips:

Column 1 Column 2

Taxable social security wages × .124 =

Taxable social security tips

Taxable Medicare wages & tips × .029 =

Taxable wages & tips subject to Additional Medicare Tax withholding

5e Add Column 2 from lines 5a, 5b, 5c, and 5d

5f Section 3121(q) Notice and Demand–Tax due to unreported tips (see instructions)

× 0.009 =

Current quarter’s adjustment for fractions of cents

Current quarter’s adjustment for sick pay

Current quarter’s adjustments for tips and group-term like insurance

Total taxes after adjustments. Combine lines 6 through 9 Qualified small business payroll tax credit for increasing research activities. Attach Form 8974

Total deposits for this quarter, including overpayment applied from a prior quarter and overpayments applied from Form 941-X, 941-X (PR), 944-X, or 944-X (SP) filed in the current quarter

14 Balance due. If line 12 is more than line 13, enter the di�erence and see instructions

15 Overpayment. If line 13 is more than line 12, enter the di�erence Check one: Apply to next return.

Send a refund.

× .124 =

7

Total taxes before adjustments. Add lines 3, 5e, and 5f6

7

8

9

10

12

13

14

11

8

9

1

2

3

5e

5f

.

.

.

. . . .

8 6 3 2 1 4 5 8 7

2

36,599

36,599 00

.36,599 00

4,538 28

1,061 37

00

3,056 47

Employer’s QUARTERLY Federal Tax Return

Phoenix Sales Service

1214 Mill Road

85621AZPhoenix Number Street

City

.

.

.

.

.

.

. 5,599.65

.

8,656.12

6 8,656.12

8,656.12

8,656.12 0.00

EXHIBIT 9A.1 Form 941

Point: Line 5a shows the matching nature of FICA tax as 6.2% × 2, or 12.4%, which is shown as 0.124.

Point: Auditors rely on the four 941 Forms filed during a year when auditing a company’s annual wages and salaries expense account.

is due, the taxes are remitted annually. Requirements for paying and reporting state unemployment taxes (SUTA) vary depending on the laws of each state. Most states require quarterly payments and reports.

Reporting Wages and Salaries Employers are required to give each employee an annual report of his or her wages subject to FICA and federal income taxes along with the amounts of these taxes withheld. This report is called a Wage and Tax Statement, or Form W-2. It must be given to employees before January 31 following the year covered by the report. Exhibit 9A.2 shows Form W-2 for one of the

Department of Treasury—Internal Revenue ServiceForm Copy 1–For State, City, or Local Tax Department

Wage and Tax StatementW-2

a Control number

AR101

86-3214587

OMB No. 1545-0006

b Employer identification number (EIN)

4,910.00 1 Wages, tips, other compensation

4,910.00 3 Social security wages

4,910.00 5 Medicare wages and tips

7 Social security tips

9 Advance EIC payment

11 Nonqualified plans 12a Code

12b Code

12c Code

333.37 2 Federal income tax withheld

304.42 4 Social security tax withheld

71.20 6 Medicare tax withheld

8 Allocated tips

10 Dependent care benefits

333-22-9999 d Employee’s social security number

Robert J. e Employee’s first name and initial

AZ 15 State 16 State wages, tips, etc.

13-902319 4,910.00 17 State income tax

26.68 18 Local wages, tips, etc. 19 Local income taxEmployer’s state ID number

f Employee’s address and ZIP code

Austin Last name

c Employer’s name, address and ZIP code

Phoenix Sales & Service 1214 Mill Road

Phoenix, AZ 85621

18 Roosevelt Blvd., Apt. C Tempe, AZ 86322

13 Statutoryemployee Retirement

plan Third-party

sick pay

14 Other

20 Locality name

EXHIBIT 9A.2 Form W-2

358 Chapter 9 Accounting for Current Liabilities

employees at Phoenix Sales & Service. Copies of Form W-2 must be sent to the Social Security Administration, where the amount of the employee’s wages subject to FICA taxes and FICA taxes withheld are posted to each employee’s Social Security account. These posted amounts become the basis for determining an employee’s retirement and survivors’ benefits. The Social Security Administration also transmits to the IRS the amount of each employee’s wages subject to federal income taxes and the amount of taxes withheld.

Payroll Records Employers must keep payroll records in addition to reporting and paying taxes. These records usually include a payroll register and an individual earnings report for each employee.

Payroll Register A payroll register usually shows the pay period dates, hours worked, gross pay, deduc- tions, and net pay of each employee for each pay period. Exhibit 9A.3 shows a payroll register for Phoenix Sales & Service. It is organized into nine columns:

Col. A Employee Identification (ID); Employee name; Social Security number (SS No.); Reference (check number); and Date (date check issued)

Col. B Pay Type (regular and overtime) Col. C Pay Hours (number of hours worked as regular and overtime) Col. D Gross Pay (amount of gross pay) Col. E FIT (federal income taxes withheld); FUTA (federal unemployment taxes) Col. F SIT (state income taxes withheld); SUTA (state unemployment taxes) Col. G FICA-SS_EE (Social Security taxes withheld, employee); FICA-SS_ER (Social Security taxes,

employer) Col. H FICA-Med_EE (Medicare tax withheld, employee); FICA-Med_ER (Medicare tax, employer) Col. I Net Pay (gross pay less amounts withheld from employees)

Net pay for each employee is computed as gross pay minus the items on the first line of columns E through H. The employer’s payroll tax for each employee is computed as the sum of items on the third line of columns E through H. A payroll register includes all data necessary to record payroll. In some software programs, the entries to record payroll are made in a special payroll journal.

Point: Gross Pay column shows regular hours worked on the first line multiplied by regular pay rate. Overtime hours multiplied by the overtime premium rate equals overtime pay on the second line. For this company, workers earn 150% of their regular rate for hours in excess of 40 per week.

A B C D E F G H I

Pay Type

Pay Hours

Gross Pay

Gross Pay

Net Pay

AR101 Robert Austin 333-22-9999 9001, 1/8/19 CJ102 Judy Cross 299-11-9201 9002, 1/8/19 DJ103 John Diaz 444-11-9090 9003, 1/8/19 KK104 Kay Keife 909-11-3344 9004, 1/8/19 ML105 Lee Miller 444-56-3211 9005, 1/8/19 SD106 Dale Sears 909-33-1234 9006, 1/8/19

Employee ID Employee SS No. Refer., Date

FICA-Med_EE

FICA-Med_ER [blank]

FICA-SS_ER

FICA-SS_EE [blank]

SUTA

SIT [blank]

FUTA

FIT [blank]

Phoenix Sales & Service Payroll Register

For Week Ended Jan. 8, 2019

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

40.00

40.00 1.00

40.00

40.00

40.00

40.00 2.00

0.00

0.00

0.00

0.00

240.00 3.00

0.00

400.00

400.00

560.00 21.00

560.00

560.00

560.00

560.00

560.00

560.00

560.00

42.00

581.00

602.00

0.00

0.00

0.00

3,200.00 63.00

3,263.00

–28.99

–2.40

–52.97

–3.49

–48.33

–3.61

–3.36

–3.36

–3.36

–68.57

–34.24

–68.57

–301.67

–19.58 –88.10

–24.15

–15.12

–16.25

–15.12

–5.49

–5.49

–15.12

–2.74

–3.87

–15.69

–4.24

–10.80

–2.32

–34.72

–34.72

–34.72

–34.72

–34.72

–34.72

–37.32

–37.32

–36.02

–36.02

–24.80

–24.80

–202.30

–202.30

–8.12

–8.12

–8.12

–8.12

–8.12

–8.12

–8.73

–8.73

–8.42

–8.42

–5.80

–5.80

–47.31

–47.31

338.09

479.35

503.75

443.10

480.18

443.10

2,687.57Totals

EXHIBIT 9A.3 Payroll Register

Chapter 9 Accounting for Current Liabilities 359

Payroll Check Payment of payroll is usually done by check or electronic funds transfer. Exhibit 9A.4 shows a payroll check for a Phoenix employee. This check includes a detachable statement of earnings (at top) showing gross pay, deductions, and net pay.

AR101 Robert Austin 333-22-9999 1/8/19 1/8/19 EMPLOYEE NO. EMPLOYEE NAME SOCIAL SECURITY NO. PAY PERIOD END

YEAR TO DATETHIS CHECKITEMTOTALHOURSRATEITEM

CHECK DATE

40.00

HOURS WORKED 400.00

GROSS THIS PERIOD 400.00

GROSS YEAR TO DATE

$338.09

NET CHECK 9001

CHECK NO.

(Detach and retain for your records)

Regular Overtime

10.00 15.00

40.00

Three Hundred Thirty–Eight and 9/100 Dollars

Gross Fed. Income tax FICA-Soc. Sec. FICA-Medicare State Income tax

400.00 -28.99 -24.80 -5.80 -2.32

400.00 -28.99 -24.80 -5.80 -2.32

PHOENIX SALES & SERVICE 1214 Mill Road Phoenix, AZ 85621 602-555-8900

Phoenix Bank and Trust Phoenix, AZ 85621 3312-87044

No. 9001

AUTHORIZED SIGNATURE

400.00

.................... 20 .......DATE January 8 19 Check No. .............9001

Robert Austin 18 Roosevelt Blvd., Apt C Tempe, AZ 86322

Pay to the order of

$ **************$338.09Amount .........................................................................................................

EXHIBIT 9A.4 Check and Statement of Earnings

Employee Earnings Report An employee earnings report is a cumulative record of an employee’s hours worked, gross earnings, deductions, and net pay. Payroll information on this report is taken from the payroll register. The employee earnings report for R. Austin at Phoenix Sales & Service is shown in Exhibit 9A.5. An employee earnings report accumulates information that can show when an employee’s

[blank][blank]Date Reference

Gross Pay

FICA-SS_EE FICA-Med_EE [blank] FIT

FUTA [blank] SIT

SUTA FICA-SS_ER FICA-Med_ER Net Pay

2,483.88

338.09

338.09

338.09

338.09

338.09

1,690.45

4,174.33

Beginning balance for Robert Austin

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

Total 5-wk month thru 12/31/19

Employee ID Employee SS No.

Year-to-date total for Robert Austin

12/03/19 9049

11/26/19 (balance)

12/10/19 9055

12/17/19 9061

12/24/19 9067

12/31/19 9073

12/31/19 (balance)

4,910.00

2,000.00

400.00

400.00

400.00

400.00

400.00

2,910.00

–29.46

–333.37 –12.00

–144.95 –2.40

–2.40

–2.40

–28.99

–28.99

–2.40 –28.99

–28.99

–28.99 –17.46

–188.42

–2.40

–304.42

–304.42 –124.00

–124.00 –24.80

–24.80

–24.80

–24.80

–24.80

–24.80 –24.80

–24.80

–24.80 –180.42

–180.42

–24.80

–71.20

–71.20 –29.00

–29.00 –5.80

–5.80

–5.80

–5.80

–5.80

–5.80 –5.80

–5.80

–5.80 –42.20

–42.20

–5.80

–132.57

–26.68 –54.00

–11.60 –10.80

–10.80

–10.80

–2.32

–2.32

–10.80 –2.32

–2.32

–2.32 –78.57

–15.08

–10.80

Phoenix Sales & Service Employee Earnings Report

For Month Ended Dec. 31, 2019

EXHIBIT 9A.5 Employee Earnings Report

Point: Year-end balances agree with W-2.

360 Chapter 9 Accounting for Current Liabilities

Employers often use a wage bracket withholding table similar to the one shown in Exhibit 9A.6 to compute the federal income taxes withheld from each employee’s gross pay. The table in Exhibit 9A.6 is for a single employee paid weekly. Tables also are provided for married employees and for biweekly, semimonthly, and monthly pay periods (most payroll software includes these tables). When using a wage bracket withholding table to compute federal income tax withheld from an employee’s gross wages, we need to locate an employee’s wage bracket within the first two columns. We then find the amount withheld by looking in the withholding allowance column for that employee.

SINGLE Persons—WEEKLY Payroll Period If the wages are–

At least

$600 610 620 630 640 650 660 670 680 690 700 710 720 730 740

$610 620 630 640 650 660 670 680 690 700 710 720 730 740 750

$76 79 81 84 86 89 91 94 96 99 101 104 106 109

111

$67 69 70 72 73 75 76 78 81 83 86 88 91 93 96

$58 59 61 62 64 65 67 68 70 71 73 74 76 78 80

$49 50 52 53 55 56 58 59 61 62 64 65 67 68 70

$39 41 42 44 45 47 48 50 51 53 54 56 57 59 60

$30 32 33 35 36 38 39 41 42 44 45 47 48 50 51

$21 22 24 25 27 28 30 31 33 34 35 37 39 40 42

$12 13 15 16 18 19 21 22 24 25 27 28 30 31 33

$6 7 8 9

10 11 12 13 14 16 17 19

20 22 23

$0 1 2 3 4 5 6 7 8 9

10 11 12 13 14

$0 0 0 0 0 0 0 1 2 3 4 5 6 7 8

But less than

And the number of withholding allowances claimed is— 0 1 2 3 4 5 6 7 8 9 10

The amount of income tax to be withheld is—

EXHIBIT 9A.6 Wage Bracket Withholding Table

Payroll Bank Account Companies with few employees often pay them with checks drawn on the compa- ny’s regular bank account. Companies with many employees often use a special payroll bank account to pay employees. When this account is used, a company either (1) draws one check for total payroll on the regular bank account and deposits it in the payroll bank account or (2) executes an electronic funds transfer to the payroll bank account. Individual payroll checks are then drawn on this payroll bank ac- count. Because only one check for the total payroll is drawn on the regular bank account each payday, use of a special payroll bank account helps with internal control. It also helps in reconciling the regular bank account. When companies use a payroll bank account, they usually include check numbers in the payroll register. The payroll register in Exhibit 9A.3 shows check numbers in column A. For instance, Check No.

Form

1

5

6

7

8 10

Your first name and middle initial

Home address (number and street or rural route)

Total number of allowances you are claiming (from line H above or from the applicable worksheet on page 2)

Employer’s name and address (Employer: Complete lines 8 and 10 only if sending to the IRS.) 9 O…ce code (optional)

Cat. No. 10220Q Form W-4

Employer identification number (EIN)

Under penalties of perjury, I declare that I have examined this certificate and, to the best of my knowledge and belief, it is true, correct, and complete.

Employee’s signature

For Privacy Act and Paperwork Reduction Act Notice, see page 2.

(This form is not valid unless you sign it.) ƒ Date ƒ

Additional amount, if any, you want withheld from each paycheck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I claim exemption from withholding for 20 , and I certify that I meet both of the following conditions for exemption.

• Last year I had a right to a refund of all federal income tax withheld because I had no tax liability, and • This year I expect a refund of all federal income tax withheld because I expect to have no tax liability. If you meet both conditions, write “Exempt” here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

City or town, state, and ZIP code

2 Your social security numberLast name

3

4

5

6

7

$

If your last name di‹ers from that shown on your social security card, check here. You must call 1–800–772–1213 for a replacement card.

Single Married Married, but withhold at higher Single rate.

Note: If married, but legally separated, or spouse is a nonresident alien, check the “Single” box.

Department of the Treasury Internal Revenue Service

OMB No. 1545–0074

20ƒ Whether you are entitled to claim a certain number of allowances or exemption from withholding issubject to review by the IRS. Your employer may be required to send a copy of this form to the IRS. W-4 Employee’s Withholding Allowance Certificate

Robert J. Austin 333-22-9999

18 Roosevelt Blvd., Apt. C

Tempe, AZ 86322

Robert J. Austin January 1

86-3214587Phoenix Sales & Service, 1214 Mill Rd, Phoenix, AZ 85621

ƒ

ƒ

1

earnings reach the tax-exempt points for FICA, FUTA, and SUTA taxes. It also gives data an employer needs to prepare Form W-2.

Payroll Procedures Employers must be able to compute federal income tax for payroll pur- poses. This section explains how we compute this tax and how to use a payroll bank account.

Computing Federal Income Taxes To compute the amount of taxes withheld from each employee’s wages, we need to determine both the employee’s wages earned and the employee’s number of withholding allow- ances. Each employee records the number of withholding allowances claimed on a withholding allowance certificate, Form W-4, filed with the employer. When the number of withholding allowances increases, the amount of income taxes withheld decreases.

Chapter 9 Accounting for Current Liabilities 361

9001 is issued to Robert Austin. With this information, the payroll register serves as a supplementary record of wages earned by and paid to employees.

Who Pays What Payroll Taxes and Benefits We conclude this appendix with the following table identifying who pays which payroll taxes and which common employee benefits such as medical, disability, pension, charitable, and union costs. Who pays which employee benefits, and what portion, is subject to agreements between companies and their workers. Also, self-employed workers must pay both the employer and employee FICA taxes for Social Security and Medicare.

APPENDIX

Corporate Income Taxes 9B This appendix covers current liabilities for income taxes of C corporations. Income tax on sole proprietor- ships, partnerships, S corporations, and LLCs is computed on their owner’s tax filings and is not covered here.

Income Tax Liabilities Corporations are subject to income taxes and must estimate their income tax liabil- ity when preparing financial statements. Because income tax expense is created by earning income, a liability is incurred when income is earned. This tax must be paid quarterly. Consider a corporation that prepares monthly financial statements. Based on its income in January, this corporation estimates that it owes income taxes of $12,100. The following adjusting entry records this estimate.

The tax liability is recorded each month until the first quarterly payment is made. If the company’s esti- mated taxes for this first quarter total $30,000, the entry to record its payment is

This process of accruing and then paying estimated income taxes continues through the year. When an- nual financial statements are prepared at year-end, the corporation knows its actual total income and the actual amount of income taxes it must pay. This information allows it to accurately record income taxes expense for the fourth quarter so that the total of the four quarters’ expense amounts equals the actual taxes paid to the government.

Deferred Income Tax Liabilities An income tax liability for corporations can arise when the amount of income before taxes that the corporation reports on its income statement is not the same as the amount of

Jan. 31 Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,100

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,100

Accrue January income taxes.

Assets = Liabilities + Equity +12,100 −12,100

Assets = Liabilities + Equity −30,000 −30,000

Apr. 10 Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Paid estimated first-quarter income taxes.

Point: IRS reports average (effective) income tax rates for categories of income earners:

Top 1% . . . . . . . . . . . . . . . . . 24% Top 5% . . . . . . . . . . . . . . . . . 20% Top 10% . . . . . . . . . . . . . . . 18% Lower 50% . . . . . . . . . . . . . <2%

Employer Payroll Taxes and Costs Employee Payroll Deductions

• FICA—Social Security taxes • FICA—Social Security taxes

• FICA—Medicare taxes • FICA—Medicare taxes

• FUTA (federal unemployment taxes) • Federal income taxes

• SUTA (state unemployment taxes) • State and local income taxes

• Share of medical coverage, if any • Share of medical coverage, if any

• Share of pension coverage, if any • Share of pension coverage, if any

• Share of other benefits, if any • Share of other benefits, if any

Year-To-Date Pay Employer Taxes Employee Taxes $0 to $7,000 FICA—Medicare FICA—Medicare FICA—Social Security FICA—Social Security FUTA State & Federal Income Tax SUTA

$7,000 to $128,400 FICA—Medicare FICA—Medicare FICA—Social Security FICA—Social Security State & Federal Income Tax

Above $128,400 FICA—Medicare FICA—Medicare State & Federal Income Tax

362 Chapter 9 Accounting for Current Liabilities

income reported on its income tax return. This difference occurs because income tax laws and GAAP measure income differently. Differences between tax laws and GAAP arise because Congress uses tax laws to generate receipts, stimulate the economy, and influence behavior, whereas GAAP is intended to provide financial information useful for business decisions. Also, tax accounting often follows the cash basis, whereas GAAP follows the accrual basis. Some differences between tax laws and GAAP are temporary. Temporary differences arise when the tax return and the income statement report a revenue or expense in different years. As an example, com- panies are often able to deduct higher amounts of depreciation in the early years of an asset’s life and smaller amounts in later years for tax reporting in comparison to GAAP. This means that in the early years, depreciation for tax reporting is often more than depreciation on the income statement. In later years, depreciation for tax reporting is often less than depreciation on the income statement. When tempo- rary differences exist between taxable income on the tax return and the income before taxes on the income statement, corporations compute income taxes expense based on the income reported on the income state- ment. The result is that income taxes expense reported in the income statement is often different from the amount of income taxes payable to the government. This difference is the deferred income tax liability. Assume that in recording its usual quarterly income tax payments, a corporation computes $25,000 of income taxes expense. It also determines that only $21,000 is currently due and $4,000 is deferred to future years (a timing difference). The entry to record this end-of-period adjustment is

Point: For a temporary difference, if GAAP income exceeds taxable income, a deferred tax liability is created. If GAAP income is initially less than taxable income, a deferred tax asset is created.

The credit to Income Taxes Payable is the amount currently due to be paid. The credit to Deferred Income Tax Liability is tax payments deferred until future years when the temporary difference reverses.

Deferred Income Tax Assets Temporary differences also can cause a company to pay income taxes before they are reported on the income statement. If so, the company reports a Deferred Income Tax Asset on its balance sheet.

Dec. 31 Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Deferred Income Tax Liability . . . . . . . . . . . . . . . . . . . . . 4,000

Record tax expense and deferred tax liability.

Assets = Liabilities + Equity +21,000 −25,000 +4,000

KNOWN LIABILITIES Current liabilities (or short-term liabilities): Liabilities due within one year. Long-term liabilities: Liabilities due after one year.

Summary: Cheat Sheet

Note and interest paid:

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

Interest expense incurred but not yet paid:

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Unearned revenue is earned: To record service or product delivered.

Unearned Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000

Note given to replace accounts payable (partial cash paid):

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Unearned Revenue . . . . . . . . . . . . . . . . . . . . . 5,000,000

Unearned revenues (or deferred revenues): Amount received in advance from customers for future products or services; to record cash received in advance.

Short-term note payable: A written promise to pay a specified amount on a stated future date within one year.

Interest formula (year assumed to have 360 days):

Principal of the note ×

Annual interest rate ×

Time expressed in fraction of year = Interest

PAYROLL LIABILITIES Gross pay: Total compensation an employee earns before deductions such as taxes. Payroll deductions (or withholdings): Amounts withheld from an employ- ee’s gross pay, either required or voluntary. FICA—Social Security taxes payable: Withholdings to cover retirement, disability, and survivorship. Social Security tax is 6.2% of the first $128,400 the employee earns for the year.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,300

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Sales Taxes Payable . . . . . . . . . . . . . . . . . . . . 300

Sales tax collection:

Note given to borrow cash:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Chapter 9 Accounting for Current Liabilities 363

FICA—Medicare taxes payable: Withholdings to cover medical bene- fits. The Medicare tax is 1.45% of all amounts the employee earns; there is no maximum limit to Medicare tax. Employee federal income taxes payable: Federal income tax withheld from each employee’s paycheck. Employee voluntary deductions: Voluntary withholdings for things such as union dues, charitable giving, and health insurance.

Federal Unemployment Tax Act (FUTA): Employers pay a federal unem- ployment tax on wages and salaries earned by their employees. FUTA taxes are between 0.6% and 6.0% of the first $7,000 earned by each employee. State Unemployment Tax Act (SUTA): Employers pay a state unemploy- ment tax on wages and salaries earned by their employees. SUTA taxes are up to 5.4% of the first $7,000 earned by each employee.

ESTIMATED LIABILITIES

Employee payroll taxes:

Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

FICA—Social Security Taxes Payable (6.2%) . . . . . 124

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . 29

Employee Federal Income Taxes Payable . . . . . . . 213

Employee Medical Insurance Payable . . . . . . . . . . 85

Employee Union Dues Payable . . . . . . . . . . . . . . . 25

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

Employer payroll taxes expense:

Payroll Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

FICA—Social Security Taxes Payable (6.2%) . . . . . 124

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . 29

State Unemployment Taxes Payable . . . . . . . . . . . 108

Federal Unemployment Taxes Payable . . . . . . . . . 12

Payment of salary to employees:

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

Accrual of vacation benefits (also called paid absences):

Vacation Benefits Expense . . . . . . . . . . . . . . . . . . . . . . . 3,200

Vacation Benefits Payable . . . . . . . . . . . . . . . . . . . 3,200

Warranty: A seller’s obligation to replace or fix a product (or service) that fails to perform as expected within a specified period. Warranty expense is recorded in the period when revenue from the sale of the prod- uct or service is reported.

CONTINGENCIES AND ANALYSIS Contingent liability: A potential liability that depends on a future event arising from a past transaction or event. An example is a pending lawsuit.

Warranty expense accrued:

Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640

Estimated Warranty Liability . . . . . . . . . . . . . . . . . 640

Warranty repairs and replacements:

Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . 200

Auto Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . 200

Vacation benefits are used:

Vacation Benefits Payable . . . . . . . . . . . . . . . . . . . . . . . . 400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Bonus plan accrued:

Employee Bonus Expense . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Bonus Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Health and pension benefits:

Employee Benefits Expense. . . . . . . . . . . . . . . . . . . . . . . 20,000

Employee Medical Insurance Payable . . . . . . . . . . 8,000

Employee Retirement Program Payable . . . . . . . . 12,000

Nonestimable

Estimable

Possible

Remote

Probable

Contingent liability

Future event is Amount owed is Record liability

No disclosure

Disclose in notes

Contingent liability (352) Current liabilities (341) Current portion of long-term debt (349) Deferred income tax liability (362) Employee benefits (349) Employee earnings report (359) Estimated liability (349) Federal depository bank (356) Federal income taxes withheld (360) Federal Insurance Contributions Act

(FICA) taxes (346)

Federal Unemployment Tax Act (FUTA) (347)

Form 940 (356) Form 941 (356) Form W-2 (357) Form W-4 (360) Gross pay (346) Known liabilities (342) Long-term liabilities (342) Merit rating (348) Net pay (346)

Payroll bank account (360) Payroll deductions (346) Payroll register (358) Short-term note payable (343) State Unemployment Tax Act

(SUTA) (347) Times interest earned (354) Wage bracket withholding table (360) Warranty (350)

Key Terms

364 Chapter 9 Accounting for Current Liabilities

Multiple Choice Quiz

1. On December 1, a company signed a $6,000, 90-day, 5% note payable, with principal plus interest due on March 1 of the following year. What amount of interest expense should be accrued at December 31 on the note? a. $300 c. $100 e. $0 b. $25 d. $75

2. An employee earned $50,000 during the year. FICA tax for Social Security is 6.2% and FICA tax for Medicare is 1.45%. The employer’s share of FICA taxes is a. $0; employee’s pay exceeds FICA limit. b. $0; FICA is not an employer tax. c. $3,100. d. $725. e. $3,825.

3. Assume the FUTA tax rate is 0.6% and the SUTA tax rate is 5.4%. Both taxes are applied to the first $7,000 of an employee’s pay. What is the total unemployment tax an employer must pay on an employee’s annual wages of $40,000?

a. $2,400 b. $420 c. $42 d. $378 e. $0; employee’s wages exceed the $7,000 maximum.

4. A company sold 10,000 TVs in July and estimates warranty expense for these TVs to be $25,000. During July, 80 TVs were serviced under warranty at a cost of $18,000. The credit balance in the Estimated Warranty Liability account at July 1 was $26,000. What is the company’s warranty ex- pense for the month of July? a. $51,000 c. $25,000 e. $18,000 b. $1,000 d. $33,000

5. AXE Co. is the defendant in a lawsuit. AXE reasonably esti- mates that this pending lawsuit will result in damages of $99,000. It is probable that AXE will lose the case. What should AXE do? a. Record a liability c. Have no disclosure b. Disclose in notes

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; $6,000 × 0.05 × 30∕360 = $25 2. e; $50,000 × (0.062 + 0.0145) = $3,825 3. b; $7,000 × (0.006 + 0.054) = $420

4. c; $25,000 5. a; Reason—it is reasonably estimated and is a probable loss. AXE

would record an estimated legal expense and liability.

A(B) Superscript letter A or B denotes assignments based on Appendix 9A or 9B.

Icon denotes assignments that involve decision making.

1. What is the difference between a current and a long- term liability?

2. What is an estimated liability? 3. What are the three important questions concerning the

uncertainty of liabilities? 4. What is the combined amount (in percent) of the employee

and employer Social Security tax rate? (Assume wages do not exceed $128,400 per year.)

5. What is the current Medicare tax rate? This rate is applied to what maximum level of salary and wages?

6. Which payroll taxes are the employee’s responsibility and which are the employer’s responsibility?

7. What determines the amount deducted from an employee’s wages for federal income taxes?

8. What is an employer’s unemployment merit rating? How are these ratings assigned to employers?

9. Why are warranty liabilities usually recognized on the balance sheet as liabilities even when they are uncertain?

10. Suppose a company has a facility located where disas- trous weather conditions often occur. Should it report a

probable loss from a future disaster as a liability on its bal- ance sheet? Explain.

11.A What is a wage bracket withholding table? 12.A What amount of income tax is withheld from the salary of

an employee who is single with two withholding allow- ances and earns $725 per week? What if the employee earns $625 and has no withholding allowances? (Use Exhibit 9A.6.)

13. Refer to Apple’s balance sheet in Appendix A. What is the amount of Apple’s accounts pay- able as of September 30, 2017?

14. Refer to Google’s balance sheet in Appendix A. What “accrued” expenses (liabilities) does Google report at December 31, 2017?

15. Refer to Samsung’s balance sheet in Appendix A. List Samsung’s current lia- bilities as of December 31, 2017.

16. Refer to Samsung’s recent balance sheet in Appendix A. What current liabil- ities related to income taxes are on its balance sheet? Explain the meaning of each income tax account identified.

Discussion Questions

APPLE

Samsung

Samsung

GOOGLE

Chapter 9 Accounting for Current Liabilities 365

Dextra Computing sells merchandise for $6,000 cash on September 30 (cost of merchandise is $3,900). Dextra collects 5% sales tax. (1) Record the entry for the $6,000 sale and its sales tax. (2) Record the entry that shows Dextra sending the sales tax on this sale to the government on October 15.

QS 9-2 Accounting for sales taxes

C2

Ticketsales, Inc., receives $5,000,000 cash in advance ticket sales for a four-date tour of Bon Jovi. Record the advance ticket sales on October 31. Record the revenue earned for the first concert date of November 5, assuming it represents one-fourth of the advance ticket sales.

QS 9-3 Unearned revenue C2

On November 7, Mura Company borrows $160,000 cash by signing a 90-day, 8%, $160,000 note payable. (1) Compute the accrued interest payable on December 31; (2) prepare the journal entry to record the ac- crued interest expense at December 31; and (3) prepare the journal entry to record payment of the note at maturity on February 5.

QS 9-4 Interest-bearing note transactions P1

On January 15, the end of the first pay period of the year, North Company’s employees earned $35,000 of sales salaries. Withholdings from the employees’ salaries include FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $6,500 of federal income taxes, $772.50 of medical in- surance deductions, and $120 of union dues. No employee earned more than $7,000 in this first period. Prepare the journal entry to record North Company’s January 15 salaries expense and related liabilities. (Round amounts to cents.)

QS 9-5 Recording employee payroll taxes

P2

Merger Co. has 10 employees, each of whom earns $2,000 per month and has been employed since January 1. FICA Social Security taxes are 6.2% of the first $128,400 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. FUTA taxes are 0.6% and SUTA taxes are 5.4% of the first $7,000 paid to each employee. Prepare the March 31 journal entry to record the March payroll taxes expense.

QS 9-6 Recording employer payroll taxes P3

Noura Company offers an annual bonus to employees (to be shared equally) if the company meets certain net income goals. Prepare the journal entry to record a $15,000 bonus owed (but not yet paid) to its work- ers at calendar year-end.

QS 9-7 Accounting for bonuses

P4

On September 1, Home Store sells a mower (that costs $200) for $500 cash with a one-year warranty that covers parts. Warranty expense is estimated at 8% of sales. On January 24 of the following year, the mower is brought in for repairs covered under the warranty requiring $35 in materials taken from the Repair Parts Inventory. Prepare the September 1 entry to record the mower sale (and cost of sale) and the January 24 entry to record the warranty repairs.

QS 9-9 Recording warranty repairs

P4

Chavez Co.’s salaried employees earn four weeks’ vacation per year. Chavez estimated and must expense $8,000 of accrued vacation benefits for the year. (a) Prepare the December 31 year-end adjusting entry for accrued vacation benefits. (b) Prepare the entry on April 1 of the next year when an employee takes a one- week vacation and is paid $500 cash for that week.

QS 9-8 Accounting for vacations

P4

QUICK STUDY

QS 9-1 Classifying liabilities

C1

Which of the following items are normally classified as current liabilities for a company that has a one- year operating cycle?

1. Portion of long-term note due in 10 months. 4. Accounts payable due in 11 months. 2. Note payable maturing in 2 years. 5. FICA taxes payable. 3. Note payable due in 18 months. 6. Salaries payable.

Riverrun Co. provides medical care and insurance benefits to its retirees. In the current year, Riverrun agrees to pay $5,500 for medical insurance and contribute an additional $9,000 to a retirement program. Record the entry for these accrued (but unpaid) benefits on December 31.

QS 9-10 Accounting for health and pension benefits P4

Huprey Co. is the defendant in the following legal claims. For each of the following claims, indicate whether Huprey should (a) record a liability, (b) disclose in notes, or (c) have no disclosure.

1. Huprey can reasonably estimate that a pending lawsuit will result in damages of $1,250,000. It is probable that Huprey will lose the case.

2. It is reasonably possible that Huprey will lose a pending lawsuit. The loss cannot be estimated. 3. Huprey is being sued for damages of $2,000,000. It is very unlikely (remote) that Huprey will

lose the case.

QS 9-11 Accounting for contingent liabilities

C3

366 Chapter 9 Accounting for Current Liabilities

Sera Corporation has made and recorded its quarterly income tax payments. After a final review of taxes for the year, the company identifies an additional $40,000 of income tax expense that should be recorded. A portion of this additional expense, $6,000, is deferred for payment in future years. Record Sera’s year- end adjusting entry for income tax expense.

QS 9-15B Recording deferred income tax liability P4

1. On July 15, Piper Co. sold $10,000 of merchandise (costing $5,000) for cash. The sales tax rate is 4%. On August 1, Piper sent the sales tax collected from the sale to the government. Record entries for the July 15 and August 1 transactions.

2. On November 3, the Milwaukee Bucks sold a six-game pack of advance tickets for $300 cash. On November 20, the Bucks played the first game of the six-game pack (this represented one-sixth of the advance ticket sales). Record the entries for the November 3 and November 20 transactions.

Exercise 9-2 Recording known current liabilities

C2

The payroll records of Speedy Software show the following information about Marsha Gottschalk, an employee, for the weekly pay period ending September 30. Gottschalk is single and claims one allowance. Compute her Social Security tax (6.2%), Medicare tax (1.45%), federal income tax withholding (use the withholding table in Exhibit 9A.6), state income tax (1.0%), and net pay for the current pay period. Round tax amounts to the nearest cent.

QS 9-14A Net pay and tax computations

P5

Check Net pay, $579.99

Total (gross) earnings for current pay period . . . . . . . . . . . . . . . . $ 740

Cumulative earnings of previous pay periods. . . . . . . . . . . . . . . . $9,700

The following items appear on the balance sheet of a company with a one-year operating cycle. Identify the proper classification of each item as follows: C if it is a current liability, L if it is a long-term liability, or N if it is not a liability.

1. Notes payable (due in 13 to 24 months). 2. Notes payable (due in 6 to 11 months). 3. Notes payable (mature in five years). 4. Current portion of long-term debt. 5. Notes payable (due in 120 days).

6. FUTA taxes payable. 7. Accounts receivable. 8. Sales taxes payable. 9. Salaries payable. 10. Wages payable.

EXERCISES

Exercise 9-1 Classifying liabilities

C1

Sylvestor Systems borrows $110,000 cash on May 15 by signing a 60-day, 12%, $110,000 note. 1. On what date does this note mature? 2. Prepare the entries to record (a) issuance of the note and (b) payment of the note at maturity.

Exercise 9-3 Accounting for note payable P1 Check (2b) Interest expense, $2,200

Keesha Co. borrows $200,000 cash on November 1 of the current year by signing a 90-day, 9%, $200,000 note. 1. On what date does this note mature? 2. How much interest expense is recorded in the current year? (Assume a 360-day year.) 3. How much interest expense is recorded in the following year? (Assume a 360-day year.) 4. Prepare journal entries to record (a) issuance of the note, (b) accrual of interest on December 31, and

(c) payment of the note at maturity.

Exercise 9-4 Interest-bearing notes payable with year-end adjustments P1 Check (2) $3,000 (3) $1,500

Park Company reports interest expense of $145,000 and income before interest expense and income taxes of $1,885,000. (1) Compute its times interest earned. (2) Park’s competitor’s times interest earned is 4.0. Is Park in a better or worse position than its competitor to make interest payments if the economy turns bad?

QS 9-12 Times interest earned

A1

Organic Farmers Co-Op has three employees and pays them weekly. Using the withholding bracket table in Exhibit 9A.6, determine each employee’s federal income tax withholding. 1. Maria earns $735 per week and claims three withholding allowances. 2. Jeff earns $607 per week and claims five withholding allowances. 3. Alicia earns $704 per week and does not claim any withholding allowances.

QS 9-13A Federal income tax withholdings

P5

Chapter 9 Accounting for Current Liabilities 367

Using the data in situation (a) of Exercise 9-5, prepare the employer’s September 30 journal entries to record salary expense and its related payroll liabilities for this employee. The employee’s federal income taxes withheld by the employer are $80 for this pay period. Round amounts to cents.

Exercise 9-6 Payroll-related journal entries P2

Using the data in situation (a) of Exercise 9-5, prepare the employer’s September 30 journal entries to record the employer’s payroll taxes expense and its related liabilities. Round amounts to cents.

Exercise 9-7 Payroll-related journal entries P3

The following monthly data are taken from Ramirez Company at July 31: sales salaries, $200,000; office salaries, $160,000; federal income taxes withheld, $90,000; state income taxes withheld, $20,000; Social Security taxes withheld, $22,320; Medicare taxes withheld, $5,220; medical insurance premiums, $7,000; life insurance premiums, $4,000; union dues deducted, $1,000; and salaries subject to unemployment taxes, $50,000. The employee pays 40% of medical and life insurance premiums. Prepare journal entries to record (1) accrued payroll, including employee deductions, for July; (2) cash payment of the net payroll (salaries payable) for July; (3) accrued employer payroll taxes, and other related employment expenses, for July—assume that FICA taxes are identical to those on employees and that SUTA taxes are 5.4% and FUTA taxes are 0.6%; and (4) cash payment of all liabilities related to the July payroll.

Exercise 9-8 Recording payroll

P2 P3

BMX Company has one employee. FICA Social Security taxes are 6.2% of the first $128,400 paid to its employee, and FICA Medicare taxes are 1.45% of gross pay. For BMX, its FUTA taxes are 0.6% and SUTA taxes are 5.4% of the first $7,000 paid to its employee. Compute BMX’s amounts for each of these four taxes as applied to the employee’s gross earnings for September under each of three separate situa- tions (a), (b), and (c). Round amounts to cents.

Exercise 9-5 Computing payroll taxes

P2 P3

Check (a) FUTA, $3.60; SUTA, $32.40

Gross Pay through August 31 Gross Pay for September

a. $ 6,400 $ 800 b. 2,000 2,100 c. 122,100 8,000

Mest Company has nine employees. FICA Social Security taxes are 6.2% of the first $128,400 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. FUTA taxes are 0.6% and SUTA taxes are 5.4% of the first $7,000 paid to each employee. Cumulative pay for the current year for each of its employees follows.

Exercise 9-9 Computing payroll taxes

P2 P3

Employee Cumulative Pay Employee Cumulative Pay Employee Cumulative Pay

Ken S. . . . . . . . . . . . $ 6,000 Michelle W. . . . . . . . $143,500 Lori K. . . . . . . . . . . . $130,900

Tim V.. . . . . . . . . . . . 40,400 Michael M. . . . . . . . 106,900 Kitty O.. . . . . . . . . . . 36,900

Steve S. . . . . . . . . . . 87,000 Zach R. . . . . . . . . . . 128,400 John W. . . . . . . . . . . 4,000

a. Prepare a table with the following six column headings. Compute the amounts in this table for each employee and then total the numerical columns.

Pay Subject to Pay Subject Pay Subject Pay Subject Cumulative FICA Social to FICA to FUTA to SUTA Employee Pay Security Medicare Taxes Taxes

b. For the company, compute each total for FICA Social Security taxes, FICA Medicare taxes, FUTA taxes, and SUTA taxes. Hint: Remember to include in those totals any employee share of taxes that the company must collect. Round amounts to cents.

Hitzu Co. sold a copier (that costs $4,800) for $6,000 cash with a two-year parts warranty to a customer on August 16 of Year 1. Hitzu expects warranty costs to be 4% of dollar sales. It records warranty expense with an adjusting entry on December 31. On January 5 of Year 2, the copier requires on-site repairs that are completed the same day. The repairs cost $209 for materials taken from the repair parts inventory. These are the only repairs required in Year 2 for this copier. 1. How much warranty expense does the company report for this copier in Year 1? 2. How much is the estimated warranty liability for this copier as of December 31 of Year 1? 3. How much is the estimated warranty liability for this copier as of December 31 of Year 2? 4. Prepare journal entries to record (a) the copier’s sale; (b) the adjustment to recognize the warranty

expense on December 31 of Year 1; and (c) the repairs that occur on January 5 of Year 2.

Exercise 9-10 Warranty expense and liability computations and entries

P4 Check (1) $240

(3) $31

368 Chapter 9 Accounting for Current Liabilities

Prepare adjusting entries at December 31 for Maxum Company’s year-end financial statements for each of the following separate transactions. 1. Employees earn vacation pay at a rate of one day per month. Maxum estimated and must expense

$13,000 of accrued vacation benefits for the year. 2. During December, Maxum Company sold 12,000 units of a product that carries a 60-day warranty.

December sales for this product total $460,000. The company expects 10% of the units to need war- ranty repairs, and it estimates the average repair cost per unit will be $15.

Exercise 9-12 Accounting for estimated liabilities

P4

Vander Co. provides medical care and insurance benefits to its retirees. In the current year, Vander agrees to pay $9,500 for medical insurance and contribute an additional 5% of the employees’ $200,000 gross salaries to a retirement program. (1) Record the entry for these accrued (but unpaid) benefits on December 31. (2) Assuming $5,000 of the retirement benefits are not to be paid for five years, how should this amount be reported on the current balance sheet?

Exercise 9-13 Accounting for health and pension benefits

P4

For each separate situation, indicate whether Cruz Company should (a) record a liability, (b) disclose in notes, or (c) have no disclosure. 1. Cruz Company guarantees the $100,000 debt of a supplier. It is not probable that the supplier will

default on the debt. 2. A disgruntled employee is suing Cruz Company. Legal advisers believe that the company will likely

need to pay damages, but the amount cannot be reasonably estimated.

Exercise 9-14 Accounting for contingent liabilities

C3

For the year ended December 31, Lopez Company implements an employee bonus program based on company net income, which the employees share equally. Lopez’s bonus expense is computed as $14,563. 1. Prepare the journal entry at December 31 to record the bonus due the employees. 2. Prepare the later journal entry at January 19 to record payment of the bonus to employees.

Exercise 9-11 Recording bonuses

P4

Use the following information from separate companies a through d to compute times interest earned. Which company indicates the strongest ability to pay interest expense as it comes due?

Net Income (Loss) Interest Expense Income Taxes

a. $119,000 $44,000 $35,000 b. 135,000 16,000 25,000 c. 138,000 12,000 30,000 d. 314,000 14,000 50,000

Exercise 9-16 Computing and interpreting times interest earned

A1

Check (b) 11.0

Selected accounts from Lue Co.’s adjusted trial balance for the year ended December 31 follow. Prepare a classified balance sheet.

Exercise 9-15 Preparing a balance sheet

C1 P2 P3 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 Employee federal income taxes payable . . . . . . . . $9,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Federal unemployment taxes payable . . . . . . . . . . 200

Salaries payable . . . . . . . . . . . . . . . . . . . . . . 34,000 FICA—Medicare taxes payable . . . . . . . . . . . . . . . . 725

Accounts receivable . . . . . . . . . . . . . . . . . . . 5,100 FICA—Social Security taxes payable . . . . . . . . . . . . 3,100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Employee medical insurance payable . . . . . . . . . . 2,000

Current portion of long-term debt . . . . . . . . 4,000 State unemployment taxes payable . . . . . . . . . . . . 1,800

Notes payable (due in 6 years) . . . . . . . . . . . 10,000 Sales tax payable (due in 2 weeks) . . . . . . . . . . . . 275

Nishi Corporation prepares financial statements for each month-end. As part of its accounting process, es- timated income taxes are accrued each month for 30% of the current month’s net income. The income taxes are paid in the first month of each quarter for the amount accrued for the prior quarter. The following infor-

Exercise 9-17B Accounting for income taxes P4

Chapter 9 Accounting for Current Liabilities 369

Lenny Florita, an unmarried employee, works 48 hours in the week ended January 12. His pay rate is $14 per hour, and his wages have deductions for FICA Social Security, FICA Medicare, and federal income taxes. He claims two withholding allowances. Compute his regular pay, overtime pay (Lenny earns $21 per hour for each hour over 40 per week), and gross pay. Then compute his FICA tax deduction (6.2% for the Social Security portion and 1.45% for the Medicare portion), income tax deduction (use the wage bracket withholding table from Exhibit 9A.6), total deductions, and net pay. Round tax amounts to the nearest cent.

Exercise 9-18A Computing gross and net pay

P5

Check Net pay, $596.30

Stark Company has five employees. Employees paid by the hour earn $10 per hour for the regular 40-hour workweek and $15 per hour beyond the 40 hours per week. Hourly employees are paid every two weeks, but salaried employees are paid monthly on the last biweekly payday of each month. FICA Social Security taxes are 6.2% of the first $128,400 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. FUTA taxes are 0.6% and SUTA taxes are 5.4% of the first $7,000 paid to each employee. The com- pany has a benefits plan that includes medical insurance, life insurance, and retirement funding for em- ployees. Under this plan, employees must contribute 5% of their gross income as a payroll withholding, which the company matches with double the amount. Following is the partially completed payroll register for the biweekly period ending August 31, which is the last payday of August.

Exercise 9-19A Preparing payroll register and related entries

P5

Cumulative Pay (Excludes Current Period)

Current-Period Gross Pay FUTA

Pay Hours

Gross Pay

Pay Type SIT

FIT

SUTA

Kathleen

Anthony

Nichole

Zoey

Gracie

Totals

Employee

$126,600.00

6,800.00

15,100.00

6,500.00

5,000.00

$160,000.00

Regular Overtime

Regular Overtime

Regular Overtime

Salary

Salary

0

4 74

8

80

80

388.00

21.00

22.00

2,380.00

90.00

25.00

100.00

110.00

80.00 300.00

$2,000.00

20.00 25.00 50.00

0.00 740.00

500.00

$7,000.00

FICA-SS_EE FICA-Med_EE

FICA-SS_ER FICA-Med_ER

EE-Ben_Plan Withholding ER-Ben_Plan Expense

Employee Net Pay (Current Period)

Note: Table abbreviations follow those in Exhibit 9A.3; “Ben_Plan” refers to employee (EE) withholding or the employer (ER) expense for the benefits plan.

a. Complete this payroll register by filling in all cells for the pay period ended August 31. Hint: See Exhibit 9A.5 for guidance. Round amounts to cents.

b. Prepare the August 31 journal entry to record the accrued biweekly payroll and related liabilities for deductions.

c. Prepare the August 31 journal entry to record the employer’s cash payment of the net payroll of part b. d. Prepare the August 31 journal entry to record the employer’s payroll taxes including the contribution

to the benefits plan. e. Prepare the August 31 journal entry to pay all liabilities (except for the net payroll in part c) for this

biweekly period.

October net income . . . . . . $28,600 November net income. . . . . $19,100 December net income . . . . . $34,600

1. Determine the amount of the accounting adjustment (dated as of December 31) to get the correct end- ing balance in the Income Taxes Payable account.

2. Prepare journal entries to record (a) the December 31 adjustment to the Income Taxes Payable account and (b) the later January 20 payment of the fourth-quarter taxes.

Check (1) $3,610

mation is available for the fourth quarter of the year just ended. When tax computations are completed on January 20 of the following year, Nishi determines that the quarter’s Income Taxes Payable account balance should be $28,300 on December 31 of the year just ended (its unadjusted balance is $24,690).

370 Chapter 9 Accounting for Current Liabilities

On January 8, the end of the first weekly pay period of the year, Regis Company’s employees earned $22,760 of office salaries and $65,840 of sales salaries. Withholdings from the employees’ salaries include FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $12,860 of federal income taxes, $1,340 of medical insurance deductions, and $840 of union dues. No employee earned more than $7,000 in this first period.

Required

1. Calculate FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the journal entry to record Regis Company’s January 8 employee payroll expenses and liabilities. Round amounts to cents.

2. Prepare the journal entry to record Regis’s employer payroll taxes resulting from the January 8 payroll. Regis’s state unemployment tax rate is 5.4% of the first $7,000 paid to each employee. The federal unemployment tax rate is 0.6%. Round amounts to cents.

Check (1) Cr. Salaries Payable, $66,782.10

(2) Dr. Payroll Taxes Expense, $12,093.90

Problem 9-2A Entries for payroll transactions

P2 P3

Tyrell Co. entered into the following transactions involving short-term liabilities.

Year 1

Apr. 20 Purchased $40,250 of merchandise on credit from Locust, terms n∕30. May 19 Replaced the April 20 account payable to Locust with a 90-day, 10%, $35,000 note payable

along with paying $5,250 in cash. July 8 Borrowed $80,000 cash from NBR Bank by signing a 120-day, 9%, $80,000 note payable. ___?____ Paid the amount due on the note to Locust at the maturity date. ___?____ Paid the amount due on the note to NBR Bank at the maturity date. Nov. 28 Borrowed $42,000 cash from Fargo Bank by signing a 60-day, 8%, $42,000 note payable. Dec. 31 Recorded an adjusting entry for accrued interest on the note to Fargo Bank.

Year 2

___?____ Paid the amount due on the note to Fargo Bank at the maturity date.

Required

1. Determine the maturity date for each of the three notes described. 2. Determine the interest due at maturity for each of the three notes. Assume a 360-day year. 3. Determine the interest expense recorded in the adjusting entry at the end of Year 1. 4. Determine the interest expense recorded in Year 2. 5. Prepare journal entries for all the preceding transactions and events.

Check (2) Locust, $875

(3) $308

(4) $252

PROBLEM SET A

Problem 9-1A Short-term notes payable transactions and entries

P1

In addition to gross pay, the company must pay two-thirds of the $60 per employee weekly health insur- ance; each employee pays the remaining one-third. The company also contributes an extra 8% of each employee’s gross pay (at no cost to employees) to a pension fund.

Required

Compute the following for the week ended August 25 (round amounts to the nearest cent): 1. Each employee’s FICA withholdings for Social Security. 2. Each employee’s FICA withholdings for Medicare. 3. Employer’s FICA taxes for Social Security.

Paloma Co. has four employees. FICA Social Security taxes are 6.2% of the first $128,400 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. Also, for the first $7,000 paid to each employee, the company’s FUTA taxes are 0.6% and SUTA taxes are 5.4%. The company is preparing its payroll calculations for the week ended August 25. Payroll records show the following information for the company’s four employees.

Problem 9-3A Payroll expenses, withholdings, and taxes

P2 P3

1

2

3

4

5

6

Current Week

30

$284 145 39

D

Income Tax Withholding Dali Trey Kiesha Chee

A

Name $127,300 127,500

6,900 1,250

B

Gross Pay through Aug. 18

C

Gross Pay $2,000

900 450 400

Check (3) $176.70

Chapter 9 Accounting for Current Liabilities 371

4. Employer’s FICA taxes for Medicare. 5. Employer’s FUTA taxes. 6. Employer’s SUTA taxes. 7. Each employee’s net (take-home) pay. 8. Employer’s total payroll-related expense for each employee.

(4) $54.38

(5) $3.00

(7) Total net pay, $2,940.92

On October 29, Lobo Co. began operations by purchasing razors for resale. The razors have a 90-day war- ranty. When a razor is returned, the company discards it and mails a new one from merchandise inventory to the customer. The company’s cost per new razor is $20 and its retail selling price is $75. The company expects warranty costs to equal 8% of dollar sales. The following transactions occurred.

Nov. 11 Sold 105 razors for $7,875 cash. 30 Recognized warranty expense related to November sales with an adjusting entry. Dec. 9 Replaced 15 razors that were returned under the warranty. 16 Sold 220 razors for $16,500 cash. 29 Replaced 30 razors that were returned under the warranty. 31 Recognized warranty expense related to December sales with an adjusting entry.

Jan. 5 Sold 150 razors for $11,250 cash. 17 Replaced 50 razors that were returned under the warranty. 31 Recognized warranty expense related to January sales with an adjusting entry.

Required

1. Prepare journal entries to record these transactions and adjustments. 2. How much warranty expense is reported for November and for December? 3. How much warranty expense is reported for January? 4. What is the balance of the Estimated Warranty Liability account as of December 31? 5. What is the balance of the Estimated Warranty Liability account as of January 31?

Check (3) $900

(4) $1,050 Cr.

(5) $950 Cr.

Problem 9-4A Estimating warranty expense and liability

P4

Shown here are condensed income statements for two different companies (assume no income taxes).

Required

1. Compute times interest earned for Miller Company and for Weaver Company. 2. What happens to each company’s net income if sales increase by 30%? 3. What happens to each company’s net income if sales increase by 50%? 4. What happens to each company’s net income if sales decrease by 10%? 5. What happens to each company’s net income if sales decrease by 40%?

Analysis Component

6. Which company would have a greater ability to pay interest expense if sales were to decrease?

Check (2) Miller net income, $200,000 (43% increase)

(4) Weaver net income, $100,000 (29% decrease)

Miller Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Variable expenses (80%) . . . . . . . . . . . 800,000

Income before interest . . . . . . . . . . . . . 200,000

Interest expense (fixed) . . . . . . . . . . . . 60,000

Net income . . . . . . . . . . . . . . . . . . . . . . $ 140,000

Weaver Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Variable expenses (60%) . . . . . . . . . . . 600,000

Income before interest . . . . . . . . . . . . . 400,000

Interest expense (fixed) . . . . . . . . . . . . 260,000

Net income . . . . . . . . . . . . . . . . . . . . . . $ 140,000

Problem 9-5A Computing and analyzing times interest earned

A1

Francisco Company has 10 employees, each of whom earns $2,800 per month and is paid on the last day of each month. All 10 have been employed continuously at this amount since January 1. On March 1, the following accounts and balances exist in its general ledger. a. FICA—Social Security Taxes Payable, $3,472; FICA—Medicare Taxes Payable, $812. (The balances

of these accounts represent total liabilities for both the employer’s and employees’ FICA taxes for the February payroll only.)

b. Employees’ Federal Income Taxes Payable, $4,000 (liability for February only). c. Federal Unemployment Taxes Payable, $336 (liability for January and February together). d. State Unemployment Taxes Payable, $3,024 (liability for January and February together).

Problem 9-6AA Entries for payroll transactions

P5

[continued on next page]

372 Chapter 9 Accounting for Current Liabilities

The company had the following payroll transactions.

Mar. 15 Issued check payable to Swift Bank, a federal depository bank authorized to accept employers’ payments of FICA taxes and employee income tax withholdings. The $8,284 check is in pay- ment of the February FICA and employee income taxes.

31 Recorded the journal entry for the March salaries payable. Then recorded the cash payment of the March payroll (the company issued checks payable to each employee in payment of the March payroll). The payroll register shows the following summary totals for the March pay period.

Salaries Federal

Office Shop Gross FICA Income Net Salaries Salaries Pay Taxes* Taxes Pay

$11,200 $16,800 $28,000 $1,736 $4,000 $21,858

$ 406

*FICA taxes are Social Security and Medicare, respectively.

31 Recorded the employer’s payroll taxes resulting from the March payroll. The company has a state unemployment tax rate of 5.4% on the first $7,000 paid to each employee. The federal rate is 0.6%.

Apr. 15 Issued check to Swift Bank in payment of the March FICA and employee income taxes. 15 Issued check to the State Tax Commission for the January, February, and March state unem-

ployment taxes. Filed the check and the first-quarter tax return with the Commission. 30 Issued check payable to Swift Bank in payment of the employer’s FUTA taxes for the first quar-

ter of the year. 30 Filed Form 941 with the IRS, reporting the FICA taxes and the employees’ federal income tax

withholdings for the first quarter.

Required

Prepare journal entries to record these transactions and events.

March 31: Dr. Payroll Taxes Expense, $2,982

April 15: Cr. Cash, $8,284 (Swift Bank)

Check March 31: Salaries Payable, $21,858

PROBLEM SET B

Problem 9-1B Short-term notes payable transactions and entries

P1

Warner Co. entered into the following transactions involving short-term liabilities.

Year 1

Apr. 22 Purchased $5,000 of merchandise on credit from Fox-Pro, terms n∕30. May 23 Replaced the April 22 account payable to Fox-Pro with a 60-day, 15% $4,600 note payable

along with paying $400 in cash. July 15 Borrowed $12,000 cash from Spring Bank by signing a 120-day, 10%, $12,000 note payable. ___?____ Paid the amount due on the note to Fox-Pro at maturity. ___?____ Paid the amount due on the note to Spring Bank at maturity. Dec. 6 Borrowed $8,000 cash from City Bank by signing a 45-day, 9%, $8,000 note payable. 31 Recorded an adjusting entry for accrued interest on the note to City Bank.

Year 2

___?____ Paid the amount due on the note to City Bank at maturity.

Required

1. Determine the maturity date for each of the three notes described. 2. Determine the interest due at maturity for each of the three notes. Assume a 360-day year. 3. Determine the interest expense recorded in the adjusting entry at the end of Year 1. 4. Determine the interest expense recorded in Year 2. 5. Prepare journal entries for all the preceding transactions and events.

Check (2) Fox-Pro, $115

(3) $50

(4) $40

Tavella Company’s first weekly pay period of the year ends on January 8. On that date, Tavella’s sales employees earned $34,745, office employees earned $21,225, and delivery employees earned $1,030 in salaries. The employees are to have withheld from their salaries FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $8,625 of federal income taxes, $1,160 of medical insur- ance deductions, and $138 of union dues. No employee earned more than $7,000 in the first pay period.

Problem 9-2B Entries for payroll transactions

P2 P3

Chapter 9 Accounting for Current Liabilities 373

Required

1. Calculate FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the journal entry to record Tavella Company’s January 8 employee payroll expenses and liabilities. Round amounts to cents.

2. Prepare the journal entry to record Tavella’s employer payroll taxes resulting from the January 8 pay- roll. Tavella’s state unemployment tax rate is 5.4% of the first $7,000 paid to each employee. The federal unemployment tax rate is 0.6%. Round amounts to cents.

Check (1) Cr. Salaries Payable, $42,716.50

(2) Dr. Payroll Taxes Expense, $7,780.50

Fishing Guides Co. has four employees. FICA Social Security taxes are 6.2% of the first $128,400 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. Also, for the first $7,000 paid to each employee, the company’s FUTA taxes are 0.6% and SUTA taxes are 5.4%. The company is preparing its payroll calculations for the week ended September 30. Payroll records show the following information for the company’s four employees.

Problem 9-3B Payroll expenses, withholdings, and taxes

P2 P3

Ahmed Carlos Jun Marie

$126,800 126,885

6,650 23,700 68

$198 182 32

1

2

3

4

5

6

BA D

Current Week Income Tax WithholdingName

Gross Pay through Sep. 23

C

Gross Pay $2,500

1,515 475

1,000

In addition to gross pay, the company must pay 60% of the $50 per employee weekly health insurance; each employee pays the remaining 40%. The company also contributes an extra 5% of each employee’s gross pay (at no cost to employees) to a pension fund.

Required

Compute the following for the week ended September 30 (round amounts to the nearest cent): 1. Each employee’s FICA withholdings for Social Security. 2. Each employee’s FICA withholdings for Medicare. 3. Employer’s FICA taxes for Social Security. 4. Employer’s FICA taxes for Medicare. 5. Employer’s FUTA taxes. 6. Employer’s SUTA taxes. 7. Each employee’s net (take-home) pay. 8. Employer’s total payroll-related expense for each employee.

Check (3) $284.58

(4) $79.61

(5) $2.10

(7) Total net pay, $4,565.81

On November 10, Lee Co. began operations by purchasing coffee grinders for resale. The grinders have a 60-day warranty. When a grinder is returned, the company discards it and mails a new one from merchan- dise inventory to the customer. The company’s cost per new grinder is $24 and its retail selling price is $50. The company expects warranty costs to equal 10% of dollar sales. The following transactions occurred.

Nov. 16 Sold 50 grinders for $2,500 cash. 30 Recognized warranty expense related to November sales with an adjusting entry. Dec. 12 Replaced six grinders that were returned under the warranty. 18 Sold 200 grinders for $10,000 cash. 28 Replaced 17 grinders that were returned under the warranty. 31 Recognized warranty expense related to December sales with an adjusting entry.

Jan. 7 Sold 40 grinders for $2,000 cash. 21 Replaced 36 grinders that were returned under the warranty. 31 Recognized warranty expense related to January sales with an adjusting entry.

Required

1. Prepare journal entries to record these transactions and adjustments. 2. How much warranty expense is reported for November and for December? 3. How much warranty expense is reported for January? 4. What is the balance of the Estimated Warranty Liability account as of December 31? 5. What is the balance of the Estimated Warranty Liability account as of January 31?

Problem 9-4B Estimating warranty expense and liability

P4

Check (3) $200

(4) $698 Cr.

(5) $34 Cr.

374 Chapter 9 Accounting for Current Liabilities

Shown here are condensed income statements for two different companies (assume no income taxes).

Ellis Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Variable expenses (50%) . . . . . . . . . . . 120,000

Income before interest . . . . . . . . . . . . . 120,000

Interest expense (fixed) . . . . . . . . . . . . 90,000

Net income . . . . . . . . . . . . . . . . . . . . . . $ 30,000

Seidel Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Variable expenses (75%) . . . . . . . . . . . 180,000

Income before interest . . . . . . . . . . . . . 60,000

Interest expense (fixed) . . . . . . . . . . . . 30,000

Net income . . . . . . . . . . . . . . . . . . . . . . $ 30,000

Problem 9-5B Computing and analyzing times interest earned

A1

Required

1. Compute times interest earned for Ellis Company and for Seidel Company. 2. What happens to each company’s net income if sales increase by 10%? 3. What happens to each company’s net income if sales increase by 40%? 4. What happens to each company’s net income if sales decrease by 20%? 5. What happens to each company’s net income if sales decrease by 50%?

Analysis Component

6. Which company would have a greater ability to pay interest expense if sales were to decrease?

Check (3) Ellis net income, $78,000 (160% increase) (4) Seidel net income, $18,000 (40% decrease)

MLS Company has five employees, each of whom earns $1,600 per month and is paid on the last day of each month. All five have been employed continuously at this amount since January 1. On June 1, the fol- lowing accounts and balances exist in its general ledger. a. FICA—Social Security Taxes Payable, $992; FICA—Medicare Taxes Payable, $232. (The balances of

these accounts represent total liabilities for both the employer’s and employees’ FICA taxes for the May payroll only.)

b. Employees’ Federal Income Taxes Payable, $1,050 (liability for May only). c. Federal Unemployment Taxes Payable, $66 (liability for April and May together). d. State Unemployment Taxes Payable, $594 (liability for April and May together). The company had the following payroll transactions.

June 15 Issued check payable to Security Bank, a federal depository bank authorized to accept employ- ers’ payments of FICA taxes and employee income tax withholdings. The $2,274 check is in payment of the May FICA and employee income taxes.

30 Recorded the journal entry for the June salaries payable. Then recorded the cash payment of the June payroll (the company issued checks payable to each employee in payment of the June pay- roll). The payroll register shows the following summary totals for the June pay period.

Problem 9-6BA Entries for payroll transactions

P5

Check June 30: Cr. Salaries Payable, $6,338

Salaries Federal

Office Shop Gross FICA Income Net Salaries Salaries Pay Taxes* Taxes Pay

$3,800 $4,200 $8,000 $496 $1,050 $6,338

$116

*FICA taxes are Social Security and Medicare, respectively.

30 Recorded the employer’s payroll taxes resulting from the June payroll. The company has a state unemployment tax rate of 5.4% on the first $7,000 paid to each employee. The federal rate is 0.6%.

July 15 Issued check payable to Security Bank in payment of the June FICA and employee income taxes. 15 Issued check to the State Tax Commission for the April, May, and June state unemployment

taxes. Filed the check and the second-quarter tax return with the State Tax Commission. 31 Issued check payable to Security Bank in payment of the employer’s FUTA taxes for the first

quarter of the year. 31 Filed Form 941 with the IRS, reporting the FICA taxes and the employees’ federal income tax

withholdings for the second quarter.

Required

Prepare journal entries to record the transactions and events.

Check June 30: Dr. Payroll Taxes Expense, $612

July 15: Cr. Cash, $2,274 (Security Bank)

Chapter 9 Accounting for Current Liabilities 375

SERIAL PROBLEM Business Solutions

C2 P2 P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 9 Review the February 26 and March 25 transactions for Business Solutions (SP 4) from Chapter 4.

Feb. 26 The company paid cash to Lyn Addie for eight days’ work at $125 per day. Mar. 25 The company sold merchandise with a $2,002 cost for $2,800 on credit to Wildcat Services,

invoice dated March 25.

Required

1. Assume that Lyn Addie is an unmarried employee. Her $1,000 of wages have deductions for FICA Social Security taxes, FICA Medicare taxes, and federal income taxes. Her federal income taxes for this pay period total $159. Compute her net pay for the eight days’ work paid on February 26. Round amounts to the nearest cent.

2. Record the journal entry to reflect the payroll payment to Lyn Addie as computed in part 1. 3. Record the journal entry to reflect the (employer) payroll tax expenses for the February 26 payroll

payment. Assume Lyn Addie has not met earnings limits for FUTA and SUTA (the FUTA rate is 0.6% and the SUTA rate is 5.4% for the company). Round amounts to the nearest cent.

4. Record the entry(ies) for the merchandise sold on March 25 if a 4% sales tax rate applies. ©Alexander Image/Shutterstock

COMPREHENSIVE PROBLEM

Bug-Off Exterminators (Review of Chapters 1–9)

CP 9 Bug-Off Exterminators provides pest control services and sells extermination products manufac- tured by other companies. The following six-column table contains the company’s unadjusted trial bal- ance as of December 31, 2019.

Unadjusted Adjusted December 31, 2019 Trial Balance Adjustments Trial Balance

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . 4,000 Allowance for doubtful accounts . . . . . . . . . . . $ 828 Merchandise inventory . . . . . . . . . . . . . . . . . . . 11,700 Trucks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Accum. depreciation—Trucks . . . . . . . . . . . . . . 0 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Accum. depreciation—Equipment . . . . . . . . . . 12,200 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . 5,000 Estimated warranty liability. . . . . . . . . . . . . . . . 1,400 Unearned services revenue . . . . . . . . . . . . . . . 0 Interest payable. . . . . . . . . . . . . . . . . . . . . . . . . 0 Long-term notes payable . . . . . . . . . . . . . . . . . 15,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 49,700 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Extermination services revenue . . . . . . . . . . . . 60,000 Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . 872 Sales (of merchandise) . . . . . . . . . . . . . . . . . . . 71,026 Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . 46,300 Depreciation expense—Trucks . . . . . . . . . . . . . 0 Depreciation expense—Equipment . . . . . . . . . 0 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 0 Rent expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Bad debts expense . . . . . . . . . . . . . . . . . . . . . . 0 Miscellaneous expense. . . . . . . . . . . . . . . . . . . 1,226 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . 6,800 Warranty expense . . . . . . . . . . . . . . . . . . . . . . . 0 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $226,026 $226,026

376 Chapter 9 Accounting for Current Liabilities

The following information in a through h applies to the company at the end of the current year. a. The bank reconciliation as of December 31, 2019, includes the following facts.

Reported on the bank statement is a canceled check that the company failed to record. (Information from the bank reconciliation allows you to determine the amount of this check, which is a payment on an account payable.)

b. An examination of customers’ accounts shows that accounts totaling $679 should be written off as uncollectible. Using an aging of receivables, the company determines that the ending balance of the Allowance for Doubtful Accounts should be $700.

c. A truck is purchased and placed in service on January 1, 2019. Its cost is being depreciated with the straight-line method using the following facts and estimates.

d. Two items of equipment (a sprayer and an injector) were purchased and put into service in early January 2017. They are being depreciated with the straight-line method using these facts and estimates.

Sprayer Injector

Original cost . . . . . . . . . . . . . . . . . . . . . . $27,000 $18,000

Expected salvage value . . . . . . . . . . . . . $ 3,000 $ 2,500

Useful life (years) . . . . . . . . . . . . . . . . . . 8 5

e. On August 1, 2019, the company is paid $3,840 cash in advance to provide monthly service for an apartment complex for one year. The company began providing the services in August. When the cash was received, the full amount was credited to the Extermination Services Revenue account.

f. The company offers a warranty for the services it sells. The expected cost of providing warranty ser- vice is 2.5% of the extermination services revenue of $57,760 for 2019. No warranty expense has been recorded for 2019. All costs of servicing warranties in 2019 were properly debited to the Estimated Warranty Liability account.

g. The $15,000 long-term note is an 8%, five-year, interest-bearing note with interest payable annually on December 31. The note was signed with First National Bank on December 31, 2019.

h. The ending inventory of merchandise is counted and determined to have a cost of $11,700. Bug-Off uses a perpetual inventory system.

Required

1. Use the preceding information to determine amounts for the following items. a. Correct (reconciled) ending balance of Cash; and the amount of the omitted check. b. Adjustment needed to obtain the correct ending balance of the Allowance for Doubtful Accounts. c. Depreciation expense for the truck used during year 2019. d. Depreciation expense for the two items of equipment used during year 2019. e. The adjusted 2019 ending balances of the Extermination Services Revenue and Unearned Services

Revenue accounts. f. The adjusted 2019 ending balances of the Warranty Expense and the Estimated Warranty Liability

accounts. g. The adjusted 2019 ending balances of the Interest Expense and the Interest Payable accounts.

(Round amounts to nearest whole dollar.) 2. Use the results of part 1 to complete the six-column table by first entering the appropriate adjustments

for items a through g and then completing the Adjusted Trial Balance columns. Hint: Item b requires two adjustments.

3. Prepare journal entries to record the adjustments entered on the six-column table. Assume Bug-Off’s adjusted balance for Merchandise Inventory matches the year-end physical count.

4. Prepare a single-step income statement, a statement of retained earnings (cash dividends during 2019 were $10,000), and a classified balance sheet.

Check (1a) Reconciled cash bal. $15,750 (1b) $551 credit

Cash balance per bank . . . . . . . . . . . . . . $15,100 Deposit in transit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,450

Cash balance per books. . . . . . . . . . . . . . 17,000 Interest earned (on bank account) . . . . . . . . . . . . . . . . . . 52

Outstanding checks . . . . . . . . . . . . . . . . . 1,800 Bank service charges (miscellaneous expense) . . . . . . . 15

Original cost. . . . . . . . $32,000 Expected salvage value . . . . . . . . . $8,000 Useful life (years) . . . . . . . . 4

(2) Adjusted trial balance totals, $238,207

(4) Net income, $9,274; Total assets, $82,771

(1f ) Estimated Warranty Liability, $2,844 Cr.

Chapter 9 Accounting for Current Liabilities 377

GENERAL LEDGER PROBLEM

GL 9-1 General Ledger assignment GL 9-1, based on Problem 9-1A, focuses on transactions related to accounts and notes payable and highlights the impact each transaction has on interest expense, if any. Prepare the journal entries related to accounts and notes payable; the schedules for accounts payable and notes payable are automatically completed using the General Ledger tool. Compute both the amount and timing of interest expense for each note. Prepare the subsequent-period journal entries related to accrued interest.

GL

COMPANY ANALYSIS A1 P4

Accounting Analysis

AA 9-1 Use the table below and Apple’s financial statements in Appendix A to answer the following.

$ millions 2017 2016 2015

Interest expense. . . . . . . . . . $2,323 $1,456 $733

1. Compute times interest earned for each of the three years shown. 2. Is Apple in a good or bad position to pay interest obligations? Assume an industry average of 10. 3. Identify Apple’s total accrued expenses in 2017.

APPLE

Required

1. Compute times interest earned for the three years’ data shown for each company. 2. In the current year, and using times interest earned, which company appears better able to pay interest

obligations? 3. In the current year, and using times interest earned, is the company in a good or bad position to pay

interest obligations for (a) Apple and (b) Google? Assume an industry average of 10.

AA 9-2 Key figures for Apple and Google follow. COMPARATIVE ANALYSIS A1 Apple Google

Current One Year Two Years Current One Year Two Years $ millions Year Prior Prior Year Prior Prior

Net income . . . . . . . . . . . . . $48,351 $45,687 $53,394 $12,662 $19,478 $16,348

Income taxes. . . . . . . . . . . . 15,738 15,685 19,121 14,531 4,672 3,303

Interest expense. . . . . . . . . 2,323 1,456 733 109 124 104

APPLE GOOGLE

AA 9-3 Comparative figures for Samsung, Apple, and Google follow.

Samsung Apple Google

Current Prior Current Prior Current Prior In millions Year Year Year Year Year Year

Net income. . . . . . . . . . . . . . . . . . . . . . W42,186,747 W22,726,092 $48,351 $45,687 $12,662 $19,478

Income taxes . . . . . . . . . . . . . . . . . . . . 14,009,220 7,987,560 15,738 15,685 14,531 4,672

Interest expense . . . . . . . . . . . . . . . . . 655,402 587,831 2,323 1,456 109 124

GLOBAL ANALYSIS A1

Required

1. Compute the times interest earned ratio for the most recent two years for Samsung using the data shown.

2. Is the change in Samsung’s times interest earned ratio favorable or unfavorable? 3. In the current year, is Samsung’s times interest earned ratio better or worse than the same ratio for

(a) Apple and (b) Google?

Samsung APPLE GOOGLE

378 Chapter 9 Accounting for Current Liabilities

ETHICS CHALLENGE P4

BTN 9-1 Cameron Bly is a sales manager for an automobile dealership. He earns a bonus each year based on revenue from the number of autos sold in the year less related warranty expenses. Actual warranty expenses have varied over the prior 10 years from a low of 3% of an automobile’s selling price to a high of 10%. In the past, Bly has tended to estimate warranty expenses on the high end to be conservative. He must work with the dealership’s accountant at year-end to arrive at the warranty expense accrual for cars sold each year. 1. Does the warranty accrual decision create any ethical dilemma for Bly? 2. Because warranty expenses vary, what percent do you think Bly should choose for the current year?

Justify your response.

Beyond the Numbers

BTN 9-2 Dusty Johnson is the accounting and finance manager for a manufacturer. At year-end, he must determine how to account for the company’s contingencies. His manager, Tom Pretti, objects to Johnson’s proposal to recognize an expense and a liability for warranty service on units of a new product introduced in the fourth quarter. Pretti comments, “There’s no way we can estimate this warranty cost. We don’t owe anyone anything until a product fails and it is returned. Let’s report an expense if and when we do any warranty work.”

Required

Prepare a one-page memorandum for Johnson to send to Pretti defending his proposal.

COMMUNICATING IN PRACTICE C3

BTN 9-3 Access the March 1, 2017, filing of the December 31, 2016, annual 10-K report of McDonald’s Corporation (ticker: MCD), which is available from SEC.gov.

Required

1. Identify the current liabilities on McDonald’s balance sheet as of December 31, 2016. 2. Use the consolidated statement of income for the year ended December 31, 2016, to compute

McDonald’s times interest earned ratio. Comment on the result. Assume an industry average of 5.0.

TAKING IT TO THE NET C1 A1

BTN 9-4 Assume that your team is in business and you must borrow $6,000 cash for short-term needs. You have been shopping banks for a loan, and you have the following two options. A. Sign a $6,000, 90-day, 10% interest-bearing note dated June 1. B. Sign a $6,000, 120-day, 8% interest-bearing note dated June 1.

Required

1. Discuss these two options and determine the better choice. Ensure that all teammates concur with the decision and understand the rationale.

2. Each member of the team is to prepare one of the following journal entries. a. Option A—at date of issuance. b. Option B—at date of issuance. c. Option A—at maturity date. d. Option B—at maturity date. 3. In rotation, each member is to explain to the team the entry he or she prepared in part 2. Ensure that all

team members concur with and understand the entries. 4. Assume that the funds are borrowed on December 1 (instead of June 1) and your business operates on

a calendar-year reporting period. Each member of the team is to prepare one of the following entries. a. Option A—the year-end adjustment. b. Option B—the year-end adjustment. c. Option A—at maturity date. d. Option B—at maturity date. 5. In rotation, each member is to explain to the team the entry he or she prepared in part 4. Ensure that all

team members concur with and understand the entries.

TEAMWORK IN ACTION C2 P1

Chapter 9 Accounting for Current Liabilities 379

BTN 9-5 Review the chapter’s opening feature about Tim Westergren and the business he founded, Pandora. Assume that he is considering expanding the business to Europe and that the current abbrevi- ated income statement appears as follows.

PANDORA Income Statement

For Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Operating expenses (55%) . . . . . . . . . . . 550,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 450,000

Assume also that the company currently has no interest-bearing debt. If it expands to Europe, it will re- quire a $300,000 loan. The company has found a bank that will loan it the money on a 7% note payable. The company believes that, at least for the first few years, sales in Europe will equal $250,000 and that all expenses at both locations will continue to equal 55% of sales.

Required

1. Prepare an income statement (showing three separate columns for current operations, European, and total) for the company assuming that it borrows the funds and expands to Europe. Annual revenues for current operations are expected to remain at $1,000,000.

2. Compute the company’s times interest earned under the expansion assumptions in part 1. 3. Assume sales in Europe are $400,000. Prepare an income statement (with columns for current opera-

tions, European, and total) for the company and compute times interest earned. 4. Assume sales in Europe are $100,000. Prepare an income statement (with columns for current opera-

tions, European, and total) for the company and compute times interest earned. 5. Comment on your results from parts 1 through 4.

ENTREPRENEURIAL DECISION A1

BTN 9-6 Check the Social Security Administration website (SSA.gov) to locate the Social Security office near you. Visit the office to request a personal earnings and estimate form. Fill out the form and mail according to the instructions. You will receive a statement from the Social Security Administration regard- ing your earnings history and future Social Security benefits you can receive. (Formerly the request could be made online. The online service has been discontinued and is now under review by the Social Security Administration due to security concerns; however, it might once again be available online.) It is good to request an earnings and benefit statement every 5 to 10 years to make sure you have received credit for all wages earned and for which you and your employer have paid taxes into the system.

HITTING THE ROAD P2

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Learning Objectives

CONCEPTUAL C1 Explain the types of notes and prepare

entries to account for notes.

C2 Appendix 10A—Explain and compute bond pricing.

C3 Appendix 10C—Describe accounting for leases and pensions.

ANALYTICAL A1 Compare bond financing with stock

financing.

P3 Record issuance and amortization of premium bonds using the straight-line method.

P4 Record the retirement of bonds.

P5 Appendix 10B—Compute and record amortization of a bond discount using the effective interest method.

P6 Appendix 10B—Compute and record amortization of a bond premium using the effective interest method.

A2 Assess debt features and their implications.

A3 Compute the debt-to-equity ratio and explain its use.

PROCEDURAL P1 Record issuance and interest expense

for par bonds.

P2 Record issuance and amortization of discount bonds using the straight-line method.

Chapter Preview

10 Accounting for Long-Term Liabilities

NTK 10-4

LONG-TERM NOTES

C1 Recording notes

DEBT ANALYSIS

A2 Debt features A3 Debt-to-equity

NTK 10-3

PREMIUM BONDS

P3 Bond payments Amortize premium

Straight-line

P4 Bond retirement

NTK 10-1

BOND BASICS

A1 Bond financing Bond trading

P1 Par bonds

NTK 10-2

DISCOUNT BONDS

Discount or premium

P2 Bond payments Amortize discount

Straight-line

381

“Believe in your product”—Scott Borba

At Face Value

OAKLAND, CA—Joey Shamah, a college student, met Scott Borba at a party. The two men talked at length, but it was not your typical “party” talk. Instead, they discussed the women’s cosmetics market!

Scott explains that he saw “all these women with Louis Vuitton purses . . . buying truckloads of lip balms and nail polishes” from 99 cent stores. “There’s a major market here,” insists Scott.

Joey and Scott agreed to work together to fill this market void by forming e.l.f. Cosmetics (elfCosmetics.com). “We felt women shouldn’t have to skip lunch or not go out for dinner or have other cutbacks to afford makeup,” recalls Joey.

As e.l.f. grows, Joey and Scott make decisions on how to finance that growth. Up to now, they have used a mix of long- term debt and equity.

Financing a large part of their business with long-term debt requires that Joey and Scott carefully manage liabilities. This is especially true with long-term financing from sources such as notes and bonds. They also know that retaining more equity in the business helped them personally when e.l.f. issued stock.

Joey and Scott welcome the financial rewards, yet they insist e.l.f. is about making the consumer feel more confident. “The con- sumer feels better inside” from using e.l.f. products, claims Scott. “There’s more of a glimmer.”

Sources: e.l.f. Cosmetics website, January 2019; CNN, January 2006

©Clemens Bilan/Douglas/Getty Images

This section explains bonds and reasons for issuing them. Both for-profit and nonprofit compa- nies, as well as governmental units, such as nations, states, cities, and schools, issue bonds.

Bond Financing Projects that need a lot of money often are financed with bonds. A bond is its issuer’s written promise to pay the par value of the bond with interest. The par value of a bond, or face value, is paid at a stated future date called the maturity date. Most bonds require the issuer to make semiannual (twice a year) interest payments. Interest is computed by multiplying the par value by the bond’s contract rate.

Advantages of Bonds There are three main advantages of bond financing. 1. Bonds do not affect owner control. Equity affects ownership in a company, but bonds do

not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of the company. A person who owns a $1,000, 11%, 20-year bond has no ownership.

2. Interest on bonds is tax deductible. Bond interest payments are tax deductible, but distri- butions to owners are not. A corporation with no bond financing, $15,000 in pretax income, and a 40% tax rate pays $6,000 ($15,000 × 40%) in taxes. Instead, if it issues bonds and pays $10,000 in bond interest expense, then taxes paid are only $2,000 ([$15,000 − $10,000] × 40%).

3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage, or trading on the equity.

To demonstrate the third point, consider Magnum Co., which has $1,000 in equity and is planning a $500 expansion ($ millions). Magnum predicts the expansion will increase income by $125 before paying interest. It currently earns $100 per year and has no interest expense. Magnum is considering three plans. Plan A is to not expand. Plan B is to expand and raise $500 from equity financing. Plan C is to expand and issue $500 of bonds that pay 10% annual interest ($50). Exhibit 10.1 shows how these plans affect net income, equity, and return on equity (Net

BASICS OF BONDS

A1 Compare bond financing with stock financing.

IN C ONTROL!

382 Chapter 10 Accounting for Long-Term Liabilities

EXHIBIT 10.1 Financing with Bonds versus Equity

Plan A: Plan B: Plan C: $ millions Do Not Expand Equity Financing Bond Financing

Income before interest expense . . . . . . . . . . . $ 100 $ 225 $ 225

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . — — (50)

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100 $ 225 $ 175 Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 $1,500 $1,000

Return on equity . . . . . . . . . . . . . . . . . . . . . . . 10.0% 15.0% 17.5%

income/Equity). Magnum earns a higher return on equity under Plan C to issue bonds. Income under Plan C ($175) is smaller than under Plan B ($225), but the return on equity is larger because of less equity investment.

Disadvantages of Bonds There are two main disadvantages of bond financing. 1. Bonds can decrease return on equity. When a company earns a lower return with the bor-

rowed funds than it pays in interest, it decreases return on equity. This is more likely when a company has low income or losses.

2. Bonds require payment of both periodic interest and the par value at maturity. Bond pay- ments are a burden when income and cash flow are low. Equity does not require payments because withdrawals (dividends) are optional.

Bond Issuing Bond issuances state the number of bonds authorized, their par value, and the contract interest rate. The legal contract between the issuer and the bond- holders is called the bond indenture. A bondholder may receive a bond certificate, which is evidence of the company’s debt—see Exhibit 10.2.

Bond Trading A bond issue is the sale of bonds, usually in denominations of $1,000 or $5,000. After bonds are issued, they often are bought and sold among inves- tors, meaning that a bond probably has had many owners before it matures. When bonds are bought and sold, they have a market value (price). Bond market values are shown as a percent of par (face) value. For example, a bond trading at 1031⁄2 is bought or sold for 103.5% of par value. A bond trading at 95 is bought or sold at 95% of par value.

Point: There are nearly 5 million individual U.S. bond issues, compared to about 12,000 individual U.S. stocks.

Courtesy of RBC Wealth Management

EXHIBIT 10.2 Bond Certificate

Point: A bond with a par value of $1,000 trading at 103½ sells for $1,035 ($1,000 × 1.035).

Quotes The IBM bond quote here is interpreted (left to right) as Bonds, issuer name; Rate, contract interest rate (4%); Mat, matures in year 2042 when principal is paid; Yld, yield rate (3.81%) of bond at current price; Vol, dollar worth ($110,000) of trades (in 1,000s); Close, closing price (103.08) for the day as percentage of par value; Chg, change (+0.73%) in closing price from prior day’s close. ■

Decision Insight

Bonds Rate Mat Yld Vol Close Chg

IBM 4 42 3.81 110 103.08 +0.73%

Bonds issued at par value are called par bonds. Assume Nike issues $100,000 of 8%, two-year bonds dated December 31, 2019, that mature on December 31, 2021, and pay interest semian- nually each June 30 and December 31. If all bonds are sold at par value, Nike records the sale as follows.

PAR BONDS P1 Record issuance and interest expense for par bonds.

Example: Compute return on equity for all three plans if Magnum is subject to a 40% income tax. Answer ($ mil.):

A = 6.0% ($100[1 − 0.4]∕$1,000)

B = 9.0% ($225[1 − 0.4]∕$1,500)

C = 10.5% ($175[1 − 0.4]∕$1,000)

Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Sold bonds at par.

Assets = Liabilities + Equity +100,000 +100,000

Chapter 10 Accounting for Long-Term Liabilities 383

Nike records the first semiannual interest payment as follows. The same entry is made every six months, including at the maturity date.

When the bonds mature, Nike records its payment of principal as follows.

June 30, 2020 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Paid semiannual interest (8% × $100,000 × 1∕2 year).

Assets = Liabilities + Equity −4,000 −4,000

Dec . 31, 2021 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Paid bond principal at maturity.

Assets = Liabilities + Equity −100,000 −100,000

This section covers bond issuances below par, called discount bonds.

Bond Discount or Premium The bond issuer pays the bond interest rate, called the contract rate (also called coupon rate, stated rate, or nominal rate). The annual interest paid is computed by multiplying the bond par value by the contract rate. The contract rate is usually stated on an annual basis, even if interest is paid semiannually. For example, a $1,000, 8% bond paying interest semiannually pays annual interest of $80 (8% × $1,000) in two semiannual payments of $40 each.

The contract rate sets the interest paid in cash, which is not necessarily the bond interest expense for the issuer. Bond interest expense depends on the bond’s market value at issuance. The bond’s market rate of interest is the rate that borrowers are willing to pay and lenders are willing to accept for a bond and its risk level. As bond risk increases, the market rate increases to compensate bond purchasers.

DISCOUNT BONDS

A company issues 8%, two-year bonds on December 31, 2019, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 8%, which implies a selling price of $7,000. Prepare journal entries to record (a) the issuance of bonds on December 31, 2019; (b) the first through fourth interest payments on each June 30 and December 31; and (c) the maturity of the bonds on December 31, 2021.

Solution

a.

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

June 30 and Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

Dec . 31 Pay semiannual interest ($7,000 × 8% × 1∕2).

b. The following entry is made for each of the four interest payments of June 30 and December 31 for both 2020 and 2021.

Dec . 31, 2021 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Record maturity and payment of bonds.

c.

Recording Par Value Bonds

NEED-TO-KNOW 10-1

P1

Do More: QS 10-2, QS 10-3, E 10-2, E 10-3

Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Sold bonds at par.

384 Chapter 10 Accounting for Long-Term Liabilities

When the contract rate and market rate are equal, a bond sells at par value. If they are not equal, it is sold at a premium above par value or at a discount below par value. Exhibit 10.3 shows the relation between the contract rate, the market rate, and a bond’s issue price.

Issuing Bonds at a Discount A discount on bonds payable occurs when a company issues bonds with a contract rate less than the market rate. This means the issue price is less than par value—the issuer gets less money at issuance than what the issuer must pay back at maturity. Assume Fila issues bonds with a $100,000 par value, an 8% annual contract rate (paid semiannually), and a two-year life. These bonds sell at a discount price of 96.400 (meaning 96.400% of par value, or $96,400); we show how to compute bond prices in Appendix 10A.

Cash Payments with Discount Bonds These bonds require Fila to pay 1. Par value of $100,000 cash at the end of the bonds’ two-year life. 2. Semiannual cash interest payments of $4,000 ($100,000 × 8% × 1/2 year).

The pattern of cash receipts and payments for Fila bonds is shown in Exhibit 10.4.

P2 Record issuance and amortization of discount bonds using the straight-line method.

Bond Sets Market Sets Bond Price Determined

Contract rate > Market rate Bond sells at premium

Contract rate = Market rate Bond sells at par

Contract rate < Market rate Bond sells at discount

Contract rate Market rate

EXHIBIT 10.3 Relation between Bond Issue Price, Contract Rate, and Market Rate

EXHIBIT 10.4 Discount Bond Cash Receipts and Payments

$100,000 $4,000 $4,000 $4,000 $4,000 o o o o o

0 6 mo . 12 mo . 18 mo . 24 mo .

} $116,000 paid

$9 6,

40 0

re c’

d

Recording Issuance of Discount Bonds When Fila accepts $96,400 cash for its bonds on the issue date of December 31, 2019, it records the sale as follows.

Bonds payable are reported as a long-term liability on Fila’s December 31, 2019, balance sheet as in Exhibit 10.5. A discount is subtracted from par value to get the carrying (book) value of bonds. Discount on Bonds Payable is a contra liability account.

Point: Book value at issuance always equals the issuer’s cash borrowed.

Long-term liabilities

Bonds payable, 8%, due December 31, 2021 . . . . . . . . . . . . $100,000

Less discount on bonds payable . . . . . . . . . . . . . . . . . . . . . . 3,600 $96,400 Carrying (book) value

EXHIBIT 10.5 Balance Sheet Presentation of Bond Discount

Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,400

Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Sold bonds at a discount on their issue date.

Assets = Liabilities + Equity +96,400 +100,000 −3,600

Amortizing Discount Bonds Fila receives $96,400 for its bonds; in return it must pay bondholders $100,000 when the bonds mature in two years (plus four interest payments). Panel A in Exhibit 10.6 shows that the four $4,000 interest payments plus the $3,600 bond dis- count equals total bond interest expense of $19,600.

The total $19,600 bond interest expense is allocated over the four semiannual periods in the bonds’ life, and the bonds’ carrying value is updated at each balance sheet date. This is done using

Chapter 10 Accounting for Long-Term Liabilities 385

EXHIBIT 10.6 Interest Computation and Entry for Discount Bonds

Bonds Payable

12/31/2019 100,000 6/30/2020 — 12/31/2020 — 6/30/2021 — 12/31/2021 100,000

12/31/2021 0

Discount on Bonds Payable

12/31/2019 3,600 6/30/2020 900 12/31/2020 900 6/30/2021 900 12/31/2021 900

12/31/2021 0

the straight-line method (or the effective interest method in Appendix 10B). Both methods reduce the bond discount to zero over the bond life. This process is called amortizing a bond discount.

Straight-Line Method Straight-line bond amortization allocates equal bond interest expense to each interest period. We divide the total bond interest expense of $19,600 by 4 (num- ber of semiannual periods in bonds’ life). This gives a bond interest expense of $4,900 per period. Panel B of Exhibit 10.6 shows how the issuer records bond interest ex- pense and updates the bond liability ac- count at the end of each of the four semiannual interest periods (June 30, 2020, through December 31, 2021).

Exhibit 10.7 shows the pattern of decreases in the Discount on Bonds Payable account and the pattern of increases in the bonds’ carrying value. Three points summarize the discount bonds’ straight-line amortization.

1. At issuance, the $96,400 carrying value equals the $100,000 par value minus the $3,600 unamortized discount.

2. During the bonds’ life, the (unamortized) discount decreases each period by the $900 amortization ($3,600/4), and carrying value (par value less unamortized discount) increases each period by $900.

3. At maturity, unamortized discount equals zero, and carrying value equals the $100,000 par value that the issuer pays the holder.

Point: Another way to compute bond interest expense: (1) Divide the $3,600 discount by 4 periods to get $900 amortized each pe- riod. (2) Add $900 to the $4,000 cash payment to get bond interest expense of $4,900 per period.

EXHIBIT 10.7 Straight-Line Amortization of Bond Discount

* Total bond discount of $3,600 less accumulated periodic amortization of $900 per semiannual interest period.

†Bond par value of $100,000 less unamortized discount.

Semiannual Unamortized Carrying Period-End Discount* Value†

(0) 12/31/2019 . . . . . . . . . . . $3,600 $ 96,400

(1) 6/30/2020 . . . . . . . . . . . 2,700 97,300

(2) 12/31/2020 . . . . . . . . . . . 1,800 98,200

(3) 6/30/2021 . . . . . . . . . . . 900 99,100

(4) 12/31/2021 . . . . . . . . . . . 0 100,000 The columns always sum to par value for discount bonds .

$96,400

$97,300

$98,200

$99,100

$100,000

12 /31

/2 01

9

6/ 30

/2 02

0

12 /31

/2 02

0

6/ 30

/2 02

1

12 /31

/2 02

1

Carrying value

Point: Amortization always gets the carrying value of a bond closer to its par value.

Ratings Game Many bond buyers rely on rating services such as Standard & Poor’s, Moody’s, and Fitch to assess bond risk. These services analyze financial statements and other factors in setting ratings. Standard & Poor’s ratings, from best quality to default, are AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Bonds rated in the A and B range are referred to as investment grade; lower-rated bonds are considered riskier. ■

Decision Insight

A company issues 8%, two-year bonds on December 31, 2019, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a sell- ing price of 96.46 or $6,752. (a) Prepare an amortization table like Exhibit 10.7 for these bonds; use the straight-line method to amortize the discount. Then prepare journal entries to record (b) the issuance of bonds on December 31, 2019; (c) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bonds on December 31, 2021.

Recording Discount Bonds

NEED-TO-KNOW 10-2

P2

Panel A: Interest Computations Four payments of $4,000 (4 pymts × [$100,000 × 0 .08 × 1∕2 yr]) . . . . . . . . . . . . . . . . . . . $ 16,000 Plus discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,600

Bond interest expense

(per interest period) = Total bond interest expense Number of interest periods =

$19,600 4

= $4,900

Panel B: Entry to Record Interest Payment and Amortization

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . . 4,900 June 30 and Discount on Bonds Payable . . . . . . . . 900 Dec . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Record semiannual interest and discount amortization (straight-line method).

Par value × ½ × Contract rate

Discount ÷ Periods

Solution

a. Semiannual Unamortized Carrying Period-End Discount Value

(0) 12/31/2019 . . . . $248 $6,752

(1) 6/30/2020 . . . . 186 6,814

(2) 12/31/2020 . . . . 124 6,876

(3) 6/30/2021 . . . . 62 6,938

(4) 12/31/2021 . . . 0 7,000

Interest computations for solutions a, b, and c Four interest payments of $280 (4 pymts × [$7,000 × 0 .08 × 1∕2 yr]) . . . . . $1,120 Plus discount . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

Total bond interest expense . . . . . . . . . . . . . . . . $1,368

Divided by number of periods . . . . . . . . . . . . . . ÷ 4 Bond interest expense per period . . . . . . . . . . . $ 342

d. Dec . 31, 2021 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Record maturity and payment of bonds.

Do More: QS 10-5, QS 10-7, QS 10-8, E 10-4, E 10-5,

E 10-6, P 10-1

Bonds Payable 12/31/2019 7,000 6/30/2020 — 12/31/2020 — 6/30/2021 — 12/31/2021 7,000

12/31/2021 0

Discount on Bonds Payable 12/31/2019 248 6/30/2020 62 12/31/2020 62 6/30/2021 62 12/31/2021 62

12/31/2021 0

c. The following entry is made for each of the four interest payments on June 30 and December 31 for both 2020 and 2021.

*$248∕4 †$7,000 × 8% × 1∕2

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342

June 30 and Discount on Bonds Payable* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

Dec . 31 Cash† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

Pay semiannual interest and record amortization.

386 Chapter 10 Accounting for Long-Term Liabilities

b. Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,752 Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Sold bonds at discount.

Point: Straight-line amortization is GAAP when the effect of using it approximates effective interest amortization.

This section covers bond issuances above par, called premium bonds.

Issuing Bonds at a Premium When the contract rate is higher than the market rate, the bonds sell at a price higher than par value—the issuer gets more money at issuance than what the issuer must pay back at maturity. The amount by which the bond price exceeds par value is the premium on bonds. Assume Adidas issues bonds with a $100,000 par value, a 12% annual contract rate, semiannual interest payments, and a two-year life. The Adidas bonds sell at a premium price of 103.600 (meaning 103.600% of par value, or $103,600); we show how to compute bond prices in Appendix 10A.

Cash Payments with Premium Bonds These bonds require Adidas to pay 1. Par value of $100,000 cash at the end of the bonds’ two-year life. 2. Semiannual cash interest payments of $6,000 ($100,000 × 12% × 1∕2 year).

The pattern of cash receipts and payments for Adidas bonds is shown in Exhibit 10.8.

Point: Contract rate yields cash interest payment. Market rate yields interest expense.

PREMIUM BONDS

P3 Record issuance and amortization of premium bonds using the straight- line method.

EXHIBIT 10.8 Premium Bond Cash Receipts and Payments

$100,000 $6,000 $6,000 $6,000 $6,000 o o o o o

0 6 mo . 12 mo . 18 mo . 24 mo .

} $124,000 paid

$1 03

,6 00

re c’

d

Chapter 10 Accounting for Long-Term Liabilities 387

Recording Issuance of Premium Bonds When Adidas receives $103,600 cash for its bonds on the issue date of December 31, 2019, it records this as follows.

Bonds payable are reported as a long-term liability on Adidas’s December 31, 2019, balance sheet as in Exhibit 10.9. A premium is added to par value to get the carrying (book) value of bonds. Premium on Bonds Payable is an adjunct (“add-on”) liability account.

Long-term liabilities

Bonds payable, 12%, due December 31, 2021 . . . . . . . . . . . . . $100,000

Plus premium on bonds payable . . . . . . . . . . . . . . . . . . . . . . . 3,600 $103,600

EXHIBIT 10.9 Balance Sheet Presentation of Bond Premium

Amortizing Premium Bonds Adidas receives $103,600 for its bonds. In return, it pays bondholders $100,000 after two years (plus four interest payments). Panel A of Exhibit 10.10 shows that the four $6,000 interest payments minus the $3,600 bond premium equals total bond interest expense of $20,400. The premium is subtracted because it reduces the issuer’s cost. Total bond interest expense is allocated over the four semiannual periods using the straight- line method (or the effective interest method in Appendix 10B).

Bonds Payable

12/31/2019 100,000 6/30/2020 — 12/31/2020 — 6/30/2021 — 12/31/2021 100,000

12/31/2021 0

Premium on Bonds Payable

12/31/2019 3,600 6/30/2020 900 12/31/2020 900 6/30/2021 900 12/31/2021 900

12/31/2021 0

Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,600

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . 3,600

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Sold bonds at a premium on their issue date.

Assets = Liabilities + Equity +103,600 +100,000 +3,600

Straight-Line Method The straight-line method allocates equal bond interest ex- pense to each semiannual interest period. We divide the total bond interest expense of $20,400 by 4 (number of semiannual periods in bonds’ life). This gives bond interest expense of $5,100 per period. Panel B of Exhibit 10.10 shows how Adidas records bond inter- est expense and updates the balance of the bond liability account for each semiannual period (June 30, 2020, through December 31, 2021).

Exhibit 10.11 shows the pattern of decreases in the unamortized Pre- mium on Bonds Payable account and

Point: A premium decreases Bond Interest Expense; a discount increases it.

Semiannual Unamortized Carrying Period-End Premium* Value†

(0) 12/31/2019 . . . . . . . . . $3,600 $103,600

(1) 6/30/2020 . . . . . . . . . 2,700 102,700

(2) 12/31/2020 . . . . . . . . . 1,800 101,800

(3) 6/30/2021 . . . . . . . . . 900 100,900

(4) 12/31/2021 . . . . . . . . . 0 100,000

* Total bond premium of $3,600 less accumulated periodic amortization of $900 per semiannual interest period.

†Bond par value of $100,000 plus unamortized premium.

During the bond life, carrying value is adjusted to par and the amortized premium to zero .

EXHIBIT 10.11 Straight-Line Amortization of Bond Premium

EXHIBIT 10.10 Interest Computation and Entry for Premium Bonds

Panel A: Interest Computations Four payments of $6,000 (4 pymts × [$100,000 × 0 .12 × 1∕2 yr]) . . . . . . . . . . . . . . . . . . . $ 24,000 Less premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,600) Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,400

Bond interest expense (per interest period)

= Total bond interest expense Number of interest periods

= $20,400

4 = $5,100

Panel B: Entry to Record Interest Payment and Amortization

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . . . . 5,100 June 30 and Premium on Bonds Payable . . . . . . . . . . . . . . . 900 Dec . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Record semiannual interest and premium amortization (straight-line method).

Premium ÷ Periods

Par value × ½ × Contract rate

388 Chapter 10 Accounting for Long-Term Liabilities

in the bonds’ carrying value. Three points summarize straight-line amortization of premium bonds.

1. At issuance, the $103,600 carrying value equals the $100,000 par value plus the $3,600 unamortized premium.

2. During the bonds’ life, the (unamortized) premium decreases each period by the $900 amor- tization ($3,600/4), and carrying value decreases each period by the same $900.

3. At maturity, unamortized premium equals zero, and carrying value equals the $100,000 par value that the issuer pays the holder.

$103,600

$102,700

$101,800

$100,900

$100,000

12 /31

/2 01

9

6/ 30

/2 02

0

12 /31

/2 02

0

6/ 30

/2 02

1

12 /31

/2 02

1

Carrying value

A company issues 8%, two-year bonds on December 31, 2019, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of 103.71 or $7,260. (a) Prepare an amortization table like Exhibit 10.11 for these bonds; use the straight- line method to amortize the premium. Then prepare journal entries to record (b) the issuance of bonds on December 31, 2019; (c) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bonds on December 31, 2021.

Solution

a.

Recording Premium Bonds

NEED-TO-KNOW 10-3

P3

Semiannual Unamortized Carrying Period-End Premium Value

(0) 12/31/2019 . . . . $260 $7,260

(1) 6/30/2020 . . . . 195 7,195

(2) 12/31/2020 . . . . 130 7,130

(3) 6/30/2021 . . . . 65 7,065

(4) 12/31/2021 . . . . 0 7,000

Interest computations for solutions a, b, and c Four interest payments of $280 (4 pymts × [$7,000 × 0 .08 × 1∕2 yr]) . . . . $1,120 Less premium . . . . . . . . . . . . . . . . . . . . . . . . . 260

Total bond interest expense . . . . . . . . . . . . . . $ 860

Divided by number of periods . . . . . . . . . . . . ÷ 4 Bond interest expense per period . . . . . . . . . $ 215

b. Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,260

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Sold bonds at premium.

Do More: QS 10-9, E 10-8, E 10-9, P 10-2, P 10-3

d. Dec . 31, 2021 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Record maturity and payment of bonds.

Bonds Payable

12/31/2019 7,000 6/30/2020 — 12/31/2020 — 6/30/2021 — 12/31/2021 7,000

12/31/2021 0

Premium on Bonds Payable

12/31/2019 260 6/30/2020 65 12/31/2020 65 6/30/2021 65 12/31/2021 65

12/31/2021 0

c. The following entry is made for each of the four interest payments on June 30 and December 31 for both 2020 and 2021.

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

June 30 and Premium on Bonds Payable* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Dec . 31 Cash† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

Pay semiannual interest and record amortization.

*$260∕4 †$7,000 × 8% × 1∕2

Bond Retirement This section covers the retirement of bonds.

Bond Retirement at Maturity The carrying value of bonds at maturity always equals par value. For example, both Exhibits 10.7 (a discount) and 10.11 (a premium) show that the

P4 Record the retirement of bonds.

Chapter 10 Accounting for Long-Term Liabilities 389

carrying value of bonds at maturity equals par value ($100,000). Retirement of these bonds at maturity, assuming interest is already paid and recorded, is as follows.

Dec . 31, 2021 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Record retirement of bonds at maturity.

Assets = Liabilities + Equity −100,000 −100,000

Bond Retirement before Maturity Issuers sometimes retire some or all of their bonds before maturity. If interest rates decline, an issuer may want to replace high-interest- paying bonds with new low-interest bonds. There are two common ways to retire bonds before maturity. Exercise a call option. An issuer can reserve the right to retire bonds early by issuing call-

able bonds. This gives the issuer an option to call the bonds before they mature by paying the par value plus a call premium.

Open market purchase. The issuer can repurchase them from bondholders at current market price.

Whether bonds are called or purchased, the issuer is likely to pay a price different from their carrying value. The issuer records a difference between the bonds’ carrying value and the amount paid as a gain or loss. Assume that Puma issued callable bonds with a par value of $100,000. The call option requires Puma to pay a call premium of $3,000 to bondholders plus the par value. Next, assume that after the June 30 interest payment, the bonds have a carrying value of $104,500. Then on July 1, Puma calls these bonds and pays $103,000 to bondholders. Puma records a $1,500 gain from the difference between the bonds’ carrying value of $104,500 and the retirement price of $103,000 as follows.

Point: Bond retirement is also called bond redemption.

Bond Retirement by Conversion Holders of convertible bonds have the right to convert their bonds to stock. When conversion occurs, the bonds’ carrying value is transferred to equity accounts and no gain or loss is recorded. (Convertible bonds are described further in the Decision Analysis section of this chapter.) Assume that on January 1 the $100,000 par value bonds of Converse, with a carrying value of $100,000, are converted to 15,000 shares of $2 par value common stock. The entry to record this conversion follows (market prices of the bonds and stock are not relevant to this entry).

Convertible Bond

July 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

Gain on Bond Retirement . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,000

Record retirement of bonds before maturity.

Assets = Liabilities + Equity −103,000 −100,000 +1,500 −4,500

Jan . 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Paid-In Capital in Excess of Par Value . . . . . . . . . . . . . . . 70,000

Record retirement of bonds by conversion.

Assets = Liabilities + Equity −100,000 +30,000 +70,000

Junk Bonds Junk bonds are company bonds with low credit ratings due to a higher likelihood of nonpayment. On the upside, the high risk of junk bonds can yield high returns if the issuer repays its debt. Investors in junk bonds identify and buy bonds with low credit ratings when they believe those bonds will survive and pay their debts. Financial statements are used to identify junk bonds that are better than what their ratings would suggest. ■

Decision Insight

390 Chapter 10 Accounting for Long-Term Liabilities

Payments of Principal and Interest Payments on an installment note include ac- crued interest expense plus part of the amount borrowed (the principal). For this section, let’s consider an installment note with equal payments. The equal total payments pattern has chang- ing amounts of both interest and principal. Foghog borrows $60,000 by signing a $60,000 note that requires three equal payments of $23,282 at each year-end. Exhibit 10.12 shows the pattern of equal total payments and its two parts, interest and principal. Column A shows the note’s beginning balance. Column B shows accrued interest at 8% of the beginning note balance. Column C shows the portion that reduces the principal owed, which equals total payment in column D minus interest expense in column B. Column E shows the note’s year-end balance.

Like bonds, notes are issued in exchange for assets such as cash. Unlike bonds, notes are usually issued to a single lender such as a bank. An issuer initially records a note at its selling price—the note’s face value minus any discount or plus any premium. Over the note’s life, the amount of interest expense allocated to each period is computed by multiplying the market rate (at issuance of the note) by the beginning-of-period note balance. The note’s carrying (book) value at any time equals its face value minus any unamortized discount or plus any unamortized premium.

Installment Notes An installment note is a liability requiring a series of payments to the lender. Installment notes are common for franchises and other businesses when lenders and borrowers agree to spread payments over time.

Issuance of Notes Assume Foghog borrows $60,000 from a bank to purchase equip- ment. It signs an 8% installment note requiring three annual payments of principal plus interest. Foghog records the note’s issuance at January 1, 2019, as follows.

LONG-TERM NOTES PAYABLE C1 Explain the types of notes and prepare entries to account for notes.

Jan . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Borrowed $60,000 by signing 8%, three-year note.

Assets = Liabilities + Equity +60,000 +60,000

Years 2019 2020 2021

$2 3,

28 2

$2 3,

28 2

$2 3,

28 2

EXHIBIT 10.12 Installment Note: Equal Total Payments Amortization Schedule

Payments

(A) (B) (C) (D) (E) Debit Debit Credit

Beginning Balance

Interest Notes Ending

Period Ending Date Expense + Payable = Cash Balance 8% × (A) (D) – (B) (computed) (A) – (C)

(1 ) 12/31/2019 . . . . . . . . $60,000 $41,518 (2) 12/31/2020 . . . . . . . . 41,518 21,557 (3) 12/31/2021 . . . . . . . . 21,557 0

2021

2019

2020

0 $5,000 $15,000 $25,000

Equal Cash Payments*

Decreasing Accrued Interest

Increasing Principal Component

En d

of Y

ea r $18,482$4,800

$19,961$3,321

$21,557$1,725

Interest Principal

$4,800 $ 18,482 $23,282 3,321 19,961 23,282 1,725 21,557 23,282

$9,846 $60,000 $69,846

* Table B.3 in Appendix B is used to compute the dollar amount of three payments that equal the initial note balance of $60,000 at 8% interest. We go to Table B.3, row 3, and across to the 8% column, where the present value factor is 2.5771. The dollar amount is then computed by solving the following equation. The amount is computed by dividing $60,000 by 2.5771, yielding $23,282.

Table Present Value Factor Dollar Amount Present Value B.3 2.5771 × ? = $60,000

Point: Principal portion of note payments.

A B

1 Rate per period 8%

2 Number of periods 3

3 Loan amount $60,000

4 Period Principal

5 1

6 2

7 3

=−PPMT(B1,A5,B2,B3)=$18,482

=−PPMT(B1,A6,B2,B3)=$19,961

=−PPMT(B1,A7,B2,B3)=$21,557

Point: Installment note payments.

A B

1 Rate per period 8%

2 Number of periods 3

3 Loan amount $60,000

4 Loan payments

=−PMT(B1,B2,B3)=$23,282

Chapter 10 Accounting for Long-Term Liabilities 391

The three $23,282 cash payments are equal, but accrued interest decreases each year because the principal balance of the note decreases. As the amount of interest decreases each year, the portion of each payment applied to principal increases. This pattern is shown in the lower part of Exhibit 10.12. Foghog uses the amounts in Exhibit 10.12 to record its first two payments (for years 2019 and 2020) as follows. Foghog records a similar entry but with different amounts for the last payment. After three years, the Notes Payable account balance is zero.

Assets = Liabilities + Equity −23,282 −18,482 −4,800

Dec . 31, 2019 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,482

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,282

Record first installment payment.

Assets = Liabilities + Equity −23,282 −19,961 −3,321

Dec . 31, 2020 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,321

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,961

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,282

Record second installment payment.

Mortgage Notes and Bonds A mortgage is a legal agreement that helps protect a lender if a borrower does not make required payments on notes or bonds. A mortgage gives the lender a right to be paid from the cash proceeds of the sale of a borrower’s assets identified in the mortgage. A mortgage contract describes the mortgage terms. Mortgage notes pledge title to specific assets as security for the note. Mortgage notes are popular in the purchase of homes and plant assets. Mortgage bonds are backed by the issuer’s assets. Accounting for mortgage notes and bonds is similar to that for unsecured notes and bonds, except that the mortgage agreement must be disclosed. For example, TIBCO Software reports that its “mortgage note payable . . . is collateralized by the commercial real property acquired.”

Lurking Debt A study reports that 29% of employees in finance and accounting witnessed the falsifying or manipu- lating of accounting information in the past year. This includes nondisclosure of some long-term liabilities. Another study reports that most people committing fraud (36%) work in the finance function of their firm (KPMG). ■

Ethical Risk

On January 1, 2019, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal payments of $282, consisting of accrued interest and principal on December 31 of each year from 2019 through 2022. 1. Prepare an amortization table for this installment note like the one in Exhibit 10.12. 2. Prepare journal entries to record the loan on January 1, 2019, and the four payments from December 31,

2019, through December 31, 2022.

Solution

1. Amortization table for loan.

C1

Recording Installment Note

NEED-TO-KNOW 10-4

Payments

(A) (B) (C) (D) (E) Debit Debit Credit Beginning Interest Notes Ending Balance Expense Payable Cash Balance Period Ending Date [Prior (E)] [5% × (A)] + [(D) − (B)] = [computed] [(A) − (C)]

2019 . . . . . . . . . . . . . . . . $1,000 $ 50 $ 232 $ 282† $768

2020 . . . . . . . . . . . . . . . . 768 38 244 282 524

2021 . . . . . . . . . . . . . . . . 524 26 256 282 268

2022 . . . . . . . . . . . . . . . . 268 14* 268 282 0

$128 $1,000 $1,128

*Adjusted for rounding. †Amount of each payment = Initial note balance∕PV of annuity for 4 periods at 5% (from Table B.3) = $1,000∕3.5460 = $282 (rounded)

Point: An annuity is a series of equal payments occurring at equal time intervals.

392 Chapter 10 Accounting for Long-Term Liabilities

Jan . 1, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Notes Payable . . . . . . . . . . . . . . . . . 1,000

Borrowed $1,000 by giving a note.

Dec . 31, 2019 Interest Expense . . . . . . . . . . . . . . . . . . . 50

Notes Payable . . . . . . . . . . . . . . . . . . . . . 232

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 282

Record first installment payment.

Dec . 31, 2020 Interest Expense . . . . . . . . . . . . . . . . . . . 38

Notes Payable . . . . . . . . . . . . . . . . . . . . . 244

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 282

Record second installment payment.

Dec . 31, 2021 Interest Expense . . . . . . . . . . . . . . . . . . . 26

Notes Payable . . . . . . . . . . . . . . . . . . . . . 256

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 282

Record third installment payment.

Dec . 31, 2022 Interest Expense . . . . . . . . . . . . . . . . . . . 14

Notes Payable . . . . . . . . . . . . . . . . . . . . . 268

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 282

Record fourth installment payment.

2.

Do More: QS 10-12, E 10-12, E 10-13, P 10-5

Debt Features and the Debt-to-Equity RatioDecision Analysis

Features of Bonds and Notes This section covers features of debt securities.

Secured or Unsecured Secured bonds (and notes) have specific assets of the issuer pledged (or mortgaged) as collateral. If the issuer does not pay its debt, the secured holders can demand that the col- lateral be sold and the proceeds used to pay the obligation. Unsecured bonds (and notes), also called debentures, are backed by the issuer’s general credit standing and are riskier than secured debt.

Term or Serial Term bonds (and notes) mature on one specified date. Serial bonds (and notes) mature at more than one date (often in series) and thus are usually repaid over a number of periods. For instance, $100,000 of serial bonds might mature at the rate of $10,000 each year from 6 to 15 years after they are issued. Sinking fund bonds reduce the holder’s risk by requiring the issuer to set aside assets to pay debt in a sinking fund.

Registered or Bearer Bonds issued in the names and addresses of their holders are registered bonds. The issuer makes bond payments by sending checks (or cash transfers) to registered holders. Bonds pay- able to whoever holds them (the bearer) are called bearer bonds or unregistered bonds. The holder of a bearer bond is presumed to be its rightful owner. Many bearer bonds are also coupon bonds. This term reflects interest coupons that are attached to the bonds. When each coupon matures, the holder presents it to a bank or broker for collection.

Convertible and/or Callable Convertible bonds (and notes) can be exchanged for a fixed number of shares of the issuing corporation’s stock. Convertible debt offers holders the potential to profit from increases in stock price. Holders still receive interest while the debt is held and the par value if they hold the debt to matu- rity. In most cases, the holders decide whether and when to convert debt to stock. Callable bonds (and notes) give the issuer the option to retire them at a stated dollar

amount before maturity.

Debt-to-Equity Ratio A company financed mainly with debt is more risky because liabilities must be repaid with interest, whereas equity financing does not. A measure to assess the risk of a company’s financing structure is the debt-to-equity ratio (see Exhibit 10.13).

Secured Debt

Unsecured Debt

A2 Assess debt features and their implications.

Convertible Debt Callable Debt

A3 Compute the debt-to-equity ratio and explain its use.

EXHIBIT 10.13 Debt-to-Equity Ratio Debt-to-equity =

Total liabilities Total equity

Chapter 10 Accounting for Long-Term Liabilities 393 Chapter 10 Accounting for Long-Term Liabilities 393

The debt-to-equity ratios for Nike and Under Armour are in Exhibit 10.14. Nike’s current-year debt-to- equity ratio is 0.87, meaning that debtholders contributed $0.87 for each $1 contributed by equity hold- ers. This implies a low-risk financing structure for Nike and is similar to its competitors. In comparison, Under Armour’s current-year ratio is 0.98. Analysis across the years shows that Nike’s debt-to-equity ratio has risen to a riskier level in recent years. In the case of Nike, the increase in debt-to-equity ratio is less concerning as it has historically earned higher returns with this financing than the interest rate it pays. Still, investors and debtholders will continue to monitor Nike’s debt-to-equity ratio to be sure it does not reach risky levels.

Bond Investor You plan to purchase bonds from one of two companies in the same industry that are similar in size and performance. The first company has $350,000 in total liabilities and $1,750,000 in equity. The second company has $1,200,000 in total liabilities and $1,000,000 in equity. Which company’s bonds are less risky based on the debt- to-equity ratio? ■ Answer: The debt-to-equity ratio for the first company is 0.2 ($350,000/$1,750,000) and for the second is 1.2 ($1,200,000/$1,000,000), suggesting that financing for the second company is riskier than for the first.

Decision Maker

Water Sports Company (WSC) patented and successfully test-marketed a new product. To produce and market the new product, WSC needs to raise $800,000 of financing. On January 1, 2019, the company obtained the money in two ways. a. WSC signed a $400,000, 10% installment note to be repaid with five equal annual installments of

$105,519 to be made on December 31 of 2019 through 2023. b. WSC issued five-year bonds with a par value of $400,000 for $430,881 cash on January 1, 2019. The

bonds have a 12% annual contract rate and pay interest on June 30 and December 31. The bonds’ annual market rate is 10%.

Required

1. For the installment note, (a) prepare an amortization table similar to Exhibit 10.12 and (b) prepare the journal entry for the first payment.

2. For the bonds, (a) prepare the January 1, 2019, journal entry to record their issuance; (b) prepare an amortization table using the straight-line method; (c) prepare the June 30, 2019, journal entry to record the first interest payment; and (d) prepare a journal entry to record retiring the bonds at a $416,000 call price on January 1, 2021.

3.B Using Appendix 10B, redo parts 2(b), 2(c), and 2(d) assuming the bonds are amortized using the effec- tive interest method.

PLANNING THE SOLUTION For the installment note, prepare a table similar to Exhibit 10.12 and use the numbers in the table’s first

line for the journal entry. Record the bonds’ issuance. Next, prepare an amortization table like Exhibit 10.11 (and Exhibit 10B.2)

and use it to get the numbers for the journal entry. Also use the table to find the carrying value as of the date of the bonds’ retirement needed for the journal entry.

COMPREHENSIVE

Accounting for Bonds and Notes— Amortization, Journal Entries, and Disposal

NEED-TO-KNOW 10-5

EXHIBIT 10.14 Analysis using Debt-to-Equity Ratio

Company $ millions Current Year 1 Year Ago 2 Years Ago

Nike Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $10,852 $ 9,138 $ 8,890 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,407 $12,258 $12,707 Debt-to-equity . . . . . . . . . . . . . . . . . . . . . . . . 0.87 0.75 0.70 Under Armour Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,988 $ 1,613 $ 1,198 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,019 $ 2,031 $ 1,668 Debt-to-equity . . . . . . . . . . . . . . . . . . . . . . . . 0.98 0.79 0.72

394 Chapter 10 Accounting for Long-Term Liabilities

SOLUTION Part 1: Installment Note

a. An amortization table for the long-term note payable follows.

(1) 12/31/2019 (2) 12/31/2020

(3) 12/31/2021 (4) 12/31/2022

(5) 12/31/2023

$ 40,000 33,448

26,241 18,313

9,593

$127,595

$ 105,519* 105,519

105,519 105,519

105,519

$ 527,595

$334,481 262,410

183,132 95,926

0

$400,000 334,481

262,410 183,132

95,926

$ 65,519 72,071

79,278 87,206

95,926

$400,000

Annual Period Ending

Payments ( )

Beginning Balance

a

( )a ( ) –a ( )c

( )b Debit Credit

( )d ( )e

Interest Expense

10% × d ( )( ) – b

Debit ( )c

Notes Payable Cash

(computed)

Ending Balance

* Annual payment = Note balance ∕ PV annuity factor = $400,000/3.7908 = $105,519 (The present value annuity factor is for five payments at a rate of 10%.)

b. Journal entry for December 31, 2019, payment.

Dec . 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,519

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,519

Record first installment payment.

Part 2: Bonds (Straight-Line Amortization)

a. Journal entry for January 1, 2019, issuance.

b. The straight-line amortization table for premium bonds follows. The semiannual discount amortization is $3,088, computed as $30,881/10 periods.

(0) 1/1/2019

(1) 6/30/2019

(2) 12/31/2019

(3) 6/30/2020

(4) 12/31/2020

(5) 6/30/2021

(6) 12/31/2021 (7) 6/30/2022

(8) 12/31/2022 (9) 6/30/2023

(10) 12/31/2023

$ 30,881

27,793

24,705

21,617 18,529

15,441

12,353

9,265 6,177

3,089

0*

$ 430,881

427,793

424,705

421,617 418,529

415,441

412,353 409,265

406,177

403,089

400,000

Unamortized Discount

Carrying Value

Semiannual Period-End

*Adjusted for rounding.

Jan . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430,881

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 30,881

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Sold bonds at a premium.

Point: Bond issue price equals present value of its future cash payments discounted at bond’s market rate.

Present Value Present Cash Flow Table Factor* Amount Value

Par (maturity) value . . . . B.1 in App. B (PV of 1) 0.6139 × $400,000 = $245,560 Interest payments . . . . . . B.3 in App. B (PV of annuity) 7.7217 × 24,000 = 185,321 Price of bond . . . . . . . . . $430,881

*Present value factors are for 10 payments using a semiannual market rate of 5%.

Chapter 10 Accounting for Long-Term Liabilities 395

c. Journal entry for June 30, 2019, bond payment.

d. Journal entry for January 1, 2021, bond retirement (use carrying value as of 12/31/2020).

Jan . 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,529 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416,000 Gain on Retirement of Bonds . . . . . . . . . . . . . . . . . . . . . . 2,529 Record bond retirement for cash.

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,912 Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,088 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Paid semiannual interest on bonds.

Part 3: Bonds (Effective Interest Amortization)—Using Appendix 10B

b. The effective interest amortization table for premium bonds.

c. Journal entry for June 30, 2019, bond payment.

d. Journal entry for January 1, 2021, bond retirement (use carrying value as of 12/31/2020).

Jan . 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,295 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416,000 Gain on Retirement of Bonds . . . . . . . . . . . . . . . . . . . . . . 4,295 Record bond retirement for cash.

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,544 Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,456 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Paid semiannual interest on bonds.

$30,881

28,425

25,846

23,138 20,295

17,310

14,176

10,885

7,429

3,800

0

$430,881

428,425

425,846

423,138 420,295

417,310

414,176

410,885 407,429

403,800

400,000

$ 24,000

24,000

24,000

24,000 24,000

24,000

24,000

24,000 24,000

24,000

$240,000

$ 21,544

21,421

21,292

21,157 21,015

20,866

20,709 20,544

20,371

20,200*

$209,119

$ 2,456

2,579

2,708 2,843

2,985

3,134

3,291

3,456 3,629

3,800

$30,881

(A) Cash

Interest Paid 6% × $400,000

(B) Interest Expense

5% × Prior (E)

(C) Premium

Amortization (A) – (B)

(D) Unamortized

Premium Prior (D) – (C)

(E) Carrying

Value $400,000 + (D)

Semiannual Interest Period

1/1/2019(0)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

6/30/2019

12/31/2019

6/30/2020

12/31/2020

6/30/2021

12/31/2021 6/30/2022

12/31/2022 6/30/2023

12/31/2023

*Adjusted for rounding.

Point: Using effective interest, carrying value is also computed as the present value of all remain- ing payments, discounted using the market rate at issuance.

APPENDIX

Bond Pricing 10A This section shows how to price the Fila discount bond and the Adidas premium bond described earlier.

Present Value of Discount Bonds The issue price of bonds is the present value of the bonds’ cash payments, discounted at the bonds’ market rate. The annual market rate is 10.031% for the Fila bonds. However, for simplicity, we assume a 10% annual rate in this appendix. When computing the

C2 Explain and compute bond pricing.

396 Chapter 10 Accounting for Long-Term Liabilities

Point: Excel for bond pricing.

A B

1 Annual contract rate 8%

2 Annual market rate 10%

3 Payments within yr 2

4 Years to maturity 2

5 Par (face) value $100,000

6 Issue price

=−PV(B2/B3,B3*B4,B5*B1/B3,B5) =$96,454

Present Value Present Cash Flow Table Factor Amount Value

$100,000 par (maturity) value . . . . . . . . . . . . B .1 (PV of 1) 0 .8227 × $100,000 = $ 82,270 $4,000 interest payments . . . . . . . . . . . . . . . B .3 (PV of ann .) 3 .5460 × 4,000 = 14,184 Price of bond . . . . . . . . . . . . . . . . . . . . . . . . . (using a 5% semiannual market rate) $96,454

Calculator N = 4 I/Yr = 5

PMT = 4,000 FV = 100,000

PV = 96,454

EXHIBIT 10A.1 Computing Issue Price for Fila Discount Bonds

Present Value of Premium Bonds We compute the issue price of the Adidas bonds by using the market rate to compute the present value of the bonds’ future cash flows. The annual mar- ket rate is 9.97% for the Adidas bonds. However, for simplicity, we assume a 10% annual rate in this appendix. When computing the present value of these bonds, we again use semiannual compounding periods because this is the time between interest payments. The annual 10% market rate is applied as a semiannual rate of 5%, and the two-year bond life is viewed as four semiannual periods. The computa- tion has two parts.

1 Find the present value of the $100,000 par value paid at maturity. 2 Find the present value of the four payments of $6,000 each; see Exhibit 10.8.

These present values are found using Excel or a calculator (see directions to the side). We also can find present value if the market rate is in present value tables. The annual market rate is 10%, or 5% semiannually. In this case, go to Table B.1, row 4, and across to the 5% column, where the present value factor is 0.8227 for the maturity payment. Second, go to Table B.3, row 4, and across to the 5% column, where the present value factor is 3.5460 for the series of interest payments. The bonds’ price is computed by multiplying the cash flow payments by their present value factors and adding them— see Exhibit 10A.2.

Point: Excel for bond pricing.

A B

1 Annual contract rate 12%

2 Annual market rate 10%

3 Payments within yr 2

4 Years to maturity 2

5 Par (face) value $100,000

6 Issue price

=−PV(B2/B3,B3*B4,B5*B1/B3,B5) =$103,546

Calculator N = 4 I/Yr = 5

PMT = 6,000 FV = 100,000

PV = 103,546

EXHIBIT 10A.2 Computing Issue Price for Adidas Premium Bonds

Present Value Present Cash Flow Table Factor Amount Value

$100,000 par (maturity) value . . . . . . . . . . . . B .1 (PV of 1) 0 .8227 × $100,000 = $ 82,270 $6,000 interest payments . . . . . . . . . . . . . . . B .3 (PV of ann .) 3 .5460 × 6,000 = 21,276 Price of bond . . . . . . . . . . . . . . . . . . . . . . . . . (using a 5% semiannual market rate) $103,546

Equivalent Payments Concept Business decisions involve the time value of money. To help in those decisions, the present value factors can be thought of as equivalent payments. For example, using the data in Exhibit 10A.1, one payment of $100,000 scheduled two years from today is the equivalent of a 0.8227 payment of $100,000 today (assuming a market with 10% return). Similarly, four semiannual payments of $4,000 over the next two years are the equivalent of 3.5460 payments of $4,000 today (again, assuming a 10% return). ■

Decision Insight

Point: Calculator inputs defined: N Number of semiannual periods I/Yr Market rate per semiannual

period FV Future (maturity) value PMT Payment (interest) per

semiannual period PV Price (present value)

present value of the Fila bonds, we use semiannual compounding periods because this is the time between interest payments; the annual market rate of 10% is considered a semiannual rate of 5%. Also, the two- year bond life is viewed as four semiannual periods. The price computation has two parts.

1 Find the present value of the $100,000 par value paid at maturity. 2 Find the present value of the four semiannual payments of $4,000 each; see Exhibit 10.4.

The present values are found using Excel or a calculator (see directions to the side). We also can find present values if the market rate is in present value tables. Appendix B at the end of this book shows present value tables and describes their use. Table B.1 in Appendix B is used for the single $100,000 maturity payment, and Table B.3 in Appendix B is used for the $4,000 series of interest payments. The annual market rate is 10%, or 5% semiannually. In this case, we go to Table B.1, row 4, and across to the 5% column to identify the present value factor of 0.8227 for the maturity payment. Next, we go to Table B.3, row 4, and across to the 5% column, where the present value factor is 3.5460 for the interest payments. We compute bond price by multiplying the cash flow payments by their present value factors and adding them—see Exhibit 10A.1.

Chapter 10 Accounting for Long-Term Liabilities 397

APPENDIX

Effective Interest Amortization 10B Effective Interest Amortization of Discount Bonds The effective interest method allocates total bond interest expense over the bonds’ life in a way that yields a constant rate of interest. This constant rate of interest is the market rate at the issue date. This means bond interest expense for a period equals the carrying value of the bond at the beginning of that period multiplied by the market rate when issued. Exhibit 10B.1 shows an effective interest amortization table for Fila bonds (as described in Exhibit 10.4). The key difference between the effective interest and straight-line methods is computing bond interest expense. Instead of assigning an equal amount of bond interest expense to each period, the effective interest method assigns a bond interest expense amount that increases over the life of a discount bond. Both methods allocate the same $19,600 of total bond interest expense over the bonds’ life, but in different patterns. Specifically, the amortization table in Exhibit 10B.1 shows that the balance of the discount (column D) is amortized until it reaches zero. Also, the bonds’ carrying value (column E) changes each period until it equals par value at maturity. Compare columns D and E to the columns in Exhibit 10.7 to see the amortization patterns. Total bond interest expense is $19,600, consisting of $16,000 of semiannual cash payments and $3,600 of the original bond discount, the same for both methods.

P5 Compute and record amor- tization of a bond discount using the effective interest method.

Point: Contract rate determines cash interest paid, but market rate determines the actual interest expense.

Effective Interest Amortization of Premium Bonds Exhibit 10B.2 shows the amortization table using the effective interest method for Adidas bonds (as described in Exhibit 10.8). Column A lists the semiannual cash payments. Column B shows the amount of bond interest expense, computed as the 4.9851% semiannual market rate at issuance multiplied by the beginning-of-period car- rying value. The amount of cash paid in column A is larger than the bond interest expense because the

EXHIBIT 10B.1 Effective Interest Amortization of Bond Discount

6/30/2020 12/31/2020

12/31/2021

6/30/2021

12/31/2019(0)

( 1 ) (2) (3)

(4)

$ 4,000 4,000

4,000

4,000

$16,000

$ 4,835$ 4,835 4,877 4,921

4,967

$19,600

$ 835 877 921

967 $3,600

2,765 $3,600

1,888

967 0

97,235

$ 96,400

98,112 99,033

100,000

Bonds: $100,000 Par Value, Semiannual Interest Payments, Two-Year Life, 4% Semiannual Contract Rate, 5.0155% Semiannual Market Rate

(A) Cash

Interest Paid

4% × $100,000

(B) Bond

Interest Expense

5.0155% × Prior (E)

(C)

Discount Amortization

(B) – (A)

(D)

Unamortized Discount

Prior (D) – (C)

Semiannual Interest

Period-End

(E)

Carrying Value

$100,000 – (D)

Column (A) is the par value ($100,000) multiplied by the semiannual contract rate (4%). Column (B) is the prior period’s carrying value multiplied by the semiannual market rate (5.0155%). Column (C) is the difference between interest paid and bond interest expense, or [(B) – (A)]. Column (D) is the prior period’s unamortized discount less the current period’s discount amortization. Column (E) is the par value less unamortized discount, or [$100,000 – (D)].

June 30, 2020 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,835 Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . 835 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Record semiannual interest and discount amortization (effective interest method).

12 /31

/2 01

9

6/ 30

/2 02

0

12 /31

/2 02

0

6/ 30

/2 02

1

12 /31

/2 02

1

Carrying value

$96,400 $97,235

$98,112

$99,033

$100,000

Bonds Payable

12/31/2019 100,000 6/30/2020 — 12/31/2020 — 6/30/2021 — 12/31/2021 100,000

12/31/2021 0

Discount on Bonds Payable

12/31/2019 3,600 6/30/2020 835 12/31/2020 877 6/30/2021 921 12/31/2021 967

12/31/2021 0

Except for differences in amounts, journal entries recording the expense and updating the liability bal- ance are the same under the effective interest method and the straight-line method. We use the numbers in Exhibit 10B.1 to record each semiannual entry during the bonds’ two-year life (June 30, 2020, through December 31, 2021). The interest payment entry at the end of the first semiannual period is

P6 Compute and record amortization of a bond premium using the effective interest method.

398 Chapter 10 Accounting for Long-Term Liabilities

cash payment is based on the higher 6% semiannual contract rate. The excess cash payment over the inter- est expense reduces the principal. These amounts are shown in column C. Column E shows the carrying value after deducting the amortized premium in column C from the prior period’s carrying value. Column D shows the premium’s reduction by periodic amortization.

EXHIBIT 10B.2 Effective Interest Amortization of Bond Premium

June 30, 2020 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,165 Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 835 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Record semiannual interest and premium amortization (effective interest method).

Column (A) is the par value ($100,000) multiplied by the semiannual contract rate (6%). Column (B) is the prior period’s carrying value multiplied by the semiannual market rate (4.9851%). Column (C) is the difference between interest paid and bond interest expense, or [(A) – (B)]. Column (D) is the prior period’s unamortized premium less the current period’s premium amortization. Column (E) is the par value plus unamortized premium, or [$100,000 + (D)].

Semiannual Interest

Period-End

(4)

12/31/2019 6/30/2020 12/31/2020 6/30/2021

12/31/2021

(0)

(2) (3)

$ 6,000 6,000 6,000

6,000 $ 24,000

(A) Cash

Interest Paid

6% × $100,000

$ 5,165 5,123

5,079 5,033

$20,400

(B) Bond

Interest Expense

4.9851% × Prior (E)

$ 835 877

921 967

$3,600

(C)

Premium Amortization

(A) – (B)

2,765 $3,600

1,888

967 0

(D)

Unamortized Premium

Prior (D) – (C)

102,765 $103,600

101,888

100,967

100,000

(E)

Carrying Value

$100,000 + (D)

Bonds: $100,000 Par Value, Semiannual Interest Payments, Two-Year Life, 6% Semiannual Contract Rate, 4.9851% Semiannual Market Rate

( 1 )

$103,600

$102,765

$100,967

$100,000

$101,888

12 /31

/2 01

9

6/ 30

/2 02

0

12 /31

/2 02

0

6/ 30

/2 02

1

12 /31

/2 02

1

Carrying value

Bonds Payable

12/31/2019 100,000 6/30/2020 — 12/31/2020 — 6/30/2021 — 12/31/2021 100,000

12/31/2021 0

Premium on Bonds Payable

12/31/2019 3,600 6/30/2020 835 12/31/2020 877 6/30/2021 921 12/31/2021 967

12/31/2021 0

When the issuer makes the first semiannual interest payment, it records the following. Similar entries with different amounts are recorded at each payment date until the bond matures at the end of 2021. The effec- tive interest method yields decreasing amounts of bond interest expense and increasing amounts of pre- mium amortization over the bonds’ life.

APPENDIX

Leases and Pensions10C Lease Liabilities A lease is an agreement between a lessor (owner) and a lessee (renter or ten- ant) that gives the lessee the right to use the asset for a period of time in return for cash (rent) payments. The financing of leases is a $1 trillion industry. The advantages of lease financing include no up-front, full cash payment and the potential to deduct rental payments from taxable income. Leases are classified as either finance leases or operating leases. In either case, for noncurrent leases the lessee records a “Right-of-Use Asset” and “Lease Liability” equal to the present value of lease pay- ments. At each period-end, the lessee records financing expense differently depending on whether it’s a finance lease or operating lease.

Finance Leases Finance leases are long-term leases where the lessee receives substantially all remaining benefits of the asset. A finance lease meets one or more of five criteria: (1) transfers ownership of lease asset to lessee, (2) has a purchase option that lessee is reasonably certain to exercise, (3) lease term is for major part of the lease asset’s remaining economic life, (4) present value of lease payments equals or exceeds substantially all of the lease asset’s fair value, or (5) the lease asset is specialized and expected to have no alternative use to lessor at lease-end. A finance lease is similar to the financing of an asset purchase. Examples include most leases of air- planes, delivery trucks, medical equipment, railcars, and department store buildings. The lessee records

C3 Describe accounting for leases and pensions.

Chapter 10 Accounting for Long-Term Liabilities 399

the leased item as its own asset along with a lease liability at the start of the lease term; the amount re- corded equals the present value of all lease payments.

Lease Start and First Payment Assume KDI Co. enters into a three-year lease of a building in which it sells sporting equipment. The lease is accounted for as a finance lease, it requires three $21,000 payments (the first at the beginning of the lease and the others at December 31 of 2019 and 2020), and the present value of its annual lease payments is $60,000 (implying a 5.086% discount rate). KDI records the asset and liability along with the first-period lease payment as follows. KDI reports the right-of-use lease asset as a long-term asset and the lease liability as a long-term liability. The portion of the lease liability expected to be paid in the next year is reported as a current liability.

Lease Asset Amortization At each year-end, KDI records amortization on the right-of-use asset (assume straight-line amortization, three-year lease term, and no salvage value) as follows.

Lease Payment for Liability and Interest KDI accrues interest expense on the lease liability at each year- end. Interest expense is computed by multiplying the lease liability by the interest rate on the lease. It records interest expense as part of its $21,000 annual lease payment as follows (for its first year).

Jan . 1, 2019 Right-of-Use Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Record right-of-use asset and lease liability.

Jan . 1, 2019 Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Record beginning-year cash lease payment.

Dec . 31, 2019 Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accumulated Amortization—Right-of-Use Asset . . . . . . . . . . 20,000

Record amortization on right-of-use asset. ($60,000−$0)∕3 yrs

Dec . 31, 2019 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,984

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,016

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Record lease payment for interest and lease liability.*

*Numbers are from a lease payment schedule as follows.

KDI’s entries for the final two years of this lease follow.

Payments

(A) (B) (C) (D) (E) Debit Debit Credit

Interest on + = Ending Balance Beginning Balance Lease Liability Lease Liability Cash Lease of Lease Liability Date of Lease Liability 5.086% × (A) (D) – (B) Payment (A) – (C)

Jan. 1, 2019 $60,000 $21,000 $21,000 $39,000 Dec 31, 2019 39,000 $1,984 19,016 21,000 19,984 Dec 31, 2020 19,984 1,016 19,984 21,000 0

$3,000 $60,000 $63,000

Dec . 31, 2020 Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Accumulated Amortization—Right-of-Use Asset . . . . . . . 20,000 Record amortization on right-of-use asset. Dec . 31, 2020 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,016 Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,984 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Record lease payment for interest and lease liability. Dec . 31, 2021 Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Accumulated Amortization—Right-of-Use Asset . . . . . . . 20,000 Record amortization on right-of-use asset.

Operating Leases Operating leases are long-term leases that do not meet any of the five cri- teria for finance leases.

Lease Start and Payments We prepare journal entries using the same lease payment schedule shown for the finance lease above. Recall this is a three-year lease that requires three $21,000 payments (the first at

400 Chapter 10 Accounting for Long-Term Liabilities

the beginning of the lease and the others at December 31 of 2019 and 2020), with a present value of its annual lease payments of $60,000 (implying a 5.086% discount rate). All entries under the finance lease apply here, but amounts for amortization entries differ.

Lease Amortization Total amortization for the lease life is the same for finance and operating leases. The difference is the yearly asset amortization. Those entries follow using the amortization calculated below.

Short-Term Leases Short-term leases have lease terms of 12 months or less and do not have long-term purchase options. Examples include most car and apartment rental agreements. The lessee records such lease payments as expenses. The lessee does not report the leased item as an asset or a liability (it is the lessor’s asset). If Verizon leases a kiosk from the mall for $300 per month, its entry follows.

2019 2020 2021

Dec . 31 Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,016 19,984 21,000

Accumulated Amortization—Right-of-Use Asset . . . . 19,016 19,984 21,000

Record amortization on right-of-use asset.*

Amortization* = Lease Payment − Interest on Lease Liability

For 2019 . . . $19,016 = $21,000 − $1,984 For 2020 . . . $19,984 = $21,000 − $1,016 For 2021 . . . $21,000 = $21,000 − $ 0

Point: In the income statement for an operating lease, Amortization Exp. and Interest Exp. are com- bined as one line item, “Lease Expense.” The balance sheet and ledger keep them separate.

July 4 Rental Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record short-term lease rental payment.

Pension Liabilities A pension plan is an agreement for the employer to provide benefits (pay- ments) to employees after they retire. Some employers pay the full cost of the pension, and some pay part of the cost. An employer records its payment into a pension plan with a debit to Pension Expense and a credit to Cash. A plan administrator invests the payments in pension assets and makes benefit payments to pension recipients (retired employees).

Defined Benefit Plan Defined benefit plans give workers defined future benefits; the employer’s contributions vary, depending on assumptions about future pension assets and liabilities. A pension liability is reported when the accumulated benefit obligation is more than the plan assets, called an underfunded plan. The accu- mulated benefit obligation is the present value of promised future pension payments to retirees. Plan assets refer to the market value of pension assets. A pension asset is reported when the accumulated benefit obliga- tion is less than the plan assets, called an overfunded plan. An employer reports pension expense when employees earn wages, which is sometimes decades before it pays pension benefits to employees.

Other Postretirement Benefits Other postretirement benefits refer to nonpension benefits such as health care and life insurance benefits. Costs of these benefits are estimated and liabilities accrued when the employees earn them. Many of these benefits are not funded.

Point: Fringe benefits are often 40% or more of salaries and wages, and pension benefits make up nearly 15% of fringe benefits.

Point: Two types of pension plans are (1) defined benefit plan—the retirement benefit is defined and the employer estimates the contribution necessary to pay these benefits—and (2) defined contribution plan—the pension contribution is defined and the employer and/or employee contribute amounts specified in the pension agreement.

BOND BASICS AND PAR BONDS Bond advantages: Bonds do not affect owner control, interest on bonds is tax deductible, and bonds can potentially increase return on equity. Bond disadvantages: Bonds can potentially decrease return on equity and require payments of both periodic interest and the par value at maturity.

Summary: Cheat Sheet

Bonds issued at par value (called par bonds):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Par bonds semiannual interest payment:

Maturity of bonds (payment of par): When the bond issuer pays the par value back to the bondholder.

Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Chapter 10 Accounting for Long-Term Liabilities 401

DISCOUNT BONDS Contract rate: The interest the bond issuer pays in cash. Market rate: The interest rate that borrowers are willing to pay and lenders are willing to accept.

Bond prices: A $1,000 bond with a price of 96.400 is sold for $964. A $1,000 bond with a price of 103½ is sold for $1,035. Carrying (book) value of a bond: Equals bond par value plus any pre- mium or minus any discount. Discount bonds: Bonds issued with a contract rate that is less than the market rate.

Contract rate > Market rate Bond sells at premium

Contract rate = Market rate Bond sells at par

Contract rate < Market rate Bond sells at discount

Issuance of discount bonds:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,400

Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 3,600

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

PREMIUM BONDS Premium bonds: Bonds issued with a contract rate higher than the market rate.

Issuance of premium bonds:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,600

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . 3,600

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Amortizing discount bonds (straight-line method):

Panel A: Interest Computations

Four payments of $4,000 (4 pymts × [$100,000 × 0 .08 × 1∕2 yr]) . . . . . $ 16,000

Plus discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,600

Bond interest expense (per interest period) =

Total bond interest expense Number of interest periods =

$19,600 4

= $4,900

Panel B: Entry to Record Interest Payment and Amortization

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . 4,900 June 30 and Discount on Bonds Payable . . . . . . . 900 Dec . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Discount ÷ Periods

Par value × ½ × Contract rate

Straight-line discount bond amortization table:

Semiannual Unamortized Carrying Period-End Discount Value

(0) 12/31/2019 . . . . . . . . . . . $3,600 $ 96,400

(1) 6/30/2020 . . . . . . . . . . . 2,700 97,300

(2) 12/31/2020 . . . . . . . . . . . 1,800 98,200

(3) 6/30/2021 . . . . . . . . . . . 900 99,100

(4) 12/31/2021 . . . . . . . . . . . 0 100,000

Straight-line premium bond amortization table:

Semiannual Unamortized Carrying Period-End Premium Value

(0) 12/31/2019 . . . . . . . . . $3,600 $103,600

(1) 6/30/2020 . . . . . . . . . 2,700 102,700

(2) 12/31/2020 . . . . . . . . . 1,800 101,800

(3) 6/30/2021 . . . . . . . . . 900 100,900

(4) 12/31/2021 . . . . . . . . . 0 100,000

BOND RETIREMENT Bond retirement by call option: Some bonds give issuers an option to call the bonds before they mature by paying par value plus a call premium. Record a gain if carrying value is greater than retirement price (shown here). Record a loss if carrying value is less than retirement price.

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 4,500

Gain on Bond Retirement . . . . . . . . . . . . . . . . . . . . 1,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,000

Bond retirement by conversion: Holders of convertible bonds can con- vert their bonds to stock. No gain or loss is recorded. Bonds are converted to stock at the bonds’ carrying value.

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Paid-In Capital in Excess of Par Value . . . . . . . . . . 70,000

Reporting of discount bonds:

Long-term liabilities

Bonds payable, 8%, due December 31, 2021 . . . . . . $100,000

Less discount on bonds payable . . . . . . . . . . . . . . . . . 3,600 $96,400

Reporting of premium bonds:

Long-term liabilities

Bonds payable, 12%, due December 31, 2021 . . . . . $100,000

Plus premium on bonds payable . . . . . . . . . . . . . . . . . 3,600 $103,600

Amortizing premium bonds (straight-line method):

Panel A: Interest Computations

Four payments of $6,000 (4 pymts × [$100,000 × 0 .12 × 1∕2 yr]) . . . . . $ 24,000 Less premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,600)

Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,400

Bond interest expense (per interest period) =

Total bond interest expense Number of interest periods =

$20,400 4

= $5,100

Panel B: Entry to Record Interest Payment and Amortization

2020–2021 Bond Interest Expense . . . . . . . . . . . . . . . . 5,100 June 30 and Premium on Bonds Payable . . . . . . . . . . . . 900 Dec . 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Premium ÷ Periods

Par value × ½ × Contract rate

402 Chapter 10 Accounting for Long-Term Liabilities

Payments of principal and interest payments for note: Payments on an installment note include accrued interest expense plus part of the amount borrowed (the principal).

Issuance of notes:

Note installment payments:

Dec . 31, 2019 Interest Expense . . . . . . . . . . . . . . . . 4,800

Notes Payable . . . . . . . . . . . . . . . . . . 18,482

Cash . . . . . . . . . . . . . . . . . . . . . 23,282

Dec . 31, 2020 Interest Expense . . . . . . . . . . . . . . . . 3,321

Notes Payable . . . . . . . . . . . . . . . . . . 19,961

Cash . . . . . . . . . . . . . . . . . . . . . 23,282

Bearer bonds (392) Bond (381) Bond certificate (382) Bond indenture (382) Callable bonds (392) Carrying (book) value of bonds (384) Contract rate (383) Convertible bonds (392) Coupon bonds (392) Debt-to-equity ratio (392)

Discount on bonds payable (384) Effective interest method (397) Finance lease (398) Installment note (390) Lease (398) Market rate (383) Mortgage (391) Operating lease (399) Par value of a bond (381) Pension plan (400)

Premium on bonds (386) Registered bonds (392) Secured bonds (392) Serial bonds (392) Short-term lease (400) Sinking fund bonds (392) Straight-line bond amortization (385) Term bonds (392) Unsecured bonds (392)

Key Terms

Multiple Choice Quiz

1. A bond traded at 971⁄2 means that a. The bond pays 971⁄2% interest. b. The bond trades at $975 per $1,000 bond. c. The market rate of interest is below the contract rate of

interest for the bond. d. The bonds can be retired at $975 each. e. The bond’s interest rate is 21⁄2%.

2. A bondholder that owns a $1,000, 6%, 15-year (term) bond has a. The right to receive $1,000 at maturity. b. Ownership rights in the bond-issuing entity. c. The right to receive $60 per month until maturity. d. The right to receive $1,900 at maturity. e. The right to receive $600 per year until maturity.

3. A company issues 8%, 20-year bonds with a par value of $500,000. The current market rate for the bonds is 8%. The

amount of interest owed to the bondholders for each semi- annual interest payment is a. $40,000. c. $20,000. e. $400,000. b. $0. d. $800,000.

4. A company issued five-year, 5% bonds with a par value of $100,000. The company received $95,735 for the bonds. Using the straight-line method, the company’s interest ex- pense for the first semiannual interest period is a. $2,926.50. c. $2,500.00. e. $9,573.50. b. $5,853.00. d. $5,000.00.

5. A company issued eight-year, 5% bonds with a par value of $350,000. The company received proceeds of $373,745. Interest is payable semiannually. The amount of premium amortized for the first semiannual interest period, assuming straight-line bond amortization, is a. $2,698. c. $8,750. e. $1,484. b. $23,745. d. $9,344.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b 2. a 3. c; $500,000 × 0.08 × 1⁄2 year = $20,000

4. a; Cash interest paid = $100,000 × 5% × 1⁄2 year = $2,500 Discount amortization = ($100,000 − $95,735)∕10 periods = $426.50

Interest expense = $2,500.00 + $426.50 = $2,926.50 5. e; ($373,745 − $350,000)∕16 periods = $1,484

Payments

(A) (B) (C) (D) (E) Debit Debit Credit

Beginning Balance

Interest Notes Ending

Period Ending Date Expense + Payable = Cash Balance 8% × (A) (D) – (B) (computed) (A) – (C)

(1 ) 12/31/2019 . . . . . . . . $60,000 $41,518

(2) 12/31/2020 . . . . . . . . . 41,518 21,557

(3) 12/31/2021 . . . . . . . . 21,557 0

$4,800 $ 18,482 $23,282

3,321 19,961 23,282

1,725 21,557 23,282

$9,846 $60,000 $69,846

LONG-TERM NOTES Installment note: A liability requiring a series of payments to the lender. Usually issued to a single lender, such as a bank. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Notes Payable . . . . . . . . . . . . . . 60,000

Chapter 10 Accounting for Long-Term Liabilities 403

A(B,C) Superscript letter A, B, or C denotes assignments based on Appendix 10A, 10B, or 10C.

Icon denotes assignments that involve decision making.

1. What is the main difference between notes payable and bonds payable?

2. What is the main difference between a bond and a share of stock?

3. What is the advantage of issuing bonds instead of ob- taining financing from the company’s owners?

4. What is a bond indenture? What provisions are usually in- cluded in it?

5. What are the contract rate and the market rate for bonds? 6. What factors affect the market rates for bonds? 7.B Does the straight-line or effective interest method pro-

duce an interest expense allocation that yields a constant rate of interest over a bond’s life? Explain.

8. Explain the concept of accrued interest on bonds at the end of an accounting period.

9. If you know the par value of bonds, the contract rate, and the market rate, how do you compute the bonds’ price?

10. What is the issue price of a $2,000 bond sold at 981⁄4? What is the issue price of a $6,000 bond sold at 1011⁄2?

11. Describe the debt-to-equity ratio and explain how creditors and owners use this ratio to evaluate a company’s risk.

12. What obligation does an entrepreneur (owner) have to investors that purchase bonds to finance the business?

13. Refer to Apple’s annual report in Appendix A. Is there any indication that Apple has issued long-term debt?

14. Refer to the statements for Samsung in Appendix A. By what amount did Samsung’s long-term borrowings increase or decrease in 2017?

15. Refer to the statement of cash flows for Samsung in Appendix A. For the year ended December 31, 2017, what was the amount for repay- ment of long-term borrowings and debentures?

16. Refer to the statements for Google in Appendix A. For the year ended December 31, 2017, what was its debt-to-equity ratio? What does this ratio tell us?

17.C When can a lease create both an asset and a liability for the lessee?

18.C Compare and contrast a finance lease with an operating lease. 19.C Describe the two basic types of pension plans.

Discussion Questions

APPLE

Samsung

Samsung

GOOGLE

QUICK STUDY

QS 10-1 Advantages of bond financing

A1

Identify the following as either an advantage (A) or a disadvantage (D) of bond financing for a company. a. Bonds do not affect owner control. b. A company earns a lower return with borrowed funds than it pays in interest. c. A company earns a higher return with borrowed funds than it pays in interest. d. Bonds require payment of periodic interest. e. Interest on bonds is tax deductible. f. Bonds require payment of par value at maturity.

Round dollar amounts to the nearest whole dollar for all assignments in this chapter.

QS 10-2 Issuing bonds at par P1

Dunphy Company issued $10,000 of 6%, 10-year bonds at par value on January 1. Interest is paid semian- nually each June 30 and December 31. Prepare the entries for (a) the issuance of the bonds and (b) the first interest payment on June 30.

QS 10-3 Issuing bonds at par

P1

Madrid Company plans to issue 8% bonds with a par value of $4,000,000. The company sells $3,600,000 of the bonds at par on January 1. The remaining $400,000 sells at par on July 1. The bonds pay interest semiannually on June 30 and December 31. 1. Record the entry for the first interest payment on June 30. 2. Record the entry for the July 1 cash sale of bonds.

On January 1, Renewable Energy issues bonds that have a $20,000 par value, mature in eight years, and pay 12% interest semiannually on June 30 and December 31. 1. Prepare the journal entry for issuance assuming the bonds are issued at (a) 99 and (b) 1031⁄2. 2. How much interest does the company pay (in cash) to its bondholders every six months if the bonds

are sold at par?

QS 10-4 Recording bond issuance and interest

P1 P2 P3

QS 10-5 Journalizing discount bond issuance P2

Enviro Company issues 8%, 10-year bonds with a par value of $250,000 and semiannual interest pay- ments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 871⁄2. Prepare the journal entry for the issuance of the bonds for cash on January 1.

404 Chapter 10 Accounting for Long-Term Liabilities

QS 10-6 Journalizing premium bond issuance P3

Garcia Company issues 10%, 15-year bonds with a par value of $240,000 and semiannual interest pay- ments. On the issue date, the annual market rate for these bonds is 8%, which implies a selling price of 1171⁄4. Prepare the journal entry for the issuance of these bonds for cash on January 1.

QS 10-7 Straight-Line: Discount bond computations

P2

Enviro Company issues 8%, 10-year bonds with a par value of $250,000 and semiannual interest pay- ments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 871⁄2. The straight-line method is used to allocate interest expense. 1. What are the issuer’s cash proceeds from issuance of these bonds? 2. What total amount of bond interest expense will be recognized over the life of these bonds? 3. What is the amount of bond interest expense recorded on the first interest payment date?

QS 10-8 Recording bond issuance and discount amortization

P2

Snap Company issues 10%, five-year bonds, on January 1 of this year, with a par value of $100,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on January 1, (b) the first interest payment on June 30, and (c) the second interest payment on December 31.

Semiannual Period-End Unamortized Discount Carrying Value

(0) January 1, issuance . . . . . . . . . . . . . . $7,360 $92,640

(1) June 30, first payment . . . . . . . . . . . . 6,624 93,376

(2) December 31, second payment . . . . . 5,888 94,112

QS 10-9 Straight-Line: Premium bond computations

P3

Enviro Company issues 8%, 10-year bonds with a par value of $250,000 and semiannual interest pay- ments. On the issue date, the annual market rate for these bonds is 5%, which implies a selling price of 123.375. The straight-line method is used to allocate interest expense. 1. What are the issuer’s cash proceeds from issuance of these bonds? 2. What total amount of bond interest expense will be recognized over the life of these bonds? 3. What is the amount of bond interest expense recorded on the first interest payment date?

QS 10-10 Bond retirement by call option P4

On July 1, Aloha Co. exercises a call option that requires Aloha to pay $408,000 for its outstanding bonds that have a carrying value of $416,000 and a par value of $400,000. The company exercises the call option after the semiannual interest is paid the day before on June 30. Record the entry to retire the bonds.

QS 10-11 Bond retirement by stock conversion P4

On January 1, the $3,000,000 par value bonds of Spitz Company with a carrying value of $3,000,000 are converted to 1,000,000 shares of $1 par value common stock. Record the entry for the conversion of the bonds.

QS 10-12 Issuance and interest for installment note

C1

On January 1, MM Co. borrows $340,000 cash from a bank and in return signs an 8% installment note for five annual payments of $85,155 each. 1. Prepare the journal entry to record issuance of the note. 2. For the first $85,155 annual payment at December 31, what amount goes toward interest expense?

What amount goes toward principal reduction of the note?

QS 10-13 Bond features and terminology

A2

Select the description that best fits each term or phrase. A. Records and tracks the bondholders’ names. B. Is unsecured; backed only by the issuer’s credit standing. C. Has varying maturity dates for amounts owed. D. The legal contract between the issuer and the bondholders. E. Can be exchanged for shares of the issuer’s stock. F. Is unregistered; interest is paid to whoever possesses them. G. Maintains a separate asset account from which bondholders are paid at maturity. H. Pledges specific assets of the issuer as collateral.

1. Registered bond 5. Convertible bond 2. Serial bond 6. Bond indenture 3. Secured bond 7. Sinking fund bond 4. Bearer bond 8. Debenture

Chapter 10 Accounting for Long-Term Liabilities 405

QS 10-15A Computing bond price C2

Compute the selling price of 8%, 10-year bonds with a par value of $250,000 and semiannual interest pay- ments. The annual market rate for these bonds is 10%. Use present value tables B.1 and B.3 in Appendix B.

QS 10-16A Computing bond price C2

Compute the selling price of 10%, 15-year bonds with a par value of $240,000 and semiannual interest pay- ments. The annual market rate for these bonds is 8%. Use present value tables B.1 and B.3 in Appendix B.

QS 10-17B Effective Interest: Bond discount computations

P5

Garcia Company issues 10%, 15-year bonds with a par value of $240,000 and semiannual interest pay- ments. On the issue date, the annual market rate for these bonds is 14%, which implies a selling price of 751⁄4. The effective interest method is used to allocate interest expense. 1. What are the issuer’s cash proceeds from issuance of these bonds? 2. What total amount of bond interest expense will be recognized over the life of these bonds? 3. What amount of bond interest expense is recorded on the first interest payment date?

QS 10-18B Effective Interest: Bond premium computations

P6

Garcia Company issues 10%, 15-year bonds with a par value of $240,000 and semiannual interest pay- ments. On the issue date, the annual market rate for these bonds is 8%, which implies a selling price of 1171⁄4. The effective interest method is used to allocate interest expense. 1. What are the issuer’s cash proceeds from issuance of these bonds? 2. What total amount of bond interest expense will be recognized over the life of these bonds? 3. What amount of bond interest expense is recorded on the first interest payment date?

QS 10-19C Recording short-term leases C3

Jin Li, an employee of ETrain.com, leases a car at O’Hare Airport for a three-day business trip. The rental cost is $250. Prepare the entry by ETrain.com to record Jin Li’s short-term car lease cost.

Exercise 10-2 Recording bond issuance at par, interest payments, and bond maturity

P1

Brussels Enterprises issues bonds at par dated January 1, 2019, that have a $3,400,000 par value, mature in four years, and pay 9% interest semiannually on June 30 and December 31. 1. Record the entry for the issuance of bonds for cash on January 1. 2. Record the entry for the first semiannual interest payment and the second semiannual interest payment. 3. Record the entry for the maturity of the bonds on December 31, 2022 (assume semiannual interest is

already recorded).

QS 10-14 Debt-to-equity ratio

A3

Compute the debt-to-equity ratio for each of the following companies. Which company appears to have a riskier financing structure?

Atlanta Company Spokane Company

Total liabilities . . . . . . . . . . . $429,000 $ 549,000

Total equity . . . . . . . . . . . . . 572,000 1,830,000

QS 10-20C Recording leases C3

Algoma, Inc., signs a five-year lease for office equipment with Office Solutions. The present value of the lease payments is $15,499. Prepare the journal entry that Algoma records at the inception of this finance lease.

No-Toxic-Toys currently has $200,000 of equity and is planning an $80,000 expansion to meet increasing demand for its product. The company currently earns $50,000 in net income, and the expansion will yield $25,000 in additional income before any interest expense.

The company has three options: (1) do not expand, (2) expand and issue $80,000 in debt that requires payments of 8% annual interest, or (3) expand and raise $80,000 from equity financing. For each option, compute (a) net income and (b) return on equity (Net income ÷ Equity). Ignore any income tax effects.

EXERCISES Exercise 10-1 Debt versus equity financing

A1

406 Chapter 10 Accounting for Long-Term Liabilities

Exercise 10-3 Recording bond issuance and interest

P1

On January 1, Boston Enterprises issues bonds that have a $3,400,000 par value, mature in 20 years, and pay 9% interest semiannually on June 30 and December 31. The bonds are sold at par. 1. How much interest will Boston pay (in cash) to the bondholders every six months? 2. Prepare journal entries to record (a) the issuance of bonds on January 1, (b) the first interest payment

on June 30, and (c) the second interest payment on December 31. 3. Prepare the journal entry for issuance assuming the bonds are issued at (a) 98 and (b) 102.

Exercise 10-4 Straight-Line: Amortization of bond discount

P2

Tano Company issues bonds with a par value of $180,000 on January 1, 2019. The bonds’ annual contract rate is 8%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 10%, and the bonds are sold for $170,862. 1. What is the amount of the discount on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare a straight-line amortization table like Exhibit 10.7 for these bonds.

Exercise 10-7 Straight-Line: Amortization table and bond interest expense

P2

Duval Co. issues four-year bonds with a $100,000 par value on January 1, 2019, at a price of $95,952. The annual contract rate is 7%, and interest is paid semiannually on June 30 and December 31. 1. Prepare a straight-line amortization table like Exhibit 10.7 for these bonds. 2. Prepare journal entries to record the first two interest payments. 3. Prepare the journal entry for maturity of the bonds on December 31, 2022 (assume semiannual interest

is already recorded).

Exercise 10-5 Straight-Line: Recording bond issuance and discount amortization

P2

Paulson Company issues 6%, four-year bonds, on January 1 of this year, with a par value of $200,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on January 1, (b) the first interest payment on June 30, and (c) the second interest payment on December 31.

Semiannual Period-End Unamortized Discount Carrying Value

(0) January 1, issuance . . . . . . . . . . . . . $13,466 $186,534

(1) June 30, first payment . . . . . . . . . . . 11,782 188,218

(2) December 31, second payment . . . 10,098 189,902

Exercise 10-6 Straight-Line: Recording bond issuance and discount amortization

P2

Dobbs Company issues 5%, two-year bonds, on December 31, 2019, with a par value of $200,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on December 31, 2019; (b) the first through fourth interest payments on each June 30 and December 31; and (c) the maturity of the bonds on December 31, 2021.

Semiannual Period-End Unamortized Discount Carrying Value

(0) 12/31/2019 . . . . . . . . . . . . . . . . . . . $12,000 $188,000

(1) 6/30/2020 . . . . . . . . . . . . . . . . . . . 9,000 191,000

(2) 12/31/2020 . . . . . . . . . . . . . . . . . . . 6,000 194,000

(3) 6/30/2021 . . . . . . . . . . . . . . . . . . . 3,000 197,000

(4) 12/31/2021 . . . . . . . . . . . . . . . . . . . 0 200,000

Exercise 10-8 Straight-Line: Recording bond issuance and premium amortization

P3

Wookie Company issues 10%, five-year bonds, on January 1 of this year, with a par value of $200,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on January 1, (b) the first interest payment on June 30, and (c) the second interest payment on December 31.

Semiannual Period-End Unamortized Premium Carrying Value

(0) January 1, issuance . . . . . . . . . . . . . $16,222 $216,222

(1) June 30, first payment . . . . . . . . . . . 14,600 214,600

(2) December 31, second payment . . . 12,978 212,978

Chapter 10 Accounting for Long-Term Liabilities 407

Exercise 10-9 Straight-Line: Amortization of bond premium

P3

Quatro Co. issues bonds dated January 1, 2019, with a par value of $400,000. The bonds’ annual contract rate is 13%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 12%, and the bonds are sold for $409,850. 1. What is the amount of the premium on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare a straight-line amortization table like Exhibit 10.11 for these bonds.

Exercise 10-10 Bond retirement by call option

P4

Tyrell Company issued callable bonds with a par value of $10,000. The call option requires Tyrell to pay a call premium of $500 plus par (or a total of $10,500) to bondholders to retire the bonds. On July 1, Tyrell exercises the call option. The call option is exercised after the semiannual interest is paid the day before on June 30. Record the entry to retire the bonds under each separate situation. 1. The bonds have a carrying value of $9,000. 2. The bonds have a carrying value of $11,000.

Exercise 10-12 Installment note amortization table C1

On January 1, 2019, Eagle Company borrows $100,000 cash by signing a four-year, 7% installment note. The note requires four equal payments of $29,523, consisting of accrued interest and principal on December 31 of each year from 2019 through 2022. Prepare an amortization table for this installment note like the one in Exhibit 10.12.

Exercise 10-13 Installment note entries

C1

Use the information in Exercise 10-12 to prepare the journal entries for Eagle to record the note’s issuance and each of the four payments.

Exercise 10-11 Straight-Line: Bond computations, amortization, and bond retirement

P2 P4

On January 1, 2019, Shay Company issues $700,000 of 10%, 15-year bonds. The bonds sell for $684,250. Six years later, on January 1, 2025, Shay retires these bonds by buying them on the open market for $731,500. All interest is accounted for and paid through December 31, 2024, the day before the purchase. The straight-line method is used to amortize any bond discount. 1. What is the amount of the discount on the bonds at issuance? 2. How much amortization of the discount is recorded on the bonds for the entire period from January 1,

2019, through December 31, 2024? 3. What is the carrying (book) value of the bonds as of the close of business on December 31, 2024? 4. Prepare the journal entry to record the bond retirement.

Exercise 10-14 Reporting liabilities section of balance sheet

C1 P2

Selected accounts from WooHoo Co.’s adjusted trial balance for the year ended December 31 follow. Prepare the liabilities section of its classified balance sheet.

Notes payable (due in 5 years) . . . . . . . . . . . $ 3,000 Discount on bonds payable . . . . . . . . . . . . . . $400

Accounts payable . . . . . . . . . . . . . . . . . . . . . . 500 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . 200

Bonds payable (due in 10 years) . . . . . . . . . . 10,000 Interest payable (due in 2 weeks) . . . . . . . . . 100

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 Sales tax payable . . . . . . . . . . . . . . . . . . . . . . 50

Exercise 10-15 Applying debt-to- equity ratio

A3

Montclair Company is considering a project that will require a $500,000 loan. It presently has total liabil- ities of $220,000 and total assets of $620,000. 1. Compute Montclair’s (a) current debt-to-equity ratio and (b) the debt-to-equity ratio assuming it bor-

rows $500,000 to fund the project. 2. If Montclair borrows the funds, does its financing structure become more or less risky?

Exercise 10-16A Computing bond interest and price; recording bond issuance C2

Bringham Company issues bonds with a par value of $800,000. The bonds mature in 10 years and pay 6% annual interest in semiannual payments. The annual market rate for the bonds is 8%. 1. Compute the price of the bonds as of their issue date. 2. Prepare the journal entry to record the bonds’ issuance.

408 Chapter 10 Accounting for Long-Term Liabilities

Exercise 10-17A Computing bond interest and price; recording bond issuance C2

Citywide Company issues bonds with a par value of $150,000. The bonds mature in five years and pay 10% annual interest in semiannual payments. The annual market rate for the bonds is 8%. 1. Compute the price of the bonds as of their issue date. 2. Prepare the journal entry to record the bonds’ issuance.

Exercise 10-18B Effective Interest: Amortization of bond discount

P5

Stanford issues bonds dated January 1, 2019, with a par value of $500,000. The bonds’ annual contract rate is 9%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 12%, and the bonds are sold for $463,140. 1. What is the amount of the discount on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare an effective interest amortization table like Exhibit 10B.1 for these bonds.

Exercise 10-19B Effective Interest: Amortization of bond premium

P6

Quatro Co. issues bonds dated January 1, 2019, with a par value of $400,000. The bonds’ annual contract rate is 13%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 12%, and the bonds are sold for $409,850. 1. What is the amount of the premium on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare an effective interest amortization table like Exhibit 10B.2 for these bonds.

Exercise 10-20C Identifying finance and operating leases

C3

In each of the following separate cases, indicate whether the company has entered into a finance lease or an operating lease.

1. The lessor retains title to the asset, and the lease term is 3 years on an asset that has a 10-year useful life.

2. The title is transferred to the lessee. The lessee can purchase the asset for $1 at the end of the lease, and the lease term is five years. The leased asset has an expected useful life of six years.

3. The present value of the lease payments is 95% of the leased asset’s market value, and the lease term is 90% of the leased asset’s useful life.

Exercise 10-21C Accounting for finance lease

C3

On January 1, Harbor (lessee) signs a five-year lease for equipment that is accounted for as a finance lease. The lease requires five $10,000 lease payments (the first at the beginning of the lease and the remaining four at December 31 of years 1, 2, 3, and 4), and the present value of the five annual lease pay- ments is $41,000, based on an 11% interest rate. 1. Prepare the January 1 journal entry Harbor records at inception of the lease for any asset or liability. 2. Prepare the January 1 entry Harbor records for the first $10,000 cash lease payment. 3. If the leased asset has a five-year useful life with no salvage value, prepare the December 31 journal

entry Harbor records each year for amortization of the leased asset.

Exercise 10-22C Analyzing lease purchase options

C3

General Motors advertised three alternatives for a 25-month lease on a new Tahoe: (1) zero dollars down and a lease payment of $1,750 per month for 25 months, (2) $5,000 down and $1,500 per month for 25 months, or (3) $38,500 down and no payments for 25 months. Use the present value Table B.3 in Appendix B to determine which is the best alternative for the customer (assume you have enough cash to accept any alternative and the annual interest rate is 12% compounded monthly).

PROBLEM SET A

Problem 10-1A Straight-Line: Amortization of bond discount

P2

Hillside issues $4,000,000 of 6%, 15-year bonds dated January 1, 2019, that pay interest semiannually on June 30 and December 31. The bonds are issued at a price of $3,456,448.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line discount amortization,

and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of a straight-line amortization table like Exhibit 10.7. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $4,143,552 (4) 12/31/2020 carrying value, $3,528,920

Chapter 10 Accounting for Long-Term Liabilities 409

Problem 10-2A Straight Line: Amortization of bond premium

P3

Refer to the bond details in Problem 10-1A, except assume that the bonds are issued at a price of $4,895,980.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line premium amortiza-

tion, and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of a straight-line amortization table like Exhibit 10.11. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $2,704,020 (4) 12/31/2020 carrying value, $4,776,516

Ellis Company issues 6.5%, five-year bonds dated January 1, 2019, with a $250,000 par value. The bonds pay interest on June 30 and December 31 and are issued at a price of $255,333. The annual market rate is 6% on the issue date.

Required

1. Calculate the total bond interest expense over the bonds’ life. 2. Prepare a straight-line amortization table like Exhibit 10.11 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments.

Check (2) 6/30/2021 carrying value, $252,668

Problem 10-3A Straight-Line: Amortization of bond premium

P3

Legacy issues $325,000 of 5%, four-year bonds dated January 1, 2019, that pay interest semiannually on June 30 and December 31. They are issued at $292,181 when the market rate is 8%.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare a straight-line amortization table like the one in Exhibit 10.7 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments.

Problem 10-4A Straight-Line: Amortization of bond discount P2

Check (2) $97,819

(3) 12/31/2020 carrying value, $308,589

On November 1, 2019, Norwood borrows $200,000 cash from a bank by signing a five-year installment note bearing 8% interest. The note requires equal payments of $50,091 each year on October 31.

Required

1. Complete an amortization table for this installment note similar to the one in Exhibit 10.12. 2. Prepare the journal entries in which Norwood records (a) accrued interest as of December 31, 2019

(the end of its annual reporting period), and (b) the first annual payment on the note.

Problem 10-5A Installment notes

C1

Check (1) 10/31/2023 ending balance, $46,382

Hartford Research issues bonds dated January 1 that pay interest semiannually on June 30 and December 31. The bonds have a $40,000 par value and an annual contract rate of 10%, and they mature in 10 years.

Required

For each separate situation, (a) determine the bonds’ issue price on January 1 and (b) prepare the journal entry to record their issuance. 1. The market rate at the date of issuance is 8%. 2. The market rate at the date of issuance is 10%. 3. The market rate at the date of issuance is 12%.

Problem 10-7AA Computing bond price and recording issuance

C2

Check (1) Premium, $5,437

(3) Discount, $4,588

At the end of the current year, the following information is available for both Pulaski Company and Scott Company.

Required

1. Compute the debt-to-equity ratios for both companies. 2. Which company has the riskier financing structure?

Pulaski Company Scott Company

Total assets . . . . . . $860,000 $440,000

Total liabilities . . . . 360,000 240,000

Total equity . . . . . . 500,000 200,000

Problem 10-6A Applying the debt-to- equity ratio

A3

410 Chapter 10 Accounting for Long-Term Liabilities

Problem 10-8AB Effective Interest: Amortization of bond discount P5

Refer to the bond details in Problem 10-4A.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like the one in Exhibit 10B.1 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments.

Check (2) $97,819

(3) 12/31/2020 carrying value, $307,308

Problem 10-9AB Effective Interest: Amortization of bond premium P6

Refer to the bond details in Problem 10-3A.

Required

1. Compute the total bond interest expense over the bonds’ life. 2. Prepare an effective interest amortization table like the one in Exhibit 10B.2 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments.

Check (2) 6/30/2021 carrying value, $252,865

Problem 10-10AB Effective Interest: Amortization of bond

P6

Ike issues $180,000 of 11%, three-year bonds dated January 1, 2019, that pay interest semiannually on June 30 and December 31. They are issued at $184,566 when the market rate is 10%.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like Exhibit 10B.2 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments.

Check (3) 6/30/2020 carrying value, $182,448

Problem 10-12AC Accounting for operating lease

C3

Refer to the lease details in Problem 10-11A. Assume that this lease is classified as an operating lease instead of a finance lease.

Required

1. Prepare the January 1 journal entry at the start of the lease to record any asset or liability. 2. Prepare the January 1 journal entry to record the first $18,000 cash lease payment. 3. Prepare the December 31 journal entry to record amortization at the end of (a) Year 1, (b) Year 2, and

(c) Year 3. 4. Prepare the December 31 journal entry to record the $18,000 cash lease payment at the end of (a) Year 1

and (b) Year 2.

Problem 10-11AC Accounting for finance lease

C3

On January 1, Rogers (lessee) signs a three-year lease for machinery that is accounted for as a finance lease. The lease requires three $18,000 lease payments (the first at the beginning of the lease and the remaining two at December 31 of Year 1 and Year 2). The present value of the three annual lease payments is $51,000, using a 6.003% interest rate. The lease payment schedule follows.

Payments (A) (B) (C) (D) (E) Debit Debit Credit Interest on Ending Balance Beginning Balance Lease Liability + Lease Liability = Cash Lease of Lease Liability Date of Lease Liability 6.003% × (A) (D) − (B) Payment (A) − (C) Jan. 1, Year 1 . . . . . $51,000 $18,000 $18,000 $33,000 Dec. 31, Year 1. . . . 33,000 $1,981 16,019 18,000 16,981 Dec. 31, Year 2 . . . 16,981 1,019 16,981 18,000 0 $3,000 $51,000 $54,000

Required

1. Prepare the January 1 journal entry at the start of the lease to record any asset or liability. 2. Prepare the January 1 journal entry to record the first $18,000 cash lease payment. 3. Prepare the December 31 journal entry to record straight-line amortization with zero salvage value at

the end of (a) Year 1, (b) Year 2, and (c) Year 3. 4. Prepare the December 31 journal entry to record the $18,000 cash lease payment at the end of (a) Year 1

and (b) Year 2.

Chapter 10 Accounting for Long-Term Liabilities 411

PROBLEM SET B

Problem 10-1B Straight-Line: Amortization of bond discount

P2

Romero issues $3,400,000 of 10%, 10-year bonds dated January 1, 2019, that pay interest semiannually on June 30 and December 31. The bonds are issued at a price of $3,010,000.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line discount amortization,

and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of a straight-line amortization table like Exhibit 10.7. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $3,790,000 (4) 6/30/2020 carrying value, $3,068,500

Problem 10-2B Straight-Line: Amortization of bond premium

P3

Refer to the bond details in Problem 10-1B, except assume that the bonds are issued at a price of $4,192,932.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line premium amortiza-

tion, and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of a straight-line amortization table like Exhibit 10.11. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $2,607,068

(4) 6/30/2020 carrying value, $4,073,991

Problem 10-3B Straight-Line: Amortization of bond premium

P3

Ripkin Company issues 9%, five-year bonds dated January 1, 2019, with a $320,000 par value. The bonds pay interest on June 30 and December 31 and are issued at a price of $332,988. Their annual market rate is 8% on the issue date.

Required

1. Calculate the total bond interest expense over the bonds’ life. 2. Prepare a straight-line amortization table like Exhibit 10.11 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments.

Check (2) 6/30/2021 carrying value, $326,493

Problem 10-4B Straight-Line: Amortization of bond discount

P2

Gomez issues $240,000 of 6%, 15-year bonds dated January 1, 2019, that pay interest semiannually on June 30 and December 31. They are issued at $198,494 when the market rate is 8%.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the life of the bonds. 3. Prepare a straight-line amortization table like the one in Exhibit 10.7 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments.

Analysis Component

5. Assume the market rate at issuance is 4% instead of 8%. Without providing numbers, describe how this change affects the amounts reported on Gomez’s financial statements.

Check (2) $257,506

(3) 6/30/2020 carrying value, $202,646

Problem 10-5B Installment notes

C1

On October 1, 2019, Gordon borrows $150,000 cash from a bank by signing a three-year installment note bearing 10% interest. The note requires equal payments of $60,316 each year on September 30.

Required

1. Complete an amortization table for this installment note similar to the one in Exhibit 10.12. 2. Prepare the journal entries to record (a) accrued interest as of December 31, 2019 (the end of its

annual reporting period), and (b) the first annual payment on the note.

Check (1) 9/30/2021 ending balance, $54,836

412 Chapter 10 Accounting for Long-Term Liabilities

At the end of the current year, the following information is available for both Atlas Company and Bryan Company.

Problem 10-6B Applying the debt-to- equity ratio

A3

Flagstaff Systems issues bonds dated January 1 that pay interest semiannually on June 30 and December 31. The bonds have a $90,000 par value and an annual contract rate of 12%, and they mature in five years.

Required

For each separate situation, (a) determine the bonds’ issue price on January 1 and (b) prepare the journal entry to record their issuance. 1. The market rate at the date of issuance is 10%. 2. The market rate at the date of issuance is 12%. 3. The market rate at the date of issuance is 14%.

Check (1) Premium, $6,948

(3) Discount, $6,326

Problem 10-7BA Computing bond price and recording issuance

C2

Required

1. Compute the debt-to-equity ratios for both companies. 2. Which company has the riskier financing structure?

Refer to the bond details in Problem 10-4B.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like the one in Exhibit 10B.1 for the bonds’ first two

years. 4. Prepare the journal entries to record the first two interest payments.

Problem 10-8BB Effective Interest: Amortization of bond discount P5 Check (2) $257,506

(3) 6/30/2020 carrying value, $200,803

Refer to the bond details in Problem 10-3B.

Required

1. Compute the total bond interest expense over the bonds’ life. 2. Prepare an effective interest amortization table like the one in Exhibit 10B.2 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments.

Problem 10-9BB Effective Interest: Amortization of bond premium P6 Check (2) 6/30/2021 carrying value, $327,136

Valdez issues $450,000 of 13%, four-year bonds dated January 1, 2019, that pay interest semiannually on June 30 and December 31. They are issued at $493,608 when the market rate is 10%.

Required

1. Prepare the January 1 journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like the one in Exhibit 10B.2 for the bonds’ first two

years. 4. Prepare the journal entries to record the first two interest payments.

Analysis Component

5. Assume that the market rate at issuance is 14% instead of 10%. Without presenting numbers, describe how this change affects the amounts reported on Valdez’s financial statements.

Problem 10-10BB Effective Interest: Amortization of bond

P6

Check (3) 6/30/2020 carrying value, $479,202

Atlas Company Bryan Company

Total assets . . . . . . $180,000 $750,000

Total liabilities . . . . 80,000 562,500

Total equity . . . . . . 100,000 187,500

Chapter 10 Accounting for Long-Term Liabilities 413

Problem 10-12BC Accounting for operating lease

C3

Refer to the lease details in Problem 10-11B. Assume that this lease is classified as an operating lease instead of a finance lease.

Required

1. Prepare the January 1 journal entry at the start of the lease to record any asset or liability. 2. Prepare the January 1 journal entry to record the first $14,000 cash lease payment. 3. Prepare the December 31 journal entry to record amortization at the end of (a) Year 1, (b) Year 2, and

(c) Year 3. 4. Prepare the December 31 journal entry to record the $14,000 cash lease payment at the end of (a) Year 1

and (b) Year 2.

Problem 10-11BC Accounting for finance lease

C3

On January 1, Kwak (lessee) signs a three-year lease for equipment that is accounted for as a finance lease. The lease requires three $14,000 lease payments (the first at the beginning of the lease and the remaining two at December 31 of Year 1 and Year 2). The present value of the three annual lease pay- ments is $39,000, using a 7.9% interest rate. The lease payment schedule follows.

Required

1. Prepare the January 1 journal entry at the start of the lease to record any asset or liability. 2. Prepare the January 1 journal entry to record the first $14,000 cash lease payment. 3. Prepare the December 31 journal entry to record straight-line amortization with zero salvage value at

the end of (a) Year 1, (b) Year 2, and (c) Year 3. 4. Prepare the December 31 journal entry to record the $14,000 cash lease payment at the end of (a) Year 1

and (b) Year 2.

Payments (A) (B) (C) (D) (E) Debit Debit Credit Interest on Ending Balance Beginning Balance Lease Liability + Lease Liability = Cash Lease of Lease Liability Date of Lease Liability 7.9% × (A) (D) − (B) Payment (A) − (C) Jan. 1, Year 1 . . . . . $39,000 $14,000 $14,000 $25,000 Dec. 31, Year 1 . . . 25,000 $1,975 12,025 14,000 12,975 Dec. 31, Year 2 . . . 12,975 1,025 12,975 14,000 0 $3,000 $39,000 $42,000

SERIAL PROBLEM Business Solutions

A1 A3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 10 Santana Rey has consulted with her local banker and is considering financing an expansion of her business by obtaining a long-term bank loan. Selected account balances at March 31, 2020, for Business Solutions follow.

Total assets . . . . . . . . . . $120,268 Total liabilities . . . . . . . . . $875 Total equity . . . . . . . . . . $119,393

Required

1. The bank has offered a long-term secured note to Business Solutions. The bank’s loan procedures require that a client’s debt-to-equity ratio not exceed 0.8. As of March 31, 2020, what is the maximum amount that Business Solutions could borrow from this bank?

2. If Business Solutions borrows the maximum amount allowed from the bank, what percentage of assets would be financed (a) by debt and (b) by equity?

3. What are some factors Santana Rey should consider before borrowing the funds? Check (1) $94,639 ©Alexander Image/Shutterstock

414 Chapter 10 Accounting for Long-Term Liabilities

ETHICS CHALLENGE C3 A1

BTN 10-1 Traverse County needs a new county government building that would cost $10 million. The politicians feel that voters will not approve a municipal bond issue to fund the building because it would increase taxes. They opt to have a state bank issue $10 million of tax-exempt securities to pay for the building construction. The county then will make yearly lease payments (of principal and interest) to repay the obligation. Unlike conventional municipal bonds, the lease payments are not binding obligations on the county and, therefore, require no voter approval.

Required

1. Do you think the actions of the politicians and the bankers in this situation are ethical? 2. In terms of risk, how do the tax-exempt securities used to pay for the building compare to a conven-

tional municipal bond issued by Traverse County?

Beyond the Numbers

COMPANY ANALYSIS A1 A2

Accounting Analysis

AA 10-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Identify Apple’s long-term debt as reported on its balance sheet at (a) September 30, 2017, and

(b) September 24, 2016. 2. Calculate the percentage change in long-term debt from September 24, 2016, to September 30, 2017. 3. If Apple’s reported long-term debt continues on the current trend, do we expect total interest expense

to increase or decrease? APPLE

AA 10-2 Key figures for Apple and Google follow.

Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Total assets . . . . . . . . . . . . . $375,319 $321,686 $197,295 $167,497

Total liabilities . . . . . . . . . . . 241,272 193,437 44,793 28,461

Total equity . . . . . . . . . . . . . 134,047 128,249 152,502 139,036

Required

1. Compute the debt-to-equity ratios for Apple and Google for both the current year and the prior year. 2. Use the ratios from part 1 to determine which company’s financing structure is least risky. 3. Is its debt-to-equity ratio more risky or less risky compared to the industry (assumed) average of 0.5

for (a) Apple and (b) Google?

COMPARATIVE ANALYSIS A3

APPLE GOOGLE

AA 10-3 Selected results from Samsung, Apple, and Google follow.

Samsung Apple Google

In millions Current Year Prior Year Current Year Current Year

Total assets . . . . . . . . . . . . W301,752,090 W262,174,324 $375,319 $197,295

Total liabilities . . . . . . . . . 87,260,662 69,211,291 241,272 44,793

Total equity . . . . . . . . . . . . 214,491,428 192,963,033 134,047 152,502

GLOBAL ANALYSIS A3

APPLE GOOGLE

Samsung

Required

1. Compute Samsung’s debt-to-equity ratio for the current year and the prior year. 2. Is Samsung’s financing structure more risky or less risky in the current year versus the prior year? 3. In the current year, is Samsung’s financing structure more risky or less risky than (a) Apple’s and

(b) Google’s?

BTN 10-2 Your business associate mentions that she is considering investing in corporate bonds cur- rently selling at a premium. She says that because the bonds are selling at a premium, they are highly valued and her investment will yield more than the going rate of return for the risk involved. Reply with a memorandum to confirm or correct your associate’s interpretation of premium bonds.

COMMUNICATING IN PRACTICE P3

Chapter 10 Accounting for Long-Term Liabilities 415

BTN 10-4B Break into teams and complete the following requirements related to effective interest amor- tization for a premium bond. 1. Each team member is to independently prepare a blank table with proper headings for amortization of

a bond premium. When all have finished, compare tables and ensure that all are in agreement.

Parts 2 and 3 require use of these facts: On January 1, 2019, McElroy issues $100,000, 9%, five-year bonds at 104.1. The market rate at issuance is 8%. McElroy pays interest semiannually on June 30 and December 31. 2. In rotation, each team member must explain how to complete one line of the bond amortization table,

including all computations for his or her line. All members are to fill in their tables during this pro- cess. You need not finish the table; stop after all members have explained a line.

3. In rotation, each team member is to identify a separate column of the table and indicate what the final number in that column will be and explain the reasoning.

4. Reach a team consensus as to what the total bond interest expense on this bond issue will be if the bond is not retired before maturity.

5. As a team, prepare a list of similarities and differences between the amortization table just prepared and the amortization table if the bond had been issued at a discount.

TEAMWORK IN ACTION P5 P6

Hint: Rotate teams to report on parts 4 and 5. Consider requiring entries for issuance and interest payments.

BTN 10-3 Access the March 23, 2017, filing of the 10-K report of Home Depot for the year ended January 29, 2017, from SEC.gov (ticker: HD). Refer to Home Depot’s balance sheet, including its note 4 (on debt).

Required

1. Identify Home Depot’s long-term liabilities and the amounts for those liabilities from Home Depot’s balance sheet at January 29, 2017.

2. Review Home Depot’s note 4. The note reports that as of January 29, 2017, it had $2.947 billion of “5.875% Senior Notes; due December 16, 2036; interest payable semiannually on June 16 and December 16.” These notes have a face value of $3.0 billion and were originally issued at $2.958 billion.

a. Why would Home Depot issue $3.0 billion of its notes for only $2.958 billion? b. How much cash interest must Home Depot pay each June 16 and December 16 on these notes?

TAKING IT TO THE NET A2

BTN 10-5 Joey Shamah and Scott Borba are the founders of e.l.f. Cosmetics. Assume that the company currently has $250,000 in equity and is considering a $100,000 expansion to meet increased demand. The $100,000 expansion would yield $16,000 in additional annual income before interest expense. Assume that the business currently earns $40,000 annual income before interest expense of $10,000, yielding a return on equity of 12% ($30,000/$250,000). To fund the expansion, the company is considering the issu- ance of a 10-year, $100,000 note with annual interest payments (the principal due at the end of 10 years).

Required

1. Using return on equity as the decision criterion, show computations to support or reject the expansion if interest on the $100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (e) 20%.

2. What general rule do the results in part 1 illustrate?

ENTREPRENEURIAL DECISION A1

BTN 10-6 Visit your city or county library. Ask the librarian to help you locate the most recent financial records of your city or county government. Examine those records.

Required

1. Determine the amount of long-term bonds and notes currently outstanding. 2. Read the supporting information to your municipality’s financial statements and record

a. The market interest rate(s) when the bonds and/or notes were issued. b. The date(s) when the bonds and/or notes will mature. c. Any rating(s) on the bonds and/or notes received from Moody’s Investors Service, Standard &

Poor’s Ratings Services, Fitch Ratings, or another rating agency.

HITTING THE ROAD A1

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Learning Objectives

CONCEPTUAL C1 Identify characteristics of corporations

and their organization.

C2 Explain characteristics of, and distribute dividends between, common and preferred stock.

C3 Explain the items reported in retained earnings.

PROCEDURAL P1 Record the issuance of corporate stock.

P2 Record transactions involving cash dividends, stock dividends, and stock splits.

P3 Record purchases and sales of treasury stock.

ANALYTICAL A1 Compute earnings per share and

describe its use.

A2 Compute price-earnings ratio and describe its use in analysis.

A3 Compute dividend yield and explain its use in analysis.

A4 Compute book value and explain its use in analysis.

Chapter Preview

11 Corporate Reporting and Analysis

NTK 11-4

TREASURY STOCK

P3 Purchasing treasury stock

Reissuing treasury stock

REPORTING AND ANALYSIS

C3 Retained earnings and equity

A1 EPS A2 PE ratio A3 Dividend yield A4 Book value

NTK 11-3

PREFERRED STOCK

C2 Issuance Dividend preferences

Rationale

NTK 11-1

COMMON STOCK

C1 Stock basics P1 Stock issuance:

Par value

No-par value

Stated value

Noncash assets

NTK 11-2

DIVIDENDS

P2 Cash dividends Stock dividends

Stock splits

NTK 11-5

417

“Trust of the consumer is critical” —Jeremy Stoppelman

Point of View

SAN FRANCISCO—“When I was in business school, I was think- ing about doing something entrepreneurial,” recalls Jeremy Stoppelman. “I’d always read the little vignettes about how someone started a small business.”

“Word of mouth was the best way to find local busi- nesses,” explains Jeremy. “If we could find a way to capture that and bring it online, that would be powerful.” To turn his idea into a business, Jeremy and his co-founders built Yelp (Yelp.com). Yelp publishes crowdsourced reviews about local businesses.

In the first few years of business, Jeremy had to make crucial decisions regarding creditor versus equity financing. When Google offered to purchase his business, Jeremy had to learn about stock types and ways to finance Yelp.

“I felt like we built this company,” recalls Jeremy, “there’s no fundamental reason for us to sell.” Instead of selling to Google, and armed with knowledge of equity financing, Jeremy raised money from individual investors. Also, instead of paying divi- dends, he reinvested Yelp income into the company.

Jeremy has some advice: “Building a great company takes time. If it’s not something you’re passionate about . . . you’re not going to make it.”

Sources: Yelp website, January 2019; Yelp Foundation, January 2018; Time, December 2014

©Maria J. Avila/MCT/Newscom

A corporation is an entity that is separate from its owners and has many of the same rights as a person. Owners of corporations are called stockholders or shareholders. Corporations are sepa- rated into two types. A privately held (or closely held) corporation does not offer its stock for public sale and usually has few stockholders. A publicly held corporation offers its stock for public sale and can have thousands of stockholders. Public sale means selling and trading stock on an organized stock market.

Corporate Advantages Separate legal entity: A corporation has many of the same rights, duties, and responsibili-

ties as a person. It takes actions through its agents, who are its officers and managers. Limited liability: Stockholders are not liable for corporate actions or debt. Transferable ownership rights: Transfer of shares from one stockholder to another has no direct

effect on operations except when it causes a change in directors who oversee the corporation. Continuous life: A corporation’s life is indefinite because it is not tied to the physical lives

of its owners. No mutual agency for stockholders: Stockholders, who are not officers and managers, can-

not bind the corporation to contracts—called lack of mutual agency. Easier capital accumulation: Buying stock is attractive to investors because of the advan-

tages above, which helps corporations collect large sums of money.

Corporate Disadvantages Government regulation: A corporation must follow a state’s incorporation laws.

Proprietorships and partnerships avoid many of these. Corporate taxation: Corporations pay many of the same taxes as proprietorships and part-

nerships plus additional taxes. The most burdensome are federal and state corporate income taxes that together can take 21% or more of pretax income. Also, corporate income is usually taxed a second time as part of stockholders’ personal income when they receive cash divi- dends. This is called double taxation.

CORPORATE FORM OF ORGANIZATION C1 Identify characteristics of corporations and their organization.

418 Chapter 11 Corporate Reporting and Analysis

Corporate Stockholders Rights of Stockholders Stockholders have specific rights under the corporation’s charter and general rights under state law. Stockholders also have the right to receive timely fi- nancial reports. When a corporation has only one class of stock, it is called common stock. State laws vary, but common stockholders usually have the right to Vote at stockholders’ meetings (or register proxy votes). Sell or dispose of their stock. Purchase their proportional share of any common stock later issued. This preemptive right

protects stockholders’ proportionate interest. For example, a stockholder who owns 25% of a corporation’s stock has the first opportunity to buy 25% of any new stock issued.

Receive the same dividend, if any, on each common share. Share in any assets remaining after creditors and preferred stockholders are paid if the corpo-

ration is liquidated. Each common share receives the same amount.

Artificial Unintelligence Dow Jones newswire mistakenly published a bogus news story about Google acquiring Apple for $9 billion. Informed investors were not fooled, as Apple’s market value was over $700 billion. However, bots designed to purchase stock of any company rumored of being acquired instantaneously purchased millions of shares of Apple. This event revealed how bots are increasingly impacting our financial markets. ■

Decision Insight

Corporate Organization and Management Incorporation A corporation is created by getting a charter from a state government. A charter application is signed by the prospective stockholders called incorporators or promoters and then filed with the state. When the application process is complete and fees paid, the charter is issued and the corporation is formed. Investors then purchase the corporation’s stock, meet as stockholders, and elect a board of directors.

Organization Expenses Organization expenses (or organization costs) are the costs to start a corporation; they include legal fees, promoters’ fees, and payments for a charter. The corporation records (debits) these costs to Organization Expenses. Organization costs are expensed as incurred.

Management Stockholders control a corpora- tion by electing a board of directors, or directors. A stockholder usually has one vote for each share of stock owned. This control relation is shown in Exhibit 11.1. Directors are responsible for overseeing corporate activities. A board is in charge of hiring and firing key executives who manage day-to-day operations. A corporation’s chief executive officer (CEO) is often its president. Several vice presidents are commonly assigned to specific areas such as finance, production, and marketing.

A corporation usually holds a stockholder meeting at least once a year to elect directors. Stockholders who do not attend stockholders’ meetings can give their voting rights to an agent by signing a proxy, a document that gives a designated agent the right to vote the stock.

EXHIBIT 11.1 Corporate Structure

Point: Bylaws are guidelines that govern the corporation.

Keep the Faith Sources for start-up money include (1) “angel” investors such as family, friends, or anyone who be- lieves in a company; (2) employees, investors, and even suppliers; and (3) venture capitalists (investors) who have a record of entrepreneurial success. ■

Decision Insight

Point: While rare, not all common stock has voting rights; Google’s C Class shares are nonvoting.

Point: Green Bay Packers are the only nonprofit, community-owned major professional team.

Stockholders

Board of Directors

President, Vice President, and Other O cers

Employees of the Corporation

Corporate governance is the system by which companies are directed and controlled.

Chapter 11 Corporate Reporting and Analysis 419

Stock Certificates and Transfer A corporation sometimes gives a stock certificate as proof of share ownership. Exhibit 11.2 shows a stock certificate issued by the Green Bay Packers. A certificate shows the company name, stockholder name, number of shares, and other information. Issuance of paper certifi- cates is becoming less common.

Registrar and Transfer Agents If a corporation’s stock is traded on a stock exchange, the corporation has a registrar and a transfer agent. A registrar keeps a list of stockholders for stock- holder meetings and dividend payments. A transfer agent assists with purchases and sales of shares. Registrars and transfer agents are usually large banks or trust companies.

Corporate Stock Capital stock is shares issued to obtain capital (owner financing).

Authorized Stock Authorized stock is the number of shares that a corporation’s charter allows it to sell. The number of authorized shares usually exceeds the number of shares issued (and outstanding) by a large amount. Outstanding stock is stock held by stockholders. No jour- nal entry is required for stock authorization. A corporation discloses the number of shares authorized in the equity section of its balance sheet or notes. Apple’s balance sheet reports 12.6 billion common shares authorized.

Selling (Issuing) Stock A corporation can sell stock directly or indirectly. To sell di- rectly, it offers its stock to buyers. This type of sale is common with privately held corporations. To sell indirectly, a corporation pays a brokerage house (investment banker) to sell its stock. Some brokerage houses underwrite stock, meaning they buy the stock from the corporation and resell it to investors.

Market Value of Stock Market value per share is the price at which a stock is bought and sold. Expected future income, dividends, growth, and economic factors influence market value. The current market value of previously issued shares does not impact the issuing corpora- tion’s stockholders’ equity.

Classes of Stock When all authorized shares have the same rights and characteristics, the stock is called common stock. A corporation sometimes issues more than one class of stock, includ- ing preferred stock and different classes of common stock. American Greetings has two types of common stock: Class A stock has 1 vote per share and Class B stock has 10 votes per share.

Par Value Stock Par value stock is stock that has a par value, which is an amount as- signed per share by the corporation in its charter. Monster Worldwide’s common stock has a par value of $0.001. Other commonly assigned par values are $5, $1 and $0.01. There is no restriction on assigned par value. In many states, the par value of a stock establishes minimum legal capital, which is the least amount that the buyers of stock must contribute to the corporation or be at risk to pay creditors at a future date.

No-Par Value Stock No-par value stock, or no-par stock, is stock not assigned an amount per share by the corporate charter. There is no minimum legal capital with no-par stock.

Stated Value Stock Stated value stock is no-par stock that has an assigned “stated” value per share. Stated value per share is the mini- mum legal capital per share in this case.

Stockholders’ Equity A corporation’s equity is called stock- holders’ equity, or shareholders’ equity. Exhibit 11.3 shows stockhold- ers’ equity consists of (1) paid-in (or contributed) capital and (2) retained

Point: Managers set a low par value when minimum legal capital or state issuance taxes are based on par.

Point: Par, no-par, and stated value do not affect the stock’s market value.

EXHIBIT 11.2 Stock Certificate

Courtesy of JJW Images

Subcategories of Authorized Stock

Authorized

Authorized & Issued

Authorized, Issued, and Outstanding

Innermost box would show a decline in shares issued if a company buys back its issued stock.

Corporation

To ta

l P ai

d- In

C ap

ita lCommon Stock

Normal bal.

Retained Earnings

Normal bal.

Normal bal.

Paid-In Capital in Excess of Par

EXHIBIT 11.3 Equity Composition

420 Chapter 11 Corporate Reporting and Analysis

earnings. Paid-in capital is the total amount of cash and other assets the corporation receives from its stockholders in exchange for its stock. Retained earnings is the cumulative net income (and loss) not distributed as dividends to its stockholders.

Stock Quote The AT&T stock quote is in- terpreted as (left to right): Hi, highest price in past 52 weeks; Lo, lowest price in past 52 weeks; Sym, company exchange symbol; Div, dividends paid per share in past year; Yld %, dividend divided by closing price; PE, stock price per share divided by earnings per share; Hi, highest price for the day; Lo, lowest price for the day; Close, closing price for the day; Net Chg, change in closing price from prior day. ■

Decision Insight

52 Weeks Hi Lo Sym Div Yld % PE Hi Lo Close Net Chg 42.70 32.55 T 2.00 5.24 7.95 38.31 37.77 37.81 +0.53

Issuance of stock affects paid-in (contributed) capital accounts; retained earnings is unaffected.

Issuing Par Value Stock Par value stock can be issued at par, at a premium (above par), or at a discount (below par). Cash or other assets are received in exchange for stock.

Issuing Par Value Stock at Par When common stock is issued at par value, we re- cord both the asset(s) received and the par value stock issued. The entry to record Dillon’s issu- ance of 30,000 shares of $10 par value stock for $300,000 cash on June 5 follows.

COMMON STOCK P1 Record the issuance of corporate stock.

Issuing Par Value Stock at a Premium A premium on stock occurs when a cor- poration sells its stock for more than par (or stated) value. If Dillon issues its $10 par value com- mon stock at $12 per share, its stock is sold at a $2 per share premium. The premium, called paid-in capital in excess of par value, is reported as part of equity; it is not revenue and is not listed on the income statement. The entry to issue 30,000 shares of $10 par value stock for $12 per share follows.

Point: Paid-In Capital in Excess of Par Value is also called Additional Paid-In Capital.

The Paid-In Capital in Excess of Par Value account is added to the par value of the stock in the equity section of the balance sheet, as shown in Exhibit 11.4.

Point: The phrase paid-in capital is interchangeable with contributed capital.

Common stock—$10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding . . . . . . . . . $300,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Retained earnings* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $425,000

EXHIBIT 11.4 Stockholders’ Equity for Stock Issued at a Premium

*This is the company’s first year of operations, with income of $65,000 and no dividends.

Assets = Liabilities + Equity +300,000 +300,000

June 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Common Stock, $10 Par Value* . . . . . . . . . . . . . . . . . . . . 300,000

Issued 30,000 shares of $10 par value stock at par.

*$10 par value × 30,000 shares

Assets = Liabilities + Equity +360,000 +300,000 +60,000

June 5 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000

Common Stock, $10 Par Value* . . . . . . . . . . . . . . . . . . . 300,000

Paid-In Capital in Excess of Par Value, Common Stock† 60,000 Sold and issued 30,000 shares of $10 par

value common stock at $12 per share.

*$10 par value × 30,000 shares †[$12 issue price − $10 par value] × 30,000 shares

Chapter 11 Corporate Reporting and Analysis 421

Issuing Par Value Stock at a Discount A discount on stock occurs when it is sold for less than par value. Most states prohibit this. If stock is issued at a discount, the amount by which issue price is less than par is debited to a Discount on Common Stock account, a contra to the Common Stock account, and its balance is subtracted from the par value of stock.

Issuing No-Par Value Stock When no-par stock is issued, the amount the corporation receives is credited to a no-par stock account. The entry to issue 1,000 shares of no-par common stock for $40 cash per share follows.

Issuing Stated Value Stock When stated value stock is issued, the stated value is credited to the stock account. Any amount above the stated value is credited to Paid-In Capital in Excess of Stated Value, which is reported in stockholders’ equity. The entry to issue 1,000 shares of no-par common stock having a stated value of $40 per share in return for $50 cash per share follows.

Frequency of Stock Types

Par 88%

Stated 3%

No-par 9%

Issuing Stock for Noncash Assets A corporation can receive assets other than cash in exchange for its stock. (It also can take lia- bilities such as a mortgage on property received.) The corporation records the assets received at their market values as of the transaction date. The stock given in exchange is recorded at its par (or stated) value with any excess recorded in the Paid-In Capital in Excess of Par (or Stated) Value account. (If no-par stock is issued, the stock is recorded at the assets’ market value.) The entry to record receipt of land valued at $105,000 in return for 4,000 shares of $20 par value common stock is

Point: Stock issued for noncash assets is recorded at the market value of either the stock or the noncash assets, whichever is more determinable.

A corporation sometimes gives shares of its stock to promoters in exchange for their work in organizing the corporation, which it records as organization expenses. The entry to issue 600 shares of $15 par value common stock for $12,000 of organizing work is

Assets = Liabilities + Equity +40,000 +40,000

Oct. 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Common Stock, No-Par Value* . . . . . . . . . . . . . . . . . . . . . . . 40,000 Issued 1,000 shares of no-par stock at $40 per share.

*$40 issue price × 1,000 no-par shares

Oct. 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Common Stock, $40 Stated Value* . . . . . . . . . . . . . . . . . . . . 40,000 Paid-In Capital in Excess of Stated Value, Common Stock† . . . 10,000 Issued 1,000 shares of $40 per share stated

value stock at $50 per share.

*$40 stated value × 1,000 shares †[$50 issue price − $40 stated value] × 1,000 shares

Assets = Liabilities + Equity +50,000 +40,000 +10,000

June 10 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000 Common Stock, $20 Par Value* . . . . . . . . . . . . . . . . . . . . . . 80,000 Paid-In Capital in Excess of Par Value, Common Stock† . . . . . . 25,000 Exchanged 4,000 shares of $20 par value stock for land.

*$20 par value × 4,000 shares †$105,000 asset value − $80,000 par value

Assets = Liabilities + Equity +105,000 +80,000 +25,000

June 5 Organization Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Common Stock, $15 Par Value* . . . . . . . . . . . . . . . . . . . . . . 9,000 Paid-In Capital in Excess of Par Value, Common Stock† . . . . . . 3,000 Gave promoters 600 shares of $15 par value

common stock in exchange for their services.

*$15 par value × 600 shares †$12,000 services value − $9,000 par value

Assets = Liabilities + Equity −12,000 +9,000 +3,000

422 Chapter 11 Corporate Reporting and Analysis

Prepare journal entries to record the following four separate issuances of stock. 1. Issued 80 shares of $5 par value common stock for $700 cash. 2. Issued 40 shares of no-par common stock to promoters in exchange for their efforts, estimated to be

worth $800. The stock has a $1 per share stated value. 3. Issued 40 shares of no-par common stock in exchange for land estimated to be worth $800. The stock

has no stated value. 4. Issued 20 shares of no-par common stock with a stated value of $30 per share for $900 cash.

Solution

Recording Stock Issuance

NEED-TO-KNOW 11-1

P1

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Common Stock, $5 Par Value* . . . . . . . . . . . . . . . . . . . . . . 400

Paid-In Capital in Excess of Par Value, Common Stock† . . 300

Issued common stock for cash.

1.

Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Common Stock, $1 Stated Value . . . . . . . . . . . . . . . . . . . . 40

Paid-In Capital in Excess of Stated Value, Common Stock . . . 760

Issued stock to promoters.

2.

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Common Stock, No-Par Value . . . . . . . . . . . . . . . . . . . . . . . 800

Issued stock in exchange for land.

3.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Common Stock, $30 Stated Value*. . . . . . . . . . . . . . . . . . . 600

Paid-In Capital in Excess of Stated Value, Common Stock† . . 300

Issued stated value stock for cash.

4.

Do More: QS 11-2, QS 11-3, QS 11-4, QS 11-5, E 11-3, E 11-4, E 11-5

Cash Dividends The board of directors decides whether to pay cash dividends. The directors may decide to keep the cash to invest in the corporation’s growth, to meet emergencies, or to pay off debt. Alterna- tively, many corporations pay cash dividends to their stockholders at regular dates.

Accounting for Cash Dividends Dividend payment has three important dates: declara- tion, record, and payment. Date of declaration is the date the directors vote to declare and pay a dividend. This creates a legal liability of the corporation to its stockholders. Date of record is the date for identifying those stockholders to receive dividends. Persons who own stock on the date of record receive dividends. Date of payment is the date when the corporation makes payment.

Declaration Date of Record

Cash Dividend Dates

Payment

The entry for a January 9 declaration of a $1 per share cash dividend by Z-Tech with 5,000 outstanding shares follows. Common Dividend Payable is a current liability.

DIVIDENDS P2 Record transactions involving cash dividends, stock dividends, and stock splits.

Point: Amazon has never declared a cash dividend.

Cash dividend to preferred

Cash dividend to

common

22%

76%

Percent of Corporations Paying Dividends

Assets = Liabilities + Equity +5,000 −5,000

Date of Declaration—Cash Dividend

Jan. 9 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Common Dividend Payable* . . . . . . . . . . . . . . . . . . . . . . 5,000

Declared $1 per common share cash dividend.†

*$1 per share declared dividend × 5,000 outstanding shares † To aid learning and show how dividends impact retained earnings, we debit (reduce) Retained Earnings on the date of declaration in this chapter and all assignments. We normally debit Dividends; then, at period-end, Dividends is closed to Retained Earnings. The effect is the same: Retained earnings is decreased from dividends.

*80 shares × $5 per share = $400 †$700 − $400 = $300

*20 shares × $30 stated value = $600 †$900 − $600 = $300

Chapter 11 Corporate Reporting and Analysis 423

The date of record for this dividend is January 22. No journal entry is made on the date of record.

The February 1 date of payment entry removes the liability and reduces cash.

Deficits and Cash Dividends A corporation with a debit (abnormal) balance for Retained Earnings has a retained earnings deficit, which occurs when a company has cumula- tive losses and/or pays more dividends than total earnings from current and prior years. A defi- cit reduces equity, as shown in Exhibit 11.5. Most states prohibit a corporation with a deficit from paying a cash dividend to protect creditors. Another type of dividend is a liquidating cash dividend, or liquidating dividend, where a corporation returns a portion of the capital contrib- uted back to stockholders.

Point: The Retained Earnings Deficit account is also called Accumulated Deficit.

Common stock—$10 par value, 5,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . $50,000

Retained earnings deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   (6,000) Total stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,000

EXHIBIT 11.5 Stockholders’ Equity with a Deficit

Stock Dividends A stock dividend, declared by a corporation’s directors, is a distribution of additional shares of its own stock to its stockholders without any payment in return. Stock dividends and cash divi- dends are different. A stock dividend does not reduce assets and equity but instead transfers a portion of equity from retained earnings to contributed capital.

Reasons for Stock Dividends Stock dividends are given for at least two reasons. First, stock dividends keep the market price of the stock affordable. When a corporation has a stock dividend, it increases the number of outstanding shares, which lowers the per share stock price. Second, a stock dividend shows management’s confidence that the company is doing well and will continue to do well.

Accounting for Stock Dividends A stock dividend transfers part of retained earn- ings to contributed capital accounts, called capitalizing retained earnings. Accounting for a stock dividend depends on whether it is a small or large stock dividend. A small stock dividend is a distribution of 25% or less of previously

outstanding shares. It is recorded by capitalizing retained earnings for an amount equal to the market value of the shares to be distributed.

A large stock dividend is a distribution of more than 25% of previously outstanding shares. It is recorded by capitalizing retained earnings for the par or stated value of the stock.

The equity section of Quest’s balance sheet just before its declaration of a stock dividend on December 31 follows.

Hint: Five Steps to Record Stock Dividends

Step 1: Identify number of shares outstanding. Step 2: Identify the stock dividend percentage. Step 3: Compute number of new shares (step 1 × step 2). Step 4: Value new shares at market (small stock dividend)

or par (large stock dividend). Step 5: Determine debit (reduction) to Retained Earnings

(step 3 × step 4).

Stockholders’ Equity Before Dividend

Common stock—$10 par value, 15,000 shares authorized, 10,000 shares issued and outstanding . . . . . . $100,000 Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $143,000

Small Stock Dividend Assume that Quest declares a 10% stock dividend on December 31. This stock dividend of 1,000 shares, computed as 10% of its 10,000 outstanding shares, is to be

Assets = Liabilities + Equity −5,000 −5,000

Date of Payment—Cash Dividend

Feb. 1 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Paid $1 per common share cash dividend.

424 Chapter 11 Corporate Reporting and Analysis

distributed on January 20 to the stockholders of record on January 15. Because the market price of Quest’s stock on December 31 is $15 per share, this small stock dividend declaration is re- corded as follows.

EXHIBIT 11.6 Stockholders’ Equity before, during, and after a Stock Dividend

Before Date of Date of After Stockholders’ Equity Dividend Declaration Payment Dividend Common stock—$10 par value, 15,000 shares authorized, 10,000 shares issued and outstanding. . . . . . . . . . . $100,000 $ $+10,000 $110,000 Common stock dividend distributable—1,000 shares . . . . . . . . . . . 0 +10,000 −10,000 0 Paid-in capital in excess of par value, common stock . . . . . . . . . . . 8,000 + 5,000 13,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 −15,000 20,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $143,000 $ 0 $ 0 $143,000

No entry is made on the date of record for a stock dividend. However, on January 20, the date of payment, Quest distributes the new shares and records the entry below (numbers from the “Pay- ment” column of Exhibit 11.6). The combined effect of these entries is to transfer (or capitalize) $15,000 of retained earnings to paid-in capital accounts (see far right column of Exhibit 11.6). A stock dividend has no effect on the ownership percentage of stockholders.

Point: A stock dividend does not affect total assets or total equity.

The balance sheet changes in three ways when a small stock dividend is declared. Common Stock Dividend Distributable, an equity account that exists only until the shares are

distributed, increases by $10,000. Paid-in capital in excess of par increases by $5,000, which is the amount in excess of par (or

stated) value. Retained earnings decreases by $15,000, reflecting the increase in both common stock and

paid-in capital in excess of par.

The impacts on stockholders’ equity from the 10% stock dividend are in Exhibit 11.6.

Point: The term distributable (not payable) is used for stock dividends. A stock dividend is never a liability because it never reduces assets.

Point: The credit to Paid-In Capital in Excess of Par Value is recorded when the stock dividend is declared. This account is not affected when stock is later distributed.

Large Stock Dividend A corporation capitalizes retained earnings equal to the par or stated value of the newly issued shares for a large stock dividend. Suppose Quest declares a stock dividend of 30% instead of 10% on December 31. Because this dividend is more than 25%, it is a large stock dividend. This means the par value of the 3,000 (10,000 outstanding shares × 30%) dividend shares is capitalized at the date of declaration with the entry below. This transaction decreases retained earnings and increases contributed capital by $30,000.

Assets = Liabilities + Equity −15,000 +10,000 + 5,000

Date of Declaration—Small Stock Dividend

Dec. 31 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Common Stock Dividend Distributable* . . . . . . . . . . . . . 10,000

Paid-In Capital in Excess of Par Value, Common Stock† 5,000

Declared a 10% stock dividend of 1,000 shares.

*10% dividend × 10,000 outstanding shares × $10 par value †10% dividend × 10,000 outstanding shares × [$15 market price − $10 par value]

Assets = Liabilities + Equity −10,000 +10,000

Date of Payment—Small Stock Dividend

Jan. 20 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . 10,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . . . 10,000

Record issuance of common stock dividend.

Date of Declaration—Large Stock Dividend

Dec. 31 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Common Stock Dividend Distributable* . . . . . . . . . . . . . 30,000

Declared a 30% stock dividend of 3,000 shares.

*30% dividend × 10,000 outstanding shares × $10 par value

Assets = Liabilities + Equity −30,000 +30,000

Chapter 11 Corporate Reporting and Analysis 425

Stock Splits A stock split is the distribution of additional shares to stockholders according to their per- cent ownership. When a stock split occurs, the corporation “calls in” its outstanding shares and issues more than one new share in exchange for each old share. Splits can be done in any ratio. Apple did a 7-for-1 stock split. Stock splits reduce the par or stated value per share. The reasons for stock splits are similar to those for stock dividends, including afford- ability and management confidence.

Assume CTI has 100,000 outstanding shares of $20 par value common stock with a cur- rent market value of $88 per share. A 2-for-1 stock split cuts par value in half as it replaces 100,000 shares of $20 par value stock with 200,000 shares of $10 par value stock. The split does not affect any equity amounts reported on the balance sheet or any individual stock- holder’s percent ownership. No journal entry is made. The only effect on the accounts is a change in the stock account description. After the split, CTI changes its stock account title to Common Stock, $10 Par Value. The stock’s description on the balance sheet also changes to reflect the additional issued and outstanding shares and the new par value.

Financial Statement Effects of Dividends and Splits

STOCK

Before 5 : 1 Split: 1 share, $50 par

After 5 : 1 Split: 5 shares, $10 par

STOCK

Cash Dividend Small Stock Dividend Large Stock Dividend Stock Split

Total assets Decrease No change No change No change

Total liabilities No change No change No change No change

Total stockholders’ equity Decrease No change No change No change

Common stock No change Increase Increase No change

Paid-in capital in excess of par No change Increase No change No change

Retained earnings Decrease Decrease Decrease No change

Entrepreneur A company you co-founded and own stock in announces a 50% stock dividend. Has the value of your stock investment increased, decreased, or remained the same? Would it make a difference if it was a 3-for-2 stock split executed in the form of a dividend? ■ Answer: The stock dividend does not affect the value of your investment or give you income. However, a stock dividend can reveal positive expectations and also improve a stock’s marketability by making it more affordable. The same answer applies to the 3-for-2 stock split.

Decision Maker

Point: A reverse stock split is the opposite of a stock split and re- sults in fewer shares. It increases the par or stated value per share.

A company began the current year with the following balances in its stockholders’ equity accounts.

P2 Recording Dividends

NEED-TO-KNOW 11-2 Common stock—$10 par, 500 shares authorized, 200 shares issued and outstanding . . . . . . . . . $2,000

Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,000

All outstanding common stock was issued for $15 per share when the company was created. Prepare journal entries to account for the following transactions during the current year.

Jan. 10 The board declared a $0.10 cash dividend per share to shareholders of record on January 28. Feb. 15 Paid the cash dividend declared on January 10. Mar. 31 Declared a 20% stock dividend when the market value of the stock was $18 per share. May 1 Distributed the stock dividend declared on March 31. Dec. 1 Declared a 40% stock dividend when the market value of the stock was $25 per share. Dec. 31 Distributed the stock dividend declared on December 1.

On the date of payment, the company makes the following entry.

Jan. 15 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . 30,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . . . 30,000

426 Chapter 11 Corporate Reporting and Analysis

Jan. 10 Retained Earningsa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Declared a $0.10 per share cash dividend. a200 outstanding shares × $0.10

Feb. 15 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Paid $0.10 per share cash dividend.

Mar. 31 Retained Earningsb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 Common Stock Dividend Distributablec . . . . . . . . . . . . . . . . . . . . . 400 Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . 320 Declared a small stock dividend of 20%, or

40 shares; market value is $18 per share. b200 outstanding shares × 20% × $18 market c40 new shares × $10 par

May 1 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Distributed 40 shares of common stock.

Dec. 1 Retained Earningsd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . . . . 960 Declared a large stock dividend of 40%, or 96 shares

(40% × [200 + 40]); par value is $10 per share. d240 outstanding shares × 40% × $10 par

Dec. 31 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . . . . . . . . . 960 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960 Distributed 96 shares of common stock.

Do More: QS 11-6, QS 11-7, QS 11-8, QS 11-9, QS 11-10,

E 11-6, E 11-7, E 11-8

Preferred stock has special rights that give it priority (or senior status) over common stock in one or more areas. Special rights usually include a preference for receiving dividends and assets in liquidation. Preferred stock has the rights of common stock unless the corporate charter excludes them. A common exclusion is the right to vote.

Issuance of Preferred Stock Preferred stock is recorded in its own separate capital accounts. If Dillon issues 50 shares of $100 par value preferred stock for $6,000 cash, the entry is

PREFERRED STOCK C2 Explain characteristics of, and distribute dividends between, common and preferred stock.

The equity section of the year-end balance sheet for Dillon, including preferred stock, is in Exhibit 11.7. (The entry for issuing no-par preferred stock is similar to issuing no-par common stock. Also, the entry for issuing preferred stock for noncash assets is similar to that for common stock.)

EXHIBIT 11.7 Stockholders’ Equity with Common and Preferred Stock

Stockholders’ Equity Preferred stock—$100 par value; 1,000 shares authorized; 50 shares issued and outstanding. . . . . . . . . . . . $ 5,000 Paid-in capital in excess of par value, preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Common stock—$10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding . . . . . . . . . . . . . 300,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $371,000

Assets = Liabilities + Equity +6,000 +5,000 +1,000

July 1 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Preferred Stock, $100 Par Value* . . . . . . . . . . . . . . . . . . 5,000

Paid-In Capital in Excess of Par Value, Preferred Stock† . . 1,000

Issued preferred stock for cash.

*$100 par value × 50 shares †$6,000 cash − [$100 par value × 50 shares]

Solution

Chapter 11 Corporate Reporting and Analysis 427

Dividend Preference of Preferred Stock Preferred stock has preference for dividends, meaning that preferred stockholders are paid their dividends before any dividends are paid to common stockholders. A preference for dividends does not guarantee dividends. If the directors do not declare a dividend, neither the preferred nor the common stockholders get dividends.

Cumulative or Noncumulative Most preferred stock has a cumulative dividend right. Cumulative preferred stock gives its owners a right to be paid both the current and all prior

periods’ unpaid dividends before any dividend is paid to common stockholders. When pre- ferred stock is cumulative and the directors either do not declare a dividend to preferred stockholders or declare one that does not cover the total amount of cumulative dividend, the unpaid dividend amount is called dividend in arrears. Accumulation of dividends in arrears on cumulative preferred stock does not guarantee they will be paid. Dividend in arrears is not a liability and is usually reported in notes to financial statements.

Noncumulative preferred stock does not have rights to prior periods’ unpaid dividends if they were not declared in those prior periods. It does have rights to current-period dividends.

To show the difference between cumulative and noncumulative preferred stock, assume that a corporation’s outstanding stock includes 1,000 shares of $100 par, 9% preferred stock—with potential dividends of $9,000 per year

(1,000 shares × $100 par × 9%). 4,000 shares of $50 par value common stock.

During 2018, the first year of operations, the directors declare cash dividends of $5,000. In 2019, they declare cash dividends of $42,000. Exhibit 11.8 shows the allocation of dividends. If the preferred stock is cumulative, the $4,000 in arrears is paid in 2019 before any other divi- dends are paid—shown in green below. With noncumulative preferred, the preferred stockhold- ers never receive the $4,000 skipped in 2018.

Point: Dividend preference does not mean that preferred stock- holders get more dividends than common stockholders.

EXHIBIT 11.8 Allocation of Dividends: Cumulative vs. Noncumulative

Preferred Stock Is Cumulative Preferred Common

Year 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 0

Year 2019

Step 1: Dividend in arrears . . . . . . . . . . . . . . . . . . $ 4,000 Step 2: Current year’s preferred dividend . . . . . . 9,000

Step 3: Remainder to common . . . . . . . . . . . . . . . $29,000

Totals for year 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 $29,000

Totals for 2018–2019 . . . . . . . . . . . . . . . . . . . . . . . . $18,000 $29,000

Preferred Stock Is Noncumulative Preferred Common

Year 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 0

Year 2019

Step 1: Current year’s preferred dividend . . . . $ 9,000

Step 2: Remainder to common . . . . . . . . . . . . . $33,000

Totals for 2018–2019 . . . . . . . . . . . . . . . . . . . . . . $14,000 $33,000

Participating or Nonparticipating Most preferred stock is nonparticipating. Nonparticipating preferred stock limits dividends each year. Once preferred stockholders

receive a stated amount, the common stockholders get any and all additional dividends. Participating preferred stock allows preferred stockholders to share with common stock-

holders any dividends paid in excess of the amount stated on the preferred stock. This par- ticipation feature applies after common stockholders get dividends equal to the preferred stock’s dividend percent.

Reasons for Issuing Preferred Stock Preferred stock is issued for several reasons. One reason is to raise money without giving up control. We can, for example, raise money by issuing preferred stock with no voting rights.

A second reason is to boost the return earned by common stockholders. Suppose a corpora- tion’s organizers expect to earn an annual after-tax income of $22,000 on an investment of $200,000. If they sell $200,000 worth of common stock, the $22,000 income produces an 11%

428 Chapter 11 Corporate Reporting and Analysis

return ($22,000∕$200,000). If they issue $150,000 of 8% preferred stock to outsiders and $50,000 of common stock to themselves, their own return increases to 20% ([$22,000 − $12,000]∕$50,000).

Use of preferred stock to increase return to common stockholders is an example of financial leverage. As a general rule, when the dividend rate on preferred stock is less than the rate the corporation earns on its assets, issuing preferred stock increases the rate earned by common stockholders.

Other reasons for issuing preferred stock include its appeal to some investors who believe that the corporation’s common stock is too risky or that the expected return on common stock is too low.

Concert Organizer Assume that you alter your business strategy from organizing concerts targeted at under 1,000 people to those targeted at between 5,000 and 20,000 people. You also incorporate because of an increased risk of lawsuits and a desire to issue stock for financing. It is important that you control the company for decisions on whom to schedule. What types of stock do you offer? ■ Answer: You have two options: (1) different classes of common stock or (2) common and preferred stock. You want to own stock that has all or a majority of voting power. The other class of stock, whether common or preferred, would have limited or no voting rights. In this way, you keep control and are able to raise money.

Decision Maker

A company’s outstanding stock consists of 80 shares of noncumulative 5% preferred stock with a $5 par value and also 200 shares of common stock with a $1 par value. During its first three years of operation, the corporation declared and paid the following total cash dividends.Allocating Cash

Dividends

NEED-TO-KNOW 11-3

C2 Part 1. Determine the amount of dividends paid each year to each of the two classes of stockholders: preferred and common. Also compute the total dividends paid to each class for the three years combined.

Part 2. Determine the amount of dividends paid each year to each of the two classes of stockholders as- suming that the preferred stock is cumulative. Also determine the total dividends paid to each class for the three years combined.

Solution—Part 2

Noncumulative Preferred Common

2018 ($15 paid) Preferred* . . . . . . . . . . . . . . . . . . . . . $15 Common—remainder . . . . . . . . . . . . $ 0 Total for the year . . . . . . . . . . . . . . . $15 $ 0

2019 ($5 paid) Preferred* . . . . . . . . . . . . . . . . . . . . . $ 5 Common—remainder . . . . . . . . . . . . $ 0 Total for the year . . . . . . . . . . . . . . . $ 5 $ 0

2020 ($200 paid) Preferred* . . . . . . . . . . . . . . . . . . . . . $20 Common—remainder . . . . . . . . . . . . $180 Total for the year . . . . . . . . . . . . . . . $20 $180

2018–2020 (combined $220 paid) Total for three years . . . . . . . . . . . . . $40 $180

* Holders of noncumulative preferred stock are entitled to no more than $20 of dividends in any one year (5% × $5 × 80 shares).

Cumulative Preferred Common

2018 ($15 paid) Preferred* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15 Common—remainder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15 $ 0 (Note: $5 in preferred dividends in arrears; [$20 × 1 yr] − $15 paid.) 2019 ($5 paid) Preferred—arrears from 2018 . . . . . . . . . . . . . . . . . . . . . . . $ 5 Preferred* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Common—remainder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5 $ 0 (Note: $20 in preferred dividends in arrears; [$20 × 2 yrs] − $15 paid − $5 paid.) 2020 ($200 paid) Preferred—arrears from 2019 . . . . . . . . . . . . . . . . . . . . . . . $20 Preferred* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Common—remainder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160 Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40 $160 (Note: $0 in preferred dividends in arrears; [$20 × 3 yrs] − $15 paid − $5 paid − $40 paid.) 2018–2020 (combined $220 paid) Total for three years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60 $160

* Holders of cumulative preferred stock are entitled to $20 of dividends declared in any year (5% × $5 × 80 shares) plus any dividends in arrears.

Do More: QS 11-11, QS 11-12, QS 11-13, QS 11-14, E 11-9,

E 11-10, E 11-11

2018 total cash dividends . . . . $15 2019 total cash dividends. . . . $5 2020 total cash dividends. . . . . $200

No preferred stock 73%

Issued preferred stock 27%

Frequency of Preferred Stock

Solution—Part 1

Chapter 11 Corporate Reporting and Analysis 429

Corporations buy back their own stock for several reasons: (1) to use their shares to acquire another corporation, (2) to avoid a takeover of the company, (3) to give them to employees as compensation, and (4) to maintain a strong market for their stock or to show confidence in the current price.

A corporation’s reacquired shares are called treasury stock, which is similar to unissued stock in several ways: (1) neither treasury stock nor unissued stock is an asset, (2) neither receives cash dividends or stock dividends, and (3) neither has voting rights.

Purchasing Treasury Stock Purchasing treasury stock reduces the corporation’s assets and equity by equal amounts. We describe the cost method of accounting for treasury stock, which is the most popular method. (The par value method is explained in advanced courses.) The simple balance sheet below shows Cyber Inc.’s account balances before any treasury stock purchase (Cyber has no liabilities).

TREASURY STOCK P3 Record purchases and sales of treasury stock.

Corporations and Treasury Stock

With treasury

stock 62%

No treasury

stock 38%

Assets Stockholders’ Equity

Cash. . . . . . . . . . . . . . . . . . $ 30,000 Common stock—$10 par; 10,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . $100,000

Other assets . . . . . . . . . . . 95,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total assets . . . . . . . . . . . . $125,000 Total stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . $125,000

Cyber then purchases 1,000 of its own shares for $11,500. The entry below reduces equity with a debit to the Treasury Stock account, which is a contra equity account.

Assets = Liabilities + Equity −11,500 −11,500

May 1 Treasury Stock, Common* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Purchased 1,000 treasury shares at $11.50 per share.

*$11.50 cost per share × 1,000 shares

Assets Stockholders’ Equity

Cash. . . . . . . . . . . . . . . . . . $ 18,500 Common stock—$10 par; 10,000 shares authorized and issued; 1,000 shares in treasury . . . . . . . . . . . . . . . $100,000

Other assets . . . . . . . . . . . 95,000 Retained earnings, $11,500 restricted by treasury stock purchase. . . 25,000

Less cost of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,500) Total assets . . . . . . . . . . . . $113,500 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $113,500

Reissuing Treasury Stock Treasury stock can be reissued by selling it at cost, above cost, or below cost.

Selling Treasury Stock at Cost If treasury stock is reissued at cost, the entry is the reverse of the one made to record the purchase. If on May 21 Cyber reissues 100 of the treasury shares purchased on May 1 at the same $11.50 per share cost, the entry is

The balance sheet below shows account balances after this transaction. The treasury stock pur- chase reduces Cyber’s cash, total assets, and total equity by $11,500 but does not reduce Com- mon Stock or Retained Earnings. The stock description says that 1,000 issued shares are in treasury, leaving only 9,000 shares still outstanding. The description for retained earnings says that it is partly restricted.

Point: A treasury stock purchase is also called a stock buyback.

430 Chapter 11 Corporate Reporting and Analysis

Selling Treasury Stock above Cost If treasury stock is sold for more than cost, the amount received in excess of cost is credited to the Paid-In Capital, Treasury Stock account. This account is reported as a separate item in the stockholders’ equity section. No “gain” is ever reported from the sale of treasury stock. If Cyber receives $12 cash per share on June 3 for 400 treasury shares costing $11.50 per share, the entry is

Selling Treasury Stock below Cost When treasury stock is sold below cost, the entry depends on whether the Paid-In Capital, Treasury Stock account has a credit balance. If it has a zero balance, the excess of cost over the sales price is debited to Retained Earnings. If the Paid-In Capital, Treasury Stock account has a credit balance, it is debited for the excess of the cost over the selling price but not to exceed the credit balance. When the credit balance is eliminated, any remaining difference between the cost and selling price is debited to Retained Earnings. If Cyber sells its remaining 500 shares of treasury stock at $10 per share on July 10, equity is reduced by $750 (500 shares × $1.50 per share excess of cost over selling price), as shown below. This entry eliminates the $200 credit balance in the Paid-In Capital account cre- ated on June 3 and then reduces the Retained Earnings balance by the remaining $550. A com- pany never reports a “loss” from the sale of treasury stock.

Point: Paid-In Capital, Treasury Stock account can have a zero or credit balance but never a debit balance.

A company began the current year with the following balances in its stockholders’ equity accounts.

Recording Treasury Stock

NEED-TO-KNOW 11-4

P3

Common stock—$10 par, 500 shares authorized, 200 shares issued and outstanding . . . . . . . . . . $2,000

Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,000

All outstanding common stock was issued for $15 per share when the company was created. Prepare jour- nal entries to account for the following transactions during the current year.

July 1 Purchased 30 shares of treasury stock at $20 per share. Sep. 1 Sold 20 treasury shares at $26 cash per share. Dec. 1 Sold the remaining 10 shares of treasury stock at $7 cash per share.

Assets = Liabilities + Equity +1,150 +1,150

May 21 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,150

Treasury Stock, Common* . . . . . . . . . . . . . . . . . . . . . . . . 1,150

Received $11.50 per share for 100 treasury shares costing $11.50 per share.

*$11.50 cost per share × 100 shares

June 3 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Treasury Stock, Common* . . . . . . . . . . . . . . . . . . . . . . . . 4,600

Paid-In Capital, Treasury Stock†. . . . . . . . . . . . . . . . . . 200 Received $12 per share for 400 treasury

shares costing $11.50 per share.

*$11.50 cost per share × 400 shares †[$12 issue price − $11.50 cost per share] × 400 shares

Assets = Liabilities + Equity +4,800 +4,600 +200

July 10 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Paid-In Capital, Treasury Stock* . . . . . . . . . . . . . . . . . . . . . . 200 Retained Earnings† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 Treasury Stock, Common‡ . . . . . . . . . . . . . . . . . . . . . . . . 5,750

Received $10 per share for 500 treasury shares costing $11.50 per share.

*[$10 issue price − $11.50 cost per share] × 500 shares; not to exceed $200 †For any amount exceeding $200 in Paid-In Capital, Treasury Stock ‡$11.50 cost per share × 500 shares

Assets = Liabilities + Equity +5,000 −200 −550 +5,750

Chapter 11 Corporate Reporting and Analysis 431

July 1 Treasury Stock, Commona . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Purchased 30 common shares at $20 per share. a30 shares × $20 cost

Sep. 1 Cashb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Treasury Stock, Commonc . . . . . . . . . . . . . . . . . . . . . . . . 400

Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . . . . . 120

Sold 20 treasury shares at $26 per share. b20 shares × $26 reissue price c20 shares × $20 cost

Dec. 1 Cashd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Paid-In Capital, Treasury Stocke . . . . . . . . . . . . . . . . . . . . . . . . 120

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Treasury Stock, Commonf . . . . . . . . . . . . . . . . . . . . . . . . . 200

Sold 10 treasury shares at $7 per share. d10 shares × $7 reissue price

eNot to exceed existing balance f10 shares × $20 cost Do More: QS 11-15, E 11-12

Treasury Stock, Common

July 1 600 Sep. 1 400 Dec. 1 200

End. bal. 0

Statement of Retained Earnings Retained earnings generally consists of cumulative net income minus any net losses and divi- dends declared. Retained earnings does not mean that a certain amount of cash or other assets is available to pay stockholders. For example, Abercrombie & Fitch has $2,474,703 thousand in retained earnings, but only $547,189 thousand in cash.

Restrictions and Appropriations Restricted retained earnings are statutory and contractual restrictions. A common statutory (or legal) restriction is to limit treasury stock pur- chases to the amount of retained earnings. A common contractual restriction is a loan agree- ment that restricts paying dividends beyond a specified amount of retained earnings. Restrictions are usually described in the notes. Appropriated retained earnings is a voluntary transfer of amounts from the Retained Earnings account to the Appropriated Retained Earnings account to inform users of special activities that require funds.

Prior Period Adjustments Prior period adjustments are corrections of material errors in past financial statements. These errors include math errors, improper accounting, and missed facts. Prior period adjustments are reported in the statement of retained earnings, net of any income tax effects. Prior period adjustments result in changing the beginning balance of retained earnings for events occurring prior to the earliest period reported in the current set of financial statements. Assume that ComUS made an error two years ago in a journal entry for the purchase of land by incorrectly debiting an expense account. When this is discovered in the current year, the statement of retained earnings includes a prior period adjustment, as shown in Exhibit 11.9.

REPORTING OF EQUITY C3 Explain the items reported in retained earnings.

EXHIBIT 11.9 Statement of Retained Earnings with a Prior Period Adjustment

Statement of Retained Earnings

Retained earnings, Dec. 31, 2018, as previously reported . . . . . . . . . . . . . . . . . $4,700

Prior period adjustment

Cost of land incorrectly expensed (net of $60 of income tax benefit) . . . 200 Retained earnings, Dec. 31, 2018, as adjusted . . . . . . . . . . . . . . . . . . . . . . . . . . 4,900

Plus net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Less cash dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300)

Retained earnings, Dec. 31, 2019. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,400

Solution

432 Chapter 11 Corporate Reporting and Analysis

Many items reported in financial statements are based on estimates. Future events reveal that some estimates were inaccurate even when based on the best data available at the time. These inaccuracies are not considered errors and are not reported as prior period adjustments. Instead, they are changes in accounting estimates and are accounted for in current and future periods.

Statement of Stockholders’ Equity A statement of stockholders’ equity lists the beginning and ending balances of key equity accounts and describes the changes that occur during the period. Exhibit 11.10 shows a condensed statement for Apple.

Statement of Stockholders’ Equity Common Common Retained Total $ millions, shares in thousands Stock Shares Stock Amount Earnings Other Equity

Beginning balance . . . . . . . . . . . . . . . . . . . . . . . . . 5,336,166 $31,251 $96,364 $ 634 $128,249 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — 48,351 — 48,351

Issuance of common stock. . . . . . . . . . . . . . . . . . . . 36,531 (913) (581) — (1,494)

Repurchase of common stock & other. . . . . . . . . . . (246,496) 5,529 (33,001) (784) (28,256)

Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — (12,803) — (12,803)

Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,126,201 $35,867 $98,330 $(150) $134,047

EXHIBIT 11.10 Statement of Stockholders’ Equity

Fake News Fake information can be used to pump up stock price and cause uninformed investors to buy the stock and drive up its price. After that, those who released fake information dump the stock at an inflated price. When later information reveals that the stock is overvalued, its price declines and investors still holding the stock lose value. This scheme is called pump ’n dump. A 15-year-old allegedly made about $1 million in one of the most infamous cases of pump ’n dump. (SEC Release No. 7891) ■

Ethical Risk

Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per ShareDecision Analysis

Earnings per Share Earnings per share, also called EPS or net income per share, is the income earned per share of outstand- ing common stock. The basic earnings per share formula is in Exhibit 11.11. When a company has no preferred stock, then preferred dividends are zero. The weighted-average common shares outstanding is measured over the income reporting period; its computation is explained in advanced courses.

A1 Compute earnings per share and describe its use.

A2 Compute price-earnings ratio and describe its use in analysis.

EXHIBIT 11.11 Basic Earnings per Share Basic earnings per share =

Net income − Preferred dividends Weighted-average common shares outstanding

Assume Quantum Co. earns $40,000 net income in 2019 and declares dividends of $7,500 on its noncu- mulative preferred stock. (If preferred stock is noncumulative, preferred dividends are only subtracted if dividends are declared in that same period. If preferred stock is cumulative, preferred dividends are sub- tracted whether declared or not.) Quantum has 5,000 weighted-average common shares outstanding dur- ing 2019. Its basic EPS is $6.50, computed as ($40,000 − $7,500) / 5,000 shares.

Price-Earnings Ratio A comparison of a company’s EPS and its market value per share reveals market expectations. This com- parison is made using a price-earnings (or PE) ratio, also called price earnings or price to earnings. Some analysts interpret this ratio as what price the market is willing to pay for a company’s current earn- ings stream. Price-earnings ratios differ across companies that have similar earnings because of either higher or lower expectations of future earnings. The price-earnings ratio is in Exhibit 11.12.

Point: Diluted EPS is another EPS measure covered in advanced courses.

Price-earnings ratio = Market value (price) per share

Earnings per share

EXHIBIT 11.12 Price-Earnings Ratio

Price-earnings ratios for Visa and Mastercard follow. Both companies have relatively high PE ratios, show- ing that investors have high expectations of future earnings for both. Based on Mastercard’s higher PE versus Visa, one interpretation is the market is willing to pay more for Mastercard’s current earnings stream.

Point: The average PE ratio of stocks in the 1950–2019 period is about 14.

APPLE

Chapter 11 Corporate Reporting and Analysis 433

Company Market Value per Share Earnings per Share P/E Ratio

Visa . . . . . . . . . . . . . . . $105.24 $2.80 37.6

Mastercard . . . . . . . . . $151.36 $3.67 41.2

Dividend Yield Investors buy company stock to get a return from either or both cash dividends and stock price increases. Stocks that pay large dividends on a regular basis, called income stocks, are attractive to investors who want recurring cash flows from their investments. In contrast, growth stocks pay little or no cash dividends but are attractive to investors because of expected stock price increases. One way to help identify whether a stock is an income stock or a growth stock is to analyze its dividend yield. Dividend yield is defined in Exhibit 11.13.

Dividend yield = Annual cash dividends per share

Market value per share

EXHIBIT 11.13 Dividend Yield

The table below shows recent dividend and stock price data for Amazon and Altria Group to compute dividend yield. Dividend yield is zero for Amazon, implying it is a growth stock. An investor in Amazon expects increases in stock prices (and eventual cash from the sale of stock). Altria has a dividend yield of 5.0%, implying it is an income stock for which dividends are important in assessing its value.

Point: The payout ratio equals cash dividends declared on com- mon stock divided by net income. A low payout ratio suggests that it is retaining earnings for growth.

Company Cash Dividends per Share Market Value per Share Dividend Yield

Amazon . . . . . . . . . . . $0.00 $1,603 0.0%

Altria Group . . . . . . . . $2.80 $ 56 5.0%

Money Manager You plan to invest in one of two companies identified as having identical future prospects. One has a PE of 19 and the other a PE of 25. Which do you invest in? ■ Answer: Because one company requires a payment of $19 for each $1 of earnings and the other requires $25, you prefer the stock with a PE of 19; it is a better deal given identical prospects.

Decision Maker

A3 Compute dividend yield and explain its use in analysis.

A4 Compute book value and explain its use in analysis.

Book Value per Share Book value per common share, defined in Exhibit 11.14, is the amount of equity applicable to common shares on a per share basis. Book value per share is the value per share if a company is liquidated at bal- ance sheet amounts. Book value is also the starting point in many stock valuation models, merger negotia- tions, price setting for public utilities, and loan contracts. The main limitation in using book value is that the difference between market value and recorded value of assets and liabilities can be large.

Book value per common share = Stockholders’ equity applicable to common shares

Number of common shares outstanding

EXHIBIT 11.14 Book Value per Common Share

Consider LTD’s equity in the table below. At the current date there are two years of preferred dividends in arrears.

Preferred stock—$100 par value, 7% cumulative, 2,000 shares authorized, 1,000 shares issued and outstanding . . . . . $100,000

Common stock—$25 par value, 12,000 shares authorized, 10,000 shares issued and outstanding . . . . . . . . . . . . . . . 250,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $447,000

LTD’s book value computations follow. Equity allocated to any preferred shares is removed before the book value of common shares is computed.

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 447,000

Less equity applicable to preferred shares: Par value (1,000 shares × $100) . . . . . . . . . . . . . . . . $100,000 Dividends in arrears ($100,000 × 7% × 2 years) . . . 14,000 (114,000) Equity applicable to common shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $333,000

Book value per common share ($333,000∕10,000 shares) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 33.30

434 Chapter 11 Corporate Reporting and Analysis

Barton Corporation began operations on January 1, 2018. The following transactions relating to stock- holders’ equity occurred in the first two years of the company’s operations.

2018

Jan. 1 Authorized the issuance of 2 million shares of $5 par value common stock and 100,000 shares of $100 par value, 10% cumulative preferred stock.

2 Issued 200,000 shares of common stock for $12 cash per share. 3 Issued 100,000 shares of common stock in exchange for a building valued at $820,000 and

merchandise inventory valued at $380,000. 4 Paid $10,000 cash to the company’s founders for organization activities. 5 Issued 12,000 shares of preferred stock for $110 cash per share.

2019

June 4 Issued 100,000 shares of common stock for $15 cash per share.

Required

1. Prepare journal entries to record these transactions. 2. Prepare the stockholders’ equity section of the balance sheet as of December 31, 2018 and 2019. 3. Prepare a table showing dividend allocations for 2018 and 2019 assuming Barton declares the follow-

ing cash dividends: 2018, $50,000, and 2019, $300,000. 4. Prepare the January 2, 2018, entry for issuance of 200,000 shares of common stock for $12 cash per share if a. Common stock is no-par stock without a stated value. b. Common stock is no-par stock with a stated value of $10 per share.

PLANNING THE SOLUTION Record journal entries for the transactions for 2018 and 2019. Determine the balances for the 2018 and 2019 equity accounts for the balance sheet. Prepare the contributed capital portion of the 2018 and 2019 balance sheets. Prepare a table similar to Exhibit 11.8 showing dividend allocations for 2018 and 2019. Record the issuance of common stock under both specifications of no-par stock.

SOLUTION 1. Journal entries.

COMPREHENSIVE

Issuance of, and Dividends to, Common and Preferred Stock; Reporting of Stockholders’ Equity

NEED-TO-KNOW 11-5

Jan. 2, 2018 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000 Common Stock, $5 Par Value . . . . . . . . . . . . . . . . . . . . . . 1,000,000 Paid-In Capital in Excess of Par Value, Common Stock . . 1,400,000 Issued 200,000 shares of common stock.

Jan. 3, 2018 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 820,000 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 Common Stock, $5 Par Value . . . . . . . . . . . . . . . . . . . . . . 500,000 Paid-In Capital in Excess of Par Value, Common Stock . . . . 700,000 Issued 100,000 shares of common stock.

Jan. 4, 2018 Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Paid founders for organization costs.

Jan. 5, 2018 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 Preferred Stock, $100 Par Value . . . . . . . . . . . . . . . . . . . 1,200,000 Paid-In Capital in Excess of Par Value, Preferred Stock . . . . 120,000 Issued 12,000 shares of preferred stock.

June 4, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 Common Stock, $5 Par Value . . . . . . . . . . . . . . . . . . . . . . 500,000 Paid-In Capital in Excess of Par Value, Common Stock . . . . 1,000,000 Issued 100,000 shares of common stock.

Chapter 11 Corporate Reporting and Analysis 435

2. Balance sheet presentations (at December 31 year-end).

Stockholders’ Equity 2019 2018

Preferred stock—$100 par value, 10% cumulative, 100,000 shares authorized, 12,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . $1,200,000 $1,200,000

Paid-in capital in excess of par value, preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 120,000

Total paid-in capital by preferred stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 1,320,000

Common stock—$5 par value, 2,000,000 shares authorized, 300,000 shares issued and outstanding in 2018, and 400,000 shares issued and outstanding in 2019. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 1,500,000

Paid-in capital in excess of par value, common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,100,000 2,100,000

Total paid-in capital by common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100,000 3,600,000

Total paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,420,000 $4,920,000

3. Dividend allocation table.

Common Preferred

2018 ($50,000) Preferred—current year (12,000 shares × $10 = $120,000) . . . . . . . . . . . . . . . . . . . . $ 0 $ 50,000 Common—remainder (300,000 shares outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0

Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 50,000

2019 ($300,000) Preferred—dividend in arrears from 2018 ($120,000 − $50,000) . . . . . . . . . . . . . . . . $ 0 $ 70,000 Preferred—current year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 120,000

Common—remainder (400,000 shares outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 0

Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,000 $190,000

4. Journal entries. a. For 2018 (no-par stock without a stated value).

b. For 2018 (no-par stock with a stated value).

Jan. 2 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Common Stock, No-Par Value . . . . . . . . . . . . . . . . . . . . . 2,400,000

Issued 200,000 shares of no-par stock at $12 per share.

Jan. 2 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Common Stock, $10 Stated Value . . . . . . . . . . . . . . . . . 2,000,000

Paid-In Capital in Excess of Stated Value, Common Stock . 400,000

Issued 200,000 shares of $10 stated value common stock at $12 per share.

COMMON STOCK Corporate advantages: Separate legal entity, limited liability, transferable ownership, continuous life, no mutual agency for shareholders, and easier capital accumulation. Corporate disadvantages: More government regulation and corporate income taxes (double taxation).

Summary: Cheat Sheet

Issuing common stock at par value:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . 300,000

Issuing no-par common stock:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Common Stock, No-Par Value . . . . . . . . . . . . . . . . . . . 40,000

Issuing common stock above par: When market value > par value.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . 300,000

Paid-In Capital in Excess of Par Value, Common Stock . 60,000

436 Chapter 11 Corporate Reporting and Analysis

Stock split: Distribution of additional shares to stockholders according to percent ownership. It does not affect any equity balances. No journal entry is made. Only effect is a change in stock account description.

Cumulative preferred stock: Preferred stockholders are paid both current and all prior periods’ unpaid dividends before any dividend is paid to com- mon stockholders. Dividend in arrears: Unpaid dividends due to cumulative preferred stock. Noncumulative preferred stock: Does not have rights to prior periods’ unpaid dividends, only current-period dividends.

TREASURY STOCK Treasury stock: Shares reacquired by the company. It reduces equity and does not receive dividends.

Issuing stated value common stock: When market value > stated value.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Common Stock, $40 Stated Value . . . . . . . . . . . . . . . 40,000

Paid-in Capital in Excess of Stated Value, Common Stock 10,000

Small stock dividend: Distribution of 25% or less of previously outstand- ing shares. Retained earnings is capitalized for an amount equal to market value of shares.

Large stock dividend: Distribution of more than 25% of previously out- standing shares. Retained earnings is capitalized for an amount equal to par or stated value of shares.

Issuing common stock for noncash assets:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000

Common Stock, $20 Par Value . . . . . . . . . . . . . . . . . . 80,000

Paid-In Capital in Excess of Par Value, Common Stock 25,000

Small stock dividend—Date of declaration:

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Common Stock Dividend Distributable . . . . . . . . . . . . 10,000

Paid-In Capital in Excess of Par Value, Common Stock 5,000

Issuing common stock in exchange for services:

Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Common Stock, $15 Par Value . . . . . . . . . . . . . . . . . . 9,000

Paid-In Capital in Excess of Par Value, Common Stock 3,000

DIVIDENDS

Declaration Record

Cash Dividend Dates

Payment

Cash dividend—Date of declaration:

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . 5,000

Cash dividend—Date of payment:

Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . 5,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Small stock dividend—Date of payment:

Common Stock Dividend Distributable . . . . . . . . . . . . . . 10,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . 10,000

Large stock dividend—Date of declaration:

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Common Stock Dividend Distributable . . . . . . . . . . . . 30,000

Large stock dividend—Date of payment:

Common Stock Dividend Distributable . . . . . . . . . . . . . . 30,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . 30,000

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Treasury stock in stockholders’ equity:

Stockholders’ Equity

Common stock—$10 par; 10,000 shares authorized and issued; 1,000 shares in treasury . . . . . . . . . . . . . . $100,000 Retained earnings, $11,500 restricted by treasury stock purchase . . . . 25,000 Less cost of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,500) Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $113,500

Selling treasury stock above cost: When sale price > reacquisition price.

Selling treasury stock below cost: When sale price < reacquisition price.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . . . . . 200

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . 5,750

REPORTING AND ANALYSIS Prior period adjustments: Corrections of material errors in past financial statements. Errors include math errors, improper accounting, and missed facts. Prior period adjustments are reported in statement of retained earn- ings, net of any income tax effects. Changes in accounting estimates: Revised estimates that were inaccurate even when based on the best data available at the time. These are not errors and are not reported as prior period adjustments. Instead, they are accounted for in current and future periods.

Selling treasury stock at cost:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,150

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . 1,150

Issuing preferred stock: When market value > par value.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Preferred Stock, $100 Par Value . . . . . . . . . . . . . . . . . 5,000

Paid-In Capital in Excess of Par Value, Preferred Stock 1,000

PREFERRED STOCK

Statement of Retained Earnings

Retained earnings, Dec. 31, 2018, as previously reported . . . . . . . . . . . . . . $4,700 Prior period adjustment Cost of land incorrectly expensed (net of $60 of income tax benefit) . . . 200 Retained earnings, Dec. 31, 2018, as adjusted . . . . . . . . . . . . . . . . . . . . . . 4,900 Plus net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Less cash dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300) Retained earnings, Dec. 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,400

Cash dividend—Date of record: No entry is made.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . 4,600

Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . . . 200

Chapter 11 Corporate Reporting and Analysis 437

Multiple Choice Quiz

1. A corporation issues 6,000 shares of $5 par value common stock for $8 cash per share. The entry to record this transac- tion includes a. A debit to Paid-In Capital in Excess of Par Value for

$18,000. b. A credit to Common Stock for $48,000. c. A credit to Paid-In Capital in Excess of Par Value for

$30,000. d. A credit to Cash for $48,000. e. A credit to Common Stock for $30,000.

2. A company reports net income of $75,000. Its weighted- average common shares outstanding is 19,000. It has no other stock outstanding. Its earnings per share is a. $4.69. c. $3.75. e. $4.41. b. $3.95. d. $2.08.

3. A company has 5,000 shares of $100 par preferred stock and 50,000 shares of $10 par common stock outstanding. Its to- tal stockholders’ equity is $2,000,000. Its book value per common share is a. $100.00. c. $40.00. e. $36.36. b. $10.00. d. $30.00.

4. A company paid cash dividends of $0.81 per share. Its earn- ings per share is $6.95 and its market price per share is $45.00. Its dividend yield is a. 1.8%. c. 15.4%. e. 8.6%. b. 11.7%. d. 55.6%.

5. A company’s shares have a market value of $85 per share. Its net income is $3,500,000, and its weighted-average common shares outstanding is 700,000. Its price-earnings ratio is a. 5.9. c. 17.0. e. 41.2. b. 425.0. d. 10.4.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. e; Entry to record this stock issuance follows. 3. d; Preferred stock = 5,000 × $100 = $500,000; Book value per share = ($2,000,000 − $500,000)∕50,000 shares = $30 per common share

4. a; $0.81∕$45.00 = 1.8% 5. c; Earnings per share = $3,500,000/700,000 shares = $5 per

share; PE ratio = $85∕$5 = 17.0

Cash (6,000 × $8) . . . . . . . . . . . . . . . . . . . . . . . . . 48,000 Common Stock (6,000 × $5) . . . . . . . . . . . . . . . 30,000 Paid-In Capital in Excess of Par Value, Common Stock. . . . . . . . . . . . . . . . . . . . . . . . 18,000

Appropriated retained earnings (431) Authorized stock (419) Basic earnings per share (432) Book value per common share (433) Capital stock (419) Change in an accounting estimate (432) Common stock (418) Corporation (417) Cumulative preferred stock (427) Date of declaration (422) Date of payment (422) Date of record (422) Diluted earnings per share (432) Discount on stock (421) Dividend in arrears (427) Dividend yield (433)

Earnings per share (EPS) (432) Financial leverage (428) Large stock dividend (423) Liquidating cash dividend (423) Market value per share (419) Minimum legal capital (419) Noncumulative preferred stock (427) Nonparticipating preferred stock (427) No-par value stock (419) Organization expenses (costs) (418) Paid-in capital (420) Paid-in capital in excess of par value (420) Par value (419) Par value stock (419) Participating preferred stock (427) Preemptive right (418)

Preferred stock (426) Premium on stock (420) Price-earnings (PE) ratio (432) Prior period adjustment (431) Proxy (418) Restricted retained earnings (431) Retained earnings (420) Retained earnings deficit (423) Reverse stock split (425) Small stock dividend (423) Stated value stock (419) Statement of stockholders’ equity (432) Stock dividend (423) Stock split (425) Stockholders’ equity (419) Treasury stock (429)

Key Terms

Icon denotes assignments that involve decision making.

1. What are organization expenses? Provide examples. 2. How are organization expenses reported?

3. Who is responsible for overseeing corporate activities? 4. What is the difference between authorized shares and out-

standing shares?

Discussion Questions

2. b; $75,000∕19,000 shares = $3.95 per share

438 Chapter 11 Corporate Reporting and Analysis

5. What is the preemptive right of common stockholders? 6. List the general rights of common stockholders. 7. What is the difference between the market value per share

and the par value per share? 8. Identify and explain the importance of the three dates rele-

vant to corporate dividends. 9. Why is the term liquidating dividend used to describe cash

dividends debited against paid-in capital accounts? 10. How does declaring a stock dividend affect the corpo-

ration’s assets, liabilities, and total equity? What are the ef- fects of the eventual distribution of that stock?

11. What is the difference between a stock dividend and a stock split?

12. How does the purchase of treasury stock affect the purchas- er’s assets and total equity?

13. How are EPS results computed for a corporation with a simple capital structure?

14. How is book value per share computed for a corporation with no preferred stock? What is the main limitation of us- ing book value per share to value a corporation?

15. Refer to Apple’s fiscal 2017 balance sheet in Appendix A. How many shares of common stock are authorized? How many shares of common stock are issued and outstanding?

16. Refer to the 2017 balance sheet for Google in Appendix A. What is the par value per share of its preferred stock? Suggest a rationale for the amount of par value it assigned.

17. Refer to the financial statements for Samsung in Appendix A. How much were its cash payments for treasury stock acquisitions for the year ended December 31, 2017?

APPLE

Samsung

GOOGLE

QUICK STUDY

QS 11-1 Characteristics of corporations

C1

Identify which of the following statements are true for the corporate form of organization. 1. Ownership rights cannot be easily transferred. 2. Owners have unlimited liability for corporate debts. 3. Capital is more easily accumulated than with most other forms of organization. 4. Corporate income that is distributed to shareholders is usually taxed twice. 5. It is a separate legal entity. 6. It has a limited life. 7. Owners are not agents of the corporation.

Prepare the journal entry to record Zende Company’s issuance of 75,000 shares of $5 par value common stock assuming the shares sell for a. $5 cash per share. b. $6 cash per share.

QS 11-2 Issuance of common stock

P1

Prepare the journal entry to record Jevonte Company’s issuance of 36,000 shares of its common stock as- suming the shares have a a. $2 par value and sell for $18 cash per share. b. $2 stated value and sell for $18 cash per share.

QS 11-3 Issuance of par and stated value common stock P1

Prepare the issuer’s journal entry for each of the following separate transactions. a. On March 1, Atlantic Co. issues 42,500 shares of $4 par value common stock for $297,500 cash. b. On April 1, OP Co. issues no-par value common stock for $70,000 cash. c. On April 6, MPG issues 2,000 shares of $25 par value common stock for $45,000 of inventory,

$145,000 of machinery, and acceptance of a $94,000 note payable.

QS 11-5 Issuance of common stock

P1

Prepare journal entries to record the following transactions for Emerson Corporation.

July 15 Declared a cash dividend payable to common stockholders of $165,000. Aug. 15 Date of record is August 15 for the cash dividend declared on July 15. Aug. 31 Paid the dividend declared on July 15.

QS 11-6 Accounting for cash dividends

P2

Prepare the journal entry to record Autumn Company’s issuance of 63,000 shares of no-par value com- mon stock assuming the shares a. Sell for $29 cash per share. b. Are exchanged for land valued at $1,827,000.

QS 11-4 Issuance of no-par common stock P1

Epic Inc. has 10,000 shares of $2 par value common stock outstanding. Epic declares a 5% stock dividend on July 1 when the stock’s market value is $8 per share. The stock dividend is distributed on July 20. Prepare journal entries for (a) declaration and (b) distribution of the stock dividend.

QS 11-7 Accounting for small stock dividends P2

Chapter 11 Corporate Reporting and Analysis 439

Belkin Inc. has 100,000 shares of $3 par value common stock outstanding. Belkin declares a 40% stock dividend on March 2 when the stock’s market value is $72 per share. Prepare the journal entry for declara- tion of the stock dividend.

QS 11-9 Accounting for large stock dividends P2

QS 11-8 Accounting for small stock dividend

P2

The stockholders’ equity section of Jun Co.’s balance sheet as of April 1 follows. On April 2, Jun declares and distributes a 10% stock dividend. The stock’s per share market value on April 2 is $20 (prior to the dividend). Prepare the stockholders’ equity section immediately after the stock dividend is distributed.

Common stock—$5 par value, 375,000 shares authorized, 200,000 shares issued and outstanding. . . . . . . . . . $1,000,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,433,000

QS 11-10 Accounting for dividends

P2

Indicate whether each of the following statements regarding dividends is true or false. 1. Cash and stock dividends reduce retained earnings. 2. Dividends payable is recorded at the time a cash dividend is declared. 3. The date of record is the date a cash dividend is paid to stockholders. 4. Stock dividends help keep the market price of stock affordable.

QS 11-15 Purchase and sale of treasury stock P3

On May 3, Zirbal Corporation purchased 4,000 shares of its own stock for $36,000 cash. On November 4, Zirbal reissued 850 shares of this treasury stock for $8,500. Prepare the May 3 and November 4 journal entries to record Zirbal’s purchase and reissuance of treasury stock.

QS 11-16 Impacts of stock issuances, dividends, splits, and treasury transactions

P2 P3

Identify whether stockholders’ equity would increase (I), decrease (D), or have no effect (NE) as a result of each separate transaction listed below.

1. A stock dividend equal to 30% of the previously outstanding shares is declared. 2. New shares of common stock are issued for cash. 3. Treasury shares of common stock are purchased. 4. Cash dividends are paid to shareholders.

QS 11-11 Preferred stock issuance and dividends C2

1. Prepare the journal entry to record Tamas Company’s issuance of 5,000 shares of $100 par value, 7% cumulative preferred stock for $102 cash per share.

2. Assuming the facts in part 1, if Tamas declares a year-end cash dividend, what is the amount of divi- dend paid to preferred shareholders? (Assume no dividends in arrears.)

QS 11-12 Dividend allocation between classes of shareholders C2

Stockholders’ equity of Ernst Company consists of 80,000 shares of $5 par value, 8% cumulative preferred stock and 250,000 shares of $1 par value common stock. Both classes of stock have been outstanding since the company’s inception. Ernst did not declare any dividends in the prior year, but it now declares and pays a $110,000 cash dividend at the current year-end. Determine the amount distributed to each class of stockholders for this two-year-old company.

QS 11-13 Dividends on noncumulative preferred stock

C2

Green Planet Corp. has 5,000 shares of noncumulative 10% preferred stock with a $2 par value and 17,000 shares of common stock with a $0.01 par value. During its first two years of operation, Green Planet declared and paid the following total cash dividends. Compute the dividends paid each year to each of the two classes of stockholders: preferred and common.

Year 1 total cash dividends . . . . $800 Year 2 total cash dividends . . . . $1,700

QS 11-14 Dividends on cumulative preferred stock C2

Use the information in QS 11-13 to compute the dividends paid each year to each of the two classes of stockholders assuming that the preferred stock is cumulative.

On December 31, Westworld Inc. has the following equity accounts and balances: Retained Earnings, $45,000; Common Stock, $1,000; Treasury Stock, $2,000; Paid-In Capital in Excess of Par Value, Common Stock, $39,000; Preferred Stock, $7,000; and Paid-In Capital in Excess of Par Value, Preferred Stock, $3,000. Prepare the stockholders’ equity section of Westworld’s balance sheet.

QS 11-17 Preparing stockholders’ equity section

C2 P1 P3

440 Chapter 11 Corporate Reporting and Analysis

On January 1, Payson Inc. had a retained earnings balance of $20,000. During the year, Payson reported net income of $30,000 and paid cash dividends of $17,000. Calculate the retained earnings balance at its December 31 year-end.

QS 11-19 Determining retained earnings balance C3

Indicate which activities of Stockton Corporation violated the rights of a stockholder who owned one share of common stock. 1. Did not allow the stockholder to sell the stock to her brother. 2. Rejected the stockholder’s request to be put in charge of its retail store. 3. Paid the stockholder a smaller dividend per share than another common stockholder. 4. Rejected the stockholder’s request to vote via proxy because she was home sick. 5. In liquidation, paid the common shareholder after all creditors were already paid.

Exercise 11-2 Rights of stockholders

C1

Murray Company reports net income of $770,000 for the year. It has no preferred stock, and its weighted- average common shares outstanding is 280,000 shares. Compute its basic earnings per share.

QS 11-20 Basic earnings per share A1

Epic Company earned net income of $900,000 this year. There were 400,000 weighted-average common shares outstanding, and preferred shareholders received a $20,000 cash dividend. Compute Epic Company’s basic earnings per share.

QS 11-21 Basic earnings per share A1

For each situation, identify whether it is treated as a prior period adjustment or change in accounting estimate. 1. A review of notes payable discovers that three years ago the company reported the entire amount of a

payment (principal and interest) on an installment note payable as interest expense. This mistake had a material effect on net income in that year.

2. After using an expected useful life of seven years and no salvage value to depreciate its office equip- ment over the preceding three years, the company decided early this year that the equipment will last only two more years.

3. Upon reviewing customer contracts, the company realizes it mistakenly reported $150,000 in revenue instead of the actual amount earned of $15,000. This mistake occurred two years ago and had a mate- rial effect on financial statements.

QS 11-18 Accounting for changes in estimates; error adjustments

C3

Compute Topp Company’s price-earnings ratio if its common stock has a market value of $20.54 per share and its EPS is $3.95. Its key competitor, Lower Deck, has a PE ratio of 9.5. For which company does the market have higher expectations of future performance?

QS 11-22 Price-earnings ratio

A2

Foxburo Company expects to pay a $2.34 per share cash dividend this year on its common stock. The cur- rent market value of Foxburo stock is $32.50 per share. Compute the expected dividend yield. If a com- petitor with a dividend yield of 3% is considered an income stock, would we classify Foxburo as a growth or an income stock?

QS 11-23 Dividend yield A3

EXERCISES

Exercise 11-1 Characteristics of corporations

C1

Next to each corporate characteristic 1 through 8, enter the letter of the description that best relates to it. 1. Owner authority and control 2. Ease of formation 3. Transferability of ownership 4. Ability to raise large capital amounts 5. Duration of life 6. Owner liability 7. Legal status 8. Tax status of income

a. Requires government approval b. Corporate income is taxed c. Separate legal entity d. Readily transferred e. One vote per share f. High ability g. Unlimited h. Limited

The stockholders’ equity section of Montel Company’s balance sheet follows. No preferred dividends are in arrears at the current date. Determine the book value per share of the common stock.

QS 11-24 Book value per common share

A4 Preferred stock—5% cumulative, $10 par value, 20,000 shares authorized, issued, and outstanding . . . . . . . . . $ 200,000 Common stock—$5 par value, 200,000 shares authorized, 150,000 shares issued and outstanding. . . . . . . . . . 750,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,850,000

Chapter 11 Corporate Reporting and Analysis 441

Rodriguez Corporation issues 19,000 shares of its common stock for $152,000 cash on February 20. Prepare journal entries to record this event under each of the following separate situations. 1. The stock has a $2 par value. 3. The stock has a $5 stated value. 2. The stock has neither par nor stated value.

Exercise 11-3 Accounting for par, stated, and no-par stock issuances

P1

Exercise 11-5 Stock issuance for noncash assets P1

Sudoku Company issues 7,000 shares of $7 par value common stock in exchange for land and a building. The land is valued at $45,000 and the building at $85,000. Prepare the journal entry to record issuance of the stock in exchange for the land and building.

Exercise 11-7 Stock split P2

Refer to the information in Exercise 11-6. Assume that instead of distributing a stock dividend, Sharper did a 3-for-1 stock split. After the split, (1) prepare the updated stockholders’ equity section and (2) compute the number of shares outstanding. Hint: A 3-for-1 split means that each old share is replaced with 3 new shares.

On June 30, Sharper Corporation’s stockholders’ equity section of its balance sheet appears as follows before any stock dividend or split. Sharper declares and immediately distributes a 50% stock dividend. After the distribution is made, (1) prepare the updated stockholders’ equity section and (2) compute the number of shares outstanding.

Common stock—$10 par value, 50,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000 Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,360,000

Exercise 11-6 Large stock dividend

P2

Prepare journal entries to record each of the following four separate issuances of stock. 1. A corporation issued 4,000 shares of $5 par value common stock for $35,000 cash. 2. A corporation issued 2,000 shares of no-par common stock to its promoters in exchange for their

efforts, estimated to be worth $40,000. The stock has a $1 per share stated value. 3. A corporation issued 2,000 shares of no-par common stock to its promoters in exchange for their

efforts, estimated to be worth $40,000. The stock has no stated value. 4. A corporation issued 1,000 shares of $50 par value preferred stock for $60,000 cash.

Exercise 11-4 Recording stock issuances

P1

The stockholders’ equity section of TVX Company on February 4 follows. Exercise 11-8 Small stock dividend

P2Common stock—$10 par value, 150,000 shares authorized, 60,000 shares issued and outstanding. . . . . . . . . . $ 600,000 Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,575,000

On February 5, the directors declare a 20% stock dividend distributable on February 28 to the February 15 stockholders of record. The stock’s market value is $40 per share on February 5 before the stock dividend. 1. Prepare entries to record both the dividend declaration and its distribution. 2. Prepare the stockholders’ equity section after the stock dividend is distributed. (Assume no other

changes to equity.)

Match each description with the characteristic of preferred stock that it best describes. A. Cumulative B. Noncumulative C. Nonparticipating D. Participating

1. Receives current and all past dividends before common stockholders receive any dividends. 2. Receives dividends exceeding the stated rate under certain conditions. 3. Not entitled to receive dividends in excess of the stated rate. 4. Loses any dividends that are not declared in the current year.

Exercise 11-9 Identifying characteristics of preferred stock

C2

York’s outstanding stock consists of 80,000 shares of noncumulative 7.5% preferred stock with a $5 par value and also 200,000 shares of common stock with a $1 par value. During its first four years of opera- tion, the corporation declared and paid the following total cash dividends. Determine the amount of divi- dends paid each year to each of the two classes of stockholders: preferred and common. Also compute the total dividends paid to each class for the four years combined.

Exercise 11-10 Dividends on common and noncumulative preferred stock

C2

Year 1 total cash dividends . . . . . . . $20,000 Year 3 total cash dividends . . . . . . . $200,000 Year 2 total cash dividends . . . . . . . 28,000 Year 4 total cash dividends . . . . . . . 350,000 Check 4-year total paid to

preferred, $108,000

442 Chapter 11 Corporate Reporting and Analysis

Use the data in Exercise 11-10 to determine the amount of dividends paid each year to each of the two classes of stockholders assuming that the preferred stock is cumulative. Also determine the total dividends paid to each class for the four years combined.

Exercise 11-11 Dividends on common and cumulative preferred stock

C2

In Draco Corporation’s first year of business, the following transactions affected its equity accounts. Prepare the stockholders’ equity section of Draco’s balance sheet as of December 31.

∙ Issued 4,000 shares of $2 par value common stock for $18. It authorized 20,000 shares. ∙ Issued 1,000 shares of 12%, $10 par value preferred stock for $23. It authorized 3,000 shares. ∙ Reacquired 200 shares of common stock for $30 each. ∙ Retained earnings is impacted by reported net income of $50,000 and cash dividends of $15,000.

Exercise 11-13 Preparing stockholders’ equity section

C2 C3 P1 P3

Tuscan Inc. had a retained earnings balance of $60,000 at December 31, 2018. During the year, Tuscan had the following selected transactions. Calculate the retained earnings balance at December 31, 2019.

∙ Reported net income of $100,000. ∙ Revised an estimate of a machine’s salvage value. Depreciation increased by $1,000 per year. ∙ An error was discovered. Three years ago, a purchase of a building was incorrectly expensed. The

effect is understated retained earnings of $12,000 (net of tax benefit). ∙ Paid cash dividends of $33,000.

Exercise 11-14 Determining retained earnings balance

C3

The following information is from Amos Company for the year ended December 31, 2019. Prepare a statement of retained earnings for Amos Company.

∙ Retained earnings at December 31, 2018 (before discovery of error), $1,375,000. ∙ Cash dividends declared and paid during the year, $43,000. ∙ Two years ago, it forgot to record depreciation expense of $55,500 (net of tax benefit). ∙ The company earned $126,000 in net income this year.

Exercise 11-15 Preparing a statement of retained earnings

C3

On October 10, the stockholders’ equity section of Sherman Systems appears as follows.Exercise 11-12 Recording and reporting treasury stock transactions

P3 Common stock—$10 par value, 72,000 shares authorized, issued, and outstanding . . . . . . $ 720,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 864,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000

1. Prepare journal entries to record the following transactions for Sherman Systems. a. Purchased 5,000 shares of its own common stock at $25 per share on October 11. b. Sold 1,000 treasury shares on November 1 for $31 cash per share. c. Sold all remaining treasury shares on November 25 for $20 cash per share. 2. Prepare the stockholders’ equity section after the October 11 treasury stock purchase.

Check (1c) Dr. Retained Earnings, $14,000

Kelley Company reports $960,000 of net income and declares $120,000 of cash dividends on its preferred stock for the year. At year-end, the company had 400,000 weighted-average shares of common stock. 1. What amount of net income is available to common stockholders? 2. What is the company’s basic EPS? Round your answer to the nearest whole cent.

Exercise 11-17 Earnings per share

A1 Check (2) $2.10

Ecker Company reports $2,700,000 of net income and declares $388,020 of cash dividends on its pre- ferred stock for the year. At year-end, the company had 678,000 weighted-average shares of common stock. 1. What amount of net income is available to common stockholders? 2. What is the company’s basic EPS?

Exercise 11-16 Earnings per share

A1

Check (2) $3.41

Chapter 11 Corporate Reporting and Analysis 443

Exercise 11-18 Price-earnings ratio computation and interpretation

A2

Compute the price-earnings ratio for each of these four separate companies. For which of these four com- panies does the market have the lowest expectation of future performance?

1

2

3

4

5

A B C

$12.00

10.00

7.50

50.00

Earnings per Share Market Value per ShareCompany

Hilton

SPG

Hyatt

Accor

$176.40

96.00

93.75

250.00

Exercise 11-19 Dividend yield computation and interpretation

A3

Compute the dividend yield for each of these four separate companies. Which company’s stock would probably not be classified as an income stock?

1

2

3

4

5

A B C

$16.06

13.86

3.96

0.48

Annual Cash Dividend per Share Market Value per ShareCompany

Etihad

United

Lingus

Allied

$220.00

132.00

72.00

80.00

Exercise 11-20 Book value per share

A4

The equity section of Cyril Corporation’s balance sheet shows the following.

Preferred stock—6% cumulative, $25 par value, 10,000 shares issued and outstanding. . . . . . . . . . . . . . . . . . . . $ 250,000

Common stock—$8 par value, 100,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,585,000

Determine the book value per share of common stock under two separate situations. 1. No preferred dividends are in arrears at the current date. 2. Three years of preferred dividends are in arrears at the current date.

Check (1) Book value of common, $13.35 per share

Common stock—$25 par value, 50,000 shares authorized, 30,000 shares issued and outstanding . . . . . . . . . . . $ 750,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,140,000

Alexander Corporation reports the following components of stockholders’ equity at December 31, 2018. Exercise 11-21 Cash dividends, treasury stock, and statement of retained earnings

C3 P2 P3

During 2019, the following transactions affected its stockholders’ equity accounts.

Jan. 2 Purchased 3,000 shares of its own stock at $25 cash per share. Jan. 7 Directors declared a $1.50 per share cash dividend payable on February 28 to the February 9

stockholders of record. Feb. 28 Paid the dividend declared on January 7. July 9 Sold 1,200 of its treasury shares at $30 cash per share. Aug. 27 Sold 1,500 of its treasury shares at $20 cash per share. Sep. 9 Directors declared a $2 per share cash dividend payable on October 22 to the September 23

stockholders of record. Oct. 22 Paid the dividend declared on September 9. Dec. 31 Closed the $52,000 credit balance (from net income) in the Income Summary account to Re-

tained Earnings.

Required

1. Prepare journal entries to record each of these transactions. 2. Prepare a statement of retained earnings for the year ended December 31, 2019. 3. Prepare the stockholders’ equity section of the company’s balance sheet as of December 31, 2019.

444 Chapter 11 Corporate Reporting and Analysis

PROBLEM SET A

Problem 11-1A Stockholders’ equity transactions and analysis

P1 A4

Kinkaid Co. was incorporated at the beginning of this year and had a number of transactions. The follow- ing journal entries impacted its stockholders’ equity during its first year of operations.

Required

1. Explain the transaction(s) underlying each journal entry (a) through (d). 2. How many shares of common stock are outstanding at year-end? 3. What is the total paid-in capital at year-end? 4. What is the book value per share of the common stock at year-end if total paid-in capital plus retained

earnings equals $695,000?

Check (2) 20,000 shares

(3) $650,000

a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Common Stock, $25 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . 50,000

b. Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Common Stock, $25 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . 25,000

c. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,500

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,500

Common Stock, $25 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . 30,000

d. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Common Stock, $25 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . 45,000

Problem 11-2A Cash dividends, treasury stock, and statement of retained earnings

C3 P2 P3

Kohler Corporation reports the following components of stockholders’ equity at December 31, 2018.

During 2019, the following transactions affected its stockholders’ equity accounts.

Jan. 2 Purchased 4,000 shares of its own stock at $20 cash per share. Jan. 5 Directors declared a $2 per share cash dividend payable on February 28 to the February 5

stockholders of record. Feb. 28 Paid the dividend declared on January 5. July 6 Sold 1,500 of its treasury shares at $24 cash per share. Aug. 22 Sold 2,500 of its treasury shares at $17 cash per share. Sep. 5 Directors declared a $2 per share cash dividend payable on October 28 to the September 25

stockholders of record. Oct. 28 Paid the dividend declared on September 5. Dec. 31 Closed the $388,000 credit balance (from net income) in the Income Summary account to Re-

tained Earnings.

Required

1. Prepare journal entries to record each of these transactions. 2. Prepare a statement of retained earnings for the year ended December 31, 2019. 3. Prepare the stockholders’ equity section of the company’s balance sheet as of December 31, 2019.

Check (2) Ending retained earnings, $504,500

Common stock—$10 par value, 100,000 shares authorized, 40,000 shares issued and outstanding. . . . . . . . . . $400,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $730,000

Chapter 11 Corporate Reporting and Analysis 445

Problem 11-3A Equity analysis—journal entries and account balances

P2

Required

1. Explain the transaction(s) underlying each journal entry. 2. Complete the following table showing the equity account balances at each indicated date (take into

account the beginning balances from September 30).

At September 30, the end of Beijing Company’s third quarter, the following stockholders’ equity accounts are reported.

In the fourth quarter, the following entries related to its equity are recorded.

Common stock, $12 par value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . 90,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Check Total equity: Oct. 2, $710,000; Dec. 31, $920,000

Sep. 30 Oct. 2 Oct. 25 Oct. 31 Nov. 5 Dec. 1 Dec. 31

Common stock . . . . . . . . . . . . . . . . . . . . $ $ $ $ $ $ $

Common stock dividend distributable . . . . . . . . . . . . . . . . . . .

Paid-in capital in excess of par, common stock . . . . . . . . . . . .

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

Total equity . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ $ $ $

360,000

0

90,000

320,000

770,000

The equity sections for Atticus Group at the beginning of the year (January 1) and end of the year (December 31) follow.

Problem 11-4A Analyzing changes in stockholders’ equity accounts

C3 P2 P3 Stockholders’ Equity (January 1) Common stock—$4 par value, 100,000 shares authorized, 40,000 shares issued and outstanding . . . . . . . . . . . . . $160,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000

Stockholders’ Equity (December 31) Common stock—$4 par value, 100,000 shares authorized, 47,400 shares issued, 3,000 shares in treasury. . . . . . $189,600

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179,200

Retained earnings ($30,000 restricted by treasury stock) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

768,800

Less cost of treasury stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30,000)

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $738,800

Oct. 2 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Oct. 25 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Oct. 31 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Common Stock Dividend Distributable. . . . . . . . . . . . . . . . . . . . . . 36,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . 39,000

Nov. 5 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Common Stock, $12 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Dec. 1 Memo—Change the title of the Common Stock account to reflect the new par value of $4.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

446 Chapter 11 Corporate Reporting and Analysis

The following transactions and events affected its equity during the year. Jan. 5 Declared a $0.50 per share cash dividend, date of record January 10. Mar. 20 Purchased treasury stock for cash. Apr. 5 Declared a $0.50 per share cash dividend, date of record April 10. July 5 Declared a $0.50 per share cash dividend, date of record July 10. July 31 Declared a 20% stock dividend when the stock’s market value was $12 per share. Aug. 14 Issued the stock dividend that was declared on July 31. Oct. 5 Declared a $0.50 per share cash dividend, date of record October 10.

Required

1. How many common shares are outstanding on each cash dividend date? 2. What is the total dollar amount for each of the four cash dividends? 3. What is the amount of retained earnings transferred to paid-in capital accounts (capitalized) for the

stock dividend? 4. What is the per share cost of the treasury stock purchased? 5. How much net income did the company earn this year?

Check (3) $88,800

(4) $10

(5) $248,000

Raphael Corporation’s balance sheet shows the following stockholders’ equity section.Problem 11-5A Computing book values and dividend allocations

C2 A4

Required

1. What are the par values of the corporation’s preferred stock and its common stock? 2. If no dividends are in arrears at the current date, what is the book value per share of common stock?

Round per share value to the nearest cent. 3. If two years’ preferred dividends are in arrears at the current date, what is the book value per share of

common stock? Round per share value to the nearest cent. 4. If two years’ preferred dividends are in arrears at the current date and the board of directors declares cash

dividends of $11,500, what total amount will be paid to the preferred and to the common shareholders?

Check (3) Book value of common, $56.25

Preferred stock—5% cumulative, $___ par value, 1,000 shares authorized, issued, and outstanding . . . . . . . . . . . . $ 50,000

Common stock—$___ par value, 4,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000

PROBLEM SET B

Problem 11-1B Stockholders’ equity transactions and analysis

P1 A4

Weiss Company was incorporated at the beginning of this year and had a number of transactions. The fol- lowing journal entries impacted its stockholders’ equity during its first year of operations.

a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . 117,000

b. Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . 39,000

c. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,300 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,300

Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . 39,200

d. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . 58,800

Required

1. Explain the transaction(s) underlying each journal entry (a) through (d). 2. How many shares of common stock are outstanding at year-end?Check (2) 6,000 shares

Chapter 11 Corporate Reporting and Analysis 447

3. What is the total paid-in capital at year-end? 4. What is the book value per share of the common stock at year-end if total paid-in capital plus retained

earnings equals $283,200?

(3) $260,000

Problem 11-2B Cash dividends, treasury stock, and statement of retained earnings

C3 P2 P3

Balthus Corp. reports the following components of stockholders’ equity at December 31, 2018.

It completed the following transactions related to stockholders’ equity during 2019.

Jan. 10 Purchased 40,000 shares of its own stock at $12 cash per share. Mar. 2 Directors declared a $1.50 per share cash dividend payable on March 31 to the March 15 stock-

holders of record. Mar. 31 Paid the dividend declared on March 2. Nov. 11 Sold 24,000 of its treasury shares at $13 cash per share. Nov. 25 Sold 16,000 of its treasury shares at $9.50 cash per share. Dec. 1 Directors declared a $2.50 per share cash dividend payable on January 2 to the December 10

stockholders of record. Dec. 31 Closed the $1,072,000 credit balance (from net income) in the Income Summary account to

Retained Earnings.

Required

1. Prepare journal entries to record each of these transactions. 2. Prepare a statement of retained earnings for the year ended December 31, 2019. 3. Prepare the stockholders’ equity section of the company’s balance sheet as of December 31, 2019.

Check (2) Ending retained earnings, $2,476,000

Common stock—$1 par value, 320,000 shares authorized, 200,000 shares issued and outstanding. . . . . . . . . . . . $ 200,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,160,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,760,000

In the fourth quarter, the following entries related to its equity are recorded.

Problem 11-3B Equity analysis—journal entries and account balances

P2

At December 31, the end of Chilton Communication’s third quarter, the following stockholders’ equity accounts are reported.

Common stock, $10 par value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 960,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . 384,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000

Jan. 17 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Feb. 5 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Feb. 28 Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,000

Common Stock Dividend Distributable. . . . . . . . . . . . . . . . . . . . . . 120,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . 132,000

Mar. 14 Common Stock Dividend Distributable . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Mar. 25 Memo—Change the title of the Common Stock account to reflect the new par value of $5.

Mar. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000

448 Chapter 11 Corporate Reporting and Analysis

Required

1. Explain the transaction(s) underlying each journal entry. 2. Complete the following table showing the equity account balances at each indicated date (take into

account the beginning balances from December 31).

Dec. 31 Jan. 17 Feb. 5 Feb. 28 Mar. 14 Mar. 25 Mar. 31

Common stock . . . . . . . . . . . . . . . . . . . $ $ $ $ $ $ $

Common stock dividend distributable . . . . . . . . . . . . . . . . . .

Paid-in capital in excess of par, common stock . . . . . . . . . . . .

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

Total equity . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ $ $ $

960,000

0

384,000

1,600,000

2,944,000

Check Total equity: Jan. 17, $2,848,000; Mar. 31, $3,568,000

Stockholders’ Equity (January 1) Common stock—$20 par value, 30,000 shares authorized, 17,000 shares issued and outstanding . . . . . . . . . . . . . $340,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $670,000

Stockholders’ Equity (December 31) Common stock—$20 par value, 30,000 shares authorized, 19,000 shares issued, 1,000 shares in treasury. . . . . . $380,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104,000

Retained earnings ($40,000 restricted by treasury stock) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295,200

779,200

Less cost of treasury stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,000)

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $739,200

Problem 11-4B Analyzing changes in stockholders’ equity accounts

C3 P2 P3

The equity sections for Hovo Corp. at the beginning of the year (January 1) and end of the year (December 31) follow.

The following transactions and events affected its equity during the year. Feb. 15 Declared a $0.40 per share cash dividend, date of record five days later. Mar. 2 Purchased treasury stock for cash. May 15 Declared a $0.40 per share cash dividend, date of record five days later. Aug. 15 Declared a $0.40 per share cash dividend, date of record five days later. Oct. 4 Declared a 12.5% stock dividend when the stock’s market value is $42 per share. Oct. 20 Issued the stock dividend that was declared on October 4. Nov. 15 Declared a $0.40 per share cash dividend, date of record five days later.

Required

1. How many common shares are outstanding on each cash dividend date? 2. What is the total dollar amount for each of the four cash dividends? 3. What is the amount of retained earnings transferred to paid-in capital accounts (capitalized) for the

stock dividend? 4. What is the per share cost of the treasury stock purchased? 5. How much net income did the company earn this year?

Check (3) $84,000

(4) $40

(5) $136,000

Problem 11-5B Computing book values and dividend allocations

C2 A4

Soltech Company’s balance sheet shows the following stockholders’ equity section.

Preferred stock—8% cumulative, $___ par value, 1,500 shares authorized, issued, and outstanding . . . . . . . . . . . . $ 375,000

Common stock—$___ par value, 18,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400,000

Chapter 11 Corporate Reporting and Analysis 449

Required

1. What are the par values of the corporation’s preferred stock and its common stock? 2. If no dividends are in arrears at the current date, what is the book value per share of common stock?

Round per share value to the nearest cent. 3. If two years’ preferred dividends are in arrears at the current date, what is the book value per share of

common stock? Round per share value to the nearest cent. 4. If two years’ preferred dividends are in arrears at the current date and the board of directors declares

cash dividends of $100,000, what total amount will be paid to the preferred and to the common shareholders?

Check (3) Book value of common, $109.17

SERIAL PROBLEM Business Solutions

P1 C1 C2

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 11 Santana Rey created Business Solutions on October 1, 2019. The company has been successful, and Santana plans to expand her business. She believes that an additional $86,000 is needed and is inves- tigating three funding sources. a. Santana’s sister Cicely is willing to invest $86,000 in the business as a common shareholder. Because

Santana currently has about $129,000 invested in the business, Cicely’s investment will mean that Santana will maintain about 60% ownership and Cicely will have 40% ownership of Business Solutions.

b. Santana’s uncle Marcello is willing to invest $86,000 in the business as a preferred shareholder. Marcello would purchase 860 shares of $100 par value, 7% preferred stock.

c. Santana’s banker is willing to lend her $86,000 on a 7%, 10-year note payable. She would make monthly payments of $1,000 per month for 10 years.

Required

1. Prepare the journal entry to reflect the initial $86,000 investment under each of the options (a), (b), and (c).

2. Evaluate the three proposals for expansion, providing the pros and cons of each option. 3. Which option do you recommend Santana adopt? Explain.

©Alexander Image/Shutterstock

GENERAL LEDGER PROBLEM

The following General Ledger assignments highlight the impact, or lack thereof, on financial statements from equity-based transactions.

GL 11-1 General Ledger assignment 11-1 is adapted from Problem 11-2A, including beginning equity balances. Prepare journal entries related to treasury stock, cash dividends, and net income. Then prepare the statement of retained earnings and the stockholders’ equity section of the balance sheet.

GL 11-2 General Ledger assignment 11-2 is adapted from Problem 11-4A, including beginning and ending equity balances. Prepare journal entries related to cash dividends and stock dividends. Calculate the number of shares outstanding, the amount of net income, and the amount of retained earnings to be capitalized as a result of the stock dividend, if any.

GL

COMPANY ANALYSIS C2 A1 A4

Accounting Analysis

AA 11-1 Use Apple’s financial statements in Appendix A to answer the following. 1. How many shares of Apple common stock are issued and outstanding at (a) September 30, 2017, and

(b) September 24, 2016? 2. What is the total amount of cash dividends paid to common stockholders for the years ended

(a) September 30, 2017, and (b) September 24, 2016? 3. Identify basic EPS amounts for fiscal years (a) 2017 and (b) 2016. 4. Is the change in Apple’s EPS from 2016 to 2017 favorable or unfavorable? 5. If Apple buys back outstanding shares from investors, would you expect EPS to increase or decrease

from the buyback?

APPLE

450 Chapter 11 Corporate Reporting and Analysis

Required

1. Compute the book value per common share for each company using these data. 2. Compute the basic EPS for each company using these data. 3. Compute the dividend yield for each company using these data. 4. Compute the price-earnings ratio for each company using these data. 5. Based on the PE ratio, for which company do investors have greater expectations about future

performance?

AA 11-2 Use the following comparative figures for Apple and Google.COMPARATIVE ANALYSIS A1 A2 A3 A4 Key Figures Apple Google

Net income (in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 12,662

Cash dividends declared per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2.40 $ 0.00

Common shares outstanding (in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,126.201 694.783

Weighted-average common shares outstanding (in millions) . . . . . . . . . . . . . . . 5,217.242 693.049

Market value (price) per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 154.12 $1,046.40

Equity applicable to common shares (in millions) . . . . . . . . . . . . . . . . . . . . . . . . . $ 134,047 $ 152,502

Required

1. Compute book value per share for Samsung. 2. Compute earnings per share (EPS) for Samsung. 3. If Samsung buys back outstanding shares from investors, would we expect EPS to increase or decrease

from the buyback?

AA 11-3 Use the following financial information for Samsung.GLOBAL ANALYSIS C3 A1

Net income less dividends available to preferred shares (in millions). . . . . . . . . . . . . . . . W 36,323,611

Number of common shares outstanding (in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119.688

Weighted-average common shares outstanding (in millions) . . . . . . . . . . . . . . . . . . . . . . 121.132

Equity applicable to common shares (in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . W214,371,961

ETHICS CHALLENGE C3

BTN 11-1 Harriet Moore is an accountant for New World Pharmaceuticals. Her duties include tracking research and development spending in the new product development division. Over the course of the past six months, Harriet has noticed that a great deal of funds have been spent on a particular project for a new drug. She hears “through the grapevine” that the company is about to patent the drug and expects it to be a major advance in antibiotics. Harriet believes that this new drug will greatly improve company perfor- mance and will cause the company’s stock to increase in value. Harriet decides to purchase shares of New World in order to benefit from this expected increase.

Required

What are Harriet’s ethical responsibilities, if any, with respect to the information she has learned through her duties as an accountant for New World Pharmaceuticals? What are the implications of her planned purchase of New World shares?

Beyond the Numbers

BTN 11-2 Teams are to select an industry, and each team member is to select a different company in that industry. Each team member then is to acquire the selected company’s financial statements (or Form 10-K) from the SEC site (SEC.gov). Use these data to identify basic EPS. Use the financial press (or finance.yahoo.com) to determine the market price of this stock, and then compute the price-earnings ratio. Communicate with teammates via a meeting, e-mail, or telephone to discuss the meaning of this ratio, how companies compare, and the industry norm. The team must prepare a single memorandum reporting the ratio for each company and identifying the team conclusions or consensus of opinion. The memorandum is to be duplicated and distributed to the instructor and teammates.

COMMUNICATING IN PRACTICE A1 A2

Hint: Make a slide of each team’s memo for a class discussion.

Samsung

APPLE GOOGLE

Chapter 11 Corporate Reporting and Analysis 451

BTN 11-3 Access the March 1, 2017, filing of the 2016 calendar-year 10-K report of McDonald’s (ticker: MCD) from SEC.gov.

Required

1. Review McDonald’s balance sheet and identify how many classes of stock it has issued. 2. What are the par values, number of authorized shares, and number of issued shares of the classes of

stock you identified in part 1? 3. Review its statement of cash flows and identify what total amount of cash it paid in 2016 to purchase

treasury stock. 4. What amount did McDonald’s pay out in common stock cash dividends for 2016?

TAKING IT TO THE NET C1 C3

BTN 11-4 This activity requires teamwork to reinforce understanding of accounting for treasury stock. 1. Write a brief team statement (a) generalizing what happens to a corporation’s financial position when

it engages in a stock buyback and (b) identifying reasons why a corporation would engage in this activity.

2. Assume that an entity acquires 100 shares of its $100 par value common stock at a cost of $134 cash per share. Discuss the entry to record this acquisition. Next, assign each team member to prepare one of the following entries (assume each entry applies to all shares).

a. Reissue treasury shares at cost. b. Reissue treasury shares at $150 per share. c. Reissue treasury shares at $120 per share; assume the paid-in capital account from treasury shares

has a $1,500 balance. d. Reissue treasury shares at $120 per share; assume the paid-in capital account from treasury shares

has a $1,000 balance. e. Reissue treasury shares at $120 per share; assume the paid-in capital account from treasury shares

has a zero balance. 3. In sequence, each member is to present his/her entry to the team and explain the similarities and

differences between that entry and the previous entry.

TEAMWORK IN ACTION P3

Hint: Instructor must be sure each team accurately completes part 1 before proceeding.

BTN 11-5 Assume that Yelp decides to launch a new website to market discount bookkeeping services to consumers. This chain, named Aladin, requires $500,000 of start-up capital. The founder contributes $375,000 of personal assets in return for 15,000 shares of common stock, but he must raise another $125,000 in cash. There are two alternative plans for raising the additional cash.

∙ Plan A is to sell 3,750 shares of common stock to one or more investors for $125,000 cash. ∙ Plan B is to sell 1,250 shares of cumulative preferred stock to one or more investors for $125,000 cash

(this preferred stock would have a $100 par value, have an annual 8% dividend rate, and be issued at par). 1. If the new business is expected to earn $72,000 of after-tax net income in the first year, what rate of

return on beginning equity will the founder earn under each alternative plan? Which plan will provide the higher expected return?

2. If the new business is expected to earn $16,800 of after-tax net income in the first year, what rate of return on beginning equity will the founder earn under each alternative plan? Which plan will provide the higher expected return?

3. Analyze and interpret the differences between the results for parts 1 and 2.

ENTREPRENEURIAL DECISION C2 P2

BTN 11-6 Review 30 to 60 minutes of financial news programming on television. Take notes on compa- nies that are catching analysts’ attention. You might hear reference to over- and undervaluation of firms and to reports about PE ratios, dividend yields, and earnings per share. Be prepared to give a brief descrip- tion to the class of your observations.

HITTING THE ROAD A1 A2 A3

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Learning Objectives

CONCEPTUAL C1 Distinguish between operating,

investing, and financing activities, and describe how noncash investing and financing activities are disclosed.

ANALYTICAL A1 Analyze the statement of cash flows and

apply the cash flow on total assets ratio.

P4 Appendix 12A—Illustrate use of a spreadsheet to prepare a statement of cash flows.

P5 Appendix 12B—Compute cash flows from operating activities using the direct method.

PROCEDURAL P1 Prepare a statement of cash flows.

P2 Compute cash flows from operating activities using the indirect method.

P3 Determine cash flows from both investing and financing activities.

Chapter Preview

12 Reporting Cash Flows

CASH FLOWS FROM OPERATING

P2 Indirect method Illustration of indirect method

Summary of indirect method adjustments

CASH FLOWS FROM INVESTING

P3 Three-step process of analysis

Analyzing noncurrent assets

Analyzing other assets

BASICS OF CASH FLOW REPORTING

C1 Purpose, measurement, and classification

Noncash activities

P1 Format and preparation

NTK 12-1

CASH FLOWS FROM FINANCING

P3 Three-step process of analysis

Analyzing noncurrent liabilities

Analyzing equity

Summary using T-accounts

A1 Analyzing cash

NTK 12-4NTK 12-2 NTK 12-3

453

“Work with people who have faith in you” —Barbara Bradley

True Colors

FORT WAYNE, IN—“I never saw myself going into business,” re- calls Barbara Bradley. Until one day, “we were at the airport when we noticed no one was carrying anything colorful or fun. So we decided to start a company to make handbags and lug- gage for women,” exclaims Barbara.

Barbara and her co-founder had no cash, so they borrowed $250 and started “cutting fabric out on a Ping-Pong table,” ex- plains Barbara. “We decided to name the company Vera Bradley (VeraBradley.com) after [my mother].”

As the business grew, Barbara had to manage cash flows. “The first year, we did $10,000 in sales,” proclaims Barbara. “Then things got chaotic.” While cash flows from operations were good, the business had to expand to meet demand.

“We went to a bank, seeking a $5,000 loan,” says Barbara. The loan was a welcome cash inflow that allowed the company to “build its own building!”

Barbara admits that she’s “not a great finance [and account- ing] person,” but she insists that accounting and attention to cash flows are key to running a successful business.

Although cash may be king, Barbara insists that “business is all about forming relationships. My father always said, ‘In busi- ness, you sell yourself first, your company second, and the product third,’ and he was right.”

Sources: Vera Bradley website, January 2019; Vera Bradley Foundation, January 2019; Fortune, October 2015

©Robin Marchant/Vera Bradley/Getty Images

Purpose of the Statement of Cash Flows The statement of cash flows reports cash receipts (inflows) and cash payments (outflows) for a period. Cash flows are separated into operating, investing, and financing activities. The details of sources and uses of cash make this statement useful. The statement of cash flows helps answer What explains the change in the cash balance? How does a company receive its cash? Where does a company spend its cash? Why do income and cash flows differ?

Importance of Cash Flows Information about cash flows influences decisions. Cash flows help users decide whether a company has enough cash to pay its debts. They also help evaluate a company’s ability to pursue opportunities. Managers use cash flow information to plan day-to-day operations and make long-term investment decisions.

W. T. Grant Co. is a classic example of the importance of cash flows. Grant reported net income of more than $40 million per year for three consecutive years. At that same time, cash outflow was more than $90 million by the end of that three-year period. Grant soon went bank- rupt. Users who relied only on Grant’s income numbers were caught off guard.

Measurement of Cash Flows Cash flows include both cash and cash equivalents. The statement of cash flows explains the difference between the beginning and ending balances of cash and cash equivalents. We con- tinue to use the phrases cash flows and the statement of cash flows, but remember that both phrases refer to cash and cash equivalents. Because cash and cash equivalents are combined, the statement of cash flows does not report transactions between cash and cash equivalents, such as cash paid to purchase cash equivalents and cash received from selling cash equivalents.

A cash equivalent has two criteria: (1) be readily convertible to a known amount of cash and (2) be sufficiently close to its maturity so its market value is unaffected by interest rate changes. American Express defines its cash equivalents as including “highly liquid investments with orig- inal maturities of 90 days or less.”

BASICS OF CASH FLOW REPORTING

Cash Equivalents

454 Chapter 12 Reporting Cash Flows

Classification of Cash Flows Cash receipts and cash payments are classified in one of three categories: operating, investing, or financing activities. A net cash inflow (source) occurs when the receipts in a category exceed the payments. A net cash outflow (use) occurs when the payments in a category exceed the receipts.

Operating Activities Operating activities include transactions and events that affect net income. Examples are the production and purchase of inventory, the sale of goods and ser- vices to customers, and the expenditures to operate the business. Not all items in income, such as unusual gains and losses, are operating activities (we discuss these exceptions later). Exhibit 12.1 lists common cash inflows and outflows from operating activities.

C1 Distinguish between operating, investing, and financing activities, and describe how noncash investing and financing activities are disclosed.

Operating Activities

Cash Outflows Cash Inflows

From collections on credit sales

From receipt of dividend revenue

From cash sales to customers

From receipt of interest revenue

To pay operating expenses

To pay taxes and fines

To pay interest owed

To pay salaries and wages

To pay suppliers for goods and services

EXHIBIT 12.1 Cash Flows from Operating Activities

Investing Activities Investing activities include transactions and events that come from the purchase and sale of long-term assets. They also include (1) the purchase and sale of short-term investments and (2) lending and collecting money for notes receivable. Exhibit 12.2 lists examples of cash flows from investing activities. Cash from collecting the principal on notes is an investing activity. However, collecting interest on notes is an operating activity; also, if a note results from sales to customers, it is an operating activity.

Point: For simplicity, we assume purchases and sales of equity and debt securities are investing activities.

Cash Inflows Cash Outflows

From selling long-term investments

From selling short-term investments

From collecting principal on notes

receivable

From selling plant assetsFrom selling

intangible assets

From selling (discounting) notes

receivable

To buy intangible assets

To buy short-term investments

To loan money in return for notes

receivable

To buy long-term investments

To buy plant assets

Investing Activities

EXHIBIT 12.2 Cash Flows from Investing Activities

Financing Activities Financing activities include transactions and events that affect long-term liabilities and equity. Examples are (1) getting cash from issuing debt and repaying debt and (2) receiving cash from or distributing cash to owners. Borrowing and repaying princi- pal on both short- and long-term debt are financing activities. However, payments of interest are operating activities. Exhibit 12.3 lists examples of cash flows from financing activities.

Financing Activities

Cash Inflows Cash OutflowsFrom issuing its common

and preferred stock

From issuing its short- and long-term debt (notes

payable and bonds payable)

From reissuing its treasury stock

From contributions by owners

To pay dividends to shareholders

Withdrawals by owners

To pay o� its short- and long-term debt (notes payable

and bonds payable)

To purchase treasury stock

EXHIBIT 12.3 Cash Flows from Financing Activities

Chapter 12 Reporting Cash Flows 455

Link between Classification of Cash Flows and the Balance Sheet Operating, investing, and financing activities are loosely linked to different parts of the balance sheet. Operating activities are affected by changes in current assets and current liabilities (and the in- come statement). Investing activities are affected by changes in long-term assets. Financing ac- tivities are affected by changes in long-term liabilities and equity. These links are shown in Exhibit 12.4. Exceptions to these links include (1) current assets unrelated to operations—such as short-term notes receivable from noncustomers and from investment securities, which are investing activities, and (2) current liabilities unrelated to operations—such as short-term notes payable and dividends payable, which are financing activities.

Current assets

Assets

Long-term assets

Operating cash flows

Investing cash flows

Financing cash flows

Current liabilities

Liabilities & Equity

Long-term liabilities & Equity

EXHIBIT 12.4 Linkage of Cash Flow Classifications to the Balance Sheet

Noncash Investing and Financing Some investing and financing activities do not affect cash flows. One example is the purchase of long-term assets using a long-term note payable (loan). This transaction impacts both investing and financing activities but does not impact current-period cash. Such transactions are reported at the bottom of the statement of cash flows or in a note to the statement—Exhibit 12.5 has examples.

EXHIBIT 12.5 Examples of Noncash Investing and Financing Activities

Retirement of debt by issuing equity stock.

Conversion of preferred stock to common stock.

Lease of assets in a long-term lease transaction.

Purchase of long-term assets by issuing a note or bond.

Exchange of noncash assets for other noncash assets.

Purchase of noncash assets by issuing equity or debt.

Format of the Statement of Cash Flows A statement of cash flows reports cash flows from three activities: operating, investing, and financing. Exhibit 12.6 shows the usual format. The statement shows the net increase or decrease from those activities and ties it into the cash balance. Any noncash investing and financing transactions are disclosed in a note or separate schedule.

P1 Prepare a statement of cash flows.

COMPANY NAME Statement of Cash Flows

For period Ended date

Cash flows from operating activities [Compute operating cash flows using indirect or direct method]

Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Cash flows from investing activities [List of individual inflows and outflows]

Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Cash flows from financing activities [List of individual inflows and outflows]

Net cash provided (used) by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Net increase (decrease) in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cash (and equivalents) balance at prior period-end. . . . . . . . . . . . . . . . . . . . . . . . . . # Cash (and equivalents) balance at current period-end . . . . . . . . . . . . . . . . . . . . . . . $ #

Separate schedule or note disclosure of any noncash investing and financing transactions is required.

EXHIBIT 12.6 Format of the Statement of Cash Flows

Point: Positive cash flows for a section are titled net cash “provided by” or “from.” Negative cash flows are labeled as net cash “used by” or “for.”

456 Chapter 12 Reporting Cash Flows

Preparing the Statement of Cash Flows Preparing a statement of cash flows has five steps, shown in Exhibit 12.7. Computing the net increase or net decrease in cash is a simple but crucial computation. It equals the current peri- od’s cash balance minus the prior period’s cash balance. This is the bottom-line figure for the statement of cash flows and is a check on accuracy.

4 Compute net cash from or for financing activities.

5 Compute net cash from all sources; then prove it by adding it to beginning cash to get ending cash.

1 Compute net increase or decrease in cash.

3 Compute net cash from or for investing activities.

2 Compute net cash from or for operating activities.

EXHIBIT 12.7 Five Steps in Preparing the Statement of Cash Flows

Analyzing the Cash Account A company’s cash receipts and cash payments are recorded in its Cash account. The Cash account is one place to look for information about cash flows. The summarized Cash T-account of Genesis, Inc., is in Exhibit 12.8. Preparing a statement of cash flows requires classifying each cash inflow or outflow as an operating, investing, or financing activity.

Payments for inventory ................. Payments for operating exp. ....... Payments for interest .................... Payments for taxes ......................... Payments for notes retirement ... Payments for dividends ................

Balance, Dec. 31, 2018 ............... Receipts from customers .......... Receipts from asset sales ......... Receipts from stock issuance ..

Balance, Dec. 31, 2019 ...............

12,000 570,000

2,000 15,000

17,000

319,000 218,000

8,000 5,000

18,000 14,000

CashEXHIBIT 12.8 Summarized Cash Account

Cash = + Equity Noncash assetsLiabilities – EXHIBIT 12.9 Relation between Cash and Noncash Accounts

Information to Prepare the Statement Information to prepare the statement of cash flows comes from three sources: (1) comparative balance sheets, (2) the current income statement, and (3) additional information. Comparative balance sheets are used to compute changes in noncash accounts from the beginning to the end of the period. The current income statement is used to help compute cash flows from operating activities. Additional information includes details that help explain cash flows and noncash activities.

Additional InformationAdditional Information

Income StatementIncome Statement

Balance Sheets

Analyzing Noncash Accounts A second approach to preparing the statement of cash flows analyzes noncash accounts and uses double-entry accounting. Exhibit 12.9 uses the accounting equation to show the relation between the Cash account and the noncash balance sheet accounts. We can explain changes in cash and prepare a statement of cash flows by ana- lyzing changes in liability accounts, equity accounts, and noncash asset accounts (along with income statement accounts).

Chapter 12 Reporting Cash Flows 457

Entrepreneur You are considering purchasing a start-up business that recently reported a $110,000 annual net loss and a $225,000 annual net cash inflow. How are these results possible? ■ Answer: Several factors can explain an increase in net cash flows when a net loss is reported, including (1) early recognition of expenses relative to revenues generated (such as research and development), (2) cash advances on long-term sales contracts not yet recognized in income, (3) issuances of debt or equity for cash to finance expansion, (4) cash sale of assets, (5) delay of cash payments, and (6) cash prepayment on sales.

Decision Maker

Indirect and Direct Methods of Reporting Cash flows provided (used) by operating activities are reported using the direct method or the indirect method. These two different meth- ods apply only to the operating activities section. The direct method separately lists operating cash receipts (such as

cash received from customers) and operating cash payments (such as cash paid for inventory). The cash payments are then subtracted from cash receipts.

The indirect method reports net income and then adjusts it for items that do not affect cash. It does not report individual items of cash inflows and cash outflows from operating activities.

The net cash amount provided by operating activities is identical under both the direct and indirect methods. The difference is with the computation and presentation. The indirect method is arguably easier. Nearly all companies report operating cash flows using the indirect method, including Apple, Google, and Samsung in Appendix A.

Demonstration Data Exhibit 12.10 shows Genesis’s income statement and balance sheets. We use this information to prepare a statement of cash flows that explains the $5,000 increase in cash.

Applying the Indirect Method Net income is computed using accrual accounting. Revenues and expenses rarely match the receipt and payment of cash. The indirect method adjusts net income to get the net cash pro- vided or used by operating activities. We begin with Genesis’s income of $38,000 and adjust it

CASH FLOWS FROM OPERATING

Operating

DirectIndirect

1%

99%

Firms Using Indirect vs. Direct

Classify each of the following cash flows as operating, investing, or financing activities. a. Purchase equipment for cash g. Cash paid for utilities b. Cash payment of wages h. Cash paid to acquire investments c. Issuance of stock for cash i. Cash paid to retire debt d. Receipt of cash dividends from investments j. Cash received as interest on investments e. Cash collections from customers k. Cash received from selling investments f. Note payable issued for cash l. Cash received from a bank loan

Solution

a. Investing c. Financing e. Operating g. Operating i. Financing k. Investing b. Operating d. Operating f. Financing h. Investing j. Operating l. Financing

Classifying Cash Flows

NEED-TO-KNOW 12-1

C1 P1

Do More: QS 12-1, QS 12-2, E 12-1

458 Chapter 12 Reporting Cash Flows

GENESIS Balance Sheets

December 31, 2019 and 2018

2019 2018 Change

Assets Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . $ 17,000 $ 12,000 $ 5,000 Increase Accounts receivable . . . . . . . . . . 60,000 40,000 20,000 Increase Inventory . . . . . . . . . . . . . . . . . . . 84,000 70,000 14,000 Increase Prepaid expenses . . . . . . . . . . . . 6,000 4,000 2,000 Increase Total current assets . . . . . . . . . . . 167,000 126,000 Long-term assets Plant assets . . . . . . . . . . . . . . . . . 250,000 210,000 40,000 Increase Accumulated depreciation . . . . . (60,000) (48,000) 12,000 Increase Total assets . . . . . . . . . . . . . . . . . . . . $357,000 $288,000

Liabilities Current liabilities Accounts payable. . . . . . . . . . . . . $ 35,000 $ 40,000 $ 5,000 Decrease Interest payable . . . . . . . . . . . . . . 3,000 4,000 1,000 Decrease Income taxes payable . . . . . . . . . 22,000 12,000 10,000 Increase Total current liabilities . . . . . . . . . 60,000 56,000 Long-term notes payable. . . . . . . . . 90,000 64,000 26,000 Increase Total liabilities. . . . . . . . . . . . . . . . . . 150,000 120,000

Equity Common stock, $5 par. . . . . . . . . . . 95,000 80,000 15,000 Increase Retained earnings . . . . . . . . . . . . . . 112,000 88,000 24,000 Increase Total equity . . . . . . . . . . . . . . . . . . . . 207,000 168,000 Total liabilities and equity . . . . . . . . $357,000 $288,000

GENESIS Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $590,000 Cost of goods sold . . . . . . . . . . . . . . . . $300,000 Wages and other operating expenses . . . . . . . . . . . . . 216,000 Interest expense. . . . . . . . . . . . . . . . . . 7,000 Depreciation expense . . . . . . . . . . . . . 24,000 (547,000)

43,000 Other gains (losses) Loss on sale of plant assets . . . . . . (6,000) Gain on retirement of notes . . . . . . 16,000 10,000 Income before taxes. . . . . . . . . . . . . . . 53,000 Income taxes expense . . . . . . . . . . . . . (15,000) Net income . . . . . . . . . . . . . . . . . . . . . . $ 38,000

Additional information for 2019 a. The accounts payable balances result from inventory purchases. b. Purchased $60,000 in plant assets by issuing $60,000 of notes

payable.

c. Sold plant assets with a book value of $8,000 (original cost of $20,000 and accumulated depreciation of $12,000) for $2,000 cash, yielding a $6,000 loss.

d. Received $15,000 cash from issuing 3,000 shares of common stock.

e. Paid $18,000 cash to retire notes with a $34,000 book value, yielding a $16,000 gain.

f. Declared and paid cash dividends of $14,000.

EXHIBIT 12.10 Financial Statements

EXHIBIT 12.11 Operating Activities Section—Indirect Method

GENESIS Statement of Cash Flows—Operating Section under Indirect Method

For Year Ended December 31, 2019

Cash flows from operating activities

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 38,000

Adjustments to reconcile net income to net cash provided by operating activities

Income statement items not affecting cash

Depreciation expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Loss on sale of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Gain on retirement of notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16,000)

Changes in current assets and liabilities

Increase in accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20,000)

Increase in inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)

Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)

Decrease in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

Decrease in interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,000)

Increase in income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

1

2

to get cash provided by operating activities of $20,000—see Exhibit 12.11. There are two types of adjustments: 1 Adjustments to income statement items that do not impact cash and 2 Adjustments for changes in current assets and current liabilities (linked to operating activi- ties). Nearly all companies group adjustments into these two types, including Apple, Google, and Samsung in Appendix A.

Chapter 12 Reporting Cash Flows 459

1 Adjustments for Income Statement Items Not Affecting Cash Some expenses and losses subtracted from net income were not cash outflows. Examples are depre- ciation, amortization, depletion, bad debts expense, loss from an asset sale, and loss from retire- ment of notes payable. The indirect method requires that

Expenses and losses with no cash outflows are added back to net income.

These expenses and losses did not reduce cash, and adding them back cancels their deductions from net income. Any cash received or paid from a transaction that yields a loss, such as from an asset sale or payoff of a note, is reported under investing or financing activities.

When net income has revenues and gains that are not cash inflows, the indirect method requires that

Revenues and gains with no cash inflows are subtracted from net income.

Section 1 of Exhibit 12.11 shows three adjustments for items that did not impact cash for Genesis.

Depreciation Depreciation expense is Genesis’s only operating item in net income that had no effect on cash flows. We add back the $24,000 depreciation expense to net income because depreciation did not reduce cash.

Loss on Sale of Plant Assets Genesis reported a $6,000 loss on sale of plant assets that reduced net income but did not affect cash flows. This $6,000 loss is added back to net income because it is not a cash outflow.

Gain on Retirement of Debt A $16,000 gain on retirement of debt increased net income but did not affect cash flows. This $16,000 gain is subtracted from net income because it was not a cash inflow.

2 Adjustments for Changes in Current Assets and Current Liabilities This section covers adjustments for changes in current assets and current liabilities.

Adjustments for Changes in Current Assets

Decreases in current assets are added to net income.

Increases in current assets are subtracted from net income.

Adjustments for Changes in Current Liabilities

Increases in current liabilities are added to net income.

Decreases in current liabilities are subtracted from net income.

The lower section of Exhibit 12.11 shows adjustments to the three noncash current assets and three current liabilities for Genesis. We explain each adjustment next.

Accounts Receivable The $20,000 increase in the current asset of accounts receivable is subtracted from income (showing less cash available). This increase means Genesis collects less cash than is reported in sales. To help see this, we use account analysis. This involves setting up a T-account, entering in black the balances and entries we know, and computing in red the cash receipts or payments. We see cash receipts are $20,000 less than sales, which is why we subtract $20,000 from income in computing the cash flow.

P2 Compute cash flows from operating activities using the indirect method.

Point: An income statement re- ports revenues, gains, expenses, and losses on an accrual basis. The statement of cash flows re- ports cash received and cash paid for operating, financing, and investing activities.

Point: Section 2 adjustments.

Account Account Increases Decreases

Current Subtract from Add to assets . . . . . net income net income

Current Add to Subtract from liabilities . . . net income net income

Accounts Receivable

Bal., Dec. 31, 2018 40,000

Sales 590,000 Cash receipts = 570,000

Bal., Dec. 31, 2019 60,000

Black numbers are from Exhibit 12.10. Red number

is computed. 40,000 + 590,000 − 60,000

460 Chapter 12 Reporting Cash Flows

Inventory The $14,000 increase in inventory is subtracted from income. The T-account shows that purchases are $14,000 more than cost of goods sold. This means that cost of goods sold excludes $14,000 of inventory purchased this year, which is why we subtract $14,000 from income in computing cash flow.

Inventory Bal., Dec. 31, 2018 70,000 Purchases = 314,000 Cost of goods sold 300,000 Bal., Dec. 31, 2019 84,000

Prepaid Expenses The $2,000 increase in prepaid expenses is subtracted from income. The T-account shows that cash paid is $2,000 more than expenses recorded, which is why we subtract $2,000 from income in computing cash flow.

Prepaid Expenses Bal., Dec. 31, 2018 4,000 Cash payments = 218,000 Wages and other

operating exp. 216,000

Bal., Dec. 31, 2019 6,000

Accounts Payable Bal., Dec. 31, 2018 40,000 Cash payments = 319,000 Purchases 314,000 Bal., Dec. 31, 2019 35,000

Accounts Payable The $5,000 decrease in accounts payable is subtracted from income. The T-account shows that cash paid is $5,000 more than purchases recorded, which is why we subtract $5,000 from income in computing cash flow.

Interest Payable Bal., Dec. 31, 2018 4,000

Cash paid for interest = 8,000 Interest expense 7,000 Bal., Dec. 31, 2019 3,000

Interest Payable The $1,000 decrease in interest payable is sub- tracted from income. The T-account shows that cash paid is $1,000 more than interest expense recorded, which is why we subtract $1,000 from income in computing cash flow.

Income Taxes Payable The $10,000 increase in income taxes payable is added to income. The T-account shows that cash paid is $10,000 less than tax expense recorded, which is why we add $10,000 to income in computing cash flow.

Income Taxes Payable Bal., Dec. 31, 2018 12,000

Cash paid for taxes = 5,000 Income taxes expense 15,000 Bal., Dec. 31, 2019 22,000

Summary of Adjustments for Indirect Method Exhibit 12.12 summarizes the adjustments to net income under the indirect method.

Net Income (or Loss) Adjustments for operating items not providing or using cash

+ Noncash expenses and losses Examples: Expenses for depreciation, depletion, and amortization; losses from disposal

of long-term assets and from retirement of debt

− Noncash revenues and gains Examples: Gains from disposal of long-term assets and from retirement of debt

Adjustments for changes in current assets and current liabilities

+ Decrease in noncash current operating asset − Increase in noncash current operating asset + Increase in current operating liability − Decrease in current operating liability Net cash provided (used) by operating activities

1

2

EXHIBIT 12.12 Summary of Adjustments for Operating Activities— Indirect Method

One for the Road Even though Tesla reported net losses and large cash outflows, its market value tripled in five years. Tesla now rivals both GM and Ford as one of the most valued U.S. automakers. Investors are counting on Tesla’s Model 3 to create positive operating cash flows. So far, Tesla has funded its operations with cash inflows from stock and debt issuances. ■

Decision Insight

©Mark Lennihan/AP Images

Chapter 12 Reporting Cash Flows 461

A company’s current-year income statement and selected balance sheet data at December 31 of the cur- rent and prior years follow. Prepare the operating activities section of the statement of cash flows using the indirect method for the current year.

P2

Reporting Operating Cash Flows (Indirect)

NEED-TO-KNOW 12-2

Income Statement For Current Year Ended December 31

Sales revenue . . . . . . . . . . . . . . . . . . . . $120

Expenses: Cost of goods sold. . . . . . . . 50

Depreciation expense . . . . . 30

Salaries expense . . . . . . . . . 17

Interest expense . . . . . . . . . 3

Net income. . . . . . . . . . . . . . . . . . . . . . . $ 20

Selected Balance Sheet Accounts

At December 31 Current Yr Prior Yr Accounts receivable . . . . $12 $10

Inventory . . . . . . . . . . . . . 6 9

Accounts payable . . . . . . 7 11

Salaries payable . . . . . . . 8 3

Interest payable. . . . . . . . 1 0

Solution

Cash Flows from Operating Activities—Indirect Method For Current Year Ended December 31

Cash flows from operating activities Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20

Adjustments to reconcile net income to net cash provided by operating activities

Income statement items not affecting cash

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30

Changes in current assets and current liabilities

Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2)

Decrease in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Decrease in accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4)

Increase in salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Increase in interest payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 33

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $53

Do More: QS 12-3, QS 12-4, QS 12-5, QS 12-6, QS 12-7,

E 12-2, E 12-3, E 12-4, E 12-5, E 12-6, E 12-7

To compute cash flows from investing activities, we analyze changes in (1) all long-term asset accounts and (2) any current accounts for notes receivable and investments in securities. Reporting of investing activities is identical under the direct method and indirect method.

Three-Step Analysis To determine cash provided or used by investing activities: (1) identify changes in investing- related accounts, (2) explain these changes using T-accounts and reconstructed entries, and (3) report the cash flow effects.

Analyzing Noncurrent Assets Genesis both purchased and sold long-term assets during the period. These transactions are investing activities and are analyzed in this section.

Plant Asset Transactions First Step Analyze Genesis’s Plant Assets account and its Accumulated Depreciation account to identify changes in those accounts. Comparative balance sheets in Exhibit 12.10 show a $40,000 increase in plant assets from $210,000 to $250,000 and a $12,000 increase in accumu- lated depreciation from $48,000 to $60,000.

CASH FLOWS FROM INVESTING

P3 Determine cash flows from both investing and financing activities.

Point: Investing activities include (1) purchasing and selling long- term assets, (2) lending and collecting on notes receivable, and (3) purchasing and selling short- term investments other than cash equivalents and trading securities.

462 Chapter 12 Reporting Cash Flows

Second Step Items b and c of the additional information in Exhibit 12.10 relate to plant assets. Recall that the Plant Assets account is impacted by both asset purchases and sales; its Accumulated Depreciation account is increased by depreciation and decreased by the removal of accumulated depreciation in asset sales. To explain changes in these accounts and to identify their cash flow effects, we prepare reconstructed entries, which is our attempt to re-create actual entries made by the preparer. Item b says Genesis purchased plant assets of $60,000 by issuing $60,000 in notes payable. The reconstructed entry is

Bal., Dec. 31, 2018 210,000

Purchase 60,000

Bal., Dec. 31, 2019 250,000

Sale 20,000

Plant Assets

Sale 12,000 Bal., Dec. 31, 2018 48,000

Depr. expense 24,000

Bal., Dec. 31, 2019 60,000

Accumulated Depreciation—Plant Assets

Reconstruction Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Reconstruction Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Reconstruction Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Loss on Sale of Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Cash flows from investing activities Cash received from sale of plant assets . . . . . . . . . . . . . . . . . . . $2,000

Item c says Genesis sold plant assets costing $20,000 (with $12,000 of accumulated deprecia- tion) for $2,000 cash, resulting in a $6,000 loss. The reconstructed entry is

We also reconstruct the entry for depreciation from the income statement, which does not impact cash.

The three reconstructed entries are shown in the following T-accounts. This reconstruction anal- ysis is complete in that changes in the long-term asset accounts are entirely explained.

Third Step Look at the reconstructed entries to identify cash flows. The identified cash flows are reported in the investing section of the statement.

The $60,000 purchase in item b, paid for by issuing notes, is a noncash investing and financing activity. It is reported in a note or in a separate schedule to the statement.

Example: If a plant asset costing $40,000 with $37,000 of accu- mulated depreciation is sold at a $3,000 gain, what is the cash flow? Answer: +$6,000

Noncash investing and financing activity Purchased plant assets with issuance of notes . . . . . . . . . . . . . . $60,000

Additional Long-Term Assets Genesis did not have any additional noncurrent assets (or nonoperating current assets). If such assets do exist, we analyze and report investing cash flows using the same three-step process.

Location, Location, Location Cash flows can be delayed or accelerated at period-end to improve or reduce current-period cash flows. Cash flows also can be misclassified. We know cash outflows under operating activities are viewed as expense payments. However, cash outflows under investing activities are viewed as a sign of growth potential. This requires investors to review where cash flows are reported. ■

Ethical Risk

Chapter 12 Reporting Cash Flows 463

Use the following information to determine this company’s cash flows from investing activities. a. A factory with a book value of $100 and an original cost of $800 was sold at a loss of $10. b. Paid $70 cash for new equipment. c. Long-term stock investments were sold for $20 cash, yielding a loss of $4. d. Sold land costing $175 for $160 cash, yielding a loss of $15.

Solution

Do More: QS 12-8, QS 12-9, QS 12-10, QS 12-11, QS 12-12,

QS 12-13, E 12-8

P3

Reporting Investing Cash Flows

NEED-TO-KNOW 12-3

Cash flows from investing activities Cash received from sale of factory (from a*—also see margin entry) . . . . $ 90

Cash paid for new equipment (from b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . (70)

Cash received from sale of long-term investments (from c). . . . . . . . . . . . 20

Cash received from sale of land (from d) . . . . . . . . . . . . . . . . . . . . . . . . . . 160

Net cash provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . $200

*Cash received from sale of factory = Book value − Loss = $100 − $10 = $90.

Reconstruction for part a. Cash . . . . . . . . . . . . . . 90 Loss on asset sale . . . . 10 Factory (BV) . . . . . 100

To compute cash flows from financing activities, we analyze changes in all noncurrent liability accounts (including the current portion of any notes and bonds) and equity accounts. These accounts include long-term debt, notes payable, bonds payable, common stock, and retained earnings. Reporting of financing activities is identical under the direct method and indirect method.

Three-Step Analysis To determine cash provided or used by financing activities: (1) identify changes in financing- related accounts, (2) explain these changes using T-accounts and reconstructed entries, and (3) report the cash flow effects.

Analyzing Noncurrent Liabilities Genesis retired notes payable by paying cash. This is a change in noncurrent liabilities.

Notes Payable Transactions First Step Review comparative balance sheets in Exhibit 12.10, which shows an increase in notes payable from $64,000 to $90,000.

Second Step Item e of the additional information in Exhibit 12.10 reports that notes with a carrying value of $34,000 are retired for $18,000 cash, resulting in a $16,000 gain. The recon- structed entry is

CASH FLOWS FROM FINANCING

Point: Examples of financing activities are (1) receiving cash from issuing debt or repaying amounts borrowed and (2) receiv- ing cash from or distributing cash to owners.

Reconstruction Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Gain on retirement of debt . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Item b of the additional information reports that Genesis purchased plant assets costing $60,000 by issuing $60,000 in notes payable. This $60,000 increase to notes payable is reported as a noncash investing and financing transaction. The Notes Payable account is explained by these reconstructed entries.

Retired notes 34,000 Bal., Dec. 31, 2018 64,000

Issued notes 60,000

Bal., Dec. 31, 2019 90,000

Notes Payable

464 Chapter 12 Reporting Cash Flows

Third Step Report cash paid for the notes retirement in the financing activities section.

Cash flows from financing activities Cash paid to retire notes . . . . . . . . . . . . . . . . . . . . . . . . $(18,000)

Analyzing Equity Genesis had two equity transactions. The first is the issuance of common stock for cash. The second is the declaration and payment of cash dividends.

Common Stock Transactions First Step Review the comparative balance sheets in Exhibit 12.10, which show an increase in common stock from $80,000 to $95,000.

Second Step Item d of the additional information in Exhibit 12.10 reports that 3,000 shares of common stock are issued at par for $5 per share. The reconstructed entry and the complete Common Stock T-account follow.

Reconstruction Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Bal., Dec. 31, 2018 80,000

Issued stock 15,000 Bal., Dec. 31, 2019 95,000

Common Stock

Cash flows from financing activities Cash received from issuing stock . . . . . . . . . . . . . . . . . $15,000

Reconstruction Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Third Step Report cash received from stock issuance in the financing activities section.

Retained Earnings Transactions First Step Review the comparative balance sheets in Exhibit 12.10, which show an increase in retained earnings from $88,000 to $112,000.

Second Step Item f of the additional information in Exhibit 12.10 reports that cash dividends of $14,000 are paid. The reconstructed entry follows.

Retained Earnings also is impacted by net income of $38,000. (Net income is covered in operat- ing activities.) The reconstructed Retained Earnings account follows.

Third Step Report cash paid for dividends in the financing activities section.Point: Stock dividends and splits do not impact cash.

Cash flows from financing activities Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . $(14,000)

Cash dividend 14,000 Bal., Dec. 31, 2018 88,000

Net income 38,000

Bal., Dec. 31, 2019 112,000

Retained Earnings

Proving Cash Balances The final stage in preparing the statement is to report the beginning and ending cash balances and prove that the net change in cash is explained by operating, investing, and financing cash flows. The last three rows of Exhibit 12.13 show that the $5,000 net increase in cash, from $12,000 at the beginning of the period to $17,000 at the end, is reconciled by net cash flows from operating ($20,000 inflow), investing ($2,000 inflow), and financing ($17,000 outflow) activities.

Chapter 12 Reporting Cash Flows 465

GENESIS Statement of Cash Flows (Indirect Method)

For Year Ended December 31, 2019

Cash flows from operating activities

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 38,000

Adjustments to reconcile net income to net cash provided by operating activities

Income statement items not affecting cash

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Loss on sale of plant assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Gain on retirement of notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16,000)

Changes in current assets and liabilities

Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20,000)

Increase in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)

Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)

Decrease in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

Decrease in interest payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,000)

Increase in income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

Cash flows from investing activities

Cash received from sale of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Net cash provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Cash flows from financing activities

Cash received from issuing stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Cash paid to retire notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (18,000)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)

Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Cash balance at prior year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Cash balance at current year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,000

EXHIBIT 12.13 Complete Statement of Cash Flows—Indirect Method

Reporter Management is in labor contract negotiations and grants you an interview. It highlights a total net cash outflow of $550,000 (which includes net cash outflows of $850,000 for investing activities and $350,000 for financing activities). What is your assessment of this company? ■ Answer: An initial reaction from the $550,000 decrease in net cash is not positive. However, closer scrutiny shows a more positive picture. Cash flow from operations is $650,000, computed as [?] − $850,000 − $350,000 = $(550,000).

Decision Maker

Use the following information to determine cash flows from financing activities. a. Issued common stock for $40 cash. b. Paid $70 cash to retire a note payable at its $70 maturity value. c. Paid cash dividend of $15. d. Paid $5 cash to acquire its treasury stock.

Solution

Do More: QS 12-14, QS 12-15, QS 12-16, QS 12-17, E 12-9

P3

Reporting Financing Cash Flows

NEED-TO-KNOW 12-4

Cash flows from financing activities Cash received from issuance of common stock (from a) . . . . . . . . . . $ 40

Cash paid to settle note payable (from b) . . . . . . . . . . . . . . . . . . . . . . (70)

Cash paid for dividend (from c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15)

Cash paid to acquire treasury stock (from d ) . . . . . . . . . . . . . . . . . . . (5)

Net cash used by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . $(50)

466 Chapter 12 Reporting Cash Flows

Exhibit 12.14 uses T-accounts to summarize how changes in Genesis’s noncash balance sheet accounts affect its cash inflows and outflows (dollar amounts in thousands). The top of the exhibit shows Genesis’s Cash T-account, and the lower part shows T-accounts for its remaining balance sheet accounts. We see that the $20,000 net cash provided by operating activities and the $5,000 net increase in cash shown in the Cash T-account agree with the same figures in the statement of cash flows in Exhibit 12.13. We explain Exhibit 12.14 in five parts.

a. Entry (1) records $38 net income on the credit side of the Retained Earnings account and the debit side of the Cash account. This $38 net income in the Cash T-account is adjusted until it reflects the $5 net increase in cash.

b. Entries (2) through (4) add the $24 depreciation and $6 loss on asset sale to net income and subtract the $16 gain on retirement of notes.

c. Entries (5) through (10) adjust net income for changes in current asset and current liability accounts.

d. Entry (11) records the noncash investing and financing transaction involving a $60 purchase of assets by issuing $60 of notes.

e. Entries (12) and (13) record the $15 stock issuance and the $14 dividend.

SUMMARY USING T-ACCOUNTS

Long-Term Notes Payable

Beg. 64

(4) 34

(11) 60

End. 90

Common Stock

Beg. 80

(12) 15

End. 95

Retained Earnings

Beg. 88

(1) 38

(13) 14

End. 112

Accounts Receivable

Beg. 40

(5) 20

End. 60

Inventory

Beg. 70

(6) 14

End. 84

Prepaid Expenses

Beg. 4

(7) 2

End. 6

Plant Assets

Beg. 210

(3) 20

(11) 60

End. 250

Accumulated Depreciation

Beg. 48

(3) 12 (2) 24

End. 60

Accounts Payable

Beg. 40

(8) 5

End. 35

Interest Payable

Beg. 4

(9) 1

End. 3

Income Taxes Payable

Beg. 12

(10) 10

End. 22

Cash

(1) Net income 38

(2) Depreciation 24 (4) Gain on retirement of notes 16

(3) Loss on sale of plant assets 6

(10) Increase in income taxes payable 10 (5) Increase in accounts receivable 20

(6) Increase in inventory 14

(7) Increase in prepaid expense 2

(8) Decrease in accounts payable 5

(9) Decrease in interest payable 1

Net cash provided by operating activities [O] 20

(3) Cash received from sale of plant assets [I] 2 (4) Cash paid to retire notes [F] 18 (12) Cash received from issuing stock [F] 15 (13) Cash paid for dividends [F] 14 Net increase in cash 5

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

Info to prepare statement of cash flows

EXHIBIT 12.14 Balance Sheet T-Accounts to Explain the Change in Cash ($ thousands)

Chapter 12 Reporting Cash Flows 467

Cash Flow on Total Assets Cash flow information can help measure a company’s ability to meet its obligations, pay dividends, expand operations, and obtain financing. The cash flow on total assets ratio is in Exhibit 12.16.

Cash Flow Analysis Decision Analysis

Analyzing Cash Sources and Uses Managers review cash flows for business decisions. Creditors evaluate a company’s ability to generate enough cash to pay debt. Investors assess cash flows before buying and selling stock. To effectively evaluate cash flows, we separately analyze investing, financing, and operating activities. Consider data from three different companies in Exhibit 12.15 that operate in the same industry and have been in business for several years. Each company has the same $15,000 net increase in cash, but its sources and uses of cash flows are different. BMX’s operating activities provide net cash flows of $90,000, allowing it to purchase plant assets of $48,000 and repay $27,000 of its debt. ATV’s operating activities provide $40,000 of cash flows, limiting its purchase of plant assets to $25,000. Trex’s $15,000 net cash increase is due to selling plant assets and incurring additional debt. Its operating activities yield a cash outflow of $24,000. Overall, analysis of cash flows reveals that BMX is more capable of generating future cash flows than is ATV or Trex.

A1 Analyze the statement of cash flows and apply the cash flow on total assets ratio.

EXHIBIT 12.15 Cash Flows of Competing Companies

$ thousands BMX ATV Trex

Cash provided (used) by operating activities . . . $90,000 $40,000 $(24,000)

Cash provided (used) by investing activities

Proceeds from sale of plant assets. . . . . . . . . 26,000

Purchase of plant assets . . . . . . . . . . . . . . . . . (48,000) (25,000)

Cash provided (used) by financing activities

Proceeds from issuance of debt . . . . . . . . . . . 13,000

Repayment of debt . . . . . . . . . . . . . . . . . . . . . (27,000)

Net increase (decrease) in cash . . . . . . . . . . . . . $15,000 $15,000 $ 15,000

Free Cash Flows Many investors use cash flows to value company stock. However, cash-based valuation models often yield different stock values due to differences in measurement of cash flows. Most models require cash flows that are “free” for distribution to shareholders. These free cash flows are defined as cash flows available to sharehold- ers after operating asset reinvestments and debt payments. A company’s growth and financial flexibility depend on adequate free cash flows. ■

Decision Insight

Point: Cash flow from operations − Capital expenditures − Debt repayments = Free cash flows

EXHIBIT 12.16 Cash Flow on Total AssetsCash flow on total assets =

Cash flow from operations Average total assets

This ratio measures actual cash flows and is not affected by accounting recognition and measurement. It can help estimate the amount and timing of cash flows from operating activities. The cash flow on total assets for competitors Nike and Under Armour are in Exhibit 12.17. In all years, Nike’s cash flow on total assets ratio exceeded Under Armour’s ratio. This means that Nike did a better job of generating operating cash flows given its assets. However, Nike’s cash flow on total assets declined from two years ago, which is not a positive result. At the same time, Under Armour’s lower and uneven cash flow on total assets make it difficult to predict the amount and timing of its cash flows.

EXHIBIT 12.17 Cash Flow on Total Assets for Two Competitors

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Nike Operating cash flows . . . . . . . . . . . . . . . . . . . $ 3,640 $ 3,096 $ 4,680 Average total assets. . . . . . . . . . . . . . . . . . . . $22,328 $21,497 $20,096

Cash flow on total assets. . . . . . . . . . . . . . . 16.3% 14.4% 23.3% Under Armour Operating cash flows . . . . . . . . . . . . . . . . . . . $ 234 $ 364 $ 15 Average total assets. . . . . . . . . . . . . . . . . . . . $ 3,825 $ 3,255 $ 2,479

Cash flow on total assets. . . . . . . . . . . . . . . 6.1% 11.2% 0.6%

468 Chapter 12 Reporting Cash Flows

Comparative balance sheets, an income statement, and additional information follow.

COMPREHENSIVE

Preparing Statement of Cash Flows—Indirect and Direct Methods

NEED-TO-KNOW 12-5

UMA COMPANY Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . $446,100 Cost of goods sold . . . . . . . . . . . . . $222,300 Other operating expenses . . . . . . 120,300 Depreciation expense . . . . . . . . . .    25,500 (368,100)     78,000 Other gains (losses) Loss on sale of equipment . . . . 3,300 Loss on retirement of bonds . . . 825 (4,125) Income before taxes . . . . . . . . . . . 73,875 Income tax expense . . . . . . . . . . . (13,725) Net income . . . . . . . . . . . . . . . . . . $  60,150

UMA COMPANY Balance Sheets

December 31, 2019 and 2018

2019 2018 Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . .   $  43,050 $ 23,925 Accounts receivable . . . . . . . . . . . . . .       34,125     39,825 Inventory . . . . . . . . . . . . . . . . . . . . . . .     156,000   146,475 Prepaid expenses . . . . . . . . . . . . . . . .         3,600       1,650 Total current assets . . . . . . . . . . . . . . .     236,775   211,875 Equipment . . . . . . . . . . . . . . . . . . . . . .     135,825   146,700 Accum. depreciation—Equipment . . .      (61,950)     (47,550) Total assets . . . . . . . . . . . . . . . . . . . . .   $310,650 $311,025

Liabilities Accounts payable . . . . . . . . . . . . . . . .   $ 28,800 $ 33,750 Income taxes payable . . . . . . . . . . . .         5,100       4,425 Dividends payable . . . . . . . . . . . . . . .                0       4,500 Total current liabilities . . . . . . . . . . . . .       33,900     42,675 Bonds payable. . . . . . . . . . . . . . . . . . .               0    37,500 Total liabilities . . . . . . . . . . . . . . . . . . .       33,900     80,175

Equity Common stock, $10 par . . . . . . . . . . .     168,750   168,750 Retained earnings . . . . . . . . . . . . . . .     108,000     62,100 Total liabilities and equity . . . . . . . . .   $310,650 $311,025

Additional Information a. Equipment costing $21,375 with accumulated deprecia-

tion of $11,100 is sold for cash.

b. Equipment purchases are for cash. c. Accumulated Depreciation is affected by depreciation

expense and the sale of equipment.

d. The balance of Retained Earnings is affected by dividend declarations and net income.

e. All sales are made on credit. f. All inventory purchases are on credit. g. Accounts Payable balances result from inventory purchases. h. Prepaid expenses relate to “other operating expenses.”

Required

1. Prepare a statement of cash flows using the indirect method for year 2019. 2.B Prepare a statement of cash flows using the direct method for year 2019.

PLANNING THE SOLUTION Prepare two blank statements of cash flows with sections for operating, investing, and financing activ-

ities using the (1) indirect method format and (2) direct method format. Compute the cash paid for equipment and the cash received from the sale of equipment using the addi-

tional information provided along with the amount for depreciation expense and the change in the bal- ances of Equipment and Accumulated Depreciation. Use T-accounts to help chart the effects of the sale and purchase of equipment on the balances of the Equipment account and the Accumulated Depreciation account.

Compute the effect of net income on the change in the Retained Earnings account balance. Assign the difference between the change in retained earnings and the amount of net income to dividends declared. Adjust the dividends declared amount for the change in the Dividends Payable balance.

Compute cash received from customers, cash paid for inventory, cash paid for other operating expenses, and cash paid for taxes.

Enter the cash effects of reconstruction entries to the appropriate section(s) of the statement. Total each section of the statement, determine the total net change in cash, and add it to the beginning

balance to get the ending balance of cash.

Chapter 12 Reporting Cash Flows 469

(3) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,150 Less increase in retained earnings . . . . . . . . . . . . . 45,900 Dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . 14,250 Plus decrease in dividends payable . . . . . . . . . . . . 4,500 Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . $ 18,750 (4)B Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 446,100 Add decrease in accounts receivable . . . . . . . . . . . 5,700 Cash received from customers . . . . . . . . . . . . . . . . $451,800 (5)B Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $ 222,300 Plus increase in inventory . . . . . . . . . . . . . . . . . . . . 9,525 Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231,825 Plus decrease in accounts payable . . . . . . . . . . . . . 4,950 Cash paid for inventory . . . . . . . . . . . . . . . . . . . . . . $236,775 (6)B Other operating expenses . . . . . . . . . . . . . . . . . . . . $ 120,300 Plus increase in prepaid expenses . . . . . . . . . . . . . 1,950 Cash paid for other operating expenses. . . . . . . . . $122,250 (7)B Income tax expense. . . . . . . . . . . . . . . . . . . . . . . . . $ 13,725 Less increase in income taxes payable. . . . . . . . . . (675) Cash paid for income taxes . . . . . . . . . . . . . . . . . . . $ 13,050

(1) Cost of equipment sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,375 Accumulated depreciation of equipment sold . . . . . . . . . . (11,100) Book value of equipment sold. . . . . . . . . . . . . . . . . . . . . . . 10,275 Loss on sale of equipment. . . . . . . . . . . . . . . . . . . . . . . . . . (3,300) Cash received from sale of equipment . . . . . . . . . . . . . . . . $ 6,975

Cost of equipment sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,375 Less decrease in the Equipment account balance . . . . . . . (10,875) Cash paid for new equipment . . . . . . . . . . . . . . . . . . . . . . . $10,500 (2) Loss on retirement of bonds . . . . . . . . . . . . . . . . . . . . . . . . $ 825 Carrying value of bonds retired. . . . . . . . . . . . . . . . . . . . . . 37,500 Cash paid to retire bonds . . . . . . . . . . . . . . . . . . . . . . . . . . $38,325

*Supporting T-account analysis for part 1 follows.

Sale 11,100

Bal., Dec. 31, 2018 47,550

Depr. expense 25,500

Bal., Dec. 31, 2019 61,950

Accumulated Depreciation—Equipment

Bal., Dec. 31, 2018 146,700 Cash purchase 10,500

Bal., Dec. 31, 2019 135,825

Sale 21,375

Equipment

SOLUTION Supporting computations for cash receipts and cash payments.

1. Indirect method.

UMA COMPANY Statement of Cash Flows (Indirect Method)

For Year Ended December 31, 2019

Cash flows from operating activities

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,150

Adjustments to reconcile net income to net cash provided by operating activities

Income statement items not affecting cash

Depreciation expense . . . . . . . . . . . . . . . . . . . . . 25,500

Loss on sale of plant assets . . . . . . . . . . . . . . . . . 3,300

Loss on retirement of bonds . . . . . . . . . . . . . . . . 825

Changes in current assets and current liabilities

Decrease in accounts receivable. . . . . . . . . . . . . 5,700

Increase in inventory . . . . . . . . . . . . . . . . . . . . . . (9,525)

Increase in prepaid expenses . . . . . . . . . . . . . . . (1,950)

Decrease in accounts payable. . . . . . . . . . . . . . . (4,950)

Increase in income taxes payable . . . . . . . . . . . . 675

Net cash provided by operating activities . . . . . . . . . . $ 79,725

Cash flows from investing activities

Cash received from sale of equipment. . . . . . . . . . . . . 6,975

Cash paid for equipment. . . . . . . . . . . . . . . . . . . . . . . . (10,500)

Net cash used in investing activities . . . . . . . . . . . . . . (3,525)

Cash flows from financing activities

Cash paid to retire bonds payable . . . . . . . . . . . . . . . . (38,325)

Cash paid for dividends. . . . . . . . . . . . . . . . . . . . . . . . . (18,750)

Net cash used in financing activities . . . . . . . . . . . . . . (57,075)

Net increase in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,125

Cash balance at prior year-end. . . . . . . . . . . . . . . . . . . . . 23,925

Cash balance at current year-end. . . . . . . . . . . . . . . . . . . $ 43,050

UMA COMPANY Statement of Cash Flows (Direct Method)

For Year Ended December 31, 2019

Cash flows from operating activities

Cash received from customers. . . . . . . . . . . . . $ 451,800

Cash paid for inventory . . . . . . . . . . . . . . . . . . (236,775)

Cash paid for other operating expenses . . . . . (122,250)

Cash paid for income taxes . . . . . . . . . . . . . . . (13,050)

Net cash provided by operating activities . . . . $ 79,725

Cash flows from investing activities

Cash received from sale of equipment . . . . . . 6,975

Cash paid for equipment . . . . . . . . . . . . . . . . . (10,500)

Net cash used in investing activities . . . . . . . . (3,525)

Cash flows from financing activities

Cash paid to retire bonds payable. . . . . . . . . . (38,325)

Cash paid for dividends . . . . . . . . . . . . . . . . . . (18,750)

Net cash used in financing activities . . . . . . . . (57,075)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . $ 19,125

Cash balance at prior year-end . . . . . . . . . . . . . . 23,925

Cash balance at current year-end . . . . . . . . . . . . $ 43,050

2.B Direct method (Appendix 12B).

470 Chapter 12 Reporting Cash Flows

APPENDIX

Spreadsheet Preparation of the Statement of Cash Flows12A

This appendix explains how to use a spreadsheet (work sheet) to prepare the statement of cash flows under the indirect method.

Preparing the Indirect Method Spreadsheet A spreadsheet, also called work sheet, can help us prepare a statement of cash flows. To demonstrate, we return to the comparative balance sheets and income statement shown in Exhibit 12.10. We use letters a through g to code changes in accounts, and letters h through m for additional information, to prepare the statement of cash flows.

a. Net income is $38,000. b. Accounts receivable increase by $20,000. c. Inventory increases by $14,000. d. Prepaid expenses increase by $2,000. e. Accounts payable decrease by $5,000. f. Interest payable decreases by $1,000. g. Income taxes payable increase by $10,000. h. Depreciation expense is $24,000. i. Plant assets costing $20,000 with accumulated depreciation of $12,000 are sold for $2,000 cash. This

yields a loss on sale of assets of $6,000. j. Notes with a book value of $34,000 are retired with a cash payment of $18,000, yielding a $16,000

gain on retirement. k. Plant assets costing $60,000 are purchased with an issuance of notes payable for $60,000. l. Issued 3,000 shares of common stock for $15,000 cash. m. Paid cash dividends of $14,000.

Exhibit 12A.1 shows the indirect method spreadsheet for Genesis. We enter both beginning and ending balance sheet amounts on the spreadsheet. We also enter information in the Analysis of Changes columns (keyed to the additional information items a through m) to explain changes in the accounts and determine the cash flows for operating, investing, and financing activities. Information about noncash investing and financing activities is reported near the bottom.

Entering the Analysis of Changes on the Spreadsheet The following steps are used to complete the spreadsheet after the beginning and ending balances of the balance sheet accounts are entered.

1 Enter net income as the first item in the statement of cash flows section for computing operating cash inflow (debit) and as a credit to Retained Earnings. (Entry a)

2 In the statement of cash flows section, adjustments to net income are entered as debits if they increase cash flows and as credits if they decrease cash flows. Applying this rule, adjust net income for the change in each noncash current asset and current liability account related to operating activities. For each adjustment to net income, the offsetting debit or credit must help reconcile the beginning and ending balances of a current asset or current liability account. (Entries b through g)

3 Enter adjustments to net income for income statement items not providing or using cash in the period. For each adjustment, the offsetting debit or credit must help reconcile a noncash balance sheet account. (Entry h)

4 Adjust net income to eliminate any gains or losses from investing and financing activities. Because the cash from a gain must be excluded from operating activities, the gain is entered as a credit in the operating activities section. Losses are entered as debits. For each adjustment, the related debit and/ or credit must help reconcile balance sheet accounts and involve reconstructed entries to show the cash flow from investing or financing activities. (Entries i and j)

5 After reviewing any unreconciled balance sheet accounts and related information, enter the remain- ing reconciling entries for investing and financing activities. Examples are purchases of plant assets,

P4 Illustrate use of a spread- sheet to prepare a statement of cash flows.

Chapter 12 Reporting Cash Flows 471

GENESIS Spreadsheet for Statement of Cash Flows—Indirect Method

For Year Ended December 31, 2019

Debit Credit

Analysis of Changes Dec. 31, 2019

Dec. 31, 2018

Balance Sheet—Debit Bal. Accounts Cash Accounts receivable Inventory Prepaid expenses Plant assets

Balance Sheet—Credit Bal. Accounts Accumulated depreciation Accounts payable Interest payable Income taxes payable Notes payable Common stock, $5 par value Retained earnings

Statement of Cash Flows Operating activities Net income Increase in accounts receivable Increase in inventory Increase in prepaid expenses Decrease in accounts payable Decrease in interest payable Increase in income taxes payable Depreciation expense Loss on sale of plant assets Gain on retirement of notes Investing activities Receipts from sale of plant assets Financing activities Payment to retire notes Receipts from issuing stock Payment of cash dividends

Noncash Investing and Financing Activities Purchase of plant assets with notes

$ 12,000 40,000 70,000

4,000 210,000

$336,000

$ 48,000 40,000

4,000 12,000 64,000 80,000 88,000

$336,000

$ 17,000 60,000 84,000

6,000 250,000

$417,000

$ 60,000 35,000

3,000 22,000 90,000 95,000

112,000 $417,000

$ 20,000 14,000 2,000

60,000

12,000 5,000 1,000

34,000

14,000

38,000

10,000 24,000

6,000

2,000

15,000

60,000 $317,000

$ 20,000

24,000

10,000 60,000 15,000 38,000

20,000 14,000 2,000 5,000 1,000

16,000

18,000

14,000

60,000 $317,000

(b) (c) (d) (k1)

( i ) (e) (f )

( j )

(m)

(a)

(g) (h) ( i )

( i )

(l )

(k2)

( i )

(h)

(g) (k2) (l) (a)

(b) (c) (d) (e) (f)

( j)

( j)

(m)

(k1)

EXHIBIT 12A.1 Spreadsheet for Preparing Statement of Cash Flows— Indirect Method

issuances of long-term debt, stock issuances, and dividend payments. Some of these may require entries in the noncash investing and financing section of the spreadsheet. (Entries k through m)

6 Check accuracy by totaling the Analysis of Changes columns and by determining that the change in each balance sheet account has been explained (reconciled).

Because adjustments i, j, and k are more challenging, we show them in the following debit and credit for- mat. These entries are for purposes of our understanding; they are not the entries actually made in the journals. Changes in the Cash account are identified as sources or uses of cash.

i. Cash—Receipt from sale of plant assets (source of cash) . . . . . . . . . . . . . . . . 2,000 Loss from sale of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Describe sale of plant assets. j. Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Cash—Payments to retire notes (use of cash) . . . . . . . . . . . . . . . . . . . . . 18,000 Gain on retirement of notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Describe retirement of notes. k1. Plant assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Cash—Purchase of plant assets financed by notes . . . . . . . . . . . . . . . . . . 60,000 Describe purchase of plant assets. k2. Cash—Purchase of plant assets financed by notes . . . . . . . . . . . . . . . . . . . . . . 60,000 Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Issue notes for purchase of assets.

472 Chapter 12 Reporting Cash Flows

APPENDIX

Direct Method of Reporting Operating Cash Flows12B

We compute operating cash flows under the direct method by adjusting accrual-based income statement items to the cash basis as follows.P5

Compute cash flows from operating activities using the direct method.

The framework for reporting cash receipts and cash payments for the operating section under the direct method is shown in Exhibit 12B.1.

Landlord

Renters Dividends

Operations Interest Taxes

Operating cash payments–

Operating cash receipts+

Net cash provided (used) by operating

activities =

Customers

Suppliers Employees

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Interest

EXHIBIT 12B.1 Major Classes of Operating Cash Flows

Operating Cash Receipts The financial statements and additional information reported by Genesis in Exhibit 12.10 show one cash receipt: sales to customers. We start with sales to customers as reported on the income statement and then adjust it to get cash received from customers.

Cash Received from Customers If all sales are for cash, cash received from customers equals the sales reported on the income statement. When some or all sales are on credit, we must adjust the amount of sales for the change in Accounts Receivable. To help us compute cash receipts, we use a T-account that includes accounts receivable balances for Genesis on December 31, 2018 and 2019. The beginning bal- ance is $40,000 and the ending balance is $60,000. Next, the income statement shows sales of $590,000, which is put on the debit side. We now reconstruct the account to determine the cash receipts from cus- tomers are $570,000, computed as $40,000 + $590,000 − [?] = $60,000.

Point: An accounts receivable in- crease implies that cash received from customers is less than sales (the converse is also true).

Bal., Dec. 31, 2018 40,000

Sales 590,000

Bal., Dec. 31, 2019 60,000

Cash receipts = 570,000

Accounts Receivable Reconstructed Entry

Cash . . . . . . . . . . 570,000 Accts Recble. . . . 20,000 Sales . . . . . . . 590,000

Cash receipts also can be computed as sales of $590,000 minus a $20,000 increase in accounts receivable. This computation is in Exhibit 12B.2. Genesis reports the $570,000 cash received from customers as a cash inflow from operating activities.

Example: If the ending balance of Accounts Receivable is $20,000 (instead of $60,000), what is cash received from customers? Answer: $610,000

+ or – Cash receipts

or cash payments

Revenue or

expense

Adjustments for changes in related

balance sheet accounts =

Chapter 12 Reporting Cash Flows 473

Other Cash Receipts Other common cash receipts involve rent, interest, and dividends. We compute cash received from these items by subtracting an increase in their receivable or adding a decrease. For example, if rent receivable increases in the period, cash received from renters is less than rent revenue reported on the income statement. If rent receivable decreases, cash received is more than reported rent revenue. The same applies to interest and dividends.

Operating Cash Payments The financial statements and additional information for Genesis in Exhibit 12.10 show four operating expenses: cost of goods sold; wages and other operating expenses; interest expense; and taxes expense. We analyze each expense to compute its cash impact.

Cash Paid for Inventory We compute cash paid for inventory by analyzing both cost of goods sold and inventory. If all inventory purchases are for cash and the balance of Inventory is unchanged, the amount of cash paid for inventory equals cost of goods sold—an uncommon situation. Instead, there normally is some change in the Inventory balance. Also, some or all purchases are often made on credit, which changes the Accounts Payable balance. When the balances of both Inventory and Accounts Payable change, we must adjust the cost of goods sold for changes in both accounts to compute cash paid for inven- tory. This is a two-step adjustment. First, we use the change in the account balance of Inventory, along with the cost of goods sold amount, to compute cost of purchases for the period. An increase in inventory means that we bought more than we sold, and we add this inventory increase to cost of goods sold to compute cost of purchases. A decrease in inventory means that we bought less than we sold, and we subtract the inventory decrease from cost of goods sold to compute purchases. We show the first step by reconstructing the Inventory account. We determine purchases to be $314,000, computed as cost of goods sold of $300,000 plus the $14,000 in- crease in inventory.

Cash received from customers = Sales + Decrease in accounts receivable

or – Increase in accounts receivable

EXHIBIT 12B.2 Formula to Compute Cash Received from Customers— Direct Method

The second step uses the change in the balance of Accounts Payable, and the cost of purchases, to com- pute cash paid for inventory. A decrease in accounts payable means that we paid for more goods than we acquired this period, and we would add the accounts payable decrease to cost of purchases to compute cash paid for inventory. An increase in accounts payable means that we paid for less than the amount of goods acquired, and we would subtract the accounts payable increase from purchases to compute cash paid for inventory. The second step is applied to Genesis by reconstructing its Accounts Payable account to get cash paid of $319,000 (or $40,000 + $314,000 − [?] = $35,000).

Bal., Dec. 31, 2018 70,000

Purchases = 314,000

Bal., Dec. 31, 2019 84,000

Cost of goods sold 300,000

Inventory

Cash payments = 319,000

Bal., Dec. 31, 2018 40,000

Purchases 314,000

Bal., Dec. 31, 2019 35,000

Accounts Payable Reconstructed EntryCOGS . . . . . . . . . . . . 300,000 Inventory . . . . . . . . . 14,000 Accounts Payable . . 5,000 Cash. . . . . . . . . . . 319,000

Alternatively, cash paid for inventory is equal to purchases of $314,000 plus the $5,000 decrease in ac- counts payable. The $319,000 cash paid for inventory is reported as a cash outflow under operating activities. This two-step adjustment to cost of goods sold to compute cash paid for inventory is in Exhibit 12B.3.

Example: If the ending balances of Inventory and Accounts Payable are $60,000 and $50,000, respectively (instead of $84,000 and $35,000), what is cash paid for inventory? Answer: $280,000

Purchases = Cost of goods sold + Increase in inventory

or –

+ or

Decrease in inventory

Cash paid for inventory = Purchases Decrease in accounts payable

Increase in accounts payable

1

2

EXHIBIT 12B.3 Two Steps to Compute Cash Paid for Inventory— Direct Method

474 Chapter 12 Reporting Cash Flows

Cash Paid for Wages and Operating Expenses (Excluding Depreciation) The Genesis income statement shows wages and other operating expenses of $216,000 (see Exhibit 12.10). To compute cash paid for wages and other operating expenses, we adjust for any changes in related balance sheet accounts. We begin by looking for any prepaid expenses and accrued liabilities related to wages and other operating expenses in the balance sheets in Exhibit 12.10. The balance sheets show prepaid expenses but no accrued liabilities. Thus, the adjustment is only for the change in prepaid expenses. The adjustment is computed by assuming that all cash paid for wages and other operating expenses is initially debited to Prepaid Expenses. This assumption allows us to reconstruct the Prepaid Expenses account to get cash paid of $218,000.

Bal., Dec. 31, 2018 4,000

Cash payments = 218,000

Bal., Dec. 31, 2019 6,000

Wages and other operating exp. 216,000

Prepaid Expenses

Reconstructed Entry Wages & Other Exp. . 216,000 Prepaid Expenses . . 2,000 Cash. . . . . . . . . . . 218,000

Cash paid also can be calculated as reported expenses of $216,000 plus the $2,000 increase in prepaid expenses. Exhibit 12B.4 summarizes the adjustments to wages (including salaries) and other operating expenses.

Cash paid for wages and other

operating expenses =

Wages and other

operating expenses

+ Increase in prepaid expenses

Decrease in prepaid expenses

+

Decrease in accrued liabilities

Increase in accrued liabilities

or or

EXHIBIT 12B.4 Formula to Compute Cash Paid for Wages and Operating Expenses— Direct Method

Cash Paid for Accrued Liabilities The Genesis balance sheet did not report accrued liabilities, but we include them in the formula to explain the adjustment to cash when they do exist. A decrease in accrued liabilities means that we paid cash for more goods or services than received this period, so cash paid is higher than the recorded expense. Alternatively, an increase in accrued liabilities implies that we paid less cash than what was received, so cash paid is less than the recorded expense.

Cash Paid for Interest and Income Taxes Computing operating cash flows for interest and taxes requires adjustments for amounts reported on the income statement for changes in related balance sheet accounts. The Genesis income statement shows interest expense of $7,000 and income taxes expense of $15,000. To compute the cash paid, we adjust interest expense for the change in interest payable and adjust income taxes expense for the change in income taxes payable. These computations involve reconstructing both liability accounts and show cash paid for interest of $8,000 and cash paid for income taxes of $5,000.

Cash paid for interest = 8,000 Bal., Dec. 31, 2018 4,000

Interest expense 7,000

Bal., Dec. 31, 2019 3,000

Interest Payable

Cash paid for taxes = 5,000 Bal., Dec. 31, 2018 12,000

Income taxes expense 15,000

Bal., Dec. 31, 2019 22,000

Income Taxes PayableReconstructed Entry Interest Expense . . . . . 7,000 Interest Payable. . . . . . 1,000 Cash. . . . . . . . . . . . . 8,000

Reconstructed Entry Income Tax Exp. . . . . . 15,000 Income Tax Pay. . . . 10,000 Cash. . . . . . . . . . . . . 5,000

The formulas to compute these amounts are in Exhibit 12B.5. Both of these cash payments are reported as operating cash outflows.

+ Decrease in interest payable

+

Increase in interest payable

Decrease in income taxes payable

Increase in income taxes payable Cash paid for taxes = Income taxes expense

Cash paid for interest = Interest expense or

or

EXHIBIT 12B.5 Formulas to Compute Cash Paid for Both Interest and Taxes—Direct Method

Analyzing Additional Expenses, Gains, and Losses Genesis has three more items reported on its income statement: depreciation, loss on sale of assets, and gain on retirement of debt. We consider each for its potential cash effects.

Depreciation Expense Depreciation expense is $24,000. It is often called a noncash expense because depreciation has no cash flows. Depreciation expense is never reported on a statement of cash flows using the direct method; nor is depletion or amortization expense.

Loss on Sale of Assets Sales of assets frequently result in gains and losses reported as part of net income, but the amount of recorded gain or loss does not impact cash. Thus, the loss or gain on a sale of assets is never reported on a statement of cash flows using the direct method.

Point: A decrease in prepaid expenses implies that reported expenses include an amount(s) that did not require a cash outflow in the period.

Chapter 12 Reporting Cash Flows 475

Gain on Retirement of Debt Retirement of debt usually yields a gain or loss reported as part of net income, but that gain or loss does not impact cash. Thus, the loss or gain from retirement of debt is never reported on a statement of cash flows using the direct method.

Summary of Adjustments for Direct Method Exhibit 12B.6 summarizes common adjustments for net income to yield net cash provided (used) by operating activities under the direct method.

Item From Income Statement Adjustments to Obtain Cash Flow Numbers

Receipts

From sales Sales Revenue + Decrease in Accounts Receivable

− Increase in Accounts Receivable

From rent Rent Revenue + Decrease in Rent Receivable

− Increase in Rent Receivable

From interest Interest Revenue + Decrease in Interest Receivable

− Increase in Interest Receivable

From dividends Dividend Revenue + Decrease in Dividends Receivable − Increase in Dividends Receivable Payments

To suppliers Cost of Goods Sold + Increase in Inventory + Decrease in Accounts Payable

− Decrease in Inventory − Increase in Accounts Payable

For operations Operating Expense + Increase in Prepaids + Decrease in Accrued Liabilities

− Decrease in Prepaids − Increase in Accrued Liabilities

To employees Wages (Salaries) Expense + Decrease in Wages (Salaries) Payable

− Increase in Wages (Salaries) Payable

For interest Interest Expense + Decrease in Interest Payable

− Increase in Interest Payable

For taxes Income Tax Expense + Decrease in Income Tax Payable

− Increase in Income Tax Payable

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EXHIBIT 12B.6 Summary of Selected Adjustments for Direct Method

Direct Method Format of Operating Activities Section Exhibit 12B.7 shows the Genesis statement of cash flows using the direct method. Operating cash outflows are subtracted from operating cash inflows to get net cash provided (used) by operating activities.

Point: The FASB requires a recon- ciliation of net income to net cash provided (used) by operating activities when the direct method is used. This reconciliation follows the operating activities section using the indirect method.

GENESIS Statement of Cash Flows (Direct Method)

For Year Ended December 31, 2019

Cash flows from operating activities

Cash received from customers . . . . . . . . . . . . . . . . . . . . . $ 570,000

Cash paid for inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . (319,000)

Cash paid for wages and other operating expenses . . . . (218,000)

Cash paid for interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,000)

Cash paid for taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

Net cash provided by operating activities . . . . . . . . . . . . $ 20,000

Cash flows from investing activities

Cash received from sale of plant assets . . . . . . . . . . . . . . 2,000

Net cash provided by investing activities . . . . . . . . . . . . . 2,000

Cash flows from financing activities

Cash received from issuing stock . . . . . . . . . . . . . . . . . . . 15,000

Cash paid to retire notes . . . . . . . . . . . . . . . . . . . . . . . . . . (18,000)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)

Net cash used in financing activities. . . . . . . . . . . . . . . . . (17,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Cash balance at prior year-end . . . . . . . . . . . . . . . . . . . . . . . 12,000

Cash balance at current year-end . . . . . . . . . . . . . . . . . . . . . $ 17,000

EXHIBIT 12B.7 Statement of Cash Flows— Direct Method

Cash from investing

Cash from financing

Cash proved

Cash from operating

476 Chapter 12 Reporting Cash Flows

A company’s current-year income statement and selected balance sheet data at December 31 of the cur- rent and prior years follow. Prepare the operating activities section of the statement of cash flows using the direct method for the current year.

P5

Reporting Operating Cash Flows (Direct)

NEED-TO-KNOW 12-6

Solution

Income Statement For Current Year Ended December 31

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . $120

Expenses: Cost of goods sold. . . . . . . . . . . . . 50

Depreciation expense . . . . . . . . . . 30

Salaries expense . . . . . . . . . . . . . . 17

Interest expense . . . . . . . . . . . . . . 3

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20

Selected Balance Sheet Accounts

At December 31 Current Yr Prior Yr

Accounts receivable . . . . $12 $10

Inventory . . . . . . . . . . . . . 6 9

Accounts payable . . . . . . 7 11

Salaries payable . . . . . . . 8 3

Interest payable. . . . . . . . 1 0

Do More: QS 12-21, QS 12-22, QS 12-23, QS 12-24, QS 12-25, QS 12-26, QS 12-27, E 12-15,

E 12-16, E 12-17, E 12-18, E 12-19

Cash Flows from Operating Activities—Direct Method For Current Year Ended December 31

Cash flows from operating activities* Cash received from customers . . . . . . . . . . . . . . . . . . . . . . $118

Cash paid for inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . (51)

Cash paid for salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12)

Cash paid for interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    (2)

Net cash provided by operating activities. . . . . . . . . . . . . . . . $53

*Supporting computations: Cash received from customers = Sales of $120 − Accounts Receivable increase of $2. Cash paid for inventory = COGS of $50 − Inventory decrease of $3 + Accounts Payable decrease of $4. Cash paid for salaries = Salaries Expense of $17 − Salaries Payable increase of $5. Cash paid for interest = Interest Expense of $3 − Interest Payable increase of $1.

BASICS OF CASH FLOW REPORTING Format for statement of cash flows:

Noncash investing and financing activities: Some investing and financ- ing activities do not affect cash flows, such as the purchase of long-term assets using a long-term note payable (loan). Such transactions are reported at the bottom of the statement of cash flows or in a note to the statement.

CASH FLOWS FROM OPERATING—INDIRECT Operating activities: Generally include transactions and events that affect net income.

Summary: Cheat Sheet

Operating cash inflow examples: Cash sales to customers, collections on credit sales, receipt of dividend revenue, receipt of interest revenue. Operating cash outflow examples: Cash to pay salaries and wages, pay operating expenses, pay suppliers for goods and services, pay interest owed, pay taxes and fines. Indirect method: Reports net income and then adjusts it for items that do not affect cash. Indirect method only affects the presentation of operating cash flows, not investing or financing sections.

COMPANY NAME Statement of Cash Flows

For period Ended date

Cash flows from operating activities [Compute operating cash flows using indirect or direct method]

Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Cash flows from investing activities [List of individual inflows and outflows]

Net cash provided (used) by investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Cash flows from financing activities [List of individual inflows and outflows]

Net cash provided (used) by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cash (and equivalents) balance at prior period-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Cash (and equivalents) balance at current period-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Separate schedule or note disclosure of any noncash investing and financing transactions is required.

Summary of adjustments for indirect method:

Net Income (or Loss) Adjustments for operating items not providing or using cash

+ Noncash expenses and losses Examples: Expenses for depreciation, depletion, and amortization;

losses from disposal of long-term assets and from retirement of debt

− Noncash revenues and gains Examples: Gains from disposal of long-term assets and from retirement of debt

Adjustments for changes in current assets and current liabilities

+ Decrease in noncash current operating asset − Increase in noncash current operating asset + Increase in current operating liability − Decrease in current operating liability Net cash provided (used) by operating activities

1

2

Chapter 12 Reporting Cash Flows 477

CASH FLOWS FROM FINANCING Financing activities: Generally include transactions and events that affect long-term liabilities and equity. Financing cash inflow examples: Cash from issuing common and pre- ferred stock, issuing short- and long-term debt (notes payable and bonds payable), reissuing treasury stock. Financing cash outflow examples: Cash to pay dividends to sharehold- ers, pay off short- and long-term debt (notes payable and bonds payable), purchase treasury stock.

CASH FLOWS FROM OPERATING—DIRECT Direct method: Separately lists operating cash receipts and operating cash payments. Cash payments are subtracted from cash receipts. Unlike the indirect method, it does not start with net income. This only affects the operating section of the statement of cash flows.

CASH FLOWS FROM INVESTING Investing activities: Generally include transactions and events that come from the purchase and sale of long-term assets. Investing cash inflow examples: Cash from selling plant assets, selling intangible assets, selling short-term and long-term investments, selling notes receivable, collecting principal (but not interest) on notes receivable. Investing cash outflow examples: Cash to buy plant assets, buy intangi- ble assets, buy short-term and long-term investments, loan money in return for notes receivable.

Example of financing section format:

Example of investing section format:

Cash flows from investing activities

Cash received from sale of plant assets . . . . . . . . . . . . . $2,000

Net cash provided by investing activities . . . . . . . . . . . . $2,000

Cash flows from financing activities

Cash received from issuing stock . . . . . . . . . . . . . . $ 15,000

Cash paid to retire notes . . . . . . . . . . . . . . . . . . . . . (18,000)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . (14,000)

Net cash used in financing activities. . . . . . . . . . . . $(17,000)

Summary of adjustments for direct method: Item From Income Statement Adjustments to Obtain Cash Flow Numbers

Receipts

From sales Sales Revenue + Decrease in Accounts Receivable

− Increase in Accounts Receivable

From rent Rent Revenue + Decrease in Rent Receivable

− Increase in Rent Receivable

From interest Interest Revenue + Decrease in Interest Receivable

− Increase in Interest Receivable

From dividends Dividend Revenue + Decrease in Dividends Receivable − Increase in Dividends Receivable Payments

To suppliers Cost of Goods Sold + Increase in Inventory + Decrease in Accounts Payable

− Decrease in Inventory − Increase in Accounts Payable

For operations Operating Expense + Increase in Prepaids + Decrease in Accrued Liabilities

− Decrease in Prepaids − Increase in Accrued Liabilities

To employees Wages (Salaries) Expense + Decrease in Wages (Salaries) Payable

− Increase in Wages (Salaries) Payable

For interest Interest Expense + Decrease in Interest Payable

− Increase in Interest Payable

For taxes Income Tax Expense + Decrease in Income Tax Payable

− Increase in Income Tax Payable

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Cash flow on total assets (467) Direct method (457) Financing activities (457)

Indirect method (457) Investing activities (454)

Operating activities (454) Statement of cash flows (453)

Key Terms

Multiple Choice Quiz

1. A company uses the indirect method to determine its cash flows from operating activities. Use the following informa- tion to determine its net cash provided or used by operating activities.

a. $23,550 used by operating activities b. $23,550 provided by operating activities c. $15,550 provided by operating activities d. $42,400 provided by operating activities e. $20,850 provided by operating activities

2. A machine with a cost of $175,000 and accumulated deprecia- tion of $94,000 is sold for $87,000 cash. The amount reported as a source of cash under cash flows from investing activities is a. $81,000. b. $6,000. c. $87,000. d. $0; this is a financing activity. e. $0; this is an operating activity.

3. A company settles a long-term note payable plus interest by paying $68,000 cash toward the principal amount and $5,440 cash for interest. The amount reported as a use of cash under cash flows from financing activities is a. $0; this is an investing activity. b. $0; this is an operating activity. c. $73,440. d. $68,000. e. $5,440.

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,200

Depreciation expense . . . . . . . . . . . . . . . . . . . . 10,000

Cash payment on note payable . . . . . . . . . . . . . 8,000

Gain on sale of land . . . . . . . . . . . . . . . . . . . . . . 3,000

Increase in inventory . . . . . . . . . . . . . . . . . . . . . 1,500

Increase in accounts payable. . . . . . . . . . . . . . . 2,850

478 Chapter 12 Reporting Cash Flows

A(B) Superscript letter A or B denotes assignments based on Appendix 12A or 12B.

Icon denotes assignments that involve decision making.

1. What is the reporting purpose of the statement of cash flows? Identify at least two questions that this statement can answer.

2. What are some investing activities reported on the state- ment of cash flows?

3. What are some financing activities reported on the state- ment of cash flows?

4.B Describe the direct method of reporting cash flows from operating activities.

5.B When a statement of cash flows is prepared using the direct method, what are some of the operating cash flows?

6. Describe the indirect method of reporting cash flows from operating activities.

7. Where on the statement of cash flows is the payment of cash dividends reported?

8. Assume that a company purchases land for $1,000,000, paying $400,000 cash and borrowing the remainder with a long-term note payable. How should this transaction be re- ported on a statement of cash flows?

9. On June 3, a company borrows $200,000 cash by giv- ing its bank a 90-day, interest-bearing note. On the state- ment of cash flows, where should this be reported?

10. If a company reports positive net income for the year, can it also show a net cash outflow from operating activi- ties? Explain.

11. Is depreciation a source of cash flow? 12. Refer to Apple’s statement of cash flows in

Appendix A. (a) Which method is used to com- pute its net cash provided by operating activities? (b) Its bal- ance sheet shows an increase in accounts receivable from September 24, 2016, to September 30, 2017; why is this in- crease in accounts receivable subtracted when computing net cash provided by operating activities for the fiscal year ended September 30, 2017?

13. Refer to Google’s statement of cash flows in Appendix A. What are its cash flows from financing activities for the year ended December 31, 2017? List the items and amounts.

14. Refer to Samsung’s 2017 statement of cash flows in Appendix A. List its cash flows from operating activities, investing activities, and fi- nancing activities.

15. Refer to Samsung’s statement of cash flows in Appendix A. What invest- ing activities result in cash outflows for the year ended December 31, 2017? List items and amounts.

Discussion Questions

APPLE

Samsung

Samsung

GOOGLE

4. The following information is available regarding a company’s annual salaries and wages. What amount of cash is paid for salaries and wages?

5. The following information is available for a company. What amount of cash is paid for inventory for the current year?

a. $252,300 c. $255,000 e. $235,900 b. $257,700 d. $274,100

a. $545,000 c. $540,800 e. $549,200 b. $554,800 d. $535,200

ANSWERS TO MULTIPLE CHOICE QUIZ

2. c; Cash received from sale of machine is reported as an investing activity.

3. d; FASB requires cash interest paid to be reported under operating. 4. a; Cash paid for salaries and wages = $255,000 + $8,200 −

$10,900 = $252,300 5. e; Increase in inventory = $112,000 − $105,000 = $7,000 Increase in accounts payable = $101,300 − $98,500 = $2,800 Cash paid for inventory = $545,000 + $7,000 − $2,800 = $549,200

Salaries and wages expense . . . . . . . . . . . . . . . . . . . . $255,000 Salaries and wages payable, prior year-end. . . . . . . . 8,200 Salaries and wages payable, current year-end. . . . . . 10,900

Cost of goods sold . . . . . . . . . . . . . . . . . . $545,000 Inventory, prior year-end . . . . . . . . . . . . . 105,000 Inventory, current year-end . . . . . . . . . . . 112,000 Accounts payable, prior year-end . . . . . . 98,500 Accounts payable, current year-end . . . . 101,300

1. b; Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,200

Depreciation expense . . . . . . . . . . . . . . . . . . . . . 10,000

Gain on sale of land . . . . . . . . . . . . . . . . . . . . . . . (3,000)

Increase in inventory . . . . . . . . . . . . . . . . . . . . . . (1,500)

Increase in accounts payable. . . . . . . . . . . . . . . . 2,850

Net cash provided by operations. . . . . . . . . . . . . $23,550

Classify the following cash flows as either operating (O), investing (I), or financing (F) activities. 1. Sold stock investments for cash. 6. Issued common stock for cash. 2. Received cash payments from customers. 7. Received cash interest on a note. 3. Paid cash for wages and salaries. 8. Paid cash interest on outstanding notes. 4. Purchased inventories with cash. 9. Received cash from sale of land. 5. Paid cash dividends. 10. Paid cash for property taxes on building.

QUICK STUDY

QS 12-1 Classifying transactions by activity

C1

Chapter 12 Reporting Cash Flows 479

Label the following headings, line items, and notes with the numbers 1 through 13 according to their se- quential order (from top to bottom) for presentation on the statement of cash flows.

a. “Cash flows from investing activities” title b. “For period Ended date” heading c. “Cash flows from operating activities” title d. Company name e. Schedule or note disclosure of noncash investing and financing transactions f. “Statement of Cash Flows” heading g. Net increase (decrease) in cash. . . . . . . . . . . . . . . . . . . . . . . . . . $ h. Net cash provided (used) by operating activities . . . . . . . . . . . . $ i. Cash (and equivalents) balance at prior period-end . . . . . . . . . . $ j. Net cash provided (used) by financing activities . . . . . . . . . . . . $ k. “Cash flows from financing activities” title l. Net cash provided (used) by investing activities. . . . . . . . . . . . . $ m. Cash (and equivalents) balance at current period-end . . . . . . . . $

QS 12-2 Statement of cash flows

P1

Bryant Co. reports net income of $20,000. For the year, depreciation expense is $7,000 and the company reports a gain of $3,000 from sale of machinery. It also had a $2,000 loss from retirement of notes. Compute cash flows from operations using the indirect method.

QS 12-3 Indirect: Computing cash flows from operations P2

Cain Inc. reports net income of $15,000. Its comparative balance sheet shows the following changes: ac- counts receivable increased $6,000; inventory decreased $8,000; prepaid insurance decreased $1,000; accounts payable increased $3,000; and taxes payable decreased $2,000. Compute cash flows from opera- tions using the indirect method.

QS 12-4 Indirect: Computing cash flows from operations P2

For each separate company, compute cash flows from operations using the indirect method. QS 12-5 Indirect: Computing cash flows from operations

P2 Twix Dots Skor

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000 $100,000 $72,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 8,000 24,000

Accounts receivable increase (decrease) . . . . . . . . . . . . . 40,000 20,000 (4,000)

Inventory increase (decrease) . . . . . . . . . . . . . . . . . . . . . . (20,000) (10,000) 10,000

Accounts payable increase (decrease) . . . . . . . . . . . . . . . 24,000 (22,000) 14,000

Accrued liabilities increase (decrease) . . . . . . . . . . . . . . . (44,000) 12,000 (8,000)

QS 12-6 Indirect: Computing cash from operations P2

Use the following information to determine cash flows from operating activities using the indirect method.

MOSS COMPANY Selected Balance Sheet Information

December 31, 2019 and 2018

2019 2018 Current assets

Cash . . . . . . . . . . . . . . . . . $84,650 $26,800

Accounts receivable. . . . . 25,000 32,000

Inventory. . . . . . . . . . . . . . 60,000 54,100

Current liabilities

Accounts payable. . . . . . . 30,400 25,700

Income taxes payable . . . 2,050 2,200

MOSS COMPANY Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . $515,000

Cost of goods sold . . . . . . . . 331,600

Gross profit . . . . . . . . . . . . . . 183,400

Operating expenses

Depreciation expense . . . $ 36,000

Other expenses . . . . . . . . 121,500 157,500

Income before taxes. . . . . . . 25,900

Income taxes expense . . . . . 7,700

Net income . . . . . . . . . . . . . . $ 18,200

480 Chapter 12 Reporting Cash Flows

CRUZ, INC. Comparative Balance Sheets

At December 31 2019 2018

Assets Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,800 $ 24,000

Accounts receivable, net . . . . . . . . . . 41,000 51,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . 85,800 95,800

Prepaid expenses . . . . . . . . . . . . . . . . 5,400 4,200

Total current assets . . . . . . . . . . . . . . 227,000 175,000

Furniture . . . . . . . . . . . . . . . . . . . . . . . 109,000 119,000

Accum. depreciation—Furniture . . . . (17,000) (9,000)

Total assets . . . . . . . . . . . . . . . . . . . . . $319,000 $285,000

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . $ 15,000 $ 21,000

Wages payable . . . . . . . . . . . . . . . . . . 9,000 5,000

Income taxes payable. . . . . . . . . . . . . 1,400 2,600

Total current liabilities . . . . . . . . . . . . 25,400 28,600

Notes payable (long-term) . . . . . . . . . 29,000 69,000

Total liabilities . . . . . . . . . . . . . . . . . . . 54,400 97,600

Equity Common stock, $5 par value . . . . . . . 229,000 179,000

Retained earnings. . . . . . . . . . . . . . . . 35,600 8,400

Total liabilities and equity. . . . . . . . . . $319,000 $285,000

CRUZ, INC. Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . $488,000

Cost of goods sold . . . . . . . . . 314,000

Gross profit . . . . . . . . . . . . . . . 174,000

Operating expenses

Depreciation expense . . . . $37,600

Other expenses . . . . . . . . . 89,100 126,700

Income before taxes. . . . . . . . 47,300

Income taxes expense . . . . . . 17,300

Net income . . . . . . . . . . . . . . . $ 30,000

QS 12-7 Indirect: Computing cash from operations P2

Required

Use the indirect method to prepare the operating activities section of Cruz’s statement of cash flows.

QS 12-9 Computing investing cash flows

P3

Indicate the effect each separate transaction has on investing cash flows. a. Sold a truck costing $40,000, with $22,000 of accumulated depreciation, for $8,000 cash. The sale

results in a $10,000 loss. b. Sold a machine costing $10,000, with $8,000 of accumulated depreciation, for $5,000 cash. The sale

results in a $3,000 gain. c. Purchased stock investments for $16,000 cash. The purchaser believes the stock is worth at least $30,000.

QS 12-8 Computing cash from asset sales

P3

The following information is from Ellerby Company’s comparative balance sheets. The current-year in- come statement reports depreciation expense on furniture of $18,000. During the year, furniture costing $52,500 was sold for its book value. Compute cash received from the sale of furniture.

At December 31 Current Year Prior Year Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $132,000 $ 184,500

Accumulated depreciation—Furniture. . . . . . (88,700) (110,700)

QS 12-10 Computing investing cash flows

P3

The plant assets section of the comparative balance sheets of Anders Company is reported below.

ANDERS COMPANY Comparative Year-End Balance Sheets

Plant assets 2019 2018 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 180,000 $ 270,000

Accumulated depreciation—Equipment . . . . . . . . . (100,000) (210,000)

Equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 $ 60,000

Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 380,000 $ 400,000

Accumulated depreciation—Buildings . . . . . . . . . . (100,000) (285,000)

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 280,000 $ 115,000

Chapter 12 Reporting Cash Flows 481

Refer to the balance sheet data above from Anders Company. During 2019, equipment with a book value of $40,000 and an original cost of $210,000 was sold at a loss of $3,000. 1. How much cash did Anders receive from the sale of equipment? 2. How much depreciation expense was recorded on equipment during 2019? 3. What was the cost of new equipment purchased by Anders during 2019?

QS 12-11 Computing investing cash flows

P3

Refer to the balance sheet data in QS 12-10 from Anders Company. During 2019, a building with a book value of $70,000 and an original cost of $300,000 was sold at a gain of $60,000. 1. How much cash did Anders receive from the sale of the building? 2. How much depreciation expense was recorded on buildings during 2019? 3. What was the cost of buildings purchased by Anders during 2019?

QS 12-14 Computing financing cash flows

P3

Indicate the effect, if any, that each separate transaction has on financing cash flows. a. Notes payable with a carrying value of $15,000 are retired for $16,000 cash, resulting in a $1,000 gain. b. Paid cash dividends of $11,000 to common stockholders. c. Acquired $20,000 worth of machinery in exchange for common stock.

Compute cash flows from investing activities using the following company information. QS 12-12 Computing cash flows from investing

P3 Sale of short-term stock investments . . . . . . . . . $ 6,000 Cash purchase of used equipment . . . . . . $5,000

Cash collections from customers . . . . . . . . . . . . . 16,000 Depreciation expense . . . . . . . . . . . . . . . . 2,000

Compute cash flows from financing activities using the following company information. QS 12-16 Computing cash flows from financing

P3 Cash received from short-term note payable . . . . . . . $20,000 Cash dividends paid . . . . . . . . . . . . . . . . . . $16,000

Purchase of short-term stock investments . . . . . . . . 5,000 Interest paid . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Use the following information for VPI Co. to prepare a statement of cash flows for the year ended December 31 using the indirect method.

QS 12-18 Indirect: Preparing statement of cash flows

P2 P3Cash balance at prior year-end . . . . . . . . . . . . . $40,000 Gain on sale of machinery . . . . . . . . . . . . . . . . . $ 2,000 Increase in inventory . . . . . . . . . . . . . . . . . . . . . 5,000 Cash received from sale of machinery . . . . . . . 9,500

Depreciation expense . . . . . . . . . . . . . . . . . . . . 4,000 Increase in accounts payable . . . . . . . . . . . . . . 1,500

Cash received from issuing stock . . . . . . . . . . . 8,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000

Cash paid for dividends . . . . . . . . . . . . . . . . . . . 1,000 Decrease in accounts receivable . . . . . . . . . . . 3,000

QS 12-13 Computing cash from asset sales P3

Refer to the data in QS 12-7. Furniture costing $55,000 is sold at its book value in 2019. Acquisitions of furniture total $45,000 cash, on which no depreciation is necessary because it is acquired at year-end. What is the cash inflow from the sale of furniture?

QS 12-17 Computing financing cash outflows P3

Refer to the data in QS 12-7. 1. Assume that all common stock is issued for cash. What amount of cash dividends is paid during 2019? 2. Assume that no additional notes payable are issued in 2019. What cash amount is paid to reduce the

notes payable balance in 2019?

The following information is from Princeton Company’s comparative balance sheets. QS 12-15 Computing financing cash flows

P3

The company’s net income for the current year ended December 31 was $48,000. 1. Compute the cash received from the sale of its common stock during the current year. 2. Compute the cash paid for dividends during the current year.

At December 31 Current Year Prior Year Common stock, $10 par value. . . . . . . . . . . . $105,000 $100,000

Paid-in capital in excess of par . . . . . . . . . . . 567,000 342,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . 313,500 287,500

482 Chapter 12 Reporting Cash Flows

Financial data from three competitors in the same industry follow. 1. Rank the three companies from high to low on cash from operating activities. 2. Which company has the largest cash outflow for investing activities? 3. Which company has the largest cash inflow from financing activities? 4. Which company has the highest cash flow on total assets ratio?

QS 12-19 Interpreting disclosures on sources and uses of cash

A1

$ 70,000 (28,000) (6,000) $ 36,000 $790,000

$ 60,000 (34,000) 0 $ 26,000

$625,000

$ (24,000) 26,000

23,000 $ 25,000

$300,000

Cash provided (used) by operating activities Cash provided (used) by investing activities Cash provided (used) by financing activities Net increase (decrease) in cash

Average total assets

CluedoYahtzeeMancala

QS 12-20A Recording entries in a spreadsheet

P4

A company uses a spreadsheet to prepare its statement of cash flows. Indicate whether each of the follow- ing items would be recorded in the Debit column or Credit column of the spreadsheet’s statement of cash flows section. a. Decrease in accounts payable d. Loss on sale of machinery b. Payment of cash dividends e. Net income c. Increase in accounts receivable f. Increase in interest payable

QS 12-21B Direct: Computing cash receipts from operations

P5

Russell Co. reports sales revenue of $30,000 and interest revenue of $5,000. Its comparative balance sheet shows that accounts receivable decreased $4,000 and interest receivable increased $1,000. Compute cash provided by operating activities using the direct method.

QS 12-23B Direct: Computing cash paid for operations P5

BTN Inc. reports operating expenses of $27,000. Its comparative balance sheet shows that accrued liabil- ities decreased $6,000 and prepaid expenses increased $2,000. Compute cash used in operating activities using the direct method.

QS 12-25B Direct: Computing cash received from customers

P5

Refer to the data in QS 12-7. 1. How much cash is received from sales to customers for year 2019? 2. What is the net increase or decrease in the Cash account for year 2019?

QS 12-26B Direct: Computing operating cash outflows

P5

Refer to the data in QS 12-7. 1. How much cash is paid to acquire inventory during year 2019? 2. How much cash is paid for “other expenses” during year 2019? Hint: Examine prepaid expenses and

wages payable.

QS 12-22B Direct: Computing cash payments to suppliers P5

Bioware Co. reports cost of goods sold of $42,000. Its comparative balance sheet shows that inventory decreased $7,000 and accounts payable increased $5,000. Compute cash payments to suppliers using the direct method.

For each separate case, compute the required cash flow information for BioClean.QS 12-24B Direct: Computing cash flows

P5 Case A: Compute cash interest received Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000

Interest receivable, beginning of year. . . . . . . . . . 600

Interest receivable, end of year . . . . . . . . . . . . . . 1,700

Case B: Compute cash paid for wages Wages expense . . . . . . . . . . . . . . . . . . . . . . . $9,000

Wages payable, beginning of year . . . . . . . . 2,200

Wages payable, end of year . . . . . . . . . . . . . 1,000

QS 12-27B Direct: Computing cash from operations P5

Refer to the data in QS 12-7. Use the direct method to prepare the operating activities section of Cruz’s statement of cash flows.

Chapter 12 Reporting Cash Flows 483

EXERCISES

Exercise 12-1 Indirect: Classifying cash flows

C1

Indicate where each item would appear on a statement of cash flows using the indirect method by placing an x in the appropriate column.

Statement of Cash Flows Noncash Not Investing Reported on Operating Investing Financing and Financing Statement Activities Activities Activities Activities or in Notes

a. Declared and paid a cash dividend . . . . . . . . . . b. Recorded depreciation expense . . . . . . . . . . . . c. Paid cash to settle long-term note payable . . . d. Prepaid expenses increased in the year . . . . . . e. Accounts receivable decreased in the year . . . f. Purchased land by issuing common stock . . . . g. Inventory increased in the year . . . . . . . . . . . . . h. Sold equipment for cash, yielding a loss . . . . . . i. Accounts payable decreased in the year . . . . . j. Income taxes payable increased in the year . . .

Hampton Company reports the following information for its recent calendar year. Prepare the operating activities section of the statement of cash flows using the indirect method.

Exercise 12-2 Indirect: Reporting cash flows from operations

P2Income Statement Data Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 Expenses: Cost of goods sold. . . . . . . . . . . . 100,000 Salaries expense . . . . . . . . . . . . . 24,000 Depreciation expense . . . . . . . . . 12,000 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,000

Selected Year-End Balance Sheet Data

Accounts receivable increase. . . . . . . . . . $10,000 Inventory decrease . . . . . . . . . . . . . . . . . . 16,000 Salaries payable increase . . . . . . . . . . . . . 1,000

Arundel Company disclosed the following information for its recent calendar year. Prepare the operating activities section of the statement of cash flows using the indirect method.

Income Statement Data

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 Expenses: Salaries expense . . . . . . . . . . . . . . . 84,000 Utilities expense . . . . . . . . . . . . . . . 14,000 Depreciation expense . . . . . . . . . . . 14,600 Other expenses . . . . . . . . . . . . . . . . 3,400 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (16,000)

Selected Year-End Balance Sheet Data

Accounts receivable decrease . . . . . . . . . $24,000 Purchased a machine for cash . . . . . . . . . 10,000 Salaries payable increase . . . . . . . . . . . . . 18,000 Other accrued liabilities decrease . . . . . . 8,000

Exercise 12-3 Indirect: Reporting cash flows from operations

P2

Using the following income statement and additional year-end information, prepare the operating activi- ties section of the statement of cash flows using the indirect method.

Exercise 12-4 Indirect: Cash flows from operating activities

P2SONAD COMPANY Income Statement

For Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,828,000 Cost of goods sold . . . . . . . . . . . . . . . . . 991,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . 837,000 Operating expenses Salaries expense . . . . . . . . . . . . . . . . $245,535 Depreciation expense . . . . . . . . . . . . 44,200 Rent expense . . . . . . . . . . . . . . . . . . . 49,600 Amortization expense—Patents . . . . 4,200 Utilities expense. . . . . . . . . . . . . . . . . 18,125 361,660 475,340 Gain on sale of equipment . . . . . . . . . . . 6,200 Net income . . . . . . . . . . . . . . . . . . . . . . . $ 481,540

Selected Year-End Balance Sheet Data

Accounts receivable . . $30,500 increase

Inventory . . . . . . . . . . . 25,000 increase

Accounts payable . . . . 12,500 decrease

Salaries payable . . . . . 3,500 decrease

484 Chapter 12 Reporting Cash Flows

Fitz Company reports the following information. Use the indirect method to prepare the operating activi- ties section of its statement of cash flows for the year ended December 31.

Exercise 12-5 Indirect: Cash flows from operating activities

P2 Selected Annual Income Statement Data Selected Year-End Balance Sheet Data Net income . . . . . . . . . . . . . . . . . . . . . . . . . $374,000 Accounts receivable decrease . . . . . . . . . . . . . . $17,100 Depreciation expense . . . . . . . . . . . . . . . . 44,000 Inventory decrease . . . . . . . . . . . . . . . . . . . . . . . 42,000 Amortization expense. . . . . . . . . . . . . . . . . 7,200 Prepaid expenses increase. . . . . . . . . . . . . . . . . 4,700 Gain on sale of plant assets . . . . . . . . . . . . 6,000 Accounts payable decrease . . . . . . . . . . . . . . . . 8,200 Salaries payable increase. . . . . . . . . . . . . . . . . . 1,200

Salud Company reports the following information. Use the indirect method to prepare the operating ac- tivities section of its statement of cash flows for the year ended December 31.

Exercise 12-6 Indirect: Cash flows from operating activities

P2 Selected Annual Income Statement Data Selected Year-End Balance Sheet Data Net income . . . . . . . . . . . . . . . . . . . . . . . . . $400,000 Accounts receivable increase. . . . . . . . . . . . . . . $40,000 Depreciation expense . . . . . . . . . . . . . . . . 80,000 Prepaid expenses decrease . . . . . . . . . . . . . . . . 12,000 Gain on sale of machinery . . . . . . . . . . . . . 20,000 Accounts payable increase. . . . . . . . . . . . . . . . . 6,000 Wages payable decrease . . . . . . . . . . . . . . . . . . 2,000

Prepare the operating activities section of the statement of cash flows for GreenGarden using the indirect method.

Exercise 12-7 Indirect: Reporting cash flows from operations

P2 Annual Income Statement Data Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Expenses: Cost of goods sold. . . . . . . . . . . . . . 30,000

Wages expense . . . . . . . . . . . . . . . . 10,000

Amortization expense . . . . . . . . . . . 1,500

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,500

Selected Year-End Balance Sheet Data

Prepaid expenses increase. . . . . . . . . . . . . . . . $3,000 Inventory increase . . . . . . . . . . . . . . . . . . . . . . 500 Accounts payable decrease . . . . . . . . . . . . . . . 1,000

Use the following information to determine cash flows from investing activities. a. Equipment with a book value of $65,300 and an original cost of $133,000 was sold at a loss of $14,000. b. Paid $89,000 cash for a new truck. c. Sold land costing $154,000 for $198,000 cash, yielding a gain of $44,000. d. Stock investments were sold for $60,800 cash, yielding a gain of $4,150.

Exercise 12-8 Cash flows from investing activities

P3

Use the following information to determine cash flows from financing activities. a. Net income was $35,000. b. Issued common stock for $64,000 cash. c. Paid cash dividend of $14,600. d. Paid $50,000 cash to settle a note payable at its $50,000 maturity value. e. Paid $12,000 cash to acquire its treasury stock. f. Purchased equipment for $39,000 cash.

Exercise 12-9 Cash flows from financing activities

P3

For each of the following separate transactions, (a) prepare the reconstructed journal entry and (b) identify the effect it has, if any, on the investing section or financing section of the statement of cash flows. 1. Sold a building costing $30,000, with $20,000 of accumulated depreciation, for $8,000 cash, resulting

in a $2,000 loss. 2. Acquired machinery worth $10,000 by issuing $10,000 in notes payable. 3. Issued 1,000 shares of common stock at par for $2 per share. 4. Notes payable with a carrying value of $40,000 were retired for $47,000 cash, resulting in a $7,000

loss.

Exercise 12-10 Reconstructed entries

P3

Chapter 12 Reporting Cash Flows 485

The following financial statements and additional information are reported. (1) Prepare a statement of cash flows using the indirect method for the year ended June 30, 2019. (2) Compute the company’s cash flow on total assets ratio for fiscal year 2019.

Exercise 12-11 Indirect: Preparing statement of cash flows

A1 P2 P3IKIBAN INC. Income Statement

For Year Ended June 30, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $678,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 411,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 267,000

Operating expenses

Depreciation expense . . . . . . . . . . . . . . . . $58,600

Other expenses . . . . . . . . . . . . . . . . . . . . . 67,000

Total operating expenses. . . . . . . . . . . . . . . . 125,600

141,400

Other gains (losses)

Gain on sale of equipment. . . . . . . . . . . . . 2,000

Income before taxes. . . . . . . . . . . . . . . . . . . . 143,400

Income taxes expense . . . . . . . . . . . . . . . . . . 43,890

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 99,510

IKIBAN INC. Comparative Balance Sheets

At June 30 2019 2018

Assets Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,500 $ 44,000

Accounts receivable, net . . . . . . . . . . 65,000 51,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . 63,800 86,500

Prepaid expenses . . . . . . . . . . . . . . . . 4,400 5,400

Total current assets . . . . . . . . . . . . . . 220,700 186,900

Equipment. . . . . . . . . . . . . . . . . . . . . . 124,000 115,000

Accum. depreciation—Equipment . . . (27,000) (9,000)

Total assets . . . . . . . . . . . . . . . . . . . . . $317,700 $292,900

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . $ 25,000 $ 30,000

Wages payable . . . . . . . . . . . . . . . . . . 6,000 15,000

Income taxes payable. . . . . . . . . . . . . 3,400 3,800

Total current liabilities . . . . . . . . . . . . 34,400 48,800

Notes payable (long term) . . . . . . . . . 30,000 60,000

Total liabilities . . . . . . . . . . . . . . . . . . . 64,400 108,800

Equity Common stock, $5 par value . . . . . . . 220,000 160,000

Retained earnings. . . . . . . . . . . . . . . . 33,300 24,100

Total liabilities and equity. . . . . . . . . . $317,700 $292,900

Additional Information a. A $30,000 note payable is retired at its $30,000 carrying (book)

value in exchange for cash. b. The only changes affecting retained earnings are net income and

cash dividends paid. c. New equipment is acquired for $57,600 cash. d. Received cash for the sale of equipment that had cost $48,600, yield-

ing a $2,000 gain. e. Prepaid Expenses and Wages Payable relate to Other Expenses on

the income statement. f. All purchases and sales of inventory are on credit. Check (1b) Cash paid for dividends, $90,310

(1d) Cash received from equip. sale, $10,000

Use the following information to prepare a statement of cash flows for the current year using the indirect method. Exercise 12-12 Indirect: Preparing statement of cash flows

P2 P3 MONTGOMERY INC.

Comparative Balance Sheets

At December 31 Current Year Prior Year

Assets Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,400 $ 30,550

Accounts receivable, net . . . . . . . . . . 10,050 12,150

Inventory . . . . . . . . . . . . . . . . . . . . . . . 90,100 70,150

Total current assets . . . . . . . . . . . . . . 130,550 112,850

Equipment. . . . . . . . . . . . . . . . . . . . . . 49,900 41,500

Accum. depreciation—Equipment . . . (22,500) (15,300)

Total assets . . . . . . . . . . . . . . . . . . . . . $157,950 $139,050

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . $ 23,900 $ 25,400

Salaries payable . . . . . . . . . . . . . . . . . 500 600

Total current liabilities . . . . . . . . . . . . 24,400 26,000

Equity Common stock, no par value . . . . . . . 110,000 100,000

Retained earnings. . . . . . . . . . . . . . . . 23,550 13,050

Total liabilities and equity. . . . . . . . . . $157,950 $139,050

MONTGOMERY INC. Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . $45,575 Cost of goods sold . . . . . . . . . (18,950) Gross profit . . . . . . . . . . . . . . . 26,625 Operating expenses Depreciation expense . . . . $7,200 Other expenses . . . . . . . . . 5,550 Total operating expenses . . . 12,750 Income before taxes . . . . . . . 13,875 Income tax expense . . . . . . . . 3,375 Net income . . . . . . . . . . . . . . . $10,500

Additional Information on Current-Year Transactions a. No dividends are declared or paid. b. Issued additional stock for $10,000 cash. c. Purchased equipment for cash; no equipment was sold.

486 Chapter 12 Reporting Cash Flows

A company reported average total assets of $1,240,000 in Year 1 and $1,510,000 in Year 2. Its net operat- ing cash flow was $102,920 in Year 1 and $138,920 in Year 2. (1) Calculate its cash flow on total assets ratio for both years. (2) Did its cash flow on total assets improve in Year 2 versus Year 1?

Exercise 12-13 Analyzing cash flow on total assets A1

Indicate where each item would appear on a statement of cash flows using the direct method by placing an x in the appropriate column.

Exercise 12-15B Direct: Classifying cash flows

C1 P5 Statement of Cash Flows Noncash Not Investing Reported on Operating Investing Financing and Financing Statement Activities Activities Activities Activities or in Notes

a. Retired long-term notes payable by issuing common stock . . . . . . . . . . . b. Paid cash toward accounts payable . . . c. Sold inventory for cash . . . . . . . . . . . . d. Paid cash dividends . . . . . . . . . . . . . . . e. Accepted note receivable in exchange for plant assets . . . . . . . . . . . . . . . . f. Recorded depreciation expense . . . . . g. Paid cash to acquire treasury stock . . . h. Collected cash from sales . . . . . . . . . . i. Borrowed cash from bank by signing a nine-month note payable . . . . . . . j. Paid cash to purchase a patent . . . . . .

Complete the following spreadsheet in preparation of the statement of cash flows. (The statement of cash flows is not required.) Prepare the spreadsheet as in Exhibit 12A.1 under the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following trans- actions and events a through h. a. Net income for the year was $100,000. b. Dividends of $80,000 cash were declared and paid. c. The only noncash expense was $70,000

of depreciation. d. Purchased plant assets for $70,000 cash.

Exercise 12-14A Indirect: Cash flows spreadsheet

P4

SCORETECK CORPORATION Spreadsheet for Statement of Cash Flows—Indirect Method

For Year Ended December 31, 2019

Dec. 31, 2019Debit Credit Analysis of Changes

Dec. 31, 2018 Balance Sheet—Debit Bal. Accounts Cash Accounts receivable Inventory Plant assets

Balance Sheet—Credit Bal. Accounts Accumulated depreciation Accounts payable Notes payable Common stock Retained earnings

Statement of Cash Flows Operating activities Net income Increase in accounts receivable Decrease in inventory Decrease in accounts payable Depreciation expense Investing activities Cash paid to purchase plant assets Financing activities Cash paid for dividends Cash from issuance of notes

$ 80,000 120,000 250,000 600,000

$1,050,000

$ 100,000 150,000 370,000 200,000 230,000

$1,050,000

$ 60,000 190,000 230,000 670,000

$1,150,000

$ 170,000 140,000 390,000 200,000 250,000

$1,150,000

e. Notes payable of $20,000 were issued for $20,000 cash.

f. $70,000 increase in accounts receivable. g. $20,000 decrease in inventory. h. $10,000 decrease in accounts payable.

Chapter 12 Reporting Cash Flows 487

Refer to the information in Exercise 12-11. Using the direct method, prepare the statement of cash flows for the year ended June 30, 2019.

Exercise 12-17B Direct: Preparing statement of cash flows P5

Refer to information in Exercise 12-4. Use the direct method to prepare the operating activities section of Sonad’s statement of cash flows.

Exercise 12-18B Direct: Cash flows from operating activities P5

For each of the following separate cases, compute the required cash flow information. Exercise 12-16B Direct: Computing cash flows

P5 Case X: Compute cash received from customers Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $515,000

Accounts receivable, Beginning balance. . . . 27,200

Accounts receivable, Ending balance . . . . . 33,600

Case Y: Compute cash paid for rent Rent expense. . . . . . . . . . . . . . . . . . . . . . . . . $139,800

Rent payable, Beginning balance. . . . . . . . . 7,800

Rent payable, Ending balance . . . . . . . . . . . 6,200

Case Z: Compute cash paid for inventory Cost of goods sold . . . . . . . . . . . . . . . . . . $525,000

Inventory, Beginning balance . . . . . . . . . 158,600

Accounts payable, Beginning balance . . . 66,700

Inventory, Ending balance . . . . . . . . . . . . 130,400

Accounts payable, Ending balance . . . . . 82,000

Use the following information about Ferron Company to prepare a complete statement of cash flows (di- rect method) for the current year ended December 31. Use a note disclosure for any noncash investing and financing activities.

Exercise 12-19B Direct: Preparing statement of cash flows and supporting note

P5Cash and cash equivalents, Dec. 31 prior year-end. . . . . . . . . . . . . . . . . . . $ 40,000

Cash and cash equivalents, Dec. 31 current year-end. . . . . . . . . . . . . . . . . 148,000

Cash received as interest. . . . . . . . . . . . . . . . . . . 3,500

Cash paid for salaries. . . . . . . . . . . . . . . . . . . . . . 76,500

Bonds payable retired by issuing common stock (no gain or loss on retirement) . . . . . . . 185,500

Cash paid to retire long-term notes payable . . . 100,000

Cash received from sale of equipment . . . . . . . . 60,250

Cash received in exchange for six-month note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Land purchased by issuing long-term note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,250

Cash paid for store equipment . . . . . . . . . . . . . . . 24,750

Cash dividends paid . . . . . . . . . . . . . . . . . . . . . . . 10,000

Cash paid for other expenses. . . . . . . . . . . . . . . . 20,000

Cash received from customers . . . . . . . . . . . . . . . 495,000

Cash paid for inventory . . . . . . . . . . . . . . . . . . . . . 254,500

The following Cash T-account shows the total debits and total credits to the Cash account of Thomas Corporation for the current year. 1. Prepare a complete statement of cash flows for the current year using the direct method. 2. Refer to the statement of cash flows prepared for part 1 to answer the following questions. (a) Which

section—operating, investing, or financing—shows the largest cash (i) inflow and (ii) outflow? (b) What is the largest individual item among the investing cash outflows? (c) Are the cash proceeds larger from issuing notes or issuing stock? (d) Does the company have a net cash inflow or outflow from borrowing activities?

Exercise 12-20B Direct: Preparing statement of cash flows from Cash T-account

P1 P3 P5

Balance, Dec. 31, prior year ........... Receipts from customers ................ Receipts from dividends ................. Receipts from land sale ................... Receipts from machinery sale ....... Receipts from issuing stock ........... Receipts from borrowing ................

Balance, Dec. 31, current year .......... ?

333,000 5,000,000

208,400 220,000 710,000

1,540,000 3,600,000

Payments for inventory ..................... Payments for wages .......................... Payments for rent ............................... Payments for interest ........................ Payments for taxes ............................. Payments for machinery ................... Payments for stock investments .... Payments for note payable .............. Payments for dividends .................... Payments for treasury stock ............

2,590,000 550,000 320,000 218,000 450,000

2,236,000 1,260,000

386,000 500,000 218,000

Cash

488 Chapter 12 Reporting Cash Flows

Required

Prepare the operating activities section of the statement of cash flows using the indirect method for the current year.

Check Cash from operating activities, $17,780

Refer to the information in Problem 12-1A.

Required

Prepare the operating activities section of the statement of cash flows using the direct method for the current year.

Problem 12-2AB Direct: Computing cash flows from operations

P5

PROBLEM SET A

Problem 12-1A Indirect: Computing cash flows from operations

P2

Lansing Company’s current-year income statement and selected balance sheet data at December 31 of the current and prior years follow.

LANSING COMPANY Income Statement

For Current Year Ended December 31

Sales revenue . . . . . . . . . . . . . . . . . . . . $97,200 Expenses Cost of goods sold . . . . . . . . . . . . . . 42,000 Depreciation expense. . . . . . . . . . . . 12,000 Salaries expense. . . . . . . . . . . . . . . . 18,000 Rent expense . . . . . . . . . . . . . . . . . . 9,000 Insurance expense . . . . . . . . . . . . . . 3,800 Interest expense . . . . . . . . . . . . . . . . 3,600 Utilities expense . . . . . . . . . . . . . . . . 2,800 Net income. . . . . . . . . . . . . . . . . . . . . . . $ 6,000

LANSING COMPANY Selected Balance Sheet Accounts

At December 31 Current Year Prior Year Accounts receivable . . . . . . . . $5,600 $5,800 Inventory . . . . . . . . . . . . . . . . . 1,980 1,540 Accounts payable . . . . . . . . . . 4,400 4,600 Salaries payable . . . . . . . . . . . 880 700 Utilities payable . . . . . . . . . . . 220 160 Prepaid insurance. . . . . . . . . . 260 280 Prepaid rent . . . . . . . . . . . . . . 220 180

Forten Company’s current-year income statement, comparative balance sheets, and additional information fol- low. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, and (5) Other Expenses are paid in advance and are initially debited to Prepaid Expenses.

Problem 12-3A Indirect: Statement of cash flows

A1 P2 P3

FORTEN COMPANY Comparative Balance Sheets

December 31

Current Year Prior Year Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,800 $ 73,500 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . 65,810 50,625 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275,656 251,800 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,250 1,875 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . 392,516 377,800 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157,500 108,000 Accum. depreciation—Equipment . . . . . . . . . . . . (36,625) (46,000) Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $513,391 $439,800

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . $ 53,141 $114,675 Short-term notes payable . . . . . . . . . . . . . . . . . . . 10,000 6,000 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . 63,141 120,675 Long-term notes payable . . . . . . . . . . . . . . . . . . . 65,000 48,750 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,141 169,425

Equity Common stock, $5 par value . . . . . . . . . . . . . . . . 162,750 150,250 Paid-in capital in excess of par, common stock . . . 37,500 0 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 185,000 120,125 Total liabilities and equity . . . . . . . . . . . . . . . . . . . $513,391 $439,800

FORTEN COMPANY Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $582,500 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 285,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 297,500 Operating expenses Depreciation expense . . . . . . . . . . . . . . . . $ 20,750 Other expenses . . . . . . . . . . . . . . . . . . . . . 132,400 153,150 Other gains (losses) Loss on sale of equipment. . . . . . . . . . . . . (5,125) Income before taxes. . . . . . . . . . . . . . . . . . . . 139,225 Income taxes expense . . . . . . . . . . . . . . . . . . 24,250 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $114,975

Additional Information on Current-Year Transactions a. The loss on the cash sale of equipment was $5,125 (details in b). b. Sold equipment costing $46,875, with accumulated depreciation of

$30,125, for $11,625 cash. c. Purchased equipment costing $96,375 by paying $30,000 cash and

signing a long-term note payable for the balance. d. Borrowed $4,000 cash by signing a short-term note payable. e. Paid $50,125 cash to reduce the long-term notes payable. f. Issued 2,500 shares of common stock for $20 cash per share. g. Declared and paid cash dividends of $50,100.

Chapter 12 Reporting Cash Flows 489

Required

1. Prepare a complete statement of cash flows using the indirect method for the current year. Disclose any noncash investing and financing activities in a note.

Analysis Component

2. Analyze and discuss the statement of cash flows prepared in part 1, giving special attention to the wisdom of the cash dividend payment.

Check Cash from operating activities, $40,900

Refer to Forten Company’s financial statements and related information in Problem 12-3A.

Required

Prepare a complete statement of cash flows using the direct method. Disclose any noncash investing and financing activities in a note.

Problem 12-5AB Direct: Statement of cash flows P5 Check Cash used in financing activities, $(46,225)

Golden Corp.’s current-year income statement, comparative balance sheets, and additional information follow. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, (5) Other Expenses are all cash expenses, and (6) any change in Income Taxes Payable reflects the accrual and cash payment of taxes.

Problem 12-6A Indirect: Statement of cash flows

P2 P3

GOLDEN CORPORATION Comparative Balance Sheets

At December 31 Current Year Prior Year

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 164,000 $107,000 Accounts receivable . . . . . . . . . . . . . . 83,000 71,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . 601,000 526,000 Total current assets . . . . . . . . . . . . . . . 848,000 704,000 Equipment . . . . . . . . . . . . . . . . . . . . . . 335,000 299,000 Accum. depreciation—Equipment . . . (158,000) (104,000) Total assets . . . . . . . . . . . . . . . . . . . . . $1,025,000 $899,000

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . $ 87,000 $ 71,000 Income taxes payable . . . . . . . . . . . . . 28,000 25,000 Total current liabilities . . . . . . . . . . . . . 115,000 96,000

Equity Common stock, $2 par value . . . . . . . 592,000 568,000 Paid-in capital in excess of par value, common stock . . . . . . 196,000 160,000 Retained earnings . . . . . . . . . . . . . . . . 122,000 75,000 Total liabilities and equity . . . . . . . . . . $1,025,000 $899,000

GOLDEN CORPORATION Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . $1,792,000 Cost of goods sold . . . . . . . . . . 1,086,000 Gross profit . . . . . . . . . . . . . . . . 706,000 Operating expenses Depreciation expense . . . . . $ 54,000 Other expenses . . . . . . . . . . 494,000 548,000 Income before taxes. . . . . . . . . 158,000 Income taxes expense . . . . . . . 22,000

Net income . . . . . . . . . . . . . . . . $ 136,000

Additional Information on Current-Year Transactions a. Purchased equipment for $36,000 cash. b. Issued 12,000 shares of common stock for $5 cash per

share.

c. Declared and paid $89,000 in cash dividends.

Refer to the information reported about Forten Company in Problem 12-3A.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1 using the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $114,975. b. Accounts receivable

increased. c. Inventory increased. d. Prepaid expenses decreased. e. Accounts payable decreased. f. Depreciation expense was

$20,750.

Problem 12-4AA Indirect: Cash flows spreadsheet

P4

Check Analysis of Changes column totals, $600,775

g. Sold equipment costing $46,875, with accumulated depreciation of $30,125, for $11,625 cash. This yielded a loss of $5,125.

h. Purchased equipment costing $96,375 by paying $30,000 cash and (i.) by signing a long-term note payable for the balance.

j. Borrowed $4,000 cash by signing a short-term note payable. k. Paid $50,125 cash to reduce the long-term notes payable. l. Issued 2,500 shares of common stock for $20 cash per share. m. Declared and paid cash dividends of $50,100.

490 Chapter 12 Reporting Cash Flows

Refer to the information reported about Golden Corporation in Problem 12-6A.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1 under the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $136,000. b. Accounts receivable increased. c. Inventory increased. d. Accounts payable increased. e. Income taxes payable increased.

Problem 12-7AA Indirect: Cash flows spreadsheet

P4

f. Depreciation expense was $54,000. g. Purchased equipment for $36,000 cash. h. Issued 12,000 shares at $5 cash per share. i. Declared and paid $89,000 of cash dividends.Check Analysis of Changes

column totals, $481,000

Refer to Golden Corporation’s financial statements and related information in Problem 12-6A.

Required

Prepare a complete statement of cash flows using the direct method for the current year.

Problem 12-8AB Direct: Statement of cash flows P5 Check Cash used in financing activities, $(29,000)

Refer to the information in Problem 12-1B.

Required

Prepare the operating activities section of the statement of cash flows using the direct method for the cur- rent year.

Problem 12-2BB Direct: Computing cash flows from operations

P5

Gazelle Corporation’s current-year income statement, comparative balance sheets, and additional infor- mation follow. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, and (5) Other Expenses are paid in advance and are initially debited to Prepaid Expenses.

Problem 12-3B Indirect: Statement of cash flows

A1 P2 P3

PROBLEM SET B

Problem 12-1B Indirect: Computing cash flows from operations

P2

Salt Lake Company’s current-year income statement and selected balance sheet data at December 31 of the current and prior years follow.

SALT LAKE COMPANY Income Statement

For Current Year Ended December 31

Sales revenue . . . . . . . . . . . . . . . . . . . . $156,000

Expenses

Cost of goods sold . . . . . . . . . . . . . . 72,000

Depreciation expense. . . . . . . . . . . . 32,000

Salaries expense. . . . . . . . . . . . . . . . 20,000

Rent expense . . . . . . . . . . . . . . . . . . 5,000

Insurance expense . . . . . . . . . . . . . . 2,600

Interest expense . . . . . . . . . . . . . . . . 2,400

Utilities expense . . . . . . . . . . . . . . . . 2,000

Net income. . . . . . . . . . . . . . . . . . . . . . . $ 20,000

SALT LAKE COMPANY Selected Balance Sheet Accounts

At December 31 Current Year Prior Year

Accounts receivable . . . . . . . . $3,600 $3,000 Inventory . . . . . . . . . . . . . . . . . 860 980 Accounts payable . . . . . . . . . . 2,400 2,600 Salaries payable . . . . . . . . . . . 900 600 Utilities payable . . . . . . . . . . . 200 0 Prepaid insurance. . . . . . . . . . 140 180 Prepaid rent . . . . . . . . . . . . . . 100 200

Required

Prepare the operating activities section of the statement of cash flows using the indirect method for the current year.

Check Cash from operating activities, $51,960

Required

Prepare a complete statement of cash flows using the indirect method for the current year. Check Cash from operating activities, $122,000

Chapter 12 Reporting Cash Flows 491

GAZELLE CORPORATION Comparative Balance Sheets

December 31

Current Year Prior Year Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $123,450 $ 61,550

Accounts receivable . . . . . . . . . . . . . . . . 77,100 80,750

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 240,600 250,700

Prepaid expenses . . . . . . . . . . . . . . . . . . 15,100 17,000

Total current assets . . . . . . . . . . . . . . . . . 456,250 410,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . 262,250 200,000

Accum. depreciation—Equipment . . . . . (110,750) (95,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . $607,750 $515,000

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . $ 17,750 $102,000

Short-term notes payable . . . . . . . . . . . . 15,000 10,000

Total current liabilities . . . . . . . . . . . . . . . 32,750 112,000

Long-term notes payable . . . . . . . . . . . . 100,000 77,500

Total liabilities . . . . . . . . . . . . . . . . . . . . . 132,750 189,500

Equity Common stock, $5 par . . . . . . . . . . . . . . 215,000 200,000

Paid-in capital in excess

of par, common stock . . . . . . . . . . . . . 30,000 0

Retained earnings . . . . . . . . . . . . . . . . . . 230,000 125,500

Total liabilities and equity . . . . . . . . . . . . $607,750 $515,000

GAZELLE CORPORATION Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $1,185,000

Cost of goods sold . . . . . . . . . . . . . . 595,000

Gross profit . . . . . . . . . . . . . . . . . . . . 590,000

Operating expenses

Depreciation expense . . . . . . . . . $ 38,600

Other expenses . . . . . . . . . . . . . . 362,850

Total operating expenses. . . . . . . . . 401,450

188,550

Other gains (losses)

Loss on sale of equipment. . . . . . (2,100)

Income before taxes. . . . . . . . . . . . . 186,450

Income taxes expense . . . . . . . . . . . 28,350

Net income . . . . . . . . . . . . . . . . . . . . $ 158,100

Additional Information on Current-Year Transactions a. The loss on the cash sale of equipment was $2,100 (details in b). b. Sold equipment costing $51,000, with accumulated

depreciation of $22,850, for $26,050 cash. c. Purchased equipment costing $113,250 by paying $43,250

cash and signing a long-term note payable for the balance. d. Borrowed $5,000 cash by signing a short-term note payable. e. Paid $47,500 cash to reduce the long-term notes payable. f. Issued 3,000 shares of common stock for $15 cash per share. g. Declared and paid cash dividends of $53,600.

Required

1. Prepare a complete statement of cash flows using the indirect method for the current year. Disclose any noncash investing and financing activities in a note.

Analysis Component

2. Analyze and discuss the statement of cash flows prepared in part 1, giving special attention to the wisdom of the cash dividend payment.

Check Cash from operating activities, $130,200

Refer to the information reported about Gazelle Corporation in Problem 12-3B.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1 using the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $158,100. b. Accounts receivable decreased. c. Inventory decreased. d. Prepaid expenses decreased. e. Accounts payable decreased. f. Depreciation expense was $38,600. g. Sold equipment costing $51,000, with accumulated depreciation of $22,850, for $26,050 cash. This

yielded a loss of $2,100. h. Purchased equipment costing $113,250 by paying $43,250 cash and (i.) by signing a long-term note

payable for the balance. j. Borrowed $5,000 cash by signing a short-term note payable. k. Paid $47,500 cash to reduce the long-term notes payable. l. Issued 3,000 shares of common stock for $15 cash per share. m. Declared and paid cash dividends of $53,600.

Problem 12-4BA Indirect: Cash flows spreadsheet

P4

Check Analysis of Changes column totals, $681,950

492 Chapter 12 Reporting Cash Flows

Refer to Gazelle Corporation’s financial statements and related information in Problem 12-3B.

Required

Prepare a complete statement of cash flows using the direct method. Disclose any noncash investing and financing activities in a note.

Problem 12-5BB Direct: Statement of cash flows P5 Check Cash used in financing activities, $(51,100)

Satu Company’s current-year income statement, comparative balance sheets, and additional information follow. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, (5) Other Expenses are cash expenses, and (6) any change in Income Taxes Payable reflects the accrual and cash payment of taxes.

Problem 12-6B Indirect: Statement of cash flows

P2 P3

SATU COMPANY Comparative Balance Sheets

At December 31 Current Year Prior Year

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,750 $ 28,400 Accounts receivable . . . . . . . . . . . . . . . . 20,222 25,860 Total current assets . . . . . . . . . . . . . . . . . 78,972 54,260 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 165,667 140,320 Equipment . . . . . . . . . . . . . . . . . . . . . . . . 107,750 77,500 Accum. depreciation—Equipment . . . . . (46,700) (31,000) Total assets . . . . . . . . . . . . . . . . . . . . . . . $305,689 $241,080

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . $ 20,372 $157,530 Income taxes payable . . . . . . . . . . . . . . . 2,100 6,100 Total current liabilities . . . . . . . . . . . . . . . 22,472 163,630

Equity Common stock, $5 par value . . . . . . . . . 40,000 25,000 Paid-in capital in excess of par, common stock . . . . . . . . . . . . . 68,000 20,000 Retained earnings . . . . . . . . . . . . . . . . . . 175,217 32,450 Total liabilities and equity . . . . . . . . . . . . $305,689 $241,080

SATU COMPANY Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . $750,800

Cost of goods sold . . . . . . . . . . 269,200

Gross profit . . . . . . . . . . . . . . . . 481,600

Operating expenses

Depreciation expense . . . . . $ 15,700

Other expenses . . . . . . . . . . 173,933 189,633

Income before taxes. . . . . . . . . 291,967

Income taxes expense . . . . . . . 89,200

Net income . . . . . . . . . . . . . . . . $202,767

Additional Information on Current-Year Transactions a. Purchased equipment for $30,250 cash. b. Issued 3,000 shares of common stock for $21 cash per

share.

c. Declared and paid $60,000 of cash dividends.

Required

Prepare a complete statement of cash flows using the indirect method for the current year. Check Cash from operating activities, $57,600

Refer to the information reported about Satu Company in Problem 12-6B.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1 under the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $202,767. b. Accounts receivable decreased. c. Inventory increased. d. Accounts payable decreased. e. Income taxes payable decreased.

Problem 12-7BA Indirect: Cash flows spreadsheet

P4

f. Depreciation expense was $15,700. g. Purchased equipment for $30,250 cash. h. Issued 3,000 shares at $21 cash per share. i. Declared and paid $60,000 of cash dividends.

Check Analysis of Changes column totals, $543,860

Refer to Satu Company’s financial statements and related information in Problem 12-6B.

Required

Prepare a complete statement of cash flows using the direct method for the current year.

Problem 12-8BB Direct: Statement of cash flows P5 Check Cash provided by financing activities, $3,000

Chapter 12 Reporting Cash Flows 493

SERIAL PROBLEM Business Solutions (Indirect)

P2 P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 12 Santana Rey, owner of Business Solutions, decides to prepare a statement of cash flows for her business. (Although the serial problem allowed for various ownership changes in earlier chapters, we will prepare the statement of cash flows using the following financial data.)

©Alexander Image/Shutterstock

BUSINESS SOLUTIONS Comparative Balance Sheets

December 31, 2019, and March 31, 2020

Mar. 31, 2020 Dec. 31, 2019

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 68,057 $48,372 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . 22,867 5,668 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 0 Computer supplies . . . . . . . . . . . . . . . . . . . . . . . 2,005 580 Prepaid insurance. . . . . . . . . . . . . . . . . . . . . . . . 1,110 1,665 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825 825 Total current assets . . . . . . . . . . . . . . . . . . . . . . 95,568 57,110 Office equipment . . . . . . . . . . . . . . . . . . . . . . . . 8,000 8,000 Accumulated depreciation—Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . (800) (400) Computer equipment . . . . . . . . . . . . . . . . . . . . . 20,000 20,000 Accumulated depreciation— Computer equipment. . . . . . . . . . . . . . . . . . . (2,500) (1,250) Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,268 $83,460

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 1,100 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . 875 500 Unearned computer service revenue . . . . . . . . 0 1,500 Total current liabilities . . . . . . . . . . . . . . . . . . . . 875 3,100

Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 98,000 73,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . 21,393 7,360 Total liabilities and equity. . . . . . . . . . . . . . . . . . $120,268 $83,460

BUSINESS SOLUTIONS Income Statement

For Three Months Ended March 31, 2020

Computer services revenue . . . . . . . . . . . . . . $25,307 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,693 Total revenue . . . . . . . . . . . . . . . . . . . . . . . . . 44,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . $14,052 Depreciation expense—Office equipment . . . 400 Depreciation expense— Computer equipment. . . . . . . . . . . . . . . . . 1,250 Wages expense. . . . . . . . . . . . . . . . . . . . . . . . 3,250 Insurance expense . . . . . . . . . . . . . . . . . . . . . 555 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . 2,475 Computer supplies expense . . . . . . . . . . . . . 1,305 Advertising expense. . . . . . . . . . . . . . . . . . . . 600 Mileage expense . . . . . . . . . . . . . . . . . . . . . . 320 Repairs expense—Computer . . . . . . . . . . . . . 960 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . 25,167 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,833

Required

Prepare a statement of cash flows for Business Solutions using the indirect method for the three months ended March 31, 2020. Recall that owner Santana Rey contributed $25,000 to the business in exchange for additional stock in the first quarter of 2020 and has received $4,800 in cash dividends.

Check Cash flows used by operations: $(515)

COMPANY ANALYSIS A1

Accounting Analysis

AA 12-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Is Apple’s statement of cash flows prepared under the direct method or the indirect method? 2. For each fiscal year 2017, 2016, and 2015, identify the amount of cash provided by operating activities

and cash paid for dividends. 3. In 2017, did Apple have sufficient cash flows from operations to pay dividends? 4. Did Apple spend more or less cash to repurchase common stock in 2017 versus 2016?

GENERAL LEDGER PROBLEM

The following General Ledger assignments highlight the impact, or lack thereof, on the statement of cash flows from summary journal entries derived from consecutive trial balances. Prepare summary journal entries reflecting changes in consecutive trial balances. Then prepare the statement of cash flows (direct method) from those entries. Finally, prepare the reconciliation to the indirect method for net cash provided (used) by operating activities.

GL 12-1 General Ledger assignment based on Exercise 12-11

GL 12-2 General Ledger assignment based on Problem 12-1

GL

GL 12-3 General Ledger assign- ment based on Problem 12-6

APPLE

494 Chapter 12 Reporting Cash Flows

ETHICS CHALLENGE C1 A1

BTN 12-1 Katie Murphy is preparing for a meeting with her banker. Her business is finishing its fourth year of operations. In the first year, it had negative cash flows from operations. In the second and third years, cash flows from operations were positive. However, inventory costs rose significantly in Year 4, and cash flows from operations will probably be down 25%. Murphy wants to secure a line of credit from her banker as a financing buffer. From experience, she knows the banker will scrutinize operating cash flows for Years 1 through 4 and will want a projected number for Year 5. Murphy knows that a steady progression upward in operating cash flows for Years 1 through 4 will help her case. She decides to use her discretion as owner and considers several business actions that will turn her operating cash flow in Year 4 from a decrease to an increase.

Required

1. Identify two business actions Murphy might take to improve cash flows from operations. 2. Comment on the ethics and possible consequences of Murphy’s decision to pursue these actions.

Beyond the Numbers

Required

1. Compute the recent two years’ cash flow on total assets ratios for Apple and Google. 2. For the current year, which company has the better cash flow on total assets ratio? 3. For the current year, does cash flow on total assets outperform or underperform the industry (as-

sumed) average of 15% for (a) Apple and (b) Google?

AA 12-2 Key figures for Apple and Google follow.

Apple Google

$ millions Current Year 1 Year Prior 2 Years Prior Current Year 1 Year Prior 2 Years Prior

Operating cash flows . . . . . . . . . $ 63,598 $ 65,824 $ 81,266 $ 37,091 $ 36,036 $ 26,572

Total assets . . . . . . . . . . . . . . . . . 375,319 321,686 290,345 197,295 167,497 147,461

COMPARATIVE ANALYSIS A1

APPLE GOOGLE

BTN 12-2 Your friend, Diana Wood, recently completed the second year of her business and just received annual financial statements from her accountant. Wood finds the income statement and balance sheet informative but does not understand the statement of cash flows. She says the first section is especially confusing because it contains a lot of additions and subtractions that do not make sense to her. Wood adds, “The income statement tells me the business is more profitable than last year and that’s most important. If I want to know how cash changes, I can look at comparative balance sheets.”

Required

Write a half-page memorandum to your friend explaining the purpose of the statement of cash flows. Speculate as to why the first section is so confusing and how it might be rectified.

COMMUNICATING IN PRACTICE C1

BTN 12-3 Access the April 14, 2016, filing of the 10-K report (for year ending December 31, 2015) of Mendocino Brewing Company, Inc. (ticker: MENB) at SEC.gov.

Required

1. Does Mendocino Brewing use the direct or indirect method to construct its consolidated statement of cash flows?

TAKING IT TO THE NET A1

GLOBAL ANALYSIS C1

AA 12-3 Key comparative information for Samsung, Apple, and Google follows.

Required

1. Compute the recent two years’ cash flow on total assets ratio for Samsung. 2. Is the change in Samsung’s cash flow on total assets ratio favorable or unfavorable? 3. For the current year, is Samsung’s cash flow on total assets ratio better or worse than (a) Apple’s and

(b) Google’s?

Samsung APPLE GOOGLE

Samsung Apple Google

Current 1 Year 2 Years Current 1 Year Current 1 Year In millions Year Prior Prior Year Prior Year Prior

Operating cash flows . . . . . W 62,162,041 W 47,385,644 W 40,061,761 $ 63,598 $ 65,824 $ 37,091 $ 36,036

Total assets . . . . . . . . . . . . . 301,752,090 262,174,324 242,179,521 375,319 321,686 197,295 167,497

Chapter 12 Reporting Cash Flows 495

BTN 12-4 Team members are to coordinate and independently answer one question within each of the follow- ing three sections. Team members should then report to the team and confirm or correct teammates’ answers. 1. Answer one of the following questions about the statement of cash flows: (a) What are this statement’s

reporting objectives? (b) What two methods are used to prepare it? Identify similarities and differ- ences between them. (c) What steps are followed to prepare the statement? (d) What types of analyses are often made from this statement’s information?

2. Identify and explain the adjustment from net income to obtain cash flows from operating activities using the indirect method for one of the following items: (a) Noncash operating revenues and expenses. (b) Nonoperating gains and losses. (c) Increases and decreases in noncash current assets. (d) Increases and decreases in current liabilities.

3.B Identify and explain the formula for computing cash flows from operating activities using the direct method for one of the following items: (a) Cash receipts from sales to customers. (b) Cash paid for inventory. (c) Cash paid for wages and operating expenses. (d) Cash paid for interest and taxes.

TEAMWORK IN ACTION C1 A1 P2 P5

Note: For teams of more than four, some pairing within teams is nec- essary. Use as an in-class activity or as an assignment. If used in class, specify a time limit on each part. Conclude with reports to the entire class, using team rotation. Each team can prepare responses on a transparency.

BTN 12-5 Review the chapter’s opener involving Vera Bradley and its founder, Barbara Bradley.

Required

1. In a business such as Vera Bradley, monitoring cash flow is always a priority. Explain how cash flow can lag behind net income.

2. What are potential sources of financing for Vera Bradley’s future expansion?

ENTREPRENEURIAL DECISION C1 A1

BTN 12-7 Visit The Motley Fool’s web page on cash flow based valuation (Fool.com/how-to-invest/ how-to-value-stocks-cash-flow-based-valuations.aspx).

Required

1. How does the Motley Fool define cash flow? What is the reasoning for this definition? 2. Per the Fool’s instruction, why do analysts focus on earnings before interest and taxes (EBIT)? 3. Visit other links at this website that interest you such as “How to Read a Balance Sheet,” or find out

what the “Fool’s Ratio” is. Write a half-page report on what you find.

HITTING THE ROAD C1

BTN 12-6 Jenna and Matt Wilder are completing their second year operating Mountain High, a downhill ski area and resort. Mountain High reports a net loss of $(10,000) for its second year, which includes an $85,000 unusual loss from fire. This past year also involved major purchases of plant assets for renovation and expansion, yielding a year-end total asset amount of $800,000. Mountain High’s net cash outflow for its second year is $(5,000); a summarized version of its statement of cash flows follows.

ENTREPRENEURIAL DECISION C1 A1

Required

Write a one-page memorandum to the Wilders evaluating Mountain High’s current performance and as- sessing its future. Give special emphasis to cash flow data and their interpretation.

Net cash flow provided by operating activities . . . . . . . . . . . . . . $ 295,000 Net cash flow used by investing activities . . . . . . . . . . . . . . . . . . (310,000) Net cash flow provided by financing activities . . . . . . . . . . . . . . 10,000

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2. For the year ended December 31, 2015, what is the largest item in reconciling the net income (or loss) to net cash provided by operating activities?

3. In the recent two years, has the company been more successful in generating operating cash flows or in generating net income? Identify the figures to support the answer.

4. In the year ended December 31, 2015, what was the largest cash outflow for investing activities and for financing activities?

5. What item(s) does the company report as supplemental cash flow information? 6. Does the company report any noncash financing activities for 2015? Identify them, if any.

Learning Objectives

CONCEPTUAL C1 Explain the purpose and identify the

building blocks of analysis.

C2 Describe standards for comparisons in analysis.

PROCEDURAL P1 Explain and apply methods of horizontal

analysis.

P2 Describe and apply methods of vertical analysis.

P3 Define and apply ratio analysis.

ANALYTICAL A1 Summarize and report results of analysis.

A2 Appendix 13A—Explain the form and assess the content of a complete income statement.

Chapter Preview

13 Analysis of Financial Statements

HORIZONTAL ANALYSIS

P1 Application of: Comparative balance sheets

Comparative income statements

Trend analysis

VERTICAL ANALYSIS

P2 Application of: Common-size balance sheet

Common-size income statement

Common-size graphics

BASICS OF ANALYSIS

C1 Analysis purpose Building blocks

C2 Standards for comparisons

Analysis tools

RATIO ANALYSIS AND REPORTING

P3 Liquidity and efficiency

Solvency

Profitability

Market prospects

A1 Analysis reports

NTK 13-3NTK 13-1 NTK 13-2

497

“Expect to win!”—Carla Harris

Numbers Rule

NEW YORK—“I grew up as an only child in a no-nonsense, no- excuses household,” recalls Carla Harris. “My parents gave me the sense that I was supposed to do well.” Fast-forward and Carla is now vice chair of Morgan Stanley’s (MorganStanley.com) prized Global Wealth Management division and past-chair of the Morgan Stanley Foundation.

Carla Harris and her colleagues at Morgan Stanley analyze financial statements for profit. One of Morgan Stanley’s key tools for analysis is ModelWare. ModelWare is a framework to analyze the nuts and bolts of companies’ financial statements and then to compare those companies head-to-head. One of its key aims is to provide comparable information that focuses on sustainable performance.

Morgan Stanley uses the accounting numbers in financial statements to produce comparable metrics using techniques such as horizontal and vertical analysis. It also computes finan- cial ratios for analysis and interpretation. Those ratios include return on equity, return on assets, asset turnover, profit margin, price-to-earnings, and many other accounting measures. The focus is to uncover the drivers of profitability and to predict future levels of those drivers.

Carla has experienced much success through analyzing financial statements. As Carla likes to say, “I’m tough and

analytical!” She says that people do not take full advantage of information available in financial statements.

Carla plays by the rules and asserts that those with account- ing know-how continue to earn profits from financial statement analysis and interpretation. Carla is proud of her success and adds: “Always start from a place of doing the right thing.”

Sources: Morgan Stanley website, January 2019; MorganStanleyIQ, November 2007; Alumni.HBS.edu/Stories, September 2006; Fortune, August 2013 and March 2016

©Jonathan Leibson/AOL/Getty Images

Financial statement analysis applies analytical tools to financial statements and related data for making business decisions.

Purpose of Analysis Internal users of accounting information manage and operate the company. They include man- agers, officers, and internal auditors. The purpose of financial statement analysis for internal users is to provide information to improve efficiency and effectiveness.

External users of accounting information are not directly involved in running the company. External users use financial statement analysis to pursue their own goals. Shareholders and creditors assess company performance to make investing and lending decisions. A board of directors analyzes financial statements to monitor management’s performance. External audi- tors use financial statements to assess “fair presentation” of financial results.

The common goal of these users is to evaluate company performance and financial condition. This includes evaluating past and current performance, current financial position, and future performance and risk.

Building Blocks of Analysis Financial statement analysis focuses on one or more of the four building blocks of financial statement analysis. The four building blocks cover different, but interrelated, aspects of financial condition or performance. Liquidity and efficiency—ability to meet short-term obligations and to efficiently

generate revenues. Solvency—ability to meet long-term obligations and generate future revenues. Profitability—ability to provide financial rewards to attract and retain financing. Market prospects—ability to generate positive market expectations.

Point: Financial statement analysis is a topic on the CPA, CMA, CIA, and CFA exams.

BASICS OF ANALYSIS C1 Explain the purpose and identify the building blocks of analysis.

Solvency Market prospects

Liquidity &

efficiency

Profitability

498 Chapter 13 Analysis of Financial Statements

Information for Analysis Financial analysis uses general-purpose financial statements that include the (1) income statement, (2) balance sheet, (3) statement of stockholders’ equity (or statement of retained earnings), (4) statement of cash flows, and (5) notes to these statements.

Financial reporting is the communication of financial information useful for making invest- ment, credit, and other business decisions. Financial reporting includes general-purpose finan- cial statements, information from SEC 10-K and other filings, press releases, shareholders’ meetings, forecasts, management letters, and auditors’ reports.

Management’s Discussion and Analysis (MD&A) is one example of useful information out- side usual financial statements. Apple’s MD&A (available at Investor.Apple.com and “Item 7” in the annual report) begins with an overview, followed by critical accounting policies and esti- mates. It then discusses operating results followed by financial condition (liquidity, capital resources, and cash flows). The final few parts discuss risks. The MD&A is an excellent starting point in understanding a company’s business.

Standards for Comparisons When analyzing financial statements, we use the following standards (benchmarks) for com- parisons. Benchmarks from a competitor or group of competitors are often best. Intracompany and industry measures are also good. Guidelines can be applied, but only if they seem reason- able given recent experience. Intracompany—The company’s current performance is compared to its prior performance

and its relations between financial items. Apple’s current net income, for example, can be compared with its prior years’ net income and in relation to its revenues or total assets.

Competitor—Competitors provide standards for comparisons. Coca-Cola’s profit margin can be compared with PepsiCo’s profit margin.

Industry—Industry statistics provide standards of comparisons. Intel’s profit margin can be compared with the industry’s profit margin.

Guidelines (rules of thumb)—Standards of comparison can develop from experience. Examples are the 2:1 level for the current ratio or 1:1 level for the acid-test ratio.

Tools of Analysis There are three common tools of financial statement analysis. This chapter describes these anal- ysis tools and how to apply them.

1. Horizontal analysis—comparison of financial condition and performance across time. 2. Vertical analysis—comparison of financial condition and performance to a base amount. 3. Ratio analysis—measurement of key relations between financial statement items.

C2 Describe standards for comparisons in analysis.

Point: Each chapter’s Accounting Analysis problems cover intra- company analysis. Comparative Analysis problems cover competi- tor analysis (Apple vs. Google vs. Samsung).

Income Statement

Balance Sheet

Statement of Stockholders' Equity

Statement ofCash Flows

Notes

Income Statement

Balance Sheet

Statement of Stockholders’ Equity

Statement ofCash Flows

Notes

Stock in Trade Blue chips are stocks of big, established companies. The phrase comes from poker, where the most valuable chips are blue. Brokers execute orders to buy or sell stock. The term comes from wine retailers—individuals who broach (break) wine casks. ■

Decision Insight

Horizontal analysis is the review of financial statement data across time. Horizontal comes from the left-to-right (or right-to-left) movement of our eyes as we review comparative financial statements across time.

Comparative Statements Comparative financial statements show financial amounts in side-by-side col- umns on a single statement, called a comparative format. Using Apple’s financial statements, this section explains how to compute dollar changes and percent changes for comparative statements.

HORIZONTAL ANALYSIS P1 Explain and apply methods of horizontal analysis.

2018 Report 2019 Report

Chapter 13 Analysis of Financial Statements 499

Dollar Changes and Percent Changes Comparing financial statements is often done by analyzing dollar amount changes and percent changes in line items. Both analyses are relevant because small dollar changes can yield large percent changes inconsistent with their im- portance. A 50% change from a base figure of $100 is less important than a 50% change from a base amount of $100,000. We compute the dollar change for a financial statement item as follows.

Dollar change = Analysis period amount − Base period amount

Analysis period refers to the financial statements under analysis, and base period refers to the financial statements used for comparison. The prior year is commonly used as a base period. We compute the percent change as follows.

Percent change (%) = Analysis period amount − Base period amount

Base period amount × 100

We must know a few rules in working with percent changes. Let’s look at four separate cases. Cases A and B: When a negative amount is in one period and a positive amount is in the

other, we cannot compute a meaningful percent change. Case C: When no amount is in the base period, no percent change is computable. Case D: When a positive amount is in the base period and zero is in the analysis period, the

decrease is 100%.

Example: When there is a value in the base period and zero in the analysis period, the decrease is 100%. Why isn’t the reverse situation an increase of 100%? Answer: A 100% increase of zero is still zero.

Change Analysis Analysis Base

Case Period Period Dollar Percent

A $ 1,500 $(4,500) $ 6,000 — B (1,000) 2,000 (3,000) — C 8,000 — 8,000 — D 0 10,000 (10,000) (100%)

Comparative Balance Sheets Analysis of comparative financial statements begins by focusing on large dollar and percent changes. We then identify the reasons and implications for these changes. We also review small changes when we expected large changes.

Exhibit 13.1 shows comparative balance sheets for Apple Inc. (ticker: AAPL). A few items stand out on the asset side. Apple’s short-term marketable securities increased by 15.5%, and its long-term marketable securities increased by 14.2%. This combined for a large $31,505 million increase in securities. In response, Apple raised its dividend and announced plans to spend at least $210 billion buying back stock by the end of the next year. Dividends and share repurchase plans are likely to slow Apple’s growth of short-term securities. Other notable increases occur with (1) property, plant and equipment, partially related to its new headquarters, and (2) inventories, which had a high percentage increase but relatively small dollar increase.

On Apple’s financing side, we see its overall 16.7% increase is driven by a 24.7% increase in liabilities; equity increased only 4.5%. The largest increase is from long-term debt, which increased by $21,780 million, or 28.9%. Much of this increase results from bond offerings by Apple to take advantage of low interest rates. We also see a modest increase of 2.0% ($1,966 million) in retained earnings, which was increased by a strong income of $48,351 million and reduced by cash dividends and stock repurchases.

Comparative Income Statements Exhibit 13.2 shows Apple’s comparative in- come statements. Apple reports an increase in sales of 6.3%. Cost of sales increased to a greater extent than sales (7.4%), which is not a positive sign. The 10.7% increase in operating expenses is primarily driven by the 15.3% increase in research and development costs, from which management and investors hope to reap future income. While Apple’s net income increased just 5.8%, its basic earnings per share increased 11.0%. This is largely due to Apple’s share buyback program.

500 Chapter 13 Analysis of Financial Statements

APPLE INC. Comparative Year-End Balance Sheets

$ millions Current Yr Prior Yr Dollar Change Percent Change

Assets Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 $ 20,484 $ (195) (1.0)% Short-term marketable securities . . . . . . . . . . . . . . . . . . . 53,892 46,671 7,221 15.5 Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874 15,754 2,120 13.5 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,855 2,132 2,723 127.7 Vendor non-trade receivables . . . . . . . . . . . . . . . . . . . . . . 17,799 13,545 4,254 31.4 Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,936 8,283 5,653 68.2 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,645 106,869 21,776 20.4 Long-term marketable securities . . . . . . . . . . . . . . . . . . . . 194,714 170,430 24,284 14.2 Property, plant and equipment, net . . . . . . . . . . . . . . . . . . 33,783 27,010 6,773 25.1 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,717 5,414 303 5.6 Acquired intangible assets, net . . . . . . . . . . . . . . . . . . . . . 2,298 3,206 (908) (28.3) Other non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 10,162 8,757 1,405 16.0 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 $321,686 $53,633 16.7

Liabilities Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 $ 37,294 $11,755 31.5% Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,744 22,027 3,717 16.9 Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,548 8,080 (532) (6.6) Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,977 8,105 3,872 47.8 Current portion of long-term debt . . . . . . . . . . . . . . . . . . . 6,496 3,500 2,996 85.6 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 100,814 79,006 21,808 27.6 Deferred revenue—non-current . . . . . . . . . . . . . . . . . . . . . 2,836 2,930 (94) (3.2) Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,207 75,427 21,780 28.9 Other non-current liabilities . . . . . . . . . . . . . . . . . . . . . . . . 40,415 36,074 4,341 12.0 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,272 193,437 47,835 24.7

Stockholders’ Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 31,251 4,616 14.8 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,330 96,364 1,966 2.0 Accumulated other comprehensive income . . . . . . . . . . . (150) 634 (784) — Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . 134,047 128,249 5,798 4.5 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . $375,319 $321,686 $53,633 16.7

EXHIBIT 13.1 Comparative Balance Sheets

APPLE

APPLE INC. Comparative Income Statements

$ millions, except per share Current Yr Prior Yr Dollar Change Percent Change

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 $13,595 6.3% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 9,672 7.4 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 3,923 4.7 Research and development . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 1,536 15.3 Selling, general and administrative . . . . . . . . . . . . . . . . . . 15,261 14,194 1,067 7.5 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 2,603 10.7 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 1,320 2.2 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1,397 103.6 Income before provision for income taxes . . . . . . . . . . . . 64,089 61,372 2,717 4.4 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 53 0.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 2,664 5.8 Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9 .27 $ 8 .35 $ 0.92 11.0 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . $ 9 .21 $ 8 .31 $ 0.90 10.8

EXHIBIT 13.2 Comparative Income Statements

APPLE

Point: Percent change is also computed by dividing the current period by the prior period and then subtracting 1.0.

Chapter 13 Analysis of Financial Statements 501

Trend Analysis Trend analysis is computing trend percents that show patterns in data across periods. Trend percent is computed as follows.

$0 2017 2007 2014 2005

$100

Millions Rati

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

Financial Results

400 600 1,200

Point: Index refers to the compari- son of the analysis period to the base period. Percents determined for each period are called index numbers.

Trend percent (%) = Analysis period amount

Base period amount × 100

Trend analysis is shown in Exhibit 13.3 using data from Apple’s current and prior financial statements.

$ millions Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago 4 Yrs Ago

Net sales . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 $233,715 $182,795 $170,910

Cost of sales . . . . . . . . . . . . . . . . . . 141,048 131,376 140,089 112,258 106,606

Operating expenses . . . . . . . . . . . . 26,842 24,239 22,396 18,034 15,305

EXHIBIT 13.3 Sales and Expenses

The trend percents—using data from Exhibit 13.3—are shown in Exhibit 13.4. The base period is the number reported four years ago, and the trend percent is computed for each year by divid- ing that year’s amount by the base period amount. For example, the net sales trend percent for the current year is 134.1%, computed as $229,234/$170,910.

In trend percent Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago 4 Yrs Ago

Net sales . . . . . . . . . . . . . . . . . . . . . 134 .1% 126 .2% 136 .7% 107 .0% 100 .0%

Cost of sales . . . . . . . . . . . . . . . . . . 132 .3 123 .2 131 .4 105 .3 100 .0

Operating expenses . . . . . . . . . . . . 175 .4 158 .4 146 .3 117 .8 100 .0

EXHIBIT 13.4 Trend Percents for Sales and Expenses

Exhibit 13.5 shows the trend percents from Exhibit 13.4 in a line graph, which helps us see trends and detect changes in direction or magnitude. It shows that the trend line for operating expenses exceeds net sales in each of the years shown. This is not positive for Apple. Apple’s net income will suffer if expenses rise faster than sales.

Exhibit 13.6 compares Apple’s revenue trend line to those of Google and Samsung. Google was able to grow revenue in each year relative to the base year. Apple was able to grow revenue overall in the last five years, but at a slower pace than Google. Samsung’s revenue was mainly flat.

Trend analysis can show rela- tions between items on different

4 Yrs Ago 3 Yrs Ago 2 Yrs Ago 1 Yr Ago Current Yr

Tr en

d Pe

rc en

t

50%

0%

200%

150%

100%

250% Net sales Cost of sales Operating expenses

EXHIBIT 13.5 Trend Percent Lines for Apple’s Sales and Expenses

Apple Google Samsung

4 Yrs Ago 3 Yrs Ago 2 Yrs Ago 1 Yr Ago Current Yr

Tr en

d in

R ev

en ue

100%

50%

0%

200%

150%

250% EXHIBIT 13.6 Revenue Trend Percent Lines—Apple, Google, and Samsung

Point: Trend analysis expresses a percent of base, not a percent of change.

APPLE

Samsung GOOGLE

502 Chapter 13 Analysis of Financial Statements

financial statements. Exhibit 13.7 compares Apple’s net sales and total assets. The increase in total assets (81.3%) has exceeded the increase in net sales (34.1%). Is

this result favorable or not? One interpretation is that Apple was less efficient in using its assets in the current year versus four years ago.

EXHIBIT 13.7 Sales and Asset Data for Apple

$ millions Current Yr 4 Yrs Ago Change

Net sales . . . . . . . . . . . . . . . $229,234 $170,910 34.1% Total assets . . . . . . . . . . . . . 375,319 207,000 81.3

Auditor Your tests reveal a 3% increase in sales from $200,000 to $206,000 and a 4% decrease in expenses from $190,000 to $182,400. Both changes are within your “reasonableness” criterion of ±5%, and thus you don’t pursue additional tests. The audit partner in charge questions your lack of follow-up and mentions the joint relation between sales and expenses. What is the partner referring to? ■ Answer: Both individual accounts (sales and expenses) yield percent changes within the ±5% acceptable range. However, a joint analysis shows an increase in sales and a decrease in expenses producing a more than 5% increase in income. This client’s profit margin is 11.46% ([$206,000 − $182,400]/$206,000) for the current year compared with 5.0% ([$200,000 − $190,000]/$200,000) for the prior year—a 129% increase!

Decision Maker

Compute trend percents for the following accounts using 3 Years Ago as the base year. Indicate whether the trend appears to be favorable or unfavorable for each account.

Horizontal Analysis

NEED-TO-KNOW 13-1

P1 $ millions Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago

Sales . . . . . . . . . . . . . . . . . . . . . . $500 $350 $250 $200

Cost of goods sold . . . . . . . . . . . 400 175 100 50

Solution

$ millions Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago

Sales . . . . . . . . . . . . . . . . . . . . . . 250% 175% 125% 100% ($500∕$200) ($350∕$200) ($250∕$200) ($200∕$200)

Cost of goods sold . . . . . . . . . . . 800% 350% 200% 100% ($400∕$50) ($175∕$50) ($100∕$50) ($50∕$50)

Analysis: The trend in sales is favorable; however, we need more information about economic condi- tions and competitors’ performances to better assess it. Cost of goods sold also is rising (as expected with increasing sales). However, cost of goods sold is rising faster than the increase in sales, which is bad news.

Do More: QS 13-3, QS 13-4, E 13-3

Vertical analysis, or common-size analysis, is used to evaluate individual financial statement items or a group of items. Vertical comes from the up-down [or down-up] movement of our eyes as we review common-size financial statements.

Common-Size Statements The comparative statements in Exhibits 13.1 and 13.2 show the change in each item over time. Common-size financial statements show changes in the relative importance of each financial statement item. All individual amounts in common-size statements are shown in common-size percents. A common-size percent is calculated as

VERTICAL ANALYSIS P2 Describe and apply methods of vertical analysis.

Sales Expenses Income

10,000 6,000 4,000

Income Statement

Common-size percent (%) = Analysis amount

Base amount × 100

Point: Numerator and denominator in common-size percent are taken from the same financial statement and from the same period.

Chapter 13 Analysis of Financial Statements 503

Common-Size Balance Sheets Common-size statements show each item as a per- cent of a base amount, which for a common-size balance sheet is total assets. The base amount is assigned a value of 100%. (Total liabilities plus equity also equals 100% because this amount equals total assets.) We then compute a common-size percent for each asset, liability, and equity item using total assets as the base amount.

Exhibit 13.8 shows common-size comparative balance sheets for Apple. Two results that stand out on both a magnitude and percentage basis include (1) issuance of long-term debt—a 2.5% increase from 23.4% to 25.9%, the largest of any liability, and (2) a 3.8% decrease in retained earnings and 1% decrease in cash and cash equivalents, largely the result of cash divi- dends and stock buybacks. The absence of other substantial changes in Apple’s balance sheet suggests a mature company, but with some lack of focus as evidenced by the large amounts for securities. This buildup in securities is a concern as the return on securities is historically smaller than the return on operating assets.

Common-Size Income Statements Analysis also involves the use of a common- size income statement. Revenue is the base amount, which is assigned a value of 100%. Each income statement item is shown as a percent of revenue. If we think of the 100% revenue amount

Point: Common-size statements often are used to compare com- panies in the same industry.

APPLE INC. Common-Size Comparative Year-End Balance Sheets

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Assets Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 $ 20,484 5.4% 6.4% Short-term marketable securities . . . . . . . . . . . . . . . . . . . 53,892 46,671 14.4 14.5 Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874 15,754 4.8 4.9 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,855 2,132 1.3 0.7 Vendor non-trade receivables . . . . . . . . . . . . . . . . . . . . . . 17,799 13,545 4.7 4.2 Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,936 8,283 3.7 2.6 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,645 106,869 34.3 33.2 Long-term marketable securities . . . . . . . . . . . . . . . . . . . 194,714 170,430 51.9 53.0 Property, plant and equipment, net . . . . . . . . . . . . . . . . . 33,783 27,010 9.0 8.4 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,717 5,414 1.5 1.7 Acquired intangible assets, net . . . . . . . . . . . . . . . . . . . . . 2,298 3,206 0.6 1.0 Other non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 10,162 8,757 2.7 2.7 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 $321,686 100.0% 100.0%

Liabilities Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 $ 37,294 13.1% 11.6% Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,744 22,027 6.9 6.8 Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,548 8,080 2.0 2.5 Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,977 8,105 3.2 2.5 Current portion of long-term debt . . . . . . . . . . . . . . . . . . . 6,496 3,500 1.7 1.1 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 100,814 79,006 26.9 24.6 Deferred revenue—noncurrent . . . . . . . . . . . . . . . . . . . . . 2,836 2,930 0.8 0.9 Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,207 75,427 25.9 23.4 Other non-current liabilties . . . . . . . . . . . . . . . . . . . . . . . . 40,415 36,074 10.8 11.2 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,272 193,437 64.3 60.1

Stockholders’ Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 31,251 9.6 9.7 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,330 96,364 26.2 30.0 Accumulated other comprehensive income . . . . . . . . . . . (150) 634 0.0 0.2 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . 134,047 128,249 35.7 39.9 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . $375,319 $321,686 100.0% 100.0%

EXHIBIT 13.8 Common-Size Comparative Balance Sheets

APPLE

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s net sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase of 0.4 cents in research and development costs, which can be a positive development if these costs lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling, general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that segment’s operating income margin (Operating income/Segment net sales). The Americas seg- ment has a 32% operating income margin. This type of graphic can raise questions about the profitability of each segment and lead to discussion of further expansions into more profitable segments. For example, the Japan segment has an operating margin of 46%. A natural question for management is what potential is there to expand sales into the Japan segment and maintain

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$0

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7 Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6 Income before provision for income taxes . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

Chapter 13 Analysis of Financial Statements 505

this operating margin? This type of analysis can help determine strategic plans.

Graphics also are used to identify (1) sources of financing, including the distribution among current liabilities, noncurrent liabilities, and equity capital, and (2) focuses of investing activities, including the distribution among current and noncurrent assets. Exhibit 13.12 shows a common-size graphic of Apple’s assets, a high percentage of which are in securities, followed by property, plant and equipment.

Common-size financial statements are useful in comparing companies. Exhibit 13.13 shows com- mon-size graphics of Apple, Google, and Samsung on financing sources. This graphic shows the larger percent of equity financing for Google versus Apple and Samsung. It also shows the larger non- current debt financing of Apple versus Google and Samsung. Comparison of a company’s common- size statements with competitors’ or industry com- mon-size statistics alerts us to differences in the structure of its financial statements.

EXHIBIT 13.12 Common-Size Graphic of Asset Components

Cash and cash equivalents 5%

Short-term marketable securities 14%

Accounts receivable, net 5%

Long-term marketable securities 52%

Acquired intangible assets, net 1%

Other long-term assets 3%

Inventories 1%

Goodwill 2%

Property, plant & equipment, net 9%

Vendor non-trade receivables 5%

Other current assets 3%

Truth Be Told In a survey of nearly 200 CFOs of large companies, roughly 20% say that firms use accounting tools to report earnings that do not fully reflect the firms’ underlying operations. One goal of financial analysis is to see through such ploys. The top reasons CFOs gave for this were to impact stock price, hit an earnings target, and influence executive pay (The Wall Street Journal). ■

Ethical Risk

Apple Google Samsung

36%

Current liabilities

Equity

Noncurrent liabilities 27%

37%

71%

22% 7%

77%

12% 11%

EXHIBIT 13.13 Common-Size Graphic of Financing Sources— Competitor Analysis

APPLE

Samsung GOOGLE

Express the following comparative income statements in common-size percents and assess whether this company’s situation has improved in the current year.

P2 Vertical Analysis

NEED-TO-KNOW 13-2

Comparative Income Statements

For Years Ended December 31 Current Yr Prior Yr

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800 $500

Total expenses . . . . . . . . . . . . . . . . . . . . . 560 400

Net income . . . . . . . . . . . . . . . . . . . . . . . . $240 $100

Current Yr Prior Yr

Sales . . . . . . . . . . . . 100% 100% ($800∕$800) ($500∕$500)

Total expenses . . . . 70% 80% ($560∕$800) ($400∕$500)

Net income . . . . . . . 30% 20%

Analysis: This company’s situation has improved. This is evident from its substantial increase in net income as a percent of sales for the current year (30%) relative to the prior year (20%). Further, the company’s sales increased from $500 to $800 (while expenses declined as a percent of sales from 80% to 70%).

Do More: QS 13-5, E 13-4, E 13-5, E 13-6

Solution

506 Chapter 13 Analysis of Financial Statements

Ratios are used to uncover conditions and trends difficult to detect by looking at individual amounts. A ratio shows a relation between two amounts. It can be shown as a percent, rate, or proportion. A change from $100 to $250 can be shown as (1) 150% increase, (2) 2.5 times, or (3) 2.5 to 1 (or 2.5:1). To be useful, a ratio must show an economically important relation. For example, a ratio of cost of goods sold to sales is useful, but a ratio of freight costs to patents is not.

This section covers important financial ratios organized into the four building blocks of financial statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market pros- pects. We use four standards for comparison: intracompany, competitor, industry, and guidelines.

Liquidity and Efficiency Liquidity is the availability of resources to pay short-term cash requirements. It is affected by the timing of cash inflows and outflows along with prospects for future performance. A lack of

liquidity often is linked to lower profitability. To creditors, lack of liquidity can cause delays in collecting payments. Efficiency is how productive a company is in using its assets. Inefficient use of assets can cause liquidity problems. This section covers key ratios used to assess liquidity and efficiency.

Working Capital and Current Ratio The amount of current assets minus cur- rent liabilities is called working capital, or net working capital. A company that runs low

on working capital is less likely to pay debts or to continue operating. When evaluating a compa- ny’s working capital, we look at the dollar amount of current assets minus current liabilities and at their ratio. The current ratio is defined as follows (see Chapter 3 for additional explanation).

RATIO ANALYSIS P3 Define and apply ratio analysis.

Ratios

Current ratio = Current assets

Current liabilities

Apple’s working capital and current ratio are shown in Exhibit 13.14. Also, Google’s (5.14), Samsung’s (2.19), and the industry’s (2.5) current ratios are shown in the margin. Although its ratio (1.28) is lower than competitors’ ratios, Apple is not in danger of defaulting on loan payments. A high current ratio suggests a strong abil- ity to meet current obligations. An exces-

sively high current ratio means that the company has invested too much in current assets compared to current obligations. An excessive investment in current assets is not an efficient use of funds because current assets normally earn a low return on investment (compared with long-term assets).

Many analysts use a guideline of 2:1 (or 1.5:1) for the current ratio. A 2:1 or higher ratio is con- sidered low risk in the short run. Analysis of the current ratio, and many other ratios, must consider type of business, composition of current assets, and turnover rate of current asset components. Business Type A service company that grants little or no credit and carries few inventories

can probably operate on a current ratio of less than 1:1 if its revenues generate enough cash to pay its current liabilities. On the other hand, a company selling high-priced clothing or furniture requires a higher ratio because of difficulties in judging customer demand and cash receipts.

Asset Composition The composition of assets is important to assess short-term liquidity. For instance, cash, cash equivalents, and short-term investments are more liquid than ac- counts and notes receivable. An excessive amount of receivables and inventory weakens a company’s ability to pay current liabilities.

Turnover Rate Asset turnover measures efficiency in using assets. A measure of asset efficiency is revenue generated.

Global: Ratio analysis is unaffected by currency but is affected by dif- ferences in accounting principles.

EXHIBIT 13.14 Apple’s Working Capital and Current Ratio

$ millions Current Yr Prior Yr

Current assets . . . . . . . . . . . . . . $128,645 $106,869

Current liabilities . . . . . . . . . . . . 100,814 79,006

Working capital . . . . . . . . . . . . $ 27,831 $ 27,863 Current ratio $128,645/$100,814 = 1.28 to 1 $106,869/$79,006 = 1.35 to 1

Current ratio Google = 5.14 Samsung = 2.19 Industry = 2.5

Chapter 13 Analysis of Financial Statements 507

Banker A company requests a one-year, $200,000 loan for expansion. This company’s current ratio is 4:1, with current assets of $160,000. Key competitors have a current ratio of 1.9:1. Using this information, do you approve the loan? ■ Answer: The loan application is likely approved for at least two reasons. First, the current ratio suggests an ability to meet short-term obligations. Second, current assets of $160,000 and a current ratio of 4:1 imply current liabilities of $40,000 (one-fourth of current assets) and a working capital excess of $120,000. The working capital is 60% of the loan.

Decision Maker

Acid-Test Ratio Quick assets are cash, short-term investments, and current receivables. These are the most liquid types of current assets. The acid-test ratio, also called quick ratio and introduced in Chapter 4, evaluates a company’s short-term liquidity.

Acid-test ratio = Cash + Short-term investments + Current receivables

Current liabilities

Apple’s acid-test ratio is computed in Exhibit 13.15. Apple’s acid-test ratio (0.91) is lower than those for Google (4.97), Samsung (1.71), and the 1:1 common guideline for an acceptable acid-test ratio. As with analysis of the current ratio, we must consider other factors. How frequently a company converts its current assets into cash also affects its ability to pay current obligations. This means analysis of short- term liquidity should consider receivables and inventories, which we cover next.

Accounts Receivable Turnover Accounts receivable turnover measures how fre- quently a company converts its receivables into cash. This ratio is defined as follows (see Chapter 7 for additional explanation). Apple’s accounts receivable turnover is computed next to the formula ($ millions). Apple’s turnover of 13.6 exceeds Google’s 6.8 and Samsung’s 9.2 turnover. Accounts receivable turnover is high when accounts receivable are quickly collected. A high turnover is favorable because it means the company does not tie up assets in accounts receivable. However, accounts receivable turnover can be too high; this can occur when credit terms are so restrictive that they decrease sales.

EXHIBIT 13.15 Acid-Test Ratio

$ millions Current Yr Prior Yr

Cash and equivalents . . . . . . . . . . . . $ 20,289 $20,484

Short-term securities . . . . . . . . . . . . 53,892 46,671

Current receivables . . . . . . . . . . . . . 17,874 15,754

Total quick assets . . . . . . . . . . . . . . . $ 92,055 $82,909

Current liabilities . . . . . . . . . . . . . . . . $100,814 $79,006

Acid-test ratio $92,055/$100,814 = 0.91 to 1 $82,909/$79,006 = 1.05 to 1

Acid-test ratio Google = 4.97 Samsung = 1.71 Industry = 0.9

Accounts receivable turnover Google = 6.8 Samsung = 9.2 Industry = 5.0

Accounts receivableturnover = Net sales

Average accounts receivable, net = $229,234

($15,754 + $17,874)/2 = 13.6 times

Inventory Turnover Inventory turnover measures how long a company holds inventory before selling it. It is defined as follows (see Chapter 5 for additional explanation). Next to the formula we compute Apple’s inventory turnover at 40.4. Apple’s inventory turnover is higher than Samsung’s 6.0 but lower than Google’s 89.6. A company with a high turnover requires a smaller investment in inventory than one producing the same sales with a lower turnover. However, high inventory turnover can be bad if inventory is so low that stock-outs occur.

Inventory turnover = Cost of goods sold Average inventory

= $141,048

($2,132 + $4,855)/2 = 40.4 times

Days’ Sales Uncollected Days’ sales uncollected measures how frequently a company collects accounts receivable and is defined as follows (Chapter 6 provides additional explana- tion). Apple’s days’ sales uncollected of 28.5 days is shown next to the formula. Both Google’s days’ sales uncollected of 60.4 days and Samsung’s 48.5 days are more than the 28.5 days for Apple. Days’ sales uncollected is more meaningful if we know company credit terms. A rough

Inventory turnover Google = 89.6 Samsung = 6.0 Industry = 7.0

©VCG/Getty Images

508 Chapter 13 Analysis of Financial Statements

Total Asset Turnover Total asset turnover measures a company’s ability to use its as- sets to generate sales and reflects on operating efficiency. The definition of this ratio follows (Chapter 8 offers additional explanation). Apple’s total asset turnover of 0.66 is shown next to the formula. Apple’s turnover is greater than that for Google (0.61), but not Samsung (0.85).

Days’ sales in inventory = Ending inventory Cost of goods sold

× 365 = $4,855

$141,048 × 365 = 12.6 days

Days’ sales in inventory Google = 6.0 Samsung = 70.5 Industry = 35

Days’ Sales in Inventory Days’ sales in inventory is used to evaluate inventory liquid- ity. We compute days’ sales in inventory as follows (Chapter 5 provides additional explanation). Apple’s days’ sales in inventory of 12.6 days is shown next to the formula. If the products in Apple’s inventory are in demand by customers, this formula estimates that its inventory will be converted into receivables (or cash) in 12.6 days. If all of Apple’s sales were credit sales, the conversion of inventory to receivables in 12.6 days plus the conversion of receivables to cash in 28.5 days implies that inventory will be converted to cash in about 41.1 days (12.6 + 28.5).

Point: Average collection period is estimated by dividing 365 by the accounts receivable turnover ra- tio. For example, 365 divided by an accounts receivable turnover of 12.6 indicates a 29-day aver- age collection period.

Total asset turnover = Net sales

Average total assets =

$229,234 ($375,319 + $321,686)/2

= 0.66 times Total asset turnover Google = 0.61 Samsung = 0.85 Industry = 1.1

Solvency Solvency is a company’s ability to meet long-term obligations and generate future revenues. Analysis of solvency is long term and uses broader measures than liquidity. An important part of solvency analysis is a company’s capital structure. Capital structure is a company’s makeup of equity and debt financing. Our analysis here focuses on a company’s ability to both meet its obligations and provide security to its creditors over the long run.

Debt Ratio and Equity Ratio One part of solvency analysis is to assess a company’s mix of debt and equity financing. The debt ratio (described in Chapter 2) shows total liabilities as a percent of total assets. The equity ratio shows total equity as a percent of total assets. Apple’s debt and equity ratios follow. Apple’s ratios reveal more debt than equity. A company is considered less risky if its capital structure (equity plus debt) has more equity. Debt is consid- ered more risky because of its required payments for interest and principal. Stockholders cannot require payment from the company. However, debt can increase income for stockholders if the company earns a higher return than interest paid on the debt.

Point: For analysis purposes, noncontrolling interest is usually included in equity.

Point: Total of debt and equity ratios always equals 100%.

$ millions Current Yr Ratios

Total liabilities . . . . . . . . . . . . . . . . . . . . . . $241,272 64.3% [Debt ratio] Total equity . . . . . . . . . . . . . . . . . . . . . . . . 134,047 35.7% [Equity ratio] Total liabilities and equity . . . . . . . . . . . . . $375,319 100 .0%

Debt ratio :: Equity ratio Google = 22.7% :: 77.3% Samsung = 28.9% :: 71.1% Industry = 35% :: 65%

Days’ sales uncollected = Accounts receivable, net

Net sales × 365 =

$17,874 $229,234

× 365 = 28.5 daysDays’ sales uncollectedGoogle = 60.4 Samsung = 48.5

guideline states that days’ sales uncollected should not exceed 11⁄3 times the days in its (1) credit period, if discounts are not offered, or (2) discount period, if favorable discounts are offered.

Debt-to-Equity Ratio The debt-to-equity ratio is another measure of solvency. We com- pute the ratio as follows (Chapter 10 offers additional explanation). Apple’s debt-to-equity ratio of 1.80 is shown next to the formula. Apple’s ratio is higher than those of Google (0.29) and Samsung (0.41), and greater than the industry ratio of 0.6. Apple’s capital structure has more

Chapter 13 Analysis of Financial Statements 509

debt than equity. Debt must be repaid with interest, while equity does not. Debt payments can be burdensome when the industry and/or the economy experience a downturn.

Times Interest Earned The amount of income before subtracting interest expense and in- come tax expense is the amount available to pay interest expense. The following times interest earned ratio measures a company’s ability to pay interest (see Chapter 9 for additional explanation).

Debt-to-equity ratio = Total liabilities

Total equity =

$241,272 $134,047

= 1.80 Debt-to-equity Google = 0.29 Samsung = 0.41 Industry = 0.6

$48,351 + $2,323 + $15,738 $2,323

= 28.6 times Times interest earned Google = 250.5 Samsung = 86.7

Times interest earned = Income before interest expense and income tax expense

Interest expense

The larger this ratio is, the less risky the company is for creditors. One guideline says that creditors are reasonably safe if the company has a ratio of two or more. Apple’s times interest earned ratio of 28.6 follows. It suggests that creditors have little risk of nonrepayment.

Profitability Profitability is a company’s ability to earn an adequate return. This section covers key profit- ability measures.

Profit Margin Profit margin measures a company’s ability to earn net income from sales (Chapter 3 offers additional explanation). Apple’s profit margin of 21.1% is shown next to the formula. To evaluate profit margin, we must consider the industry. For instance, an appliance company might require a profit margin of 15%, whereas a retail supermarket might require a profit margin of 2%. Apple’s 21.1% profit margin is better than Google’s 11.4%, Samsung’s 17.6%, and the industry’s 11% margin.

Profit margin = Net income

Net sales =

$48,351 $229,234

= 21.1% Profit margin Google = 11.4% Samsung = 17.6% Industry = 11%

Return on Total Assets Return on total assets is defined as follows. Apple’s return on total assets of 13.9% is shown next to the formula. Apple’s 13.9% return on total assets is higher than Google’s 6.9% and the industry’s 8%, but lower than Samsung’s 15.0%. We also should evaluate any trend in the return.

Return on total assets = Net income

Average total assets =

$48,351 ($375,319 + $321,686)/2

= 13.9% Return on total assets Google = 6.9% Samsung = 15.0% Industry = 8%

The relation between profit margin, total asset turnover, and return on total assets follows.

Profit margin × Total asset turnover = Return on total assets

Net income Net sales

× Net sales

Average total assets =

Net income Average total assets

Both profit margin and total asset turnover affect operating efficiency, as measured by return on total assets. This formula is applied to Apple as follows. This analysis shows that Apple’s supe- rior return on assets versus that of Google is driven by its high profit margin and good asset turnover.

21.1% × 0.66 = 13.9% (with rounding) Google = 11.4% × 0.61 ≃ 6.9% Samsung = 17.6% × 0.85 ≃ 15.0%

(with rounding)

510 Chapter 13 Analysis of Financial Statements

Return on Common Stockholders’ Equity The most important goal in operating a company is to earn income for its owner(s). Return on common stockholders’ equity measures a company’s ability to earn income for common stockholders and is defined as follows.

Return on common stockholders’ equity = Net income − Preferred dividends

Average common stockholders’ equity

Apple’s return on common stockholders’ equity is computed as follows. The denominator in this computation is the book value of common equity. Dividends on cumulative preferred stock are subtracted from income whether they are declared or are in arrears. If preferred stock is non- cumulative, its dividends are subtracted only if declared. Apple’s 36.9% return on common stockholders’ equity is superior to Google’s 8.7% and Samsung’s 20.5%.

$48,351 − $0 ($128,249 + $134,047)/2

= 36.9% Return on common equity Google = 8.7% Samsung = 20.5% Industry = 15%

Take It to the Street Wall Street is synonymous with financial markets, but its name comes from the street location of the original New York Stock Exchange. The street’s name comes from stockades built by early settlers to protect New York from pirate attacks. ■

Decision Insight

Market Prospects Market measures are useful for analyzing corporations with publicly traded stock. These market measures use stock price, which reflects the market’s (public’s) expectations for the company. This includes market expectations of both company return and risk.

Price-Earnings Ratio Computation of the price-earnings ratio follows (Chapter 11 provides additional explanation). This ratio is used to measure market expectations for future growth. The market price of Apple’s common stock at the start of the current fiscal year was $154.12. Using Apple’s $9.27 basic earnings per share, we compute its price-earnings ratio as follows. Apple’s price-earnings ratio is less than that for Samsung and Google, but it is higher than the industry norm for this period.

23.90 15.00 15.34 17.89 19.45 13.67 13.60 25.65 15.45 18.85 23.56 18.85 17.23

+3.58% +12.3% +5.34% +5.94% +2.13% +6.43% -11.6% +23.1% +5.56% -3.67% +11.3% +2.54% +12.3%

400.20 253.95 285.32 248.20 989.26 320.34 208.98 432.62 765.23 564.23 256.25 524.65 754.62

530.000 320.000 430.000 900.000 600.000 380.000 220.000 750.000 250.000 120.000 158.000 245.000 658.000

Price-earnings ratio = Market price per common share

Earnings per share =

$154.12 $9.27

= 16.6 PE (year-end) Google = 57.3 Samsung = 22.9 Industry = 11

Dividend Yield Dividend yield is used to compare the dividend-paying performance of different companies. We compute dividend yield as follows (Chapter 11 offers additional expla- nation). Apple’s dividend yield of 1.6%, based on its fiscal year-end market price per share of $154.12 and its $2.40 cash dividends per share, is shown next to the formula. Some companies, such as Google, do not pay dividends because they reinvest the cash to grow their businesses in the hope of generating greater future earnings and dividends.

Dividend yield = Annual cash dividends per share

Market price per share =

$2.40 $154.12

= 1.6%

Point: Low expectations = low PE. High expectations = high PE.

Bull Session A bear market is a declining market. The phrase comes from bear-skin hunters who sold the skins before the bears were caught. The term bear was then used to describe investors who sold shares they did not own in anticipation of a price decline. A bull market is a rising market. This phrase comes from the once-popular sport of bear and bull baiting. The term bull means the opposite of bear. ■

Decision Insight

Dividend yield Google = 0.0% Samsung = 1.6%

©Partner Media GmbH/Alamy Stock Photo

Chapter 13 Analysis of Financial Statements 511

Ratio Formula Measure of

Liquidity and Efficiency

Current ratio = Current assets

Current liabilities Short-term debt-paying ability

Acid-test ratio = Cash + Short-term investments + Current receivables

Current liabilities Immediate short-term debt-paying ability

Accounts receivable turnover = Net sales

Average accounts receivable, net Efficiency of collection

Inventory turnover = Cost of goods sold Average inventory

Efficiency of inventory management

Days’ sales uncollected = Accounts receivable, net

Net sales × 365 Liquidity of receivables

Days’ sales in inventory = Ending inventory

Cost of goods sold × 365 Liquidity of inventory

Total asset turnover = Net sales

Average total assets Efficiency of assets in producing sales

Solvency

Debt ratio = Total liabilities

Total assets Creditor financing and leverage

Equity ratio = Total equity Total assets

Owner financing

Debt-to-equity ratio = Total liabilities

Total equity Debt versus equity financing

Times interest earned = Income before interest expense and income tax expense

Interest expense Protection in meeting interest payments

Profitability

Profit margin ratio = Net income Net sales

Net income in each sales dollar

Gross margin ratio = Net sales − Cost of goods sold

Net sales Gross margin in each sales dollar

Return on total assets = Net income

Average total assets Overall profitability of assets

Return on common stockholders’ equity = Net income − Preferred dividends

Average common stockholdersʼ equity Profitability of owner investment

Book value per common share = Shareholdersʼ equity applicable to common shares

Number of common shares outstanding Liquidation at reported amounts

Basic earnings per share = Net income − Preferred dividends

Weighted-average common shares outstanding Net income per common share

Market Prospects

Price-earnings ratio = Market price per common share

Earnings per share Market value relative to earnings

Dividend yield = Annual cash dividends per share

Market price per share Cash return per common share

EXHIBIT 13.16 Financial Statement Analysis Ratios

Summary of Ratios Exhibit 13.16 summarizes the ratios illustrated in this chapter and throughout the book.

512 Chapter 13 Analysis of Financial Statements

Use the following financial statements of Precision Co. to complete these requirements. 1. Prepare comparative income statements showing the percent increase or decrease for the current year

in comparison to the prior year. 2. Prepare common-size comparative balance sheets for both years. 3. Compute the following ratios for the current year and identify each one’s building block category for

financial statement analysis. a. Current ratio b. Acid-test ratio c. Accounts receivable turnover d. Days’ sales uncollected e. Inventory turnover f. Debt ratio

COMPREHENSIVE

Applying Horizontal, Vertical, and Ratio Analyses

NEED-TO-KNOW 13-4

g. Debt-to-equity ratio h. Times interest earned i. Profit margin ratio j. Total asset turnover k. Return on total assets l. Return on common stockholders’ equity

For each ratio listed, identify whether the change in ratio value from the prior year to the current year is favorable or unfavorable.

Solution

P3 Ratio Analysis

NEED-TO-KNOW 13-3

Ratio Current Yr Prior Yr Change

1 . Profit margin ratio . . . . . . . . . . . . . . . . . . . . . . 6% 8% Unfavorable

2 . Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50% 70% Favorable

3 . Gross margin ratio . . . . . . . . . . . . . . . . . . . . . . 40% 36% Favorable

4 . Accounts receivable turnover . . . . . . . . . . . . . 8 .8 9 .4 Unfavorable

5 . Basic earnings per share . . . . . . . . . . . . . . . . $2 .10 $2 .00 Favorable

6 . Inventory turnover . . . . . . . . . . . . . . . . . . . . . . 3 .6 4 .0 Unfavorable

Do More: QS 13-6 through QS 13-13, E 13-7, E 13-8, E 13-9, E 13-10, E 13-11,

P 13-4

Ratio Current Yr Prior Yr

1 . Profit margin . . . . . . . . . . . 6% 8%

2 . Debt ratio . . . . . . . . . . . . . . 50% 70%

3 . Gross margin . . . . . . . . . . . 40% 36%

Ratio Current Yr Prior Yr

4 . Accounts receivable turnover . . . . . . 8 .8 9 .4

5 . Basic earnings per share . . . . . . . . . $2 .10 $2 .00

6 . Inventory turnover . . . . . . . . . . . . . . . 3 .6 4 .0

Analysis ReportingDecision Analysis

A financial statement analysis report usually consists of six sections.

1. Executive summary—brief analysis of results and conclusions. 2. Analysis overview—background on the company, its industry, and the economy. 3. Evidential matter—financial statements and information used in the analysis, including ratios,

trends, comparisons, and all analytical measures used. 4. Assumptions—list of assumptions about a company’s industry and economic environment, and

other assumptions underlying estimates. 5. Key factors—list of favorable and unfavorable factors, both quantitative and qualitative, for com-

pany performance; usually organized by areas of analysis. 6. Inferences—forecasts, estimates, interpretations, and conclusions of the analysis report.

We must remember that the user dictates relevance, meaning that the analysis report should include a brief table of contents to help readers focus on those areas most relevant to their decisions. Finally, writing is important. Mistakes in grammar and errors of fact compromise the report’s credibility.

A1 Summarize and report results of analysis.

Short and Sweet Short selling refers to selling stock before you buy it. Here’s an example: You borrow 100 shares of Nike stock, sell them at $55 each, and receive money from their sale. You then wait. You hope that Nike’s stock price falls to, say, $50 each and you can replace the borrowed stock for less than you sold it, reaping a profit of $5 each less any transaction costs. ■

Decision Insight

Chapter 13 Analysis of Financial Statements 513

PRECISION COMPANY Comparative Income Statements

For Years Ended December 31 Current Yr Prior Yr

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,486,000 $2,075,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . 1,523,000 1,222,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . 963,000 853,000

Operating expenses

Advertising expense . . . . . . . . . . . . . . . . 145,000 100,000

Sales salaries expense . . . . . . . . . . . . . . 240,000 280,000

Office salaries expense . . . . . . . . . . . . . 165,000 200,000

Insurance expense . . . . . . . . . . . . . . . . . 100,000 45,000

Supplies expense . . . . . . . . . . . . . . . . . . 26,000 35,000

Depreciation expense . . . . . . . . . . . . . . 85,000 75,000

Miscellaneous expenses . . . . . . . . . . . . 17,000 15,000

Total operating expenses . . . . . . . . . . . 778,000 750,000

Operating income . . . . . . . . . . . . . . . . . . . . 185,000 103,000

Interest expense . . . . . . . . . . . . . . . . . . . . . 44,000 46,000

Income before taxes . . . . . . . . . . . . . . . . . . 141,000 57,000

Income tax expense . . . . . . . . . . . . . . . . . . 47,000 19,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,000 $ 38,000

Earnings per share . . . . . . . . . . . . . . . . . . . $ 0 .99 $ 0 .40

PRECISION COMPANY Comparative Year-End Balance Sheets

At December 31 Current Yr Prior Yr

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,000 $ 42,000

Short-term investments . . . . . . . . . . . . . . . . 65,000 96,000

Accounts receivable, net . . . . . . . . . . . . . . . 120,000 100,000

Merchandise inventory . . . . . . . . . . . . . . . . 250,000 265,000

Total current assets . . . . . . . . . . . . . . . . . . . 514,000 503,000

Plant assets

Store equipment, net . . . . . . . . . . . . . . . . . . 400,000 350,000

Office equipment, net . . . . . . . . . . . . . . . . . 45,000 50,000

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . 625,000 675,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000

Total plant assets . . . . . . . . . . . . . . . . . . . . . 1,170,000 1,175,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000

Liabilities Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 164,000 $ 190,000

Short-term notes payable . . . . . . . . . . . . . . 75,000 90,000

Taxes payable . . . . . . . . . . . . . . . . . . . . . . . . 26,000 12,000

Total current liabilities . . . . . . . . . . . . . . . . . 265,000 292,000

Long-term liabilities

Notes payable (secured by mortgage on buildings) . . . . . . . . . . . . . . 400,000 420,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 665,000 712,000

Stockholders’ Equity Common stock, $5 par value . . . . . . . . . . . . . . 475,000 475,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 544,000 491,000

Total stockholders’ equity . . . . . . . . . . . . . . . . 1,019,000 966,000

Total liabilities and equity . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000

PLANNING THE SOLUTION Set up a four-column income statement; enter the current-year

and prior-year amounts in the first two columns and then enter the dollar change in the third column and the percent change from the prior year in the fourth column.

Set up a four-column balance sheet; enter the current-year and prior-year year-end amounts in the first two columns and then com- pute and enter the amount of each item as a percent of total assets.

Compute the required ratios using the data provided. Use the average of beginning and ending amounts when appropriate (see Exhibit 13.16 for definitions).

SOLUTION 1.

PRECISION COMPANY Comparative Income Statements

For Years Ended December 31 Current Yr Prior Yr Dollar Change Percent Change

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,486,000 $2,075,000 $411,000 19.8% Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 1,523,000 1,222,000 301,000 24.6 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 963,000 853,000 110,000 12.9 Operating expenses Advertising expense . . . . . . . . . . . . . . . . . . . 145,000 100,000 45,000 45.0 Sales salaries expense . . . . . . . . . . . . . . . . . 240,000 280,000 (40,000) (14.3) Office salaries expense . . . . . . . . . . . . . . . . 165,000 200,000 (35,000) (17.5) Insurance expense . . . . . . . . . . . . . . . . . . . . 100,000 45,000 55,000 122.2 Supplies expense . . . . . . . . . . . . . . . . . . . . . 26,000 35,000 (9,000) (25.7) Depreciation expense . . . . . . . . . . . . . . . . . 85,000 75,000 10,000 13.3 Miscellaneous expenses . . . . . . . . . . . . . . . 17,000 15,000 2,000 13.3 Total operating expenses . . . . . . . . . . . . . . 778,000 750,000 28,000 3.7 Operating income . . . . . . . . . . . . . . . . . . . . . . . 185,000 103,000 82,000 79.6 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 44,000 46,000 (2,000) (4.3) Income before taxes . . . . . . . . . . . . . . . . . . . . . 141,000 57,000 84,000 147.4 Income tax expense . . . . . . . . . . . . . . . . . . . . 47,000 19,000 28,000 147.4 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,000 $ 38,000 $ 56,000 147.4 Earnings per share . . . . . . . . . . . . . . . . . . . . . . $ 0 .99 $ 0 .40 $ 0.59 147.5

514 Chapter 13 Analysis of Financial Statements

2. PRECISION COMPANY

Common-Size Comparative Year-End Balance Sheets Common-Size Percents

At December 31 Current Yr Prior Yr Current Yr* Prior Yr*

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,000 $ 42,000 4.7% 2.5% Short-term investments . . . . . . . . . . . . . . 65,000 96,000 3.9 5.7 Accounts receivable, net . . . . . . . . . . . . . 120,000 100,000 7.1 6.0 Merchandise inventory . . . . . . . . . . . . . . . 250,000 265,000 14.8 15.8 Total current assets . . . . . . . . . . . . . . . . . 514,000 503,000 30.5 30.0 Plant assets

Store equipment, net . . . . . . . . . . . . . . . . 400,000 350,000 23.8 20.9 Office equipment, net . . . . . . . . . . . . . . . . 45,000 50,000 2.7 3.0 Buildings, net . . . . . . . . . . . . . . . . . . . . . . 625,000 675,000 37.1 40.2 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000 5.9 6.0 Total plant assets . . . . . . . . . . . . . . . . . . . 1,170,000 1,175,000 69.5 70.0 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000 100.0% 100.0%

Liabilities Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . $ 164,000 $ 190,000 9.7% 11.3% Short-term notes payable . . . . . . . . . . . . 75,000 90,000 4.5 5.4 Taxes payable . . . . . . . . . . . . . . . . . . . . . . 26,000 12,000 1.5 0.7 Total current liabilities . . . . . . . . . . . . . . . 265,000 292,000 15.7 17.4 Long-term liabilities

Notes payable (secured by

mortgage on buildings) . . . . . . . . . . . . 400,000 420,000 23.8 25.0 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . 665,000 712,000 39.5 42.4

Stockholders’ Equity Common stock, $5 par value . . . . . . . . . . . . 475,000 475,000 28.2 28.3 Retained earnings . . . . . . . . . . . . . . . . . . . . . 544,000 491,000 32.3 29.3 Total stockholders’ equity . . . . . . . . . . . . . . . 1,019,000 966,000 60.5 57.6 Total liabilities and equity . . . . . . . . . . . . . . . $1,684,000 $1,678,000 100.0% 100.0%

*Columns do not always exactly add to 100 due to rounding.

3. Ratios: a. Current ratio: $514,000/$265,000 = 1.9:1 (liquidity and efficiency) b. Acid-test ratio: ($79,000 + $65,000 + $120,000)/$265,000 = 1.0:1 (liquidity and efficiency) c. Average receivables: ($120,000 + $100,000)/2 = $110,000 Accounts receivable turnover: $2,486,000/$110,000 = 22.6 times (liquidity and efficiency) d. Days’ sales uncollected: ($120,000/$2,486,000) × 365 = 17.6 days (liquidity and efficiency) e. Average inventory: ($250,000 + $265,000)/2 = $257,500 Inventory turnover: $1,523,000/$257,500 = 5.9 times (liquidity and efficiency) f. Debt ratio: $665,000/$1,684,000 = 39.5% (solvency) g. Debt-to-equity ratio: $665,000/$1,019,000 = 0.65 (solvency) h. Times interest earned: $185,000/$44,000 = 4.2 times (solvency) i. Profit margin ratio: $94,000/$2,486,000 = 3.8% (profitability) j. Average total assets: ($1,684,000 + $1,678,000)/2 = $1,681,000 Total asset turnover: $2,486,000/$1,681,000 = 1.48 times (liquidity and efficiency) k. Return on total assets: $94,000/$1,681,000 = 5.6% or 3.8% × 1.48 = 5.6% (profitability) l. Average total common equity: ($1,019,000 + $966,000)/2 = $992,500 Return on common stockholders’ equity: $94,000/$992,500 = 9.5% (profitability)

Chapter 13 Analysis of Financial Statements 515

APPENDIX

Sustainable Income 13A When a company’s activities include income-related events not part of its normal, continuing operations, it must disclose these events. To alert users to these activities, companies separate the income statement into continuing operations, discontinued segments, comprehensive income, and earnings per share. Exhibit 13A.1 shows such an income statement for ComUS. These separations help us measure sustain- able income, which is the income level most likely to continue into the future. Sustainable income is com- monly used in performance measures.

A2 Explain the form and assess the content of a complete income statement.

ComUS Income Statement

For Year Ended December 31

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,478,000

Operating expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,950,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Other selling, general, and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 515,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,520,000)

Other unusual and/or infrequent gains (losses)

Loss on plant relocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (45,000)

Gain on sale of surplus land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000

Income from continuing operations before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,985,000

Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (595,500)

Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,389,500

Discontinued segment Income from operating Division A (net of $180,000 taxes) . . . . . . . . . . . . . . . . . . . . . . . 420,000

Loss on disposal of Division A (net of $66,000 tax benefit) . . . . . . . . . . . . . . . . . . . . . . . (154,000) 266,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,655,500

Earnings per common share (200,000 outstanding shares) Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6 .95

Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .33

Net income (basic earnings per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8 .28

1

2

3

⎫ ⎪ ⎬ ⎪ ⎭

⎫ ⎪ ⎬ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

EXHIBIT 13A.1 Income Statement (all-inclusive) for a Corporation

1 Continuing Operations Section 1 shows revenues, expenses, and income from continu- ing operations. This information is used to predict future operations, and most view this section as the most important. Gains and losses that are normal and frequent are reported as part of continuing operations. Gains and losses that are either unusual and/or infrequent are reported as part of continuing operations but after the nor- mal revenues and expenses. Items considered unusual and/or infrequent include (1) property taken away by a foreign government, (2) condemning of property, (3) prohibiting use of an asset from a new law, (4) losses and gains from an unusual and infrequent calamity (“act of God”), and (5) financial effects of labor strikes.

2 Discontinued Segments A business segment is a part of a company that is separated by its products/services or by geographic location. A segment has assets, liabilities, and financial results of operations that can be separated from those of other parts of the company. A gain or loss from selling or closing down a segment is separately reported. Section 2 of Exhibit 13A.1 reports both (a) income from operating the discontinued segment before its disposal and (b) the loss from disposing of the segment’s net assets. The income tax effects of each are reported separately from the income tax expense in section 1 .

3 Earnings per Share Section 3 of Exhibit 13A.1 reports earnings per share for both continuing operations and discontinued segments (when they both exist). Earnings per share is covered in Chapter 11. Changes in Accounting Principles Changes in accounting principles require retrospec- tive application to prior periods’ financial statements. Retrospective application means applying a different

Point: FASB no longer allows extraordinary items.

516 Chapter 13 Analysis of Financial Statements

accounting principle to prior periods as if that principle had always been used. Retrospective application enhances the consistency of financial information between periods, which improves the usefulness of information, especially with comparative analyses.

Small Business Owner You own an orange grove near Jacksonville, Florida. A bad frost destroys about one-half of your oranges. You are currently preparing an income statement for a bank loan. Where on the income statement do you report the loss of oranges? ■ Answer: The frost loss is likely unusual, meaning it is reported in the nonrecurring section of continuing operations. Managers would highlight this loss apart from ongoing, normal results so that the bank views it separately from normal operations.

Decision Maker

BASICS OF ANALYSIS Liquidity and efficiency: Ability to meet short-term obligations and efficiently generate revenues. Solvency: Ability to meet long-term obligations and generate future revenues. Profitability: Ability to provide financial rewards to attract and retain financing. Market prospects: Ability to generate positive market expectations. General-purpose financial statements: Include the (1) income statement, (2) balance sheet, (3) statement of stockholders’ equity (or statement of re- tained earnings), (4) statement of cash flows, and (5) notes to these statements.

HORIZONTAL ANALYSIS Comparative financial statements: Show financial amounts in side-by- side columns on a single statement. Analysis period: The financial statements under analysis. Base period: The financial statements used for comparison. The prior year is commonly used as a base period.

Apple comparative balance sheet: The prior year is the base period and current year is the analysis period.

Summary: Cheat Sheet

Dollar change formula: Dollar change = Analysis period amount − Base period amount

Percent change formula:

Percent change (%) = Analysis period amount − Base period amount

Base period amount × 100

$ millions Current Yr Prior Yr Dollar Change Percent Change

Assets Cash and cash equivalents . . . . . . . . . . . . $20,289 $20,484 $ (195) (1.0)% Short-term marketable securities . . . . . . . 53,892 46,671 7,221 15.5 Accounts receivable, net . . . . . . . . . . . . . . 17,874 15,754 2,120 13.5

Trend analysis: Computing trend percents that show patterns in data across periods.

Trend percent (%) = Analysis period amount

Base period amount × 100

Apple trend analysis: 4 years ago is the base period, and each subsequent year is the analysis period.

Base amount: Comparative balance sheets use total assets, and compara- tive income statements use net sales.

VERTICAL ANALYSIS Common-size financial statements: Show changes in the relative impor- tance of each financial statement item. All individual amounts in common- size statements are shown in common-size percents. Common-size percent formula:

Common-size percent (%) = Analysis amount

Base amount × 100

In trend percent Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago 4 Yrs Ago

Net sales . . . . . . . . . . . . . . . . . 134 .1% 126 .2% 136 .7% 107 .0% 100 .0% Cost of sales . . . . . . . . . . . . . . 132 .3 123 .2 131 .4 105 .3 100 .0 Operating expenses . . . . . . . . 175 .4 158 .4 146 .3 117 .8 100 .0

Apple common-size balance sheet:

RATIO ANALYSIS AND REPORTING Ratio Formula

Liquidity and Efficiency

Current ratio = Current assets

Current liabilities

Acid-test ratio = Cash + Short-term investments + Current receivables

Current liabilities

Accounts receivable turnover = Net sales

Average accounts receivable, net

Inventory turnover = Cost of goods sold Average inventory

Days’ sales uncollected = Accounts receivable, net

Net sales × 365

Days’ sales in inventory = Ending inventory

Cost of goods sold × 365

Total asset turnover = Net sales

Average total assets Solvency

Debt ratio = Total liabilities

Total assets

Equity ratio = Total equity Total assets

Debt-to-equity ratio = Total liabilities

Total equity

Times interest earned = Income before interest expense and income tax expense

Interest expense Profitability

Profit margin ratio = Net income Net sales

Gross margin ratio = Net sales − Cost of goods sold

Net sales

Return on total assets = Net income

Average total assets

Return on common stockholders’ equity = Net income − Preferred dividends

Average common stockholdersʼ equity

Basic earnings per share = Net income − Preferred dividends

Weighted-average common shares outstanding Market Prospects

Price-earnings ratio = Market price per common share

Earnings per share

Dividend yield = Annual cash dividends per share

Market price per share

Apple common-size income statement: Common-Size Percents

$ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales $229,234 $215,639 100.0% 100.0% Cost of sales 141,048 131,376 61.5 60.9 Gross margin 88,186 84,263 38.5 39.1

Common-Size Percents $ millions Current Yr Prior Yr Current Yr Prior Yr

Goodwill 5,717 5,414 1.5% 1.7% Acquired intangible assets, net 2,298 3,206 0.6 1.0 Other assets 10,162 8,757 2.7 2.7 Total assets $375,319 $321,686 100.0 100.0

Chapter 13 Analysis of Financial Statements 517

A Superscript letter A denotes assignments based on Appendix 13A.

Icon denotes assignments that involve decision making.

1. Explain the difference between financial reporting and financial statements.

2. What is the difference between comparative financial state- ments and common-size comparative statements?

3. Which items are usually assigned a 100% value on (a) a common-size balance sheet and (b) a common-size income statement?

4. What three factors would influence your evaluation as to whether a company’s current ratio is good or bad?

5. Suggest several reasons why a 2:1 current ratio might not be adequate for a particular company.

6. Why is working capital given special attention in the process of analyzing balance sheets?

7. What does the number of days’ sales uncollected indicate?

8. What does a relatively high accounts receivable turn- over indicate about a company’s short-term liquidity?

9. Why is a company’s capital structure, as measured by debt and equity ratios, important to financial statement analysts?

10. How does inventory turnover provide information about a company’s short-term liquidity?

Discussion Questions

Business segment (515) Common-size financial statement (502) Comparative financial statement (498) Efficiency (497) Equity ratio (508) Financial reporting (498)

Financial statement analysis (497) General-purpose financial

statements (498) Horizontal analysis (498) Liquidity (497) Market prospects (497)

Profitability (497) Ratio analysis (498) Solvency (497) Vertical analysis (498) Working capital (506)

Key Terms

Multiple Choice Quiz

1. A company’s sales in the prior year were $300,000 and in the current year were $351,000. Using the prior year as the base year, the sales trend percent for the current year is a. 17%. c. 100%. e. 48%. b. 85%. d. 117%.

Use the following information for questions 2 through 5.

2. What is Ella Company’s current ratio? a. 0.69 d. 6.69 b. 1.31 e. 2.39 c. 3.88

3. What is Ella Company’s acid-test ratio? a. 2.39 d. 6.69 b. 0.69 e. 3.88 c. 1.31

4. What is Ella Company’s debt ratio? a. 25.78% d. 137.78% b. 100.00% e. 34.74% c. 74.22%

5. What is Ella Company’s equity ratio? a. 25.78% d. 74.22% b. 100.00% e. 137.78% c. 34.74%

ELLA COMPANY Balance Sheet December 31

Assets Cash . . . . . . . . . . . . . . . . . $ 86,000

Accounts receivable . . . . . 76,000

Merchandise inventory . . 122,000

Prepaid insurance . . . . . . 12,000

Long-term investments . . 98,000

Plant assets, net . . . . . . . . 436,000

Total assets . . . . . . . . . . . . $830,000

Liabilities Current liabilities . . . . . . . . $124,000

Long-term liabilities . . . . . . 90,000

Equity Common stock . . . . . . . . . . 300,000

Retained earnings . . . . . . . 316,000

Total liabilities and equity . . $830,000

ANSWERS TO MULTIPLE CHOICE QUIZ

1. d; ($351,000∕$300,000) × 100 = 117% 2. e; ($86,000 + $76,000 + $122,000 + $12,000)∕$124,000 = 2.39 3. c; ($86,000 + $76,000)∕$124,000 = 1.31

4. a; ($124,000 + $90,000)∕$830,000 = 25.78% 5. d; ($300,000 + $316,000)∕$830,000 = 74.22%

518 Chapter 13 Analysis of Financial Statements

11. What ratios would you compute to evaluate manage- ment performance?

12. Why would a company’s return on total assets be dif- ferent from its return on common stockholders’ equity?

13. Where on the income statement does a company report an unusual gain not expected to occur more often than once every two years or so?

14. Refer to Apple’s financial statements in Appendix A. Compute its profit margin for the years ended September 30, 2017, and September 24, 2016.

15. Refer to Google’s financial statements in Appendix A to compute its equity ratio as of December 31, 2017, and December 31, 2016.

16. Refer to Samsung’s financial statements in Appendix A. Compute its debt ratio as of December 31, 2017, and December 31, 2016.

17. Use Samsung’s financial statements in Appendix A to compute its return on total assets for fiscal year ended December 31, 2017.APPLE

GOOGLE

Samsung

Samsung

QUICK STUDY

QS 13-1 Financial reporting

C1

Identify which of the following items are not included as part of general-purpose financial statements but are part of financial reporting.

a. Income statement f. Statement of cash flows b. Balance sheet g. Stock price information and analysis c. Shareholders’ meetings h. Statement of shareholders’ equity d. Financial statement notes i. Management discussion and analysis of financial e. Company news releases performance

QS 13-2 Standard of comparison

C2

Identify which standard of comparison, (a) intracompany, (b) competitor, (c) industry, or (d) guidelines, best describes each of the following examples.

1. Compare Ford’s return on assets to GM’s return on assets. 2. Compare a company’s acid-test ratio to the 1:1 rule of thumb. 3. Compare Netflix’s current-year sales to its prior-year sales. 4. Compare McDonald’s profit margin to the fast-food industry profit margin.

QS 13-3 Horizontal analysis

P1

Compute the annual dollar changes and percent changes for each of the following accounts.

Current Yr Prior Yr

Short-term investments . . . . . . . . . . . . $374,634 $234,000

Accounts receivable . . . . . . . . . . . . . . . 97,364 101,000

Notes payable . . . . . . . . . . . . . . . . . . . . 0 88,000

QS 13-5 Common-size analysis P2

Refer to the information in QS 13-4. Determine the prior-year and current-year common-size percents for cost of goods sold using net sales as the base.

QS 13-6 Computing current ratio and acid-test ratio P3

Pritchett Co. reported the following year-end data: cash of $15,000; short-term investments of $5,000; ac- counts receivable (current) of $8,000; inventory of $20,000; prepaid (current) assets of $6,000; and total current liabilities of $20,000. Compute the (a) current ratio and (b) acid-test ratio. Round to one decimal.

QS 13-7 Computing accounts receivable turnover and days’ sales uncollected P3

Mifflin Co. reported the following for the current year: net sales of $60,000; cost of goods sold of $38,000; beginning balance in accounts receivable of $14,000; and ending balance in accounts receivable of $6,000. Compute (a) accounts receivable turnover and (b) days’ sales uncollected. Round to one decimal. Hint: Recall that accounts receivable turnover uses average accounts receivable and days’ sales uncollected uses the ending balance in accounts receivable.

QS 13-4 Trend percents

P1

Use the following information to determine the prior-year and current-year trend percents for net sales using the prior year as the base year.

$ thousands Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . $801,810 $453,000

Cost of goods sold . . . . . . . . . . . . . . . . 392,887 134,088

Chapter 13 Analysis of Financial Statements 519

SCC Co. reported the following for the current year: net sales of $48,000; cost of goods sold of $40,000; beginning balance in inventory of $2,000; and ending balance in inventory of $8,000. Compute (a) inven- tory turnover and (b) days’ sales in inventory. Hint: Recall that inventory turnover uses average inventory and days’ sales in inventory uses the ending balance in inventory.

QS 13-8 Computing inventory turnover and days’ sales in inventory P3

Dundee Co. reported the following for the current year: net sales of $80,000; cost of goods sold of $60,000; beginning balance of total assets of $115,000; and ending balance of total assets of $85,000. Compute total asset turnover. Round to one decimal.

QS 13-9 Computing total asset turnover P3

Paddy’s Pub reported the following year-end data: income before interest expense and income tax expense of $30,000; cost of goods sold of $17,000; interest expense of $1,500; total assets of $70,000; total liabil- ities of $20,000; and total equity of $50,000. Compute the (a) debt-to-equity ratio and (b) times interest earned. Round to one decimal.

QS 13-10 Computing debt-to-equity ratio and times interest earned P3

Edison Co. reported the following for the current year: net sales of $80,000; cost of goods sold of $56,000; net income of $16,000; beginning balance of total assets of $60,000; and ending balance of total assets of $68,000. Compute (a) profit margin and (b) return on total assets.

QS 13-11 Computing profit margin and return on total assets P3

Franklin Co. reported the following year-end data: net income of $220,000; annual cash dividends per share of $3; market price per (common) share of $150; and earnings per share of $10. Compute the (a) price-earnings ratio and (b) dividend yield.

QS 13-12 Computing price-earnings ratio and dividend yield P3

For each ratio listed, identify whether the change in ratio value from the prior year to the current year is usually regarded as favorable or unfavorable.

QS 13-13 Ratio interpretation

P3 Ratio Current Yr Prior Yr Ratio Current Yr Prior Yr

1 . Profit margin . . . . . . 9% 8% 5 . Accounts receivable turnover . . . . . 5 .5 6 .7

2 . Debt ratio . . . . . . . . 47% 42% 6 . Basic earnings per share . . . . . . . . . $1 .25 $1 .10

3 . Gross margin . . . . . 34% 46% 7 . Inventory turnover . . . . . . . . . . . . . . 3 .6 3 .4

4 . Acid-test ratio . . . . . 1 .00 1 .15 8 . Dividend yield . . . . . . . . . . . . . . . . . 2 .0% 1 .2%

QS 13-14 Analyzing short-term financial condition

A1

Morgan Company and Parker Company are similar firms operating in the same industry. Write a half- page report comparing Morgan and Parker using the available information. Your discussion should in- clude their ability to meet current obligations and to use current assets efficiently.

Team Project: Assume that the two companies apply for a one-year loan from the team. Identify additional information the compa- nies must provide before the team can make a loan decision.

Current ratio Acid-test ratio

Accounts receivable turnover Merchandise inventory turnover

Working capital

Morgan

1.7 1.0

30.5 24.2

$70,000

Current Yr 1 Yr Ago 1.6 1.1

25.2 21.9

$58,000

2 Yrs Ago 2.1 1.2

29.2 17.1

$52,000

Parker

3.2 2.8

16.4 14.5

$131,000

Current Yr 1 Yr Ago 2 Yrs Ago 2.7 2.5

15.2 13.0

$103,000

1.9 1.6

16.0 12.6

$78,000

Which of the following gains or losses would Organic Foods account for as unusual and/or infrequent? a. A hurricane destroys rainwater tanks that result in a loss for Organic Foods. b. The used vehicle market is weak and Organic Foods is forced to sell its used delivery truck at a loss. c. Organic Foods owns an organic farm in Venezuela that is seized by the government. The company

records a loss.

QS 13-15A Identifying unusual and/or infrequent gains or losses

A2

520 Chapter 13 Analysis of Financial Statements

EXERCISES

Exercise 13-1 Building blocks of analysis

C1

Match the ratio to the building block of financial statement analysis to which it best relates. A. Liquidity and efficiency B. Solvency C. Profitability D. Market prospects

1. Equity ratio 6. Accounts receivable turnover 2. Return on total assets 7. Debt-to-equity ratio 3. Dividend yield 8. Times interest earned 4. Book value per common share 9. Gross margin ratio 5. Days’ sales in inventory 10. Acid-test ratio

Exercise 13-3 Computing and analyzing trend percents

P1

Compute trend percents for the following accounts using 2015 as the base year. For each of the three accounts, state whether the situation as revealed by the trend percents appears to be favorable or unfavorable.

2019 2018 2017 2016 2015

Sales . . . . . . . . . . . . . . . . . . . . . . . . $282,880 $270,800 $252,600 $234,560 $150,000

Cost of goods sold . . . . . . . . . . . . . 128,200 122,080 115,280 106,440 67,000

Accounts receivable . . . . . . . . . . . . 18,100 17,300 16,400 15,200 9,000

Exercise 13-5 Determining income effects from common-size and trend percents

P1 P2

Common-size and trend percents for Roxi Company’s sales, cost of goods sold, and expenses follow. Determine whether net income increased, decreased, or remained unchanged in this three-year period.

Common-Size Percents Trend Percents

Current Yr 1 Yr Ago 2 Yrs Ago Current Yr 1 Yr Ago 2 Yrs Ago

Sales . . . . . . . . . . . . . . . . . . . 100 .0% 100 .0% 100 .0% 105 .4% 104 .2% 100 .0%

Cost of goods sold . . . . . . . . 63 .4 61 .9 59 .1 113 .1 109 .1 100 .0

Total expenses . . . . . . . . . . . 15 .3 14 .8 15 .1 106 .8 102 .1 100 .0

Exercise 13-2 Identifying financial ratios

C2

Identify which of the following six metrics a through f best completes questions 1 through 3 below. a. Days’ sales uncollected d. Return on total assets b. Accounts receivable turnover e. Total asset turnover c. Working capital f. Profit margin 1. Which two ratios are key components in measuring a company’s operating efficiency?

Which ratio summarizes these two components? 2. What measure reflects the difference between current assets and current liabilities? 3. Which two short-term liquidity ratios measure how frequently a company collects its accounts?

Exercise 13-4 Computing and interpreting common-size percents

P2

Compute common-size percents for the following comparative income statements (round percents to one decimal). Using the common-size percents, which item is most responsible for the decline in net income?

GOMEZ CORPORATION Comparative Income Statements

For Years Ended December 31 Current Yr Prior Yr

Sales . . . . . . . . . . . . . . . . . . . . . . . $740,000 $625,000

Cost of goods sold . . . . . . . . . . . . 560,300 290,800

Gross profit . . . . . . . . . . . . . . . . . . 179,700 334,200

Operating expenses . . . . . . . . . . . 128,200 218,500

Net income . . . . . . . . . . . . . . . . . . $ 51,500 $115,700

Simon Company’s year-end balance sheets follow. (1) Express the balance sheets in common-size per- cents. Round percents to one decimal. (2) Assuming annual sales have not changed in the last three years, is the change in accounts receivable as a percentage of total assets favorable or unfavorable? (3) Is the change in merchandise inventory as a percentage of total assets favorable or unfavorable?

Exercise 13-6 Common-size percents

P2

Chapter 13 Analysis of Financial Statements 521

At December 31 Current Yr 1 Yr Ago 2 Yrs Ago

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,800 $ 35,625 $ 37,800

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . 89,500 62,500 50,200

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . 112,500 82,500 54,000

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,700 9,375 5,000

Plant assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278,500 255,000 230,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $523,000 $445,000 $377,500

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $129,900 $ 75,250 $ 51,250

Long-term notes payable secured by mortgages on plant assets . . . . . . . . . . . . . . . . . . . 98,500 101,500 83,500

Common stock, $10 par value . . . . . . . . . . . . . . . . . . . 163,500 163,500 163,500

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131,100 104,750 79,250

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . $523,000 $445,000 $377,500

Refer to Simon Company’s balance sheets in Exercise 13-6. (1) Compute the current ratio for each of the three years. Did the current ratio improve or worsen over the three-year period? (2) Compute the acid-test ratio for each of the three years. Did the acid-test ratio improve or worsen over the three-year period? Round ratios to two decimals.

Exercise 13-7 Analyzing liquidity

P3

Refer to the Simon Company information in Exercises 13-6 and 13-8. For both the current year and one year ago, compute the following ratios: (1) debt ratio and equity ratio—percent rounded to one decimal, (2) debt-to-equity ratio—rounded to two decimals; based on debt-to-equity ratio, does the company have more or less debt in the current year versus one year ago? and (3) times interest earned—rounded to one decimal. Based on times interest earned, is the company more or less risky for creditors in the current year versus one year ago?

Exercise 13-9 Analyzing risk and capital structure

P3

Refer to Simon Company’s financial information in Exercises 13-6 and 13-8. For both the current year and one year ago, compute the following ratios: (1) profit margin ratio—percent rounded to one decimal; did profit margin improve or worsen in the current year versus one year ago? (2) total asset turnover—rounded to one decimal, and (3) return on total assets—percent rounded to one decimal. Based on return on total assets, did Simon’s operating efficiency improve or worsen in the current year versus one year ago?

Exercise 13-10 Analyzing efficiency and profitability

P3

Refer to Simon Company’s financial information in Exercises 13-6 and 13-8. Additional information about the company follows. For both the current year and one year ago, compute the following ratios: (1) return on common stockholders’ equity—percent rounded to one decimal, (2) dividend yield—percent rounded to one decimal, and (3) price-earnings ratio on December 31—rounded to one decimal. Assuming Simon’s com- petitor has a price-earnings ratio of 10, which company has higher market expectations for future growth?

Exercise 13-11 Analyzing profitability

P3

Common stock market price, December 31, current year . . . . . $30 .00 Annual cash dividends per share in current year . . . . $0 .29

Common stock market price, December 31, 1 year ago . . . . . . 28 .00 Annual cash dividends per share 1 year ago . . . . . . . . 0 .24

Refer to the Simon Company information in Exercise 13-6. The company’s income statements for the cur- rent year and one year ago follow. Assume that all sales are on credit and then compute (1) days’ sales uncollected, (2) accounts receivable turnover, (3) inventory turnover, and (4) days’ sales in inventory. For each ratio, determine if it improved or worsened in the current year. Round to one decimal.

Exercise 13-8 Analyzing and interpreting liquidity

P3

For Year Ended December 31 Current Yr 1 Yr Ago

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $673,500 $532,000

Cost of goods sold . . . . . . . . . . . . . . . . . . $411,225 $345,500

Other operating expenses . . . . . . . . . . . . 209,550 134,980

Interest expense . . . . . . . . . . . . . . . . . . . . 12,100 13,300

Income tax expense . . . . . . . . . . . . . . . . . 9,525 8,845

Total costs and expenses . . . . . . . . . . . . . 642,400 502,625

Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 31,100 $ 29,375

Earnings per share . . . . . . . . . . . . . . . . . . $ 1 .90 $ 1 .80

522 Chapter 13 Analysis of Financial Statements

Following are data for BioBeans and GreenKale, which sell organic produce and are of similar size. 1. Compute the profit margin and the return on total assets for both companies. 2. Based on analysis of these two measures, which company is the preferred investment?

Exercise 13-13 Analyzing efficiency and profitability

P3 BioBeans GreenKale

Average total assets . . . . . . . . . . . $187,500 $150,000

Net sales . . . . . . . . . . . . . . . . . . . . 75,000 60,000

Net income . . . . . . . . . . . . . . . . . . 15,000 9,000

Following is an incomplete current-year income statement.Exercise 13-14 Reconstructing an income statement with ratios

P3 Income Statement

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (a) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (b) Selling, general, and administrative expenses . . . . . . . . . . 7,000 Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (c)

Determine amounts a, b, and c. Additional information follows: ∙ Return on total assets is 16% (average total assets is $68,750). ∙ Inventory turnover is 5 (average inventory is $6,000). ∙ Accounts receivable turnover is 8 (average accounts receivable is $6,250).

Refer to the information in Exercise 13-15. 1. Which company has the better (a) profit margin, (b) asset turnover, and (c) return on assets? 2. Which company has the better rate of growth in sales? 3. Did Roak successfully use financial leverage in the current year? Did Clay?

Exercise 13-16 Interpreting financial ratios

A1 P3

In the current year, Randa Merchandising, Inc., sold its interest in a chain of wholesale outlets, taking the company completely out of the wholesaling business. The company still operates its retail outlets. A list- ing of the major sections of an income statement follows. A. Net sales less operating expense section B. Other unusual and/or infrequent gains (losses)

Exercise 13-17A Income statement categories

A2

Exercise 13-12 Computing current ratio and profit margin

P3

Nintendo Company, Ltd., recently reported the following financial information (amounts in millions). Compute Nintendo’s current ratio and profit margin. Round to two decimals.

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,036 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,464

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,477 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 871

Exercise 13-15 Analyzing efficiency and financial leverage

A1

Roak Company and Clay Company are similar firms that operate in the same industry. Clay began opera- tions two years ago and Roak started five years ago. In the current year, both companies pay 6% interest on their debt to creditors. The following additional information is available.

Roak Company Clay Company

Current Yr 1 Yr Ago 2 Yrs Ago Current Yr 1 Yr Ago 2 Yrs Ago

Total asset turnover . . . . . . . 3 .1 2 .8 3 .0 1 .7 1 .5 1 .1

Return on total assets . . . . . 7 .4% 7 .0% 6 .9% 4 .8% 4 .5% 3 .2%

Profit margin ratio . . . . . . . . 2 .4% 2 .5% 2 .3% 2 .8% 3 .0% 2 .9%

Sales . . . . . . . . . . . . . . . . . . . $410,000 $380,000 $396,000 $210,000 $170,000 $110,000

Write a half-page report comparing Roak and Clay using the available information. Your analysis should include their ability to use assets efficiently to produce profits. Comment on their success in employing financial leverage in the current year.

Chapter 13 Analysis of Financial Statements 523

Use the financial data for Randa Merchandising, Inc., in Exercise 13-17A to prepare its December 31 year- end income statement. Ignore the earnings per share section.

Exercise 13-18A Income statement presentation A2

HAROUN COMPANY Comparative Income Statements

For Years Ended December 31

$ thousands 2019 2018 2017 2016 2015 2014 2013

Sales . . . . . . . . . . . . . . . $1,694 $1,496 $1,370 $1,264 $1,186 $1,110 $928

Cost of goods sold . . . . 1,246 1,032 902 802 752 710 586

Gross profit . . . . . . . . . . 448 464 468 462 434 400 342

Operating expenses . . . 330 256 234 170 146 144 118

Net income . . . . . . . . . . $ 118 $ 208 $ 234 $ 292 $ 288 $ 256 $224

HAROUN COMPANY Comparative Year-End Balance Sheets

At December 31, $ thousands 2019 2018 2017 2016 2015 2014 2013

Assets Cash . . . . . . . . . . . . . . . . . . . . $ 58 $ 78 $ 82 $ 84 $ 88 $ 86 $ 89

Accounts receivable, net . . . 490 514 466 360 318 302 216

Merchandise inventory . . . . . 1,838 1,364 1,204 1,032 936 810 615

Other current assets . . . . . . . 36 32 14 34 28 28 9

Long-term investments . . . . . 0 0 0 146 146 146 146

Plant assets, net . . . . . . . . . . 2,020 2,014 1,752 944 978 860 725

Total assets . . . . . . . . . . . . . . $4,442 $4,002 $3,518 $2,600 $2,494 $2,232 $1,800

Liabilities and Equity Current liabilities . . . . . . . . . . $1,220 $1,042 $ 718 $ 614 $ 546 $ 522 $ 282

Long-term liabilities . . . . . . . 1,294 1,140 1,112 570 580 620 400

Common stock . . . . . . . . . . . 1,000 1,000 1,000 850 850 650 650

Other paid-in capital . . . . . . . 250 250 250 170 170 150 150

Retained earnings . . . . . . . . . 678 570 438 396 348 290 318

Total liabilities and equity . . . $4,442 $4,002 $3,518 $2,600 $2,494 $2,232 $1,800

PROBLEM SET A

Problem 13-1A Calculating and analyzing trend percents

P1

Selected comparative financial statements of Haroun Company follow.

C. Taxes reported on income (loss) from continuing operations D. Income (loss) from operating a discontinued segment, or gain (loss) from its disposal Indicate where each of the following income-related items for this company appears on its current-year income statement by writing the letter of the appropriate section in the blank beside each item.

Section Item Debit Credit

_______ 1 . Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,900,000

_______ 2 . Gain on state’s condemnation of company property . . . . . . . . . . 230,000

_______ 3 . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000

_______ 4 . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,000

_______ 5 . Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232,000

_______ 6 . Gain on sale of wholesale business segment, net of tax . . . . . . . 775,000

_______ 7 . Loss from operating wholesale business segment, net of tax . . . 444,000

_______ 8 . Loss of assets from meteor strike . . . . . . . . . . . . . . . . . . . . . . . . . 640,000

524 Chapter 13 Analysis of Financial Statements

Required

1. Compute trend percents for all components of both statements using 2013 as the base year. Round percents to one decimal.

Analysis Component

2. Refer to the results from part 1. (a) Did sales grow steadily over this period? (b) Did net income as a percent of sales grow over the past four years? (c) Did inventory increase over this period?

Check (1) 2019, Total assets trend, 246.8%

Problem 13-3A Transactions, working capital, and liquidity ratios

P3

Plum Corporation began the month of May with $700,000 of current assets, a current ratio of 2.50:1, and an acid-test ratio of 1.10:1. During the month, it completed the following transactions (the company uses a perpetual inventory system).

May 2 Purchased $50,000 of merchandise inventory on credit. 8 Sold merchandise inventory that cost $55,000 for $110,000 cash. 10 Collected $20,000 cash on an account receivable. 15 Paid $22,000 cash to settle an account payable. 17 Wrote off a $5,000 bad debt against the Allowance for Doubtful Accounts account. 22 Declared a $1 per share cash dividend on its 50,000 shares of outstanding common stock. 26 Paid the dividend declared on May 22. 27 Borrowed $100,000 cash by giving the bank a 30-day, 10% note. 28 Borrowed $80,000 cash by signing a long-term secured note. 29 Used the $180,000 cash proceeds from the notes to buy new machinery.

Check May 22: Current ratio, 2.19; Acid-test ratio, 1.11

May 29: Current ratio, 1.80; Working capital, $325,000

Required

1. Compute each year’s current ratio. Round ratios to one decimal. 2. Express the income statement data in common-size percents. Round percents to two decimals. 3. Express the balance sheet data in trend percents with 2017 as base year. Round percents to two decimals.

Analysis Component

4. Refer to the results from parts 1, 2, and 3. (a) Did cost of goods sold make up a greater portion of sales for the most recent year? (b) Did income as a percent of sales improve in the most recent year? (c) Did plant assets grow over this period?

Check (3) 2019, Total assets trend, 131.71%

KORBIN COMPANY Comparative Balance Sheets

At December 31 2019 2018 2017

Assets Current assets . . . . . . . . . . . . . $ 52,390 $ 37,924 $ 51,748

Long-term investments . . . . . . 0 500 3,950

Plant assets, net . . . . . . . . . . . 100,000 96,000 60,000

Total assets . . . . . . . . . . . . . . . $152,390 $134,424 $115,698

Liabilities and Equity Current liabilities . . . . . . . . . . . $ 22,800 $ 19,960 $ 20,300

Common stock . . . . . . . . . . . . 72,000 72,000 60,000

Other paid-in capital . . . . . . . . 9,000 9,000 6,000

Retained earnings . . . . . . . . . . 48,590 33,464 29,398

Total liabilities and equity . . . . $152,390 $134,424 $115,698

KORBIN COMPANY Comparative Income Statements

For Years Ended December 31 2019 2018 2017

Sales . . . . . . . . . . . . . . . . . . . . . $555,000 $340,000 $278,000

Cost of goods sold . . . . . . . . . . 283,500 212,500 153,900

Gross profit . . . . . . . . . . . . . . . . 271,500 127,500 124,100

Selling expenses . . . . . . . . . . . . 102,900 46,920 50,800

Administrative expenses . . . . . 50,668 29,920 22,800

Total expenses . . . . . . . . . . . . . 153,568 76,840 73,600

Income before taxes . . . . . . . . . 117,932 50,660 50,500

Income tax expense . . . . . . . . . 40,800 10,370 15,670

Net income . . . . . . . . . . . . . . . . $ 77,132 $ 40,290 $ 34,830

Selected comparative financial statements of Korbin Company follow.Problem 13-2A Ratios, common-size statements, and trend percents

P1 P2 P3

Chapter 13 Analysis of Financial Statements 525

Required

Prepare a table, similar to the following, showing Plum’s (1) current ratio, (2) acid-test ratio, and (3) working capital after each transaction. Round ratios to two decimals.

1

2

3

A B

Beginning

Current Assets

$700,000

Transaction

C

D

E

2.50

F G

1.10 —

Current Ratio

Acid-Test Ratio

Working Capital

Current Liabilities

Quick Assets

Selected current year-end financial statements of Cabot Corporation follow. All sales were on credit; selected balance sheet amounts at December 31 of the prior year were inventory, $48,900; total assets, $189,400; common stock, $90,000; and retained earnings, $33,748.

Problem 13-4A Calculating financial statement ratios

P3

Required

Compute the following: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory turnover, (5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity. Round to one decimal place; for part 6, round to two decimals.

Check Acid-test ratio, 2.2 to 1; Inventory turnover, 7.3

CABOT CORPORATION Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . $448,600

Cost of goods sold . . . . . . 297,250

Gross profit . . . . . . . . . . . . 151,350

Operating expenses . . . . . 98,600

Interest expense . . . . . . . . 4,100

Income before taxes . . . . . 48,650

Income tax expense . . . . . 19,598

Net income . . . . . . . . . . . . $ 29,052

CABOT CORPORATION Balance Sheet

December 31 of Current Year

Assets Liabilities and Equity Cash . . . . . . . . . . . . . . . . . . $ 10,000 Accounts payable . . . . . . . . . . . . . . . . . $ 17,500

Short-term investments . . 8,400 Accrued wages payable . . . . . . . . . . . . 3,200

Accounts receivable, net . 33,700 Income taxes payable . . . . . . . . . . . . . 3,300

Merchandise inventory . . . 32,150 Long-term note payable, secured

Prepaid expenses . . . . . . . 2,650 by mortgage on plant assets . . . . . . 63,400

Plant assets, net . . . . . . . . 153,300 Common stock . . . . . . . . . . . . . . . . . . . 90,000

Retained earnings . . . . . . . . . . . . . . . . 62,800

Total assets . . . . . . . . . . . . $240,200 Total liabilities and equity . . . . . . . . . . $240,200

Barco Kyan Barco Kyan Company Company Company Company

Data from the current year-end balance sheets Data from the current year’s income statement Assets Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $770,000 $880,200 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,500 $ 34,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . 585,100 632,500

Accounts receivable, net . . . . . . . . . . . . . . 46,500 64,600 Interest expense . . . . . . . . . . . . . . . . . . . . 7,900 13,000

Merchandise inventory . . . . . . . . . . . . . . . . 84,440 132,500 Income tax expense . . . . . . . . . . . . . . . . . 14,800 24,300

Prepaid expenses . . . . . . . . . . . . . . . . . . . . 5,000 6,950 Net income . . . . . . . . . . . . . . . . . . . . . . . . 162,200 210,400

Plant assets, net . . . . . . . . . . . . . . . . . . . . . 290,000 304,400 Basic earnings per share . . . . . . . . . . . . . . 4 .51 5 .11

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $445,440 $542,450 Cash dividends per share . . . . . . . . . . . . . 3 .81 3 .93

Liabilities and Equity Beginning-of-year balance sheet data Current liabilities . . . . . . . . . . . . . . . . . . . . . $ 61,340 $ 93,300 Accounts receivable, net . . . . . . . . . . . . . . $ 29,800 $ 54,200

Long-term notes payable . . . . . . . . . . . . . . 80,800 101,000 Merchandise inventory . . . . . . . . . . . . . . . 55,600 107,400

Common stock, $5 par value . . . . . . . . . . . 180,000 206,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . 398,000 382,500

Retained earnings . . . . . . . . . . . . . . . . . . . . 123,300 142,150 Common stock, $5 par value . . . . . . . . . . 180,000 206,000

Total liabilities and equity . . . . . . . . . . . . . . $445,440 $542,450 Retained earnings . . . . . . . . . . . . . . . . . . . 98,300 93,600

Summary information from the financial statements of two companies competing in the same industry follows.

Problem 13-5A Comparative ratio analysis

P3

526 Chapter 13 Analysis of Financial Statements

Required

1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts receivable turnover, (d) inventory turnover, (e) days’ sales in inventory, and ( f ) days’ sales uncollected. Round to one deci- mal place. Identify the company you consider to be the better short-term credit risk and explain why.

2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total assets, and (d) return on common stockholders’ equity. Assuming that each company’s stock can be purchased at $75 per share, compute their (e) price-earnings ratios and ( f ) dividend yields. Round to one decimal place. Identify which company’s stock you would recommend as the better investment and explain why.

Check (1) Kyan: Accounts receivable turnover, 14.8; Inventory turnover, 5.3

(2) Barco: Profit margin, 21.1%; PE, 16.6

Debit Credit

a . Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,000

b . Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . $ 34,000

c . Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,850

d . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

e . Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,400

f . Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . 71,600

g . Gain from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

h . Accumulated depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . 174,500

i . Loss from operating a discontinued segment (pretax) . . . . . . . . . . . 18,250

j . Gain on insurance recovery of tornado damage . . . . . . . . . . . . . . . 20,000

k . Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 998,000

l . Depreciation expense—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000

m . Correction of overstatement of prior year’s sales (pretax) . . . . . . . . 16,000

n . Gain on sale of discontinued segment’s assets (pretax) . . . . . . . . . 34,000

o . Loss from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,250

p . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?

q . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482,500

Problem 13-6AA Income statement computations and format

A2

Selected account balances from the adjusted trial balance for Olinda Corporation as of its calendar year- end December 31 follow.

Required

Answer each of the following questions by providing supporting computations. 1. Assume that the company’s income tax rate is 30% for all items. Identify the tax effects and after-tax

amounts of the three items labeled pretax. 2. Compute the amount of income from continuing operations before income taxes. What is the amount

of the income tax expense? What is the amount of income from continuing operations? 3. What is the total amount of after-tax income (loss) associated with the discontinued segment? 4. What is the amount of net income for the year?

Check (3) $11,025

(4) $257,425

Selected comparative financial statements of Tripoly Company follow.

TRIPOLY COMPANY Comparative Income Statements

For Years Ended December 31

$ thousands 2019 2018 2017 2016 2015 2014 2013

Sales . . . . . . . . . . . . . . . . . $560 $610 $630 $680 $740 $770 $860

Cost of goods sold . . . . . . 276 290 294 314 340 350 380

Gross profit . . . . . . . . . . . . 284 320 336 366 400 420 480

Operating expenses . . . . . 84 104 112 126 140 144 150

Net income . . . . . . . . . . . . $200 $216 $224 $240 $260 $276 $330

PROBLEM SET B

Problem 13-1B Calculating and analyzing trend percents

P1

Chapter 13 Analysis of Financial Statements 527

TRIPOLY COMPANY Comparative Year-End Balance Sheets

At December 31, $ thousands 2019 2018 2017 2016 2015 2014 2013

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . $ 44 $ 46 $ 52 $ 54 $ 60 $ 62 $ 68

Accounts receivable, net . . . . . . 130 136 140 144 150 154 160

Merchandise inventory . . . . . . . . 166 172 178 180 186 190 208

Other current assets . . . . . . . . . . 34 34 36 38 38 40 40

Long-term investments . . . . . . . . 36 30 26 110 110 110 110

Plant assets, net . . . . . . . . . . . . . 510 514 520 412 420 428 454

Total assets . . . . . . . . . . . . . . . . . $920 $932 $952 $938 $964 $984 $1,040

Liabilities and Equity Current liabilities . . . . . . . . . . . . . $148 $156 $186 $190 $210 $260 $ 280

Long-term liabilities . . . . . . . . . . 92 120 142 148 194 214 260

Common stock . . . . . . . . . . . . . . 160 160 160 160 160 160 160

Other paid-in capital . . . . . . . . . . 70 70 70 70 70 70 70

Retained earnings . . . . . . . . . . . . 450 426 394 370 330 280 270

Total liabilities and equity . . . . . . $920 $932 $952 $938 $964 $984 $1,040

Required

1. Compute trend percents for all components of both statements using 2013 as the base year. Round percents to one decimal.

Analysis Component

2. Analyze and comment on the financial statements and trend percents from part 1.

Check (1) 2019, Total assets trend, 88.5%

Selected comparative financial statement information of Bluegrass Corporation follows.

BLUEGRASS CORPORATION Comparative Year-End Balance Sheets

At December 31 2019 2018 2017

Assets Current assets . . . . . . . . . . . . . . . . . $ 54,860 $ 32,660 $ 36,300

Long-term investments . . . . . . . . . . 0 1,700 10,600

Plant assets, net . . . . . . . . . . . . . . . 112,810 113,660 79,000

Total assets . . . . . . . . . . . . . . . . . . . $167,670 $148,020 $125,900

Liabilities and Equity Current liabilities . . . . . . . . . . . . . . . $ 22,370 $ 19,180 $ 16,500

Common stock . . . . . . . . . . . . . . . . 46,500 46,500 37,000

Other paid-in capital . . . . . . . . . . . . 13,850 13,850 11,300

Retained earnings . . . . . . . . . . . . . . 84,950 68,490 61,100

Total liabilities and equity . . . . . . . . $167,670 $148,020 $125,900

BLUEGRASS CORPORATION Comparative Income Statements

For Years Ended December 31 2019 2018 2017

Sales . . . . . . . . . . . . . . . . . . . . . . $198,800 $166,000 $143,800

Cost of goods sold . . . . . . . . . . . 108,890 86,175 66,200

Gross profit . . . . . . . . . . . . . . . . . 89,910 79,825 77,600

Selling expenses . . . . . . . . . . . . . 22,680 19,790 18,000

Administrative expenses . . . . . . 16,760 14,610 15,700

Total expenses . . . . . . . . . . . . . . 39,440 34,400 33,700

Income before taxes . . . . . . . . . . 50,470 45,425 43,900

Income tax expense . . . . . . . . . . 6,050 5,910 5,300

Net income . . . . . . . . . . . . . . . . . $ 44,420 $ 39,515 $ 38,600

Problem 13-2B Ratios, common-size statements, and trend percents

P1 P2 P3

Required

1. Compute each year’s current ratio. Round ratios to one decimal. 2. Express the income statement data in common-size percents. Round percents to two decimals. 3. Express the balance sheet data in trend percents with 2017 as the base year. Round percents to two

decimals.

Analysis Component

4. Comment on any significant relations revealed by the ratios and percents computed.

Check (3) 2019, Total assets trend, 133.18%

528 Chapter 13 Analysis of Financial Statements

Problem 13-3B Transactions, working capital, and liquidity ratios P3

Koto Corporation began the month of June with $300,000 of current assets, a current ratio of 2.5:1, and an acid-test ratio of 1.4:1. During the month, it completed the following transactions (the company uses a perpetual inventory system).

June 1 Sold merchandise inventory that cost $75,000 for $120,000 cash. 3 Collected $88,000 cash on an account receivable. 5 Purchased $150,000 of merchandise inventory on credit. 7 Borrowed $100,000 cash by giving the bank a 60-day, 10% note. 10 Borrowed $120,000 cash by signing a long-term secured note. 12 Purchased machinery for $275,000 cash. 15 Declared a $1 per share cash dividend on its 80,000 shares of outstanding common stock. 19 Wrote off a $5,000 bad debt against the Allowance for Doubtful Accounts account. 22 Paid $12,000 cash to settle an account payable. 30 Paid the dividend declared on June 15.

Required

Prepare a table, similar to the following, showing the company’s (1) current ratio, (2) acid-test ratio, and (3) working capital after each transaction. Round ratios to two decimals.

Check June 3: Current ratio, 2.88; Acid-test ratio, 2.40

June 30: Working capital, $(10,000); Current ratio, 0.97

1

2

3

A B

Beginning

Current Assets

$300,000

Transaction

C

D

E

2.50

F G

1.40 —

Current Ratio

Acid-Test Ratio

Working Capital

Current Liabilities

Quick Assets

Selected current year-end financial statements of Overton Corporation follow. (All sales were on credit; selected balance sheet amounts at December 31 of the prior year were inventory, $17,400; total assets, $94,900; common stock, $35,500; and retained earnings, $18,800.)

Problem 13-4B Calculating financial statement ratios

P3

Required

Compute the following: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory turnover, (5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity. Round to one decimal place; for part 6, round to two decimals.

Check Acid-test ratio, 1.6 to 1; Inventory turnover, 15.3

OVERTON CORPORATION Income Statement

For Current Year Ended December 31

Sales . . . . . . . . . . . . . . . . . $315,500 Cost of goods sold . . . . . . 236,100 Gross profit . . . . . . . . . . . . 79,400 Operating expenses . . . . . 49,200 Interest expense . . . . . . . . 2,200 Income before taxes . . . . . 28,000 Income tax expense . . . . . 4,200 Net income . . . . . . . . . . . . $ 23,800

OVERTON CORPORATION Balance Sheet

December 31 of Current Year

Assets Liabilities and Equity Cash . . . . . . . . . . . . . . . . . . . . $ 6,100 Accounts payable . . . . . . . . . . . . . . . $ 11,500 Short-term investments . . . . 6,900 Accrued wages payable . . . . . . . . . . 3,300 Accounts receivable, net . . . 15,100 Income taxes payable . . . . . . . . . . . 2,600 Merchandise inventory . . . . . 13,500 Long-term note payable, secured Prepaid expenses . . . . . . . . . 2,000 by mortgage on plant assets . . . . 30,000 Plant assets, net . . . . . . . . . . 73,900 Common stock, $5 par value . . . . . . 35,000 Retained earnings . . . . . . . . . . . . . . 35,100 Total assets . . . . . . . . . . . . . . $117,500 Total liabilities and equity . . . . . . . . $117,500

Summary information from the financial statements of two companies competing in the same industry follows.

Problem 13-5B Comparative ratio analysis P3

Chapter 13 Analysis of Financial Statements 529

Fargo Ball Fargo Ball Company Company Company Company

Data from the current year-end balance sheets Data from the current year’s income statement Assets Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $393,600 $667,500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 36,500 Cost of goods sold . . . . . . . . . . . . . . . . . . . 290,600 480,000

Accounts receivable, net . . . . . . . . . . . . . . 88,700 79,500 Interest expense . . . . . . . . . . . . . . . . . . . . 5,900 12,300

Merchandise inventory . . . . . . . . . . . . . . . . 86,800 82,000 Income tax expense . . . . . . . . . . . . . . . . . 5,700 12,300

Prepaid expenses . . . . . . . . . . . . . . . . . . . . 9,700 10,100 Net income . . . . . . . . . . . . . . . . . . . . . . . . 33,850 61,700

Plant assets, net . . . . . . . . . . . . . . . . . . . . . 176,900 252,300 Basic earnings per share . . . . . . . . . . . . . . 1 .27 2 .19

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $382,100 $460,400

Liabilities and Equity Beginning-of-year balance sheet data

Current liabilities . . . . . . . . . . . . . . . . . . . . . $ 90,500 $ 97,000 Accounts receivable, net . . . . . . . . . . . . . . $ 72,200 $ 73,300

Long-term notes payable . . . . . . . . . . . . . . 93,000 93,300 Merchandise inventory . . . . . . . . . . . . . . . 105,100 80,500

Common stock, $5 par value . . . . . . . . . . . 133,000 141,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . 383,400 443,000

Retained earnings . . . . . . . . . . . . . . . . . . . . 65,600 129,100 Common stock, $5 par value . . . . . . . . . . 133,000 141,000

Total liabilities and equity . . . . . . . . . . . . . . $382,100 $460,400 Retained earnings . . . . . . . . . . . . . . . . . . . 49,100 109,700

Required

1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts receivable turn- over, (d) inventory turnover, (e) days’ sales in inventory, and ( f ) days’ sales uncollected. Round to one decimal place. Identify the company you consider to be the better short-term credit risk and explain why.

2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total assets, and (d) return on common stockholders’ equity. Assuming that each company paid cash dividends of $1.50 per share and each company’s stock can be purchased at $25 per share, compute their (e) price-earnings ratios and ( f ) dividend yields. Round to one decimal place; for part b, round to two decimals. Identify which company’s stock you would recommend as the better investment and explain why.

Check (1) Fargo: Accounts receivable turnover, 4.9; Inventory turnover, 3.0

(2) Ball: Profit margin, 9.2%; PE, 11.4

Selected account balances from the adjusted trial balance for Harbor Corp. as of its calendar year-end December 31 follow.

Debit Credit

a . Accumulated depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000

b . Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

c . Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,640,000

d . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?

e . Loss on hurricane damage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000

f . Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . 220,000

g . Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328,000

h . Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

i . Loss from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

j . Gain from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000

k . Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

l . Loss from operating a discontinued segment (pretax) . . . . . . . . . . . . . 120,000

m . Depreciation expense—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156,000

n . Correction of overstatement of prior year’s expense (pretax) . . . . . . . 48,000

o . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,040,000

p . Loss on sale of discontinued segment’s assets (pretax) . . . . . . . . . . . 180,000

q . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,000

Problem 13-6BA Income statement computations and format

A2

530 Chapter 13 Analysis of Financial Statements

Required

Answer each of the following questions by providing supporting computations. 1. Assume that the company’s income tax rate is 25% for all items. Identify the tax effects and after-tax

amounts of the three items labeled pretax. 2. What is the amount of income from continuing operations before income taxes? What is the amount of

income tax expense? What is the amount of income from continuing operations? 3. What is the total amount of after-tax income (loss) associated with the discontinued segment? 4. What is the amount of net income for the year?

Check (3) $(225,000)

(4) $522,000

SERIAL PROBLEM Business Solutions

P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 13 Use the following selected data from Business Solutions’s income statement for the three months ended March 31, 2020, and from its March 31, 2020, balance sheet to complete the requirements.

©Alexander Image/Shutterstock

Required

1. Compute the gross margin ratio (both with and without services revenue) and net profit margin ratio (round the percent to one decimal).

2. Compute the current ratio and acid-test ratio (round to one decimal). 3. Compute the debt ratio and equity ratio (round the percent to one decimal). 4. What percent of its assets are current? What percent are long term? Round percents to one decimal.

Computer services revenue . . . . . . . $25,307 Net income . . . . . . . . . $ 18,833 Current liabilities . . . . . $ 875

Net sales (of goods) . . . . . . . . . . . . . 18,693 Quick assets . . . . . . . . 90,924 Total liabilities . . . . . . . 875

Total sales and revenue . . . . . . . . . . 44,000 Current assets . . . . . . 95,568 Total equity . . . . . . . . . . 119,393

Cost of goods sold . . . . . . . . . . . . . . 14,052 Total assets . . . . . . . . 120,268

COMPANY ANALYSIS A1 P1 P2

Accounting Analysis

AA 13-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Using fiscal 2015 as the base year, compute trend percents for fiscal years 2015, 2016, and 2017 for

net sales, cost of sales, operating income, other income (expense) net, provision for income taxes, and net income. Round percents to one decimal.

2. Compute common-size percents for fiscal years 2016 and 2017 for the following categories of assets: (a) total current assets; (b) property, plant and equipment, net; and (c) goodwill plus acquired intan- gible assets, net. Round percents to one decimal.

3. Using current assets as a percent of total assets to measure liquidity, did Apple’s asset makeup become more liquid or less liquid in 2017?

APPLE

$ millions Apple Google $ millions Apple Google

Cash and equivalents . . . . . . . . . . . . . $20,289 $ 10,715 Cost of sales . . . . . . . . . . $141,048 $ 45,583

Accounts receivable, net . . . . . . . . . . 17,874 18,336 Revenues . . . . . . . . . . . . . 229,234 110,855

Inventories . . . . . . . . . . . . . . . . . . . . . 4,855 749 Total assets . . . . . . . . . . . 375,319 197,295

Retained earnings . . . . . . . . . . . . . . . . 98,330 113,247

AA 13-2 Key figures for Apple and Google follow.COMPARATIVE ANALYSIS C2 P2

APPLE GOOGLE

Required

1. Compute common-size percents for each of the companies using the data provided. Round percents to one decimal.

2. If Google decided to pay a dividend, would retained earnings as a percent of total assets increase or decrease?

3. Which company has a higher gross margin ratio on sales?

Chapter 13 Analysis of Financial Statements 531

Required

1. Compute common-size percents for Samsung using the data provided. Round percents to one decimal.

2. What is Samsung’s gross margin ratio on sales? 3. Does Samsung’s gross margin ratio outperform or underperform the industry (assumed) average

of 25%?

AA 13-3 Key figures for Samsung follow (in ₩ millions). GLOBAL ANALYSIS A1

Cash and equivalents . . . . . . . . . . . . . . . ₩ 30,545,130

Accounts receivable, net . . . . . . . . . . . . 27,695,995

Inventories . . . . . . . . . . . . . . . . . . . . . . . 24,983,355

Retained earnings . . . . . . . . . . . . . . . . . . 215,811,200

Cost of sales . . . . . . . . . . . . . . . . . . . . . . ₩129,290,661

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . 239,575,376

Total assets . . . . . . . . . . . . . . . . . . . . . . . 301,752,090 Samsung

ETHICS CHALLENGE A1

BTN 13-1 As Beacon Company controller, you are responsible for informing the board of directors about its financial activities. At the board meeting, you present the following information.

Beyond the Numbers

2019 2018 2017

Sales trend percent . . . . . . . . . . . . . . . . . . . . . . 147 .0% 135 .0% 100 .0%

Selling expenses to sales . . . . . . . . . . . . . . . . . . 10 .1% 14 .0% 15 .6%

Sales to plant assets ratio . . . . . . . . . . . . . . . . . 3 .8 to 1 3 .6 to 1 3 .3 to 1

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 .9 to 1 2 .7 to 1 2 .4 to 1

Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .1 to 1 1 .4 to 1 1 .5 to 1

Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . 7 .8 times 9 .0 times 10 .2 times

Accounts receivable turnover . . . . . . . . . . . . . . 7 .0 times 7 .7 times 8 .5 times

Total asset turnover . . . . . . . . . . . . . . . . . . . . . . 2 .9 times 2 .9 times 3 .3 times

Return on total assets . . . . . . . . . . . . . . . . . . . . . 10 .4% 11 .0% 13 .2%

Return on stockholders’ equity . . . . . . . . . . . . . 10 .7% 11 .5% 14 .1%

Profit margin ratio . . . . . . . . . . . . . . . . . . . . . . . . 3 .6% 3 .8% 4 .0%

After the meeting, the company’s CEO holds a press conference with analysts in which she mentions the following ratios.

2019 2018 2017

Sales trend percent . . . . . . . . . . . . . . . . . . . . . . 147 .0% 135 .0% 100 .0%

Selling expenses to sales . . . . . . . . . . . . . . . . . . 10 .1% 14 .0% 15 .6%

Sales to plant assets ratio . . . . . . . . . . . . . . . . . 3 .8 to 1 3 .6 to 1 3 .3 to 1

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 .9 to 1 2 .7 to 1 2 .4 to 1

Required

1. Why do you think the CEO decided to report 4 ratios instead of the 11 prepared? 2. Comment on the possible consequences of the CEO’s reporting of the ratios selected.

BTN 13-2 Each team is to select a different industry, and each team member is to select a different company in that industry and acquire its financial statements. Use those statements to analyze the com- pany, including at least one ratio from each of the four building blocks of analysis. When necessary, use the financial press to determine the market price of its stock. Communicate with teammates via a meet- ing, e-mail, or telephone to discuss how different companies compare to each other and to industry norms. The team is to prepare a single one-page memorandum reporting on its analysis and the conclu- sions reached.

COMMUNICATING IN PRACTICE A1 P3

532 Chapter 13 Analysis of Financial Statements

BTN 13-3 Access the February 21, 2017, filing of the December 31, 2016, 10-K report of The Hershey Company (ticker: HSY) at SEC.gov and complete the following requirements.

Required

Compute or identify the following profitability ratios of Hershey for its years ending December 31, 2016, and December 31, 2015. Interpret its profitability using the results obtained for these two years. 1. Profit margin ratio (round the percent to one decimal). 2. Gross profit ratio (round the percent to one decimal). 3. Return on total assets (round the percent to one decimal). (Total assets at year-end 2014 were

$5,622,870 in thousands.) 4. Return on common stockholders’ equity (round the percent to one decimal). (Total shareholders’ eq-

uity at year-end 2014 was $1,519,530 in thousands.) 5. Basic net income per common share (round to the nearest cent).

TAKING IT TO THE NET P3

BTN 13-4 A team approach to learning financial statement analysis is often useful.

Required

1. Each team should write a description of horizontal and vertical analysis that all team members agree with and understand. Illustrate each description with an example.

2. Each member of the team is to select one of the following categories of ratio analysis. Explain what the ratios in that category measure. Choose one ratio from the category selected, present its formula, and explain what it measures.

a. Liquidity and efficiency c. Profitability b. Solvency d. Market prospects 3. Each team member is to present his or her notes from part 2 to teammates. Team members are to con-

firm or correct other teammates’ presentations.

TEAMWORK IN ACTION P1 P2 P3

Hint: Pairing within teams may be necessary for part 2. Use as an in-class activity or as an assign- ment. Consider presentations to the entire class using team rotation with slides.

BTN 13-5 Assume that Carla Harris of Morgan Stanley (MorganStanley.com) has impressed you with the company’s success and its commitment to ethical behavior. You learn of a staff opening at Morgan Stanley and decide to apply for it. Your resume is successfully screened from those received and you advance to the interview process. You learn that the interview consists of analyzing the following finan- cial facts and answering analysis questions below. (The data are taken from a small merchandiser in out- door recreational equipment.)

ENTREPRENEURIAL DECISION A1 P1 P2 P3

2019 2018 2017

Sales trend percents . . . . . . . . . . . . . . . . . . . . . . . 137 .0% 125 .0% 100 .0%

Selling expenses to sales . . . . . . . . . . . . . . . . . . . 9 .8% 13 .7% 15 .3%

Sales to plant assets ratio . . . . . . . . . . . . . . . . . . 3 .5 to 1 3 .3 to 1 3 .0 to 1

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 .6 to 1 2 .4 to 1 2 .1 to 1

Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .8 to 1 1 .1 to 1 1 .2 to 1

Merchandise inventory turnover . . . . . . . . . . . . . 7 .5 times 8 .7 times 9 .9 times

Accounts receivable turnover . . . . . . . . . . . . . . . 6 .7 times 7 .4 times 8 .2 times

Total asset turnover . . . . . . . . . . . . . . . . . . . . . . . 2 .6 times 2 .6 times 3 .0 times

Return on total assets . . . . . . . . . . . . . . . . . . . . . . 8 .8% 9 .4% 11 .1%

Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . 9 .75% 11 .50% 12 .25%

Profit margin ratio . . . . . . . . . . . . . . . . . . . . . . . . . 3 .3% 3 .5% 3 .7%

Required

Use these data to answer each of the following questions with explanations. 1. Is it becoming easier for the company to meet its current liabilities on time and to take advantage of

any available cash discounts? Explain. 2. Is the company collecting its accounts receivable more rapidly? Explain.

Chapter 13 Analysis of Financial Statements 533

3. Is the company’s investment in accounts receivable decreasing? Explain. 4. Is the company’s investment in plant assets increasing? Explain. 5. Is the owner’s investment becoming more profitable? Explain. 6. Did the dollar amount of selling expenses decrease during the three-year period? Explain.

BTN 13-6 You are to devise an investment strategy to enable you to accumulate $1,000,000 by age 65. Start by making some assumptions about your salary. Next, compute the percent of your salary that you will be able to save each year. If you will receive any lump-sum monies, include those amounts in your calculations. Historically, stocks have delivered average annual returns of around 10%. Given this history, you probably should not assume that you will earn above 10% on the money you invest. It is not necessary to specify exactly what types of assets you will buy for your investments; just assume a rate you expect to earn. Use the future value tables in Appendix B to calculate how your savings will grow. Experiment a bit with your figures to see how much less you have to save if you start at, for example, age 25 versus age 35 or 40. (For this assignment, do not include inflation in your calculations.)

HITTING THE ROAD C1 P3

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Learning Objectives

CONCEPTUAL C1 Explain the purpose and nature of, and

the role of ethics in, managerial accounting.

C2 Describe accounting concepts useful in classifying costs.

C3 Define product and period costs and explain how they impact financial statements.

ANALYTICAL A1 Assess raw materials inventory

management using raw materials inventory turnover and days’ sales in raw materials inventory.

PROCEDURAL P1 Compute cost of goods sold for a

manufacturer and for a merchandiser.

P2 Prepare a schedule of cost of goods manufactured and explain its purpose and links to financial statements.

C4 Explain how balance sheets and income statements for manufacturing, merchandising, and service companies differ.

C5 Explain manufacturing activities and the flow of manufacturing costs.

C6 Describe trends in managerial accounting.

Chapter Preview

14 Managerial Accounting Concepts and Principles

COST FLOWS

C5 Flow of activities P2 Schedule of cost of

goods manufactured

C6 Trends

A1 Inventory analysis

MANAGERIAL REPORTING

C4 Manufacturing costs Nonmanufacturing costs

Balance sheet

P1 Income statement

MANAGERIAL COST CONCEPTS

C2 Types of cost classifications

C3 Identification of cost classifications

Cost concepts for service companies

NTK 14-4NTK 14-3NTK 14-2NTK 14-1

MANAGERIAL ACCOUNTING BASICS

C1 Purpose and nature of managerial accounting

Fraud and ethics

Career paths

535

“Make the world better”—Kwami Williams

It Grows on Trees

BOSTON—On a college trip to Ghana, students Kwami Williams and Emily Cunningham were struck by the extreme poverty and subsistence farming amid such fertile land and tropical climate. However, one bountiful crop—the moringa tree—caught their eye. Locals call it the “miracle tree” because it grows and spreads so easily.

Moringa leaves are packed with nutrients, and oil from its seeds makes a silky skin moisturizer. Seizing the opportunity, Kwami and Emily started their business, MoringaConnect (MoringaConnect.com).

“Starting a business in Ghana is not easy,” admits Emily. Government corruption and persistent power outages are some of the hurdles. “We had to build trust with local farmers.” Now, over 2,000 Ghanaian farmers supply the company with raw ma- terials for its two product lines: True Moringa beauty supplies sold in the United States and Minga Foods powder sold in Ghana.

Kwami and Emily point out that knowing basic managerial principles, cost classifications, and cost flows was crucial to set- ting up operations. “We manage the whole supply chain,” ex- plains Emily. “A good accounting system is needed to monitor costs and operations.” Regarding income, Kwami says, “we’ve

provided over $400,000 to farmers.” The company also tracks nonfinancial measures like crop yield.

While the global market for moringa is growing, Kwami and Emily remain focused on Ghanaians, advising farmers, buying moringa seeds at a fair price, and employing locals in the company’s processing center. Proclaims Emily, “Our purpose is to have an ethical business that improves living and work- ing conditions!”

Sources: MoringaConnect website, January 2019; beautyliestruth.com/blog/truemoringa; bondenavant.com/true-moringa-interview/; mywekustastes.com, February 11, 2017; bostonmagazine.com, June 8, 2016

©MoringaConnect

Managerial accounting provides financial and nonfinancial information to an organization’s managers. Managers include, for example, employees in charge of a company’s divisions; the heads of marketing, information technology, and human resources; and top-level managers such as the chief executive officer (CEO) and chief financial officer (CFO). This section explains the purpose of managerial accounting (also called management accounting) and compares it with financial accounting.

Purpose of Managerial Accounting The purpose of managerial accounting is to provide useful information to aid in three key man- agerial tasks. Determining the costs of an organization’s products and services. Planning future activities. Comparing actual results to planned results.

For example, managerial accounting information can help the marketing manager decide whether to advertise on social media such as Twitter; it also can help Google’s information technology manager decide whether to buy new computers.

The managerial accounting system collects cost information and assigns it to an organiza- tion’s products and services. Cost information is important for many decisions, such as product pricing, profitability analysis, and whether to make or buy a component. Much of managerial accounting involves gathering information about costs for planning and control decisions.

Planning is the process of setting goals and making plans to achieve them. Companies make long-term strategic plans that usually span a 5- to 10-year horizon. Short-term plans then trans- late the strategic plan into actions, which are more concrete and consist of better-defined goals. A short-term plan often covers a one-year period that, when translated into monetary terms, is known as a budget.

C1 Explain the purpose and nature of, and the role of ethics in, managerial accounting.

Point: Costs are important to man- agers because they impact both the financial position and profit- ability of a business. Managerial accounting assists in analysis, planning, and control of costs.

Point: Planning involves risk. Enterprise risk management (ERM) includes the systems and processes companies use to mini- mize risks such as data breaches, fraud, and loss of assets.

MANAGERIAL ACCOUNTING BASICS

536 Chapter 14 Managerial Accounting Concepts and Principles

Nature of Managerial Accounting Managerial accounting differs from financial accounting. We list seven key differences in Exhibit 14.2.

Control is the process of monitoring planning decisions and evaluating an organization’s activities and employees. Feedback provided by the control function allows managers to revise their plans. Managers periodically compare actual results with planned results and take correc- tive actions to obtain better results. Exhibit 14.1 portrays the important management functions of planning and control and the types of questions they seek to answer.

Monitoring

Feedback

Planning • Build a new factory? • Develop new products? • Expand into new markets?

Control • Are costs too high? • Are services profitable? • Are customers satisfied?

EXHIBIT 14.1 Planning and Control (including monitoring and feedback)

“This company’s outlook is good.

I’ll buy its stock.”

“This department is doing well.

We’ll expand its product line.”

External: Investors, creditors, and others outside of the organization’s managers

Help external users make investment, credit, and other decisions

Structured and often controlled by GAAP

Often available only after an audit

The past; historical information with some predictions

The whole organization

Monetary information

1. Users and decision makers

2. Purpose of information

3. Flexibility of reporting

4. Timeliness of information

5. Time dimension

6. Focus of information

7. Nature of information

Internal: Managers, employees, and decision makers inside the organization

Help managers make planning and control decisions

Relatively flexible (no GAAP constraints)

Available quickly without an audit

The future; many projections and estimates, with some historical information

An organization’s projects, processes, and divisions

Mostly monetary; some nonmonetary

Financial Accounting Managerial Accounting

EXHIBIT 14.2 Key Differences between Managerial Accounting and Financial Accounting

Users and Decision Makers Companies report to different groups of decision makers. Financial accounting information is provided primarily to external users including in- vestors, creditors, and regulators. External users do not manage a company’s daily activities. Managerial accounting information is provided primarily to internal managers and employees who make and implement decisions about a company’s business activities.

Purpose of Information External users of financial accounting information often must decide whether to invest in or lend to a company. Internal decision makers must plan a company’s future to take advantage of opportunities or to overcome obstacles. They also try to control activities.

Flexibility of Reporting An extensive set of rules, or GAAP, aims to protect external users from false or misleading information in financial reports. Managers are responsible for preventing and detecting fraudulent activities in their companies, including their financial re- ports. Managerial accounting does not rely on extensive rules. Instead, companies determine what information they need to make planning and control decisions, and then they decide how that information is best collected and reported.

Timeliness of Information Independent auditors often must audit a company’s finan- cial statements before providing them to external users. As audits take time to complete, financial reports to outsiders usually are not available until well after the period-end. However,

Point: It is desirable to accumulate some information for management reports in a database separate from financial accounting records.

Chapter 14 Managerial Accounting Concepts and Principles 537

managers can quickly obtain managerial accounting information. External auditors need not review it. Estimates and projections are acceptable. To get information quickly, managers often accept less precision in reports. For example, an early internal report to management could esti- mate net income for the year between $4.2 and $4.5 million. An audited income statement could later show net income for the year at $4.4 million. The internal report is not precise, but its in- formation can be more useful because it is available earlier.

Time Dimension External financial reports deal primarily with results of past activities and current conditions. While some predictions such as service lives and salvage values of plant assets are necessary, financial accounting avoids predictions whenever possible. Managerial ac- counting regularly includes predictions. One important managerial accounting report is a bud- get, which predicts revenues, expenses, and other items. Making predictions, and evaluating those predictions, are important skills for managers.

Focus of Information Companies often organize into divisions and departments, but external investors own shares in or make loans to the entire company. Financial accounting fo- cuses primarily on a company as a whole, as shown in the top part of Exhibit 14.3.

The focus of managerial accounting is different. While the CEO manages the whole com- pany, most other managers are responsible for much smaller sets of activities. These lower-level managers need reports on their specific activities. This information includes the level of success achieved by each individual, product, or department in each division of the whole company, as shown in the bottom part of Exhibit 14.3.

Nature of Information Both financial and managerial accounting systems report mon- etary information. Managerial accounting systems also report considerable nonmonetary infor- mation. Common examples of nonmonetary information include customer and employee satisfaction data, percentage of on-time deliveries, product defect rates, energy from renewable sources, and employee diversity.

Fraud and Ethics in Managerial Accounting Fraud, and the role of ethics in reducing fraud, are important factors in running business opera- tions. Fraud involves the use of one’s job for personal gain through the deliberate misuse of the employer’s assets. Examples include theft of the employer’s cash or other assets, overstating reimbursable expenses, payroll schemes, and financial statement fraud. Three factors must exist for a person to commit fraud: opportunity, financial pressure, and rationalization. This is known as the fraud triangle. Fraud affects all business and it is costly: The 2016 Report to the Nations from the Association of Certified Fraud Examiners (ACFE) estimates the average U.S. business loses 5% of its annual revenues to fraud.

The most common type of fraud, where employees steal or misuse the employer’s resources, results in an average loss of $130,000 per occurrence. For example, in a billing fraud, an employee sets up a bogus supplier. The employee then prepares bills from the supplier and pays these bills from the employer’s checking account. The employee cashes the checks sent to the bogus supplier and uses them for his or her own personal benefit. An organization’s best chance to minimize fraud is through reducing opportunities for employees to commit fraud.

Implications of Fraud for Managerial Accounting Fraud increases a business’s costs and hurts information reliability. Left undetected, inaccurate costs can result in poor pricing decisions, an improper product mix, and faulty performance evaluations. All of these can lead to poor results for the company. Managers rely on a reliable internal control system to monitor and control business activities. An internal control system is the policies and procedures managers use to Ensure reliable accounting. Uphold company policies. Protect assets. Promote efficient operations.

Combating fraud requires ethics in accounting. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identifying the ethical path can be difficult. The Institute of Management Accountants (IMA), the professional association for management accountants, has issued a code of ethics to help accountants solve ethical dilemmas.

Point: Internal auditing in manage- rial accounting evaluates informa- tion reliability not only inside but outside the company.

EXHIBIT 14.3 Focus of External and Internal Reports

Company Performance

Company Performance

Reports to external users focus on the company as a whole.

Company Performance

Product Performance

Reports to internal users focus on company units and divisions.

©Joe Prachatree/Shutterstock

O pp

or tu

nit y

Rationalization

Financial Pressure

538 Chapter 14 Managerial Accounting Concepts and Principles

The IMA’s Statement of Ethical Professional Practice requires that management accountants be competent, maintain confidentiality, act with integrity, and communicate information in a fair and credible manner.

The IMA provides a “road map” for resolving ethical conflicts. It suggests that an employee follow the company’s policies on how to resolve such conflicts. If the conflict remains un resolved, an employee should contact the next level of management (such as the immediate supervisor) who is not involved in the ethical conflict.

Point: The Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior officers and the content of that code.

Production Manager Three friends go to a restaurant. David, a self-employed entrepreneur, says, “I’ll pay and de- duct it as a business expense.” Denise, a salesperson, takes the check and says, “I’ll put this on my company’s credit card. It won’t cost us anything.” Derek, a factory manager, says, “I’ll use my company’s credit card and call it overhead on a cost-plus contract with a client.” (A cost-plus contract means the company receives its costs plus a percent of those costs.) “That way, my company pays for dinner and makes a profit.” Who should pay? ■ Answer: All three friends want to pay the bill with someone else’s money. To prevent such practices, companies have internal controls. Some entertainment expenses are justifiable and even encouraged. For example, the tax law allows certain deductions for entertainment having a business purpose. Corporate policies sometimes allow and encourage reimbursable spending for social activities, and contracts can include entertainment as allowable costs. Nevertheless, without further details, this bill should be paid from personal accounts.

Decision Ethics

Career Paths Managerial accountants are highly regarded and in high demand. Managerial accountants must have strong communication skills, understand how businesses work, and be team players. They must be able to analyze information and think critically, and they are often considered to be important business advisors. Exhibit 14.4 shows estimated annual salaries from recent surveys. Salary variation depends on management level, company size, geographic location, professional designation, experience, and other factors.

Top-Level Managers Annual Salary

Chief financial officer (CFO) . . . . . $290,000

Controller/Treasurer . . . . . . . . . . . 180,000

Senior-Level Managers Annual Salary

Division controller . . . . . . . . . . . . $130,000

General manager . . . . . . . . . . . . . 105,000

Mid- and Entry-Level Jobs Annual Salary

Financial analyst . . . . . . . . . . . . . . $85,000

Senior accountant . . . . . . . . . . . . 85,000

Staff accountant . . . . . . . . . . . . . . 60,000

EXHIBIT 14.4 Average Annual Salaries for Selected Management Levels

Managerial accounting information is used in many careers. Marketing staff need sales and cost data to decide which products to promote. Management needs sales force details to evaluate performance. Entrepreneurs use costs, budgets, and financial statements to succeed. Nonbusiness majors, including engineers, health care professionals, and others, increasingly

use accounting information as their careers advance.

Following are aspects of accounting information. Classify each as pertaining more to financial accounting or to managerial accounting. 1. Primary users are external 5. Controlled by GAAP 2. Includes more nonmonetary information 6. Used in managers’ planning decisions 3. Focuses more on the future 7. Focuses on the whole organization 4. Uses many estimates and projections 8. Not constrained by GAAP Solution

Managerial Accounting Basics

NEED-TO-KNOW 14-1

C1

Financial Managerial

1 . Primary users are external . . . . . . . . . . . . . . X

2 . Includes more nonmonetary information . . . X

3 . Focuses more on the future . . . . . . . . . . . . . X

4 . Uses many estimates and projections . . . . . X

Financial Managerial

5 . Controlled by GAAP . . . . . . . . . . . . . . . . . . . X

6 . Used in managers’ planning decisions . . . X

7 . Focuses on the whole organization . . . . . . X

8 . Not constrained by GAAP . . . . . . . . . . . . . . X

Do More: QS 14-1, E 14-1

Point: The IMA issues the Certified Management Accountant (CMA) and the Certified Financial Manager (CFM) certifications.

Point: Employees with the Certified Management Accountant (CMA) or Certified Financial Manager (CFM) certifications typically earn higher salaries than those without.

Chapter 14 Managerial Accounting Concepts and Principles 539

Direct versus Indirect A cost is often traced to a cost object, which is a product, pro- cess, department, or customer to which costs are assigned. Direct costs are traceable to a single cost object. Indirect costs cannot be easily and cost-beneficially traced to a single cost object.

Assuming the cost object is a bicycle, Rocky Mountain Bikes will identify the costs that can be directly traced to bicycles. The direct costs traceable to a bicycle include direct material and direct labor costs used in its production.

What are indirect costs associated with bicycles? One example is the salary of the supervisor. She monitors the production process and other factory activities, but she does not actually make bikes. Thus, her salary cannot be directly traced to bikes. Another example is a maintenance depart- ment that provides services to many departments. If the cost object is the bicycle, the wages of the maintenance department employees who clean the factory area are indirect costs. Exhibit 14.6 lists more examples of direct and indirect costs when the cost object is a bicycle.

Because managers use costs for many different purposes, organizations classify costs in different ways. This section explains three common ways to classify costs and links them to managerial deci- sions. We illustrate these cost classifications with Rocky Mountain Bikes, a manufacturer of bicycles.

Types of Cost Classifications Fixed versus Variable A cost can be classified by how it changes, in total, with changes in the volume of activity. Fixed costs do not change with changes in the volume of activity (within a range of activity

known as an activity’s relevant range). For example, straight-line depreciation on equipment is a fixed cost.

Variable costs change in proportion to changes in the volume of activity. Sales commissions computed as a percent of sales revenue are variable costs.

Additional examples of fixed and variable costs for a bike manufacturer are provided in Exhibit 14.5. Classifying costs as fixed or variable helps in cost-volume-profit analyses and short-term decision making.

MANAGERIAL COST CONCEPTS C2 Describe accounting concepts useful in classifying costs.

Variable Cost: Cost of bicycle tires increases by $15 for each

bike produced.

Fixed Cost: Rent for Rocky Mountain Bikes’s building is $22,000. It doesn’t change with the number of bikes produced.

EXHIBIT 14.5 Fixed and Variable Costs (in total)

OIL OIL OIL

OIL O IL O

IL

Direct Costs (for bicycle)

• Tires • Seats • Handlebars • Cables • Bike maker wages

• Frames • Chains • Brakes • Pedals • Bike maker benefits

Indirect Costs (for bicycle)

• Factory accounting • Factory administration • Factory rent • Factory manager’s salary

• Factory light and heat • Factory intranet • Insurance on factory • Factory equipment depreciation*

*For all depreciation methods other than units-of-production.

EXHIBIT 14.6 Direct and Indirect Costs for a Bicycle

540 Chapter 14 Managerial Accounting Concepts and Principles

Product versus Period Costs Product costs are those costs necessary to create a product and consist of: direct materials,

direct labor, and factory overhead. Overhead refers to production costs other than direct ma- terials and direct labor. Product costs are capitalized as inventory during and after completion of products; they become cost of goods sold when those products are sold.

Period costs are nonproduction costs and are usually associated more with activities linked to a time period than with completed products. Common examples include salaries of the sales staff, wages of maintenance workers, advertising expenses, and depreciation on office furniture and equipment. Period costs are expensed in the period when incurred either as selling ex- penses or as general and administrative expenses.

Exhibit 14.7 shows the different effects of product and period costs. Period costs flow directly to the current income statement as expenses. They are not reported as assets. Product costs are first assigned to inventory. Their final treatment depends on when inventory is sold or disposed of. Product costs assigned to finished goods that are sold in year 2019 are reported on the 2019 income statement as cost of goods sold. Product costs assigned to unsold inventory are carried forward on the balance sheet at the end of year 2019. If this inventory is sold in year 2020, prod- uct costs assigned to it are reported as cost of goods sold in that year’s income statement.

Balance sheet → Income stmt.

Point: Product costs are either in the income statement as part of cost of goods sold or in the balance sheet as inventory. Period costs appear only on the income statement as operating expenses.

C3 Define product and period costs and explain how they impact financial statements.

Entrepreneur You wish to trace as many of your assembly department’s direct costs as possible. You can trace 90% of them in an economical manner. To trace the other 10%, you need sophisticated and costly accounting software. Do you buy this software? ■ Answer: Tracing all costs directly to cost objects is desirable if it can be economically done. In this case, you can trace 90% of the assembly department’s direct costs. It may not be economical to spend more money on new software to trace the final 10% of costs. You need to make a cost-benefit trade-off. If the software offers benefits beyond tracing the remaining 10% of the assembly department’s costs, your decision should consider this.

Decision Maker

Costs Classified As Example Managerial Decision

Variable or Fixed . . . . . . . . . . . . . How many units must we sell to break even? What will profit be if we lower selling price? Should we add a new line of business?

Direct or Indirect . . . . . . . . . . . . . How well did our departments perform?

Product or Period . . . . . . . . . . . . What is the cost of our inventory? Are selling expenses too high?

EXHIBIT 14.8 Summary of Cost Classifications and Example Managerial Decisions

Point: Later chapters discuss more ways to classify costs.

Operating expenses

Cost of goods sold

Year 2019 Income Statement

Inventory sold in

year 2019

Inventory not sold until

year 2020

*This diagram excludes costs to acquire assets other than inventory.

Product costs

(inventory) y

ntill 0

nventory.

Inventory • Raw materials • Work in process • Finished goods

December 31, 2019 Balance Sheet

Year 2019 costs

incurred*

Year 2020 Income Statement

Cost of goods sold

Period costs

(expenses)

Inventory sold in

2020

EXHIBIT 14.7 Period and Product Costs in Financial Statements

Exhibit 14.8 summarizes typical managerial decisions for common cost classifications.

Income statement

Chapter 14 Managerial Accounting Concepts and Principles 541

Cost Item Fixed or Variable Direct or Indirect Product or Period

Bicycle tires and wheels . . . . . . . . . . . . . . . . . . . . . . Variable Direct Product Wages of assembly worker* . . . . . . . . . . . . . . . . . . . Variable Direct Product Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Indirect Period Production manager’s salary . . . . . . . . . . . . . . . . . . Fixed Indirect Product Office depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Indirect Period Factory depreciation (straight-line) . . . . . . . . . . . . . Fixed Indirect Product Oil and grease applied to gears/chains† . . . . . . . . . Variable Indirect Product Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . Variable Indirect Period

* In some cases wages can be classified as fixed costs. For example, union contracts might limit an employer’s ability to adjust its labor force in response to changes in demand. In this book, unless told otherwise, assume that factory wages are variable costs.

†Oil and grease are indirect costs as it is not practical to track how much of each is applied to each bike.

EXHIBIT 14.9 Examples of Multiple Cost Classifications

Identification of Cost Classifications Costs can be classified using any one (or combination) of the three different ways described here. Understanding how to classify costs in several different ways enables managers to use cost informa- tion for a variety of decisions. Factory rent, for instance, is classified as a product cost; it also is fixed with respect to the number of units produced, and it is indirect with respect to the product. Potential multiple classifications are shown in Exhibit 14.9 when the finished bike is the cost object.

Cost Concepts for Service Companies Cost concepts also apply to service organizations. For example, consider Southwest Airlines, and assume the cost object is a flight. The airline’s cost of beverages for passengers is a variable cost based on number of flights. The monthly cost of leasing an aircraft is fixed with respect to number of flights. We can trace a flight crew’s salary to a specific flight, whereas we likely can- not trace wages for the ground crew to a specific flight. Classification as product versus period costs is not relevant to service companies because services are not inventoried. Instead, costs incurred by a service firm are expensed in the reporting period when incurred.

Managers in service companies must understand and apply cost concepts. For example, an airline manager must often decide between canceling or rerouting flights. The manager must be able to estimate costs saved by canceling a flight versus rerouting. Knowledge of fixed costs is equally important. We explain more about the cost requirements for these and other managerial decisions throughout this book.

Selling expenses

Administrative expenses

All Costs

Direct materials

Direct labor

Manufacturing overhead

• Indirect materials

• Indirect labor • Other indirect costs

Product costs Period costs

Service Costs

• Beverages and snacks • Pilot and copilot salaries • Attendant salaries • Fuel and oil costs • Travel agent fees • Ground crew salaries

©Justin Sullivan/Getty Images

Following are selected costs of a company that manufactures computer chips. Classify each as either a prod- uct cost or a period cost. Then classify each of the product costs as direct material, direct labor, or overhead. 1. Plastic boards used to mount chips 2. Advertising costs 3. Factory maintenance workers’ salaries 4. Real estate taxes paid on the sales office

C2 C3 Cost Classification

NEED-TO-KNOW 14-2 5. Real estate taxes paid on the factory 6. Factory supervisor salary 7. Depreciation on factory equipment 8. Assembly worker hourly pay to make chips

Solution

Product Costs

Direct Material Direct Labor Overhead Period Cost

1 . Plastic boards used to mount chips . . . . . . . . . X 2 . Advertising costs . . . . . . . . . . . . . . . . . . . . . . . . . X 3 . Factory maintenance workers’ salaries . . . . . . . X 4 . Real estate taxes paid on the sales office . . . . . X 5 . Real estate taxes paid on the factory . . . . . . . . . X 6 . Factory supervisor salary . . . . . . . . . . . . . . . . . . X 7 . Depreciation on factory equipment . . . . . . . . . . X 8 . Assembly worker hourly pay to make chips . . . X

Do More: QS 14-4, QS 14-5, E 14-5

542 Chapter 14 Managerial Accounting Concepts and Principles

Companies with manufacturing activities differ from both merchandising and service compa- nies. The main difference between merchandising and manufacturing companies is that mer- chandisers buy goods ready for sale while manufacturers produce goods from materials, labor, and equipment. Amazon is a merchandiser. It buys and sells goods without physically changing them. Adidas is a manufacturer of shoes, apparel, and accessories. It purchases materials such as

leather, cloth, dye, plastic, rubber, glue, and laces and then converts these materials to products. Southwest Airlines is a service company that transports people and items. Best Buy is a merchandiser that also provides services via its Geek Squad, showing that

some companies pursue multiple activities.

Manufacturing companies like Dell, PepsiCo, and Intel separate their costs into manufactur- ing and nonmanufacturing costs. We discuss this next.

Manufacturing Costs Direct Materials Direct materials are tangible components of a finished product. Direct materials costs are the expenditures for direct materials that are separately and readily traced through the manufacturing process to finished goods. Examples of direct materials in manufactur- ing a mountain bike include its tires, seat, frame, pedals, brakes, cables, gears, and handlebars.

Direct Labor Direct labor refers to employees who physically convert materials to fin- ished product. Direct labor costs are the wages and benefits for direct labor that are separately and readily traced through the manufacturing process to finished goods. Examples of direct la- bor in manufacturing a mountain bike include operators directly involved in converting raw materials into finished products (welding, painting, forming) and assembly workers who attach materials such as tires, seats, pedals, and brakes.

Factory Overhead Factory overhead, also called manufacturing overhead, consists of all manufacturing costs that are not direct materials or direct labor. Factory overhead costs are not separately or readily traced to finished goods. Factory overhead costs are indirect costs that include indirect materials, indirect labor, and other indirect costs not directly traceable to the product. Indirect materials are components used in manufacturing the product, but they are not clearly

identified with specific product units. Direct materials are often classified as indirect materials when their costs are low. Examples include screws and nuts used in assembling mountain bikes, and staples and glue used in manufacturing shoes. Applying the materiality principle, it is not cost-beneficial to trace costs of each of these materials to individual products.

Indirect labor are workers who assist or supervise in manufacturing the product, but they are not clearly identified with specific product units. Indirect labor costs refer to the costs of work- ers who assist in or supervise manufacturing. Examples include costs for employees who main- tain and repair manufacturing equipment and salaries of production supervisors. Those workers do not assemble products, though they are indirectly related to production. Overtime premiums paid to direct laborers are also included in overhead because overtime is due to delays, interrup- tions, or constraints not necessarily identifiable to a specific product or batches of product.

Indirect other costs include factory utilities (water, gas, electricity), factory rent, depreciation on factory buildings and equipment, factory insurance, property taxes on factory buildings and equipment, and factory accounting and legal services.

Nonmanufacturing Costs Factory overhead does not include selling and administrative expenses because they are not incurred in manufacturing products. These expenses are period costs, and they are recorded as

Direct materials + Direct labor + Overhead = Total mfg. costs

MANAGERIAL REPORTING

Typical Manufacturing Costs

Direct materials

45%

Direct labor 15%

Factory overhead

40%

Point: When overhead costs vary with production, they are called variable overhead. When overhead costs don’t vary with production, they are called fixed overhead.

Selling expenses + Administrative expenses = Total nonmfg. costs

Chapter 14 Managerial Accounting Concepts and Principles 543

expenses on the income statement when incurred. For a manufacturing company, such costs are also called nonmanufacturing costs. Examples of nonmanufacturing costs follow.

Selling Expenses Administrative Expenses ∙ Advertising costs ∙ Office accounting ∙ Delivery costs ∙ Office employee wages ∙ Salesperson salaries ∙ Office rent ∙ Salesperson commissions ∙ Office equipment depreciation ∙ Salesperson travel costs ∙ Office insurance ∙ Salesperson smartphone costs ∙ Office manager’s salary

Prime and Conversion Costs We can classify product costs into prime or conversion costs as in Exhibit 14.10. Direct materials costs and direct labor costs are prime costs—costs directly associated with the manufacture of finished goods. Direct labor costs and overhead costs are conversion costs—costs incurred in the process of converting raw materials to finished goods. Direct labor costs are considered both prime costs and conversion costs.

Costs and the Balance Sheet Manufacturers have three inventories instead of the single inventory that merchandisers carry. The three inventories are raw materials, work in process, and finished goods.

Raw Materials Inventory Raw materials inventory is the goods a company acquires to use in making products. Companies use raw materials in two ways: directly and indirectly. Raw materials that are possible and practical to trace to a product are called direct materials; they are included in raw materials inventory. Raw materials that are either impossible or imprac- tical to trace to a product are classified as indirect materials (such as solder used for welding); they often come from factory supplies or raw materials inventory.

Work in Process Inventory Work in process inventory, also called goods in pro- cess inventory, consists of products in the process of being manufactured but not yet com- plete. The amount of work in process inventory depends on the type of production process. Work in process inventory is less for a computer maker such as Dell than for an airplane maker such as Boeing.

Finished Goods Inventory Finished goods inventory consists of completed prod- ucts ready for sale. It is similar to merchandise inventory owned by a merchandising company.

Balance Sheets for Manufacturers, Merchandisers, and Servicers The current assets section of the balance sheet is different for merchandising and service companies as compared to manufacturing companies. A merchandiser reports only merchandise inventory rather than the three types of inventory reported by a manufacturer. A service company’s bal- ance sheet does not have any inventory held for sale. Exhibit 14.11 shows the current assets section of the balance sheet for a manufacturer, a merchandiser, and a service company. The manufacturer, Rocky Mountain Bikes, shows three different inventories. The merchandiser, Tele-Mart, shows one inventory, and the service provider, Northeast Air, shows no inventory.

Manufacturers often own unique plant assets such as small tools, factory buildings, factory equipment, and patents to manufacture products. Merchandisers and service providers also own plant assets, including buildings, delivery vehicles, and airplanes.

Costs and the Income Statement The main difference between the income statement of a manufacturer and that of a merchandiser involves the items making up cost of goods sold. In this section, we look at how manufacturers and merchandisers determine and report cost of goods sold.

Prim e Costs

PrimeCosts

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Conversio nC

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Direct Labor

Direct Materials

Factory Overhead

EXHIBIT 14.10 Prime and Conversion Costs and Their Makeup

Prime costs = Direct materials + Direct labor .

Conversion costs = Direct labor + Factory overhead .

C4 Explain how balance sheets and income statements for manufacturing, merchandising, and service companies differ.

Point: This chapter accounts for indirect materials in Factory Supplies.

P1 Compute cost of goods sold for a manufacturer and for a merchandiser.

544 Chapter 14 Managerial Accounting Concepts and Principles

Cost of Goods Sold Exhibit 14.12 compares the components of cost of goods sold for a merchandiser with those for a manufacturer. Merchandisers add cost of goods purchased to beginning merchandise inventory and then

subtract ending merchandise inventory to compute cost of goods sold. Manufacturers add cost of goods manufactured to beginning finished goods inventory and

then subtract ending finished goods inventory to compute cost of goods sold.

ROCKY MOUNTAIN BIKES Balance Sheet (partial)

December 31, 2019

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . $11,000

Accounts receivable, net . . . . . 30,150

Raw materials inventory . . . . . . 9,000

Work in process inventory . . . . . 7,500

Finished goods inventory . . . . . 10,300

Factory supplies . . . . . . . . . . . . 350

Prepaid insurance . . . . . . . . . . . 300

Total current assets . . . . . . . . . . $68,600

TELE-MART (Merchandiser) Balance Sheet (partial)

December 31, 2019

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . $11,000

Accounts receivable, net . . . . . 30,150

Merchandise inventory . . . . . . . 21,000

Supplies . . . . . . . . . . . . . . . . . . . 350

Prepaid insurance . . . . . . . . . . . 300

Total current assets . . . . . . . . . . $62,800

NORTHEAST AIR (Service Provider) Balance Sheet (partial)

December 31, 2019

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . $11,000

Accounts receivable, net . . . . . . 30,150

Supplies . . . . . . . . . . . . . . . . . . . 350

Prepaid insurance . . . . . . . . . . . 300

Total current assets . . . . . . . . . . $41,800

EXHIBIT 14.11 Balance Sheets for Manufacturer, Merchandiser, and Service Provider

Merchandiser Beginning merchandise inventory

Cost of goods purchased

Ending merchandise inventory

+ –

Manufacturer Beginning finished goods inventory

Cost of goods manufactured

Ending finished goods inventory

= Cost of goods sold

–+

EXHIBIT 14.12 Cost of Goods Sold Computation

In computing cost of goods sold, a merchandiser uses merchandise inventory, whereas a manufacturer uses finished goods inventory. A manufacturer’s inventories of raw materials and work in process are not included in finished goods because they are not available for sale. A manufacturer also shows cost of goods manufactured instead of cost of goods purchased. A merchandiser’s cost of goods purchased is the cost of buying products to be sold. A manufac- turer’s cost of goods manufactured is the sum of direct materials, direct labor, and factory over- head costs incurred in making products. The Cost of Goods Sold sections for both a merchandiser (Tele-Mart) and a manufacturer (Rocky Mountain Bikes) are shown in Exhibit 14.13. The remaining income statement sections are similar for merchandisers and manufacturers.

*Cost of goods manufactured is in the income statement of Exhibit 14.14.

Merchandising Company (Tele-Mart)

Cost of goods sold Beginning merchandise inventory . . . . . . $ 14,200 Cost of merchandise purchased . . . . . . . . 234,150 Goods available for sale . . . . . . . . . . . . . . . . 248,350 Less ending merchandise inventory . . . . 12,100 Cost of goods sold . . . . . . . . . . . . . . . . . . . . $236,250

Manufacturing Company (Rocky Mtn. Bikes)

Cost of goods sold Beginning finished goods inventory . . . . . . $ 11,200 Cost of goods manufactured* . . . . . . . . . . . 170,500 Goods available for sale . . . . . . . . . . . . . . . . . 181,700 Less ending finished goods inventory . . . . 10,300 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . $171,400

EXHIBIT 14.13 Cost of Goods Sold for a Merchandiser and Manufacturer

Costs for a Service Company Because a service provider does not make or buy in- ventory to be sold, it does not report cost of goods manufactured or cost of goods sold. Instead,

Chapter 14 Managerial Accounting Concepts and Principles 545

its operating expenses include all of the costs it incurs in providing its service. Southwest Airlines, for example, reports large operating expenses for employee pay and benefits, fuel and oil, and depreciation. Southwest’s operating expenses also include selling expenses and general and administrative expenses.

Income Statements for Manufacturers, Merchandisers, and Servicers Exhibit 14.14 shows the income statement for Rocky Mountain Bikes. Its operating expenses include selling expenses and general and administrative expenses, which include salaries for those business functions as well as depreciation for related equipment. Operating expenses do not include manufacturing costs such as factory workers’ wages and depreciation of production equipment and the factory buildings. These manufacturing costs are reported as part of cost of goods manufactured and included in cost of goods sold. This exhibit also shows the income statement for Tele-Mart (merchandiser) and Northeast Air (service provider). Tele-Mart reports cost of merchandise purchased instead of cost of goods manufactured. Tele-Mart reports its operating expenses like those of the manufacturing company. The income statement for Northeast Air shows only operating expenses.

TELE-MART (Merchandiser) Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $345,000

Cost of goods sold

Merchandise inventory, Dec . 31, 2018 . . . . . . . . $ 14,200

Cost of merchandise purchased . . . . . . . . . . . . . 234,150

Goods available for sale . . . . . . . . . . . . . . . . . . . 248,350

Merchandise inventory, Dec . 31, 2019 . . . . . . . . 12,100

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 236,250

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,750

Operating expenses

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . 43,150

General and administrative expenses . . . . . . . . . 26,750

Total operating expenses . . . . . . . . . . . . . . . . . . 69,900

Income before income taxes . . . . . . . . . . . . . . . . . . 38,850

Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . 16,084

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,766

NORTHEAST AIR (Service Provider) Income Statement

For Year Ended December 31, 2019

Service revenue . . . . . . . . . . . . . . . . . . . $425,000

Operating expenses

Salaries and wages . . . . . . . . . . . . . . $127,750

Fuel and oil . . . . . . . . . . . . . . . . . . . . 159,375

Maintenance and repairs . . . . . . . . . 29,750

Rent . . . . . . . . . . . . . . . . . . . . . . . . . . 42,500

Depreciation . . . . . . . . . . . . . . . . . . . . 14,000

General and admin . expenses . . . . . . 20,000

Total operating expenses . . . . . . . . . 393,375

Income before income taxes . . . . . . . . . 31,625

Income tax expense . . . . . . . . . . . . . . . . 13,100

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 18,525

ROCKY MOUNTAIN BIKES (Manufacturer) Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $310,000 Cost of goods sold

Finished goods inventory, Dec . 31, 2018 . . . . . . . . . . . $ 11,200

Cost of goods manufactured (from Exhibit 14 .13) . . . . 170,500

Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . 181,700

Less finished goods inventory, Dec . 31, 2019 . . . . . . 10,300

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,600

Operating expenses

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,150

General and administrative expenses . . . . . . . . . . . . . . 21,750

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . 59,900

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . 78,700

Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 46,100

EXHIBIT 14.14 Income Statements for Manufacturer, Merchandiser, and Service Provider

546 Chapter 14 Managerial Accounting Concepts and Principles

Indicate whether the following financial statement items apply to a manufacturer, a merchandiser, or a service provider. Some items apply to more than one type of organization.

1. Merchandise inventory 5. Operating expenses 2. Finished goods inventory 6. Cost of goods manufactured 3. Cost of goods sold 7. Supplies inventory 4. Selling expenses 8. Raw materials inventory

Solution

Costs and Inventories for Different Businesses

NEED-TO-KNOW 14-3

C4

Do More: E 14-7

Manufacturer Merchandiser Service Provider

1 . Merchandise inventory . . . . . . . . . . . . . . . . . ✓ 2 . Finished goods inventory . . . . . . . . . . . . . . . ✓ 3 . Cost of goods sold . . . . . . . . . . . . . . . . . . . . ✓ ✓ 4 . Selling expenses . . . . . . . . . . . . . . . . . . . . . ✓ ✓ ✓ 5 . Operating expenses . . . . . . . . . . . . . . . . . . . ✓ ✓ ✓ 6 . Cost of goods manufactured . . . . . . . . . . . . ✓ 7 . Supplies inventory . . . . . . . . . . . . . . . . . . . . . ✓ ✓ ✓ 8 . Raw materials inventory . . . . . . . . . . . . . . . . ✓

Flow of Manufacturing Activities For planning and control we must know the flow of manufacturing activities and costs. Exhibit 14.15 shows the flow of manufacturing activities and their cost flows. Looking across the top row, the activities flow consists of materials activity followed by production activity followed by sales activity. The boxes below those activities show the costs for each activity and how costs flow across the three activities.

C5 Explain manufacturing activities and the flow of manufacturing costs.

COST FLOWS AND COST OF GOODS MANUFACTURED

Balance Sheet Income Statement Cost of goods sold

Financial Reports

Materials Activity (raw materials)

Production Activity (work in process)

Sales Activity (finished goods)

Work in process beginning inventory

Factory overhead used

Direct labor used

Direct materials used

Finished goods beginning inventory

Goods manufactured

Raw materials beginning inventory

Raw materials purchases

Raw materials ending inventory Work in process ending inventory Finished goods ending inventory

DM* used

Unsold

Finished

Unfinished

Sold

IM used

Unused material

*DM = direct materials, IM = indirect materials.

EXHIBIT 14.15 Activities and Cost Flows in Manufacturing

Chapter 14 Managerial Accounting Concepts and Principles 547

Materials Activity The left side of Exhibit 14.15 shows the flow of raw materials. Manufacturers usually start a period with some beginning raw materials inventory left over from the previous period. The company then acquires more raw materials in the current period. Adding these purchases to beginning inventory gives total raw materials available for use in production. These raw materials are then either used in production in the current period or re- main in raw materials inventory at the end of the period for use in future periods.

Production Activity The middle section of Exhibit 14.15 describes production activity. The following factors and their costs come together in production. Beginning work in process inventory, that is, the costs of partially complete products from

the prior period. Direct materials, direct labor, and factory overhead incurred in the current period.

The production activity that takes place in the period results in products that are either fin- ished or not finished at the end of the period. The cost of finished products makes up the cost of goods manufactured for the current period. The cost of goods manufactured is the total cost of making and finishing products in the period. That amount is included on the income statement in the computation of cost of goods sold, as we showed in Exhibit 14.14. Unfinished products are identified as ending work in process inventory. The cost of unfinished products consists of raw materials, direct labor, and factory overhead and is reported on the current period’s balance sheet. The costs of both finished goods manufactured and work in process are product costs.

Sales Activity The far right side of Exhibit 14.15 shows what happens to the finished goods: The cost of the beginning inventory of finished goods plus the cost of the newly com- pleted units (goods manufactured) equals total finished goods available for sale in the current period. As they are sold, the cost of finished products sold is reported on the income statement as cost of goods sold. The cost of any finished products not sold in the period is reported as a current asset, finished goods inventory, on the current period’s balance sheet.

Schedule of Cost of Goods Manufactured Managers of manufacturing firms analyze product costs. Those managers aim to make better decisions about materials, labor, and overhead to reduce the cost of goods manufactured and increase income. A company’s manufacturing activities are described in a report called a schedule of cost of goods manufactured (also called a manufacturing statement or a state- ment of cost of goods manufactured). The schedule of cost of goods manufactured summa- rizes the types and amounts of costs incurred in the manufacturing process. Exhibit 14.16 shows the schedule of cost of goods manufactured for Rocky Mountain Bikes. The schedule is divided into four parts: direct materials, direct labor, overhead, and computation of cost of goods manufactured.

1 Compute direct materials used. Add the beginning raw materials inventory of $8,000 to the current period’s purchases of $86,500. This yields $94,500 of total raw materials avail- able for use. A physical count of inventory shows $9,000 of ending raw materials inventory. If $94,500 of materials were available for use and $9,000 of materials remain in inventory, then $85,500 of direct materials were used in the period. (This chapter assumes that only direct materials costs flow through the Raw Materials Inventory account and indirect mate- rials costs are recorded in Factory Supplies.)

2 Compute direct labor costs used. Rocky Mountain Bikes had total direct labor costs of $60,000 for the period. This amount includes wages, payroll taxes, and fringe benefits.

3 Compute total factory overhead costs used. The statement lists each important factory overhead item and its cost. All of these costs are indirectly related to manufacturing activi- ties. (Period expenses, such as selling expenses and other costs not related to manufacturing activities, are not reported on this statement.) Total factory overhead cost is $30,000. Some companies report only total factory overhead on the schedule of cost of goods manufactured and attach a separate schedule listing individual overhead costs.

P2 Prepare a schedule of cost of goods manufactured and explain its purpose and links to financial statements.

Raw Materials Inventory

Beg . bal . 8,000 Purch . 86,500 Mtls. used 85,500

End . bal . 9,000

Point: Manufacturers sometimes report variable and fixed overhead separately in the schedule of cost of goods manufactured to provide more information to managers about cost behavior.

548 Chapter 14 Managerial Accounting Concepts and Principles

4 Compute cost of goods manufactured. Total manufacturing costs for the period are $175,500 ($85,500 + $60,000 + $30,000), the sum of direct materials, direct labor, and overhead costs. This amount is added to beginning work in process inventory, which gives the total work in process during the period of $178,000 ($175,500 + $2,500). A physical count shows $7,500 of work in process inventory remains at the end of the period. We then compute the current peri- od’s cost of goods manufactured of $170,500 by taking the $178,000 total work in process and subtracting the $7,500 cost of ending work in process inventory. The cost of goods manufac- tured amount is also called net cost of goods manufactured or cost of goods completed.

Key calculations in the schedule of costs of goods manufactured are summarized as follows.

Total manufacturing costs =

Direct materials used +

Direct labor used +

Factory overhead used

Cost of goods manufactured =

Total manufacturing costs +

Beginning work in process inventory −

Ending work in process inventory

Using the Schedule of Cost of Goods Manufactured Management uses the schedule of cost of goods manufactured to plan and control manufacturing activities. To provide timely information for decision making, the schedule is often prepared monthly, weekly, or even daily. In anticipation of release of its much-hyped tablet, Microsoft grew its inventory of critical components and its finished goods inventory. The schedule of cost of goods manufactured is rarely published because managers view its information as proprietary and harmful if released to competitors.

Estimating Cost per Unit Managers use the schedule of cost of goods manufactured to make rough estimates of per unit costs. For example, if Rocky Mountain Bikes makes 1,000 bikes during the year, the average manufacturing cost per unit is $170.50 (computed as $170,500/1,000). Average cost per unit is not always appropriate for managerial decisions. We show in the next two chapters how to compute more reliable unit costs for managerial decisions.

Work in Process Inventory

Beg . bal . 2,500 Mfg . costs 175,500 COG Mfg. 170,500 End . bal . 7,500

EXHIBIT 14.16 Schedule of Cost of Goods Manufactured

ROCKY MOUNTAIN BIKES Schedule of Cost of Goods Manufactured

For Year Ended December 31, 2019

Direct materials Raw materials inventory, Dec . 31, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,500

Raw materials available for use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,500

Less raw materials inventory, Dec . 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 85,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Factory overhead Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600 Repairs—Factory equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Property taxes—Factory building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 Factory supplies used (indirect materials) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Factory insurance expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100 Depreciation expense—Factory assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500 Amortization expense—Patents (on factory equipment) . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $175,500 Add work in process inventory, Dec . 31, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Total cost of work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,000 Less work in process inventory, Dec . 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $170,500

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Chapter 14 Managerial Accounting Concepts and Principles 549

Manufacturing Cost Flows across Accounting Reports Cost information is also used to complete financial statements at the end of an accounting period. Exhibit 14.17 summarizes how product costs flow through the accounting system. Direct materials, direct la- bor, and overhead costs are summarized in the schedule of cost of goods manufactured; then the amount of cost of goods manufactured from that statement is used to compute cost of goods sold on the income statement. Physical counts determine the dollar amounts of ending inventories, and those amounts are included on the end-of-period balance sheet. (Note: This exhibit shows only partial reports.)

ROCKY MOUNTAIN BIKES Income Statement

For Year Ended December 31, 2019

Sales Cost of goods sold Beg. finished goods Cost of goods manuf. End. finished goods Cost of goods sold Gross profit Operating expenses Income before tax

$310,000

11,200 170,500

171,400

138,600

(10,300)

59,900

ROCKY MOUNTAIN BIKES Schedule of Cost of Goods

Manufactured For Year Ended December 31, 2019

$ 85,500 60,000 30,000 175,500

2,500 178,000

$170,500

Direct materials used* Direct labor used Factory overhead** Total mfg. costs Beg. work in process Total work in process End. work in process Cost of goods manuf.

(7,500)

ROCKY MOUNTAIN BIKES Balance Sheet–PARTIAL

December 31, 2019

Cash Accounts receivable, net Raw materials inventory Work in process inventory Finished goods inventory Factory supplies Prepaid insurance Total current assets

$11,000 30,150 9,000 7,500

10,300 350

300 $68,600

$ 78,700 *Direct materials used is computed in Exhibit 14.16. **Overhead items are listed in Exhibit 14.16.

EXHIBIT 14.17 Manufacturing Cost Flows across Accounting Reports

Part A: Compute the following three cost amounts using the information below. 1. Cost of materials used 2. Cost of goods manufactured 3. Cost of goods sold

P1 P2 C5 Key Cost Measures

NEED-TO-KNOW 14-4

Solution

1. $70,900 2. $173,900 3. $160,500

Begin . inv . 15,500

Purchases 66,000 Avail . for use 81,500

End . inv . 10,600 Matls used 70,900

Raw Materials Inventory

Begin . inv . 29,000 Matls used 70,900 Labor 38,000 Overhead 80,000 Total mfg . costs 217,900

End . inv . 44,000

Work in Process Inventory

Cost of goods manuf. 173,900

Begin . inv . 24,000

Cost of goods manuf . 173,900 Avail . for sale 197,900

End . inv . 37,400

Finished Goods Inventory

Cost of goods sold 160,500

Beginning raw materials inventory . . . . . . . . . . . . . $15,500 Ending raw materials inventory . . . . . . . . . . . . . . $10,600

Beginning work in process inventory . . . . . . . . . . . 29,000 Ending work in process inventory . . . . . . . . . . . . 44,000

Beginning finished goods inventory . . . . . . . . . . . . 24,000 Ending finished goods inventory . . . . . . . . . . . . . 37,400

Raw materials purchased . . . . . . . . . . . . . . . . . . . . . 66,000 Direct labor used . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000

Total factory overhead used . . . . . . . . . . . . . . . . . . . 80,000

Part B: Refer to each of the nine cost items listed above with their dollar amounts and indicate in which sec- tion of the schedule of cost of goods manufactured it appears as shown in Exhibit 14.16. Section 1 refers to direct materials; 2 refers to direct labor; 3 refers to factory overhead; and 4 refers to computation of cost of goods manufactured. Write X for any item that does not appear on the schedule of cost of goods manufactured.

Solution

Beginning raw materials inventory Ending raw materials inventory Beginning work in process inventory Ending work in process inventory Beginning finished goods inventory Ending finished goods inventory Raw materials purchased Direct labor used Total factory overhead used

1 1 4 4 X X 1 2 3

Do More: QS 14-8, QS 14-9, QS 14-10, E 14-8, E 14-11

550 Chapter 14 Managerial Accounting Concepts and Principles

Trends in Managerial Accounting Tools and techniques of managerial accounting continue to evolve due to changes in the busi- ness environment. This section describes some of these changes.

Customer Orientation There is increased emphasis on customers as the most impor- tant constituent of a business. Customers expect value for the money they spend to buy products and services. They want the right service (or product) at the right time and the right price. This customer orientation means that managers and employees understand the changing needs and wants of customers and align management and operating practices accordingly.

Global Economy Our global economy expands competitive boundaries and provides customers more choices. The global economy also produces changes in business activities. One notable case that reflects these changes in customer demand and global competition is auto manufacturing. The top three Japanese auto manufacturers (Honda, Nissan, and Toyota) once controlled more than 40% of the U.S. auto market. Customers perceived that Japanese auto manufacturers provided value not available from other manufacturers. Many European and North American auto manufacturers responded to this challenge and regained much of the lost market share.

E-Commerce People have become increasingly interconnected via smartphones, text messaging, and other electronic applications. Consumers expect and demand to be able to buy items electronically, whenever and wherever they want. Many businesses allow for online trans- actions. Online sales make up about 8% of total retail sales. Some companies such as BucketFeet, a footwear retailer, only sell online to keep costs lower.

Service Economy Businesses that provide services, such as telecommunications and health care, constitute an ever-growing part of our economy. Many service companies, such as Uber, employ part-time workers. This “gig economy” changes companies’ cost structures and the nature of competition. In developed economies, service businesses typically account for over 60% of total economic activity.

Lean Principles Many companies have adopted the lean business model, whose goal is to eliminate waste while “satisfying the customer” and “providing a positive return” to the com- pany. This is often paired with continuous improvement. Continuous improvement rejects the notions of “good enough” or “acceptable” and challenges employees and managers to continu- ously experiment with new and improved business practices. This has led companies to adopt practices such as total quality management (TQM) and just-in-time (JIT) manufacturing. Continuous improvement underlies both practices; the difference is in the focus. Total quality management focuses on quality improvement to business activities. Managers

and employees seek to uncover waste in business activities, including accounting activities such as payroll and disbursements. To encourage an emphasis on quality, the U.S. Congress established the Malcolm Baldrige National Quality Award (MBNQA). Entrants must con- duct a thorough analysis and evaluation of their business using guidelines from the Baldrige committee. Ritz Carlton Hotel is a recipient of the Baldrige award in the service category. The company applies a core set of values, collectively called The Gold Standards, to improve customer service.

Just-in-time manufacturing is a system that acquires inventory and produces only when needed. An important aspect of JIT is that companies manufacture products only after they receive an order (a demand-pull system) and then deliver the customer’s re- quirements on time. This means that processes must be aligned to eliminate delays and inefficiencies including inferior inputs and outputs. Companies also must establish good communications with their suppliers. On the downside, JIT is more susceptible to dis- ruption than traditional systems. As one example, several General Motors plants were temporarily shut down due to a strike at a supplier that provided components just in time to the assembly division.

C6 Describe trends in managerial accounting.

Improveme nt

Co ntinuous

Customer Orientation

E- Co

m m

er ce

Lean Principles

Point: Goals of a TQM process include reduced waste, better inventory control, fewer defects, and continuous improvement. JIT concepts have similar aims.

Point: Quality control standards include those developed by the International Organization for Standardization (ISO). To be certified under ISO 9000 standards, a company must use a quality control system and document that it achieves the desired quality level.

Point: The time between buying raw materials and selling finished goods is called throughput time.

Chapter 14 Managerial Accounting Concepts and Principles 551

Value Chain The value chain refers to the series of activities that add value to a company’s products or services. Exhibit 14.18 illustrates a possible value chain for a retail cookie company. Companies can use lean practices across the value chain to increase efficiency and profits.

Acquire raw materials Baking Sales Service

EXHIBIT 14.18 Typical Value Chain (cookie retailer)

How Lean Principles Impact the Value Chain Adopting lean principles can be challenging because systems and procedures that a company follows must be realigned. Managerial account- ing has an important role in providing accurate cost and performance information. Developing such a system is important to measuring the “value” provided to customers. The price that cus- tomers pay for acquiring goods and services is a key determinant of value. In turn, the costs a company incurs are key determinants of price.

Corporate Social Responsibility In addition to maximizing shareholder value, cor- porations must consider the demands of other stakeholders, including employees, suppliers, and society in general. Corporate social responsibility (CSR) is a concept that goes beyond fol- lowing the law. For example, to reduce its impact on the environment, Three Twins Ice Cream uses only cups and spoons made from organic ingredients. United By Blue, an apparel and jewelry company, removes one pound of trash from waterways for every product sold. Many companies extend the concept of CSR to include sustainability, which considers fu- ture generations when making business decisions.

Triple Bottom Line Triple bottom line focuses on three measures: financial (“profits”), social (“people”), and environmental (“planet”). Adopting a triple bottom line impacts how businesses report. In response to a growing trend of such reporting, the Sustainability Accounting Standards Board (SASB) was established to develop report- ing standards for businesses’ sustainability activities. Some of the business sectors for which the SASB has developed reporting standards include health care, nonrenewable re- sources, and renewable resources and alternative energy.

Point: Companies like Microsoft, Google, and Walt Disney, ranked at the top of large multinational companies in terms of CSR, disclose CSR results on their websites.

Economic

EnvironmentalSo ci

al

Triple Bottom Line

Balanced Scorecard The balanced scorecard aids continuous improvement by augmenting financial measures with information on the “drivers” (indicators) of future financial performance along four dimensions: (1) financial—profitabil- ity and risk, (2) customer—value creation and product and service differentiation, (3) internal business processes— business activities that create customer and owner satisfaction, and (4) learning and growth— organizational change, innovation, and growth. ■

Decision Insight

In creating sustainability accounting standards, the Sustainability Accounting Standards Board (SASB) has created reporting guidelines. The SASB considers sustainability information as material if its disclosure would affect the views of equity investors on a company’s financial condition or operating performance.

Material information can vary across industries; for example, while environmental “planet” issues such as air quality, wastewater management, and biodiversity impacts are important for investments in companies in the nonrenewable resources sectors, such issues are likely not as important for investments in banks. In contrast, “people” issues such as diversity and inclusion, fair labor practices, and employee health are considered material for most sectors, particularly those that use considerable direct labor.

SUSTAINABILITY AND ACCOUNTING

©MoringaConnect

552 Chapter 14 Managerial Accounting Concepts and Principles

MoringaConnect, this chapter’s feature company, focuses on sustainability. The company trains and advises Ghanaian farmers in techniques to improve their crop yield. The company’s products also do not use synthetic preservatives, and thus are better for consumers.

The company plants moringa trees to ensure sustainability. Emily Cunningham, MoringaConnect co- founder, proclaims that “for every customer order, we plant a tree. We are over half a million trees now and hope to reach one million by the end of the year.” This is an example of the triple bottom line in action.

Sustainability Returns A recent study shows the value of invest- ing in material sustainability issues. Companies with good ratings on material sustainability issues perform better than companies with poor ratings. The chart here shows that high sustainability firms have 4% higher stock returns and almost 7% higher return on sales than low sustainability firms. Source: hbswk.hbs.edu/item/corporate-sustainability-first- evidence-on-materiality. ■

Decision Insight

Stock return

Return on sales

0% 2% 4% 6% 8% 10%

+6.89%

+4.05%

High Sustainability Firms vs. Low Sustainability Firms

Raw Materials Inventory Turnover and Days’ Sales in Raw Materials InventoryDecision Analysis

Managerial accounting information helps managers perform analyses that are not readily available to external users of accounting information. Inventory management is one example. Using publicly available financial statements, an external user can compute the inventory turnover ratio. However, a managerial accountant can go much further.

Raw Materials Inventory Turnover A manager can assess how effectively a company manages its raw materials inventory by computing the raw materials inventory turnover ratio as shown in Exhibit 14.19.

A1 Assess raw materials inventory management using raw materials inventory turnover and days’ sales in raw materials inventory.

EXHIBIT 14.19 Raw Materials Inventory Turnover

Raw materials inventory turnover = Raw materials used/Average raw materials inventory

This ratio reveals how many times a company turns over (uses in production) its raw materials inven- tory during a period. Generally, a high ratio of raw materials inventory turnover is preferred, as long as raw materials inventory levels are adequate to meet demand. To illustrate, Rocky Mountain Bikes reports direct (raw) materials used of $85,500 for the year, with a beginning raw materials inventory of $8,000 and an ending raw materials inventory of $9,000 (see Exhibit 14.16). Raw materials inventory turnover for Rocky Mountain Bikes for that year is computed below.

Raw materials inventory turnover = $85,500/[($8,000 + $9,000)/2] = 10.06 (rounded)

Days’ Sales in Raw Materials Inventory To further assess raw materials inventory management, a manager can measure the adequacy of raw mate- rials inventory to meet production demand. Days’ sales in raw materials inventory reveals how much raw materials inventory is available in terms of the number of days’ sales. It is a measure of how long it takes raw materials to be used in production. It is defined and computed for Rocky Mountain Bikes in Exhibit 14.20.

EXHIBIT 14.20 Days’ Sales in Raw Materials Inventory Turnover

Days’ sales in raw materials inventory = (Ending raw materials inventory/Raw materials used) × 365 = $9,000/$85,500 × 365 = 38.4 days (rounded)

The following account balances and other information are from SUNN Corporation’s accounting records for year-end December 31, 2019. Use this information to prepare (1) a table listing factory overhead costs, (2) a schedule of cost of goods manufactured (show only the total factory overhead cost), and (3) an in- come statement.

COMPREHENSIVE

Income Statement and COGM Schedule

NEED-TO-KNOW 14-5

Work in process inventory, Dec . 31, 2018 . . . . . . . . . . . . . . . $ 8,000

Work in process inventory, Dec . 31, 2019 . . . . . . . . . . . . . . . 9,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,400

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000

Property taxes on factory equipment . . . . . . . . . . . . . . . . . . . 14,000

Raw materials inventory, Dec . 31, 2018 . . . . . . . . . . . . . . . . . 60,000

Raw materials inventory, Dec . 31, 2019 . . . . . . . . . . . . . . . . . 78,000

Raw materials purchases (direct materials) . . . . . . . . . . . . . . . 313,000

Repairs expense—Factory equipment . . . . . . . . . . . . . . . . . . . 31,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,630,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 85,000

Amortization expense—Factory patents . . . . . . . . . . . . . . . . . 16,000

Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Depreciation expense—Office equipment . . . . . . . . . . . . . . . 37,000

Depreciation expense—Factory building . . . . . . . . . . . . . . . . 133,000

Depreciation expense—Factory equipment . . . . . . . . . . . . . . 78,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Factory insurance used up . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,000

Factory supervisor salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,000

Factory supplies used (indirect materials) . . . . . . . . . . . . . . . . 21,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000

Finished goods inventory, Dec . 31, 2018 . . . . . . . . . . . . . . . . 15,000

Finished goods inventory, Dec . 31, 2019 . . . . . . . . . . . . . . . . 12,500

Chapter 14 Managerial Accounting Concepts and Principles 553

PLANNING THE SOLUTION Analyze the account balances and select those that are part of factory overhead costs. Arrange these costs in a table that lists factory overhead costs for the year. Analyze the remaining costs and select those related to production activity for the year; selected costs

should include the materials and work in process inventories and direct labor. Prepare a schedule of cost of goods manufactured for the year showing the calculation of the cost of

direct materials used in production, the cost of direct labor, and the total factory overhead cost. Assume that only direct materials costs flow through the Raw Materials Inventory account. When presenting overhead cost on this statement, report only total overhead cost from the table of overhead costs for the year. Show the costs of beginning and ending work in process inventory to determine cost of goods manufactured.

Organize the remaining revenue and expense items into the income statement for the year. Combine cost of goods manufactured from the schedule of cost of goods manufactured with the finished goods inventory amounts to compute cost of goods sold for the year.

CFO Your company regularly reports days’ sales in raw materials of 20 days, which is similar to that of competitors. A manager argues that profit can be increased if the company applies just-in-time principles and cuts it down to 2 days. Do you drop it to 2 days? ■ Answer: Cutting days’ sales in raw materials to 2 days might increase profits. Having less money tied up in inventory is a positive. However, if the company loses customers over out-of-stock inventory or if production is delayed (with costs), then the increase in profit might be outweighed by the increase in costs.

Decision Maker

This suggests that it will take 38 days for Rocky Mountain Bikes’s raw materials inventory to be used in production. Assuming production needs can be met, companies usually prefer a lower number of days’ sales in raw materials inventory. Just-in-time manufacturing techniques can be useful in lowering days’ sales in raw materials inventory; for example, Dell keeps less than seven days of production needs in raw materials inventory for most of its computer components.

554 Chapter 14 Managerial Accounting Concepts and Principles

SUNN CORPORATION Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,630,000 Cost of goods sold Finished goods inventory, Dec . 31, 2018 . . . . . . . . . . $ 15,000 Cost of goods manufactured . . . . . . . . . . . . . . . . . . . 1,114,000 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . 1,129,000 Less finished goods inventory, Dec . 31, 2019 . . . . . . 12,500 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,116,500 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513,500 Operating expenses Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Depreciation expense—Office equipment . . . . . . . . . 37,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . 55,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . 380,000 Income before income taxes . . . . . . . . . . . . . . . . . . . . . . 133,500 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,400 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,100

SUNN CORPORATION Factory Overhead Costs

For Year Ended December 31, 2019

Amortization expense—Factory patents . . . . . . . . . . . . . . $ 16,000 Depreciation expense—Factory building . . . . . . . . . . . . . 133,000 Depreciation expense—Factory equipment . . . . . . . . . . . 78,000 Factory insurance used up . . . . . . . . . . . . . . . . . . . . . . . . 62,000 Factory supervisor salary . . . . . . . . . . . . . . . . . . . . . . . . . 74,000 Factory supplies used (indirect materials) . . . . . . . . . . . . . 21,000 Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 Property taxes on factory equipment . . . . . . . . . . . . . . . . 14,000 Repairs expense—Factory equipment . . . . . . . . . . . . . . . 31,000 Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . $570,000

SUNN CORPORATION Schedule of Cost of Goods Manufactured

For Year Ended December 31, 2019

Direct materials Raw materials inventory, Dec . 31, 2018 . . . . . . . . . . . . $ 60,000 Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . 313,000 Raw materials available for use . . . . . . . . . . . . . . . . . . . 373,000 Less raw materials inventory, Dec . 31, 2019 . . . . . . . . 78,000 Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570,000 Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . 1,115,000 Add work in process inventory, Dec . 31, 2018 . . . . . . . . . 8,000 Total cost of work in process . . . . . . . . . . . . . . . . . . . . . . . . 1,123,000 Less work in process inventory, Dec . 31, 2019 . . . . . . . . 9,000 Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . $1,114,000

Work in Process Inventory

Beginning 8,000 Dir . Mtls . Used 295,000

Dir . Labor 250,000

FOH 570,000

1,123,000 COGM 1,114,000

Ending 9,000

Finished Goods Inventory

Beginning 15,000 COGM 1,114,000

Avail . 1,129,000 COGS 1,116,500

Ending 12,500

Raw Materials Inventory

Beginning 60,000 Purch . 313,000

Avail . 373,000 Dir. Mtls. Used 295,000

Ending 78,000

SOLUTION

Summary: Cheat Sheet

COST CLASSIFICATIONS Fixed: Costs that do not change as volume changes. Variable: Costs that change in proportion to volume changes. Direct: Costs that are traceable to a single cost object. Indirect: Costs that are not easily traced to a single cost object. Product (manufacturing) costs: Costs necessary to make a product. Direct materials + Direct labor + Overhead. Capitalize as inventory until goods are sold.

Period (nonmanufacturing) costs: Costs of nonproduction activities. Expense immediately in period when incurred.

MANUFACTURING COSTS Direct materials: Materials that are traced to finished goods. Direct labor: Convert materials to finished goods. Overhead: Support production, but not separately traced to finished goods. Indirect materials + Indirect labor + Other indirect costs.

Chapter 14 Managerial Accounting Concepts and Principles 555

SCHEDULE OF COST OF GOODS MFG.

RAW MATERIALS INVENTORY MANAGEMENT RM inventory turnover = Raw materials used/Average RM inventory Days’ sales in RM inventory = (Ending RM inventory/RM used) × 365

Work in Process Inventory

Beg . bal . DM used

DL used

FOH used COGM

End . bal .

Finished Goods Inventory

Beg . bal . COGM

COGS

End . bal .

Raw Materials Inventory

Beg . bal . Purchases

DM Used

End . bal .

COSTS AND THE INCOME STATEMENT

Merchandiser

Beginning merchandise inventory

Cost of goods purchased

Ending merchandise inventory

+ –

Manufacturer Beginning finished

goods inventory Cost of

goods manufactured Ending finished goods inventory

= Cost of goods sold

–+

FLOW OF MANUFACTURING COSTS

Continuous improvement (550) Control (536) Conversion costs (543) Corporate social responsibility

(CSR) (551) Cost object (539) Cost of goods manufactured (547) Customer orientation (550) Days’ sales in raw materials

inventory (552) Direct costs (539) Direct labor (542) Direct labor costs (542) Direct materials (542) Direct materials costs (542) Enterprise risk management (ERM) (535)

Ethics (537) Factory overhead (542) Factory overhead costs (542) Finished goods inventory (543) Fixed cost (539) Indirect costs (539) Indirect labor (542) Indirect labor costs (542) Indirect materials (542) Institute of Management

Accountants (IMA) (537) Internal control system (537) ISO 9000 standards (550) Just-in-time (JIT) manufacturing (550) Lean business model (550) Managerial accounting (535)

Period costs (540) Planning (535) Prime costs (543) Product costs (540) Raw materials inventory (543) Raw materials inventory turnover (552) Sarbanes-Oxley Act (538) Schedule of cost of goods

manufactured (547) Sustainability Accounting Standards

Board (SASB) (551) Total quality management (TQM) (550) Triple bottom line (551) Value chain (551) Variable cost (539) Work in process inventory (543)

Key Terms

Multiple Choice Quiz

1. Continuous improvement a. Is used to reduce inventory levels. b. Is applicable only in service businesses. c. Rejects the notion of “good enough.” d. Is used to reduce ordering costs. e. Is applicable only in manufacturing businesses.

2. A direct cost is one that is a. Variable with respect to the cost object. b. Traceable to the cost object. c. Fixed with respect to the cost object. d. Allocated to the cost object. e. A period cost.

DM = direct materials; DL = direct labor; FOH = factory overhead; COGM = cost of goods manufactured; COGS = cost of goods sold

COSTS AND THE BALANCE SHEET

Merchandiser

Current assets

Merchandise inventory . . . $21,000

Manufacturer

Current assets

Raw materials inventory . . . . . $ 9,000

Work in process inventory . . . . 7,500

Finished goods inventory . . . . 10,300

Schedule of Cost of Goods Manufactured For Year Ended

$ 85,500 60,000 30,000 175,500

2,500 178,000

$170,500

Direct materials used* Direct labor used Factory overhead** Total mfg. costs Beg. work in process Total work in process End. work in process Cost of goods manuf.

(7,500)

*Direct materials used is computed: BI + Purch – El. **Overhead items can be listed separately.

Economic

Environm entalSo

ci al

Triple Bottom Line

Triple Bottom Line

Lean

Customer Satisfaction JIT

(Just-in-Time)

Supply Chain

Management

Value Streams Pull Production Zero Waste and Zero Defects

Employee Involvement

Continuous Improvement

Quality

556 Chapter 14 Managerial Accounting Concepts and Principles

Icon denotes assignments that involve decision making.

1. Describe the managerial accountant’s role in business plan- ning, control, and decision making.

2. Distinguish between managerial and financial accounting on a. Users and decision makers. d. Time dimension. b. Purpose of information. e. Focus of information. c. Flexibility of practice. f. Nature of information. 3. Identify the usual changes that a company must make

when it adopts a customer orientation. 4. Distinguish between direct labor and indirect labor. 5. Distinguish between (a) factory overhead and (b) selling

and administrative overhead. 6. Distinguish between direct material and indirect material. 7. What product cost is both a prime cost and a conversion cost? 8. Assume that we tour Apple’s factory where

it makes iPhones. List three direct costs and three indirect costs that we are likely to see.

9. Should we evaluate a production manager’s perfor- mance on the basis of operating expenses? Why?

10. Explain why knowledge of cost behavior is useful in product performance evaluation.

11. Explain why product costs are capitalized but period costs are expensed in the current accounting period.

12. Explain how business activities and inventories for a manufacturing company, a merchandising company, and a service company differ.

13. Why does managerial accounting often involve work- ing with numerous predictions and estimates?

14. How do an income statement and a balance sheet for a man- ufacturing company and a merchandising company differ?

15. Besides inventories, what other assets often appear on man- ufacturers’ balance sheets but not on merchandisers’ bal- ance sheets?

16. Why does a manufacturing company require three different inventory categories?

17. Manufacturing activities of a company are described in the . This schedule summarizes the types and amounts

of costs incurred in its manufacturing . 18. What are the three categories of manufacturing costs? 19. List several examples of factory overhead. 20. List the four components of a schedule of

cost of goods manufactured and provide spe- cific examples of each for Apple.

21. Prepare a proper title for the annual schedule of cost of goods manufactured of Google. Does the date match the balance sheet or income statement? Why?

22. Describe the relations among the income statement, the schedule of cost of goods manufactured, and a detailed listing of factory overhead costs.

23. Define and describe two measures to assess raw mate- rials inventory management.

24. The triple bottom line includes what three main dimensions?

25. Access 3M Co.’s annual report (10-K) for the fiscal year ended December 31, 2017, at the SEC’s EDGAR data- base (SEC.gov) or its website (3M.com). From its balance sheet, identify the titles and amounts of its inventory components.

Discussion Questions

APPLE

GOOGLE

3. Costs that are incurred as part of the manufacturing pro- cess, but are not clearly traceable to the specific unit of product or batches of product, are called a. Period costs. d. Operating expenses. b. Factory overhead. e. Fixed costs. c. Variable costs.

4. The three major cost components of manufacturing a product are a. Direct materials, direct labor, and factory overhead. b. Period costs, product costs, and conversion costs. c. Indirect labor, indirect materials, and fixed expenses. d. Variable costs, fixed costs, and period costs. e. Overhead costs, fixed costs, and direct costs.

5. A company reports the following for the current year.

Its cost of goods manufactured for the current year is a. $1,500. d. $2,800. b. $1,700. e. $4,700. c. $7,500.

Finished goods inventory, beginning of year . . . . . . . . . . $6,000

Finished goods inventory, ending of year . . . . . . . . . . . . 3,200

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c 2. b 3. b 4. a

5. e; Beginning finished goods + Cost of goods manufactured (COGM) − Ending finished goods = Cost of goods sold

$6,000 + COGM − $3,200 = $7,500 COGM = $4,700

APPLE

Chapter 14 Managerial Accounting Concepts and Principles 557

QUICK STUDY

QS 14-1 Managerial accounting versus financial accounting

C1

Identify whether each description most likely applies to managerial (M) or financial (F) accounting. 1. Its primary users are company managers. 2. Its information is often available only after an audit is complete. 3. Its primary focus is on the organization as a whole. 4. Its principles and practices are very flexible. 5. It focuses mainly on past results.

QS 14-2 Fixed and variable costs

C2

A cell phone company offers two different plans. Plan A costs $80 per month for unlimited talk and text. Plan B costs $0.20 per minute plus $0.10 per text message sent. You need to purchase a plan for your teen- age sister. Your sister currently uses 1,700 minutes and sends 1,600 texts each month. 1. What is your sister’s total cost under each of the two plans? 2. Suppose your sister doubles her monthly usage to 3,400 minutes and sends 3,200 texts. What is your

sister’s total cost under each of the two plans?

QS 14-4 Direct and indirect costs

C2

Diez Company produces sporting equipment, including leather footballs. Identify each of the following costs as direct (D) or indirect (I). The cost object is a football produced by Diez.

1. Electricity used in the production plant. 2. Labor used on the football production line. 3. Salary of manager who supervises the entire plant. 4. Depreciation on equipment used to produce sports equipment. 5. Leather used to produce footballs.

QS 14-3 Fixed and variable costs

C2

Listed below are product costs for production of footballs. Classify each cost as either variable (V) or fixed (F).

1. Leather covers for footballs. 2. Machinery depreciation (straight-line). 3. Wages of assembly workers.

4. Lace to hold footballs together. 5. Insurance premium on building. 6. Factory supervisor salary.

QS 14-6 Product and period costs

C3

Identify each of the following costs as either a product cost (PROD) or a period cost (PER). 1. Factory maintenance. 2. Sales commissions. 3. Depreciation—Factory equipment. 4. Depreciation—Office equipment.

5. Rent on factory building. 6. Interest expense. 7. Office manager salary. 8. Indirect materials used in making goods.

QS 14-5 Classifying product costs

C2

Identify each of the following costs as either direct materials (DM), direct labor (DL), or factory overhead (FO). The company manufactures tennis balls.

1. Rubber used to form the cores. 2. Factory maintenance. 3. Wages paid to assembly workers.

4. Glue used in binding rubber cores to felt covers. 5. Depreciation—Factory equipment. 6. Cans to package the balls.

QS 14-7 Inventory reporting for manufacturers

C4

Compute ending work in process inventory for a manufacturer with the following information.

Raw materials purchased . . . . . . . . . . . . . . . $124,800

Direct materials used . . . . . . . . . . . . . . . . . . 74,300

Direct labor used . . . . . . . . . . . . . . . . . . . . . 55,000

Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . $ 95,700

Work in process inventory, beginning of year . . . . . . . . 26,500

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . 221,800

QS 14-8 Manufacturing cost flows

C5

Compute the total manufacturing cost for a manufacturer with the following information for the month.

Raw materials purchased . . . . . . . . . . . . . . . $32,400

Direct materials used . . . . . . . . . . . . . . . . . . 53,750

Direct labor used . . . . . . . . . . . . . . . . . . . . . 12,000

Factory supervisor salary . . . . . . . . . . . . . . . 8,000

Salesperson commissions . . . . . . . . . . . . . . . . . . . . . . . . $6,200

Depreciation expense—Factory building . . . . . . . . . . . . 3,500

Depreciation expense—Delivery equipment . . . . . . . . . 2,200

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250

558 Chapter 14 Managerial Accounting Concepts and Principles

QS 14-9 Cost of goods sold

P1

Compute cost of goods sold using the following information.

Finished goods inventory, beginning . . . . . . . . . . . . . $ 500

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . 4,000

Finished goods inventory, ending . . . . . . . . . . . . . . $750

Finished goods inventory, beginning . . . . . . . . . . . . . $345,000 Cost of goods manufactured . . . . . . . . . . . . . . $918,700

Work in process inventory, beginning . . . . . . . . . . . . 83,500 Finished goods inventory, ending . . . . . . . . . . 283,600

Work in process inventory, ending . . . . . . . . . . . . . . . 72,300

QS 14-10 Cost of goods sold

P1

Compute cost of goods sold using the following information.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $190,500 Work in process, beginning . . . . . . . . . . . . . . . $157,600

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,150 Work in process, ending . . . . . . . . . . . . . . . . . 142,750

Factory overhead costs . . . . . . . . . . . . . . . . . . . . . . . 24,000

QS 14-11 Cost of goods manufactured

P2

Prepare the schedule of cost of goods manufactured for Barton Company using the following information.

3M Co. reports beginning raw materials inventory of $855 million and ending raw materials inventory of $717 million. If 3M purchased $3,646 million of raw materials during the year, what is the amount of raw materials it used during the year?

QS 14-14 Direct materials used C5

3M Co. reports beginning raw materials inventory of $855 million and ending raw materials inventory of $717 million. Assume 3M purchased $3,646 million of raw materials and used $3,784 million of raw materials during the year. Compute raw materials inventory turnover (round to one decimal) and the num- ber of days’ sales in raw materials inventory (round to the nearest day).

QS 14-15 Raw materials inventory management A1

Use the following information to compute the cost of direct materials used for the current year. Assume the Raw Materials Inventory account is used only for direct materials.

January 1 December 31

Inventories

Raw materials inventory . . . . . . . . . . . . . . . . . . . $ 6,000 $ 7,500

Work in process inventory . . . . . . . . . . . . . . . . . . 12,000 9,000

Finished goods inventory . . . . . . . . . . . . . . . . . . 8,500 5,500

Activity during current year

Materials purchased . . . . . . . . . . . . . . . . . . . . . . $123,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,000

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . 39,000

QS 14-12 Direct materials used

P2

Nestlé reports beginning raw materials inventory of 3,815 and ending raw materials inventory of 3,499 (both numbers in millions of Swiss francs). Assume Nestlé purchased 13,860 and used 14,176 (in mil- lions) in raw materials during the year. Compute raw materials inventory turnover (round to one decimal) and the number of days’ sales in raw materials inventory (round to the nearest day).

QS 14-17 Raw materials inventory management

A1

Nestlé reports beginning raw materials inventory of 3,815 and ending raw materials inventory of 3,499 (both numbers in millions of Swiss francs). If Nestlé purchased 13,860 (in millions) of raw materials dur- ing the year, what is the amount of raw materials it used during the year?

QS 14-16 Direct materials used

C5

Match each concept with its best description by entering its letter A through E in the blank. 1. Just-in-time manufacturing A. Focuses on quality throughout the production process. 2. Continuous improvement B. Flexible product designs can be modified to accommodate

customer choices. 3. Customer orientation C. Every manager and employee constantly looks for ways to

improve company operations. 4. Total quality management D. Reports on financial, social, and environmental performance. 5. Triple bottom line E. Inventory is acquired or produced only as needed.

QS 14-13 Trends in managerial accounting

C6

Chapter 14 Managerial Accounting Concepts and Principles 559

EXERCISES

Exercise 14-1 Sources of accounting information

C1

Indicate in the following chart the most likely source of information for each business decision. Use M for managerial accounting information and F for financial accounting information.

Business Decision Primary Information Source

1 . Determine whether to lend to a company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 . Evaluate a purchasing department’s performance . . . . . . . . . . . . . . . . . . . . . . . . 3 . Report financial performance to board of directors . . . . . . . . . . . . . . . . . . . . . . . 4 . Estimate product cost for a new line of shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 . Plan the budget for next quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . Measure profitability of an individual store . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 . Prepare financial reports according to GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 . Determine location and size for a new plant . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Exercise 14-4 Cost classifications for a service company

C2

Listed below are costs of providing an airline service. Classify each cost as (a) either variable (V) or fixed (F) and (b) either direct (D) or indirect (I). Consider the cost object to be a flight. Flight attendants and pilots are paid based on hours of flight time.

Cost a. Variable or Fixed b. Direct or Indirect

1 . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2 . Beverages served on planes . . . . . . . . . . . . . . . . . . . . . . . .

3 . Regional vice president salary . . . . . . . . . . . . . . . . . . . . . . .

4 . Depreciation (straight-line) on ground equipment . . . . . . .

5 . Fuel used in planes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 . Flight attendant wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 . Pilot wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8 . Aircraft maintenance manager salary . . . . . . . . . . . . . . . . .

Exercise 14-3 Cost classifications for a service provider

C2

TechPro offers instructional courses in e-commerce website design. The company holds classes in a build- ing that it owns. Classify each of TechPro’s costs below as (a) variable (V) or fixed (F) and (b) direct (D) or indirect (I). Assume the cost object is an individual class.

1. Depreciation on classroom building 2. Monthly Internet connection cost 3. Instructional manuals for students

a. b. a. b. 4. Travel expenses for salesperson 5. Depreciation on computers used for classes 6. Instructor wage (per class)

Exercise 14-5 Classifying manufacturing costs

C2

Selected costs related to Apple’s iPhone are listed below. Classify each cost as either direct materials (DM), direct labor (DL), factory overhead (FO), selling expenses (S), or general and administrative (GA) expenses.

1. Display screen 2. Assembly-line supervisor salary 3. Wages for assembly workers 4. Salary of the chief executive

officer

5. Glue to hold iPhone cases together 6. Uniforms provided for each factory worker 7. Wages for retail store worker 8. Depreciation (straight-line) on robotic

equipment used in assembly

Exercise 14-2 Cost classification

C2

Listed here are product costs for the production of soccer balls. Classify each cost (a) as either variable (V) or fixed (F) and (b) as either direct (D) or indirect (I). What patterns do you see regarding the relation between costs classified in these two ways?

Product Cost a. Variable or Fixed b. Direct or Indirect

1 . Leather covers for soccer balls . . . . . . . . . . . . . . . . . . . . . .

2 . Annual flat fee paid for office security . . . . . . . . . . . . . . . . .

3 . Coolants for machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 . Wages of assembly workers . . . . . . . . . . . . . . . . . . . . . . . . .

5 . Thread to hold leather together . . . . . . . . . . . . . . . . . . . . . .

6 . Taxes on factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 . Machinery depreciation (straight-line) . . . . . . . . . . . . . . . .

560 Chapter 14 Managerial Accounting Concepts and Principles

Exercise 14-6 Cost classification

C3

Tesla, a vehicle manufacturer, incurs the following costs. (1) Classify each cost as either a product (PROD) or period (PER) cost. If a product cost, identify it as direct materials (DM), direct labor (DL), or factory overhead (FO), and then as a prime (PR) or conversion (CONV) cost. (2) Classify each product cost as either a direct cost (DIR) or an indirect cost (IND) using the product as the cost object.

Check Garcon COGS, $91,030

Garcon Co. Pepper Co.

Beginning finished goods inventory . . . . . . . . . . . . . . . $ 12,000 $ 16,450

Beginning work in process inventory . . . . . . . . . . . . . . 14,500 19,950

Beginning raw materials inventory (direct materials) . . . 7,250 9,000

Rental cost on factory equipment . . . . . . . . . . . . . . . . . 27,000 22,750

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 35,000

Ending finished goods inventory . . . . . . . . . . . . . . . . . 17,650 13,300

Ending work in process inventory . . . . . . . . . . . . . . . . . 22,000 16,000

Ending raw materials inventory . . . . . . . . . . . . . . . . . . . 5,300 7,200

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 12,000

Factory supplies used (indirect materials) . . . . . . . . . . . 8,200 3,200

General and administrative expenses . . . . . . . . . . . . . 21,000 43,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250 7,660

Repairs—Factory equipment . . . . . . . . . . . . . . . . . . . . . 4,780 1,500

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . 33,000 52,000

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 46,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,030 290,010

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 15,700

Factory equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . 212,500 115,825

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . 13,200 19,450

Exercise 14-8 Cost of goods manufactured and cost of goods sold computation

P1 P2

Using the following data from both Garcon Company and Pepper Company for the year ended December 31, 2019, compute (1) the cost of goods manufactured and (2) the cost of goods sold.

Exercise 14-7 Balance sheet identification and preparation

C4

Current assets for two different companies at fiscal year-end are listed here. One is a manufacturer, Rayzer Skis Mfg., and the other, Sunrise Foods, is a grocery distribution company. 1. Identify which set of numbers relates to the manufacturer and which to the merchandiser. 2. Prepare the current asset section for each company from this information. Discuss why the current

asset section for these two companies is different.

Account Company 1 Company 2

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 $ 5,000

Raw materials inventory . . . . . . . . . . . . . . . . . . . . . . . . — 42,000

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 —

Work in process inventory . . . . . . . . . . . . . . . . . . . . . . . — 30,000

Finished goods inventory . . . . . . . . . . . . . . . . . . . . . . . — 50,000

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . 62,000 75,000

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 900

If Product Cost, Then: If Product Cost, Then:

Direct Materials, Direct Prime or Cost Direct or Indirect Product or Period Labor, or Factory Overhead Conversion

1 . Factory electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2 . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3 . Amortization of patents on factory machine . . . . . . . . . . .

4 . Batteries for electric cars . . . . . . . . . . . . . . . . . . . . . . . . . .

5 . Office supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 . Wages to assembly workers . . . . . . . . . . . . . . . . . . . . . . .

Chapter 14 Managerial Accounting Concepts and Principles 561

Refer to the data in Exercise 14-8. For each company, prepare (1) an income statement and (2) the current assets section of the balance sheet. Ignore income taxes.

Exercise 14-9 Preparing financial statements for a manufacturer C4 P2

Refer to the data in Exercise 14-8. For each company, compute the total (1) prime costs and (2) conversion costs.

Exercise 14-10 Cost classification C2

Compute cost of goods sold for each of these two companies for the year. Exercise 14-11 Cost of goods sold computation

P1

Check Unimart COGS, $660,000

$275,000

500,000

115,000

$450,000

375,000

900,000

Merchandise

Beginning inventory

Cost of purchases Cost of goods manufactured Ending inventory

Merchandise Finished goods

Finished goods

Unimart Precision

Manufacturing

A B C 1 2 3 4 5 6 7 8 9 10

For each of the following accounts for a manufacturing company, place a ✓ in the appropriate column indicating that it appears on the balance sheet, the income statement, the schedule of cost of goods manu- factured, and/or a detailed listing of factory overhead costs. Assume that the income statement shows the calculation of cost of goods sold and the schedule of cost of goods manufactured shows only the total amount (not detailed listing) of factory overhead. An account can appear on more than one report.

Exercise 14-12 Components of accounting reports

P2

A B C D E 1 2 3 4 5 6 7 8 9 10 11 12 13

Accounts receivable Beginning finished goods inventory Computer supplies used (o�ce) Depreciation expense—Factory building Depreciation expense—O�ce building Wages for assembly workers Ending work in process inventory Factory maintenance wages Property taxes on factory building Raw materials purchases Sales

Account Balance

Sheet Income

Statement Sched. of Cost

of Goods Manuf’d Overhead

Report

Given the following selected account balances of Delray Mfg., prepare its schedule of cost of goods manufactured for the current year ended December 31. Include a listing of the individual overhead ac- count balances in this schedule.

Exercise 14-13 Preparing schedule of cost of goods manufactured

P2 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,250,000

Raw materials inventory, beginning . . . . . . . . . . . . 37,000

Work in process inventory, beginning . . . . . . . . . . 53,900

Finished goods inventory, beginning . . . . . . . . . . . 62,750

Raw materials purchases . . . . . . . . . . . . . . . . . . . . 175,600

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000

Factory supplies used (indirect materials) . . . . . . . 17,840

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,000

Repairs—Factory equipment . . . . . . . . . . . . . . . . $ 5,250

Rent cost of factory building . . . . . . . . . . . . . . . . . 57,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . 94,000

General and administrative expenses . . . . . . . . . 129,300

Raw materials inventory, ending . . . . . . . . . . . . . 42,700

Work in process inventory, ending . . . . . . . . . . . . 41,500

Finished goods inventory, ending . . . . . . . . . . . . 67,300 Check Cost of goods manufactured, $534,390

Exercise 14-14 Income statement preparation P2

Refer to the information in Exercise 14-13 to prepare an income statement for Delray Mfg. (a manufac- turer). Assume that its cost of goods manufactured is $534,390.

562 Chapter 14 Managerial Accounting Concepts and Principles

Exercise 14-15 Schedule of cost of goods manufactured and cost of goods sold P1 P2

Beck Manufacturing reports the following information in T-account form for 2019. 1. Prepare the schedule of cost of goods manufactured for the year. 2. Compute cost of goods sold for the year.

Begin . inv . 10,000

Purchases 45,000 Avail . for use 55,000

End . inv . 8,500 DM used 46,500

Raw Materials Inventory

Begin . inv . 14,000 DM used 46,500 Direct labor 27,500 Overhead 55,000 Mfg . costs 143,000

End . inv . 12,000

Work in Process Inventory

Cost of goods manuf. 131,000

Begin . inv . 16,000

Cost of goods manuf . 131,000 Avail . for sale 147,000

End . inv . 18,000

Finished Goods Inventory

Cost of goods sold 129,000

Exercise 14-16 Cost flows in manufacturing

C5

The following chart shows how costs flow through a business as a product is manufactured. Not all boxes in the chart show cost amounts. Compute the cost amounts for the boxes that contain question marks.

Raw materials purchases $532,000

Beginning raw materials inventory

$145,500

Direct labor used in production

$350,000

Beginning work in process inventory

$84,500

Finished goods manufactured

$1,593,500

Factory overhead used in production

$750,000

Ending raw materials inventory $175,000

Finished goods available for sale

$1,740,250

Ending finished goods inventory

$139,950

Materials Activity

Production Activity

Sales Activity

Raw materials available for use in production

?$

Direct materials used in production

?$

Total work in process

?$

Finished goods sold ?$

Beginning finished goods inventory

?$

Ending work in process inventory

?$

Many fast-food restaurants compete on lean business practices. Match each of the following activities at a fast-food restaurant with one of the three lean business practices a, b, or c that it strives to achieve. Some activities might relate to more than one lean business practice.

1. Courteous employees a. Just-in-time (JIT) 2. Food produced to order b. Continuous improvement (CI) 3. Clean tables and floors c. Total quality management (TQM) 4. Orders filled within three minutes 5. Standardized food-making processes 6. New product development

Exercise 14-17 Lean business practice

C6

Chapter 14 Managerial Accounting Concepts and Principles 563

In its recent annual report and related Global Responsibility Report, Starbucks provides information on company performance on several dimensions. Indicate whether the following items best fit into the finan- cial (label your answer “Profit”), social (label your answer “People”), or environmental (label your answer “Planet”) aspects of triple bottom line reporting.

1. Sales revenue totaled $22.4 billion. 2. 99% of coffee was purchased from suppliers certified for responsible farming and ethics. 3. Reduced water consumption. 4. Net income totaled $2.9 billion. 5. Increased purchases of energy from renewable sources. 6. Stopped working with factories that had poor working conditions.

Exercise 14-18 Triple bottom line

C6

PROBLEM SET A

Problem 14-1A Cost computation, classification, and analysis

C2 C3

Listed here are the total costs associated with the production of 1,000 drum sets manufactured by TrueBeat. The drum sets sell for $500 each.

Variable or Fixed Product or Period

Costs Variable Fixed Product Period

1 . Plastic for casing—$17,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,000 $17,000

2 . Wages of assembly workers—$82,000 . . . . . . . . . . . . . . . . . . . . . . . . . .

3 . Property taxes on factory—$5,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 . Accounting staff salaries—$35,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5 . Drum stands (1,000 stands purchased)—$26,000 . . . . . . . . . . . . . . . . .

6 . Rent cost of equipment for sales staff—$10,000 . . . . . . . . . . . . . . . . . .

7 . Upper management salaries—$125,000 . . . . . . . . . . . . . . . . . . . . . . . .

8 . Annual flat fee for factory maintenance service—$10,000 . . . . . . . . . .

9 . Sales commissions—$15 per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10 . Machinery depreciation, straight-line—$40,000 . . . . . . . . . . . . . . . . . .

Required

1. Classify each cost and its amount as (a) either variable or fixed and (b) either product or period. (The first cost is completed as an example.)

2. Compute the manufacturing cost per drum set.

Analysis Component

3. Assume that 1,200 drum sets are produced in the next year. What do you predict will be the total cost of plastic for the casings and the per unit cost of the plastic for the casings?

4. Assume that 1,200 drum sets are produced in the next year. What do you predict will be the total cost of property taxes and the per unit cost of the property taxes?

Check (1) Total variable production cost, $125,000

In its recent annual report and related Corporate Responsibility Report, Hyatt provides information on company performance on several dimensions. Indicate whether the following items below best fit into the financial (label your answer “Profit”), social (label your answer “People”), or environmental (label your answer “Planet”) aspects of triple bottom line reporting.

1. Sales revenue totaled $4.4 billion. 2. Increased women in management positions. 3. Invested in career programs in Brazil. 4. Operating cash flows totaled $489 million. 5. Earned awards for best LGBT workplace. 6. Nearly all hotels recycle at least one waste stream.

Exercise 14-19 Triple bottom line

C6

564 Chapter 14 Managerial Accounting Concepts and Principles

Problem 14-2A Classifying costs

C2 C3

The following calendar year-end information is taken from the December 31, 2019, adjusted trial balance and other records of Leone Company.

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 28,750

Depreciation expense—Office equipment . . . . . . . . . 7,250

Depreciation expense—Selling equipment . . . . . . . . . 8,600

Depreciation expense—Factory equipment . . . . . . . . 33,550

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,600

Factory supplies used (indirect materials) . . . . . . . . . . 7,350

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675,480

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,875

Miscellaneous production costs . . . . . . . . . . . . . . $ 8,425

Office salaries expense . . . . . . . . . . . . . . . . . . . . . 63,000

Raw materials purchases (direct materials) . . . . . 925,000

Rent expense—Office space . . . . . . . . . . . . . . . . . 22,000

Rent expense—Selling space . . . . . . . . . . . . . . . . 26,100

Rent expense—Factory building . . . . . . . . . . . . . . 76,800

Maintenance expense—Factory equipment . . . . 35,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,462,500

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . 392,560

Required

1. Classify each cost as either a product or period cost. 2. Classify each product cost as either direct materials, direct labor, or factory overhead. 3. Classify each period cost as either selling expenses or general and administrative expenses.

Problem 14-4A Ending inventory computation and evaluation

C4

Nazaro’s Boot Company makes specialty boots for the rodeo circuit. At year-end, the company had (a) 300 pairs of boots in finished goods inventory and (b) 1,200 heels at a cost of $8 each in raw materials inventory. During the year, the company purchased 35,000 additional heels at $8 each and manufactured 16,600 pairs of boots.

Required

1. Determine the unit and dollar amounts of raw materials inventory in heels at year-end.

Analysis Component

2. Compute the dollar amount of working capital that can be reduced at year-end if the ending heel raw material inventory is cut by half.

Problem 14-5A Inventory computation and reporting C4 P1

Shown here are annual financial data taken from two different companies.

Problem 14-3A Schedule of cost of goods manufactured and income statement; inventory analysis

A1 P2

Using the data from Problem 14-2A and the following additional inventory information for Leone Company, complete the requirements below. Assume income tax expense is $233,725 for the year.

Required

1. Prepare the company’s 2019 schedule of cost of goods manufactured. 2. Prepare the company’s 2019 income statement that reports separate categories for (a) selling expenses

and (b) general and administrative expenses.

Analysis Component

3. Compute the (a) inventory turnover, defined as cost of goods sold divided by average inventory, and (b) days’ sales in inventory, defined as 365 times ending inventory divided by cost of goods sold, for both its raw materials inventory and its finished goods inventory. (To compute turnover and days’ sales in inventory for raw materials, use raw materials used rather than cost of goods sold.) Round answers to one decimal place.

Check (1) Cost of goods manufactured, $1,935,650

Inventories Raw materials, December 31, 2018 . . . . . . . . . $166,850 Work in process, December 31, 2019 . . . . . . . . $ 19,380

Raw materials, December 31, 2019 . . . . . . . . . 182,000 Finished goods, December 31, 2018 . . . . . . . . 167,350

Work in process, December 31, 2018 . . . . . . . 15,700 Finished goods, December 31, 2019 . . . . . . . . 136,490

Chapter 14 Managerial Accounting Concepts and Principles 565

Music World Wave-Board Retail Manufacturing

Beginning inventory Merchandise . . . . . . . . . . . . . . . . . . . . . . $200,000 Finished goods . . . . . . . . . . . . . . . . . . . . . $500,000 Cost of purchases . . . . . . . . . . . . . . . . . . . . . 300,000 Cost of goods manufactured . . . . . . . . . . . . 875,000 Ending inventory Merchandise . . . . . . . . . . . . . . . . . . . . . . 175,000 Finished goods . . . . . . . . . . . . . . . . . . . . . 225,000

Required

1. Compute the cost of goods sold section of the income statement for the year for each company. 2. Identify the inventory accounts and describe where each is reported on the income statement and bal-

ance sheet for both companies.

Check (1) Wave-Board’s cost of goods sold, $1,150,000

PROBLEM SET B

Problem 14-1B Cost computation, classification, and analysis

C2 C3

Listed here are the total costs associated with the production of 15,000 Blu-ray Discs (BDs) manufactured by Maxwell. The BDs sell for $18 each.

Variable or Fixed Product or Period

Costs Variable Fixed Product Period

1 . Plastic for BDs—$1,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500 $1,500 2 . Wages of assembly workers—$30,000 . . . . . . . . . . . . . . . . . . . . . . . . . 3 . Cost of factory rent—$6,750 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 . Systems staff salaries—$15,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 . Labeling—$0 .25 per BD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . Cost of office equipment rent—$1,050 . . . . . . . . . . . . . . . . . . . . . . . . . . 7 . Upper management salaries—$120,000 . . . . . . . . . . . . . . . . . . . . . . . . 8 . Annual fixed fee for cleaning service—$4,520 . . . . . . . . . . . . . . . . . . . . 9 . Sales commissions—$0 .50 per BD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 . Machinery depreciation, straight-line—$18,000 . . . . . . . . . . . . . . . . . .

Required

1. Classify each cost and its amount as (a) either variable or fixed and (b) either product or period. (The first cost is completed as an example.)

2. Compute the manufacturing cost per BD.

Analysis Component

3. Assume that 10,000 BDs are produced in the next year. What do you predict will be the total cost of plastic for the BDs and the per unit cost of the plastic for the BDs? Explain.

4. Assume that 10,000 BDs are produced in the next year. What do you predict will be the total cost of factory rent and the per unit cost of the factory rent? Explain.

Check (2) Total variable production cost, $35,250

The following calendar year-end information is taken from the December 31, 2019, adjusted trial balance and other records of Best Bikes.

Problem 14-2B Classifying costs

C2 C3 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . $ 20,250 Depreciation expense—Office equipment . . . . . . . 8,440 Depreciation expense—Selling equipment . . . . . . 10,125 Depreciation expense—Factory equipment . . . . . . . 35,400 Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . 121,500 Factory supplies used (indirect materials) . . . . . . . 6,060 Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562,500 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000

Miscellaneous production costs . . . . . . . . . . . . . $ 8,440 Office salaries expense . . . . . . . . . . . . . . . . . . . . 70,875 Raw materials purchases (direct materials) . . . . 894,375 Rent expense—Office space . . . . . . . . . . . . . . . . 23,625 Rent expense—Selling space . . . . . . . . . . . . . . . 27,000 Rent expense—Factory building . . . . . . . . . . . . . 93,500 Maintenance expense—Factory equipment . . . . 30,375 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,942,625 Sales salaries expense . . . . . . . . . . . . . . . . . . . . 295,300

566 Chapter 14 Managerial Accounting Concepts and Principles

Required

1. Classify each cost as either a product or period cost. 2. Classify each product cost as either direct materials, direct labor, or factory overhead. 3. Classify each period cost as either selling expenses or general and administrative expenses.

Racer’s Edge makes specialty skates for the ice skating circuit. At year-end, the company had (a) 1,500 skates in finished goods inventory and (b) 2,500 blades at a cost of $20 each in raw materials inventory. During the year, Racer’s Edge purchased 45,000 additional blades at $20 each and manufactured 20,750 pairs of skates.

Required

1. Determine the unit and dollar amounts of raw materials inventory in blades at year-end.

Analysis Component

2. Write a half-page memorandum to the production manager explaining why a just-in-time inventory system for blades should be considered. Include the amount of working capital that can be reduced at year-end if the ending blade raw materials inventory is cut in half.

Problem 14-4B Ending inventory computation and evaluation

C4

Problem 14-3B Schedule of cost of goods manufactured and income statement; analysis of inventories

A1 P2

Using the information from Problem 14-2B and the following additional inventory information for Best Bikes, complete the requirements below. Assume income tax expense is $136,700 for the year.

Required

1. Prepare the company’s 2019 schedule of cost of goods manufactured. 2. Prepare the company’s 2019 income statement that reports separate categories for (a) selling expenses

and (b) general and administrative expenses.

Analysis Component

3. Compute the (a) inventory turnover, defined as cost of goods sold divided by average inventory, and (b) days’ sales in inventory, defined as 365 times ending inventory divided by cost of goods sold, for both its raw materials inventory and its finished goods inventory. (To compute turnover and days’ sales in inventory for raw materials, use raw materials used rather than cost of goods sold.) Discuss some possible reasons for differences between these ratios for the two types of inventories. Round answers to one decimal place.

Check (1) Cost of goods manufactured, $1,816,995

Inventories Raw materials, December 31, 2018 . . . . . . . . . $40,375 Work in process, December 31, 2019 . . . . . . . . $ 14,100

Raw materials, December 31, 2019 . . . . . . . . . 70,430 Finished goods, December 31, 2018 . . . . . . . . 177,200

Work in process, December 31, 2018 . . . . . . . 12,500 Finished goods, December 31, 2019 . . . . . . . . 141,750

Shown here are annual financial data taken from two different companies.Problem 14-5B Inventory computation and reporting

C4 P1

Required

1. Compute the cost of goods sold section of the income statement for the year for each company. 2. Write a half-page memorandum to your instructor (a) identifying the inventory accounts and (b) iden-

tifying where each is reported on the income statement and balance sheet for both companies.

Check (1) TeeMart cost of goods sold, $200,000

TeeMart Aim Labs (Retail) (Manufacturing)

Beginning inventory

Merchandise . . . . . . . . . . . . . . . . . . . . . . $100,000

Finished goods . . . . . . . . . . . . . . . . . . . . $300,000

Cost of purchases . . . . . . . . . . . . . . . . . . . . . 250,000

Cost of goods manufactured . . . . . . . . . . . . 586,000

Ending inventory

Merchandise . . . . . . . . . . . . . . . . . . . . . . 150,000

Finished goods . . . . . . . . . . . . . . . . . . . . 200,000

Chapter 14 Managerial Accounting Concepts and Principles 567

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 14 Santana Rey, owner of Business Solutions, decides to diversify her business by also manufactur- ing computer workstation furniture.

Required

1. Classify the following manufacturing costs of Business Solutions as either (a) variable (V) or fixed (F) and (b) direct (D) or indirect (I).

SERIAL PROBLEM Business Solutions

C2 C4 P1 P2

2. Prepare a schedule of cost of goods manufactured for Business Solutions for the month ended January 31, 2020. Assume the following manufacturing costs:

Direct materials: $2,200 Factory overhead: $490 Direct labor: $900 Beginning work in process: none (December 31, 2019) Ending work in process: $540 (January 31, 2020) Beginning finished goods inventory: none (December 31, 2019) Ending finished goods inventory: $350 (January 31, 2020) 3. Prepare the cost of goods sold section of a partial income statement for Business Solutions for the

month ended January 31, 2020. Check (3) COGS, $2,700

Manufacturing Costs a. Variable or Fixed b. Direct or Indirect

1 . Monthly flat fee to clean workshop . . . . . . . . . . . . . . . . . . .

2 . Laminate coverings for desktops . . . . . . . . . . . . . . . . . . . . .

3 . Taxes on assembly workshop . . . . . . . . . . . . . . . . . . . . . . . .

4 . Glue to assemble workstation component parts . . . . . . . . .

5 . Wages of desk assembler . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 . Electricity for workshop . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 . Depreciation on manufacturing tools . . . . . . . . . . . . . . . . . .

©Alexander Image/Shutterstock

COMPANY ANALYSIS C1

Accounting Analysis

AA 14-1 Managerial accounting is more than recording, maintaining, and reporting financial results. Managerial accountants must provide managers with both financial and nonfinancial information includ- ing estimates, projections, and forecasts. An important estimate for Apple is its reserve for warranty claims, and the company must provide shareholders information on this estimate.

Required

1. Access Apple’s annual report in Appendix A and locate “Accrued Warranty and Indemnification” on page A-9 of its notes. What amount of warranty expense did Apple record for 2017?

2. What amount of warranty claims did Apple pay during 2017? 3. What is Apple’s accrued warranty liability at the end of 2017?

AA 14-2 Both Apple and Google (Alphabet) invest in research and development. Access each company’s 2017 income statement from Appendix A.

Required

1. Compute the ratio of research and development expense to net sales for Apple. 2. Compute the ratio of research and development expense to net sales for Google. 3. Which company spent more (as a percentage of net sales) on research and development?

COMPARATIVE ANALYSIS C2

APPLE GOOGLE

APPLE

568 Chapter 14 Managerial Accounting Concepts and Principles

AA 14-3 Samsung’s 2017 annual report discloses the warranty information below. Like Apple, Samsung offers warranties on its products.

GLOBAL ANALYSIS C1

APPLE Samsung

ETHICS CHALLENGE C3

BTN 14-1 Assume that you are the managerial accountant at Infostore, a manufacturer of hard drives, CDs, and DVDs. Its reporting year-end is December 31. The chief financial officer is concerned about having enough cash to pay the expected income tax bill because of poor cash flow manage- ment. On November 15, the purchasing department purchased excess inventory of CD raw materials in anticipation of rapid growth of this product beginning in January. To decrease the company’s tax liability, the chief financial officer tells you to record the purchase of this inventory as part of sup- plies and expense it in the current year; this would decrease the company’s tax liability by increasing expenses.

Required

1. In which account should the purchase of CD raw materials be recorded? 2. How should you respond to this request by the chief financial officer?

Beyond the Numbers

BTN 14-2 Write a one-page memorandum to a prospective college student about salary expectations for graduates in business. Compare and contrast the expected salaries for accounting (including dif- ferent subfields such as public, corporate, tax, audit, and so forth), marketing, management, and finance majors. Prepare a graph showing average starting salaries (and those for experienced profes- sionals in those fields if available). To get this information, stop by your school’s career services office; libraries also have this information. The website JobStar.org (click on “Salary Info”) also can get you started.

COMMUNICATING IN PRACTICE C6

BTN 14-3 Managerial accounting professionals follow a code of ethics. As a member of the Institute of Management Accountants, the managerial accountant must comply with standards of ethical conduct.

Required

1. Read the Statement of Ethical Professional Practice posted at IMAnet.org. (Under “Career Resources” select “Ethics Center,” and then select “IMA Statement of Ethical Professional Practice.”)

2. What four overarching ethical principles underlie the IMA’s statement? 3. Describe the courses of action the IMA recommends in resolving ethical conflicts.

TAKING IT TO THE NET C1

Required

1. What amount of warranty expense did Samsung record in 2017? What amount of warranty claims did Samsung pay in 2017?

2. Access Apple’s report in Appendix A and locate “Accrued Warranty and Indemnification” on page A-9 of its notes. What amount of warranty expense did Apple record during 2017? What amount of warranty claims did Apple pay in 2017?

3. Using answers from parts 1 and 2, which company was more accurate in estimating warranty claims for 2017?

In millions of Korean won Warranty Liability

Balance at January 1, 2017 . . . . . . . . . . . . . . . . . . . . . ₩1,747,857

Charged to the statement of profit or loss . . . . . . . . . 2,032,311

Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,920,926)

Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,336

Balance at December 31, 2017 . . . . . . . . . . . . . . . . . . ₩2,011,578

Chapter 14 Managerial Accounting Concepts and Principles 569

BTN 14-4 The following calendar-year information is taken from the adjusted trial balance and other records of Dahlia Company.

TEAMWORK IN ACTION C5 P2

Advertising expense . . . . . . . . . . . . . . . . . . . . . . $ 19,125

Depreciation expense—Office equipment . . . . . 8,750

Depreciation expense—Selling equipment . . . . 10,000

Depreciation expense—Factory equipment . . . . 32,500

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . 122,500

Factory supplies used (indirect materials) . . . . . . 15,750

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,250

Inventories

Raw materials, beginning . . . . . . . . . . . . . . . . 177,500

Raw materials, ending . . . . . . . . . . . . . . . . . . . 168,125

Work in process, beginning . . . . . . . . . . . . . . 15,875

Work in process, ending . . . . . . . . . . . . . . . . . 14,000

Finished goods, beginning . . . . . . . . . . . . . . . 164,375

Finished goods, ending . . . . . . . . . . . . . . . . . . 129,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 650,750

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Miscellaneous production costs . . . . . . . . . . . . . 8,500

Office salaries expense . . . . . . . . . . . . . . . . . . . . 100,875

Raw materials purchases (direct materials) . . . . 872,500

Rent expense—Office space . . . . . . . . . . . . . . . . 21,125

Rent expense—Selling space . . . . . . . . . . . . . . . 25,750

Rent expense—Factory building . . . . . . . . . . . . . 79,750

Maintenance expense—Factory equipment . . . . 27,875

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,275,000

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . 286,250

Required

1. Each team member is to be responsible for computing one of the following amounts. You are not to duplicate your teammates’ work. Get any necessary amounts from teammates. Each member is to explain the computation to the team in preparation for reporting to class.

a. Direct materials used d. Total cost of work in process b. Factory overhead e. Cost of goods manufactured c. Total manufacturing costs 2. Check your cost of goods manufactured amount with the instructor. If it is correct, proceed to part 3. 3. Each team member is to be responsible for computing one of the following amounts. You are not to

duplicate your teammates’ work. Get any necessary amounts from teammates. Each member is to explain the computation to the team in preparation for reporting to class.

a. Net sales d. Total operating expenses b. Cost of goods sold e. Net income or loss before taxes c. Gross profit

BTN 14-6 Visit your favorite fast-food restaurant. Observe its business operations.

Required

1. Describe all business activities from the time a customer arrives to the time that customer departs. 2. List all costs you can identify with the separate activities described in part 1. 3. Classify each cost from part 2 as fixed or variable and explain your classification.

HITTING THE ROAD C2

BTN 14-5 Kwami Williams and Emily Cunningham of MoringaConnect must understand manufactur- ing costs to effectively operate and succeed as a profitable and efficient business.

Required

1. What are the three main categories of manufacturing costs Kwami and Emily must monitor and con- trol? Provide examples of each.

2. What are four goals of a total quality management process? Hint: The goals are listed in a margin “Point.” How can MoringaConnect use TQM to improve its business activities?

ENTREPRENEURIAL DECISION C2 C6

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Describe important features of job order

production.

C2 Explain job cost sheets and how they are used in job order costing.

ANALYTICAL A1 Apply job order costing in pricing

services.

P3 Describe and record the flow of overhead costs in job order costing.

P4 Determine adjustments for overapplied and underapplied factory overhead.

PROCEDURAL P1 Describe and record the flow of

materials costs in job order costing.

P2 Describe and record the flow of labor costs in job order costing.

Chapter Preview

15 Job Order Costing and Analysis

ADJUSTING OVERHEAD AND SERVICE USES

Overhead account

P4 Underapplied or overapplied overhead

Job order costing for services

A1 Pricing services

NTK 15-6

OVERHEAD COSTS

P3 Predetermined overhead rate

Applied overhead

Actual overhead

Summary of cost flows

Job cost sheets for decisions

Schedule of cost of goods manufactured

NTK 15-4, 15-5

MATERIALS AND LABOR COSTS

P1 Materials cost flows and documents

P2 Labor cost flows and documents

Linking materials and labor with job cost sheet

NTK 15-2, 15-3NTK 15-1

JOB ORDER COSTING

Cost accounting system

C1 Job order production Job order vs. process operations

Production activities

Cost flows

C2 Job cost sheet

571

“You’re never too young to be an entrepreneur” —Brennan Agranoff

Custom Kid

PORTLAND, OR—At a high school game, basketball fanatic Brennan Agranoff noticed most players were wearing plain Nike elite socks. Why not print custom designs on them, he won- dered? Brennan’s company, HoopSwagg (hoopswagg.com), stemmed from that simple question.

Brennan faced several hurdles in getting HoopSwagg off the ground. Only 13 years old at the time, he had no business train- ing, no knowledge of the sock-making process, and no capital. Undaunted, Brennan spent six months learning about business logistics and machinery needs. He then convinced his parents, who “thought the concept was a bit out there,” to loan him $3,000. “We checked out his numbers,” says mother Maia, “and they made sense.” Brennan taught himself computer coding to set up his website and how to use graphic design tools to develop his designs.

Brennan’s learning extended to accounting and how to track materials, labor, and overhead costs. Businesses like Brennan’s that produce goods to customer order use job order costing to determine the cost of each order. Understanding what customers want, and the costs required, enables Brennan to properly price orders. Rising sales required a new 1,500-square- foot production building that increased overhead costs. Job order costing enables entrepreneurs like Brennan to control

these and other types of costs that are often the downfall of start-ups.

From modest beginnings working from his parents’ garage, HoopSwagg now processes 70–100 orders per day, generating over $1 million per year in revenue. Brennan recently bought a competitor, increasing his customer base and number of designs. “Get out of your comfort zone and go for it,” Brennan advises aspiring young entrepreneurs.

Sources: HoopSwagg website, January 2019; money.cnn.com, April 20, 2017; entrepreneur.com, August 18, 2017; kgw.com, April 21, 2017

©HoopSwagg

This section describes a cost accounting system, job order production and costing, and a job cost sheet.

Cost Accounting System A cost accounting system accumulates production costs and assigns them to products and ser- vices. Timely information about inventories and costs is used by managers to control costs and set selling prices.

The two basic types of cost accounting systems are job order costing and process costing. We describe job order costing in this chapter and process costing in the next chapter.

Job Order Production Many companies produce products individually designed to meet the needs of a specific cus- tomer. Each customized product is manufactured separately, and its production is called job order production, or job order manufacturing (also called customized production, which is the production of products in response to special orders). Examples of such products or services include special-order machines, a factory building, custom jewelry, wedding invitations, tattoos, and audits by an accounting firm.

The production activities for a customized product represent a job. A key feature of job order production is the diversity, often called heterogeneity, of the products produced. Each customer order differs from another customer order in some important respect. These differences can be large or small. For example, Nike allows custom orders over the Internet, enabling customers to select materials and colors and to personalize their shoes with letters and numbers.

When a job involves producing more than one unit of a custom product, it is called a job lot. Products produced as job lots could include benches for a park, imprinted T-shirts for a 10K race, or advertising signs for a chain of stores. Although these orders involve more than one unit, the volume of production is typically low, such as 50 benches, 200 T-shirts, or 100 signs.

C1 Describe important features of job order production.

JOB ORDER COSTING

Courtesy of JJW Images

572 Chapter 15 Job Order Costing and Analysis

Job Order vs. Process Operations Process operations, also called process manufacturing or process production, is the mass pro- duction of products in a continuous flow of steps. Unlike job order production, where every product differs depending on customer needs, process operations are designed to mass-produce large quantities of identical products. For example, each year Penn makes millions of tennis balls and The Hershey Company produces over a billion pounds of chocolate.

Exhibit 15.1 lists important features of job order and process operations. Movies made by Walt Disney and financial audits done by KPMG are examples of job order service operations. Order processing in large mail-order firms like L.L. Bean is an example of a process service operation.

Point: Many professional examina- tions, including the CPA and CMA exams, require knowledge of job order and process costing.

EXHIBIT 15.1 Comparing Job Order and Process Operations

Job Order Operations Process Operations

•  Custom orders  •  Repetitive procedures

•  Heterogeneous products  •  Homogeneous products    and services     and services

•  Low production volume  •  High production volume

•  High product flexibility  •  Low product flexibility

•  Low standardization  •  High standardization

Production Activities in Job Order Costing An overview of job order production activity and cost flows is shown in Exhibit 15.2. This exhibit shows the March production activity of Road Warriors, which installs entertainment systems and security devices in cars and trucks. The company customizes any vehicle by adding speakers, amplifiers, video systems, alarms, and reinforced exteriors.

Indirect Materials

Indirect Labor

Direct Materials

Direct Labor

Overhead Costs

Completed

Completed

Completed

Delivered

Delivered

Work in Process Inventory Finished Goods Inventory Cost of Goods Sold

Job B15

Job B16

Job B15

Job B18

Job B16

Job B17 Job B17

Job B15

Job B16

Job B19

Overhead

Labor

Manufacturing Costs

Materials

EXHIBIT 15.2 Job Order Production Activities and Cost Flows

Job order production requires materials, labor, and overhead costs. Direct materials are used in manufacturing and can be clearly identified with one job. Direct labor is employee effort on one particular job. Overhead costs support production of more than one job.

Common overhead items are depreciation on factory buildings and equipment, factory sup- plies (indirect materials), supervision and maintenance (indirect labor), factory insurance and property taxes, cleaning, and utilities.

Exhibit 15.2 shows that materials, labor, and overhead are added to five jobs started during the month (March). Alarm systems are added to Jobs B15 and B16; Job B17 receives a high-end audio and video entertainment system. Road Warriors completed Jobs B15, B16, and B17 in March and delivered Jobs B15 and B16 to customers. At the end of March, Jobs B18 and B19 remain in work in process inventory and Job B17 is in finished goods inventory.

Chapter 15 Job Order Costing and Analysis 573

Target Costing Many producers determine a target cost for their jobs. Target cost is determined as follows: Expected selling price − Desired profit = Target cost. If the projected target cost of the job as determined by job cost- ing is too high, the producer can apply value engineering, which is a method of determining ways to reduce job cost until the target cost is met. ■

Decision Insight

Cost Flows Manufacturing costs flow through inventory accounts (Raw Materials Inventory, Work in Pro- cess Inventory, and Finished Goods Inventory) until the related goods are sold. While a job is being produced, its accumulated costs are kept in Work in Process Inventory. When a job is finished, its accumulated costs are transferred from Work in Process Inventory to Finished Goods Inventory. When a finished job is delivered to a customer, its accumulated costs are transferred from Finished Goods Inventory to Cost of Goods Sold.

These general ledger inventory accounts, however, do not provide enough cost detail for managers of job order operations to plan and control production activities. Managers need to know the costs of each individual job (or job lot). Subsidiary records store this information about the costs for each individual job. The next section describes the use of these subsidiary records and how they relate to general ledger accounts.

Job Cost Sheet A major aim of a job order costing system is to determine the cost of producing each job or job lot. In the case of a job lot, the system also computes the cost per unit. The accounting system must include separate records for each job or job lot to accomplish this.

A job cost sheet is a cost record maintained for each job. Exhibit 15.3 shows a job cost sheet for Road Warriors. This job cost sheet identifies the customer, the job number, the costs, and key dates. Only product costs are recorded on job cost sheets. Direct materials and direct labor costs incurred on the job are recorded on this sheet. For Job B15, the direct materials and direct labor costs total $600 and $1,000, respectively. Estimated overhead costs are included on job cost sheets, through a process we discuss later in the chapter. For Job B15, estimated overhead costs are $1,600, computed as $1,000 of actual direct labor costs × 160%. When each job is complete, the supervisor enters the completion date and signs the sheet. Managers use job cost sheets to monitor costs incurred to date and to predict and control costs for each job.

Point: Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold are general ledger accounts.

Point: Documents (electronic and paper) are crucial in a job order system. The job cost sheet is the cornerstone. It aids in grasping concepts of capitalizing product costs and product cost flow.

C2 Explain job cost sheets and how they are used in job order costing.

Road Warriors, Los Angeles, California JOB COST SHEET

Date

3/3/2019 3/7/2019 3/9/2019 3/10/2019

3/3/2019 3/4/2019 3/5/2019 3/8/2019 3/9/2019 3/10/2019 3/11/2019

3/11/2019R-4698 R-4705 R-4725 R-4777

L-3393 L-3422 L-3456 L-3479 L-3501 L-3535 L-3559

160% of Direct Labor Cost

$ 100 225 180 95

$ 120 150 180 60 90

240 160

$1,600

Requisition Cost Date Time Ticket Cost Date Rate Cost

Direct Materials Direct Labor Overhead

Customer’s Name Carroll Connor

Address 1542 High Point Dr.

Job Description Level 1 Alarm System on Ford Expedition

Date promised

REMARKS: SUMMARY:

March 15

Total $600

Materials

Labor

Overhead

$ 600

1,000

1,600

Total cost $3,200Signed:

City & State Malibu, California

Job No. B15

Date started March 3 Date completed March 11

Total $1,000 Total $1,600

Completed job on March 11, and shipped to customer on March 15. Met all specifications and requirements.

EXHIBIT 15.3 Job Cost Sheet

DM (actual) + DL (actual) + FOH (estimated) = Total job cost

574 Chapter 15 Job Order Costing and Analysis

Linking Job Cost Sheets with General Ledger Accounts Balances in the general led- ger accounts equal the sums of costs on job cost sheets as defined in the table below.

A manufacturer’s job cost sheet reports direct materials of $1,200 and direct labor of $250 for printing 200 T-shirts for a bikers’ reunion. Estimated overhead is computed as 140% of direct labor costs. 1. What is the estimated overhead cost for this job? 2. What is the total cost per T-shirt for this job? 3. What journal entry does the manufacturer make upon completion of this job to transfer costs from

work in process to finished goods?

Solution

1. Estimated overhead = $250 × 140% = $350 2. Cost per T-shirt = Total cost/Total number in job lot = $1,800/200 = $9 per shirt 3.

Job Cost Sheet

NEED-TO-KNOW 15-1

C2

Do More: QS 15-2, QS 15-15,  E 15-2, E 15-3

Finished Goods Inventory  . . . . . . . . . . . . . . . . . . . . . . . . .   1,800

    Work in Process Inventory . . . . . . . . . . . . . . . . . . . . .     1,800

Transfer cost of completed job.

We look at job order costing in more detail, including the source documents for each cost flow.

Materials Cost Flows and Documents Continuing our example, assume that Road Warriors begins the month (March) with $1,000 in Raw Materials Inventory and $0 balances in the Work in Process Inventory and Finished Goods Inventory accounts. We begin with analysis of the flow of materials costs in Exhibit 15.4. When materials are first received from suppliers, employees count and inspect them and record the items’ quantity and cost on a receiving report. The receiving report serves as the source document for recording materials received in both a materials ledger card and in the general ledger. In nearly all job order cost systems, materials ledger cards (or digital files) are perpetual records that are updated each time materials are purchased and each time materials are issued for use in production.

P1 Describe and record the flow of materials costs in job order costing.

MATERIALS AND LABOR COSTS

MaterialsPoint: Some companies certify certain suppliers based on the quality of their materials. Goods received from these suppliers are not always inspected by the pur- chaser to save costs.

Requisitions

Requisitions

Receiving Reports

Direct Materials

Indirect Materials Indirect Materials

Factory Overhead Ledger

Job B15 Job B16

Job B17 Job B18

Job B19

Materials (for specific jobs)

(for general factory use)

Labor

Job Cost Sheets

Overhead

Alarm System Wiring Speakers

Amplifiers

Received Issued

Materials Ledger Cards

Balance

EXHIBIT 15.4 Materials Cost Flows

Raw Materials Inventory Work in Process Inventory

Finished Goods Inventory

Finished Goods Inventory

Work in Process Inventory

JOB B18 JOB B17JOB B19

Raw Materials Inventory

BalanceBalanceBalance

Speakers Wiring

Amplifiers

# # #

General ledger account Balance equals sum of costs on job cost sheets for

Work in Process Inventory  . . . . . . . . . . . .   All jobs not yet done

Finished Goods Inventory  . . . . . . . . . . . .   All jobs complete but not yet sold

Cost of Goods Sold . . . . . . . . . . . . . . . . . .   All jobs sold and delivered during that period

Chapter 15 Job Order Costing and Analysis 575

Materials Purchases Road Warriors bought $2,750 of materials on credit on March 4, 2019. These include both direct and indirect materials. This purchase is recorded below. Each individual materials ledger card is updated to reflect the added materials.

Mar . 4  Raw Materials Inventory   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   2,750

      Accounts Payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     2,750

  Record purchase of materials for production.

Materials Use (Requisitions) Exhibit 15.4 shows that materials can be requisitioned for use either on a specific job (direct materials) or as overhead (indirect materials). Direct ma- terials include costs, such as alarm system wiring, that are easily traced to individual jobs. Indirect materials include costs, such as those for screws, that are not easily traced to jobs. Direct materials costs flow to job cost sheets. Indirect materials costs flow to the Indirect Materials account in the factory overhead ledger, which is a subsidiary ledger controlled by the Factory Overhead account in the general ledger. The factory overhead ledger includes all of the individual overhead costs.

Exhibit 15.5 shows a materials ledger card for one type of material received and issued by Road Warriors. The card identifies the item as alarm system wiring and shows the item’s stock number, its location in the storeroom, information about the maximum and minimum quantities that should be available, and the reorder quantity. For example, two units of alarm system wiring were purchased on March 4, 2019, as evidenced by receiving report C-7117. After this purchase the company has three units of alarm system wiring in inventory.

Alarm system wiringItem M–347Stock No. Bin 137Location in Storeroom

5 unitsMaximum quantity 1 unitMinimum quantity 2 unitsQuantity to reorder

1 $225 $225 C-7117 2 $225 3 225 675$4503/4/2019

3/7/2019 21R–4705 $225$225 450225

Date Units Unit Price

Total Price

Receiving Report Number Units

Unit Price

Total Price Units

Unit Price

Total Price

Requi- sition

Number

Received Issued Balance

MATERIALS LEDGER CARD Road Warriors ROAD W

ARRIO RS

ROAD W ARRIO

RS

Los Angeles, California

EXHIBIT 15.5 Materials Ledger Card

When materials are needed in production, a production manager prepares a materials req­ uisition and sends it to the materials manager. For direct materials, the requisition shows the job number, the type of material, the quantity needed, and the production manager’s signature. Exhibit 15.6 shows the materials requisition for alarm system wiring for Job B15. For requisi- tions of indirect materials, the “Job No.” line in the requisition form might read “For General Factory Use.”

MATERIALS REQUISITION

B15Job No. 3/7/2019Date

M–347Material Stock No. Material Description

1Quantity Requested Requested By

1Quantity Provided

Alarm system wiring

Date Provided

Filled By Material Received By

No. R–4705Road Warriors ROAD W

ARRIO RS

ROAD W ARRIO

RS

Los Angeles, California

3/7/2019

EXHIBIT 15.6 Materials Requisition

576 Chapter 15 Job Order Costing and Analysis

Requisitions often are accumulated by job and recorded in one journal entry. The frequency of entries depends on the job, the industry, and management procedures. In this example, Road Warriors records materials requisitions at the end of each week. Total amounts of materials requisitions follow.

Point: Companies can use LIFO, FIFO, or the weighted-average method in computing the cost of materials requisitions.

Direct materials—requisitioned for specific jobs   Job B15  . . . . . . . . . . . . . . . . . . . .   $    600

  Job B16  . . . . . . . . . . . . . . . . . . . .   300

  Job B17  . . . . . . . . . . . . . . . . . . . .   500

  Job B18  . . . . . . . . . . . . . . . . . . . .   150

  Job B19  . . . . . . . . . . . . . . . . . . . .         250

Total direct materials  . . . . . . . . . . . $1,800 Indirect materials—requisitioned for general factory use  . . . . . . .         550 Total materials requisitions  . . . . . . .   $ 2,350

Mar . 7  Work in Process Inventory  . . . . . . . . . . .   1,800

      Raw Materials Inventory  . . . . . . . .     1,800

    Record use of direct materials.

Use of direct materials for the week (including alarm system wiring for Job B15) yields this entry.

This entry is posted both to general ledger accounts and to subsidiary records. Exhibit 15.7 shows the postings to general ledger accounts (Work in Process Inventory and Raw Materials Inventory) and to the job cost sheets (subsidiary records). The exhibit shows summary job cost sheets for all five jobs, and it shows a detailed partial job cost sheet (excerpted from Exhibit 15.3) for Job B15.

The Raw Materials Inventory account began the month with $1,000 of beginning inventory; it was increased for the March 4 purchase of $2,750. The $1,800 cost of materials used reduces Raw Materials Inventory and increases Work in Process Inventory. The total amount of direct materials used so far ($1,800) is also reflected in the job cost sheets. Later we show the account- ing for indirect materials. At this point, it is important to know that requisitions of indirect mate- rials are not separately recorded on job cost sheets.

Point: Posting to subsidiary records includes debits to job cost sheets and credits to materials ledger cards.

Raw Materials Inventory

Beg. bal. 1,000

Beg. bal. 0

DM used 1,800

Purch. 2,750 DM used 1,800

Work in Process Inventory

End. bal. 1,950*

End. bal. 1,800

*1,950 is the total from all materials ledger cards (not shown here).

Subsidiary Job Cost Sheets

Job B15 Details (excerpted from Exhibit 15.3)

General Ledger Accounts

Dir. Mtls.

Job B19

$250Dir. Mtls.

Job B18

$150Dir. Mtls.

Job B17

$500Dir. Mtls.

Job B15

$600 Dir. Mtls.

Job B16

$300

Date

3/3/2019 3/7/2019 3/9/2019 3/10/2019

R-4698 R-4705 R-4725 R-4777

$100 225 180 95

Requisition Cost Date Time Ticket Cost Date Rate Cost

Direct Materials Direct Labor Overhead

Total $600 Total Total

EXHIBIT 15.7 Posting Direct Materials Used to the General Ledger and Job Cost Sheets

Prepare journal entries to record the following transactions. 1. A manufacturing company purchased $1,200 of materials (on account) for use in production. 2. The company used $200 of direct materials on Job 1 and $350 of direct materials on Job 2.

Solution

Recording Direct Materials

NEED-TO-KNOW 15-2

P1 Do More: QS 15-4, E 15-8

Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . . .   1,200

    Accounts Payable   . . . . . . . . . . . . . . . . . . . . . .     1,200

Record purchase of materials on account.

Work in Process Inventory  . . . . . . . . . . . . . . . . . . . .   550

    Raw Materials Inventory  . . . . . . . . . . . . . . . . .      550

Record use of direct materials in production.

1. 2.

Chapter 15 Job Order Costing and Analysis 577

P2 Describe and record the flow of labor costs in job order costing.

Labor Point: Many employee fraud schemes involve payroll, including overstated hours on time tickets.

Indirect Labor Indirect Materials

Salary Contracts, Time Tickets Factory Overhead Ledger

Job B15 Job B16

Job B17 Job B18

Job B19

Materials Labor

Job Cost Sheets

Direct LaborTime Tickets Overhead

Indirect Labor

Labor Cost Flows and Documents Exhibit 15.8 shows that labor costs are classified as either direct or indirect. Direct labor costs flow to job cost sheets. To assign direct labor costs to individual jobs, companies use time tick­ ets to track how each employee’s time is used and to record how much time they spent on each job. This process is often automated: Employees swipe electronic identification badges, and a computer system assigns employees’ hours worked to individual jobs. An employee who works on several jobs during a day completes separate time tickets for each job. In all cases, supervi- sors check and approve the accuracy of time tickets.

Indirect labor includes factory costs like supervisor salaries and maintenance worker wages. These costs are not assigned directly to individual jobs. Instead, the company determines the amounts of supervisor salaries from their salary contracts and the amounts of maintenance worker wages from time tickets and classifies those costs as overhead. Indirect labor costs flow to the factory overhead ledger. EXHIBIT 15.8

Labor Cost Flows

Exhibit 15.9 shows a time ticket reporting the time a Road Warrior employee spent working on Job B15. The employee’s supervisor signed the ticket to confirm its accuracy. The hourly rate and total labor cost are recorded after the time ticket is turned in.

TIME TICKET

TIME AND RATE INFORMATION:

Remarks ................................................. .................................................

Date .................. 20 .........March 8 19No. L–3479

Road Warriors ROAD W

ARRIO RS

ROAD W ARRIO

RS

Los Angeles, California

Start Time

Employee Name

Finish Time

9:00 12:00

Elapsed Time Hourly Rate

$203.0

Total Cost $60Approved By ................................

T. Zeller

Employee Number

3969

Job No.

B15

EXHIBIT 15.9 Time Ticket

Time tickets are often accumulated and recorded in one journal entry. The frequency of these entries varies across companies. In this example, Road Warriors journalizes direct labor monthly. During March, Road Warriors’s factory payroll costs total $5,300. Of this amount, $4,200 can be traced directly to jobs, and the remaining $1,100 is classified as indirect labor, as shown below.

Direct labor—traceable to specific jobs   Job B15  . . . . . . . . . . . . . . . . . . . . . . . . .  $ 1,000

  Job B16  . . . . . . . . . . . . . . . . . . . . . . . . .  800

  Job B17  . . . . . . . . . . . . . . . . . . . . . . . . .  1,100

  Job B18  . . . . . . . . . . . . . . . . . . . . . . . . .  700

  Job B19  . . . . . . . . . . . . . . . . . . . . . . . . .  600

Total direct labor . . . . . . . . . . . . . . . . . . . . $4,200 Indirect labor—general factory use  . . . .  1,100 Total labor cost . . . . . . . . . . . . . . . . . . . . . .  $ 5,300

This entry records direct labor based on all the direct labor time tickets for the month.

Mar . 31  Work in Process Inventory  . . . . . . . . . . .   4,200

      Factory Wages Payable  . . . . . . . . .     4,200

Record direct labor used for the month.

578 Chapter 15 Job Order Costing and Analysis

Dir. Mtls.

Job B19

$250Dir. Mtls.

Job B18

$150Dir. Mtls.

Job B17

$ 500Dir. Mtls.

Job B15

$ 600

Dir. Labor 1,000 Dir. Labor 800 Dir. Labor 1,100 Dir. Labor 700 Dir. Labor 600 Dir. Mtls.

Job B16

$300

Subsidiary Job Cost Sheets

Job B15 Details (excerpted from Exhibit 15.3)

Date

3/3/2019 3/7/2019 3/9/2019 3/10/2019

R-4698 R-4705 R-4725 R-4777

$ 100 225 180 95

Requisition Cost Date Time Ticket Cost Date Rate Cost

Direct Materials Direct Labor Overhead

Total $600 Total Total

Factory Wages Payable

Beg. bal. 0 DL used 4,200

Beg. bal. 0 DM used 1,800 DL used 4,200

Work in Process Inventory

End. bal. 6,000

3/3/2019 3/4/2019 3/5/2019 3/8/2019 3/9/2019 3/10/2019 3/11/2019

L-3393 L-3422 L-3456 L-3479 L-3501 L-3535 L-3559

$ 120 150 180

60 90

240 160

$1,000

General Ledger Accounts

This entry is posted to the general ledger accounts, Work in Process Inventory and Factory Wages Payable (or Cash, if paid), and to individual job cost sheets. Exhibit 15.10 shows these postings. The exhibit shows summary job cost sheets for all five jobs, and it shows a partial job cost sheet (excerpted from Exhibit 15.3) for Job B15.

EXHIBIT 15.10 Posting Direct Labor to General Ledger and Job Cost Sheets

Time tickets are used to determine how much of the monthly direct labor cost ($4,200) to assign to specific jobs. This total matches the amount of direct labor posted to the Work in Pro- cess Inventory general ledger account. After this entry is posted, the balance in Work in Process Inventory is $6,000, consisting of $1,800 of direct materials and $4,200 of direct labor. Later we show the accounting for indirect labor, which is not separately recorded on job cost sheets.

A manufacturing company used $5,400 of direct labor in production activities in May. Of this amount, $3,100 of direct labor was used on Job A1 and $2,300 of direct labor was used on Job A2. Prepare the journal entry to record direct labor used.

Solution

Recording Direct Labor

NEED-TO-KNOW 15-3

P2

Do More: QS 15-5, E 15-9

Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   5,400

    Factory Wages Payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     5,400

Record direct labor used in production.

Unlike direct materials and direct labor, actual overhead costs are not traced directly to indi- vidual jobs. Still, each job’s total cost must include estimated overhead costs.

Overhead Process Accounting for overhead costs follows the four-step process shown in Exhibit 15.11. Overhead accounting requires managers to first estimate what total overhead costs will be for the coming period. We cannot wait until the end of a period to apply overhead to jobs because managers’ decisions require up-to-date costs. Overhead cost, even if it is not exactly precise, is needed to estimate a job’s total costs before its completion. Such estimated costs are useful in setting prices and identifying costs that are out of control. At the end of the year, the company adjusts its estimated overhead to the actual amount of overhead incurred for that year and then considers whether to change its predetermined overhead rate for the next year. We discuss each of these steps.

OVERHEAD COSTS P3 Describe and record the flow of overhead costs in job order costing.

Overhead

Chapter 15 Job Order Costing and Analysis 579

Set Predetermined Overhead Rate Estimating overhead in advance requires a predetermined overhead rate, also called predeter- mined overhead allocation (or application) rate. This requires an estimate of total overhead cost and an estimated activity base such as total direct labor cost before the start of the period. Exhibit 15.12 shows the formula for computing a predetermined overhead rate (estimates are commonly based on annual amounts). This rate is used during the period to apply estimated overhead to jobs, based on each job’s actual usage of the activity. Some companies use multiple predetermined overhead rates for different types of products and services.

Job B15 Job B16

Job B17 Job B18

Job B19

Materials La bor

Job Cost Sheets

Overhead

Set Predetermined Overhead Rate

— Beginning of period — ——— During the period ——— — End of period —

Apply Estimated Overhead to Specific Jobs

Record Actual Overhead

Adjust Overhead

EXHIBIT 15.11 Four-Step Process for Overhead

Predeterminedoverhead rate = Estimated overheadcosts

Estimated activitybase

                    Appliedoverhead = Overhead rate × Actual amount

of activity base used

Point: Predetermined overhead rates can be estimated using mathematical equations, statistical analysis, or professional experience.

EXHIBIT 15.12 Predetermined Overhead Rate Formula

Predetermined overhead rate = Estimated overhead costs Estimated activity base

Mar . 31  Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   6,720

      Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     6,720

    Apply overhead at 160% of direct labor.

The $6,720 of overhead is then applied to each individual job based on the amount of the activity base that job used (in this example, direct labor). Exhibit 15.13 shows these calculations for March’s production activity.

Overhead Activity Base We apply overhead by linking it to another factor used in production, such as direct labor or machine hours. The factor to which overhead costs are linked is known as the activity (or allocation) base. There should be a “cause and effect” relation between the base and overhead costs. A manager must think carefully about how many and which activity bases to use. This managerial decision influences the accuracy with which overhead costs are applied to individual jobs, which might impact a manager’s decisions for pricing or performance evaluation.

Apply Estimated Overhead Road Warriors applies (also termed allocates, assigns, or charges) overhead by linking it to direct labor costs using this formula.

Applied overhead = Predetermined overhead rate × Actual amount of activity base used

At the start of the current year, management estimates total direct labor costs of $125,000 and total overhead costs of $200,000. Using these estimates, management computes its predetermined over- head rate as 160% of direct labor cost ($200,000 ÷ $125,000). Earlier we showed that Road War- riors used $4,200 of direct labor in March. We now apply the predetermined overhead rate of 160% to get $6,720 (equal to $4,200 × 1.60) of estimated overhead for March. The entry is

©wavebreakmedia/Shutterstock

Point: Factory Overhead is a temporary account that is closed to zero at the end of the year.

Adjust COGS for Actual − Estimate

580 Chapter 15 Job Order Costing and Analysis

EXHIBIT 15.13 Applying Estimated Overhead to Specific Jobs*

*160% of direct labor cost

Direct Labor Predetermined Applied Job Cost Overhead Rate Overhead

B15  . . . . . . . . . . .   $1,000  1 .6  $1,600

B16  . . . . . . . . . . .   800  1 .6  1,280

B17  . . . . . . . . . . .   1,100  1 .6  1,760

B18  . . . . . . . . . . .   700  1 .6  1,120

B19  . . . . . . . . . . .   600  1 .6  960

Total  . . . . . . . . . . .   $4,200    $6,720

Road Warriors ROAD W

ARRIO RS

ROAD W ARRIO

RS

Los Angeles, California

Dir. Mtls.

Job B19

$ 250Dir. Mtls. Job B18

$ 150Dir. Mtls.

Job B17

$ 500Dir. Mtls. Job B15

$ 600 Dir. Labor 1,000 Dir. Labor 800 Dir. Labor 1,100 Dir. Labor 700 Dir. Labor 600

Dir. Mtls. Job B16

$ 300

Overhead Total

1,600 Overhead 1,280 Overhead 1,760 Overhead 1,120 Overhead 960 $3,200 Total $2,380 Total $3,360 Total $1,970 Total $1,810

Subsidiary Job Cost Sheets

Job B15 Details (excerpted from Exhibit 15.3)

Date

3/3/2019 3/7/2019 3/9/2019 3/10/2019

R-4698 R-4705 R-4725 R-4777

$ 100 225 180 95

Requisition Cost Date Time Ticket Cost Date Rate Cost

Direct Materials Direct Labor Overhead

Total $600 Total Total

3/3/2019 3/4/2019 3/5/2019 3/8/2019 3/9/2019 3/10/2019 3/11/2019

L-3393 L-3422 L-3456 L-3479 L-3501 L-3535 L-3559

$ 120 150 180 60 90

240 160

$1,000

Factory Overhead

Beg. bal. 0 OH applied 6,720

Beg. bal. 0 DM used 1,800 DL used 4,200 OH applied 6,720

Work in Process Inventory

End. bal. 12,720

3/11/2019 160% of Direct Labor Cost

$1,600

$1,600

General Ledger Accounts

After the applied overhead is recorded and the amounts of overhead applied to each job are deter- mined (Exhibit 15.13), postings to general ledger accounts and to individual job cost sheets fol- low, as in Exhibit 15.14. For all five jobs, summary job cost sheets are presented first, and then a more detailed partial job cost sheet (excerpted from Exhibit 15.3) is shown for Job B15. (Com- pare the partial job cost sheet for Job B15 in this exhibit to the complete version in Exhibit 15.3.)

EXHIBIT 15.14 Posting Overhead to General Ledger and Job Cost Sheets

At this point, $6,720 of estimated overhead has been posted to general ledger accounts and to individual job cost sheets. In addition, the ending balance in the Work in Process Inventory account ($12,720) equals the sum of the ending balances in the job cost sheets. In the next sec- tion we discuss how to record actual overhead.

A manufacturing company estimates it will incur $240,000 of overhead costs in the next year. The company applies overhead using machine hours and estimates it will use 1,600 machine hours in the next year. During the month of June, the company used 80 machine hours on Job 1 and 70 machine hours on Job 2. 1. Compute the predetermined overhead rate to be used to apply overhead during the year. 2. Determine how much overhead should be applied to Job 1 and to Job 2 for June. 3. Prepare the journal entry to record overhead applied for June.

Solution

1. $240,000∕1,600 = $150 per machine hour 2. 80 × $150 = $12,000 applied to Job 1; 70 × $150 = $10,500 applied to Job 2 3.

Recording Applied Overhead

NEED-TO-KNOW 15-4

P3

Do More: QS 15-6, QS 15-7,   QS 15-8, E 15-10

Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   22,500

    Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     22,500

Record applied overhead.

Chapter 15 Job Order Costing and Analysis 581

Record Actual Overhead We now show the accounting for actual overhead costs. Actual overhead costs are not recorded in job cost sheets. (Recall, allocated overhead costs are recorded on job cost sheets.) Factory overhead includes all factory costs other than direct materials and direct labor. Two major sources of overhead costs are indirect materials and indirect labor. These costs are recorded from materials requisition forms for indirect materials and from salary contracts or time tickets for indirect labor. Other sources of information on overhead costs include (1) vouchers authoriz- ing payment for factory items such as supplies or utilities and (2) adjusting journal entries for costs such as depreciation on factory assets.

Actual factory overhead costs are recorded with debits to the Factory Overhead general led- ger account and with credits to various accounts. While journal entries for different types of overhead costs might be recorded with varying frequency, in our example we assume these entries are made at the end of the month.

Record Indirect Materials Used During March, Road Warriors incurred $550 of actual indirect materials costs, as supported by materials requisitions. The use of these indirect materials yields the following entry.

Point: Companies also incur non- manufacturing costs, such as ad- vertising, salespersons’ salaries, and depreciation on assets not used in production. These types of costs are not considered over- head, but instead are treated as period costs and charged directly to the income statement.

This entry is posted to the general ledger accounts, Factory Overhead and Raw Materials Inven- tory, and is posted to Indirect Materials in the subsidiary factory overhead ledger. Unlike the recording of direct materials, actual indirect materials costs incurred are not recorded in Work in Process Inventory and are not posted to job cost sheets.

Record Indirect Labor Used During March, Road Warriors incurred $1,100 of ac- tual indirect labor costs. These costs might be supported by time tickets for maintenance work- ers or by salary contracts for production supervisors. The use of this indirect labor yields the following entry.

This entry is posted to the general ledger accounts, Factory Overhead and Factory Wages Pay- able, and is posted to Indirect Labor in the subsidiary factory overhead ledger. Unlike the recording of direct labor, actual indirect labor costs incurred are not recorded in Work in Process Inventory and are not posted to job cost sheets.

Record Other Overhead Costs During March, Road Warriors incurred $5,270 of actual other overhead costs. These costs could include items such as factory building rent, depre- ciation on the factory building, factory utilities, and other costs indirectly related to production activities. These costs are recorded with debits to Factory Overhead and credits to other accounts such as Cash, Accounts Payable, Utilities Payable, and Accumulated Depreciation—Factory Equipment. The entry to record Road Warriors’s other overhead costs for March follows.

Mar . 31  Factory Overhead   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   550

      Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . .     550

  Record indirect materials used during the month.

Mar . 31  Factory Overhead   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   1,100

      Factory Wages Payable   . . . . . . . . . . . . . . . . . . . . . . . . . .     1,100

  Record indirect labor used during the month.

Mar . 31  Factory Overhead   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   5,270

      Accumulated Depreciation—Factory Equipment   . . . . . .     2,400

      Rent Payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     1,620

      Utilities Payable   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     250

      Prepaid Insurance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     1,000

  Record actual overhead costs for the month.

582 Chapter 15 Job Order Costing and Analysis

This entry is posted to the general ledger account, Factory Overhead, and is posted to separate accounts for each of the overhead items in the subsidiary factory overhead ledger. These actual overhead costs are not recorded in Work in Process Inventory and are not posted to job cost sheets. Only estimated overhead is recorded in Work in Process Inventory and posted to job cost sheets.

Factory Overhead 0 550 1,100 5,270 6,920

A manufacturing company used $400 of indirect materials and $2,000 of indirect labor during the month. The company also incurred $1,200 for depreciation on factory equipment, $500 for depreciation on office equipment, and $300 for factory utilities. Prepare the necessary journal entries.

Solution

Recording Actual Overhead

NEED-TO-KNOW 15-5

P3

Do More: E 15-6, E 15-10

Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  3,900

    Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    400

    Factory Wages Payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    2,000

    Accumulated Depreciation—Factory Equipment*  . . . . . . . . . . . . . .    1,200

    Utilities Payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    300

Record actual overhead costs used in production.

Depreciation Expense   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  500

    Accumulated Depreciation—Office Equipment  . . . . . . . . . . . . . . . .    500 

Record depreciation on office equipment.

*Depreciation on office equipment is a period cost and is excluded from factory overhead.

Summary of Cost Flows In this section we summarize the flow of costs. Exhibit 15.15 shows how costs for a manufac- turing company flow to its financial statements.

Work in Process Inventory

Beg . bal . DM used  Cost of goods DL used*  manufactured OH applied†  (COGM)‡

End . bal .

Raw Materials Inventory

Beg . bal . Purch .

Mtls . available   DM used

End . bal .

Balance Sheet Income Statement

Finished Goods Inventory

Beg . bal . COGM  Cost of goods sold

End . bal .

Cost of goods sold . . . . . . . . . . . . .

Selling expenses  .  .  .  .  .  .  .  .  .  .  .  .  .  .

General and admin . expenses  . . .

*From time tickets. † Predetermined overhead rate × Actual amount of activity base used. ‡ Reported on schedule of cost of goods manufactured.

EXHIBIT 15.15 Cost Flows and Reports

Exhibit 15.15 shows that direct materials used, direct labor used, and factory overhead applied flow through the Work in Process Inventory and Finished Goods Inventory balance sheet accounts. The cost of goods manufactured (COGM) is computed and shown on the schedule of cost of goods manufactured. When goods are sold, their costs are transferred from Finished Goods Inventory on the balance sheet to the income statement as cost of goods sold. For Road Warriors, the journal entries to record the flow of costs from Work in Process Inventory to Fin- ished Goods Inventory, and from Finished Goods Inventory to Cost of Goods Sold, are

Point: Sales revenue is also recorded (see Exhibit 15.17).

Mar . 31  Finished Goods Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   8,940

      Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . .     8,940

    Transfer cost of goods manufactured.

  Cost of Goods Sold   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   5,580

      Finished Goods Inventory  . . . . . . . . . . . . . . . . . . . . . . . . .     5,580

    Record cost of goods sold.

Chapter 15 Job Order Costing and Analysis 583

Period costs (selling expenses and general and administrative expenses) do not impact inventory accounts. As a result, they do not impact cost of goods sold, and they are not reported on the schedule of cost of goods manufactured. They are reported on the income statement as operating expenses.

Cost Flows—Road Warriors We next show the flow of costs and their reporting for our Road Warriors example. The upper part of Exhibit 15.16 shows the flow of Road Warriors’s product costs through general ledger accounts. Arrow lines are numbered to show the flows of costs for March. Each numbered cost flow reflects journal entries made in March. The lower part of Exhibit 15.16 shows summarized job cost sheets at the end of March. The sum of costs assigned to the two jobs in process ($1,970 + $1,810) equals the $3,780 balance in Work in Process Inventory. Costs assigned to the completed Job B17 equal the $3,360 balance in Finished Goods Inventory. These balances in Work in Process Inventory and Finished Goods Inventory are reported on the end-of-period balance sheet. The sum of costs assigned to the sold Jobs B15 and B16 ($3,200 + $2,380) equals the $5,580 balance in Cost of Goods Sold. This amount is reported on the income statement for the period.

Fin. Goods Inventory 0 8,940 5,580 3,360

Materials purchased

Direct materials used

Direct labor used

Indirect materials used

Indirect labor used

Overhead applied

Other overhead used

Finished goods

Goods sold

Raw Materials Inventory*

1,400

1,000 1,800 2,750 550

Other Accounts

Factory Overhead

200

550 5,270 6,720 1,100

Work in Process Inventory*

1,800 6,720 8,940 4,200

Finished Goods Inventory*

8,940 5,580

3,780Factory Wages Payable

5,300

3,360

Cost of Goods Sold†

5,580

5,580

1,100 4,200

Work in Process

Control Control Detail

Finished Goods Delivered Goods

Subsidiary Job Cost Sheets

*The ending balances in the inventory accounts are reported on the balance sheet. †The Cost of Goods Sold balance is reported on the income statement.

Key:

9

7

9

8

6

5

4

3

2

1

2

6

3

8

Matls.

Labor

Ovhd.

Total

Job B19 $ 250

600

960

$1,810

Matls.

Labor

Ovhd.

Total

Job B18 $ 150

700

1,120

$1,970

Matls.

Labor

Ovhd.

Total

Job B17 $ 500

1,100

1,760

$3,360

Matls.

Labor

Ovhd.

Total

Job B15 $ 600

1,000

1,600

$3,200

Matls.

Labor

Ovhd.

Total

Job B16 $ 300

800

1,280

$2,380

1

5

7

4

Road Warriors ROAD W

ARRIO RS

ROAD W ARRIO

RS

Los Angeles, California

EXHIBIT 15.16 Job Order Cost Flows and Ending Job Cost Sheets

Exhibit 15.17 shows the journal entries made in March. Each entry is numbered to link with the arrow lines in Exhibit 15.16. In addition, Exhibit 15.17 concludes with the summary journal entry to record the sales (on account) of Jobs B15 and B16.

Using Job Cost Sheets for Managerial Decisions Managers’ decisions depend on timely information in job cost sheets. In controlling operations, managers must assess the profitability of the company’s products or services. Road Warriors completed and sold two jobs (B15 and B16) and earned a total gross profit of $2,200 ($7,780 selling price − $5,580 cost of goods sold). If this gross profit is higher than expected, managers will try to determine if there are production efficiencies that can be applied to future jobs. For

Sales . . . . . . . . $7,780 COGS . . . . . . . 5,580 Gross profit. . . $2,200

Controlling

584 Chapter 15 Job Order Costing and Analysis

EXHIBIT 15.17 Entries for Job Order Costing*

  Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . .   2,750

      Accounts Payable  . . . . . . . . . . . . . . . . . . . . .     2,750

Acquired raw materials.

  Work in Process Inventory . . . . . . . . . . . . . . . . . . .   1,800

      Raw Materials Inventory  . . . . . . . . . . . . . . . .     1,800

Assign costs of direct materials used.

  Work in Process Inventory . . . . . . . . . . . . . . . . . . .   4,200

      Factory Wages Payable . . . . . . . . . . . . . . . . .     4,200

Assign costs of direct labor used.

  Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . .   550

      Raw Materials Inventory  . . . . . . . . . . . . . . . .     550

Record use of indirect materials.

  Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . .   1,100

      Factory Wages Payable . . . . . . . . . . . . . . . . .     1,100

Record indirect labor costs.

1

2

3

4

5

*Exhibit 15.17 provides summary journal entries. Actual overhead is debited to Factory Overhead. Applied overhead is credited to Factory Overhead.

  Work in Process Inventory . . . . . . . . . . . . . . . . . . .   6,720

      Factory Overhead  . . . . . . . . . . . . . . . . . . . . .     6,720

Apply overhead at 160% of direct labor.

  Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . .   5,270

      Cash (and other accounts)  . . . . . . . . . . . . . .     5,270

Record factory overhead costs such as insurance, utilities, rent, and depreciation.

  Finished Goods Inventory  . . . . . . . . . . . . . . . . . . .   8,940

      Work in Process Inventory  . . . . . . . . . . . . . .     8,940

Record completion of Jobs B15, B16, and B17.

  Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . .   5,580

      Finished Goods Inventory . . . . . . . . . . . . . . .     5,580

Record cost of goods sold for Jobs B15 and B16.

  Accounts Receivable  . . . . . . . . . . . . . . . . . . . . . . .   7,780

      Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     7,780

Record sale of Jobs B15 and B16.

6

7

8

9

10

example, has the business found a way to reduce the amount of direct labor? If gross profit is less than expected, managers will determine if costs are out of control. In this case, can the com- pany find cheaper raw materials without sacrificing product quality? Is the company using costly overtime to complete jobs? Similarly, managers can evaluate costs to date for the in-pro- cess jobs (B18 and B19) to determine whether production processes are going as planned.

In planning future production, managers must consider selling prices. Can the company raise selling prices without losing business to competitors? Can the company match competitors’ price cuts and earn profit? Managers also can use information in job cost sheets to adjust the compa- ny’s sales mix toward more profitable types of jobs. The detailed and timely information in job cost sheets helps managers make better decisions for each job and for the business as a whole.

Job costs can also be used in bidding on new custom jobs. Some companies use cost­plus pricing, where a markup is added to cost to yield a target price. For example, if the estimated production costs for a potential customer’s job total $1,000 and Road Warriors wants a markup of 30% of production costs, it could bid a price of $1,300 (computed as $1,000 + [$1,000 × 30%]).

Schedule of Cost of Goods Manufactured We end the Road Warriors example with the schedule of cost of goods manufactured in Exhibit 15.18. This schedule is similar to the one reported in the previous chapter, with one key differ- ence: Total manufacturing costs include overhead applied rather than actual overhead costs. In this example, actual overhead costs were $6,920, while applied overhead was $6,720. We dis- cuss how to account for the difference between applied and actual overhead in the next section.

Planning

Bidding

Work in Process Inventory

Beg. bal. 0 DM used 1,800 DL used 4,200 OH applied 6,720

Ttl. mfg. costs 12,720 COGM 8,940

End. bal. 3,780

*Actual overhead = $6,920. Overhead is $200 underapplied.

ROAD WARRIORS Schedule of Cost of Goods Manufactured

For the Month of March 2019

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $  1,800

Direct labor used  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4,200

Factory overhead applied*  . . . . . . . . . . . . . . . . . . . . . . . . .   6,720

Total manufacturing costs  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .   12,720

Add: Work in process, March 1, 2019 . . . . . . . . . . . . . . . . .   0

Total cost of work in process . . . . . . . . . . . . . . . . . . . . . . . .   12,720

Less: Work in process, March 31, 2019  . . . . . . . . . . . . . . .   3,780

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . .   $  8,940

EXHIBIT 15.18 Schedule of Cost of Goods Manufactured

Road Warriors ROAD W

ARRIO RS

ROAD W ARRIO

RS

Los Angeles, California

Point: Companies sometimes use more detailed schedules of cost of goods manufactured, as seen in the previous chapter.

Chapter 15 Job Order Costing and Analysis 585

Refer to the debits in the Factory Overhead account in Exhibit 15.16 (or Exhibit 15.17). The total cost of actual factory overhead incurred during March is $6,920 ($550 + $5,270 + $1,100). The $6,920 of actual overhead costs does not equal the $6,720 of overhead applied to work in process inventory (see 6 ). This leaves a debit of $200 in the Factory Overhead account. Because it is hard to precisely forecast future costs, actual overhead rarely equals applied over- head. Companies usually wait until the end of the year to adjust the Factory Overhead account for differences between actual and applied overhead. We show how this is done next.

Factory Overhead Account Exhibit 15.19 shows a Factory Overhead account. The company applies overhead (credits the Factory Overhead account) using a predetermined rate estimated at the beginning of the year. During the year, the company records actual overhead costs with debits to the Factory Overhead account. At year-end we determine whether applied overhead is more or less than actual overhead. When less overhead is applied than is actually incurred, the remaining debit balance in the

Factory Overhead account is called underapplied overhead. When more overhead is applied than is actually incurred, the resulting credit balance in the

Factory Overhead account is called overapplied overhead.

When overhead is underapplied, it means that individual jobs have not been charged enough overhead during the year, and cost of goods sold for the year is too low. When overhead is over- applied, it means that jobs have been charged too much overhead during the year, and cost of goods sold is too high. In either case, a journal entry is needed to adjust Factory Overhead and Cost of Goods Sold. Exhibit 15.20 summarizes this entry, assuming the difference between applied and actual overhead is not material.

ADJUSTING OVERHEAD

Factory Overhead

  Actual  Applied    amounts  amounts

EXHIBIT 15.19 Factory Overhead T-account

Example: If we do not adjust for underapplied overhead, will net income be overstated or under- stated? Answer: Overstated.

EXHIBIT 15.20 Adjusting Factory Overhead

Overhead Overhead Costs Balance Overhead Is Jobs Are Adjusting Journal Entry Required

Actual > Applied  Debit  Underapplied  Undercosted  Cost of Goods Sold  . . . . . . . . . . . .   #           Factory Overhead  . . . . . . . . . . .     #

Actual < Applied  Credit  Overapplied  Overcosted  Factory Overhead  . . . . . . . . . . . . .   #           Cost of Goods Sold  . . . . . . . . . .     #

Adjust Underapplied or Overapplied Overhead To illustrate, assume that Road Warriors applied $200,000 of overhead to jobs during 2019, which is the amount of overhead estimated in advance for the year. We further assume that Road Warriors incurred a total of $200,480 of actual overhead costs during 2019. This means, at the end of the year, the Factory Overhead account has a debit balance of $480. This amount is the difference between estimated (applied) and actual overhead costs for the year.

The $480 debit balance reflects manufacturing costs not assigned to jobs. This means the bal- ances in Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold do not include all production costs incurred. However, the difference between applied and actual overhead in this case is immaterial, and it is closed to Cost of Goods Sold with the following adjusting entry.

P4 Determine adjustments for overapplied and underapplied factory overhead.

Point: When the underapplied or overapplied overhead is material, the amount is normally allocated to the Cost of Goods Sold, Finished Goods Inventory, and Work in Process Inventory accounts. This process is covered in advanced courses.

Dec . 31  Cost of Goods Sold   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   480

      Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     480

Adjust for underapplied overhead costs.

The $480 debit (increase) to Cost of Goods Sold reduces income by $480. After this entry, the Factory Overhead account has a zero balance. Also, Cost of Goods Sold reflects actual overhead costs for the period. If instead we had overapplied overhead at the end of the period, we would debit Factory Overhead and credit Cost of Goods Sold for the amount.

Factory Overhead

Actual . . . . . . . . . . . . . $200,480 Applied . . . . . . . . . . . . 200,000

Underapplied . . . . . . . $ 480

586 Chapter 15 Job Order Costing and Analysis

Job Order Costing of Services Job order costing also applies to service companies. Most service companies meet customers’ needs by performing a custom service for a specific customer. Examples include an accountant auditing a client’s financial statements, an interior designer remodeling an office, a wedding consultant planning and supervising a reception, and a lawyer defending a client.

Job order costing has some important differences for service firms. Most service firms have neither raw materials inventory nor finished goods inventory. They

do, however, have inventories of supplies, and they can have work in process inventory. Often these supplies are immaterial and are considered overhead costs.

Direct labor is often used to apply overhead because service firms do not use direct materials. Service firms typically use different account titles, for example Services in Process

Inventory and Services Overhead.

Exhibit 15.21 shows the flow of costs for a service firm called AdWorld, a developer of advertising materials. During the month, AdWorld worked on custom advertising campaigns for clients that wanted ads for three different platforms: mobile devices, television, and radio. In this chapter’s Decision Analysis section we show an example of using job order costing to price advertising services for AdWorld.

Traced to service

Allocated to service

Direct costs ................ $

Indirect costs ........... .. $ Total cost of service ...$

Service Cost

A manufacturing company applied $300,000 of overhead to its jobs during the year. For the independent scenarios below, prepare the journal entry to adjust over- or underapplied overhead. Assume the adjust- ment amounts are not material. 1. Actual overhead costs incurred during the year equal $305,000. 2. Actual overhead costs incurred during the year equal $298,500.

Solution

Adjusting Overhead

NEED-TO-KNOW 15-6

P4

Do More: QS 15-11, QS 15-12,   E 15-13, E 15-14

Cost of Goods Sold  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   5,000

    Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . .     5,000

Close underapplied overhead to Cost of Goods Sold.

Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   1,500

    Cost of Goods Sold  . . . . . . . . . . . . . . . . . . . . . . . .     1,500

Close overapplied overhead to Cost of Goods Sold.

1. 2.

Services in Process Inventory Cost of Services

Indirect Labor

Direct Labor

Overhead Costs

Overhead

Service Costs

Labor

Completed

Completed Job A2

Job A1

Job A2

Job A1

Job A3

EXHIBIT 15.21 Flow of Costs for Service Firms

Management Consultant You control and manage costs for a consulting company. At the end of a recent month, three consulting jobs were completed and two are 60% complete. Each unfinished job is estimated to cost $10,000 and to earn revenue of $12,000. You are unsure how to recognize inventory and record costs and revenues. Do you recognize any inventory? If so, how much? How much revenue is recorded for unfinished jobs this month? ■ Answer: Service companies do not recognize work in process inventory or finished goods inventory. For the two jobs that are 60% complete, you could recognize revenues and costs at 60% of the total expected amounts or revenue of $7,200 (0.60 × $12,000) and costs of $6,000 (0.60 × $10,000), yielding net income of $1,200 from each job.

Decision Maker

Chapter 15 Job Order Costing and Analysis 587

Professional service firms in accounting, consulting, law, and financial services compete for highly tal- ented employees with strong technical skills. In addition, a more diverse workforce is likely to lead to different points of view that arguably can produce even better services and ultimately more profit for the company. Enhancing workforce diversity can also help attract and retain talented people.

Although workforce diversity is typically not recorded on job cost sheets, many companies measure and report it. Along these lines, the Sustainability Accounting Standards Board has developed suggested reporting guidelines for professional service firms. The SASB recommends that companies disclose infor- mation on gender and ethnicity for both senior management employees and all other employees.

Consistent with SASB guidelines, the United States Postal Service (USPS), a leading employer of women and minorities, discloses that women comprise roughly 40% and minorities comprise roughly 40% of its overall workforce. Moreover, roughly 21% of USPS’s employees are black, 8% Hispanic, and 8% Asian.

HoopSwagg, the focus of this chapter’s opening feature, customizes socks for charities and fund- raisers. For each pair of Breast Cancer Camo Custom Elite socks sold, the company donates $2 to breast cancer research. For sales of custom-designed socks to honor certain individuals, company founder Brennan Agranoff donates all of the sales to charities of the family’s choosing. Brennan notes that “helping others is one of the best things you can do for the world, and you never know what opportunities arise when you work for a greater cause.”

SUSTAINABILITY AND ACCOUNTING

©HoopSwagg

Pricing for Services Decision Analysis

The chapter described job order costing mainly within a manufacturing setting. However, service provid- ers also use job order costing. Consider AdWorld, an advertising agency that develops web-based ads (and ads for other types of media). Each of its customers has unique requirements, so costs for each individual job must be tracked separately. AdWorld uses two types of labor: web designers ($65 per hour) and computer staff ($50 per hour). It also incurs overhead costs that it assigns using two different predetermined overhead allocation rates: $125 per designer hour and $96 per staff hour. For each job, AdWorld must estimate the number of designer and staff hours needed. Then, total costs of each job are determined using the procedures in the chapter. To illustrate, a chip manufacturer requested a quote from AdWorld for an advertising engagement. AdWorld estimates that the job will require 43 designer hours and 61 staff hours, with the following total estimated cost for this job.

AdWorld can use this cost infor- mation to help determine the price quote for the job (see Decision Maker, Sales Manager, below).

AdWorld must also consider the market, that is, how much com- petitors will quote for this job. Competitor information is often unavailable; therefore, AdWorld’s managers must use estimates based on their assessment of the competi- tive environment.

A1 Apply job order costing in pricing services.

Estimated Job Cost—Advertising Services

Direct Labor Designers (43 hours × $65) . . . . . . . . . . . . . . . . . . . . .  $2,795 Staff (61 hours × $50)  . . . . . . . . . . . . . . . . . . . . . . . . .  3,050 Total direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    $  5,845 Overhead Designer related (43 hours × $125)  . . . . . . . . . . . . . .  5,375 Staff related (61 hours × $96) . . . . . . . . . . . . . . . . . . .  5,856 Total overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    11,231 Total estimated job cost . . . . . . . . . . . . . . . . . . . . . . . .    $17,076

AdWorld

Sales Manager As AdWorld’s sales manager, assume that you estimate costs pertaining to a proposed job as $17,076. Your normal pricing policy is to apply a markup of 18% from total costs. However, you learn that three other agencies are likely to bid for the same job, and that their quotes will range from $16,500 to $22,000. What price should you quote? What factors other than cost must you consider? ■ Answer: The price based on AdWorld’s normal pricing policy is $20,150 ($17,076 × 1.18), which is within the price range offered by competitors. One option is to apply normal pricing policy and quote a price of $20,150. It is, however, useful to assess competitor pricing, especially in terms of service quality and other benefits. Although price is an input customers use to select suppliers, factors such as quality and timeliness (responsiveness) of suppliers are important. Accordingly, the price can reflect such factors.

Decision Maker

Price Quote

Job cost $17,076

Markup (18%) 3,074

Price $20,150

588 Chapter 15 Job Order Costing and Analysis

The following information reflects Walczak Company’s job order production activities for May.

COMPREHENSIVE

Job Costs, Journal Entries, and Schedule of Cost of Goods Manufactured

NEED-TO-KNOW 15-7

Required

1. Determine the total cost for each part a through e. a. The April 30 inventory of jobs in process. b. Materials (direct and indirect) used during May. c. Labor (direct and indirect) used during May. d. Factory overhead incurred and applied during May and the amount of any over- or underapplied

overhead on May 31. e. The total cost of each job as of May 31, the May 31 inventories of both work in process and finished

goods, and the cost of goods sold during May. 2. Prepare summarized journal entries for the month to record each part a through f. a. Materials purchases (on credit), direct materials used in production, direct labor used in production,

and overhead applied. b. Actual overhead costs, including indirect materials, indirect labor, and other overhead costs. c. Transfer of each completed job to the Finished Goods Inventory account. d. Cost of goods sold. e. The sale (on account) of Job 401 for $35,000. f. Removal of any underapplied or overapplied overhead from the Factory Overhead account.

(Assume the amount is not material.) 3. Prepare a schedule of cost of goods manufactured for May.

PLANNING THE SOLUTION Determine the cost of the April 30 work in process inventory by totaling the materials, labor, and

applied overhead costs for Job 401. Compute the cost of materials used and labor by totaling the amounts assigned to jobs and to overhead. Compute the total overhead incurred by summing the amounts for the three components. Compute the

amount of applied overhead by multiplying the total direct labor cost by the predetermined overhead rate. Compute the underapplied or overapplied amount as the difference between the actual cost and the applied cost.

Determine the total cost charged to each job by adding the costs incurred in April (if any) to the cost of materials, labor, and overhead applied during May.

Group the costs of the jobs according to their completion status. Record the direct materials costs assigned to the three jobs. Transfer costs of Jobs 401 and 402 from Work in Process Inventory to Finished Goods. Record the costs of Job 401 as cost of goods sold. Record the sale (on account) of Job 401 for $35,000. On the schedule of cost of goods manufactured, remember to include the beginning and ending work

in process inventories and to use applied rather than actual overhead.

Materials and labor   Raw materials purchases . . . . . . . . . . .   $16,000   Factory payroll cost  . . . . . . . . . . . . . . .   15,400

Overhead costs incurred     Indirect materials . . . . . . . . . . . . . . . . .   $5,000     Indirect labor  . . . . . . . . . . . . . . . . . . . .   3,500     Other factory overhead  . . . . . . . . . . . .   9,500

Job 401 Job 402 Job 403

Work in process inventory, April 30     Direct materials  . . . . . . . . . . . . . . . . . . . . . . .   $3,600     Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . .     1,700     Applied overhead   . . . . . . . . . . . . . . . . . . . . .     2,550 Costs during May     Direct materials  . . . . . . . . . . . . . . . . . . . . . . .     3,550  $3,500  $1,400     Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . .     5,100    6,000    800     Applied overhead . . . . . . . . . . . . . . . . . . . . . .   ?  ?  ? Status on May 31  . . . . . . . . . . . . . . . . . . . . . . . . Finished (sold) Finished (unsold) In process

Walczak’s predetermined overhead rate is 150% of direct labor cost. Costs are applied to the three jobs worked on during May as follows.

Chapter 15 Job Order Costing and Analysis 589

SOLUTION 1. Total cost of a. April 30 inventory of b. Materials used during May.

jobs in process (Job 401).

Direct materials . . . . . . . . . . . . .   $3,600 Direct labor . . . . . . . . . . . . . . . .   1,700 Applied overhead . . . . . . . . . . .   2,550 Total cost . . . . . . . . . . . . . . . . . .   $7,850

Direct materials     Job 401 . . . . . . . . . . . . . . . . . . . . .  $  3,550     Job 402 . . . . . . . . . . . . . . . . . . . . .  3,500     Job 403 . . . . . . . . . . . . . . . . . . . . .  1,400 Total direct materials  . . . . . . . . . . . .  8,450 Indirect materials  . . . . . . . . . . . . . . .  5,000 Total materials used  .  .  .  .  .  .  .  .  .  .  .  .  .  $13,450

Total cost of the May 31 inventory of work in process (Job 403) = $3,400 Total cost of the May 31 inventory of finished goods (Job 402) = $18,500 Total cost of goods sold during May (Job 401) = $24,150

c. Labor used during May. d. Factory overhead incurred and applied in May.

Direct labor     Job 401 . . . . . . . . . . . . . . . . .   $  5,100     Job 402 . . . . . . . . . . . . . . . . .   6,000     Job 403 . . . . . . . . . . . . . . . . .   800 Total direct labor . . . . . . . . . . . .   11,900 Indirect labor . . . . . . . . . . . . . . .   3,500 Total labor used  . . . . . . . . . . . .   $15,400

Actual overhead     Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . .  $   5,000     Indirect labor  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  3,500     Other factory overhead  . . . . . . . . . . . . . . . . . . . . . .  9,500 Total actual overhead . . . . . . . . . . . . . . . . . . . . . . . . . .  18,000 Overhead applied (150% × $11,900) . . . . . . . . . . . . .  17,850 Underapplied overhead . . . . . . . . . . . . . . . . . . . . . . . .  $      150

401 402 403

Work in process, April 30     Direct materials  . . . . . . . . . . . . . . . . . . .   $  3,600     Direct labor . . . . . . . . . . . . . . . . . . . . . . .   1,700     Applied overhead* . . . . . . . . . . . . . . . . .   2,550 Cost incurred in May     Direct materials (from part b) . . . . . . . . .   3,550  $  3,500  $1,400     Direct labor . . . . . . . . . . . . . . . . . . . . . . .   5,100  6,000  800     Applied overhead* . . . . . . . . . . . . . . . . .   7,650  9,000  1,200 Total costs . . . . . . . . . . . . . . . . . . . . . . . . . .   $24,150  $18,500  $3,400

*Equals 150% of that job’s direct labor cost.

e. Total cost of each job.

2. Journal entries. a. Record raw materials purchases, direct materials used, direct labor used, and overhead applied.

  Raw Materials Inventory   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   16,000

      Accounts Payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     16,000

Record materials purchases.

  Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   8,450

      Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . .     8,450

Assign direct materials to jobs.

  Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   11,900

      Factory Wages Payable   . . . . . . . . . . . . . . . . . . . . . . . . . .     11,900

Assign direct labor to jobs.

  Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   17,850

      Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     17,850

Apply overhead to jobs.

590 Chapter 15 Job Order Costing and Analysis

  Factory Overhead   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   5,000

      Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . .     5,000

Record indirect materials.

  Factory Overhead   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   3,500

      Factory Wages Payable   . . . . . . . . . . . . . . . . . . . . . . . . . .     3,500

Record indirect labor.

  Factory Overhead   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   9,500

      Cash  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     9,500

Record other actual factory overhead.

c. Transfer cost of completed jobs to Finished Goods Inventory.

b. Record actual overhead costs.

d. Record cost of job sold.

  Finished Goods Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   42,650

      Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . .     42,650

Record completion of jobs ($24,150 for Job 401 + $18,500 for Job 402).

  Cost of Goods Sold   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   24,150

      Finished Goods Inventory  . . . . . . . . . . . . . . . . . . . . . . . . .     24,150

Record costs for sale of Job 401.

  Accounts Receivable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   35,000

      Sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     35,000

Record sale of Job 401.

  Cost of Goods Sold   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   150

      Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     150

Assign underapplied overhead to Cost of Goods Sold.

e. Record sales for job sold.

f. Close underapplied overhead to cost of goods sold.

3.

WALCZAK COMPANY Schedule of Cost of Goods Manufactured

For Month Ended May 31

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $  8,450

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   11,900

Factory overhead applied* . . . . . . . . . . . . . . . . . . . . . .   17,850

Total manufacturing costs  . . . . . . . . . . . . . . . . . . . . . .   38,200

Add: Work in process, April 30 . . . . . . . . . . . . . . . . . . .   7,850

Total cost of work in process  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .   46,050

Less: Work in process, May 31 . . . . . . . . . . . . . . . . . . .   3,400

Cost of goods manufactured  . . . . . . . . . . . . . . . . . . . .   $42,650

*Actual overhead = $18,000. Overhead is $150 underapplied.

Chapter 15 Job Order Costing and Analysis 591

JOB ORDER PRODUCTION Job: Production of a custom product. Job lot: Producing more than one unit of a custom product. Job cost sheet: Cost record kept for each job.

Direct materials used + Direct labor used + Overhead applied = Total job cost

FLOW OF MANUFACTURING COSTS

Total of $ amounts on all job cost sheets = General ledger balances of Work in Process Inventory, Finished Goods Inventory, and COGS.

Summary: Cheat Sheet

Work in Process Inventory

Beg . bal . DM used

DL used

FOH used    COGM

End . bal .

Finished Goods Inventory

Beg . bal . COGM

    COGS

End . bal .

Raw Materials Inventory

Beg . bal . Purchases

DM Used

End . bal .

Assign costs of direct labor used

Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . .   11,900

    Factory Wages Payable  . . . . . . . . . . . . . . . . . . . . . .     11,900

Apply overhead using predetermined rate

Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . .   17,850

    Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . .     17,850

Record use of indirect materials

Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   5,000

    Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . .     5,000

Record indirect labor costs

Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   3,500

    Factory Wages Payable  . . . . . . . . . . . . . . . . . . . . . .     3,500

Record completion of jobs

Finished Goods Inventory   . . . . . . . . . . . . . . . . . . . . . . . .   42,650

    Work in Process Inventory .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .      42,650

Record cost of goods sold for sold jobs

Cost of Goods Sold  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   24,150

    Finished Goods Inventory  . . . . . . . . . . . . . . . . . . . .     24,150

Record sales for sold jobs

Accounts Receivable   . . . . . . . . . . . . . . . . . . . . . . . . . . . .   35,000

    Sales  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     35,000

Assign underapplied overhead to cost of goods sold

Cost of Goods Sold  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   150

    Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . .     150

Assign overapplied overhead to cost of goods sold

Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   150

     Cost of Goods Sold  . . . . . . . . . . . . . . . . . . . . . . . . .     150

Record actual overhead costs such as insurance, rent, utilities, and depreciation

Factory Overhead  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   9,500

    Cash (and other accounts)   . . . . . . . . . . . . . . . . . . .     9,500

Factory Overhead Overhead Costs Balance Overhead Is Adjusting Journal Entry Required

Actual > Applied  Debit  Underapplied  Cost of Goods Sold . . . . . . . .   #         Factory Overhead  . . . . . .     #

Actual < Applied  Credit  Overapplied  Factory Overhead . . . . . . . . .   #         Cost of Goods Sold  . . . . .     #

Adjust overhead and COGS at period­end

JOURNAL ENTRIES Acquire raw materials

Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . . . . . . .   16,000     Accounts Payable   . . . . . . . . . . . . . . . . . . . . . . . . . .     16,000

Assign costs of direct materials used

Work in Process Inventory  . . . . . . . . . . . . . . . . . . . . . . . .   8,450     Raw Materials Inventory  . . . . . . . . . . . . . . . . . . . . .     8,450

Cost accounting system (571) Cost­plus pricing (584) Finished Goods Inventory (573) Job (571) Job cost sheet (573) Job lot (571) Job order costing system (573)

Job order production (571) Materials ledger card (574) Materials requisition (575) Overapplied overhead (585) Predetermined overhead rate (579) Process operations (572) Receiving report (574)

Services in Process Inventory (586) Services Overhead (586) Target cost (573) Time ticket (577) Underapplied overhead (585) Work in Process Inventory (573)

Key Terms

DM = direct materials; DL = direct labor; FOH = factory overhead; COGM = cost of goods manufactured; COGS = cost of goods sold

Factory Overhead

  Actual  Applied    amounts  amounts

OVERHEAD

Predeterminedoverhead rate = Estimated overhead costs Estimated activity base

Appliedoverhead = Overhead

rate × Actual amount of activity base used

592 Chapter 15 Job Order Costing and Analysis

Multiple Choice Quiz

1. A company’s predetermined overhead rate is 150% of its direct labor costs. How much overhead is applied to a job that requires total direct labor costs of $30,000? a. $15,000 d. $60,000 b. $30,000 e. $75,000 c. $45,000

2. A company uses direct labor costs to apply overhead. Its production costs for the period are: direct materials, $45,000; direct labor, $35,000; and overhead applied, $38,500. What is its predetermined overhead rate? a. 10% d. 91% b. 110% e. 117% c. 86%

3. A company’s ending inventory of finished goods has a total cost of $10,000 and consists of 500 units. If the overhead applied to these goods is $4,000 and the predetermined overhead rate is 80% of direct labor costs, how much direct materials cost was incurred in producing these 500 units? a. $10,000 d. $5,000 b. $6,000 e. $1,000 c. $4,000

The cost of goods manufactured is a. $193,000. c. $185,000. e. $176,200. b. $211,800. d. $144,600.

5. At the end of its current year, a company learned that its overhead was underapplied by $1,500 and that this amount is not considered material. Based on this information, the company should a. Credit the $1,500 to Finished Goods Inventory. b. Credit the $1,500 to Cost of Goods Sold. c. Debit the $1,500 to Cost of Goods Sold. d. Do nothing about the $1,500 because it is not material

and it is likely that overhead will be overapplied by the same amount next year.

e. Include the $1,500 on the income statement as “Other Expense.”

Beginning balance  9,000

Direct materials  94,200

Direct labor  59,200

Overhead applied  31,600

Ending balance  17,800

 Cost of goods  manufactured                

Work in Process Inventory

4. A company’s Work in Process Inventory T-account follows.

1. Why must a company estimate the amount of factory over- head assigned to individual jobs or job lots?

2. Some companies use labor cost to apply factory over- head to jobs. Identify another factor (or base) a company might reasonably use to apply overhead costs.

3. What information is recorded on a job cost sheet? How do management and employees use job cost sheets?

4. In a job order costing system, what records serve as a sub- sidiary ledger for Work in Process Inventory? For Finished Goods Inventory?

5. What journal entry is recorded when a materials manager receives a materials requisition and then issues materials (both direct and indirect) for use in the factory?

6. How does the materials requisition help safeguard a company’s assets?

7. Google uses a “time ticket” for some em- ployees. How are time tickets used in job order costing?

8. What events cause debits to be recorded in the Factory Overhead account? What events cause credits to be re- corded in the Factory Overhead account?

9. Google applies overhead to product costs. What account(s) is(are) used to eliminate overapplied or underapplied overhead from the Factory Overhead account, assuming the amount is not material?

10. Assume that Apple produces a batch of 1,000 iPhones. Does it account for this as 1,000 individual jobs or as a job lot? Explain (consider costs and benefits).

Discussion Questions

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $30,000 × 150% = $45,000 2. b; $38,500∕$35,000 = 110%

3. e; Direct materials + Direct labor + Overhead = Total cost; Direct materials + ($4,000∕0.80) + $4,000 = $10,000 Direct materials = $1,000

4. e; $9,000 + $94,200 + $59,200 + $31,600 − Finished goods = $17,800.

Thus, finished goods = $176,200 5. c

?

Icon denotes assignments that involve decision making.

GOOGLE

GOOGLE

APPLE

Chapter 15 Job Order Costing and Analysis 593

11. Why must a company use predetermined overhead rates when using job order costing?

12. How would a hospital apply job order costing? Explain. 13. Harley­Davidson manufactures 30 custom-made, luxury-

model motorcycles. Does it account for these motorcycles as 30 individual jobs or as a job lot? Explain.

14. Assume Sprint will install and service a server to link all of a customer’s employees’ smartphones to a centralized com- pany server for an up-front flat price. How can Sprint use a job order costing system?

Clemens Cars’s job cost sheet for Job A40 shows that the cost to add security features to a car was $10,500. The car was delivered to the customer, who paid $14,900 in cash for the added features. What journal entries should Clemens record for the completion and delivery of Job A40?

QS 15-2 Job cost sheets C2

During the current month, a company that uses job order costing purchases $50,000 in raw materials for cash. It then uses $12,000 of raw materials indirectly as factory supplies and uses $32,000 of raw materi- als as direct materials. Prepare journal entries to record these three transactions.

QS 15-4 Raw materials journal entries P1

During the current month, a company that uses job order costing incurred a monthly factory payroll of $180,000. Of this amount, $40,000 is classified as indirect labor and the remainder as direct. Prepare journal entries to record these transactions.

QS 15-5 Labor journal entries P2

A company estimates the following manufacturing costs for the next period: direct labor, $468,000; direct materials, $390,000; and factory overhead, $117,000. Compute its predetermined overhead rate as a per- cent of (1) direct labor and (2) direct materials. Express your answers as percents, rounded to the nearest whole number.

QS 15-6 Factory overhead rates

P3

At the beginning of the year, a company predicts total overhead costs of $560,000. The company applies overhead using machine hours and estimates it will use 1,400 machine hours during the year. What amount of overhead should be applied to Job 65A if that job uses 13 machine hours during January?

QS 15-7 Applying overhead P3

At the beginning of the year, a company predicts total direct materials costs of $900,000 and total over- head costs of $1,170,000. If the company uses direct materials costs as its activity base to apply overhead, what is the predetermined overhead rate it should use during the year?

QS 15-8 Predetermined overhead rate P3

Label each item a through e below as a feature of either a job order (J) or process (P) operation. a. Heterogeneous products and services d. Low production volume b. Routine, repetitive procedures e. Low product standardization c. Low product flexibility

QS 15-3 Comparing process and job order operations

C1

QUICK STUDY

QS 15-1 Jobs and job lots C1

Determine which of the following are most likely to be considered as a job and which as a job lot. 1. Hats imprinted with company logo 4. A 90-foot motor yacht 2. Little League trophies 5. Wedding dresses for a chain of stores 3. A handcrafted table 6. A custom-designed home

QS 15-9 Applying overhead

P3

On March 1 a dressmaker starts work on three custom-designed wedding dresses. The company uses job order costing and applies overhead to each job (dress) at the rate of 40% of direct materials costs. During the month, the jobs used direct materials as shown below. Compute the amount of overhead applied to each of the three jobs.

Job 1 Job 2 Job 3

Direct materials used  . . . . . . . . . . . .   $5,000  $7,000  $1,500 

594 Chapter 15 Job Order Costing and Analysis

QS 15-11 Entry for over- or underapplied overhead P4

A company applies overhead at a rate of 150% of direct labor cost. Actual overhead cost for the current period is $950,000, and direct labor cost is $600,000. Prepare the journal entry to close over- or underap- plied overhead to Cost of Goods Sold.

QS 15-12 Entry for over- or underapplied overhead

P4

A company’s Factory Overhead account shows total debits of $624,000 and total credits of $646,000 at the end of the year. Prepare the journal entry to close the balance in the Factory Overhead account to Cost of Goods Sold.

QS 15-13 Job order costing of services A1

An advertising agency is estimating costs for advertising a music festival. The job will require 200 direct labor hours at a cost of $50 per hour. Overhead costs are applied at a rate of $65 per direct labor hour. What is the total estimated cost for this job?

QS 15-14 Job order costing of services A1

An advertising agency used 65 hours of direct labor in creating advertising for a music festival. Direct labor costs $50 per hour. The agency applies overhead at a rate of $40 per direct labor hour. Prepare jour- nal entries to record the agency’s direct labor and the applied overhead costs for this job.

QS 15-10 Manufacturing cost flows

P1 P2 P3

Refer to the information in QS 15-9. During the month, the jobs used direct labor as shown below. Jobs 1 and 3 are not finished by the end of March, and Job 2 is finished but not sold by the end of March. (1) Determine the amounts of direct materials, direct labor, and factory overhead applied that would be re- ported on job cost sheets for each of the three jobs for March. (2) Determine the total dollar amount of Work in Process Inventory at the end of March. (3) Determine the total dollar amount of Finished Goods Inventory at the end of March. Assume the company has no beginning Work in Process or Finished Goods inventories.

Job 1 Job 2 Job 3

Direct labor used . . . . . . . . . . . . . . . .   $9,000  $4,000  $3,000

QS 15-15 Job cost sheet

C2

EcoSkate makes skateboards from recycled plastic. For a recent job lot of 100 skateboards, the company incurred direct materials costs of $600 and direct labor costs of $200. Overhead is applied using a rate of 150% of direct materials costs. What is the total manufacturing cost of this job lot? What is the cost per skateboard?

EXERCISES

Exercise 15-1 Job order production

C1

Match each of the terms/phrases numbered 1 through 5 with the best definition a through e. 1. Cost accounting system 2. Target cost 3. Job 4. Process operation 5. Job order production

a. Production activities for a custom product. b. Production activities for a special order. c. A system that records manufacturing costs. d. The expected selling price of a job minus its desired profit. e. Mass production in a continuous flow of steps.

Exercise 15-2 Job cost computation

C2

The following information is from the materials requisitions and time tickets for Job 9-1005 completed by Great Bay Boats. The requisitions are identified by code numbers starting with the letter Q, and the time tickets start with W. At the start of the year, management estimated that overhead cost would equal 110% of direct labor cost for each job. Determine the total cost on the job cost sheet for Job 9-1005.

Date Document Amount

7/1 . . . . . . . . . . . . . . . . . . . . . . . . . .   Q-4698  $1,250

7/1 . . . . . . . . . . . . . . . . . . . . . . . . . .   W-3393  600

7/5 . . . . . . . . . . . . . . . . . . . . . . . . . .   Q-4725  1,000

7/5 . . . . . . . . . . . . . . . . . . . . . . . . . .   W-3479  450

7/10 . . . . . . . . . . . . . . . . . . . . . . . . .   W-3559  300

Chapter 15 Job Order Costing and Analysis 595

Job 102 Job 103 Job 104

Direct materials . . . . . . . . . . . .   $15,000  $33,000  $27,000

Direct labor . . . . . . . . . . . . . . .   8,000  14,200  21,000

Overhead applied . . . . . . . . . .   4,000  7,100  10,500

As of the end of June, the job cost sheets at Racing Wheels, Inc., show the following total costs accumu- lated on three custom jobs.

Exercise 15-3 Analyzing cost flows

C2

Job 102 was started in production in May, and the following costs were assigned to it in May: direct mate- rials, $6,000; direct labor, $1,800; and overhead, $900. Jobs 103 and 104 were started in June. Overhead cost is applied with a predetermined rate based on direct labor cost. Jobs 102 and 103 were finished in June, and Job 104 is expected to be finished in July. No raw materials were used indirectly in June. Using this information, answer the following questions. (Assume this company’s predetermined overhead rate did not change across these months.) 1. What was the cost of the raw materials requisitioned in June for each of the three jobs? 2. How much direct labor cost was incurred during June for each of the three jobs? 3. What predetermined overhead rate is used during June? 4. How much total cost is transferred to finished goods during June? Check (4) $81,300

Starr Company reports the following information for August. Exercise 15-4 Recording product costs

P1 P2 P3

Prepare journal entries to record the following events. 1. Raw materials purchased. 3. Direct labor used in production. 2. Direct materials used in production. 4. Applied overhead.

Raw materials purchased on account  .  .  .  .  $76,200

Direct materials used in production . . . . . .  $48,000

Factory wages earned (direct labor)  . . .   $15,350

Overhead rate . . . . . . . . . . . . . . . . . . . . .   120% of direct labor cost

1. Prepare journal entries for the following transactions and events a through e in July. a. Direct materials used in production. d. The sale of Job 120. b. Direct labor used in production. e. Cost of goods sold for Job 120. c. Overhead applied. 2. Compute the July 31 balances of the Work in Process Inventory and the Finished Goods Inventory

accounts. (Assume there are no jobs in Finished Goods Inventory as of June 30.)

Custom Cabinetry has one job in process (Job 120) as of June 30; at that time, its job cost sheet reports direct materials of $6,000, direct labor of $2,800, and applied overhead of $2,240. Custom Cabinetry ap- plies overhead at the rate of 80% of direct labor cost. During July, Job 120 is sold (on account) for $22,000, Job 121 is started and completed, and Job 122 is started and still in process at the end of the month. Custom Cabinetry incurs the following costs during July.

Exercise 15-5 Manufacturing cost flows

P1 P2 P3

July Product Costs Job 120 Job 121 Job 122 Total

Direct materials . . . . . . . . . . . . .   $1,000  $6,000  $2,500  $9,500

Direct labor . . . . . . . . . . . . . . . .     2,200    3,700    2,100    8,000

Overhead applied . . . . . . . . . . .   ? ? ? ?

Exercise 15-6 Recording events in job order costing

P1 P2 P3 P4

Using Exhibit 15.17 as a guide, prepare summary journal entries to record the following transactions and events a through g for a company in its first month of operations. a. Raw materials purchased on account, $90,000. b. Direct materials used in production, $36,500. Indirect materials used in production, $19,200. c. Paid cash for factory payroll, $50,000. Of this total, $38,000 is for direct labor and $12,000 is for indi-

rect labor. d. Paid cash for other actual overhead costs, $11,475. e. Applied overhead at the rate of 125% of direct labor cost. f. Transferred cost of jobs completed to finished goods, $56,800. g. Sold jobs on account for $82,000. The jobs had a cost of $56,800.

596 Chapter 15 Job Order Costing and Analysis

Exercise 15-8 Journal entries for materials

P1

Use information in Exercise 15-7 to prepare journal entries for the following events for the month of May. 1. Raw materials purchases for cash. 3. Indirect materials usage. 2. Direct materials usage.

Exercise 15-9 Journal entries for labor

P2

Use information in Exercise 15-7 to prepare journal entries for the following events for the month of May. 1. Direct labor usage. 3. Total payroll paid in cash. 2. Indirect labor usage.

Exercise 15-10 Journal entries for overhead P3

Use information in Exercise 15-7 to prepare journal entries for the following events for the month of May. 1. Incurred other overhead costs (record credit to Other Accounts). 2. Applied overhead to work in process.

Exercise 15-7 Cost flows in job order costing

P1 P2 P3 P4

The following information is available for Lock-Tite Company, which produces special-order security products and uses a job order costing system.

April 30 May 31

Inventories

    Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $43,000  $     52,000

    Work in process  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   10,200  21,300

    Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   63,000  35,600

Activities and information for May

    Raw materials purchases (paid with cash)  . . . . . . . . . . . . . . . . . . . . . . . . . . . .     210,000

    Factory payroll (paid with cash) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     345,000

    Factory overhead

        Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     15,000

        Indirect labor  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     80,000

        Other overhead costs  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     120,000

    Sales (received in cash) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     1,400,000

    Predetermined overhead rate based on direct labor cost . . . . . . . . . . . . . . . .     70%

Compute the following amounts for the month of May. 1. Cost of direct materials used. 4. Cost of goods sold. (Do not consider any underapplied or overapplied overhead.) 2. Cost of direct labor used. 5. Gross profit. 3. Cost of goods manufactured. 6. Overapplied or underapplied overhead.Check (3) $625,400

JOB COST SHEET Customer’s Name Keiser Co . Job No. 13-56

Job Description  5 plasma monitors—61 inch

Overhead Direct Materials Direct Labor Costs Applied

Date Requisition No. Amount Time-Ticket No. Amount Rate Amount

Mar . 8  4-129  $5,000  T-306  $  700

Mar . 11  4-142  7,020  T-432  1,250

Mar . 18  4-167  3,330  T-456  1,250

Totals

Shire Computer’s predetermined overhead rate is based on direct labor cost. Management estimates the company will incur $747,500 of overhead costs and $575,000 of direct labor cost for the year. During March, Shire began and completed Job 13-56. 1. What is the predetermined overhead rate for the year? 2. Use the information on the following job cost sheet to determine the total cost of the job.

Exercise 15-11 Overhead rate; costs assigned to jobs

P3 Check (2) $22,710

Chapter 15 Job Order Costing and Analysis 597

Refer to information in Exercise 15-7. Prepare the journal entry to close overapplied or underapplied over- head to Cost of Goods Sold.

Exercise 15-13 Adjusting factory overhead P4

Lorenzo Company applies overhead to jobs on the basis of direct materials cost. At year-end, the Work in Process Inventory account shows the following.

Exercise 15-12 Analyzing costs assigned to work in process

P3

Dec. 31 31

31 31

Direct materials cost Direct labor cost Overhead applied To finished goods

1,500,000 1,800,000 2,400,000

50,000

1,500,000 300,000 600,000

2,350,000

1 2 3 4 5 6

A B C D E Work in Process Inventory—Acct. No. 121

CreditDebitExplanation BalanceDate

1. Determine the predetermined overhead rate used (based on direct materials cost). 2. Only one job remained in work in process inventory at December 31. Its direct materials cost is

$30,000. How much direct labor cost and overhead cost are assigned to this job?

Record the journal entry to close over- or underapplied factory overhead to Cost of Goods Sold for each of the two companies below.

Exercise 15-14 Adjusting factory overhead

P4 Storm Concert Valle Home Promotions Builders

Actual indirect materials costs . . . . . . . . . . . . .  $22,000  $  12,500

Actual indirect labor costs  . . . . . . . . . . . . . . . .  46,000  46,500

Other overhead costs . . . . . . . . . . . . . . . . . . . .  17,000  47,000

Overhead applied . . . . . . . . . . . . . . . . . . . . . . .  88,200  105,200

Exercise 15-15 Factory overhead computed, applied, and adjusted

P3 P4

At the beginning of the year, Custom Mfg. established its predetermined overhead rate by using the fol- lowing cost predictions: overhead costs, $750,000, and direct materials costs, $625,000. At year-end, the company’s records show that actual overhead costs for the year are $830,000. Actual direct materials cost had been assigned to jobs as follows.

Jobs completed and sold . . . . . . . . . . . . . . . . . . . . .   $513,750

Jobs in finished goods inventory . . . . . . . . . . . . . . .   102,750

Jobs in work in process inventory . . . . . . . . . . . . . .   68,500

Total actual direct materials cost . . . . . . . . . . . . . . .   $685,000

1. Determine the predetermined overhead rate using predicted direct materials costs. 2. Set up a T-account for Factory Overhead and enter the overhead costs incurred and the amounts

applied to jobs during the year using the predetermined overhead rate. 3. Determine whether overhead is overapplied or underapplied (and the amount) during the year. 4. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold.

Check (3) $8,000 underapplied

Exercise 15-16 Factory overhead computed, applied, and adjusted

P3 P4

At the beginning of the year, Infodeo established its predetermined overhead rate for movies produced during the year by using the following cost predictions: overhead costs, $1,680,000, and direct labor costs, $480,000. At year-end, the company’s records show that actual overhead costs for the year are $1,652,000. Actual direct labor cost had been assigned to jobs as follows.

Movies completed and released  . . . . . . . . . . . . . . .   $425,000

Movies still in production . . . . . . . . . . . . . . . . . . . . .   50,000

Total actual direct labor cost  . . . . . . . . . . . . . . . . . .   $475,000

598 Chapter 15 Job Order Costing and Analysis

1. Determine the predetermined overhead rate for the year. 2. Set up a T-account for overhead and enter the overhead costs incurred and the amounts applied to

movies during the year using the predetermined overhead rate. 3. Determine whether overhead is overapplied or underapplied (and the amount) during the year. 4. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold.

Check (3) $10,500 overapplied

Exercise 15-17 Overhead rate calculation and allocation

P3

Moonrise Bakery applies factory overhead based on direct labor costs. The company incurred the follow- ing costs during the year: direct materials costs, $650,000; direct labor costs, $3,000,000; and factory overhead costs applied, $1,800,000. 1. Determine the company’s predetermined overhead rate for the year. 2. Assuming that the company’s $71,000 ending Work in Process Inventory account for the year had

$20,000 of direct labor costs, determine the inventory’s direct materials costs.

Exercise 15-18 Job order costing for services

A1

Hansel Corporation has requested bids from several architects to design its new corporate headquarters. Frey Architects is one of the firms bidding on the job. Frey estimates that the job will require the follow- ing direct labor.

Architects Sta� Clerical

150 300 500

$300 75 20

1 2 3 4

A B C Hourly RateEstimated HoursLabor

Frey applies overhead to jobs at 175% of direct labor cost. Frey would like to earn at least $80,000 profit on the architectural job. Based on past experience and market research, it estimates that the competition will bid between $285,000 and $350,000 for the job. 1. What is Frey’s estimated cost of the architectural job? 2. If Frey bids a price of $285,000, will it earn its target profit of $80,000? 3. What price would cover Frey’s costs and earn the desired target profit?

Check (1) $213,125

1. Prepare journal entries to record direct labor and the overhead applied. 2. Prepare the journal entry to record the cost of services provided. Assume the beginning Services in

Process Inventory account has a zero balance.

Diaz and Associates incurred the following costs in completing a tax return for a large company. Diaz ap- plies overhead at 50% of direct labor cost.

Exercise 15-19 Job order costing of services

A1 Labor Hours Used Hourly Rate

Partner . . . . . . . . . . . . . . . . . . . .       5  $500 Senior manager  . . . . . . . . . . . .     12    200 Staff accountants  . . . . . . . . . . .   100      50

A recent balance sheet for Porsche AG shows beginning raw materials inventory of €83 million and end- ing raw materials inventory of €85 million. Assume the company purchased raw materials (on account) for €3,108 million during the year. Prepare journal entries to record (a) the purchase of raw materials and (b) the use of raw materials in production.

Exercise 15-20 Direct materials journal entries P1

PROBLEM SET A

Problem 15-1A Production costs computed and recorded; reports prepared

P1 P2 P3 P4

Marcelino Co.’s March 31 inventory of raw materials is $80,000. Raw materials purchases in April are $500,000, and factory payroll cost in April is $363,000. Overhead costs incurred in April are: indirect materials, $50,000; indirect labor, $23,000; factory rent, $32,000; factory utilities, $19,000; and factory equipment depreciation, $51,000. The predetermined overhead rate is 50% of direct labor cost. Job 306 is sold for $635,000 cash in April. Costs of the three jobs worked on in April follow.

Chapter 15 Job Order Costing and Analysis 599

Job 306 Job 307 Job 308

Balances on March 31

    Direct materials  . . . . . . . . . . . . . .   $  29,000  $  35,000

    Direct labor . . . . . . . . . . . . . . . . . .   20,000  18,000

    Applied overhead . . . . . . . . . . . . .   10,000  9,000

Costs during April

    Direct materials  . . . . . . . . . . . . . .   135,000  220,000  $100,000

    Direct labor . . . . . . . . . . . . . . . . . .   85,000  150,000  105,000

    Applied overhead . . . . . . . . . . . . . ? ? ? Status on April 30 . . . . . . . . . . . . . . .   Finished (sold)  Finished (unsold)  In process

Required

1. Determine the total of each production cost incurred for April (direct labor, direct materials, and applied overhead) and the total cost assigned to each job (including the balances from March 31).

2. Prepare journal entries for the month of April to record the following. a. Materials purchases (on credit). b. Direct materials used in production. c. Direct labor paid and assigned to Work in Process Inventory. d. Indirect labor paid and assigned to Factory Overhead. e. Overhead costs applied to Work in Process Inventory. f. Actual overhead costs incurred, including indirect materials. (Factory rent and utilities are paid in

cash.) g. Transfer of Jobs 306 and 307 to Finished Goods Inventory. h. Cost of goods sold for Job 306. i. Revenue from the sale of Job 306. j. Assignment of any underapplied or overapplied overhead to the Cost of Goods Sold account. (The

amount is not material.) 3. Prepare a schedule of cost of goods manufactured. 4. Compute gross profit for April. Show how to present the inventories on the April 30 balance sheet. 5. Over- or underapplied overhead is closed to Cost of Goods Sold. Is this adjustment also posted to

individual job cost sheets?

(3) Cost of goods manufactured, $828,500

Check (2j ) $5,000 underapplied

Bergamo Bay’s computer system generated the following trial balance on December 31, 2019. The com- pany’s manager knows something is wrong with the trial balance because it does not show any balance for Work in Process Inventory but does show a balance for the Factory Overhead account. In addition, the accrued factory payroll (Factory Wages Payable) has not been recorded.

Problem 15-2A Source documents, journal entries, overhead, and financial reports

P1 P2 P3 P4 Debit Credit

Cash   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $170,000

Accounts receivable   . . . . . . . . . . . . . . . . . .   75,000

Raw materials inventory . . . . . . . . . . . . . . . .   80,000

Work in process inventory  . . . . . . . . . . . . . .   0

Finished goods inventory   . . . . . . . . . . . . . .   15,000

Prepaid rent  . . . . . . . . . . . . . . . . . . . . . . . . .   3,000

Accounts payable   . . . . . . . . . . . . . . . . . . . .     $  17,000

Notes payable . . . . . . . . . . . . . . . . . . . . . . . .     25,000

Common stock  . . . . . . . . . . . . . . . . . . . . . . .     50,000

Retained earnings   . . . . . . . . . . . . . . . . . . . .     271,000

Sales  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     373,000

Cost of goods sold  . . . . . . . . . . . . . . . . . . . .   218,000

Factory overhead  . . . . . . . . . . . . . . . . . . . . .   115,000

Operating expenses   . . . . . . . . . . . . . . . . . .   60,000

Totals   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $736,000  $736,000

600 Chapter 15 Job Order Costing and Analysis

After examining various files, the manager identifies the following six source documents that need to be processed to bring the accounting records up to date.

Materials requisition 21-3010: $10,200 direct materials to Job 402

Materials requisition 21-3011: $18,600 direct materials to Job 404

Materials requisition 21-3012: $5,600 indirect materials

Labor time ticket 6052: $36,000 direct labor to Job 402

Labor time ticket 6053: $23,800 direct labor to Job 404

Labor time ticket 6054: $8,200 indirect labor

Jobs 402 and 404 are the only units in process at year-end. The predetermined overhead rate is 200% of direct labor cost.

Required

1. Use information on the six source documents to prepare journal entries to assign the following costs. a. Direct materials costs to Work in Process Inventory. b. Direct labor costs to Work in Process Inventory. c. Overhead costs to Work in Process Inventory. d. Indirect materials costs to the Factory Overhead account. e. Indirect labor costs to the Factory Overhead account. 2. Determine the revised balance of the Factory Overhead account after making the entries in part 1.

Determine whether there is any under- or overapplied overhead for the year. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold, assuming the amount is not material.

3. Prepare a revised trial balance. 4. Prepare an income statement for 2019 and a balance sheet as of December 31, 2019. 5. Assume that the $5,600 on materials requisition 21-3012 should have been direct materials charged to

Job 404. Indicate whether this error results in overstated or understated total assets on the balance sheet at December 31, 2019.

Check (2) $9,200 underapplied overhead

(3) T. B. totals, $804,000

(4) Net income, $85,800

Widmer Watercraft’s predetermined overhead rate is 200% of direct labor. Information on the company’s production activities during May follows. a. Purchased raw materials on credit, $200,000. b. Materials requisitions record use of the following materials for the month.

Problem 15-3A Source documents, journal entries, and accounts in job order costing

P1 P2 P3

c. Paid $15,000 cash to a computer consultant to reprogram factory equipment. d. Time tickets record use of the following labor for the month. These wages were paid in cash.

e. Applied overhead to Jobs 136, 138, and 139. f. Transferred Jobs 136, 138, and 139 to Finished Goods. g. Sold Jobs 136 and 138 on credit at a total price of $525,000.

Job 136 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $  48,000 Job 137 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   32,000 Job 138 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   19,200 Job 139 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   22,400 Job 140 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   6,400 Total direct materials  . . . . . . . . . . . . . . . . . . . . . . . .   128,000 Indirect materials  . . . . . . . . . . . . . . . . . . . . . . . . . . .   19,500 Total materials used  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .   $147,500

Job 136   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $  12,000 Job 137   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   10,500 Job 138   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   37,500 Job 139   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   39,000 Job 140   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   3,000 Total direct labor   . . . . . . . . . . . . . . . . . . . . . . . . . . .   102,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   24,000 Total   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $126,000

Chapter 15 Job Order Costing and Analysis 601

h. The company incurred the following overhead costs during the month (credit Prepaid Insurance for expired factory insurance).

Depreciation of factory building  . . . . . . . . . . . .   $68,000 Depreciation of factory equipment  . . . . . . . . . .   36,500

Expired factory insurance . . . . . . . . . . . . . . . . . .   $10,000 Accrued property taxes payable  . . . . . . . . . . . .   35,000

i. Applied overhead at month-end to the Work in Process Inventory account (Jobs 137 and 140) using the predetermined overhead rate of 200% of direct labor cost.

Required

1. Prepare a job cost sheet for each job worked on during the month. Use the following simplified form.

Job No . __________

Materials . . . . . . . . . . .   $

Labor . . . . . . . . . . . . . .

Overhead  . . . . . . . . . .

Total cost  . . . . . . . . . .   $

2. Prepare journal entries to record the events and transactions a through i. 3. Set up T-accounts for each of the following general ledger accounts, each of which started the month

with a zero balance: Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, Factory Overhead, Cost of Goods Sold. Then post the journal entries to these T-accounts and deter- mine the balance of each account.

4. Prepare a report showing the total cost of each job in process and prove that the sum of their costs equals the Work in Process Inventory account balance. Prepare similar reports for Finished Goods Inventory and Cost of Goods Sold.

Check (2e) Cr. Factory Overhead, $177,000

(4) Finished Goods Inventory, $139,400

Problem 15-4A Overhead allocation and adjustment using a predetermined overhead rate

P3 P4

At the beginning of the year, Learer Company’s manager estimated total direct labor cost assuming 50 persons working an average of 2,000 hours each at an average wage rate of $25 per hour. The manager also estimated the following manufacturing overhead costs for the year.

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $   319,200

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   240,000

Rent on factory building  . . . . . . . . . . . . . . . . . . . . . . . . .   140,000

Factory utilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   88,000

Factory insurance expired  . . . . . . . . . . . . . . . . . . . . . . .   68,000

Depreciation—Factory equipment  . . . . . . . . . . . . . . . . .   480,000

Repairs expense—Factory equipment  . . . . . . . . . . . . . .   60,000

Factory supplies used   . . . . . . . . . . . . . . . . . . . . . . . . . .   68,800

Miscellaneous production costs   . . . . . . . . . . . . . . . . . .   36,000

Total estimated overhead costs  . . . . . . . . . . . . . . . . . . .   $1,500,000

At year-end, records show the company incurred $1,520,000 of actual overhead costs. It completed and sold five jobs with the following direct labor costs: Job 201, $604,000; Job 202, $563,000; Job 203, $298,000; Job 204, $716,000; and Job 205, $314,000. In addition, Job 206 is in process at the end of the year and had been charged $17,000 for direct labor. No jobs were in process at the beginning of the year. The company’s predetermined overhead rate is based on direct labor cost.

Required

1. Determine the following. a. Predetermined overhead rate for the year. b. Total overhead cost applied to each of the six jobs during the year. c. Over- or underapplied overhead at year-end. 2. Assuming that any over- or underapplied overhead is not material, prepare the adjusting entry to allo-

cate any over- or underapplied overhead to Cost of Goods Sold at the end of the year.

Check (1c) 12,800 underapplied

602 Chapter 15 Job Order Costing and Analysis

Problem 15-5A Production transactions, subsidiary records, and source documents

P1 P2 P3 P4

Sager Company manufactures variations of its product, a technopress, in response to custom orders from its customers. On May 1, the company had no inventories of work in process or finished goods but held the following raw materials.

Material M . . . . . . . . . . . . . . . . . . . . . .   200 units @ $250 = $50,000 Material R  . . . . . . . . . . . . . . . . . . . . . .   95 units @   180 =  17,100 Paint  . . . . . . . . . . . . . . . . . . . . . . . . . .   55 units @     75 =     4,125 Total cost . . . . . . . . . . . . . . . . . . . . . . .     $71,225

On May 4, the company began working on two technopresses: Job 102 for Worldwide Company and Job 103 for Reuben Company.

Required

Using Exhibit 15.3 as a guide, prepare job cost sheets for Jobs 102 and 103. Using Exhibit 15.5 as a guide, prepare materials ledger cards for Material M, Material R, and paint. Enter the beginning raw materials inventory dollar amounts for each of these materials on their respective ledger cards. Then, follow the instructions in this list of activities. a. Purchased raw materials on credit and recorded the following information from receiving reports and

invoices.

Receiving Report No . 426, Material M, 250 units at $250 each .    Receiving Report No . 427, Material R, 90 units at $180 each .

Instructions: Record these purchases with a single journal entry. Enter the receiving report informa- tion on the materials ledger cards.

b. Requisitioned the following raw materials for production.

Instructions: Enter amounts for direct materials requisitions on the materials ledger cards and the job cost sheets. Enter the indirect materials amount on the materials ledger card. Do not record a journal entry at this time.

c. Received the following employee time tickets for work in May.

Requisition No . 35, for Job 102, 135 units of Material M .

Requisition No . 36, for Job 102, 72 units of Material R .

Requisition No . 37, for Job 103, 70 units of Material M .

Requisition No . 38, for Job 103, 38 units of Material R .

Requisition No . 39, for 15 units of paint .

Time tickets Nos . 1 to 10 for direct labor on Job 102, $90,000 .

Time tickets Nos . 11 to 30 for direct labor on Job 103, $65,000 .

Time tickets Nos . 31 to 36 for equipment repairs, $19,250 .

Instructions: Record direct labor from the time tickets on the job cost sheets. Do not record a journal entry at this time.

d. Paid cash for the following items during the month: factory payroll, $174,250, and miscellaneous over- head items, $102,000. Use the time tickets to record the total direct and indirect labor costs.

Instructions: Record these payments with journal entries. e. Finished Job 102 and transferred it to the warehouse. The company assigns overhead to each job with

a predetermined overhead rate equal to 80% of direct labor cost. Instructions: Enter the applied overhead on the cost sheet for Job 102, fill in the cost summary section

of the cost sheet, and then mark the cost sheet “Finished.” Prepare a journal entry to record the job’s completion and its transfer to Finished Goods.

f. Delivered Job 102 and accepted the customer’s promise to pay $400,000 within 30 days. Instructions: Prepare journal entries to record the sale of Job 102 and the cost of goods sold. g. Applied overhead cost to Job 103 based on the job’s direct labor to date. Instructions: Enter overhead on the job cost sheet but do not make a journal entry at this time. h. Recorded the total direct and indirect materials costs as reported on all the requisitions for the month. Instructions: Prepare a journal entry to record these costs. i. Recorded the total overhead costs applied to jobs. Instructions: Prepare a journal entry to record the allocation of these overhead costs. j. Compute the balance in the Factory Overhead account as of the end of May.

Check (h) Dr. Work in Process Inventory, $71,050

( j) Balance in Factory Overhead, $1,625 Cr., overapplied

Chapter 15 Job Order Costing and Analysis 603

PROBLEM SET B

Problem 15-1B Production costs computed and recorded; reports prepared

P1 P2 P3 P4

Perez Mfg.’s August 31 inventory of raw materials is $150,000. Raw materials purchases in September are $400,000, and factory payroll cost in September is $232,000. Overhead costs incurred in September are: indirect materials, $30,000; indirect labor, $14,000; factory rent, $20,000; factory utilities, $12,000; and factory equipment depreciation, $30,000. The predetermined overhead rate is 50% of direct labor cost. Job 114 is sold for $380,000 cash in September. Costs for the three jobs worked on in September follow.

Job 114 Job 115 Job 116

Balances on August 31     Direct materials  . . . . . . . . . . . . . . . . .  $  14,000  $  18,000     Direct labor . . . . . . . . . . . . . . . . . . . . .  18,000  16,000     Applied overhead . . . . . . . . . . . . . . . .  9,000  8,000 Costs during September     Direct materials  . . . . . . . . . . . . . . . . .  100,000  170,000  $  80,000     Direct labor . . . . . . . . . . . . . . . . . . . . .  30,000  68,000    120,000     Applied overhead . . . . . . . . . . . . . . . . ? ? ? Status on September 30   . . . . . . . . . . . .  Finished (sold)  Finished (unsold)  In process

Required

1. Determine the total of each production cost incurred for September (direct labor, direct materials, and applied overhead) and the total cost assigned to each job (including the balances from August 31).

2. Prepare journal entries for the month of September to record the following. a. Materials purchases (on credit). b. Direct materials used in production. c. Direct labor paid and assigned to Work in Process Inventory. d. Indirect labor paid and assigned to Factory Overhead. e. Overhead costs applied to Work in Process Inventory. f. Actual overhead costs incurred, including indirect materials. (Factory rent and utilities are paid in cash.) g. Transfer of Jobs 114 and 115 to the Finished Goods Inventory. h. Cost of Job 114 in the Cost of Goods Sold account. i. Revenue from the sale of Job 114. j. Assignment of any underapplied or overapplied overhead to the Cost of Goods Sold account. (The

amount is not material.) 3. Prepare a schedule of cost of goods manufactured. 4. Compute gross profit for September. Show how to present the inventories on the September 30 bal-

ance sheet.

Analysis Component

5. The over- or underapplied overhead adjustment is closed to Cost of Goods Sold. Discuss how this adjustment impacts business decision making regarding individual jobs or batches of jobs.

Check (2j) $3,000 overapplied

(3) Cost of goods manufactured, $500,000

Cavallo Mfg.’s computer system generated the following trial balance on December 31, 2019. The com- pany’s manager knows that the trial balance is wrong because it does not show any balance for Work in Process Inventory but does show a balance for the Factory Overhead account. In addition, the accrued factory payroll (Factory Wages Payable) has not been recorded.

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $  64,000 Accounts receivable   . . . . . . . . . . . . . . . . . .   42,000 Raw materials inventory . . . . . . . . . . . . . . . .   26,000 Work in process inventory  . . . . . . . . . . . . . .   0 Finished goods inventory   . . . . . . . . . . . . . .   9,000 Prepaid rent  . . . . . . . . . . . . . . . . . . . . . . . . .   3,000 Accounts payable   . . . . . . . . . . . . . . . . . . . .     $  10,500 Notes payable . . . . . . . . . . . . . . . . . . . . . . . .     13,500 Common stock  . . . . . . . . . . . . . . . . . . . . . . .     30,000 Retained earnings   . . . . . . . . . . . . . . . . . . . .     87,000 Sales  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     180,000 Cost of goods sold  . . . . . . . . . . . . . . . . . . . .   105,000 Factory overhead  . . . . . . . . . . . . . . . . . . . . .   27,000 Operating expenses   . . . . . . . . . . . . . . . . . .   45,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $321,000  $321,000

Problem 15-2B Source documents, journal entries, overhead, and financial reports

P1 P2 P3 P4

604 Chapter 15 Job Order Costing and Analysis

After examining various files, the manager identifies the following six source documents that need to be processed to bring the accounting records up to date.

Materials requisition 94-231: $4,600 direct materials to Job 603

Materials requisition 94-232: $7,600 direct materials to Job 604

Materials requisition 94-233: $2,100 indirect materials

Labor time ticket 765: $5,000 direct labor to Job 603

Labor time ticket 766: $8,000 direct labor to Job 604

Labor time ticket 777: $3,000 indirect labor

Jobs 603 and 604 are the only units in process at year-end. The predetermined overhead rate is 200% of direct labor cost.

Required

1. Use information on the six source documents to prepare journal entries to assign the following costs. a. Direct materials costs to Work in Process Inventory. b. Direct labor costs to Work in Process Inventory. c. Overhead costs to Work in Process Inventory. d. Indirect materials costs to the Factory Overhead account. e. Indirect labor costs to the Factory Overhead account. 2. Determine the revised balance of the Factory Overhead account after making the entries in part 1.

Determine whether there is under- or overapplied overhead for the year. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold, assuming the amount is not material.

3. Prepare a revised trial balance. 4. Prepare an income statement for 2019 and a balance sheet as of December 31, 2019.

Analysis Component

5. Assume that the $2,100 indirect materials on materials requisition 94-233 should have been direct materials charged to Job 604. Without providing specific calculations, describe the impact of this error on the income statement for 2019 and the balance sheet at December 31, 2019.

Check (2) $6,100 underapplied overhead

(3) T. B. totals, $337,000

(4) Net income, $23,900

Starr Mfg.’s predetermined overhead rate is 200% of direct labor. Information on the company’s produc- tion activities during September follows. a. Purchased raw materials on credit, $125,000. b. Materials requisitions record use of the following materials for the month.

Problem 15-3B Source documents, journal entries, and accounts in job order costing

P1 P2 P3

c. Paid $11,000 cash for miscellaneous factory overhead costs. d. Time tickets record use of the following labor for the month. These wages are paid in cash.

e. Applied overhead to Jobs 487, 489, and 490. f. Transferred Jobs 487, 489, and 490 to Finished Goods.

Job 487 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $30,000

Job 488 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   20,000

Job 489 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   12,000

Job 490 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   14,000

Job 491 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4,000

Total direct materials  . . . . . . . . . . . . . . . . . . . . . . . . . .   80,000

Indirect materials  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   12,000

Total materials used  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .   $92,000

Job 487 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $  8,000

Job 488 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   7,000

Job 489 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   25,000

Job 490 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   26,000

Job 491 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   2,000

Total direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   68,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   16,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $84,000

Chapter 15 Job Order Costing and Analysis 605

g. Sold Jobs 487 and 489 on credit for a total price of $340,000. h. The company incurred the following overhead costs during the month (credit Prepaid Insurance for

expired factory insurance).

Depreciation of factory building  . . . . . . . . . . . .   $37,000 Depreciation of factory equipment  . . . . . . . . . .   21,000

Expired factory insurance . . . . . . . . . . . . . . . . . .   $  7,000 Accrued property taxes payable  . . . . . . . . . . . .   31,000

i. Applied overhead at month-end to the Work in Process Inventory account (Jobs 488 and 491) using the predetermined overhead rate of 200% of direct labor cost.

Required

1. Prepare a job cost sheet for each job worked on in the month. Use the following simplified form.

Job No . __________

Materials . . . . . . . . . . .   $

Labor . . . . . . . . . . . . . .

Overhead  . . . . . . . . . .

Total cost  . . . . . . . . . .   $

2. Prepare journal entries to record the events and transactions a through i. 3. Set up T-accounts for each of the following general ledger accounts, each of which started the month

with a zero balance: Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, Factory Overhead, Cost of Goods Sold. Then post the journal entries to these T-accounts and deter- mine the balance of each account.

4. Prepare a report showing the total cost of each job in process and prove that the sum of their costs equals the Work in Process Inventory account balance. Prepare similar reports for Finished Goods Inventory and Cost of Goods Sold.

Check (2e) Cr. Factory Overhead, $118,000 (3) Finished Goods Inventory, $92,000 bal.

Problem 15-4B Overhead allocation and adjustment using a predetermined overhead rate

P3 P4

At the beginning of the year, Pavelka Company’s manager estimated next year’s total direct labor cost assuming 50 persons working an average of 2,000 hours each at an average wage rate of $15 per hour. The manager also estimated the following manufacturing overhead costs for the year.

At year-end, records show the company incurred $725,000 of actual overhead costs. It completed and sold five jobs with the following direct labor costs: Job 625, $354,000; Job 626, $330,000; Job 627, $175,000; Job 628, $420,000; and Job 629, $184,000. In addition, Job 630 is in process at the end of the year and had been charged $10,000 for direct labor. No jobs were in process at the beginning of the year. The compa- ny’s predetermined overhead rate is based on direct labor cost.

Required

1. Determine the following. a. Predetermined overhead rate for the year. b. Total overhead cost applied to each of the six jobs during the year. c. Over- or underapplied overhead at year-end. 2. Assuming that any over- or underapplied overhead is not material, prepare the adjusting entry to allo-

cate any over- or underapplied overhead to Cost of Goods Sold at the end of the year.

Check (1c) $11,500 overapplied

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $159,600

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   120,000

Rent on factory building  . . . . . . . . . . . . . . . . . . . . . . . . .   70,000

Factory utilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   44,000

Factory insurance expired   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .   34,000

Depreciation—Factory equipment  . . . . . . . . . . . . . . . . .   240,000

Repairs expense—Factory equipment  . . . . . . . . . . . . . .   30,000

Factory supplies used   . . . . . . . . . . . . . . . . . . . . . . . . . .   34,400

Miscellaneous production costs   . . . . . . . . . . . . . . . . . .   18,000

Total estimated overhead costs  . . . . . . . . . . . . . . . . . . .   $750,000

606 Chapter 15 Job Order Costing and Analysis

Problem 15-5B Production transactions, subsidiary records, and source documents

P1 P2 P3 P4

King Company produces variations of its product, a megatron, in response to custom orders from its cus- tomers. On June 1, the company had no inventories of work in process or finished goods but held the fol- lowing raw materials.

On June 3, the company began working on two megatrons: Job 450 for Encinita Company and Job 451 for Fargo, Inc.

Required

Using Exhibit 15.3 as a guide, prepare job cost sheets for Jobs 450 and 451. Using Exhibit 15.5 as a guide, prepare materials ledger cards for Material M, Material R, and paint. Enter the beginning raw materials inventory dollar amounts for each of these materials on their respective ledger cards. Then, follow instruc- tions in this list of activities. a. Purchased raw materials on credit and recorded the following information from receiving reports and

invoices.

Receiving Report No . 20, Material M, 150 units at $200 each .    Receiving Report No . 21, Material R, 70 units at $160 each .

Instructions: Record these purchases with a single journal entry. Enter the receiving report informa- tion on the materials ledger cards.

b. Requisitioned the following raw materials for production.

Instructions: Enter amounts for direct materials requisitions on the materials ledger cards and the job cost sheets. Enter the indirect materials amount on the materials ledger card. Do not record a journal entry at this time.

c. Received the following employee time tickets for work in June.

Requisition No . 223, for Job 450, 80 units of Material M .

Requisition No . 224, for Job 450, 60 units of Material R .

Requisition No . 225, for Job 451, 40 units of Material M .

Requisition No . 226, for Job 451, 30 units of Material R .

Requisition No . 227, for 12 units of paint .

Time tickets Nos . 1 to 10 for direct labor on Job 450, $40,000 .

Time tickets Nos . 11 to 20 for direct labor on Job 451, $32,000 .

Time tickets Nos . 21 to 24 for equipment repairs, $12,000 .

Instructions: Record direct labor from the time tickets on the job cost sheets. Do not record a journal entry at this time.

d. Paid cash for the following items during the month: factory payroll, $84,000, and miscellaneous over- head items, $36,800. Use the time tickets to record the total direct and indirect labor costs.

Instructions: Record these payments with journal entries. e. Finished Job 450 and transferred it to the warehouse. The company assigns overhead to each job with

a predetermined overhead rate equal to 70% of direct labor cost. Instructions: Enter the applied overhead on the cost sheet for Job 450, fill in the cost summary section

of the cost sheet, and then mark the cost sheet “Finished.” Prepare a journal entry to record the job’s completion and its transfer to Finished Goods.

f. Delivered Job 450 and accepted the customer’s promise to pay $290,000 within 30 days. Instructions: Prepare journal entries to record the sale of Job 450 and the cost of goods sold. g. Applied overhead cost to Job 451 based on the job’s direct labor used to date. Instructions: Enter overhead on the job cost sheet but do not make a journal entry at this time.

Material M . . . . . . . . . . . . . . . . . . . . . . .   120 units @ $200 = $24,000 Material R  . . . . . . . . . . . . . . . . . . . . . . .   80 units @   160 =   12,800 Paint  . . . . . . . . . . . . . . . . . . . . . . . . . . .   44 units @     72 =     3,168 Total cost . . . . . . . . . . . . . . . . . . . . . . . .     $39,968

Chapter 15 Job Order Costing and Analysis 607

FINANCIAL ANALYSIS P1

Accounting Analysis

AA 15-1 Manufacturers and merchandisers can apply just-in-time (JIT) to their inventory management. Apple wants to know the impact of a JIT inventory system on operating cash flows. Review Apple’s state- ment of cash flows in Appendix A to answer the following.

Required

1. Identify the impact on operating cash flows (increase or decrease) for changes in inventory levels (increase or decrease) for each of the fiscal years ended September 30, 2017, and September 24, 2016.

2. What impact (increase or decrease) would a JIT inventory system have on Apple’s (a) inventory and (b) operating cash flows?

APPLE

SERIAL PROBLEM Business Solutions

P1 P2 P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 15 The computer workstation furniture manufacturing that Santana Rey started in January is pro- gressing well. As of the end of June, Business Solutions’s job cost sheets show the following total costs accumulated on three furniture jobs.

Job 602 Job 603 Job 604

Direct materials . . . . . . . . . . . .   $1,500  $3,300  $2,700

Direct labor . . . . . . . . . . . . . . .   800  1,420  2,100

Overhead  . . . . . . . . . . . . . . . .   400  710  1,050

Job 602 was started in production in May, and these costs were assigned to it in May: direct materials, $600; direct labor, $180; and overhead, $90. Jobs 603 and 604 were started in June. Overhead cost is applied with a predetermined rate based on direct labor costs. Jobs 602 and 603 are finished in June, and Job 604 is expected to be finished in July. No raw materials are used indirectly in June. (Assume this com- pany’s predetermined overhead rate did not change over these months.)

Required

1. What is the cost of the raw materials used in June for each of the three jobs and in total? 2. How much total direct labor cost is incurred in June? 3. What predetermined overhead rate is used in June? 4. How much cost is transferred to Finished Goods Inventory in June?

Check (1) Total materials, $6,900

©Alexander Image/Shutterstock

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in accounting so that the financial professional can focus on the impacts of each transaction on various reports and performance measures.

GL 15-1 General Ledger assignment GL 15-1, based on Problem 15-1A, focuses on transactions related to job order costing. Prepare summary journal entries to record the cost of jobs and their flow through the manufacturing environment. Then prepare a schedule of cost of goods manufactured and a partial income statement.

GL

h. Recorded the total direct and indirect materials costs as reported on all the requisitions for the month. Instructions: Prepare a journal entry to record these costs. i. Recorded the total overhead costs applied to jobs. Instructions: Prepare a journal entry to record the allocation of these overhead costs. j. Compute the balance in the Factory Overhead account as of the end of June.

( j) Balance in Factory Overhead, $736 Cr., overapplied

Check (h) Dr. Work in Process Inventory, $38,400

608 Chapter 15 Job Order Costing and Analysis

BTN 15-1 Assume that your company sells portable housing to both general contractors and the govern- ment. It sells jobs to contractors on a bid basis. A contractor asks for three bids from different manufactur- ers. The combination of low bid and high quality wins the job. However, jobs sold to the government are bid on a cost-plus basis. This means price is determined by adding all costs plus a profit based on cost at a specified percent, such as 10%. You observe that the amount of overhead applied to government jobs is higher than that applied to contract jobs. These allocations concern you.

Required

Write a half-page memo to your company’s chief financial officer outlining your concerns with overhead allocation.

ETHICS CHALLENGE P3

Beyond the Numbers

Point: Students could compare responses and discuss differ- ences in concerns with allocating overhead.

AA 15-2 Apple’s and Google’s income statements in Appendix A both show increasing sales and cost of sales. The gross margin ratio can be used to analyze how well companies control costs as sales increase.

Required

1. Compute the gross margin ratio for Apple for each of the fiscal years ended September 30, 2017, and September 24, 2016.

2. Compute the gross margin ratio for Google for each of the fiscal years ended December 31, 2017, and December 31, 2016.

3. Which company (Apple, Google, or neither) improved its control of costs during 2017, as reflected in the gross margin ratio?

COMPARATIVE ANALYSIS P1

APPLE GOOGLE

AA 15-3 Apple and Samsung compete in the global marketplace. Apple’s and Samsung’s financial state- ments are in Appendix A.

Required

1. Compute the ratio of inventory to total assets for Apple as of September 30, 2017, and for Samsung as of December 31, 2017. Express your answers as percentages, rounded to two decimal places.

2. Based on the answer to part 1, which company’s (Apple’s or Samsung’s) inventory policy more closely follows a JIT system?

GLOBAL ANALYSIS P1

APPLE Samsung

BTN 15-2 Assume that you are preparing for a second interview with a manufacturing company. The company is impressed with your credentials, but it has several qualified applicants. You anticipate that in this second interview, you must show what you offer over other candidates. You learn the company is not satisfied with the timeliness of its information and its inventory management. The company manufactures custom-order holiday decorations and display items. To show your abilities, you plan to recommend that the company use a job order accounting system.

Required

In preparation for the interview, prepare notes outlining the following: 1. Your recommendation and why it is suitable for this company. 2. A general description of the documents that the proposed system requires. 3. How the documents in part 2 facilitate the operation of the job order accounting system.

COMMUNICATING IN PRACTICE C1 C2

Point: Have students present a mock interview, one assuming the role of the president of the com- pany and the other the applicant.

BTN 15-3 Many contractors work on custom jobs that require a job order costing system.

Required

Access the AMSI-Construction Software website (softwareconnect.com/construction/amsi­construction­ software/); scroll down and read the section on StarBuilder—Job Cost Accounting. Prepare a one-page memorandum for the CEO of a construction company providing information about the job order costing software this company offers. Would you recommend that the company purchase this software?

TAKING IT TO THE NET C1

Chapter 15 Job Order Costing and Analysis 609

BTN 15-4 Consider the activities undertaken by a medical clinic in your area.

Required

1. Is a job order costing system appropriate for the clinic? Explain. 2. Identify as many factors as possible to lead you to conclude that the clinic uses a job order system.

TEAMWORK IN ACTION C1

BTN 15-6 Home builders often use job order costing.

Required

1. You (or your team) are to prepare a job cost sheet for a single-family home under construction. List four items of both direct materials and direct labor. Explain how you think overhead should be applied.

2. Contact a builder and compare your job cost sheet to this builder’s job cost sheet. If possible, speak to that company’s accountant. Write your findings in a short report.

HITTING THE ROAD C2 P1 P2 P3

BTN 15-5 Refer to the chapter opener regarding Brennan Agranoff and his company, HoopSwagg. All successful businesses track their costs, and it is especially important for start-up businesses to monitor and control costs.

Required

1. Assume that Brennan Agranoff uses a job order costing system. For the basic cost category of direct materials, explain how Brennan’s job cost sheet would differ from a job cost sheet for a service company.

2. For the basic cost categories of direct materials, direct labor, and overhead, provide examples of the types of costs that would fall into each category for HoopSwagg.

ENTREPRENEURIAL DECISION C1 C2

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Explain process operations and the way

they differ from job order operations.

C2 Define and compute equivalent units and explain their use in process costing.

C3 Describe accounting for production activity and preparation of a process cost summary using weighted average.

C4 Appendix 16A—Describe accounting for production activity and preparation of a process cost summary using FIFO.

P2 Record the flow of labor costs in process costing.

P3 Record the flow of factory overhead costs in process costing.

P4 Record the transfer of goods across departments, to Finished Goods Inventory, and to Cost of Goods Sold.

ANALYTICAL A1 Compare process costing and job

order costing.

A2 Explain and illustrate a hybrid costing system.

PROCEDURAL P1 Record the flow of materials costs in

process costing.

Chapter Preview

16 Process Costing and Analysis

NTK 16-4

ACCOUNTING FOR COSTS AND TRANSFERS

P1 Accounting for materials P2 Accounting for labor P3 Accounting for overhead P4 Accounting for transfers

A2 Hybrid costing system C4 Appendix: FIFO method

NTK 16-1

PROCESS OPERATIONS

C1 Organization of process operations

A1 Process cost vs. job order systems

C2 Equivalent units (EUP)

NTK 16-2, 16-3

PROCESS COSTING ILLUSTRATION

C3 Overview of GenX Collect product costs

Physical flow of units

Computing EUP

Cost per EUP

Cost reconciliation

Process cost summary

611

“Always room for ice cream”—Suzy Batlle

¡Todos Gritamos por Helado!

MIAMI—Suzy Batlle was new to running a business when she started Azucar Ice Cream Company (azucaricecream.com). But Suzy knew ice cream, having grown up in a family that ate it nearly every night. “We Cuban people love ice cream,” ex- claims Suzy from her shop in the Little Havana section of Miami. Suzy took classes to learn the ice cream–making pro- cess and mastered the legal and permitting process to open her store.

Suzy’s recipes use tropical fruits found throughout Central and South America—ruby-red guava, mamey, papaya, and plan- tains, for example—and stem from an adventurous streak passed down through her family.

“My grandmother traveled extensively,” explains Suzy, “and always made ice cream with the new exotic fruits she found. We have Cuban-inspired flavors you won’t see anywhere else.”

Ice cream is made in a process operation and produced in large volumes. “I’ll buy 1,000 pounds of mamey at a time” says Suzy. These perishable raw materials enter a continuous pro- duction process that also uses direct labor (Suzy has 14 employ- ees) and overhead (depreciation on processing machines, for example).

Each production run yields many gallons of ice cream. Suzy uses a process costing system to determine her production costs per gallon. Suzy credits courses from nearby Miami Dade College with improving her management and accounting skills.

Azucar is flourishing, and Suzy plans to open more stores. Suzy advises, “Work hard and love what you do!”

Sources: Azucar Ice Cream Company website, January 2019; Saveur, July 7, 2016; Miami Today, February 2, 2016; Mic.com, November 28, 2016

©Azucar Ice Cream Company

Process operations involve the mass production of similar products in a continuous flow of sequential processes. Process operations require a high level of standardization to produce large volumes of products. Thus, process operations use a standardized process to make similar prod- ucts; job order operations use a customized process to make unique products.

Penn makes tennis balls in a process operation. Tennis balls must be identical in terms of bounce, playability, and durability. This uniformity requires Penn to use a production process that can repeatedly make large volumes of tennis balls to the same specifications. Process oper- ations also extend to services, such as mail sorting in large post offices and order processing in retailers like Amazon. Other companies using process operations include:

PROCESS OPERATIONS C1 Explain process operations and the way they differ from job order operations.

Company Product Company Product

General Mills . . . . . . . . . . . . . . . . Cereals Heinz . . . . . . . . . . . . . . . . . . . . Ketchup Pfizer . . . . . . . . . . . . . . . . . . . . . . Pharmaceuticals Kar’s . . . . . . . . . . . . . . . . . . . . . Trail mix Procter & Gamble . . . . . . . . . . . . Household products Hershey . . . . . . . . . . . . . . . . . . Chocolate Coca-Cola . . . . . . . . . . . . . . . . . . Soft drinks Suja . . . . . . . . . . . . . . . . . . . . . Organic juice

Organization of Process Operations Each of the above products is made in a series of repetitive processes, or steps. Tennis ball pro- duction includes the three steps shown in Exhibit 16.1. Understanding such processes is crucial for measuring product costs. Increasingly, process operations use machines and automation to control product quality and reduce manufacturing costs.

In a process operation, each process is a separate production department, workstation, or work center. Each process applies direct labor, overhead, and, perhaps, direct materials to move the product toward completion. The final process or department in the series finishes the goods and makes them ready for sale. Courtesy of Ken W. Shaw

612 Chapter 16 Process Costing and Analysis

EXHIBIT 16.1 Process Operations: Making Tennis Balls* * See a virtual tour of a process operation

at PennRacquet.com/video.html

Packaging the tennis balls

Gluing felt covers to cores

Forming rubber cores

In Exhibit 16.1, the first step in tennis ball production involves cutting rubber into pellets and forming the core of each ball. These rubber cores are passed to the second department, where felt is cut into covers and glued to the rubber cores. The completed tennis balls are then passed to the final department for quality checks and packaging.

Comparing Process and Job Order Costing Systems We use Exhibit 16.2 to discuss similarities and differences in job order and process systems next.

A1 Compare process costing and job order costing.

Finished goods

Job cost sheet

WIP Inventory

Job B15

Finished goods

Job B15 Cost per unit

Job cost sheet Job cost sheet

Job cost sheet

Cost per unit

Job Order System

Process System

Direct materials

Overhead

WIP Inventory Core dept.

WIP Inventory Felt dept.

WIP Inventory Packaging

Cost per unit

Cost per unit Core dept.

Cost per unit Felt dept.

Cost per unit Packaging

Direct labor

Direct materials

Overhead

Direct labor

Job B16 Job B16

EXHIBIT 16.2 Cost Flows: Comparing Job Order and Process Costing Systems

Job order and process operations share the following features. Both use materials, labor, and overhead costs. Both aim to compute the cost per unit of product (or service).

Chapter 16 Process Costing and Analysis 613

Job order and process operations have important differences.

Cost object In a job order system, the cost object is a job. In a process system, the cost object is the process (or department).

Cost per unit Job order costing system measures cost per unit after completion of a job. Process costing system measures unit costs at the end of a period (such as a month) by combining costs per equivalent unit from each department.

Job cost sheets Only job order systems use job cost sheets. Work in process Job order costing systems often use one Work in Process Inventory account. inventory Process costing systems use separate Work in Process Inventory accounts

for each process.

Transferring Costs across Departments In process costing, manufacturing costs are transferred across Work in Process (WIP) Inventory accounts. After production is complete, the completed goods and their accumulated costs are transferred from the Work in Process Inventory account for the final department in the series of processes to the Finished Goods Inventory account.

WIP—Core Dept. WIP—Felt Dept. WIP—Packaging Dept. Finished Goods

A B C

Exhibit 16.3 summarizes the journal entries to capture this flow of manufacturing costs for a tennis ball manufacturer—from A , then from B , and then from C .

Packaging the tennis balls

Gluing felt covers to cores

Forming rubber cores

WIP Inventory—Felt department . . . . . . . . . # WIP Inventory—Core department . . . . #

Transfer costs of partly completed goods to next dept.

WIP Inventory—Packaging department . . . . . # WIP Inventory—Felt department . . . . . #

Transfer costs of partly completed goods to next dept.

Finished Goods Inventory . . . . . . . . . . . . . . . . . . # WIP Inventory—Packaging department . . . #

Transfer costs of completed products to finished goods.

A B C

EXHIBIT 16.3 Flow of Costs through Separate Work in Process Accounts

Equivalent Units of Production Companies with process operations typically end each period with inventories of both finished goods and work in process. For example, a maker of tennis balls ends each period with both com- pleted tennis balls and partially completed tennis balls in inventory. Perhaps only the Core depart- ment has completed its work on a batch of tennis balls. How does a process manufacturer measure its production activity when it has some partially completed goods at the end of a period? A key

C2 Define and compute equivalent units and explain their use in process costing.

Complete the table with either a yes or no regarding the attributes of job order and process costing systems.

Solution

a. yes b. yes c. no d. yes e. yes f. no g. yes h. yes

Job Order vs. Process Costing Systems

NEED-TO-KNOW 16-1

C1 A1

Do More: QS 16-1, QS 16-2, E 16-1, E 16-2

Job Order Process

Uses direct materials, direct labor, and overhead costs . . . . . . . . . . . . . . . . .

Uses job cost sheets to accumulate costs . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Typically uses several Work in Process Inventory accounts . . . . . . . . . . . . . . .

Yields a cost per unit of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

a. e. b. f. c. g.

d. h.

614 Chapter 16 Process Costing and Analysis

idea in process costing is equivalent units of production (EUP), which is the number of units that could have been started and completed given the costs incurred during the period.

EUP is explained as follows: 10,000 tennis balls that are 60% through the production process is equivalent to 6,000 (10,000 × 60%) tennis balls that completed the entire production process. This means that the cost to put 10,000 units 60% of the way through the production process is equivalent to the cost to put 6,000 units completely through the production process. Knowing the costs of partially completed goods allows us to measure production activity for the period.

EUP for Materials and Conversion Costs Equivalent units of production for di- rect materials are often not the same with respect to direct labor and overhead. For example, direct materials, like rubber for tennis ball cores, might enter production entirely at the begin- ning of a process. In contrast, direct labor and overhead might be used continuously throughout the process. How does a manufacturer account for these timing differences? With equivalent units of production. For example, if all of the direct materials to produce 10,000 units have en- tered the production process, but those units have received only 20% of their direct labor and overhead costs, equivalent units are computed as:

=

EUP: Physical unit #s × Complete % EUP for direct materials = 10,000 × 100% = 10,000 EUP for direct labor = 10,000 × 20% = 2,000 EUP for overhead = 10,000 × 20% = 2,000

Direct labor and factory overhead are often classified as conversion costs—that is, as costs of converting direct materials into finished products. Many businesses with process operations compute conversion cost per equivalent unit, which is the combined costs of direct labor and factory overhead per equivalent unit. If direct labor and overhead enter the production process at about the same rate, it is convenient to combine them as conversion costs.

Weighted Average versus FIFO There are two ways to compute equivalent units. These methods make different assumptions about how costs flow. Weighted-average method combines units and costs across two periods in computing

equivalent units. FIFO method computes equivalent units based only on production activity in the current period.

The objectives, concepts, and journal entries (but not dollar amounts) are the same under the weighted-average and FIFO methods; the computations of equivalent units differ. While the FIFO method is generally more precise than the weighted-average method, it requires more calculations. Often, the differences between the two methods are small. With a just-in-time inventory system, these different methods yield very similar results because inventories are immaterial. In this chap- ter we assume the weighted-average method; we illustrate the FIFO method in Appendix 16A.

Point: When overhead is applied based on direct labor cost, the percentage of completion for direct labor and overhead will be the same.

We provide a step-by-step illustration of process costing. Each process (or department) in a process operation follows these steps:

1. Determine the physical flow of units. 2. Compute equivalent units of production. 3. Compute cost per equivalent unit of production. 4. Assign and reconcile costs.

We show these steps for the first of two sequential processes of a trail mix manufacturer.

Overview of GenX Company’s Process Operation GenX Company produces an organic trail mix called FitMix. Its target customers are active people who are interested in fitness and the environment. GenX sells FitMix to wholesale distributors, who in turn sell it to retailers. FitMix is manufactured in a continuous, two-process operation (Roasting and Blending), shown in Exhibit 16.4.

PROCESS COSTING ILLUSTRATION C3 Describe accounting for production activity and preparation of a process cost summary using weighted average.

Chapter 16 Process Costing and Analysis 615

Storeroom–materials are received and then

distributed when requisitioned.

Production floor–area where roasting is done

and products are blended.

Warehouse–finished products are stored

before being shipped to wholesalers.

Loading dock (outgoing products)

Loading dock (incoming materials)

Blending department

Roasting department

Production support o�ces– used by administrative

and maintenance employees who support

manufacturing operations.

Front entrance

Employees’ entrance

Locker rooms–workers change from street

clothes into sanitized uniforms before working

in the factory.

EXHIBIT 16.4 GenX’s Process OperationIn the first process (Roasting department), GenX roasts, oils, and salts organically grown

peanuts. These peanuts are then passed to the Blending department, the second process. In the Blending department, machines blend organic chocolate pieces and organic dried fruits with the peanuts from the first process. The blended mix is then inspected and packaged for delivery. In both departments, direct materials enter production at the beginning of the process, while con- version costs occur continuously throughout each department’s processing.

Pre-Step: Collect Production and Cost Data Exhibit 16.5 presents production data (in units) for GenX’s Roasting department. This exhibit includes the percentage of completion for both materials and conversion; beginning work in process inventory is 100% complete with respect to materials but only 65% complete with respect to conversion. Ending work in process inventory is 100% complete with respect to materials but only 25% complete with respect to conversion. Units completed and transferred to the Blending department are 100% complete with respect to both materials and conversion.

Beginning work in process inventory

(March 31) 30,000

Units started this period

(April) 90,000

Units completed and transferred

(April) 100,000

Ending work in process inventory

(April 30) 20,000

=

=

+ –

Total units to account for

120,000

Total units accounted for

120,000

Percentage of Completion

Direct materials . . .100% 100% 100% Conversion . . . . . . 65% 100% 25%

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

EXHIBIT 16.5 Production Data (in units) for Roasting Department

616 Chapter 16 Process Costing and Analysis

Exhibit 16.6 presents production cost data for GenX’s Roasting department. We use the data in Exhibits 16.5 and 16.6 to illustrate the four-step approach to process costing.

EXHIBIT 16.6 Roasting Department Production Cost Data

GenX—Roasting Department: Production Cost Data (April) Beginning work in process inventory (March 31)

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000

Conversion costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,900 $ 189,900

Costs during the current period (April)

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000

Direct labor costs* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171,000

Factory overhead costs applied (120% of direct labor)* . . . . . . . . . . . . . . 205,200 655,200

Total production costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

*Total conversion costs for the month equal $376,200 (= $171,000 + $205,200).

Step 1: Determine Physical Flow of Units A physical flow reconciliation is a report that reconciles (1) the physical units started in a period with (2) the physical units completed in that period. A physical flow reconciliation for GenX’s Roasting department for April is shown in Exhibit 16.7.

GenX—Roasting Department

Units to Account For Units Accounted For

Beginning work in Units completed and process inventory . . . . . . . . . . . . . 30,000 units transferred out . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Units started this period . . . . . . . . . . 90,000 units Ending work in process inventory . . . . . . . . . 20,000 units

Total units to account for . . . . . . . . . 120,000 units Total units accounted for . . . . . . . . . . . . . . . . 120,000 units

reconciled

EXHIBIT 16.7 Physical Flow Reconciliation

WIP–Roasting (in units)

Beg. inv. 30,000 Started 90,000

To acct. for 120,000 100,000 Tr. out

End. inv. 20,000

Step 2: Compute Equivalent Units of Production The second step is to compute equivalent units of production for direct materials and conversion costs for April. Because direct materials and conversion costs typically enter a process at different rates, departments must compute equivalent units separately for direct materials and conversion costs. Exhibit 16.8 shows the formula to compute equivalent units under the weighted-average method for both direct materials and conversion costs.

EXHIBIT 16.8 Computing EUP—Weighted- Average Method

Equivalent units of production (EUP)

Number of whole units completed and transferred out*=

Number of equivalent units in ending work in process+

*Transferred to next department or finished goods inventory.

For GenX’s Roasting department, we convert the 120,000 physical units to equivalent units based on how each input has been used. The Roasting department fully completed its work on 100,000 units and partially completed its work on 20,000 units (from Exhibit 16.5). Equivalent units are computed by multiplying the number of units accounted for (from step 1) by the per- centage of completion for each input—see Exhibit 16.9.

Point: We see that under weighted average, units in begin- ning work in process are com- bined with units produced in the current period to get EU (and costs per EU). This approach combines production activity across two periods.

GenX—Roasting Department

Direct Equivalent Units of Production Materials Conversion

Equivalent units completed and transferred out (100,000 × 100%) . . . . . . . . . . . . 100,000 EUP 100,000 EUP Equivalent units for ending work in process

Direct materials (20,000 × 100%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 EUP Conversion (20,000 × 25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 EUP Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP

EXHIBIT 16.9 Equivalent Units of Production—Weighted Average

Chapter 16 Process Costing and Analysis 617

The first row of Exhibit 16.9 reflects 100,000 completed units transferred out in April. These units have 100% of the materials and conversion required, or 100,000 equivalent units of each input (100,000 × 100%).

Rows two, three, and four refer to the 20,000 partially completed units. For direct materials, the units in ending work in process inventory include all materials required, so there are 20,000 equivalent units (20,000 × 100%) of materials in the unfinished physical units. For conversion, the units in ending work in process inventory include 25% of the conversion required, which implies 5,000 equivalent units of conversion (20,000 × 25%).

The final row reflects the total equivalent units of production, which is whole units of prod- uct that could have been manufactured with the amount of inputs used to create some complete and some incomplete units. The amount of inputs used to produce 100,000 complete units and to start 20,000 additional units is equivalent to the amount of direct materials in 120,000 whole units and the amount of conversion in 105,000 whole units.

EUP for Transferred out + EUP for WIP

= EUP for Total

©Ken Whitmore/Stone/Getty Images

Step 3: Compute Cost per Equivalent Unit Under the weighted-average method, computation of EUP does not separate the units in begin- ning inventory from those started this period. Similarly, the weighted-average method combines the costs of beginning work in process inventory with the costs incurred in the current period. Total cost is then divided by the equivalent units of production (from step 2) to compute the average cost per equivalent unit. This is illustrated in Exhibit 16.10. For direct materials, the cost is $3.00 per EUP. For conversion, the cost is $4.62 per EUP.

Step 4: Assign and Reconcile Costs The EUP from step 2 and the cost per EUP from step 3 are used in step 4 to assign costs to (a) the 100,000 units that the Roasting department completed and transferred to the Blending department and (b) the 20,000 units that remain in process in the Roasting department. This is illustrated in Exhibit 16.11.

GenX—Roasting Department

Direct Cost per Equivalent Unit of Production Materials Conversion

Costs of beginning work in process inventory* . . . . . . . . . . . . . . . . . $ 81,000 $108,900

Costs incurred this period* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000 376,200‡

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 $485,100

÷ Equivalent units of production (from step 2) . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP = Cost per equivalent unit of production . . . . . . . . . . . . . . . . . . . . . . . . $3 .00 per EUP† $4 .62 per EUP§

*From Exhibit 16.6 †$360,000 ÷ 120,000 EUP ‡$171,000 + $205,200, from Exhibit 16.6 §$485,100 ÷ 105,000 EUP

EXHIBIT 16.10 Cost per Equivalent Unit of Production—Weighted Average

Cost per EUP = Total costs

EUP

EUP—Direct Materials and Conversion (Weighted Average)

NEED-TO-KNOW 16-2

C2

Do More: QS 16-5, QS 16-10, E 16-4, E 16-8

A department began the month with 8,000 units in work in process inventory. These units were 100% complete with respect to direct materials and 40% complete with respect to conversion.

During the current month, the department started 56,000 units and completed 58,000 units. Ending work in process inventory includes 6,000 units, 80% complete with respect to direct materials and 70% complete with respect to conversion. Use the weighted-average method of process costing to: 1. Compute the department’s equivalent units of production for the month for direct materials. 2. Compute the department’s equivalent units of production for the month for conversion.

Solution—see supporting unit computations to the side

1. EUP for materials = 58,000 + (6,000 × 80%) = 62,800 EUP 2. EUP for conversion = 58,000 + (6,000 × 70%) = 62,200 EUP

WIP (in units)

Beg. inv. 8,000 Started 56,000

To acct. for 64,000 58,000 Tr. out

End. inv. 6,000

618 Chapter 16 Process Costing and Analysis

Cost of Units Completed and Transferred The 100,000 units completed and transferred to the Blending department required 100,000 EUP of direct materials and 100,000 EUP of conversion. We assign $300,000 (100,000 EUP × $3.00 per EUP) of direct materials cost to those units. We also assign $462,000 (100,000 EUP × $4.62 per EUP) of conversion cost to those units. Total cost of the 100,000 completed and transferred units is $762,000 ($300,000 + $462,000), and the average cost per unit is $7.62 ($762,000 ÷ 100,000 units).

Cost of Units in Ending Work in Process Inventory There are 20,000 incom- plete units in work in process inventory at period-end. For direct materials, those units have 20,000 EUP of material (from step 2) at a cost of $3.00 per EUP (from step 3), which yields the materials cost of work in process inventory of $60,000 (20,000 EUP × $3.00 per EUP). For conversion, the in-process units reflect 5,000 EUP (from step 2). Using the $4.62 conversion cost per EUP (from step 3), we obtain conversion costs for in-process inventory of $23,100 (5,000 EUP × $4.62 per EUP). Total cost of work in process inventory at period-end is $83,100 ($60,000 + $23,100).

Reconciliation Management verifies that total costs assigned to units completed and transferred plus the costs of units in process (from Exhibit 16.11) equal the costs incurred by production. Exhibit 16.12 shows the costs incurred by production this period. We then reconcile the costs accounted for in Exhibit 16.11 with the costs to account for in Exhibit 16.12.

20,000 Partially completed units

Conversion 5,000 EUP

Materials 20,000 EUP

Total costs = $845,100

In WIP—Roasting $83,100

To Blending $762,000

GenX—Roasting Department Cost of units completed and transferred to Blending dept. Direct materials (100,000 EUP × $3 .00 per EUP) . . . . . . . . . . . . . . . . . . $300,000 Conversion (100,000 EUP × $4 .62 per EUP) . . . . . . . . . . . . . . . . . . . . . . 462,000 Cost of units completed this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $762,000

Cost of ending work in process inventory Direct materials (20,000 EUP × $3 .00 per EUP) . . . . . . . . . . . . . . . . . . . 60,000 Conversion (5,000 EUP × $4 .62 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . 23,100 Cost of ending work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . 83,100

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100*

EXHIBIT 16.11 Report of Costs Accounted For—Weighted Average* * Equals total production costs from Exhibit 16.6.

GenX—Roasting Department Cost of beginning work in process inventory Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000

Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,900 $ 189,900

Cost incurred this period Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000

Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376,200 655,200

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

EXHIBIT 16.12 Report of Costs to Account For—Weighted Average

The Roasting department manager is responsible for $845,100 in costs: $189,900 from beginning work in process inventory plus $655,200 of materials and conversion incurred in the period. At period-end, that manager must show where these costs are assigned. The Roasting department manager reports that $83,100 is assigned to units in process and $762,000 is assigned to units completed and transferred out to the Blending department (per Exhibit 16.11). The sum of these amounts equals $845,100. Thus, the total costs to account for equal the total costs accounted for (minor differences sometimes occur from rounding).

Chapter 16 Process Costing and Analysis 619

A department began the month with conversion costs of $65,000 in its beginning work in process in- ventory. During the current month, the department incurred $55,000 of conversion costs. Equivalent units of production for conversion for the month were 15,000 units. The department completed and transferred 12,000 units to the next department. The department uses the weighted-average method of process costing. 1. Compute the department’s cost per equivalent unit for conversion for the month. 2. Compute the department’s conversion cost of units transferred to the next department for the

month.

Solution

1. ($65,000 + $55,000)∕15,000 units = $8.00 per EUP for conversion

2. 12,000 units × $8.00 = $96,000 conversion cost transferred to next department

Cost per EUP— Conversion, with Transfer

NEED-TO-KNOW 16-3

C3

Do More: QS 16-11, E 16-6

Process Cost Summary An important managerial accounting report for a process costing system is the process cost summary (also called production report), which is prepared separately for each process or pro- duction department. A process cost summary describes the costs charged to each department, reports the equivalent units of production achieved by each department, and determines the costs assigned to each department’s output. It is prepared using a combination of Exhibits 16.7, 16.9, 16.10, 16.11, and 16.12.

The process cost summary for the Roasting department is shown in Exhibit 16.13. It sum- marizes the process costing steps.

DATA Total costs charged to the department, including direct materials and conversion costs incurred, as well as the cost of the beginning work in process inventory.

1 Physical flow of units. This reconciles the physical units started with the physical units completed in the period. 2 Equivalent units of production for the department. Equivalent units for direct materials

and conversion are shown in separate columns. 3 Costs per equivalent unit for direct materials and conversion. 4 Assignment of total costs among units worked on in the period. The $762,000 is the

total cost of the 100,000 units transferred out of the Roasting department to the Blending department. The $83,100 is the cost of the 20,000 partially completed units in ending inven- tory in the Roasting department. The assigned costs are then added to show that the total $845,100 cost charged to the Roasting department is now assigned to the units in step 4 .

Using a Process Cost Summary Process summary reports can be used by managers to: Control costs—The Roasting department’s equivalent costs per unit for April can be com-

pared with prior months. If materials and/or conversion costs have changed a lot, managers should determine why and take corrective action.

Evaluate performance—GenX’s top management can evaluate both the Roasting and Blending department managers based on their control of costs. Often, actual equivalent costs per unit are compared to budgeted amounts.

Evaluate process improvements—Organizations strive to improve their processes. The suc- cess of process changes can be evaluated by examining how equivalent costs per unit change after the process improvement.

Provide information for financial statements—The cost of goods sold and ending inven- tory amounts on process cost summaries are reported on the income statement and balance sheet, respectively.

Point: The key report in a job or- der costing system is a job cost sheet, which reports manufactur- ing costs per job. A process cost summary reports manufacturing costs per equivalent unit of a pro- cess or department.

Roasting Dept. Costs per EUP

April March DM $3.00 $3.10 Conv. 4.62 4.58 Total $7.62 $7.68

620 Chapter 16 Process Costing and Analysis

In this section we illustrate the journal entries to account for a process manufacturer. Exhibit 16.14 illustrates the flow of costs for GenX Company’s Roasting department. Mate- rials, labor, and overhead costs flow into the manufacturing processes. GenX keeps sepa- rate Work in Process Inventory accounts for the Roasting and Blending departments; when goods are packaged and ready for sale, their costs are transferred to the Finished Goods Inventory account.

As in job order costing, a process costing system uses source documents, including materials requisitions and time tickets. While some companies might combine direct labor and overhead into conversion costs when computing costs per equivalent unit (as we showed), labor and over- head costs are accounted for separately within the company’s general ledger accounts. Also, because overhead costs typically cannot be tied to individual processes, but rather benefit all processes or departments, most process operation companies use a single Factory Overhead account to accumulate actual and applied overhead costs.

ACCOUNTING FOR PROCESS COSTING re

co nc

ile d

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

GenX COMPANY—ROASTING DEPARTMENT Process Cost Summary (Weighted-Average Method)

For Month Ended April 30

Costs Charged to Production Costs of beginning work in process

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000

Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,900 $ 189,900

Costs incurred this period

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000

Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376,200 655,200

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

Unit Information Units to account for: Units accounted for:

Beginning work in process . . . . . . . . . . . . . 30,000 Completed and transferred out . . . . . . . . . . . . . 100,000

Units started this period . . . . . . . . . . . . . . . 90,000 Ending work in process . . . . . . . . . . . . . . . . . . . 20,000

Total units to account for . . . . . . . . . . . . . . 120,000 Total units accounted for . . . . . . . . . . . . . . . . . . 120,000

Equivalent Units of Production (EUP) Direct Materials Conversion Units completed and transferred out (100,000 × 100%) . . . . . . . . . . . . . . . . . 100,000 EUP 100,000 EUP Units of ending work in process

Direct materials (20,000 × 100%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 EUP Conversion (20,000 × 25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 EUP Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP

Cost per EUP Direct Materials Conversion Costs of beginning work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000 $108,900

Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000 376,200

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 $485,100

÷ EUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP Cost per EUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 .00 per EUP $4 .62 per EUP

Cost Assignment and Reconciliation Costs transferred out (cost of goods manufactured)

Direct materials (100,000 EUP × $3 .00 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 Conversion (100,000 EUP × $4 .62 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462,000 $ 762,000 Costs of ending work in process

Direct materials (20,000 EUP × $3 .00 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Conversion (5,000 EUP × $4 .62 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,100 83,100 Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

4

2

3

EXHIBIT 16.13 Process Cost Summary (Weighted Average)

WIP–Roasting (in $)

Beg. inv. 189,900 Incurred 655,200

Subtotal 845,100 762,000 Tr. out

End. inv. 83,100

DATA

1

Chapter 16 Process Costing and Analysis 621

As with job order costing, process manufacturers must allocate, or apply, overhead to pro- cesses. This requires good allocation bases. With increasing automation, companies with pro- cess operations use fewer direct labor hours and often use machine hours to allocate overhead.

Sometimes a single allocation base will not provide good overhead allocations. For example, direct labor cost might be a good allocation base for GenX’s Roasting department, but not for its Blending department. As a result, a process manufacturer can use different overhead allocation rates for different production departments. However, all applied overhead is credited to a single Factory Overhead account.

Exhibit 16.15 presents cost data for GenX. Roasting department costs are from Exhibit 16.6. Blending department costs are provided in Exhibit 16.15. We use these data to show the journal entries in a process costing system.

Point: Actual overhead is debited to Factory Overhead.

Factory overhead

Work in process— Blending

Work in process— Roasting

Finished goods

inventory

Delivered to

customers

Raw materials inventory

Factory payroll

Packaged FitMix

Sold FitMix

10 In

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In di

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Raw materials

Direct materials

Other overhead

Labor

Direct labor

1 2

9a3

4

7

6

5

8

Applied overhead

9b

Transfer to next process

EXHIBIT 16.14 Process Manufacturing Operations and Costs: GenX

GenX—Cost Data for Month Ending April 30 Raw materials inventory (March 31) . . . . . . . . . . . . $100,000

Beginning work in process inventories (March 31)

Work in process—Roasting . . . . . . . . . . . . . . . . . $189,900

Work in process—Blending . . . . . . . . . . . . . . . . . 151,688

Materials purchased (on account) . . . . . . . . . . . . . . $400,000

Materials requisitions during April

Direct materials—Roasting . . . . . . . . . . . . . . . . . $279,000

Direct materials—Blending . . . . . . . . . . . . . . . . . 102,000

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . 71,250

Factory payroll for April

Direct labor—Roasting . . . . . . . . . . . . . . . . . . . . $171,000

Direct labor—Blending . . . . . . . . . . . . . . . . . . . . 183,160

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,350

Other actual overhead costs during April

Insurance expense—Factory . . . . . . . . . . . . . . . $ 11,930

Utilities payable—Factory . . . . . . . . . . . . . . . . . . 7,945

Depreciation expense—Factory equipment . . . 220,650

Other (paid in cash) . . . . . . . . . . . . . . . . . . . . . . . 21,875

EXHIBIT 16.15 Cost Data—GenX (Weighted Average)

Accounting for Materials Costs In Exhibit 16.14, arrow line 1 reflects the arrival of purchased raw materials at GenX’s factory. These materials include organic peanuts, chocolate pieces, dried fruits, oil, salt, and packaging. They also include supplies for the production support office. GenX uses a perpetual inventory system and makes all purchases on credit. The summary entry for receipt of raw materials in April follows (dates in journal entries are omitted because they are summary entries, often reflecting two or more transactions or events).

P1 Record the flow of materials costs in process costing.

Assets = Liabilities + Equity +400,000 +400,000

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Acquired materials on credit for factory use.

1

622 Chapter 16 Process Costing and Analysis

Arrow line 2 in Exhibit 16.14 reflects the flow of direct materials to production in the Roasting and Blending departments. These direct materials are physically combined into the finished product. The manager of a process usually obtains materials by submitting a materials requisition to the materials storeroom manager. The entry to record the use of direct materials by GenX’s production departments in April follows. These direct materials costs flow into each department’s separate Work in Process Inventory account.

In Exhibit 16.14, arrow line 3 reflects the flow of indirect materials from the storeroom to fac- tory overhead. These materials are not clearly linked with any specific production process or depart- ment but are used to support overall production activity. As these costs cannot be linked directly to either the Roasting or Blending departments, they are recorded in GenX’s single Factory Overhead account. The following entry records the cost of indirect materials used by GenX in April.

Example: What types of materials might the flow of arrow line ③ in Exhibit 16.14 reflect? Answer: Goggles, gloves, protective cloth- ing, oil, salt, and cleaning supplies.

Assets = Liabilities + Equity +279,000 +102,000 −381,000

Work in Process Inventory—Roasting . . . . . . . . . . . . . . . . . . . 279,000

Work in Process Inventory—Blending . . . . . . . . . . . . . . . . . . . 102,000

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 381,000

Assign costs of direct materials used in production.

2

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,250

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 71,250

Record indirect materials used in April.

3

Accounting for Labor Costs Exhibit 16.14 shows GenX’s factory payroll costs as reflected in arrow line 4 . Exhibit 16.15 shows costs of $171,000 for Roasting department direct labor, $183,160 for Blending depart- ment direct labor, and $78,350 for indirect labor. This total payroll of $432,510 is a product cost, and it is assigned to either Work in Process Inventory or Factory Overhead.

Time reports from the production departments and the production support office trigger pay- roll entries. (For simplicity, we do not separately identify withholdings and additional payroll taxes for employees.) In a process operation, the direct labor of a production department includes all labor used exclusively by that department. This is the case even if labor is not applied to the product itself. If a production department in a process operation, for instance, has a full-time manager and a full-time maintenance worker, their salaries are direct labor costs of that process and are not factory overhead.

Arrow line 5 in Exhibit 16.14 shows GenX’s use of direct labor. The following entry then records direct labor used. These direct labor costs flow into each department’s separate Work in Process Inventory account.

P2 Record the flow of labor costs in process costing.

Arrow line 6 in Exhibit 16.14 reflects GenX’s indirect labor costs. These employees provide clerical, maintenance, and other services that help production in both the Roasting and Blending departments. For example, they order materials, deliver them to the factory floor, repair equip- ment, operate and program computers used in production, keep payroll and other production records, clean up, and move goods across departments. The following entry records these indi- rect labor costs.

Point: A department’s indirect labor cost might include an allocated portion of wages of a manager who supervises two or more departments. Allocation of costs between departments is discussed in a later chapter.

Assets = Liabilities + Equity +171,000 +354,160 +183,160

Work in Process Inventory—Roasting . . . . . . . . . . . . . . . . . . . 171,000

Work in Process Inventory—Blending . . . . . . . . . . . . . . . . . . . 183,160

Factory Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . 354,160

Record direct labor used in production.

5

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,350

Factory Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . 78,350

Record indirect labor as overhead.

6

Chapter 16 Process Costing and Analysis 623

After GenX posts these entries for direct and indirect labor, the Factory Wages Payable account has a credit balance of $432,510 ($354,160 + $78,350). The entry below shows the payment of this total payroll. After this entry, the Factory Wages Payable account has a zero balance.

Accounting for Factory Overhead Overhead costs other than indirect materials and indirect labor are reflected by arrow line 7 in Exhibit 16.14. These overhead items include the costs of insuring production assets, renting the factory building, using factory utilities, and depreciating factory equipment not directly related to a specific process. The following entry records these other overhead costs for April.

Applying Overhead to Work in Process Companies use predetermined overhead rates to apply overhead. These rates are estimated at the beginning of a period and used to apply overhead during the period. This allows managers to obtain up-to-date estimates of the costs of their processes during the period. This is important for process costing, where goods are trans- ferred across departments before the entire production process is complete.

Arrow line 8 in Exhibit 16.14 reflects the application of factory overhead to the two pro- duction departments. Factory overhead is applied to processes by relating overhead cost to another variable such as direct labor hours or machine hours used. In many situations, a single allocation basis such as direct labor hours (or a single rate for the entire plant) fails to provide useful allocations. As a result, management may use different rates for different production departments. In our example, GenX applies overhead using a predetermined rate of 120% of direct labor cost as shown in Exhibit 16.16.

Point: The time it takes to process (cycle) products through a process is sometimes used to allocate costs.

Factory Wages Payable

354,160 Dir L 78,350 Ind L 432,510 Pymt 0 Bal.

P3 Record the flow of factory overhead costs in process costing.

EXHIBIT 16.16 Applying Factory Overhead

Production Direct Labor Predetermined Overhead Department Cost Rate Applied

Roasting . . . . . . . . . . $171,000 120% $205,200

Blending . . . . . . . . . . 183,160 120 219,792

Total . . . . . . . . . . . . . $424,992

GenX records its applied overhead with the following entry.

Assets = Liabilities + Equity −432,510 −432,510

Factory Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432,510

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432,510

Record factory wages for April.

4

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262,400

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,930

Utilities Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,945

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,875

Accumulated Depreciation—Factory Equipment . . . . . . 220,650

Record other overhead costs incurred in April.

7

Work in Process Inventory—Roasting . . . . . . . . . . . . . . . . . . . 205,200

Work in Process Inventory—Blending . . . . . . . . . . . . . . . . . . . 219,792

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424,992

Applied overhead costs to production departments at 120% of direct labor cost.

8

624 Chapter 16 Process Costing and Analysis

Accounting for Transfers Transfers across Departments Arrow line 9a in Exhibit 16.14 reflects the transfer of partially completed units from the Roasting department to the Blending department. The process cost summary for the Roasting department (Exhibit 16.13) shows that the 100,000 units transferred to the Blending department are assigned a cost of $762,000. The entry to record this transfer follows.

Tower Mfg. allocates overhead based on machine hours. Tower estimates it will incur $200,000 of total overhead costs and use 10,000 machine hours in the coming year. During February, the Assembly depart- ment of Tower Mfg. used 375 machine hours. In addition, Tower incurred actual overhead costs as follows during February: indirect materials, $1,800; indirect labor, $5,700; depreciation on factory equipment, $8,000; and factory utilities, $500. 1. Compute the company’s predetermined overhead rate for the year. 2. Prepare journal entries to record (a) overhead applied for the Assembly department for February and

(b) actual overhead costs used during February.

Solution

1. Predetermined overhead rate = Estimated overhead costs ÷ Estimated activity base = $200,000/10,000 machine hours = $20 per machine hour

Overhead Rate and Costs

NEED-TO-KNOW 16-4

P1 P2 P3

2a. Work in Process Inventory—Assembly . . . . . . . . . . . . . . . . . . . 7,500

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Record applied overhead (375 hours × $20 per hour).

Do More: QS 16-25, E 16-23

2b. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Factory Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . 5,700

Accumulated Depreciation—Factory Equipment . . . . . . 8,000

Utilities Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Record actual overhead.

P4 Record the transfer of goods across departments, to Finished Goods Inventory, and to Cost of Goods Sold.

Work in Process Inventory—Blending . . . . . . . . . . . . . . . . . . . 762,000

Work in Process Inventory—Roasting . . . . . . . . . . . . . . . 762,000

Record transfer of 100,000 units from Roasting department to Blending department.

9a Assets = Liabilities + Equity +762,000 −762,000

Units and costs transferred out of the Roasting department are transferred into the Blending department. Exhibit 16.17 shows this transfer using T-accounts for the separate Work in Process Inventory accounts (first in units and then in dollars).

Budget Officer You are classifying costs of a new processing department as either direct or indirect. This depart- ment’s manager instructs you to classify most of the costs as indirect so it will be charged a lower amount of over- head (because this department uses less labor, which is the overhead allocation base). This would penalize other departments with higher allocations and cause the ratings of managers in other departments to suffer. What action do you take? ■ Answer: By classifing costs as indirect, the manager is passing some of his department’s costs to a common overhead pool that other departments will partially absorb. Because overhead costs are allocated on direct labor for this company and the new department has a low direct labor cost, the new department is assigned less overhead. Such action suggests unethical behavior. You must object to such reclassification. If this man- ager refuses to comply, you must inform someone in a more senior position.

Decision Ethics

Chapter 16 Process Costing and Analysis 625

As Exhibit 16.17 shows, the Blending department began the month with 12,000 units in beginning inventory, with a related cost of $151,688. In computing its production activity and costs, the Blending department must also consider the units and costs transferred in from the Roasting department, as shown in Exhibit 16.17. The 100,000 units transferred in from the Roasting department, and their related costs of $762,000, are added to the Blending depart- ment’s number of units and separate Work in Process (WIP) Inventory account.

The Blending department adds additional direct materials and conversion costs. The Blend- ing department incurred direct materials costs of $102,000 and conversion costs of $402,952 during the month. (Although not illustrated here, the concepts and methods used in this second department would be similar to those we showed in detail for the first department. The units and costs transferred in are considered separately from the materials and conversion added in the second department. This is shown in advanced courses.)

Accounting for Transfer to Finished Goods Arrow line 9b in Exhibit 16.14 reflects the transfer of units and their related costs from the Blending department to finished goods inventory. At the end of the month, the Blending department transferred 97,000 com- pleted units, with a related cost of $1,262,940, to finished goods. The entry to record this trans- fer follows.

Assets = Liabilities + Equity +1,262,940 −1,262,940

Accounting for Transfer to Cost of Goods Sold Arrow line 10 reflects the sale of finished goods. Assume that GenX sold 106,000 units of FitMix this period, and that its beginning finished goods inventory was 26,000 units with a cost of $338,520. Also assume that its ending finished goods inventory consists of 20,000 units at a cost of $260,400. Using this information, cost of goods sold is computed as in Exhibit 16.18.

Finished Goods Inventory

Beg. bal. 338,520 COGM 1,262,940

Avail. 1,601,460 COGS 1,341,060 End. bal. 260,400

EXHIBIT 16.18 Cost of Goods Sold

GenX—Cost of Goods Sold Beginning finished goods inventory . . . . . . . . . . . . . . . . . . $ 338,520

+ Cost of goods manufactured this period . . . . . . . . . . . . . . 1,262,940 = Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . 1,601,460 − Ending finished goods inventory . . . . . . . . . . . . . . . . . . . . 260,400 = Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,341,060

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,262,940

Work in Process Inventory—Blending . . . . . . . . . . . . . . . 1,262,940

Record transfer of completed goods.

9b

30,000 units

90,000 units

120,000 units

20,000 units

Roasting Department—Units

100,000 units transferred out

Beg . inv .

Started

Total

End . inv .

12,000 units

100,000 units 112,000 units

15,000 units

97,000 units transferred to Finished Goods

Blending Department—Units

Beg . inv .

Transferred in Total

End . inv .

151,688

762,000 102,000

402,952

1,418,640

155,700

1,262,940 Transferred to FG

WIP Inventory—Blending Dept. ($)

Beg . inv .†

Transferred in DM

Conv .

Total

End . inv .

†$91,440 transferred in + $10,000 DM + $50,248 conversion

189,900

279,000

376,200

845,100

83,100

WIP Inventory—Roasting Dept. ($)

762,000 Transferred out

Beg . inv .*

DM

Conv .

Total

End . inv .

*$81,000 direct materials + $108,900 conversion

EXHIBIT 16.17 Production and Cost Activity—Transfer to Blending Department

626 Chapter 16 Process Costing and Analysis

©Natalia Kolesnikova/AFP/Getty Images

The summary entry to record cost of goods sold for this period follows.

Trends in Process Operations Process Design Management concerns with production efficiency can lead companies to entirely reorganize production processes. For example, instead of producing different types of computers in a series of departments, a separate work center for each computer type can be es- tablished in one department. The process cost system is then changed to account for each work center’s costs.

Just-in-Time Production Companies are increasingly adopting just-in-time techniques. With a just-in-time inventory system, inventory levels can be minimal. If raw materials are not ordered or received until needed, a Raw Materials Inventory ac- count might be unnecessary. Instead, materials cost is immediately debited to the Work in Process Inventory account. Similarly, a Finished Goods Inventory account may not be needed. Instead, cost of finished goods may be immediately debited to the Cost of Goods Sold account.

Robotics and Automation Companies are increasingly automating their production processes and using robots. Manufacturers use robots on tasks that are hard for humans to perform. This results in reduced direct labor costs and a healthier workforce.

Continuous Processing In some companies, like Pepsi Bottling, mate- rials move continuously through the manufacturing process. In these cases, a materials consumption report summarizes the materials used and replaces materials requisitions.

Services Service-based businesses are increasingly prevalent. For routine, standardized services like oil changes and simple tax returns, computing costs based on the process is simpler and more useful than a cost per individual job. More complex service companies use process departments to perform specific tasks for consumers. Hospitals, for example, have radiology and physical therapy facilities, each with special equipment and trained employees. When pa- tients need services, they are processed through departments to receive prescribed care.

Customer Orientation Focus on customer orientation also leads to improved pro- cesses. A manufacturer of control devices improved quality and reduced production time by forming teams to study processes and suggest improvements. An ice cream maker studied cus- tomer tastes to develop a more pleasing ice cream texture.

Yield Many process operations convert large amounts of raw materials into finished goods. In addition to information in process cost summaries, managers often measure Yield, which is the amount of material output divided by the amount of material input. For example, assume a maker of trail mix started 10,000 pounds (units) of peanuts into its production process and ended with finished goods of 9,650 pounds. The Yield is computed as: 9,650/10,000 = 96.5%. Yield might be less than 100% due to lost or stolen peanuts, roasting issues that burned peanuts, or other production problems. When yields are lower than expected, managers usually ask why and then take corrective action.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,341,060

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . 1,341,060

Record cost of goods sold for April.

10 Assets = Liabilities + Equity −1,341,060 −1,341,060

Chapter 16 Process Costing and Analysis 627

Hybrid Costing System Decision Analysis

Many organizations use a hybrid costing system that contains features of both process and job order operations. A recent survey of manufacturers revealed that a majority use hybrid systems (also called operation costing systems). To illustrate, consider a car manufacturer’s assembly line. The line resembles a process operation in that the assembly steps for each car are nearly identical. But the specifications of most cars have several important differences. At the Ford Mustang plant, each car assembled can be different from the previous car and the next car. This means that the costs of materials (subassemblies or components) for each car can differ. Accordingly, while the conversion costs (direct labor and overhead) can be accounted for using a process costing system, the component costs (direct materials) are accounted for using a job order sys- tem (separately for each car or type of car). A hybrid system of processes requires a hybrid costing system to properly cost products or ser- vices. In the Ford plant, the assembly costs per car are readily determined using process costing. The costs of additional components then can be added to the assembly costs to determine each car’s total cost (as in job order costing). To illustrate, consider the following information for a daily assembly process at Ford.

The assembly process costs $22,600 per car. Depending on the type of wheels and sound system the cus- tomer requests, the cost of a car can range from $23,460 to $24,440 (a $980 difference). Today companies are increasingly trying to standardize processes while attempting to meet individual customer needs. For example, Lightning Wear makes custom team uniforms, which are the same except

A2 Explain and illustrate a hybrid costing system.

©David M G/Shutterstock

Assembly Process Costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10 .6 million

Conversion costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12 .0 million

Number of cars assembled . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Costs of three different types of wheels . . . . . . . . . . . . . . . $240; $330; $480

Costs of three different types of sound systems . . . . . . . . . $620; $840; $1,360

In addition to making continuous process improvements to reduce materials waste and increase yield, Suzy Batlle, founder of Azucar Ice Cream Company, seeks high-quality fresh ingredients. For Suzy, buying from local suppliers provides a sustainable supply chain that benefits her business and the local community. ©Emily Michot/TNS/Newscom

General Mills Performance Dashboard (partial)

Ingredient Primary Challenges Target* Progress

Vanilla Smallholder farmer incomes, quality of ingredients 100% 45%

Oats Declining supply due to profitability versus other crops 100 35

Sugarcane Child and forced labor, working conditions 100 42

Palm oil Deforestation, indigenous peoples’ rights 100 83

*Target and progress amounts are the percent of the ingredient sourced sustainably. Source: General Mills, Global Sustainability Report, 2017.

Food processor General Mills needs a steady supply of high-quality corn, oats, and sugarcane. These agricultural inputs face risks due to water scarcity and climate change that could disrupt General Mills’s process operations and hurt profits.

Buying from suppliers that follow sustainable principles reduces risk of reputational damage. The Sustainability Accounting Standards Board (SASB) recommends that food processors disclose informa- tion on priority food ingredients (those that are essential to the company’s products), including details on the company’s strategies to address strategic risks.

Consistent with SASB guidelines, General Mills disclosed the following information in its recent Global Responsibility Report.

SUSTAINABILITY AND ACCOUNTING

628 Chapter 16 Process Costing and Analysis

for the team logo and colors added in the final process. The Planters Company packages peanuts in dif- ferent sizes and types of packaging for different retailers. To the extent that differences among individual customers’ requests are large, understanding the costs to satisfy those requests is important. Thus, moni- toring and controlling both process and job order costs are important.

Entrepreneur Your company makes similar products for three different customers. One customer demands 100% quality inspection of products at your location before shipping. The added costs of that inspection are spread across all three customers. If you charge the customer the costs of 100% quality inspection, you could lose that customer and experience a loss. Moreover, your other two customers do not question the amounts they pay. What actions (if any) do you take? ■ Answer: By spreading the added quality-related costs across three customers, the price you charge is lower for the customer that demands the 100% quality inspection. You recover much of the added costs from the other two customers. This act likely breaches the trust placed by the other two customers. Your costing system should be changed, and you should consider renegotiating the pricing and/or quality test agreement with this one customer (at the risk of losing this customer).

Decision Ethics

Pennsylvania Company produces a product that passes through two processes: Grinding and Mixing. Information related to its Grinding department manufacturing activities for July follows. The company uses the weighted-average method of process costing.COMPREHENSIVE 1

Weighted-Average Method

NEED-TO-KNOW 16-5

Grinding Department Beginning work in process inventory (units) . . . . . . . . 5,000

Percentage completed—Materials . . . . . . . . . . . . . . 100%

Percentage completed—Conversion . . . . . . . . . . . . 70%

Beginning work in process inventory (costs)

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Direct labor incurred . . . . . . . . . . . . . . . . . . . . . . . . . 9,600

Overhead applied (200% of direct labor) . . . . . . . . 19,200

Total costs of beginning work in process . . . . . . . . $48,800

Units started this period . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Units transferred to Mixing this period . . . . . . . . . . . . . 17,000

Ending work in process inventory (units) . . . . . . . . . . 8,000

Percentage completed—Materials . . . . . . . . . . . . . . 100%

Percentage completed—Conversion . . . . . . . . . . . . 20%

Grinding Department Raw Materials Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Raw materials purchased on credit . . . . . . . . . . . . 211,400

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . (190,000)

Indirect materials used . . . . . . . . . . . . . . . . . . . . . (51,400)

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . $ 70,000

Factory Payroll Direct labor incurred . . . . . . . . . . . . . . . . . . . . . . . $ 55,500

Indirect labor incurred . . . . . . . . . . . . . . . . . . . . . . 50,625

Total payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $106,125

Factory Overhead Indirect materials used . . . . . . . . . . . . . . . . . . . . . $ 51,400

Indirect labor used . . . . . . . . . . . . . . . . . . . . . . . . . 50,625

Other overhead costs . . . . . . . . . . . . . . . . . . . . . . . 71,725

Total factory overhead incurred . . . . . . . . . . . . . . $173,750

Factory Overhead Applied Overhead applied (200% of direct labor) . . . . . . . $111,000

Required

Complete the requirements below for the Grinding department. 1. Prepare a physical flow reconciliation for July. 2. Compute the equivalent units of production in July for direct materials and conversion. 3. Compute the costs per equivalent unit of production in July for direct materials and conversion. 4. Prepare a report of costs accounted for and a report of costs to account for.

PLANNING THE SOLUTION Track the physical flow to determine the number of units completed in July. Compute the equivalent units of production for direct materials and conversion.

Chapter 16 Process Costing and Analysis 629

Compute the costs per equivalent unit of production with respect to direct materials and conversion, and determine the cost per unit for each.

Compute the total cost of the goods transferred to Mixing by using the equivalent units and unit costs. Determine (a) the cost of the beginning work in process inventory, (b) the materials and conversion costs added to the beginning work in process inventory, and (c) the materials and conversion costs added to the units started and completed in the month.

SOLUTION 1. Physical flow reconciliation.

Units to Account For Units Accounted For

Beginning work in Units completed and process inventory . . . . . . . . . . . . 5,000 units transferred out . . . . . . . . . . . . . . . . . . . . . . . 17,000 units

Units started this period . . . . . . . . . 20,000 units Ending work in process inventory . . . . . . . . . . 8,000 units

Total units to account for . . . . . . . . 25,000 units Total units accounted for . . . . . . . . . . . . . . . . . 25,000 units

reconciled

2. Equivalent units of production (weighted average).

Direct Equivalent Units of Production Materials Conversion

Equivalent units completed and transferred out . . . . . . . . . . 17,000 EUP 17,000 EUP

Equivalent units in ending work in process

Direct materials (8,000 × 100%) . . . . . . . . . . . . . . . . . . . . 8,000 EUP Conversion (8,000 × 20%) . . . . . . . . . . . . . . . . . . . . . . . . 1,600 EUP Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . 25,000 EUP 18,600 EUP

3. Costs per equivalent unit of production (weighted average).

Direct Costs per Equivalent Unit of Production Materials Conversion

Costs of beginning work in process . . . . . . . . . . . . . . . . . $ 20,000 $ 28,800

Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . 190,000 166,500*

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000 $195,300

÷ Equivalent units of production (from part 2) . . . . . . . . . . 25,000 EUP 18,600 EUP = Costs per equivalent unit of production . . . . . . . . . . . . . $8 .40 per EUP $10 .50 per EUP

*Direct labor of $55,500 + overhead applied of $111,000

4. Reports of costs accounted for and of costs to account for (weighted average).

Report of Costs Accounted For

Cost of units transferred out (cost of goods manufactured) Direct materials ($8 .40 per EUP × 17,000 EUP) . . . . . . . . $142,800 Conversion ($10 .50 per EUP × 17,000 EUP) . . . . . . . . . . . 178,500 Cost of units completed this period . . . . . . . . . . . . . . . . . . $ 321,300

Cost of ending work in process inventory Direct materials ($8 .40 per EUP × 8,000 EUP) . . . . . . . . . 67,200 Conversion ($10 .50 per EUP × 1,600 EUP) . . . . . . . . . . . . 16,800 Cost of ending work in process inventory . . . . . . . . . . . . . 84,000

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,300

Report of Costs to Account For

Cost of beginning work in process inventory Direct materials . . . . . . . . . . . . . . $ 20,000

Conversion . . . . . . . . . . . . . . . . . . 28,800 $ 48,800

Cost incurred this period Direct materials . . . . . . . . . . . . . . 190,000

Conversion . . . . . . . . . . . . . . . . . . 166,500 356,500

Total costs to account for . . . . . . . $405,300

reconciled

630 Chapter 16 Process Costing and Analysis

Refer to the information in Need-To-Know 16-5. For the Grinding department, complete requirements 1 through 4 using the FIFO method. (Round the cost per equivalent unit of conversion to two decimal places.)

SOLUTION 1. Physical flow reconciliation (FIFO).

COMPREHENSIVE 2

FIFO Method (Appendix 16A)

NEED-TO-KNOW 16-6

2. Equivalent units of production (FIFO).

3. Costs per equivalent unit of production (FIFO).

4. Reports of costs accounted for and of costs to account for (FIFO).

Report of Costs Accounted For Cost of units transferred out (cost of goods manufactured) Cost of beginning work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,800 Cost to complete beginning work in process Direct materials ($9 .50 per EUP × 0 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Conversion ($11 .03 per EUP × 1,500 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,545 16,545 Cost of units started and completed this period Direct materials ($9 .50 per EUP × 12,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,000 Conversion ($11 .03 per EUP × 12,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,360 246,360 Total cost of units finished this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311,705

Cost of ending work in process inventory Direct materials ($9 .50 per EUP × 8,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76,000 Conversion ($11 .03 per EUP × 1,600 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,648 Total cost of ending work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,648 Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,353

Report of Costs to Account For Cost of beginning work in process inventory Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,800 $ 48,800

Costs incurred this period Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166,500 356,500 Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,300

re co

nc ile

d (w

ith $

53

ro un

di ng

d iff

er en

ce )

Units to Account For Units Accounted For

Beginning work in Units completed and process inventory . . . . . . . . . . . . 5,000 units transferred out . . . . . . . . . . . . . . . . . . . . . . . 17,000 units

Units started this period . . . . . . . . . 20,000 units Ending work in process inventory . . . . . . . . . . 8,000 units

Total units to account for . . . . . . . . 25,000 units Total units accounted for . . . . . . . . . . . . . . . . . 25,000 units

reconciled

Equivalent Units of Production Direct Materials Conversion

(a) Equivalent units complete beginning work in process Direct materials (5,000 × 0%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 EUP Conversion (5,000 × 30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 EUP (b) Equivalent units started and completed . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 EUP 12,000 EUP (c) Equivalent units in ending work in process Direct materials (8,000 × 100%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 EUP Conversion (8,000 × 20%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600 EUP Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 EUP 15,100 EUP

*Direct labor of $55,500 plus overhead applied of $111,000 †Rounded

Costs per Equivalent Unit of Production Direct Materials Conversion

Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $190,000 $ 166,500*

÷ Equivalent units of production (from part 2) . . . . . . . . . . . . . . . . 20,000 EUP 15,100 EUP = Costs per equivalent unit of production . . . . . . . . . . . . . . . . . . . $9 .50 per EUP $11 .03 per EUP†

Chapter 16 Process Costing and Analysis 631

COMPREHENSIVE 3

NEED-TO-KNOW 16-7

Journal Entries for Process Costing

Garcia Manufacturing produces a product that passes through a molding process and then through an as- sembly process. Partial information related to its manufacturing activities for July follows.

Factory Overhead Applied Molding (150% of direct labor) . . . . . . . . . . . . . . . $ 63,000

Assembly (200% of direct labor) . . . . . . . . . . . . . 110,750

Total factory overhead applied . . . . . . . . . . . . . . . $173,750

Cost Transfers From Molding to Assembly . . . . . . . . . . . . . . . . . . $277,200

From Assembly to finished goods . . . . . . . . . . . . 578,400

From finished goods to cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 506,100

Direct materials Raw materials purchased on credit . . . . . . . . . $400,000

Direct materials used—Molding . . . . . . . . . . . . 190,000

Direct materials used—Assembly . . . . . . . . . . . 88,600

Direct Labor Direct labor—Molding . . . . . . . . . . . . . . . . . . . . $ 42,000

Direct labor—Assembly . . . . . . . . . . . . . . . . . . . 55,375

Factory Overhead (Actual costs) Indirect materials used . . . . . . . . . . . . . . . . . . . $ 51,400

Indirect labor used . . . . . . . . . . . . . . . . . . . . . . 50,625

Other overhead costs . . . . . . . . . . . . . . . . . . . . 71,725

Total factory overhead incurred . . . . . . . . . . . . $173,750

Required

Prepare summary journal entries to record the transactions and events of July for (a) raw materials pur- chases, (b) direct materials usage, (c) indirect materials usage, (d) direct labor usage, (e) indirect labor usage, (f) other overhead costs (credit Other Accounts), (g) application of overhead to the two depart- ments, (h) transfer of partially completed goods from Molding to Assembly, (i) transfer of finished goods out of Assembly, and (j) the cost of goods sold.

SOLUTION Summary journal entries for the transactions and events in July.

a. Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . 400,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . 400,000 Record raw materials purchases. b. Work in Process Inventory—Molding . . . . . . . . . . . . 190,000 Work in Process Inventory—Assembly . . . . . . . . . . . 88,600 Raw Materials Inventory . . . . . . . . . . . . . . . . . 278,600 Record direct materials usage. c. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,400 Raw Materials Inventory . . . . . . . . . . . . . . . . . 51,400 Record indirect materials usage. d. Work in Process Inventory—Molding . . . . . . . . . . . . 42,000 Work in Process Inventory—Assembly . . . . . . . . . . . 55,375 Factory Wages Payable . . . . . . . . . . . . . . . . . . 97,375 Record direct labor usage. e. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,625 Factory Wages Payable . . . . . . . . . . . . . . . . . . 50,625 Record indirect labor usage.

f. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,725 Other Accounts . . . . . . . . . . . . . . . . . . . . . . . . . 71,725 Record other overhead costs. g. Work in Process Inventory—Molding . . . . . . . . . . . . 63,000 Work in Process Inventory—Assembly . . . . . . . . . . . 110,750 Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . 173,750 Record application of overhead. h. Work in Process Inventory—Assembly . . . . . . . . . . . 277,200 Work in Process Inventory—Molding . . . . . . . 277,200 Record transfer of partially completed

goods from Molding to Assembly. i. Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . 578,400 Work in Process Inventory—Assembly . . . . . . 578,400 Record transfer of finished goods

out of Assembly. j. Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . 506,100 Finished Goods Inventory . . . . . . . . . . . . . . . . 506,100 Record cost of goods sold.

APPENDIX

FIFO Method of Process Costing 16A The FIFO method of process costing assigns costs to units assuming a first-in, first-out flow of product. The key difference between the FIFO and weighted-average methods lies in the treatment of beginning work in process inventory. Under the weighted-average method, the number of units and the costs in beginning work in process inventory are combined with production activity in the current period to compute costs per equiv- alent unit. Thus, the weighted-average method combines production activity across two periods.

C4 Describe accounting for production activity and preparation of a process cost summary using FIFO.

632 Chapter 16 Process Costing and Analysis

The FIFO method, in contrast, focuses on production activity in the current period only. The FIFO method assumes that the units that were in process at the beginning of the period are completed during the current period. Thus, under the FIFO method, equivalent units of production are computed as shown in Exhibit 16A.1.

In computing cost per equivalent unit, the FIFO method ignores the cost of beginning work in process inventory. Instead, FIFO uses only the costs incurred in the current period, as shown in Exhibit 16A.2.

EXHIBIT 16A.1 Computing EUP—FIFO Method

Equivalent units of production (EUP)

Number of equivalent units needed to complete

beginning work in process

= Number of whole units

started, completed, and transferred out*

+

*Transferred to next department or finished goods inventory.

+ Number of equivalent units in ending work

in process

EXHIBIT 16A.2 Cost per EUP—FIFO Method

Cost per EUP (FIFO) = Manufacturing costs added during current period

Equivalent units of production during current period

Data We use the data in Exhibit 16A.3 to illustrate the FIFO method for GenX’s Roasting department. EXHIBIT 16A.3 Production Data—Roasting Department (FIFO method)

GenX—Roasting Department: Production Data (April)

Beginning work in process inventory (March 31)

Units of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 units

Percentage of completion—Direct materials . . . . . . . . . . . . . . . . . . . . . . . 100%

Percentage of completion—Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . 65%

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000

Conversion costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,900

Production activity during the current period (April)

Units started this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 units

Units transferred out (completed) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $279,000

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $171,000

Factory overhead costs applied (120% of direct labor) . . . . . . . . . . . . . . . $205,200

Ending work in process inventory (April 30)

Units of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Percentage of completion—Direct materials . . . . . . . . . . . . . . . . . . . . . . . 100%

Percentage of completion—Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . 25%

Exhibit 16A.3 shows selected information from GenX’s Roasting department for the month of April. Accounting for a department’s activity for a period includes four steps: (1) determine physical flow, (2) compute equivalent units, (3) compute cost per equivalent unit, and (4) determine cost assignment and reconciliation. This appendix describes each of these steps using the FIFO method for process costing.

Step 1: Determine Physical Flow of Units A physical flow reconciliation is a report that reconciles (1) the physical units started in a period with (2) the physical units completed in that period. The physical flow reconciliation for GenX’s Roasting department for April is shown in Exhibit 16A.4.

EXHIBIT 16A.4 Physical Flow Reconciliation

GenX—Roasting Department

Units to Account For Units Accounted For

Beginning work in Units completed and process inventory . . . . . . . . . . . . . 30,000 units transferred out . . . . . . . . . . . . . . . . . . . . . 100,000 units

Units started this period . . . . . . . . . . 90,000 units Ending work in process inventory . . . . . . . . 20,000 units

Total units to account for . . . . . . . . . 120,000 units Total units accounted for . . . . . . . . . . . . . . . 120,000 units

reconciled Point: Step 1 is exactly the same under the weighted-average method.

Chapter 16 Process Costing and Analysis 633

In computing equivalent units of production using FIFO, the Roasting department must consider these three distinct groups of units:

Units in beginning work in process inventory (30,000). Units started and completed during the month (70,000). Units in ending work in process inventory (20,000).

GenX’s Roasting department then computes equivalent units of production under FIFO as shown in Exhibit 16A.6. We compute EUP for each of the three distinct groups of units and sum them to find total EUP.

Step 2: Compute Equivalent Units of Production—FIFO Exhibit 16A.4 shows that the Roasting department completed 100,000 units during the month. The FIFO method assumes that the units in beginning inventory were the first units completed during the month. Thus, FIFO assumes that of the 100,000 completed units, 30,000 consist of units in beginning work in process inven- tory that were completed during the month. This means that 70,000 (100,000 − 30,000) units were both started and completed during the month. Exhibit 16A.5 shows how units flowed through the Roasting department, assuming FIFO.

Units completed 100,000

Units in beginning WIP

30,000

Units started and completed

70,000 =–

EXHIBIT 16A.5 FIFO—Flow of Completed Units

GenX—Roasting Department

Equivalent Units of Production Direct Materials Conversion

(a) Equivalent units to complete beginning work in process

Direct materials (30,000 × 0%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 EUP Conversion (30,000 × 35%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 EUP (b) Equivalent units started and completed (70,000 × 100%)* . . . . . . . . . . . . 70,000 EUP 70,000 EUP (c) Equivalent units in ending work in process

Direct materials (20,000 × 100%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 EUP Conversion (20,000 × 25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 EUP Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP

*Units completed this period . . . . . . . . . . . . . . . . . . . . 100,000 units Less units in beginning work in process . . . . . . . . . . 30,000 units Units started and completed this period. . . . . . . . . . . 70,000 units

EXHIBIT 16A.6 Equivalent Units of Production—FIFO

Point: EUP = Number of physical units × Percent of work completed this period.

EUP for Transferred out + EUP for WIP = EUP for Total

Direct Materials To calculate the equivalent units of production for direct materials, we start with the equivalent units in beginning work in process inventory. We see that beginning work in process inventory was 100% complete with respect to materials; no materials were needed to complete these units. Thus, this group of units required 0 EUP during the month. Next, we consider the units started and completed during the month. In terms of direct materials, the 70,000 units started and completed during the month received 100% of their materials during the month. Thus, EUP for this group is 70,000 units (70,000 × 100%). Finally, we consider the units in ending work in process inventory. The Roasting department started but did not complete 20,000 units during the month. This group received all of its materials during the month. Thus, EUP for this group is 20,000 units (20,000 × 100%). The sum of the EUP for these three distinct groups of units is 90,000 (computed as 0 + 70,000 + 20,000), which is the total number of equivalent units of production for direct materials during the month.

Conversion To calculate the equivalent units of production for conversion, we start by determining the per- centage of conversion costs needed to complete the beginning work in process inventory. As Exhibit 16A.3 shows, the beginning work in process inventory of 30,000 units was 65% complete with respect to conver- sion. Thus, this group of units required an additional 35% of conversion costs during the period to com- plete those units (100% − 65%), or 10,500 EUP (30,000 × 35%). Next, we consider the units started and completed during the month. The units started and completed during the month incurred 100% of their conversion costs during the month. Thus, EUP for this group is 70,000 units (70,000 × 100%). Finally, we consider the units in ending work in process inventory. The ending work in process inventory incurred 25% of its conversion costs (see Exhibit 16A.3) during the month. Thus, EUP for this group is 5,000 units

634 Chapter 16 Process Costing and Analysis

(20,000 × 25%). The sum of the EUP for these three distinct groups of units is 85,500 (computed as 10,500 + 70,000 + 5,000). Thus, the Roasting department’s equivalent units of production for conversion for the month is 85,500 units.

A department started the month with beginning work in process inventory of $130,000 ($90,000 for direct materials and $40,000 for conversion). During the month, the department incurred additional direct mate- rials costs of $700,000 and conversion costs of $500,000. Assume that equivalent units for the month were computed as 250,000 for materials and 200,000 for conversion. 1. Compute the department’s cost per equivalent unit of production for the month for direct materials. 2. Compute the department’s cost per equivalent unit of production for the month for conversion.

Solution

1. Cost per EUP of materials = $700,000/250,000 = $2.80 2. Cost per EUP of conversion = $500,000/200,000 = $2.50

C4

Cost per EUP—Direct Materials and Conversion (FIFO)

NEED-TO-KNOW 16-9

Do More: QS 16-15, E 16-7

Step 3: Compute Cost per Equivalent Unit—FIFO To compute cost per equiva- lent unit, we take the direct materials and conversion costs added in April and divide by the equivalent units of production from step 2. Exhibit 16A.7 illustrates these computations.

It is essential to compute costs per equivalent unit for each input because production inputs are added at different times in the process. The FIFO method computes the cost per equivalent unit based solely on this period’s EUP and costs (unlike the weighted-average method, which adds in the costs of the beginning work in process inventory).

Step 4: Assign and Reconcile Costs The equivalent units determined in step 2 and the cost per equivalent unit computed in step 3 are both used to assign costs (1) to units that the production department completed and transferred to the Blending department and (2) to units that remain in process at period-end.

A department began the month with 50,000 units in work in process inventory. These units were 90% complete with respect to direct materials and 40% complete with respect to conversion. During the month, the department started 286,000 units; 220,000 of these units were completed during the month. The re- maining 66,000 units are in ending work in process inventory, 80% complete with respect to direct materi- als and 30% complete with respect to conversion. Use the FIFO method of process costing to: 1. Compute the department’s equivalent units of pro-

duction for the month for direct materials. 2. Compute the department’s equivalent units of pro-

duction for the month for conversion.

Solution—computations to the side show another way to get solutions

1. EUP for materials = (50,000 × 10%) + (220,000 × 100%) + (66,000 × 80%) = 277,800 EUP 2. EUP for conversion = (50,000 × 60%) + (220,000 × 100%) + (66,000 × 30%) = 269,800 EUP

C4

EUP—Direct Materials and Conversion (FIFO)

NEED-TO-KNOW 16-8

Do More: QS 16-14, QS 16-15, E 16-5, E 16-10

Materials Conversion

Current Current Units Month % EUP Month % EUP Finish BI 50,000 10% 5,000 60% 30,000 Start & finish 220,000 100% 220,000 100% 220,000 Start EI 66,000 80% 52,800 30% 19,800 277,800 269,800

GenX—Roasting Department

Cost per Equivalent Unit of Production Direct Materials Conversion

Costs incurred this period (from Exhibit 16A .3) . . . . . . . . . . . . . $279,000 $376,200 ÷ Equivalent units of production (from step 2) . . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP

Cost per equivalent unit of production . . . . . . . . . . . . . . . . . . . . $3 .10 per EUP $4 .40 per EUP

EXHIBIT 16A.7 Cost per Equivalent Unit of Production—FIFO

Cost per EUP = Total costs

EUP

Chapter 16 Process Costing and Analysis 635

As it did in computing equivalent units in step 2, the Roasting department now must compute costs for three distinct groups of units:

Costs to complete the beginning work in process inventory. Costs to complete the units started and completed during the month. Costs of ending work in process inventory.

From the first section of Exhibit 16A.8, the cost of units completed in April includes the $189,900 cost carried over from March for work already applied to the 30,000 units that make up beginning work in process inventory, plus the $46,200 incurred in April to complete those units. The next section includes the $525,000 of cost assigned to the 70,000 units started and completed this period. Thus, the total cost of goods manufactured in April is $761,100.

The computation for cost of ending work in process inventory is in the final section of Exhibit 16A.8. That cost of $84,000 ($62,000 + $22,000) also is the ending balance for the Work in Process Inventory— Roasting account. The Roasting department manager verifies that the total costs assigned to units transferred out and units still in process equal the total costs incurred by production. We reconcile the costs accounted for (in Exhibit 16A.8) to the costs that production was charged for as shown in Exhibit 16A.9.

The Roasting department production manager is responsible for $845,100 in costs: $189,900 that had been assigned to the department’s work in process inventory as of April 1 plus $655,200 of costs the depart- ment incurred in April. At period-end, the manager must identify where those costs were assigned. The production manager can report that $761,100 of cost was assigned to units completed in April and $84,000 was assigned to units still in process at period-end.

Process Cost Summary The final report is the process cost summary, which summarizes key information from previous exhibits. Reasons for the summary are to (1) help managers control and monitor costs, (2) help upper management assess department manager performance, and (3) provide cost information for financial reporting. The process cost summary, using FIFO, for GenX’s Roasting depart- ment is in Exhibit 16A.10. It summarizes the process costing steps. DATA Total costs charged to the department, including direct materials and conversion costs incurred, as well as the cost of the beginning work in process inventory. 1 Physical flow of units. This reconciles the physical units started with the physical units completed in the period. 2 Equivalent units of production for the department. Equivalent units for direct materials and conver- sion are shown in separate columns. 3 Costs per equivalent unit for direct materials and conversion. 4 Assignment of total costs among units worked on in the period.

GenX—Roasting Department Cost of beginning work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 189,900 Cost to complete beginning work in process Direct materials ($3 .10 per EUP × 0 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Conversion ($4 .40 per EUP × 10,500 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,200 46,200 Cost of units started and completed this period Direct materials ($3 .10 per EUP × 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,000 Conversion ($4 .40 per EUP × 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,000 525,000 Total cost of units finished and transferred out this period . . . . . . . . . . . . . . . . . . . . . 761,100 Cost of ending work in process inventory Direct materials ($3 .10 per EUP × 20,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,000 Conversion ($4 .40 per EUP × 5,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Total cost of ending work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,000 Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

EXHIBIT 16A.8 Report of Costs Accounted For—FIFO

Cost of beginning work in process inventory Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,900 $ 189,900 Costs incurred this period Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376,200 655,200 Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

EXHIBIT 16A.9 Report of Costs to Account For—FIFO

Total costs = $845,100

In WIP—Roasting $84,000

To Blending $761,100

636 Chapter 16 Process Costing and Analysis

Cost Manager As cost manager for an electronics manufacturer, you apply a process costing system using FIFO. Your company plans to adopt a just-in-time system and eliminate inventories. What is the impact of using FIFO (versus the weighted-average method) given these plans? ■ Answer: Differences between the FIFO and weighted-average methods are great- est when large work in process inventories exist and when costs fluctuate. The method used if inventories are eliminated does not matter; both produce identical costs.

Decision Maker

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EXHIBIT 16A.10 Process Cost Summary (FIFO)

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GenX COMPANY— ROASTING DEPARTMENT Process Cost Summary (FIFO Method)

For Month Ended April 30

Costs charged to production Costs of beginning work in process inventory

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,000

Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,900 $ 189,900

Costs incurred this period

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,000

Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376,200 655,200

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

Unit information Units to account for Units accounted for

Beginning work in process . . . . . . . . . . . . . 30,000 Transferred out . . . . . . . . . . . . . . . . . . . . 100,000

Units started this period . . . . . . . . . . . . . . . 90,000 Ending work in process . . . . . . . . . . . . . 20,000

Total units to account for . . . . . . . . . . . . . . 120,000 Total units accounted for . . . . . . . . . . . . 120,000

Equivalent units of production Direct Materials Conversion Equivalent units to complete beginning work in process

Direct materials (30,000 × 0%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 EUP Conversion (30,000 × 35%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 EUP Equivalent units started and completed . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 EUP 70,000 EUP

Equivalent units in ending work in process

Direct materials (20,000 × 100%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 EUP Conversion (20,000 × 25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 EUP Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP

Cost per equivalent unit of production Direct Materials Conversion Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $279,000 $376,200

÷ Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP Cost per equivalent unit of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 .10 per EUP $4 .40 per EUP

Cost assignment and reconciliation (cost of units completed and transferred out) Cost of beginning work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 189,900

Cost to complete beginning work in process

Direct materials ($3 .10 per EUP × 0 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Conversion ($4 .40 per EUP × 10,500 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,200 46,200 Cost of units started and completed this period

Direct materials ($3 .10 per EUP × 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,000 Conversion ($4 .40 per EUP × 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,000 525,000 Total cost of units finished this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 761,100

Cost of ending work in process Direct materials ($3 .10 per EUP × 20,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,000 Conversion ($4 .40 per EUP × 5,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Total cost of ending work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,000

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $845,100

WIP—Roasting (in $)

Beg. Inv. 189,900 Incurred 655,200

Subtotal 845,100 761,100 Tr. out

End. Inv. 84,000

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DATA

Chapter 16 Process Costing and Analysis 637

Process operation: Mass production of similar products in a flow of sequential processes. Conversion costs: Direct labor + Applied overhead.

FLOW OF COSTS

PHYSICAL FLOW OF UNITS

Summary: Cheat Sheet

Finished goods

WIP Inventory Process 1

WIP Inventory Process 2

WIP Inventory Process 3

Cost per EU*

Cost per EU* Process 1

*EU = equivalent unit

Cost per EU* Process 2

Cost per EU* Process 3

Direct materials

Overhead

Direct labor

Units to Account For Units Accounted For

Beginning work in Units completed and process inventory . . . . . . . 30,000 units transferred out . . . . . . . . . . . . . . . . 100,000 units Units started this period . . . . 90,000 units Ending work in process inventory . . . 20,000 units Total units to account for . . . . 120,000 units Total units accounted for . . . . . . . . . . 120,000 units

reconciled

EQUIVALENT UNITS OF PRODUCTION (EUP) EUP: Number of units that could have been started and completed given the costs incurred. Compute separately for direct materials and conversion costs. Weighted-average: Combines units and costs across two periods in com- puting EUP. Weighted-average (WA) computations:

Equivalent units of production (EUP)

Number of whole units completed and transferred out*=

Number of equivalent units in ending work in process+

*Transferred to next department or finished goods inventory.

Cost per EUP (WA) = Costs of beginning WIP + Costs incurred this period

Equivalent units of production

FIFO: Based on current-period production activity. FIFO computations:

*Transferred to next department or finished goods inventory.

Equivalent units of production (EUP)

Number of equivalent units needed to complete

beginning work in process

= Number of whole units

started, completed, and transferred out*

+ + Number of equivalent units in ending work

in process

Cost per EUP (FIFO) = Manufacturing costs added during current period

Equivalent units of production during current period

ASSIGN COSTS

JOURNAL ENTRIES Acquire raw materials:

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Assign costs of direct materials used:

Work in Process Inventory—Process 1 . . . . . . . . . . . . . . 279,000

Work in Process Inventory—Process 2 . . . . . . . . . . . . . . 102,000

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . 381,000

Assign costs of direct labor used:

Work in Process Inventory—Process 1 . . . . . . . . . . . . . . 171,000

Work in Process Inventory—Process 2 . . . . . . . . . . . . . . 183,160

Factory Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . 354,160

Apply overhead using predetermined rate:

Work in Process Inventory—Process 1 . . . . . . . . . . . . . . 205,200

Work in Process Inventory—Process 2 . . . . . . . . . . . . . . 219,792

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424,992

Record use of indirect materials:

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . 5,000

Record indirect labor costs:

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500

Factory Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . 3,500

Record actual overhead costs such as insurance, rent, utilities, and depreciation:

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Cash (and other accounts) . . . . . . . . . . . . . . . . . . . . . . 9,500

Record transfer of costs to next department:

Work in Process Inventory—Process 2 . . . . . . . . . . . . . . 762,000

Work in Process Inventory—Process 1 . . . . . . . . . . . . 762,000

Record transfer of costs to finished goods:

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . 1,262,940

Work in Process Inventory—Process 2 . . . . . . . . . . . . 1,262,940

Record cost of goods sold for sold jobs:

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,150

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . 24,150

Record sales for sold jobs:

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Assign underapplied overhead to cost of goods sold:

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Assign overapplied overhead to cost of goods sold:

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Total costs to account for

In Work in Process Inventory

Transferred out

638 Chapter 16 Process Costing and Analysis

Multiple Choice Quiz

1. Equivalent units of production are equal to a. Physical units that were completed this period from all

effort being applied to them. b. The number of units introduced into the process this period. c. The number of finished units actually completed this

period. d. The number of units that could have been started and

completed given the cost incurred. e. The number of units in the process at the end of the period.

2. Recording the cost of raw materials purchased for use in a process costing system includes a a. Credit to Raw Materials Inventory. b. Debit to Work in Process Inventory. c. Debit to Factory Overhead. d. Credit to Factory Overhead. e. Debit to Raw Materials Inventory.

3. The Cutting department started the month with a beginning work in process inventory of $20,000. During the month, it was assigned the following costs: direct materials, $152,000; direct labor, $45,000; and overhead applied at the

rate of 40% of direct labor cost. Inventory with a cost of $218,000 was transferred to the next department. The end- ing balance of Work in Process Inventory—Cutting is a. $330,000. c. $220,000. e. $118,000. b. $17,000. d. $112,000.

4. A process’s beginning work in process inventory consists of 10,000 units that are 20% complete with respect to conver- sion costs. A total of 40,000 units are completed this pe- riod. There are 15,000 units in work in process, one-third complete for conversion, at period-end. The equivalent units of production (EUP) with respect to conversion at period-end, assuming the weighted-average method, are a. 45,000 EUP. c. 5,000 EUP. e. 43,000 EUP. b. 40,000 EUP. d. 37,000 EUP.

5. Assume the same information as in question 4. Also assume that beginning work in process had $6,000 in conversion cost and that $84,000 in conversion is added during this pe- riod. What is the cost per EUP for conversion? a. $0.50 per EUP c. $2.00 per EUP e. $2.25 per EUP b. $1.87 per EUP d. $2.10 per EUP

ANSWERS TO MULTIPLE CHOICE QUIZ

1. d 2. e 3. b; $20,000 + $152,000 + $45,000 + $18,000 − $218,000 = $17,000

4. a; 40,000 + (15,000 × 1∕3) = 45,000 EUP 5. c; ($6,000 + $84,000) ÷ 45,000 EUP = $2 per EUP

Conversion cost per equivalent unit (614) Equivalent units of production

(EUP) (614) FIFO method (614)

Hybrid costing system (627) Job order costing system (613) Materials consumption report (626) Operation costing system (627)

Process cost summary (619) Process costing system (613) Process operations (611) Weighted-average method (614)

Key Terms

A Superscript letter A denotes assignments based on Appendix 16A.

Icon denotes assignments that involve decision making.

1. What is the main factor for a company in choosing be- tween job order costing and process costing systems? Give two likely applications of each system.

2. The focus in a job order costing system is the job or batch. Identify the main focus in process costing.

3. Can services be delivered by means of process opera- tions? Support your answer with an example.

4. Are the journal entries that match cost flows to product flows in process costing primarily the same or much differ- ent than those in job order costing? Explain.

5. Identify the control document for materials flow when a materials requisition slip is not used.

6. Explain in simple terms the notion of equivalent units of production (EUP). Why is it necessary to use EUP in process costing?

7. What are the two main inventory methods used in process costing? What are the differences between these methods?

8. Why is it possible for direct labor in process operations to include the labor of employees who do not work directly on products or services?

Discussion Questions

Chapter 16 Process Costing and Analysis 639

9. Direct labor costs flow through what accounts in a company’s process cost system?

10. At the end of a period, what balance should remain in the Factory Overhead account?

11. Is it possible to have under- or overapplied overhead costs in a process costing system? Explain.

12. Explain why equivalent units of production for both direct labor and overhead can be the same as, and why they can be different from, equivalent units for direct materials.

13. List the four steps in accounting for production activity in a reporting period (for process operations).

14. Companies such as Apple commonly prepare a process cost summary. What purposes does a process cost summary serve?

15. Are there situations where Google can use process costing? Identify at least one and explain it.

16. Samsung produces digital televi- sions with a multiple-process production line. Identify and list some of its production processing steps and departments.

17. General Mills needs a steady supply of ingredients for processing. What are some risks the company faces regard- ing its ingredients?

18. How could a company manager use a process cost summary to determine if a program to reduce water usage is successful?

19. Explain a hybrid costing system. Identify a product or service operation that might be suited to a hybrid costing system.

APPLE

GOOGLE

Samsung

QUICK STUDY

QS 16-1 Process vs. job order operations C1

For each of the following products and services, indicate whether it is more likely produced in a process operation (P) or in a job order operation (J).

1. Tennis courts 2. Organic juice

3. Audit of financial statements 4. Luxury yachts

5. Vanilla ice cream 6. Tennis balls

QS 16-2 Process vs. job order costing

A1

Label each statement below as either true (T) or false (F). 1. The cost per equivalent unit is computed as the total costs of a process divided by the number

of equivalent units passing through that process. 2. Service companies are not able to use process costing. 3. Costs per job are computed in both job order and process costing systems. 4. Job order and process operations both combine materials, labor, and overhead in producing

products or services.

QS 16-3 Process vs. job order operations

C1

For each of the following products and services, indicate whether it is more likely produced in a process operation (P) or a job order operation (J).

1. Beach toys 4. Wedding reception 7. Tattoos 2. Concrete swimming pool 5. Custom suits 8. Guitar picks 3. iPhones 6. Juice 9. Solar panels

QS 16-5 Weighted average: Computing equivalent units of production C2

Refer to QS 16-4. Compute the total equivalent units of production for conversion using the weighted- average method.

QS 16-6A FIFO: Computing equivalent units C4

Refer to QS 16-4. Compute the total equivalent units of production for conversion using the FIFO method.

QS 16-4 Physical flow reconciliation

C2

Prepare a physical flow reconciliation with the information below.

Blending Process Units of Product Percent of Conversion

Beginning work in process . . . . . . . . . . . . . 150,000 80%

Goods started . . . . . . . . . . . . . . . . . . . . . . . 310,000 100

Goods completed . . . . . . . . . . . . . . . . . . . . 340,000 100

Ending work in process . . . . . . . . . . . . . . . 120,000 25

640 Chapter 16 Process Costing and Analysis

QS 16-7 Weighted average: Cost per EUP C3

A production department’s beginning inventory cost includes $394,900 of conversion costs. This depart- ment incurs an additional $907,500 in conversion costs in the month of March. Equivalent units of pro- duction for conversion total 740,000 for March. Calculate the cost per equivalent unit of conversion using the weighted-average method.

QS 16-9A FIFO: Computing equivalent units C4

Refer to QS 16-8 and compute the total equivalent units of production for conversion for July using the FIFO method.

QS 16-11 Weighted average: Cost per EUP C3

Refer to the information in QS 16-10. Calculate the Assembly department’s cost per equivalent unit of production for materials and for conversion for November. Use the weighted-average method.

QS 16-12 Weighted average: Assigning costs to output

C3

Refer to the information in QS 16-10. Assign costs to the Assembly department’s output—specifically, the units transferred out to the Painting department and the units that remain in process in the Assembly de- partment at month-end. Use the weighted-average method.

QS 16-13 Weighted average: Journal entry to transfer costs P4

Refer to the information in QS 16-10. Prepare the November 30 journal entry to record the transfer of costs from the Assembly department to the Painting department. Use the weighted-average method.

QS 16-14A FIFO: Equivalent units of production C4

Refer to the information in QS 16-10. Calculate the Assembly department’s equivalent units of production for materials and for conversion for November. Use the FIFO method.

QS 16-8 Weighted average: Computing equivalent units of production C2

The following refers to units processed by an ice cream maker in July. Compute the total equivalent units of production for conversion for July using the weighted-average method.

Gallons of Product Percent of Conversion

Beginning work in process . . . . . . . . . . . . 320,000 25%

Goods started . . . . . . . . . . . . . . . . . . . . . . . 620,000 100

Goods completed . . . . . . . . . . . . . . . . . . . . 680,000 100

Ending work in process . . . . . . . . . . . . . . . 260,000 75

QS 16-10 Weighted average: Equivalent units of production C2

The following information applies to QS 16-10 through QS 16-17.

Carlberg Company has two manufacturing departments, Assembly and Painting. The Assembly depart- ment started 10,000 units during November. The following production activity unit and cost information refers to the Assembly department’s November production activities.

Percent of Direct Percent of Assembly Department Units Materials Conversion

Beginning work in process . . . . . . . . . . . . . . . 2,000 60% 40%

Units transferred out . . . . . . . . . . . . . . . . . . . 9,000 100 100

Ending work in process . . . . . . . . . . . . . . . . . 3,000 80 30

Required

Calculate the Assembly department’s equivalent units of production for materials and for conversion for November. Use the weighted-average method.

Beginning work in process inventory—Assembly dept . . . . $1,581 (consists of $996 for direct materials and $585 for conversion)

Costs added during the month:

Direct materials . . . . . . . . . . . $10,404

Conversion . . . . . . . . . . . . . . . $12,285

Chapter 16 Process Costing and Analysis 641

QS 16-15A FIFO: Cost per EUP C4

Refer to the information in QS 16-10. Calculate the Assembly department’s cost per equivalent unit of production for materials and for conversion for November. Use the FIFO method.

QS 16-16A FIFO: Assigning costs to output C4

Refer to the information in QS 16-10. Assign costs to the Assembly department’s output—specifically, the units transferred out to the Painting department and the units that remain in process in the Assembly de- partment at month-end. Use the FIFO method.

QS 16-17A FIFO: Journal entry to transfer costs P4

Refer to the information in QS 16-10. Prepare the November 30 journal entry to record the transfer of costs from the Assembly department to the Painting department. Use the FIFO method.

QS 16-19 Weighted average: Assigning costs to output

C3

Refer to information in QS 16-18. Using the weighted-average method, assign direct materials costs to the Molding department’s output—specifically, the units transferred out to the Packaging department and the units that remain in process in the Molding department at month-end.

QS 16-18 Weighted average: Computing equivalent units and cost per EUP (direct materials)

C2 C3

Zia Co. makes flowerpots from recycled plastic in two departments, Molding and Packaging. At the be- ginning of the month, the Molding department has 2,000 units in inventory, 70% complete as to materials. During the month, the Molding department started 18,000 units. At the end of the month, the Molding department had 3,000 units in ending inventory, 80% complete as to materials. Units completed in the Molding department are transferred into the Packaging department.

Cost information for the Molding department for the month follows.

Using the weighted-average method, compute the Molding department’s (a) equivalent units of produc- tion for materials and (b) cost per equivalent unit of production for materials for the month. (Round to two decimal places.)

Beginning work in process inventory (direct materials) . . . . . . . . $ 1,200

Direct materials added during the month . . . . . . . . . . . . . . . . . . . 27,900

QS 16-20 Transfer of costs; ending WIP balances C3

Azule Co. manufactures in two sequential processes, Cutting and Binding. The two departments report the information below for a recent month. Determine the ending balances in the Work in Process Inventory accounts of each department.

Cutting Binding

Beginning work in process

Transferred in from Cutting dept . . . . . $ 1,200

Direct materials . . . . . . . . . . . . . . . . . . $ 845 1,926

Conversion . . . . . . . . . . . . . . . . . . . . . . 2,600 3,300

Cutting Binding

Costs added during March

Direct materials . . . . . . . . . . . . . . . . $ 8,240 $ 6,356

Conversion . . . . . . . . . . . . . . . . . . . . 11,100 18,575

Transferred in from Cutting dept . . . 15,685

Transferred to finished goods . . . . . 30,000

QS 16-21A FIFO: Computing equivalent units and cost per EUP (direct materials)

C4

BOGO Inc. has two sequential processing departments, Roasting and Mixing. At the beginning of the month, the Roasting department had 2,000 units in inventory, 70% complete as to materials. During the month, the Roasting department started 18,000 units. At the end of the month, the Roasting department had 3,000 units in ending inventory, 80% complete as to materials.

Cost information for the Roasting department for the month follows.

Using the FIFO method, compute the Roasting department’s (a) equivalent units of production for materi- als and (b) cost per equivalent unit of production for materials for the month.

Beginning work in process inventory (direct materials) . . . . . . . . . . . . . $ 2,170

Direct materials added during the month . . . . . . . . . . . . . . . . . . . . . . . . 27,900

642 Chapter 16 Process Costing and Analysis

Refer to QS 16-21. Using the FIFO method, assign direct materials costs to the Roasting department’s output—specifically, the units transferred out to the Mixing department and the units that remain in pro- cess in the Roasting department at month-end.

QS 16-22 A FIFO: Assigning costs to output C4

Hotwax makes surfboard wax in two sequential processes. This period, Hotwax purchased on account $62,000 in raw materials. Its Mixing department requisitioned $50,000 of direct materials for use in produc- tion. Prepare journal entries to record its (1) purchase of raw materials and (2) requisition of direct materials.

QS 16-23 Recording costs of materials P1

Prepare journal entries to record the following production activities for Hotwax. 1. Incurred $75,000 of direct labor in its Mixing department and $50,000 of direct labor in its Shaping

department (credit Factory Wages Payable). 2. Incurred indirect labor of $10,000 (credit Factory Wages Payable). 3. Total factory payroll of $135,000 was paid in cash.

QS 16-24 Recording costs of labor

P2

Prepare journal entries to record the following production activities for Hotwax. 1. Requisitioned $9,000 of indirect materials for use in production of surfboard wax. 2. Incurred $156,000 overhead costs (credit Other Accounts). 3. Applied overhead at the rate of 140% of direct labor costs. Direct labor costs were $75,000 in the

Mixing department and $50,000 in the Shaping department.

QS 16-25 Recording costs of factory overhead

P1 P3

Identify each of the following features as applying more to job order operations (J), process operations (P), or both job order and process operations (B).

1. Cost object is a process. 4. Uses indirect costs. 2. Measures unit costs only at period-end. 5. Uses only one Work in Process account. 3. Transfers costs between Work in Process 6. Uses materials, labor, and overhead costs.

Inventory accounts.

Exercise 16-2 Comparing process and job order operations

C1

Hotwax completed products costing $275,000 and transferred them to finished goods. Prepare the journal entry to record the transfer of units from Shaping to finished goods inventory.

QS 16-26 Recording transfer of costs to finished goods P4

EXERCISES

Exercise 16-1 Process vs. job order operations C1

For each of the following products and services, indicate whether it is more likely produced in a process operation (P) or in a job order operation (J).

1. Beach towels 4. Headphones 7. Cut flower arrangements 2. Bolts and nuts 5. Designed patio 8. House paints 3. Lawn chairs 6. Door hardware 9. Concrete swimming pools

Match each of the following items A through G with the best numbered description of its purpose. A. Factory Overhead account E. Raw Materials Inventory account B. Process cost summary F. Materials requisition C. Equivalent units of production G. Finished Goods Inventory account D. Work in Process Inventory accounts

1. Notifies the materials manager to send materials to a production department. 2. Holds indirect costs until assigned to production. 3. Hold production costs until products are transferred from production to finished goods (or

another department). 4. Standardizes partially completed units into equivalent completed units. 5. Holds costs of finished products until sold to customers. 6. Describes the activity and output of a production department for a period. 7. Holds costs of materials until they are used in production or as factory overhead.

Exercise 16-3 Terminology in process costing

C1 A1

Chapter 16 Process Costing and Analysis 643

Refer to the information in Exercise 16-4 and complete the requirements for each of the three separate as- sumptions using the FIFO method for process costing.

Exercise 16-5A FIFO: Computing equivalent units C4

A production department in a process manufacturing system completed its work on 80,000 units of product and transferred them to the next department during a recent period. Of these units, 24,000 were in process at the beginning of the period. The other 56,000 units were started and completed during the period. At period-end, 16,000 units were in process. Compute the production department’s equivalent units of produc- tion for direct materials under each of three separate assumptions using the weighted-average method: 1. All direct materials are added to products when processing begins. 2. Beginning inventory is 40% complete as to materials and conversion costs. Ending inventory is 75%

complete as to materials and conversion costs. 3. Beginning inventory is 60% complete as to materials and 40% complete as to conversion costs. Ending

inventory is 30% complete as to materials and 60% complete as to conversion costs.

Exercise 16-4 Weighted average: Computing equivalent units

C2

Refer to the information in Exercise 16-6. Assume that Fields uses the FIFO method of process costing. 1. Calculate the equivalent units of production for the Forming department. 2. Calculate the costs per equivalent unit of production for the Forming department.

Exercise 16-7A FIFO: Costs per EUP

C4

During April, the first production department of a process manufacturing system completed its work on 300,000 units of a product and transferred them to the next department. Of these transferred units, 60,000 were in process in the production department at the beginning of April and 240,000 were started and com- pleted in April. April’s beginning inventory units were 60% complete with respect to materials and 40% complete with respect to conversion. At the end of April, 82,000 additional units were in process in the production department and were 80% complete with respect to materials and 30% complete with respect to conversion. Compute the number of equivalent units with respect to both materials used and conversion used in the first production department for April using the weighted-average method.

Exercise 16-8 Weighted average: Computing equivalent units of production

C2

Exercise 16-6 Weighted average: Cost per EUP and costs assigned to output

C3

Fields Company has two manufacturing departments, Forming and Painting. The company uses the weighted-average method of process costing. At the beginning of the month, the Forming department has 25,000 units in inventory, 60% complete as to materials and 40% complete as to conversion costs. The beginning inventory cost of $60,100 consisted of $44,800 of direct materials costs and $15,300 of conver- sion costs.

During the month, the Forming department started 300,000 units. At the end of the month, the Forming department had 30,000 units in ending inventory, 80% complete as to materials and 30% complete as to conversion. Units completed in the Forming department are transferred to the Painting department.

Cost information for the Forming department follows.

1. Calculate the equivalent units of production for the Forming department. 2. Calculate the costs per equivalent unit of production for the Forming department. 3. Using the weighted-average method, assign costs to the Forming department’s output—specifically,

its units transferred to Painting and its ending work in process inventory.

Beginning work in process inventory . . . . . . . . . . . . . . . . . . $ 60,100

Direct materials added during the month . . . . . . . . . . . . . . . 1,231,200

Conversion added during the month . . . . . . . . . . . . . . . . . . . 896,700

The production department described in Exercise 16-8 had $850,368 of direct materials and $649,296 of conversion costs charged to it during April. Also, its April beginning inventory of $167,066 consists of $118,472 of direct materials cost and $48,594 of conversion costs. 1. Compute the direct materials cost per equivalent unit for April. 2. Compute the conversion cost per equivalent unit for April. 3. Using the weighted-average method, assign April’s costs to the department’s output—specifically, its

units transferred to the next department and its ending work in process inventory.

Exercise 16-9 Weighted average: Costs assigned to output and inventories

C2

644 Chapter 16 Process Costing and Analysis

Refer to the information in Exercise 16-8 to compute the number of equivalent units with respect to both materials and conversion costs in the production department for April using the FIFO method.

Exercise 16-10A FIFO: Computing equivalent units of production C4

Refer to the information in Exercise 16-9 and complete its parts 1, 2, and 3 using the FIFO method.Exercise 16-11A FIFO: Costs assigned to output C4 P4

The following partially completed process cost summary describes the July production activities of the Molding department at Ashad Company. Its production output is sent to the next department. All direct materials are added to products when processing begins. Beginning work in process inventory is 20% com- plete with respect to conversion. Prepare its process cost summary using the weighted-average method.

Exercise 16-12 Weighted average: Completing a process cost summary C3

Direct Equivalent Units of Production Materials Conversion

Units transferred out . . . . . . . . . . . . . . 32,000 EUP 32,000 EUP

Units of ending work in process . . . . 2,500 EUP 1,500 EUP

Equivalent units of production . . . . . . 34,500 EUP 33,500 EUP

Direct Costs per EUP Materials Conversion

Costs of beginning work in process . . . . $ 18,550 $ 2,280

Costs incurred this period . . . . . . . . . . 357,500 188,670

Total costs . . . . . . . . . . . . . . . . . . . . . . . $376,050 $190,950

Units

Units in beginning work in process (all completed during July) . . . . 2,000

Units started this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,500

Units completed and transferred out . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Units in ending work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Refer to the information in Exercise 16-12. Prepare a process cost summary using the FIFO method. (Round cost per equivalent unit calculations to two decimal places.)

Exercise 16-13A FIFO: Completing a process cost summary

C3 C4

The following additional information describes the company’s manufacturing activities for June.

Pro-Weave manufactures stadium blankets by passing the products through a Weaving department and a Sewing department. The following information is available regarding its June inventories.

Exercise 16-14 Production cost flow and measurement; journal entries

P4 Beginning Ending Inventory Inventory

Raw materials inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 120,000 $ 185,000

Work in process inventory—Weaving . . . . . . . . . . . . . . . . . . . . . . . 300,000 330,000

Work in process inventory—Sewing . . . . . . . . . . . . . . . . . . . . . . . . 570,000 700,000

Finished goods inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,266,000 1,206,000

Raw materials purchases (on credit) . . . . . . . . . . . . . . . . . . . $ 500,000

Factory payroll cost (paid in cash) . . . . . . . . . . . . . . . . . . . . . 3,060,000

Other factory overhead cost (Other Accounts credited) . . . . 156,000

Materials used

Direct—Weaving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 240,000

Direct—Sewing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Labor used

Direct—Weaving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000

Direct—Sewing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000

Overhead rates as a percent of direct labor

Weaving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80%

Sewing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150%

Sales (on credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000

Chapter 16 Process Costing and Analysis 645

Required

1. Compute the (a) cost of products transferred from Weaving to Sewing, (b) cost of products transferred from Sewing to finished goods, and (c) cost of goods sold.

2. Prepare journal entries dated June 30 to record (a) goods transferred from Weaving to Sewing, (b) goods transferred from Sewing to finished goods, (c) sale of finished goods, and (d) cost of goods sold.

Check (1c) Cost of goods sold, $3,275,000

Oslo Company produces large quantities of a standardized product. The following information is available for the first process in its production activities for May.

Exercise 16-17 Weighted average: Process cost summary C3

Units Costs Beginning work in process inventory . . . . . . . . . . 4,000 Beginning work in process inventory

Started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Direct materials . . . . . . . . . . . . . . . . . . . . $2,880

Ending work in process inventory . . . . . . . . . . . . . 3,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . 5,358 $ 8,238

Direct materials added . . . . . . . . . . . . . . . . 197,120

Status of ending work in process inventory Direct labor added . . . . . . . . . . . . . . . . . . . . 123,680 Materials—Percent complete . . . . . . . . . . . . . . 100% Overhead applied (90% of direct labor) . . . 111,312

Conversion—Percent complete . . . . . . . . . . . . . 25% Total costs to account for . . . . . . . . . . . . . . $440,350

Ending work in process inventory . . . . . . . . $ 50,610

Prepare a process cost summary report for this process using the weighted-average method. Check Cost per equivalent unit: materials, $12.50

RSTN Co. produces its product through two sequential processing departments. Direct materials and con- version are added to the product evenly throughout each process.

During October, the first process finished and transferred 150,000 units of its product to the second process. Of these units, 30,000 were in process at the beginning of the month and 120,000 were started and completed during the month. The beginning work in process inventory was 30% complete. At the end of the month, the work in process inventory consisted of 20,000 units that were 80% complete.

Compute the number of equivalent units of production for the first process for October using the FIFO method.

Exercise 16-18A FIFO: Equivalent units

C4 P4

The flowchart below shows the August production activity of the Punching and Bending departments of Wire Box Company. Use the amounts shown on the flowchart to compute the missing numbers identified by question marks.

Exercise 16-19 Production cost flows

P1 P2 P3 P4

Elliott Company produces large quantities of a standardized product. The following information is avail- able for the first process in its production activities for March.

Exercise 16-16 Weighted average: Process cost summary C3

Prepare a process cost summary report for this process using the weighted-average method. Check Cost per equivalent unit: conversion, $25.92

Units Costs Beginning work in process inventory . . . . . . . . . . . 2,000 Beginning work in process inventory

Started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Direct materials . . . . . . . . . . . . . . . . . . . . . $2,500

Ending work in process inventory . . . . . . . . . . . . . . 5,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . . 6,360 $ 8,860

Direct materials added . . . . . . . . . . . . . . . . 168,000

Status of ending work in process inventory Direct labor added . . . . . . . . . . . . . . . . . . . . 199,850 Materials—Percent complete . . . . . . . . . . . . . . . 100% Overhead applied (140% of direct labor) . . . 279,790

Conversion—Percent complete . . . . . . . . . . . . . 35% Total costs to account for . . . . . . . . . . . . . . . $656,500

Ending work in process inventory . . . . . . . . $ 84,110

Refer to the information in Exercise 16-14. Prepare journal entries dated June 30 to record (a) raw materi- als purchases, (b) direct materials usage, (c) indirect materials usage, (d) direct labor usage, (e) indirect labor usage, ( f ) other overhead costs, (g) overhead applied, and (h) payment of total payroll costs.

Exercise 16-15 Recording product costs

P1 P2 P3

646 Chapter 16 Process Costing and Analysis

Beginning inventory $18,000

Warehouse Ending

inventory $_______

Cost of goods sold $231,900

Cost of goods available for sale

$_______?

Beginning work in process

$9,750

Bending

Direct materials

$_______

Direct labor

$30,750

Factory overhead $36,900

Ending work in process

$12,750

Total costs in process in Bending department

$249,150

?

Costs transferred to finished goods

$_______?

?

Beginning work in process

$7,500

Punching

Direct materials $60,000

Direct labor

$12,000

Factory overhead $15,000

Ending work in process

$6,000

Total costs in process in Punching department

$_______?

Costs transferred to Bending $_______?

Hi-Test Company uses the weighted-average method of process costing to assign production costs to its products. Information for the company’s first production process for September follows. Assume that all materials are added at the beginning of this production process, and that conversion costs are added uniformly throughout the process.

Exercise 16-20 Weighted average: Process cost summary

C3

Work in process inventory, September 1 (2,000 units, 100% complete with respect to direct materials, 80% complete with respect to direct labor and overhead; consists of $45,000 of direct materials cost and $56,320 conversion cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $101,320 Costs incurred in September Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,000 Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $341,000 Work in process inventory, September 30 (7,000 units, 100% complete with respect to direct materials, 40% complete with respect to conversion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ? Units started in September . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Units completed and transferred to finished goods inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000

Compute each of the following using the weighted-average method of process costing. 1. The number of equivalent units for materials for the month. 2. The number of equivalent units for conversion for the month. 3. The cost per equivalent unit of materials for the month. 4. The cost per equivalent unit for conversion for the month. 5. The total cost of goods transferred out. 6. The total cost of ending work in process inventory.

Chapter 16 Process Costing and Analysis 647

Prepare journal entries to record the following production activities. 1. Purchased $80,000 of raw materials on credit. 2. Used $42,000 of direct materials in the Roasting department. 3. Used $22,500 of indirect materials in production.

Exercise 16-21 Recording costs of materials

P1

Prepare journal entries to record the following production activities. 1. Incurred $42,000 of direct labor in the Roasting department and $33,000 of direct labor in the Blending

department (credit Factory Wages Payable). 2. Incurred $20,000 of indirect labor in production (credit Factory Wages Payable). 3. Paid factory payroll of $95,000.

Exercise 16-22 Recording costs of labor

P2

Prepare journal entries to record the following production activities. 1. Paid overhead costs (other than indirect materials and indirect labor) of $38,750. 2. Applied overhead at 110% of direct labor costs. Direct labor costs were $42,000 in the Roasting

department and $33,000 in the Blending department.

Exercise 16-23 Recording overhead costs

P3

Prepare journal entries to record the following production activities. 1. Transferred completed goods from the Assembly department to finished goods inventory. The goods

cost $135,600. 2. Sold $315,000 of goods on credit. Their cost is $175,000.

Exercise 16-24 Recording cost of completed goods

P4

The following journal entries are recorded in Kiesha Co.’s process costing system. Kiesha produces ap- parel and accessories. Overhead is applied to production based on direct labor cost for the period. Prepare a brief explanation (including any overhead rates applied) for each journal entry a through k.

Exercise 16-26 Interpretation of journal entries in process costing

P1 P2 P3 P4

a. Raw Materials Inventory . . . . . . . . . . . . . . . . . . 52,000 Accounts Payable . . . . . . . . . . . . . . . . . . 52,000

b. Work in Process Inventory . . . . . . . . . . . . . . . . 42,000 Raw Materials Inventory . . . . . . . . . . . . . 42,000

c. Work in Process Inventory . . . . . . . . . . . . . . . . 32,000 Factory Wages Payable . . . . . . . . . . . . . . 32,000

d. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . 6,000 Factory Wages Payable . . . . . . . . . . . . . . 6,000

e. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . 12,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

f. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . 10,000 Raw Materials Inventory . . . . . . . . . . . . . 10,000

g. Factory Wages Payable . . . . . . . . . . . . . . . . . . 38,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000

h. Work in Process Inventory . . . . . . . . . . . . . . . . 33,600 Factory Overhead . . . . . . . . . . . . . . . . . . 33,600

i. Finished Goods Inventory . . . . . . . . . . . . . . . . 88,000 Work in Process Inventory . . . . . . . . . . . 88,000

j. Accounts Receivable . . . . . . . . . . . . . . . . . . . . 250,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

k. Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . 100,000 Finished Goods Inventory . . . . . . . . . . . . 100,000

Exercise 16-25 Recording cost flows in a process cost system

P1 P2 P3 P4

Re-Tire produces bagged mulch made from recycled tires. Production involves shredding tires and bag- ging the pieces in the Bagging department. All direct materials enter in the Shredding process. The follow- ing describes production operations for October.

A B 1 2 3 4 5 6

Direct materials used (Shredding) Direct labor used (20% in Shredding; 80% in Bagging) Predetermined overhead rate (based on direct labor) Transferred to Bagging Transferred from Bagging to finished goods

175% $ 595,000 $ 580,000

$ 130,000 $ 522,000

The company’s revenue for the month totaled $950,000 from credit sales, and its cost of goods sold for the month is $540,000. Prepare summary journal entries dated October 31 to record its October production activities for (1) direct materials usage, (2) direct labor incurred, (3) overhead applied, (4) goods transfer from Shredding to Bagging, (5) goods transfer from Bagging to finished goods, (6) credit sales, and (7) cost of goods sold.

Check (3) Cr. Factory Overhead, $227,500

648 Chapter 16 Process Costing and Analysis

PROBLEM SET A

Problem 16-1A Production cost flow and measurement; journal entries

P1 P2 P3 P4

Sierra Company manufactures soccer balls in two sequential processes: Cutting and Stitching. All direct materials enter production at the beginning of the cutting process. The following information is available regarding its May inventories.

Beginning Ending Inventory Inventory

Raw materials inventory . . . . . . . . . . . . . . . . $ 6,000 $ 9,250

Work in process inventory—Cutting . . . . . . 43,500 51,500

Work in process inventory—Stitching . . . . . 63,300 60,500

Finished goods inventory . . . . . . . . . . . . . . . 20,100 8,250

The following additional information describes the company’s production activities for May.

Required

1. Compute the amount of (a) production costs transferred from Cutting to Stitching, (b) production costs transferred from Stitching to finished goods, and (c) cost of goods sold.

2. Prepare summary journal entries dated May 31 to record the following May activities: (a) raw materi- als purchases, (b) direct materials usage, (c) indirect materials usage, (d) direct labor costs incurred, (e) indirect labor costs incurred, ( f ) payment of factory payroll, (g) other overhead costs (credit Other Accounts), (h) overhead applied, (i) goods transferred from Cutting to Stitching, ( j) goods transferred from Stitching to finished goods, (k) cost of goods sold, and (l) sales.

Check (1c) Cost of goods sold, $213,905

Direct Materials Raw materials purchased on credit . . . . . $ 25,000

Direct materials used—Cutting . . . . . . . . 21,750

Direct materials used—Stitching . . . . . . . 0

Direct Labor Direct labor—Cutting . . . . . . . . . . . . . . . . $ 15,600

Direct labor—Stitching . . . . . . . . . . . . . . . 62,400

Total factory payroll paid (in cash) . . . . . . 133,000

Factory Overhead (actual costs) Indirect materials used . . . . . . . . $ 6,000

Indirect labor used . . . . . . . . . . . . 55,000

Other overhead costs . . . . . . . . . 47,000

Factory Overhead Rates Cutting . . . . . . . . . . . . . . . . . . . . . 150% of direct materials used

Stitching . . . . . . . . . . . . . . . . . . . . 120% of direct labor used

Sales . . . . . . . . . . . . . . . . . . . . . . . $256,000

Victory Company uses weighted-average process costing to account for its production costs. The company has two production processes. Conversion cost is added evenly throughout each process. Direct materials are added at the beginning of the first process. Additional information for the first process follows.

During November, the first process transferred 700,000 units of product to the second process. At the end of November, work in process inventory consists of 180,000 units that are 30% complete with respect to conversion. Beginning work in process inventory had $420,000 of direct materials and $139,000 of conversion cost. The direct material cost added in November is $2,220,000, and the conversion cost added is $3,254,000. Beginning work in process consisted of 60,000 units that were 100% complete with respect to direct materials and 80% complete with respect to conversion. Of the units completed, 60,000 were from beginning work in process and 640,000 units were started and completed during the period.

Required

For the first process: 1. Determine the equivalent units of production with respect to (a) direct materials and (b) conversion. 2. Compute both the direct material cost and the conversion cost per equivalent unit. 3. Compute the direct material cost and the conversion cost assigned to (a) units completed and trans-

ferred out and (b) ending work in process inventory.

Problem 16-2A Weighted average: Cost per equivalent unit; costs assigned to products

C2 C3

Check (2) Conversion cost per equivalent unit, $4.50 (3b) $783,000

Problem 16-3A Weighted average: Process cost summary; equivalent units

C2 C3 P4

Fast Co. produces its product through two processing departments: Cutting and Assembly. Direct materi- als are added at the start of production in the Cutting department, and conversion costs are added evenly throughout each process. The company uses monthly reporting periods for its weighted-average process costing system. The Work in Process Inventory—Cutting account has a balance of $84,300 as of October 1, which consists of $17,100 of direct materials and $67,200 of conversion costs.

During the month, the Cutting department incurred the following costs.

Direct materials . . . . . . . . . . . . $144,400 Conversion . . . . . . . . . . . . . . . $862,400

Chapter 16 Process Costing and Analysis 649

Check (1) Costs transferred out, $982,500

At the beginning of the month, 30,000 units were in process in the Cutting department. During October, the Cutting department started 140,000 units and transferred 150,000 units to the Assembly department. At the end of the month, the Cutting department’s work in process inventory consisted of 20,000 units that were 80% complete with respect to conversion costs.

Required

1. Prepare the Cutting department’s process cost summary for October using the weighted-average method.

2. Prepare the journal entry dated October 31 to transfer the cost of the partially completed units to Assembly.

Tamar Co. manufactures a single product in two departments: Forming and Assembly. All direct materials are added at the beginning of the forming process. Conversion costs are added evenly throughout each process. During May, the Forming department started 21,600 units and completed and transferred 22,200 units of product to the Assembly department. The Forming department’s 3,000 units of beginning work in process consisted of $19,800 of direct materials and $221,940 of conversion costs. It has 2,400 units (100% complete with respect to direct materials and 80% complete with respect to conversion) in process at month-end. During the month, $496,800 of direct materials costs and $2,165,940 of conversion costs were charged to the Forming department.

Required

1. Prepare the Forming department’s process cost summary for May using the weighted-average method. 2. Prepare the journal entry dated May 31 to transfer the cost of units to Assembly.

Analysis Component

3. The costing process depends on numerous estimates. a. Identify two major estimates that determine the cost per equivalent unit. b. Assume management compensation is based on maintaining low inventory amounts. Is manage-

ment more likely to overestimate or understimate the percentage complete?

Check (1) EUP for conversion, 24,120 (2) Cost transferred out, $2,664,000

Problem 16-4A Weighted average: Process cost summary, equivalent units, cost estimates

C2 C3 P4

QualCo manufactures a single product in two departments: Cutting and Assembly. During May, the Cutting department completed a number of units of a product and transferred them to Assembly. Of these trans- ferred units, 37,500 were in process in the Cutting department at the beginning of May and 150,000 were started and completed in May. May’s Cutting department beginning inventory units were 60% complete with respect to materials and 40% complete with respect to conversion. At the end of May, 51,250 addi- tional units were in process in the Cutting department and were 60% complete with respect to materials and 20% complete with respect to conversion. The Cutting department had $505,035 of direct materials and $396,568 of conversion cost charged to it during May. Its beginning inventory included $74,075 of direct materials cost and $28,493 of conversion cost. 1. Compute the number of units transferred to Assembly. 2. Compute the number of equivalent units with respect to both materials used and conversion used in the

Cutting department for May using the FIFO method. 3. Compute the direct materials cost and the conversion cost per equivalent unit for the Cutting department. 4. Using the FIFO method, assign the Cutting department’s May costs to the units transferred out and

assign costs to its ending work in process inventory.

Check (2) EUP for materials, 195,750

Problem 16-6AA FIFO: Costs per equivalent unit; costs assigned to products

C2 C4

Refer to the data in Problem 16-4A. Assume that Tamar uses the FIFO method to account for its process costing system. The following additional information is available for the Forming department:

∙ Beginning work in process consisted of 3,000 units that were 100% complete with respect to direct materials and 40% complete with respect to conversion.

∙ Of the 22,200 units transferred out, 3,000 were from beginning work in process. The remaining 19,200 were units started and completed during May.

Required

1. Prepare the Forming department’s process cost summary for May using FIFO. 2. Prepare the journal entry dated May 31 to transfer the cost of units to Assembly.

Problem 16-5AA FIFO: Process cost summary; equivalent units; cost estimates

C3 C4 P4

Check (1) EUP for conversion, 22,920 (2) Cost transferred out, $2,667,840

650 Chapter 16 Process Costing and Analysis

Required

1. Compute the amount of (a) production costs transferred from Mixing to Blending, (b) production costs transferred from Blending to finished goods, and (c) cost of goods sold.

2. Prepare journal entries dated March 31 to record the following March activities: (a) raw materials pur- chases, (b) direct materials usage, (c) indirect materials usage, (d) direct labor costs, (e) indirect labor costs, ( f ) payment of factory payroll, (g) other overhead costs (credit Other Accounts), (h) overhead applied, (i) goods transferred from Mixing to Blending, ( j) goods transferred from Blending to finished goods, (k) cost of goods sold, and (l) sales.

Check (1c) Cost of goods sold, $408,438

Dengo Co. makes a trail mix in two departments: Roasting and Blending. Direct materials are added at the beginning of each process, and conversion costs are added evenly throughout each process. The company uses the FIFO method of process costing. During October, the Roasting department completed and trans- ferred 22,200 units to the Blending department. Of the units completed, 3,000 were from beginning inven- tory and the remaining 19,200 were started and completed during the month. Beginning work in process was 100% complete with respect to direct materials and 40% complete with respect to conversion. The company has 2,400 units (100% complete with respect to direct materials and 80% complete with respect to conversion) in process at month-end. Information on the Roasting department’s costs of beginning work in process inventory and costs added during the month follows.

Problem 16-7AA FIFO: Process cost summary, equivalent units, cost estimates

C2 C3 C4 P4

Required

1. Prepare the Roasting department’s process cost summary for October using the FIFO method. 2. Prepare the journal entry dated October 31 to transfer the cost of completed units to the Blending

department.

Analysis Component

3. The company provides incentives to department managers by paying monthly bonuses based on their success in controlling costs per equivalent unit of production. Assume that a production department underestimates the percentage of completion for units in ending inventory with the result that its equivalent units of production for October are understated. Will this error increase or decrease the October bonuses paid?

Check (1) EUP for conversion, 22,920 (2) Cost transferred out to Blending, $1,333,920

PROBLEM SET B

Problem 16-1B Production cost flow and measurement; journal entries

P1 P2 P3 P4

Ho Chee I.C. makes ice cream in two sequential processes: Mixing and Blending. Direct materials enter pro- duction at the beginning of each process. The following information is available regarding its March inventories.

Beginning Ending Inventory Inventory

Raw materials inventory . . . . . . . . . . . . . . . . $ 72,000 $110,000

Work in process inventory—Mixing . . . . . . . 156,000 250,000

Work in process inventory—Blending . . . . . 160,000 198,000

Finished goods inventory . . . . . . . . . . . . . . . 80,200 60,250

The following additional information describes the company’s production activities for March.

Direct Materials Raw materials purchased on credit . . . . . . $212,000

Direct materials used—Mixing . . . . . . . . . . 174,000

Direct materials used—Blending . . . . . . . . 44,000

Direct Labor Direct labor—Mixing . . . . . . . . . . . . . . . . . . $ 52,500

Direct labor—Blending . . . . . . . . . . . . . . . . 74,680

Total factory payroll paid (in cash) . . . . . . . 196,680

Factory Overhead (actual costs) Indirect materials used . . . . . . . . . . . . . . . . . . . . . . . . . $41,200

Indirect labor used . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,500

Other overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . 64,660

Factory Overhead Rates Mixing . . . . . . . . . . . . . . . . . . . . . . 75% of direct materials used

Blending . . . . . . . . . . . . . . . . . . . . 60% of direct labor used

Sales . . . . . . . . . . . . . . . . . . . . . . . $490,000

Cost Direct Materials Conversion

Beginning work in process inventory . . . . . . . . . . . . . . . . . $ 9,900 $ 110,970

Added during the month . . . . . . . . . . . . . . . . . . . . . . . . . . . 248,400 1,082,970

Chapter 16 Process Costing and Analysis 651

Problem 16-2B Weighted average: Cost per equivalent unit; costs assigned to products

C2 C3

Abraham Company uses process costing to account for its production costs. The company has two produc- tion processes. Conversion is added evenly throughout each process. Direct materials are added at the beginning of the first process. Additional information for the first process follows.

During September, the first process transferred 80,000 units of product to the next process. Beginning work in process consisted of 2,000 units that were 100% complete with respect to direct materials and 85% complete with respect to conversion. Of the units completed, 2,000 were from beginning work in process and 78,000 units were started and completed during the period. Beginning work in process had $58,000 of direct materials and $86,400 of conversion cost. At the end of September, the work in process inventory consists of 8,000 units that are 25% complete with respect to conversion. The direct materials cost added in September is $712,000, and conversion cost added is $1,980,000. The company uses the weighted-average method.

Required

For the first process: 1. Determine the equivalent units of production with respect to (a) conversion and (b) direct materials. 2. Compute both the conversion cost and the direct materials cost per equivalent unit. 3. Compute both conversion cost and direct materials cost assigned to (a) units completed and trans-

ferred out and (b) ending work in process inventory.

Analysis Component

4. Assume that an error is made in determining the percentage of completion for units in ending inven- tory in the first process. Instead of being 25% complete with respect to conversion, they are actually 75% complete. Write a one-page memo to the plant manager describing how this error affects its September financial statements.

Check (2) Conversion cost per equivalent unit, $25.20 (3b) $120,400

Problem 16-3B Weighted average: Process cost summary; equivalent units

C2 C3 P4

Brun Company produces its product through two processing departments: Mixing and Baking. Direct materials are added at the beginning of the mixing process. Conversion costs are added evenly. The com- pany uses monthly reporting periods for its weighted-average process costing. The Work in Process Inventory—Mixing account had a balance of $21,300 on November 1, which consisted of $6,800 of direct materials and $14,500 of conversion costs.

During the month, the Mixing department incurred the following costs.

Check (1) Cost transferred out, $1,160,000

At the beginning of the month, 7,500 units were in process in the Mixing department. During November, the Mixing department started 104,500 units and transferred 100,000 units of its product to Baking. At the end of the month, the Mixing department’s work in process inventory consisted of 12,000 units that were 100% complete with respect to direct materials and 25% complete with respect to conversion.

Required

1. Prepare the Mixing department’s process cost summary for November using the weighted-average method. 2. Prepare the journal entry dated November 30 to transfer the cost of the completed units to Baking.

Direct materials . . . . . . . . . . . . $116,400 Conversion . . . . . . . . . . . . . . . $1,067,000

Problem 16-4B Weighted average: Process cost summary; equivalent units; cost estimates

C2 C3 P4

Switch Co. manufactures a single product in two departments: Cutting and Assembly. Direct labor and overhead are added evenly throughout each process. Direct materials are added at the beginning of the cutting process. During January, the Cutting department started 250,000 units and completed and trans- ferred 220,000 units of product to the Assembly department. The Cutting department’s 10,000 units of beginning work in process consisted of $7,500 of direct materials and $49,850 of conversion. In process in the Cutting department at month-end are 40,000 units (50% complete with respect to direct materials and 30% complete with respect to conversion). During the month, the Cutting department used direct materials of $112,500 in production and incurred conversion costs of $616,000.

Required

1. Prepare the Cutting department’s process cost summary for January using the weighted-average method. 2. Prepare the journal entry dated January 31 to transfer the cost of units from Cutting to Assembly.

Analysis Component

3. The cost accounting process depends on several estimates. a. Identify two major estimates that affect the cost per equivalent unit. b. In what direction might you anticipate a bias from management for each estimate in part 3a (assume

that management compensation is based on maintaining low inventory amounts)? Explain your answer.

Check (1) EUP for conversion, 232,000 (2) Cost transferred out, $741,400

652 Chapter 16 Process Costing and Analysis

Problem 16-5BA FIFO: Process cost summary; equivalent units; cost estimates

C3 C4 P4

Refer to the information in Problem 16-4B. Assume that Switch uses the FIFO method to account for its process costing system. The following additional information is available for the Cutting department.

∙ Beginning work in process consists of 10,000 units that were 75% complete with respect to direct ma- terials and 60% complete with respect to conversion.

∙ Of the 220,000 units transferred out, 10,000 were from beginning work in process; the remaining 210,000 were units started and completed during January.

Required

1. Prepare the Cutting department’s process cost summary for January using FIFO. Round cost per EUP to three decimal places.

2. Prepare the journal entry dated January 31 to transfer the cost of units to Assembly.

Check (1) Conversion EUP, 226,000

(2) Cost transferred out, $743,554

Problem 16-6BA FIFO: Costs per equivalent unit; costs assigned to products

C2 C4

Harson Co. manufactures a single product in two departments: Forming and Assembly. During May, the Forming department completed a number of units of a product and transferred them to Assembly. Of these transferred units, 62,500 were in process in the Forming department at the beginning of May and 175,000 were started and completed in May. May’s Forming department beginning inventory units were 40% com- plete with respect to materials and 80% complete with respect to conversion. At the end of May, 76,250 additional units were in process in the Forming department and were 80% complete with respect to materials and 20% complete with respect to conversion. The Forming department had $683,750 of direct materials and $446,050 of conversion cost charged to it during May. Its beginning inventory included $99,075 of direct materials cost and $53,493 of conversion cost. 1. Compute the number of units transferred to Assembly. 2. Compute the number of equivalent units with respect to both materials used and conversion used in the

Forming department for May using the FIFO method. 3. Compute the direct materials cost and the conversion cost per equivalent unit for the Forming department. 4. Using the FIFO method, assign the Forming department’s May costs to the units transferred out and

assign costs to its ending work in process inventory.

Check (2) EUP for materials, 273,500

Problem 16-7BA FIFO: Process cost summary, equivalent units, cost estimates

C2 C3 C4 P4

Belda Co. makes organic juice in two departments: Cutting and Blending. Direct materials are added at the beginning of each process, and conversion costs are added evenly throughout each process. The com- pany uses the FIFO method of process costing. During March, the Cutting department completed and transferred 220,000 units to the Blending department. Of the units completed, 10,000 were from begin- ning inventory and the remaining 210,000 were started and completed during the month. Beginning work in process was 75% complete with respect to direct materials and 60% complete with respect to conver- sion. The company has 40,000 units (50% complete with respect to direct materials and 30% complete with respect to conversion) in process at month-end. Information on the Cutting department’s costs of beginning work in process inventory and costs added during the month follows.

Cost Direct Materials Conversion

Beginning work in process inventory . . . . . . . . . . . . . . . $ 16,800 $ 97,720

Added during the month . . . . . . . . . . . . . . . . . . . . . . . . . 223,200 1,233,960

Check (1) EUP for conversion, 226,000 (2) Cost transferred out, $1,486,960

Required

1. Prepare the Cutting department’s process cost summary for March using the FIFO method. 2. Prepare the journal entry dated March 31 to transfer the cost of completed units to the Blending department.

Analysis Component

3. The company provides incentives to department managers by paying monthly bonuses based on their success in controlling costs per equivalent unit of production. Assume that a production department overestimates the percentage of completion for units in ending inventory with the result that its equiv- alent units of production for March are overstated. What impact does this error have on the March bonuses paid to the managers of the production department? What impact, if any, does this error have on these managers’ April bonuses?

Chapter 16 Process Costing and Analysis 653

SERIAL PROBLEM Business Solutions

C1 A1

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 16 The computer workstation furniture manufacturing that Santana Rey started for Business Solutions is progressing well. Santana uses a job order costing system to account for the production costs of this product line. Santana is wondering whether process costing might be a better method for her to keep track of and monitor her production costs.

Required

1. What are the features that distinguish job order costing from process costing? 2. Should Santana continue to use job order costing or switch to process costing for her workstation fur-

niture manufacturing? Explain. ©Alexander Image/Shutterstock

COMPREHENSIVE PROBLEM

Major League Bat Company Weighted average: Review of Chapters 14 and 16

CP 16 Major League Bat Company manufactures baseball bats. In addition to its work in process inventories, the company maintains inventories of raw materials and finished goods. It uses raw materials as direct materials in production and as indirect materials. Its factory payroll costs include direct labor for production and indirect labor. All materials are added at the beginning of the process, and conversion costs are applied uniformly throughout the production process.

Required

You are to maintain records and produce measures of inventories to reflect the July events of this com- pany. Set up the following general ledger accounts and enter the June 30 balances: Raw Materials Inventory, $25,000; Work in Process Inventory, $8,135 ($2,660 of direct materials and $5,475 of conver- sion); Finished Goods Inventory, $110,000; Sales, $0; Cost of Goods Sold, $0; Factory Wages Payable, $0; and Factory Overhead, $0. 1. Prepare journal entries to record the following July transactions and events. a. Purchased raw materials for $125,000 cash (the company uses a perpetual inventory system). b. Used raw materials as follows: direct materials, $52,440; and indirect materials, $10,000. c. Recorded factory wages payable costs as follows: direct labor, $202,250; and indirect labor, $25,000. d. Paid factory payroll cost of $227,250 with cash (ignore taxes). e. Incurred additional factory overhead costs of $80,000 paid in cash. f. Applied factory overhead to production at 50% of direct labor costs. 2. Information about the July inventories follows. Use this information with that from part 1 to prepare a

process cost summary, assuming the weighted-average method is used.

Check (1f) Cr. Factory Overhead, $101,125

Units Beginning inventory . . . . . 5,000 units

Started . . . . . . . . . . . . . . . 14,000 units

Ending inventory . . . . . . . 8,000 units

Beginning inventory Materials—Percent complete . . . . . . 100%

Conversion—Percent complete . . . . . 75%

Ending inventory Materials—Percent complete . . . . . . 100%

Conversion—Percent complete . . . . . 40%

(2) EUP for conversion, 14,200

3. Using the results from part 2 and the available information, make computations and prepare journal entries to record the following:

g. Total costs transferred to finished goods for July (label this entry g). h. Sale of finished goods costing $265,700 for $625,000 in cash (label this entry h). 4. Post entries from parts 1 and 3 to the ledger accounts set up at the beginning of the problem. 5. Compute the amount of gross profit from the sales in July. Hint: Add any underapplied overhead to, or

deduct any overapplied overhead from, the cost of goods sold. Ignore the corresponding journal entry.

(3g) $271,150

The General Ledger tool in Connect automates several of the procedural steps in accounting so that the finan- cial professional can focus on the impacts of each transaction on various reports and performance measures.

GL 16-1 General Ledger assignment GL 16-1, based on Problem 16-1A, focuses on transactions related to process costing. Prepare summary journal entries to record the cost of units manufactured and their flow through the manufacturing environment. Then prepare a schedule of cost of goods manufactured and a partial income statement.

GENERAL LEDGER PROBLEM

GL

654 Chapter 16 Process Costing and Analysis

COMPANY ANALYSIS C2

Accounting Analysis

AA 16-1 Apple has entered into contracts that require the future purchase of goods or services (“uncon- ditional purchase obligations”). At year-end 2017, Apple reports the following for these future payments.

Required

1. As of year-end 2017, what was the total dollar amount (in millions) of Apple’s future payments for unconditional purchase obligations?

2. As of year-end 2017, compute the ratio of the total dollar amount of Apple’s future payments for unconditional purchase obligations divided by Apple’s total liabilities. (Obtain total liabilities from Apple’s balance sheet as of September 30, 2017, in Appendix A.)

3. Is the ratio computed in part 2 greater than or less than the ratio of accounts payable divided by total liabilities as of year-end 2017? (Obtain accounts payable from Apple’s balance sheet as of September 30, 2017, in Appendix A.).

APPLE

AA 16-2 Apple and Google work to maintain high-quality and low-cost operations. One ratio routinely computed for this assessment is the cost of goods sold divided by total expenses. A decline in this ratio can mean that the company is spending too much on selling and administrative activities. An increase in this ratio beyond a reasonable level can mean that the company is not spending enough on selling activities. (Assume for this analysis that total expenses equal the cost of goods sold plus total operating expenses.)

Required

1. For Apple and Google, refer to Appendix A and compute the ratios of cost of goods sold to total expenses for fiscal years 2017 and 2016. Record answers as percents, rounded to one decimal.

2. Based on answers to part 1, which company had a greater percentage reduction in selling and adminis- trative expenses in 2017?

COMPARATIVE ANALYSIS C1

APPLE

GOOGLE

AA 16-3 Samsung, Apple, and Google are competitors in the global marketplace. Selected data for Samsung follow.

GLOBAL ANALYSIS C1

Korean won in billions 2017 2016

Cost of goods sold . . . . . . . . . . . . . W129,291 W120,278

Operating expenses . . . . . . . . . . . . 56,640 52,348

Total expenses . . . . . . . . . . . . . . . . W185,931 W172,626

Required

1. Review the discussion of the importance of the cost of goods sold divided by total expenses ratio in AA 16-2. Compute the cost of goods sold to total expenses ratio for Samsung for the two years of data provided. Record answers as percents, rounded to one decimal.

2. Which company (Apple, Google, or Samsung) has the highest ratio of cost of goods sold to total expenses for 2017? (AA 16-2 part 1 must be completed to answer this requirement.)

Samsung APPLE GOOGLE

BTN 16-1 Many accounting and accounting-related professionals are skilled in financial analysis, but most are not skilled in manufacturing. This is especially the case for process manufacturing environments (for example, a bottling plant or chemical factory). To provide professional accounting and financial ser- vices, one must understand the industry, product, and processes. We have an ethical responsibility to develop this understanding before offering services to clients in these areas.

Beyond the Numbers

ETHICS CHALLENGE P1

$ millions 2018 2019 2020 2021 2022

Future payments . . . . . . . . . . $1,798 $2,675 $1,626 $1,296 $1,268

Chapter 16 Process Costing and Analysis 655

BTN 16-4 The purpose of this team activity is to ensure that each team member understands process operations and the related accounting entries. Find the activities and flows identified in Exhibit 16.14 with numbers 1 through 10. Pick a member of the team to start by describing activity number 1 in this exhibit, then verbalizing the related journal entry, and describing how the amounts in the entry are com- puted. The other members of the team are to agree or disagree; discussion is to continue until all members express understanding. Rotate to the next numbered activity and next team member until all activities and entries have been discussed. If at any point a team member is uncertain about an answer, the team member may pass and get back in the rotation when he or she can contribute to the team’s discussion.

TEAMWORK IN ACTION C1 P1 P2 P3 P4

BTN 16-2 You hire a new assistant production manager whose prior experience is with a company that produced goods to order. Your company engages in continuous production of homogeneous products that go through various production processes. Your new assistant e-mails you questioning some cost classifi- cations on an internal report—specifically why the costs of some materials that do not actually become part of the finished product, including some labor costs not directly associated with producing the prod- uct, are classified as direct costs. Respond to this concern via memorandum.

COMMUNICATING IN PRACTICE C1 A1 P1 P2

BTN 16-3 Many companies use technology to help them improve processes. One example of such a tool is robotic process automation. Access deloitte.com/us/en/pages/operations/articles/a-guide-to-robotic- process-automation-and-intelligent-automation.html and read the information displayed.

Required

What processes are robotic process automation (RPA) tools most useful for? Explain how RPA tools work and list their proposed benefits.

TAKING IT TO THE NET C1

BTN 16-5 This chapter’s opener featured Suzy Batlle and her company Azucar Ice Cream Company.

Required

1. Suzy tries to buy raw materials just-in-time for their use in production. How does holding raw materials inventories increase costs? If the items are not used in production, how can they impact profits? Explain.

2. How can companies like Suzy’s use yield to improve their production processes? 3. Suppose Azucar Ice Cream decides to allow customers to make their own unique ice cream flavors.

Why might the company then use a hybrid costing system?

ENTREPRENEURIAL DECISION C3 A2

Direct Direct Variable Fixed Cost Description Material Labor Overhead Cost Cost

Manual sorting . . . . . . . . . . . . . . . . . . . . . . . . . . . X X

Overhead allocation suggestions:

. . .

Conversion

BTN 16-6 In process costing, the process is analyzed first, and then a unit measure is computed in the form of equivalent units for direct materials, conversion (direct labor and overhead), and both types of costs combined. The same analysis applies to both manufacturing and service processes.

Required

Visit your local U.S. Postal Service office. Look into the back room, and you will see several ongoing processes. Select one process, such as sorting, and list the costs associated with this process. Your list should include materials, labor, and overhead; be specific. Classify each cost as fixed or variable. At the bottom of your list, outline how overhead should be assigned to your identified process. The following format (with an example) is suggested.

HITTING THE ROAD C2

Point: The class can compare and discuss the different processes studied and the answers provided.

Required

Write a one-page action plan, in memorandum format, discussing how you would obtain an understanding of key business processes of a company that hires you to provide financial services. The memorandum should specify an industry, a product, and one selected process and should draw on at least one reference, such as a professional journal or industry magazine.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Distinguish between the plantwide

overhead rate method, the departmental overhead rate method, and the activity- based costing method.

C2 Explain cost flows for activity-based costing.

C3 Describe the four types of activities that cause overhead costs.

PROCEDURAL P1 Allocate overhead costs to products

using the plantwide overhead rate method.

P2 Allocate overhead costs to products using the departmental overhead rate method.

P3 Allocate overhead costs to products using activity-based costing.

ANALYTICAL A1 Identify and assess advantages and

disadvantages of the plantwide overhead and departmental overhead rate methods.

A2 Identify and assess advantages and disadvantages of activity-based costing.

Chapter Preview

17 Activity-Based Costing and Analysis

ASSIGNING OVERHEAD COSTS

C1 Alternative methods P1 Single plantwide overhead

rate method

P2 Multiple departmental overhead rate method

A1 Assessing plantwide and departmental rate methods

NTK 17-1

ACTIVITY-BASED COSTING

C2 Steps in activity-based costing

P3 Applying activity-based costing

A2 Assessing activity-based costing

NTK 17-2

ACTIVITY-BASED MANAGEMENT

C3 Types of activities Costs of quality

Lean manufacturing

ABC for services

Customer profitability

NTK 17-3

657

“Believe in yourself . . . success will come” —Sarah Taylor Brigham

Brewing Profits

CHARLOTTE, NC—Sarah Taylor Brigham and Justin Brigham’s dream was to run their own brewery. With little more than opti- mism, determination, and a willingness to work hard, the duo started Sycamore Brewing (sycamorebrew.com). “We had no idea what we were getting into!” laughs Sarah. The Brighams did much of the construction work needed to transform an auto garage into a brewery, and Justin spent several sleepless nights getting the brewhouse working.

“Our goal was to brew 100 different beers in our first year,” says Justin. To do that, Justin had to convert his recipes designed for a 5-gallon brewing system into 500-gallon batches. Justin uses only top-quality ingredients and monitors the activities in his brewing process to control costs. Sarah and Justin know that how they control and allocate overhead costs is crucial for product pricing and product mix decisions. Overhead costs, including brewery maintenance, supervision, and cleanup, must be allo- cated to products. In small businesses with few product lines, a single plantwide overhead rate is often sufficient.

Sycamore Brewing has had over 200% annual growth since its inception. As businesses grow and offer more diverse product

lines, more detailed costing techniques are often needed. Activity-based costing is useful when different product lines use different amounts of the activities that drive overhead costs.

Sycamore’s recipe is working. The company has over 50 employees and a new automated production facility, and re- cently began selling its beer in grocery stores. Sarah advises aspiring young entrepreneurs to “focus on your passion.” “I’m so fired up for Sycamore’s next chapter!” she says.

Sources: Sycamore Brewing website, January 2019; CharlotteFive.com, October 12, 2017; The Charlotte Observer, October 22, 2015; CharlotteAgenda.com, October 19, 2016

©Sycamore Brewing

Product pricing, product mix decisions, and cost control depend on accurate product cost infor- mation. Product cost consists of direct materials, direct labor, and overhead (indirect costs). Because direct materials and direct labor can be traced to units of output, assigning these costs to products is usually straightforward. Overhead costs, however, are not directly related to pro- duction and cannot be traced to units of product like direct materials and direct labor can. We use an allocation system to assign overhead costs such as utilities and factory maintenance. This chapter shows three methods of overhead allocation: (1) the single plantwide overhead rate method, (2) the departmental overhead rate method, and (3) the activity-based costing method.

Alternative Methods of Overhead Allocation Exhibit 17.1 summarizes some key features of the three alternative methods. The plantwide overhead rate method and the departmental overhead rate method use

volume-based measures such as direct labor hours or machine hours to allocate overhead costs to products. The plantwide method uses a single rate for allocating overhead costs, and the departmental rate method uses at least two rates. The departmental method arguably pro- vides more accurate cost allocations than the plantwide method.

Activity-based costing focuses on activities (not just volume) and their costs. Rates based on these activities are used to assign overhead to products in proportion to the amount of activity required to produce them. Activity-based costing typically uses more overhead allocation rates than the plantwide and departmental methods.

ASSIGNING OVERHEAD COSTS C1 Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

Point: Evidence suggests over- head costs have steadily in- creased while direct labor costs have steadily decreased as a per- centage of total manufacturing costs over recent decades. This puts greater importance on accurate cost allocations.

EXHIBIT 17.1 Overhead Cost Allocation Methods

Allocation Method Number of Overhead Rates Overhead Allocation Rates Based on

Plantwide rate . . . . . . . . . . . . . . . . . . One rate Volume-based measures such as direct labor hours or machine hours

Departmental rate . . . . . . . . . . . . . . Two or more rates Volume-based measures such as direct labor hours or machine hours

Activity-based costing . . . . . . . . . . . At least two (but often Activities that drive costs, such as number many) rates of batches of product produced

658 Chapter 17 Activity-Based Costing and Analysis

Plantwide Overhead Rate Method The first method of allocating overhead costs to products is the single plantwide overhead rate method, or simply the plantwide overhead rate method.

Cost Flows under Plantwide Overhead Rate Method For the plantwide overhead rate method, the target of the cost assignment, or cost object, is the unit of product— see Exhibit 17.2. The overhead rate is determined using a volume-related measure such as direct labor hours or machine hours, both of which are readily available in most manufacturing set- tings. In some industries, overhead costs are closely related to these volume-related measures. If so, it is logical to use this method to assign overhead costs to products.

P1 Allocate overhead costs to products using the plantwide overhead rate method.

Applying the Plantwide Overhead Rate Method Under the single plantwide overhead rate method, total budgeted overhead costs are divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plantwide overhead rate. This rate then is ap- plied to assign overhead costs to all products based on their actual usage of the allocation base.

To illustrate, consider KartCo, a go-kart manufacturer that produces both standard and cus- tom go-karts for amusement parks. The standard go-kart is a basic model sold mainly to amuse- ment parks that service county and state fairs. Custom go-karts are produced for theme parks that want unique go-karts to fit specific themes.

Assume that KartCo applies the plantwide overhead rate method and uses direct labor hours (DLH) as its overhead allocation base. KartCo’s budgeted DLH information for the coming year is in Exhibit 17.3.

Overhead Cost

Product 1 Product 2 Product 3

Single Plantwide Overhead Rate

Indirect Costs

Cost Objects

Cost Allocation

Base

EXHIBIT 17.2 Plantwide Overhead Rate Method

EXHIBIT 17.3 KartCo’s Budgeted Direct Labor Hours

Number of Units Direct Labor Hours per Unit Total Direct Labor Hours

Standard go-kart . . . . . . . . 5,000 × 15 = 75,000 Custom go-kart . . . . . . . . . 1,000 × 25 = 25,000 Total . . . . . . . . . . . . . . . . . . 100,000

KartCo’s budgeted overhead cost information for the coming year is in Exhibit 17.4. Its over- head cost consists of indirect labor and factory utilities.

EXHIBIT 17.4 KartCo’s Budgeted Overhead Cost

Overhead Item Budgeted Cost

Indirect labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Total budgeted overhead cost . . . . . . . . . . . . . . . . $4,800,000

Chapter 17 Activity-Based Costing and Analysis 659

This plantwide overhead rate is then used to allocate overhead cost to products based on the number of direct labor hours required to produce each unit as follows.

The single plantwide overhead rate for KartCo is computed as

Plantwide = Total budgeted ÷ Total budgeted directoverhead rate overhead cost labor hours = $4,800,000 ÷ 100,000 DLH = $48 per DLH

Overhead allocated to each product unit = Plantwide overhead rate × DLH per unit

KartCo allocates overhead cost to its two products as follows (on a per unit basis).

Overhead Cost per Unit Using the Plantwide Rate Method

Standard go-kart . . . . . . . . $48 per DLH × 15 DLH per unit = $  720 per unit Custom go-kart . . . . . . . . . $48 per DLH × 25 DLH per unit = $1,200 per unit

Exhibit 17.5 summarizes the plantwide overhead method for KartCo.

Overhead Cost $4,800,000

Standard Go-Karts Overhead Allocated

$48 per DLH × 15 DLH = $720 per unit

Custom Go-Karts Overhead Allocated

$48 per DLH × 25 DLH = $1,200 per unit

Plantwide Overhead Rate $4,800,000/100,000 DLH = $48 per DLH

EXHIBIT 17.5 Plantwide Method—KartCo

KartCo uses these per unit overhead costs, and per unit direct materials and direct labor costs from other records, to compute product cost per unit as follows.

Product Cost per Unit Using the Plantwide Rate Method

Direct Materials Direct Labor Overhead Product Cost per Unit

Standard go-kart . . . . . . . . . . . . $400 + $350 + $ 720 = $1,470 Custom go-kart . . . . . . . . . . . . . . 600 + 500 + 1,200 = 2,300

KartCo sells its standard model go-karts for $2,000 and its custom go-karts for $3,500. A recent report from its marketing staff indicates that competitors are selling go-karts like Kart- Co’s standard model for $1,200. KartCo management is concerned that selling at this lower price would result in a loss of $270 ($1,200 − $1,470) on each standard go-kart sold.

Interestingly, KartCo has been swamped with orders for its custom go-kart and cannot meet demand. Accordingly, management is considering dropping the standard model and concentrat- ing on the custom model. Yet management recognizes that its pricing decisions are influenced by its cost allocations. Before making any strategic decisions, management asks its cost analysts to further review KartCo’s overhead allocation. The cost analysts first consider the departmental overhead rate method.

660 Chapter 17 Activity-Based Costing and Analysis

Departmental Overhead Rate Method Many companies have several departments that produce various products using different amounts of overhead. Under such circumstances, a single plantwide overhead rate can produce cost assignments that do not reflect the cost to manufacture products. Multiple overhead rates can result in better overhead cost allocations and improve management decisions.

Cost Flows under Departmental Overhead Rate Method The departmen- tal overhead rate method uses a different overhead rate for each production department. This is usually done through a four-step process (see Exhibit 17.6):

1 Assign overhead costs to departmental cost pools. 2 Select an allocation base for each department. 3 Compute overhead allocation rates for each department. 4 Use departmental overhead rates to assign overhead costs to cost objects (products).

P2 Allocate overhead costs to products using the departmental overhead rate method.

Cost Pools

Cost Objects

Cost Allocation

Base

Indirect CostsOverhead Cost

Department A Department B

Product 3Product 2Product 1

Department B Overhead RateDepartment A Overhead Rate

EXHIBIT 17.6 Departmental Overhead Rate Method

The departmental overhead method uses several departments and several overhead rates. This allows each department to have its own overhead rate and its own allocation base. For example, an Assembly department may use direct labor hours to allocate its overhead cost, whereas a Machining department may use machine hours as its base.

Applying the Departmental Overhead Rate Method KartCo has two pro- duction departments, the Machining department and the Assembly department.

1 The first step requires that KartCo assign its $4,800,000 overhead cost to its two produc- tion departments. KartCo determines that $4,200,000 of overhead costs is traceable to its Machining department and the remaining $600,000 is traceable to its Assembly department.

2 The second step requires each department to determine an allocation base. For KartCo, the Machining department uses machine hours (MH) to allocate its overhead; the Assembly department uses direct labor hours (DLH) to allocate its overhead. The budgeted information for KartCo’s Machining and Assembly departments is shown below.

Number

Machining Department Assembly Department

of Units Hours per Unit Total Hours Hours per Unit Total Hours

Standard go-kart . . . . . . . . 5,000 10 MH per unit 50,000 MH 5 DLH per unit 25,000 DLH

Custom go-kart . . . . . . . . . 1,000 20 MH per unit 20,000 MH 5 DLH per unit 5,000 DLH

Totals . . . . . . . . . . . . . . . . . 70,000 MH 30,000 DLH

3 In step three, each department computes its own overhead rate using this formula.

Departmental overhead rate = Total budgeted departmental overhead cost

Total amount of departmental allocation base

Machining $4,200,000

Assembly $600,000

Overhead Cost $4,800,000

Chapter 17 Activity-Based Costing and Analysis 661

KartCo’s departmental overhead rates are computed as follows.

Machining department overhead rate = $4,200,000 70,000 MH

= $60 per MH

Assembly department overhead rate = $600,000

30,000 DLH = $20 per DLH

4 Step four applies overhead costs to each product using departmental overhead rates. Because each standard go-kart requires 10 MH from the Machining department and five DLH from the Assembly department, the overhead cost allocated to each standard go-kart is $600 from the Machining department (10 MH × $60 per MH) and $100 from the Assembly department (5 DLH × $20 per DLH). The same procedure is applied for its custom go-kart. Exhibit 17.7 summarizes KartCo’s overhead allocation per go-kart using the departmental method.

EXHIBIT 17.7 Overhead Allocation Using Departmental Overhead Rates

Standard Go-Kart Custom Go-Kart

Departmental Overhead Overhead Department Overhead Rate Hours per Unit Allocated Hours per Unit Allocated

Machining . . . . . . . . . . $60 per MH 10 MH per unit $600 20 MH per unit $1,200

Assembly . . . . . . . . . . . $20 per DLH 5 DLH per unit 100 5 DLH per unit 100

Totals . . . . . . . . . . . . . . $700 $1,300

Departmental versus Plantwide Overhead Rate Methods Allocated over- head costs vary depending upon the allocation methods used. Exhibit 17.8 summarizes and compares the allocated overhead costs for standard and custom go-karts under the single plant- wide overhead rate and the departmental overhead rate methods.

The overhead cost allocated to each standard go-kart decreased from $720 under the plant- wide overhead rate method to $700 under the departmental overhead rate method, whereas overhead cost allocated to each custom go-kart increased from $1,200 to $1,300. These differ- ences occur because the custom go-kart requires more hours in the Machining department (20 MH) than the standard go-kart requires (10 MH).

Point: Total budgeted overhead costs are the same under both the plantwide and departmental rate methods.

EXHIBIT 17.8 Comparison of Plantwide Overhead Rate and Departmental Overhead Rate Methods

Overhead per Unit Using: Standard Go-Kart Custom Go-Kart

Plantwide overhead rate method . . . . . . . . . . . . . . . . $720 $1,200

Departmental overhead rate method . . . . . . . . . . . . . 700 1,300

For KartCo, using the departmental overhead rate method yields the following total product cost per unit.

Product Cost per Unit Using Departmental Rate Method

Direct Materials Direct Labor Overhead Product Cost per Unit

Standard go-kart . . . . . . . . . . . . $400 + $350 + $ 700 = $1,450 Custom go-kart . . . . . . . . . . . . . 600 + 500 + 1,300 = 2,400

The total product costs per unit under the departmental overhead rate method differ from those under the plantwide overhead rate method. Compared to the plantwide overhead rate method, the departmental overhead rate method usually results in more accurate overhead allo- cations. When cost analysts are able to logically trace overhead costs to different cost allocation bases, costing accuracy is improved. These cost data imply that KartCo cannot make a profit on its standard go-kart if it meets competitors’ $1,200 price, as it would lose $250 (computed as $1,200 − $1,450) per go-kart.

662 Chapter 17 Activity-Based Costing and Analysis

Assessing Plantwide and Departmental Overhead Rate Methods The plantwide and departmental overhead rate methods have three key advantages: (1) They are based on readily available information, like direct labor hours. (2) They are easy to implement. (3) They are consistent with GAAP and can be used for external reporting. Both suffer from an important disadvantage, in that overhead costs are frequently too complex to be explained by only one factor like direct labor hours or machine hours.

Plantwide Overhead Rate Method The usefulness of the single plantwide over- head rate depends on two assumptions: (1) overhead costs change with the allocation base (such as direct labor hours) and (2) all products use overhead costs in the same proportions.

For companies with many different products or those with products that use overhead costs in very different ways, the assumptions of the single plantwide rate are not reasonable. Most of KartCo’s overhead is related to machining, and a custom go-kart uses more machine hours than does a standard go-kart. When overhead costs, like machinery depreciation, bear little relation to direct labor hours used, allocating overhead cost using a single plantwide overhead rate based on direct labor hours can distort product cost and lead to poor managerial decisions. Despite such shortcomings, some companies continue to use the plantwide method for its simplicity.

Departmental Overhead Rate Method The departmental overhead rate method assumes that (1) different products are similar in volume, complexity, and batch size and (2) departmental overhead costs are directly proportional to the department allocation base (such as direct labor hours and machine hours for KartCo).

When products differ in batch size and complexity, they usually consume different amounts of overhead costs. This is likely the case for KartCo with its high-volume standard model and its low-volume custom model built to customer specifications. However, the departmental over- head rate method can distort product costs. Because the departmental overhead rate method still allocates overhead costs based on measures closely related to production volume, it fails to accurately assign many overhead costs, like machine depreciation or utility costs, that are not driven by production volume.

A1 Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods.

©Radharc Images/Alamy Stock Photo

Department Manager Three department managers hire a consulting firm for advice on increasing departmental effectiveness and efficiency. The consulting firm spends 50% of its efforts on department A and 25% on each of the other two departments. The manager for department A suggests that the three departments equally share the consulting fee. As a manager of one of the other two departments, do you believe equal sharing is fair? ■ Answer: When dividing a bill, common sense suggests fairness. That is, if one department consumes more services than another, we attempt to share the bill in proportion to consumption. Equally dividing the bill among the number of departments is fair if each consumed equal services. This same notion applies in assigning costs to products and services. For example, dividing overhead costs by the number of units is fair if all products consumed overhead in equal proportion.

Decision Ethics

A manufacturer reports the following budgeted data for its two production departments.

Plantwide and Departmental Rate Methods

NEED-TO-KNOW 17-1

P1 P2

Machining Assembly

Manufacturing overhead costs . . . . . . . . . . . . . . . . $600,000 $300,000

Machine hours to be used (MH) . . . . . . . . . . . . . . . . 20,000 0

Direct labor hours to be used (DLH) . . . . . . . . . . . . 20,000 5,000

1. What is the company’s single plantwide overhead rate based on direct labor hours? 2. What are the company’s departmental overhead rates if the Machining department assigns overhead

based on machine hours and the Assembly department assigns overhead based on direct labor hours? 3. Using the departmental overhead rates from part 2, how much overhead should be assigned to a job

that uses 16 machine hours in the Machining department and 5 direct labor hours in the Assembly department?

Chapter 17 Activity-Based Costing and Analysis 663

Solution

1. Plantwide overhead rate = $600,000 + $300,000

20,000 DLH + 5,000 DLH =

$900,000 25,000 DLH

= $36 per direct labor hour

2. Machining department rate = $600,000

20,000 MH = $30 per machine hour

Assembly department rate = $300,000

5,000 DLH = $60 per direct labor hour

3. Overhead assigned to job = (16 MH × $30 per MH) + (5 DLH × $60 per DLH) = $780 Do More: QS 17-9, QS 17-10,

QS 17-11, E 17-3

Activity-based costing (ABC) attempts to more accurately assign overhead costs by focusing on activities. Unlike the plantwide rate method, ABC uses more than a single rate. Unlike the departmental rate method, ABC focuses on activities rather than departments. We illustrate the activity-based costing method of assigning overhead costs.

Steps in Activity-Based Costing The basic principle underlying activity-based costing is that an activity, which is a task, opera- tion, or procedure, is what causes costs to be incurred. For example: Cutting raw materials consumes labor and machine hours. Storing products consumes employee time for driving a forklift, electricity to power the fork-

lift, and wear and tear on the forklift. Training employees drives costs such as fees or salaries paid to trainers and the training sup-

plies required.

All of an organization’s activities use resources. An activity cost pool is a collection of costs that are related to the same activity. For example, handling raw materials requires several activ- ities, including wages of receiving department employees, wages of forklift employees who move materials, and depreciation on forklifts. These activities can be grouped into a single cost pool because they are all caused by the amount of materials moved.

There are four steps to the ABC method (see Exhibit 17.9):

1. Identify activities and the overhead costs they cause. 2. Trace overhead costs to activity cost pools. 3. Compute overhead allocation rates for each activity. 4. Use the activity overhead rates to assign overhead costs to cost objects (products).

ACTIVITY-BASED COSTING

C2 Explain cost flows for activity-based costing.

©Carl Lyttle/The Image Bank/Getty Images

Cost Pools

Cost Objects

Cost Allocation

Base

Indirect CostsOverhead Cost

Product 1 Product 2 Product 3

Activity Cost Pool Y

Activity Cost Pool Z

Activity Cost Pool X

Activity Overhead Rate

Activity Overhead Rate

Activity Overhead Rate

EXHIBIT 17.9 Activity-Based Costing Method

664 Chapter 17 Activity-Based Costing and Analysis

Applying Activity-Based Costing Step 1: Identify Activities and the Overhead Costs They Cause Step 1 in applying ABC is to identify activities and the costs they cause. KartCo has total overhead costs of $4,800,000, consisting of $4,000,000 in indirect labor costs and $800,000 in factory utilities costs. After reviewing activities with production employees, KartCo identifies the ac- tivities and their costs shown in Exhibit 17.10.

P3 Allocate overhead costs to products using activity- based costing.

Activity Indirect Labor Factory Utilities Total Overhead

Machine setup . . . . . . . . . . . . . . . . $ 700,000 — $ 700,000

Machine repair . . . . . . . . . . . . . . . . . 1,300,000 — 1,300,000

Factory maintenance . . . . . . . . . . . . 800,000 — 800,000

Engineer salaries . . . . . . . . . . . . . . 1,200,000 — 1,200,000

Assembly line power . . . . . . . . . . . . — $600,000 600,000

Heating and lighting . . . . . . . . . . . . — 200,000 200,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000 $800,000 $4,800,000

EXHIBIT 17.10 KartCo Overhead Cost Details

Step 2: Trace Overhead Costs to Activity Cost Pools Step 2 in applying ABC is to assign activities and their overhead costs to activity cost pools. KartCo management assigns its overhead costs to four activity cost pools: craftsmanship, setup, design modification, and plant services (see Exhibit 17.11). To assign costs to activity cost pools, management looks for costs that are caused by similar activities.

Exhibit 17.11 shows that $600,000 of overhead costs are assigned to the crafts- manship cost pool; $2,000,000 to the setup cost pool; $1,200,000 to the design

modification cost pool; and $1,000,000 to the plant services cost pool. The use of cost pools reduces the potential number of overhead rates from six (one for each of its six activities) to four (one for each activity cost pool).

Design Modification

Craftsmanship Setup Plant Services

EXHIBIT 17.11 Assigning Overhead to Activity Cost Pools

Activity Cost Pools Activity Cost Pool Cost

Craftsmanship: Assembly line power $ 600,000 $ 600,000 Setup: Machine setup 700,000 Machine repair 1,300,000 2,000,000

Design modification: Engineer salaries 1,200,000 1,200,000 Plant services: Factory maintenance 800,000 Heating and lighting 200,000 1,000,000

Total overhead cost $4,800,000

Step 3: Compute Overhead Allocation Rates for Each Activity Step 3 is to compute activity overhead (cost pool) rates used to assign overhead costs to final cost ob- jects such as products. Proper determination of activity rates depends on (1) proper identifica- tion of the factor that drives the cost in each activity cost pool and (2) proper measures of activities.

The factor that drives cost, or activity cost driver, is an activity that causes costs in the pool to be incurred. For KartCo’s overhead, craftsmanship costs are mainly driven by the direct labor hours used to assemble products; setup costs are driven by the number of batches produced; design modification costs are driven by the number of new designs; and plant services costs are driven by the square feet of building space occupied. These activity cost drivers serve as the

Chapter 17 Activity-Based Costing and Analysis 665

allocation base for each activity cost pool. KartCo then determines an expected activity level for each activity cost pool, as shown below.

Activity Cost Pools Activity Driver (# of) Expected Activity Level

Craftsmanship . . . . . . . . . . . . . . . . . Direct labor hours 30,000 DLH

Setup . . . . . . . . . . . . . . . . . . . . . . . . Batches 200 batches

Design modification . . . . . . . . . . . . Designs 10 design modifications

Plant services . . . . . . . . . . . . . . . . . Square feet 20,000 square feet

In general, cost pool activity rates are computed as follows.

Cost pool activity rate = Overhead costs assigned to pool ÷ Expected activity level

Craftsmanship cost pool activity rate = $600,000 ÷ 30,000 DLH = $20 per DLH

For KartCo, the activity rate for the craftsmanship cost pool is computed as follows.

The activity rate computations for KartCo are summarized in Exhibit 17.12.

Activity Overhead Costs Expected Activity Rate

Cost Pools Activity Driver Assigned to Pool Activity Level

Craftsmanship . . . . . . . . . . . . Direct labor hours $ 600,000 30,000 DLH $20 per DLH

Setup . . . . . . . . . . . . . . . . . . Batches 2,000,000 200 batches $10,000 per batch

Design modification . . . . . . . Number of designs 1,200,000 10 designs $120,000 per design

Plant services . . . . . . . . . . . . Square feet 1,000,000 20,000 sq . ft . $50 per sq . ft .

÷ = EXHIBIT 17.12 Activity Rates for KartCo

Step 4: Assign Overhead Costs to Cost Objects Step 4 is to assign overhead costs in each activity cost pool to cost objects using activity rates. To do this, overhead costs are allocated to products based on the actual levels of activities used.

For KartCo, overhead costs in each pool are allocated to the standard go-karts and the custom go-karts using the activity rates from Exhibit 17.12. The actual activities used by each product line and the overhead costs allocated to standard and custom go-karts under ABC for KartCo are summarized in Exhibit 17.13. To illustrate, of the $600,000 of overhead costs in the craftsman- ship cost pool, $500,000 is allocated to standard go-karts as follows.

Overhead from craftsmanship pool allocated to standard go-kart = Activities consumed × Activity rate = 25,000 DLH × $20 per DLH = $500,000

Standard go-karts used 25,000 direct labor hours, and the activity rate for craftsmanship is $20 per direct labor hour. Multiplying the number of direct labor hours by the activity rate yields the craftsmanship costs assigned to standard go-karts ($500,000). Custom go-karts con- sumed 5,000 direct labor hours, so we assign $100,000 (5,000 DLH × $20 per DLH) of crafts- manship costs to that product line. We similarly allocate overhead costs of setup, design modification, and plant services pools to each type of go-kart.

KartCo assigned no design modification costs to standard go-karts because standard go-karts are sold as “off-the-shelf” items. Using ABC, a total of $1,500,000 of overhead costs is allo- cated to standard go-karts and a total of $3,300,000 is allocated to custom go-karts. While the

Point: In ABC, overhead is allocated based on the actual level of activities used, multiplied by a predetermined activity rate for each cost pool.

666 Chapter 17 Activity-Based Costing and Analysis

Total Overhead Cost Allocated

Standard Go-Karts Overhead Allocated

25,000 DLH × $20 = 40 batches × $10,000 = 0 designs × $120,000 = 12,000 sq. ft. × $50 =

$ 500,000 400,000

0 600,000

$1,500,000

Custom Go-Karts Overhead Allocated

5,000 DLH × $20 = 160 batches × $10,000 = 10 designs × $120,000 = 8,000 sq. ft. × $50 =

$ 100,000 1,600,000 1,200,000

400,000 $3,300,000

$ 600,000 2,000,000 1,200,000 1,000,000

$4,800,000

Overhead Cost $4,800,000

Setup $2,000,000

Design Modification $1,200,000

Craftsmanship $600,000

÷ 30,000 DLH = $20 per DLH

÷ 10 design modifications

= $120,000 per design

÷ 200 batches = $10,000 per batch

Plant Services $1,000,000

÷ 20,000 sq. ft. = $50 per sq. ft.

Annual BudgetAnnual BudgetAnnAnAnnual BudgetAnnual BudgetBu

=+

EXHIBIT 17.13 Overhead Allocated to Go-Karts for KartCo

$4,800,000 total overhead cost allocated is the same as under the plantwide and departmental rate methods, the amounts allocated to the two product lines differ.

Overhead cost per unit is computed by dividing total overhead cost allocated to each product line by the number of product units. KartCo’s overhead cost per unit for its standard and custom go-karts is computed and shown in Exhibit 17.14.

EXHIBIT 17.14 Overhead Cost per Unit for Go-Karts Using ABC

(A) (B) (A ÷ B) Total Overhead Cost Allocated Units Produced Overhead Cost per Unit

Standard go-kart . . . . . . . . . $1,500,000 5,000 units $ 300 per unit

Custom go-kart . . . . . . . . . . 3,300,000 1,000 units 3,300 per unit

Total product cost per unit for KartCo using ABC for its two products follows.

Direct Materials Direct Labor Overhead Product Cost per Unit

Standard go-kart . . . . . . $400 + $350 + $ 300 = $1,050 Custom go-kart . . . . . . . 600 + 500 + 3,300 = 4,400

Assuming that ABC more accurately assigns costs, KartCo’s management now sees how its competitors can sell their standard models at $1,200 and why KartCo is flooded with orders for custom go-karts. Specifically, if the cost to produce a standard go-kart is $1,050, as shown above (and not $1,470 as computed using the plantwide rate or $1,450 as computed using departmental rates), a profit of $150 ($1,200 − $1,050) occurs on each standard unit sold at the competitive $1,200 market price. Further, selling its custom go-kart at $3,500 is a mistake because KartCo loses $900 ($3,500 − $4,400) on each custom go-kart sold. KartCo has under- priced its custom go-kart relative to its production costs and competitors’ prices, which explains why the company has more custom orders than it can supply.

Exhibit 17.15 summarizes KartCo’s overhead allocation per go-kart under the plantwide rate method, departmental rate method, and ABC. Overhead cost allocated to standard go-karts is

Point: Accurately assigning costs to products is key to setting many product prices. If product costs are inaccurate and result in prices that are too low, the company loses money on each item sold. Likewise, if product prices are improperly set too high, the company loses business to competitors. ABC can be used to more accurately set prices.

Chapter 17 Activity-Based Costing and Analysis 667

much less under ABC than under either of the volume-based costing methods. One reason for this difference is the large design modification costs that were spread over all go-karts under both the plantwide rate and the departmental rate methods even though standard go-karts require no design modification. When ABC is used, overhead costs commonly shift from standardized, high-volume products to low-volume, customized specialty products that consume more resources.

Differences between ABC and Multiple Departmental Rates Using ABC differs from using multiple departmental rates in how overhead cost pools are identified and in how overhead cost in each pool is allocated. When using multiple departmental rates, each de- partment is a cost pool, and overhead cost allocated to each department is assigned to products using a volume-based factor (such as direct labor hours or machine hours). This assumes that overhead costs in each department are directly proportional to the volume-based factor.

ABC, on the other hand, recognizes that overhead costs are more complex. For example, purchasing costs might make up one activity cost pool, spanning more than one department and being driven by a single cost driver (number of invoices). ABC emphasizes activities and costs of carrying out these activities. Therefore, ABC arguably better reflects the complex nature of overhead costs and how these costs are used in making products.

Overhead Cost Overhead Cost per Go-Kart

Allocation Method Standard Go-Kart Custom Go-Kart

Plantwide method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $720 $1,200

Departmental method . . . . . . . . . . . . . . . . . . . . . . . . . 700 1,300

Activity-based costing . . . . . . . . . . . . . . . . . . . . . . . . . 300 3,300

EXHIBIT 17.15 Comparison of Overhead Allocations by Method

Entrepreneur You own a start-up pharmaceutical company. You assign overhead to products based on machine hours in the packaging area. Profits are slim due to increased competition. One of your larger overhead costs is $10,000 for cleaning and sterilization that occurs each time the packaging system is converted from one product to another. Can you reduce cleaning and sterilizing costs by reducing the number of units produced? If not, what should you do to control these overhead costs? ■ Answer: Cleaning and sterilizing costs are not directly related to the volume of product manufac- tured. Thus, changing the number of units produced does not necessarily reduce these costs. Costs of cleaning and sterilizing are related to changing from one product line to another. The way to control those costs is to control the number of times the packaging system has to be changed for a different product line. Thus, efficient product scheduling would help reduce those overhead costs and improve profitability.

Decision Maker

A manufacturer makes two types of snowmobiles, Basic and Deluxe, and reports the following data to be used in applying activity-based costing. The company budgets production of 6,000 Basic snowmobiles and 2,000 Deluxe snowmobiles.

P3 Activity-Based Costing

NEED-TO-KNOW 17-2

Activity Cost Pool Activity Cost Driver Cost Assigned to Pool Basic Deluxe

Machine setup . . . . . . . . . Number of setups $ 150,000 200 setups 300 setups

Materials handling . . . . . . Number of parts 250,000 10 parts per unit 20 parts per unit

Machine depreciation . . . . Machine hours (MH) 720,000 1 MH per unit 1 .5 MH per unit

Total . . . . . . . . . . . . . . . . . . $1,120,000

1. Compute overhead activity rates for each activity cost pool using ABC. 2. Compute the total amount of overhead cost to be allocated to each of the company’s product lines using

ABC. 3. Compute the overhead cost per unit for each product line using ABC.

668 Chapter 17 Activity-Based Costing and Analysis

Solution

1. Machine setup activity rate = $150,000

200 + 300 = $300 per machine setup

Materials handling activity rate = $250,000

60,000 + 40,000* = $2.50 per part

*(6,000 units × 10 parts per unit for Basic, 2,000 units × 20 parts per unit for Deluxe)

Machine depreciation activity rate = $720,000

6,000 + 3,000† = $80 per machine hour

†(6,000 units × 1 MH per unit for Basic, 2,000 units × 1.5 MH per unit for Deluxe) 2.

Activity Cost Pool Activity Pool Rate Basic Deluxe

Machine setup . . . . . . . $300 per setup $300 × 200 = $ 60,000 $300 × 300 = $ 90,000 Materials handling . . . . $2 .50 per part $2 .50 × 6,000 × 10 = 150,000 $2 .50 × 2,000 × 20 = 100,000 Machine depreciation . . $80 per MH $80 × 6,000 × 1 = 480,000 $80 × 2,000 × 1 .5 = 240,000 Totals . . . . . . . . . . . . . . . $690,000 $430,000

3. Basic snowmobile overhead cost per unit = $690,000

6,000 = $115 per unit

Deluxe snowmobile overhead cost per unit = $430,000

2,000 = $215 per unit

Do More: QS 17-13, QS 17-14, QS 17-15, E 17-4, E 17-14,

E 17-15

Assessing Activity-Based Costing While activity-based costing can improve the accuracy of overhead cost allocations to products, it too has limitations. This section describes the major advantages and disadvantages of activity- based costing.

Advantages of Activity-Based Costing More Effective Overhead Cost Control KartCo’s design modifications were costly. ABC can be used to identify activities that can benefit from process improvement by focusing on ac- tivities instead of focusing only on direct labor or machine hours. For KartCo, identification of large design modification costs would allow managers to work on ways to improve this process.

Better Production and Pricing Decisions As in the KartCo example, ABC can provide more accurate overhead cost allocation. This is because ABC uses more cost pools and activity rates than other methods. More accurate costs allow managers to focus production activities on more profitable products and to set selling prices above product cost.

Additional Uses ABC has uses beyond determining product costs. For example, ABC can be used to Allocate the selling and administrative costs expensed by GAAP to activities; such costs can

include marketing costs, order processing costs, and order return costs. Analyzing these ac- tivities and their costs can lead to cost reductions.

Determine the profitability of various market segments or customers. Accurately assigning the costs of shipping, advertising, and customer service might reveal that some customers or segments should not be pursued. ABC provides better customer profitability information by including all the costs consumed to serve a customer. Many companies use ABC techniques for these analyses, even if they don’t use ABC in determining overall product costs.

Disadvantages of Activity-Based Costing Costs to Implement and Maintain ABC Designing and implementing an ABC system is costly. For ABC to be effective, a thorough analysis of cost activities must be performed and

Point: ABC is not acceptable under GAAP for external financial reporting.

A2 Identify and assess advantages and disadvantages of activity-based costing.

©Paul Gilham/Getty Images

Chapter 17 Activity-Based Costing and Analysis 669

appropriate cost pools must be determined. Collecting and analyzing cost data is expensive, and so is maintaining an ABC system. While technology, such as bar coding, has made it possible for many companies to use ABC, it is still too costly for some.

Some Product Cost Distortion Remains Even with ABC, product costs can be distorted because Some costs cannot be readily classified into ABC cost pools. Some cost drivers may not have a strong cause-effect relation with the costs in some pools.

Uncertainty with Decisions Remains Managers must interpret ABC data with caution in making decisions. In the KartCo case, given the huge design modification costs for custom go- karts determined under ABC, a manager might be tempted to decline some custom go-kart or- ders to save overhead costs. However, in the short run, some or all of the design modification costs cannot be saved even if some custom go-kart orders are rejected. Managers must examine carefully the controllability of costs before making decisions.

Activity Levels and Cost Management Activities causing overhead costs can be separated into four levels: (1) unit-level activities, (2) batch-level activities, (3) product-level activities, and (4) facility-level activities. These four activities are described as follows.

ACTIVITY-BASED MANAGEMENT C3 Describe the four types of activities that cause overhead costs.

Batch-level activities are performed only on each batch or group of units. For example, machine setup is needed only for each batch regardless of the units in that batch, and customer order processing must be performed for each order regardless of the number of units ordered. Batch-level costs do not vary with the number of units, but instead vary with the number of batches.

Unit-level activities are performed on each product unit. For example, the Machining department needs electricity to power the machinery to produce each unit of product. Unit-level costs tend to change with the number of units produced.

Product-level activities are performed on each product line and are not a�ected by either the numbers of units or batches. For example, product design is needed only for each product line. Product-level costs do not vary with the number of units or batches produced.

Facility-level activities are performed to sustain facility capacity as a whole and are not caused by any specific product. For example, rent and factory maintenance costs are incurred no matter what is being produced. Facility-level costs do not vary with what is manufactured, the number of batches produced, or the output quantity.

Activity Levels

Setup

Design Modification Annual BudgetAnnual Budget

• Managers • O�cers and directors

• Internal auditors • Sales sta�

• Budget o�cers • Controllers

2007 2005 2003 2001

12%

10%

8%

6% 4%

2%

0%

–2%

Return on Assets: Circ uit City Best Buy

AnnAn

• Inte • Sales st• Sales sta • Budget o�cee • Controllers• Controllers

200707 2005 20032003 20012001

12%

10%

8%

6% 4%

2%

0%

––2%2%

Retueturn on Assetsts: Circ uit CityCircui Best Buyuy

Annual Budgetnnual BudgetBu

• Managersrs • O�cers an rsand directors

Internal aududitors sta�

�ceeersrsers

Craftsmanship

Plant Services

In the KartCo example, the craftsmanship pool reflects unit-level costs, the setup pool reflects batch-level costs, the design modification pool reflects product-level costs, and plant services reflect facility-level costs. Exhibit 17.16 shows additional examples of activities com- monly found within each of the four activity levels. This list also includes common activity drivers.

Understanding the four levels of overhead costs is a first step toward controlling costs. Activity- based management (ABM) is an outgrowth of ABC that uses the link between activities and costs for better management.

670 Chapter 17 Activity-Based Costing and Analysis

Activity-based management can be useful in distinguishing value-added activities, which add value to a product, from non-value-added activities, which do not. KartCo’s value-added activities include machining, assembly, and the costs of engineering design changes. Its non- value-added activity is machine repair. ABM aids in cost control by reducing how much of an activity is performed.

Activity Level Examples of Activity Activity Driver (Measure)

Unit level Cutting parts Machine hours Assembling components Direct labor hours Printing checks Number of checks

Batch level Calibrating machines Number of batches Receiving shipments Number of orders Sampling product quality Number of lots produced Recycling hazardous waste Tons recycled

Product level Designing modifications Change requests Organizing production Engineering hours Controlling inventory Parts per product

Facility level Cleaning workplace Square feet of floors* Providing electricity Kilowatt hours* Providing personnel support Number of employees* Reducing greenhouse gas emissions Tons of CO2

* Facility-level costs are not traceable to individual product lines, batches, or units. They are normally assigned to units using a unit-level driver such as direct labor hours or machine hours even though they are caused by another activity.

EXHIBIT 17.16 Examples of Activities by Activity Level

The ABCs of Decisions Business managers must make long- term strategic decisions, day-to-day operating decisions, and deci- sions on the type of financing the business needs. Survey evidence suggests that managers find ABC more useful in making strategic, operating, and financing decisions than non-ABC meth- ods. Managers using ABC also felt better able to apply activity- based management. ■

Decision Insight

Costing systems and decisions

0 1 2 3 4 5 6

Financial

Strategic

Operational

Ty pe

o f d

ec is

io n

Non-ABC methods ABC method

Average response: 0=Not useful, 6=Extremely useful Source: Stratton et al., Management Accounting Quarterly, 2009.

Costs of Quality A focus on the costs of activities, via ABC and ABM, lends itself to assessments of the costs of quality. These costs refer to costs resulting from manufacturing defective products or providing services that do not meet customer expectations.

Exhibit 17.17 summarizes the typical costs of quality. These costs can be summarized in a cost of quality report, which lists the costs of quality activities by category. A focus on activi- ties and quality costs can lead to higher quality and lower costs.

Prevention costs Internal failure costs

Costs of Good Quality Costs of Poor Quality

Appraisal costs External failure costs

Cost of Quality Report Quality Activity Cost

Prevention Training . . . . . . . . . . . . . . . . . . . . . . $ 22,000 Appraisal Inspecting materials . . . . . . . . . . . . 37,500 Testing finished goods . . . . . . . . . . 14,200 Internal failure Rework . . . . . . . . . . . . . . . . . . . . . . 8,250 Scrap . . . . . . . . . . . . . . . . . . . . . . . . 11,750 External failure Warranty claims . . . . . . . . . . . . . . . 45,700 Total cost of quality . . . . . . . . . . . . . . . $139,400

EXHIBIT 17.17 Types and Reporting of Quality Costs

Chapter 17 Activity-Based Costing and Analysis 671

Costs of Good Quality Prevention and appraisal costs are incurred before a good or service is provided to a customer. The purpose of these costs is to reduce the chance the customer is provided a defective good or service. These are the costs of trying to ensure that only good- quality items are produced. Prevention activities focus on quality training and improvement programs to ensure quality is

built into the product or service. Appraisal activities include the costs of inspections to ensure that materials and supplies

meet specifications and inspections of finished goods.

Costs of Poor Quality Internal and external failure costs are the costs of making poor- quality items. Internal failure costs are incurred after a company has manufactured a defective product but

before that product has been delivered to a customer. Internal failure costs include the costs of reworking products, reinspecting reworked products, and scrap.

External failure costs are incurred after a customer has been provided a defective product or service. Examples of this type of cost include costs of warranty repairs and costs of recalling products. This category also includes lost profits due to dissatisfied customers buying from other companies.

Lean Manufacturing Focusing on activities is common in lean manufacturing, which strives to eliminate waste while satisfying customers. Lean manufacturers produce to customer orders (a “pull” system) rather than to forecasted demand (a “push” system). Common features of lean manufacturing include Just-in-time (JIT) inventory systems to reduce the costs of moving and storing inventory.

With JIT, raw materials are put into production after a customer order, and the finished goods are delivered soon after completion. This reduces the costs of storing and moving inventory.

Cellular manufacturing, where products are made by teams of employees in small worksta- tions (“cells”). Producing an entire product in one cell allows manufacturers to reduce ma- chine setup times, produce in smaller batches, and meet customer orders more quickly.

Building quality into products by focusing on the costs of good quality. Lean manufacturers do not have time to rework defective products and usually are not able to meet customer or- ders from inventory.

Many lean manufacturers embrace lean accounting, which typically includes Lean thinking to eliminate waste in the accounting process. Alternative performance measures, like the percentage of products made without defects and

the percentage of on-time deliveries. Simplified product costing. With JIT, most of the product costs during a period will be in-

cluded in cost of goods sold rather than in inventory. Instead of transferring costs across in- ventory accounts during a period, a backflush costing system measures the costs of inventory only at the end of the period. Costs of unfinished products are “flushed out” of Cost of Goods Sold and transferred to inventory accounts.

ABC for Service Providers Although we’ve shown how to use ABC in a manufacturing setting, ABC also applies to service providers. The only requirements for ABC are the existence of costs and demand for reliable cost information. Shipping companies like FedEx and UPS use ABC to track the activities and costs involved with delivering packages. Southwest Airlines uses ABC to allocate costs to its passenger and ticketing cost pools. First Tennessee National Corporation, a bank, applied ABC and found that 30% of its certificate of deposit (CD) customers provided nearly 90% of its profits from CDs. Further, 30% of the bank’s CD customers were actually losing money for the bank. The bank’s management used ABC to correct the problem and increase profits.

Point: Prevention and appraisal costs are usually considered value-added costs, while internal and external costs are considered non-value-added costs.

672 Chapter 17 Activity-Based Costing and Analysis

Laboratories performing medical tests, accounting and law offices, and advertising agencies are other examples of service firms that can benefit from ABC. (Refer to this chapter’s Decision Analysis for an example of applying ABC to assess customer profitability and this chapter’s Comprehensive Need-to-Know for an example of applying ABC to a law firm.)

In applying ABC, service companies must classify costs by activity levels. Exhibit 17.18 shows typical activities within the four activity levels (unit, batch, service, and facility) for three service providers.

EXHIBIT 17.18 Examples of Activities for Service Providers

Activity Level

Unit Level

Batch Level

Service Level

Facility Level

Sell a ticket to a fan

Hire vendors and security for a game

Schedule a season of games

Clean the arena, provide utilities, update the website

Check in a guest

Prepare bu�et, receive supply shipments

Schedule personnel

Clean rooms, maintain pool

Register a student

Deliver an online course

Create a new course

Maintain course sites, control course data

Sports Arena Hotel Online Education

Identify the activity levels of each of the following overhead activities as unit level (U), batch level (B), product or service level (P or S), or facility level (F).

1. Cutting steel for go-kart frames 6. Painting go-karts 2. Receiving shipments of tires 7. Setting up machines for production 3. Using electricity for equipment 8. Recycling hazardous waste 4. Modifying custom go-kart design 9. Reducing water usage 5. Selling an airline ticket 10. Creating a new online course

Solution

1. U 2. B 3. F 4. P 5. U 6. U 7. B 8. B 9. F 10. S

Activities Causing Overhead Costs

NEED-TO-KNOW 17-3

C3

Do More: QS 17-4, QS 17-5, E 17-1, E 17-2

Analyzing activities leads many companies to study supply chain management, which involves the coor- dination and control of goods, services, and information as they move from suppliers to consumers. A recent study by Accenture estimates that supply chains account for 50%–70% of total expenses and green- house gas emissions for most manufacturing companies. More effective supply chains can benefit the bottom line and the environment.

Walmart, in conjunction with The Sustainability ConsortiumTM, developed an index to assess its sup- pliers’ policies and programs related to sustainability. Companies with high scores on the index are identi- fied as Sustainability Leaders on Walmart’s website, enabling customers to readily identify and perhaps buy from companies committed to sustainable practices. Walmart, in conjunction with its suppliers, is meeting its goal of eliminating 20 million metric tons of greenhouse gases from its supply chain.

Sarah Taylor Brigham and Justin Brigham, owners of Sycamore Brewing, this chapter’s feature com- pany, try to buy local ingredients whenever possible. “We want to contribute in a meaningful way to our community,” says Justin. The company also impacts the people aspect of the triple bottom line by keeping production local and hiring from the Charlotte area.

SUSTAINABILITY AND ACCOUNTING

©Sycamore Brewing

©Gallo Images/Getty Images; ©Jade LLC/Blend Images; ©Prasit Rodphan/Shutterstock

Chapter 17 Activity-Based Costing and Analysis 673

Analysis indicates that a total profit margin of $1,000 is generated from this customer. KartCo’s manage- ment can see that if this customer requires service technicians to travel more than 600 miles ($1,500 ÷ $2.50 per mile), the sale of 10 standard go-karts to this customer would be unprofitable. ABC encourages management to consider all resources consumed to serve a customer, not just manufacturing costs that are the focus of traditional costing methods.

Customer Profitability Decision Analysis

Are all customers equal? To answer this, let’s return to KartCo and assume that costs of providing cus- tomer support (such as delivery, installation, and warranty work) are related to the distance a technician must travel to provide services. Also assume that, as a result of applying activity-based costing, KartCo plans to sell its standard go-kart for $1,200 per unit. If the annual cost of customer services is expected to be $250,000 and the distance traveled by technicians is 100,000 miles annually, KartCo would want to link the cost of customer services with individual customers to make efficient marketing decisions. Using these data, an activity rate of $2.50 per mile ($250,000∕100,000 miles) is computed for assign- ing customer service costs to individual customers. KartCo would compute a typical customer profit- ability report for one of its customers, Six Flags, as follows.

Customer Profitability Report—Six Flags

Sales (10 standard go-karts × $1,200) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 Less: Product costs Direct materials (10 go-karts × $400 per go-kart) . . . . . . . . . . . . . . . . . . . . . . . $4,000 Direct labor (10 go-karts × $350 per go-kart) . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Overhead (10 go-karts × $300 per go-kart, Exhibit 17 .14) . . . . . . . . . . . . . . . . 3,000 10,500 Product profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Less: Customer service costs (200 miles × $2 .50 per mile) . . . . . . . . . . . . . . . . . . . . 500 Customer profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000

Silver Law Firm provides litigation and mediation services to a variety of clients. Attorneys keep track of the time they spend on each case, which is used to charge fees to clients at a rate of $300 per hour. A man- agement advisor commented that activity-based costing might prove useful in evaluating the costs of its legal services, and the firm has decided to evaluate its fee structure by comparing ABC to its alternative cost allocations. The following data relate to a typical month at the firm. During a typical month, the firm handles seven mediation cases and three litigation cases.

COMPREHENSIVE

Overhead Allocation for a Service Provider

NEED-TO-KNOW 17-4

Activity

Total

Consumption by Service Type Activity

Driver Amount Litigation Mediation Cost

Providing legal advice . . . . . . . . . . . . . . Billable hours 200 75 125 $30,000 Overhead costs Internal support departments Preparing documents . . . . . . . . . . . . Documents 30 16 14 $ 4,000 Occupying office space . . . . . . . . . . . Billable hours 200 75 125 1,200 Heating and lighting of office . . . . . . Billable hours 200 75 125 350 External support departments Registering court documents . . . . . . Documents 30 16 14 1,250 Retaining consultants (investigators, psychiatrists) . . . . . . Court dates 6 5 1 10,000 Using contract services (couriers, security guards) . . . . . . Court dates 6 5 1 5,000 Total overhead costs . . . . . . . . . . . . . . . . $21,800

Required

1. Determine the cost of providing legal services to each type of case using activity-based costing (ABC). 2. Determine the cost of each type of case using a single plantwide rate for nonattorney costs based on

billable hours.

674 Chapter 17 Activity-Based Costing and Analysis

3. Determine the cost of each type of case using multiple departmental overhead rates for the internal support department (based on number of documents) and external support department (based on billable hours).

4. Compare and discuss the costs assigned under each method for management decisions.

PLANNING THE SOLUTION Compute pool rates and assign costs to cases using ABC. Compute costs for the cases using the volume-based methods and discuss differences between these

costs and the costs computed using ABC.

SOLUTION 1. We need to set up activity pools and compute pool rates for ABC. All activities except “occupying office

space” and “heating and lighting” are unit-level activities (meaning they are traceable to the individual cases handled by the law firm). “Preparing documents” and “registering documents” are both driven by the number of documents associated with each case. We can therefore combine these activities and their costs into a single pool, which we call “clerical support.” Similarly, “retaining consultants” and “using services” are related to the number of times the attorneys must go to court (court dates). We combine these activities and their costs into another activity cost pool labeled “litigation support.” The costs as- sociated with occupying office space and the heating and lighting are facility-level activities and are not traceable to individual cases, yet they are costs that must be covered by fees charged to clients. We as- sign these costs using a convenient base—in this example we use the number of billable hours, which attorneys record for each client. Providing legal advice is the direct labor for a law firm.

Activity Pool Activity Pool Rate (Pool Cost Activity Cost Pools Cost Cost Driver ÷ Activity Driver)

Providing legal advice . . . . . . . . . . . . . . . $30,000 $30,000 200 billable hours $150 per billable hour Clerical support Preparing documents . . . . . . . . . . . . . . 4,000 Registering documents . . . . . . . . . . . . 1,250 5,250 30 documents $175 per document Litigation support Retaining consultants . . . . . . . . . . . . . . 10,000 Using services . . . . . . . . . . . . . . . . . . . 5,000 15,000 6 court dates $2,500 per court date Facility costs Occupying office space . . . . . . . . . . . . 1,200 Heating and lighting . . . . . . . . . . . . . . 350 1,550 200 billable hours $7 .75 per billable hour

We next determine the cost of providing each type of legal service as shown in the following table. Specifically, the pool rates from above are used to assign costs to each type of service provided by the law firm. Because litigation consumed 75 billable hours of attorney time, we assign $11,250 (75 billable hours × $150 per billable hour) of the cost of providing legal advice to this type of case. Mediation required 125 hours of attorney time, so $18,750 (125 billable hours × $150 per billable hour) of the cost to provide legal advice is assigned to mediation cases. Clerical support costs $175 per document, so the costs associated with activities in this cost pool are assigned to litigation cases (16 documents × $175 per document = $2,800) and mediation cases (14 documents × $175 per document = $2,450). The costs of activities in the litigation support and the facility cost pools are similarly assigned to the two case types.

We compute the total cost of litigation ($27,131.25) and mediation ($24,668.75) and divide these totals by the number of cases of each type to determine the average cost of each case type: $9,044 for litigation and $3,524 for mediation. This analysis shows that charging clients $300 per billable hour without regard to the type of case results in litigation clients being charged less than the cost to provide that service ($7,500 versus $9,044).

Activity Cost Pools Pool Rate Litigation Mediation

Providing legal advice . . . . $150 per billable hour 75 hours $11,250 .00 125 hours $18,750 .00 Clerical support . . . . . . . . . $175 per document 16 docs 2,800 .00 14 docs 2,450 .00 Litigation support . . . . . . . . $2,500 per court date 5 court dates 12,500 .00 1 court date 2,500 .00 Facility costs . . . . . . . . . . . . $7 .75 per billable hour 75 hours 581 .25 125 hours 968 .75 Total cost . . . . . . . . . . . . . . $27,131 .25 $24,668 .75

÷ Number of cases . . . . . . . 3 cases 7 cases Average cost per case . . . . $9,044 $3,524 Average fee per case . . . . . $7,500* $5,357†

*(75 billable hours × $300 per hour) ÷ 3 cases †(125 billable hours × $300 per hour) ÷ 7 cases

Chapter 17 Activity-Based Costing and Analysis 675

2. The cost of each type of case using a single plantwide rate for nonattorney costs (that is, all costs ex- cept for those related to providing legal advice) based on billable hours is as follows.

Total overhead cost /Total billable hours = $21,800/200 billable hours = $109 per hour

We then determine the cost of providing each type of legal service as follows.

Litigation Mediation

Providing legal advice . . . . . . . . . . . . . $150 per billable hour 75 hours $11,250 125 hours $18,750

Overhead (from part 2) . . . . . . . . . . . . . $109 per billable hour 75 hours 8,175 125 hours 13,625

Total cost . . . . . . . . . . . . . . . . . . . . . . . . $19,425 $32,375

÷ Number of cases . . . . . . . . . . . . . . . . 3 cases 7 cases Average cost per case . . . . . . . . . . . . . $6,475 $4,625 Average fee per case . . . . . . . . . . . . . . $7,500 $5,357 (from part 1)

3. The cost of each type of case using multiple departmental overhead rates for the internal support de- partment (based on number of documents) and external support department (based on billable hours) is determined as follows.

Departmental Departmental Rate Cost Base (Departmental Cost ÷ Base)

Internal support department

Preparing documents . . . . . . . . . . . . $ 4,000

Occupying office space . . . . . . . . . . 1,200

Heating and lighting of office . . . . . . 350 $5,550 30 documents $185 per document

External support department

Registering documents . . . . . . . . . . 1,250

Retaining consultants . . . . . . . . . . . 10,000

Using contract services . . . . . . . . . . 5,000 $16,250 200 billable $81 .25 per hour hours

The departmental overhead rates computed above are used to assign overhead costs to the two types of legal services. For the internal support department, we use the overhead rate of $185 per document to assign $2,960 ($185 × 16 documents) to litigation and $2,590 ($185 × 14 documents) to mediation. For the external support department, we use the overhead rate of $81.25 per hour to assign $6,093.75 ($81.25 × 75 hours) to litigation and $10,156.25 ($81.25 × 125 hours) to mediation. As shown below, the resulting average costs of litigation cases and mediation cases are $6,768 and $4,499, respectively. Using this method of cost assignment, it appears that the fee of $300 per billable hour is adequate to cover costs associated with each case.

Litigation Mediation

Attorney fees . . . . . . . . . . . . . $150 per billable hour 75 hours $11,250 .00 125 hours $18,750 .00

Internal support . . . . . . . . . . $185 per document 16 documents 2,960 .00 14 documents 2,590 .00

External support . . . . . . . . . . $81 .25 per hour 75 hours 6,093 .75 125 hours 10,156 .25

Total cost . . . . . . . . . . . . . . . . $20,303 .75 $31,496 .25

÷ Number of cases . . . . . . . . 3 cases 7 cases Average cost per case . . . . . $6,768 $4,499 Average fee per case . . . . . . $7,500 $5,357 (from part 1)

676 Chapter 17 Activity-Based Costing and Analysis

4. A comparison and discussion of the costs assigned under each method follows.

Method of Assigning Overhead Costs

Activity-Based Plantwide Departmental Average Cost per Case Costing Overhead Rate Overhead Rates

Litigation cases . . . . . . . . . . . . . . . . . . . . $9,044 $6,475 $6,768

Mediation cases . . . . . . . . . . . . . . . . . . . 3,524 4,625 4,499

The departmental and plantwide overhead rate methods assign overhead with volume-related mea- sures (billable hours and document filings). Litigation cases appear profitable under these methods. ABC, however, focuses on activities that drive costs. A large part of overhead costs was for consultants and contract services, which were unrelated to the number of cases but related to the type of cases consuming those resources. Using ABC, the costs shift from the high-volume cases (mediation) to the low-volume cases (litigation). Using ABC, the fees charged to litigate cases is insufficient (average revenue of $7,500 versus average cost of $9,044). The law firm is charging too little for the complex cases that require litigation.

ASSIGNING OVERHEAD COSTS Plantwide rate method: Uses one overhead rate.

Overhead rate = Total budgeted overhead cost

Total budgeted amount of allocation base

Summary: Cheat Sheet

Departmental overhead rate method: Uses different overhead rates for each department.

Cost Pools

Cost Objects

Cost Allocation

Base

Indirect CostsOverhead Cost

Department A Department B

Product 3Product 2Product 1

Department B Overhead RateDepartment A Overhead Rate

Departmental overhead rate = Total budgeted departmental overhead cost

Total amount of departmental allocation base

ACTIVITY-BASED COSTING Activity cost pool: Collection of costs that are related to the same activity. Activity cost driver: Activity that causes costs in the pool to be incurred.

Cost Pools

Cost Objects

Cost Allocation

Base

Indirect CostsOverhead Cost

Product 1 Product 2 Product 3

Activity Cost Pool Y

Activity Cost Pool Z

Activity Cost Pool X

Activity Overhead Rate

Activity Overhead Rate

Activity Overhead Rate

Four Steps of ABC costing: 1. Identify activities and the costs they cause. 2. Trace overhead costs to activity cost pools. 3. Compute overhead rates for each activity.

Cost pool activity rate = Overhead costs assigned to pool ÷ Expected activity level

Overhead Cost

Product 1 Product 2 Product 3

Single Plantwide Overhead Rate

Indirect Costs

Cost Objects

Cost Allocation

Base

4. Use activity overhead rates to assign overhead costs to cost objects.

Overhead allocated =

Activities consumed ×

Activity rate

Chapter 17 Activity-Based Costing and Analysis 677

COSTS OF QUALITY Prevention—Training and quality improvement Appraisal—Inspections Internal failure—Rework and scrap External failure— Warranty claims, recalls,

dissatisfied customers

ACTIVITY LEVELS Unit—performed on each unit. Batch—performed on batches or groups of units. Product—performed on each product line. Facility—performed to sustain facility capacity.

Activity (663) Activity-based costing (ABC) (663) Activity-based management (ABM) (669) Activity cost driver (664) Activity cost pool (663) Activity overhead (cost pool) rate (664)

Backflush costing (671) Batch-level activities (669) Cost object (658) Cost of quality report (670) Costs of quality (670) Facility-level activities (669)

Lean accounting (671) Product-level activities (669) Supply chain management (672) Unit-level activities (669) Value-added activities (670)

Key Terms

Multiple Choice Quiz

1. In comparison to a traditional cost system, and when there are batch-level or product-level costs, an activity-based costing system usually shifts costs from a. Low-volume to high-volume products. b. High-volume to low-volume products. c. Standardized to specialized products. d. Specialized to standardized products.

2. Which of the following statements is true? a. An activity-based costing system is generally easier to

implement and maintain than a traditional costing system. b. Activity-based management eliminates waste by allo-

cating costs to products that waste resources. c. Activity-based costing uses a single rate to allocate

overhead. d. Activity rates in activity-based costing are computed by

dividing costs from the first-stage allocations by the ac- tivity measure for each activity cost pool.

3. All of the following are examples of batch-level activities except a. Purchase order processing. b. Setting up equipment. c. Clerical activity associated with processing purchase

orders to produce an order for a standard product. d. Employee recreational facilities.

4. A company has two products: A and B. It uses activity-based costing and prepares the following analysis showing bud- geted cost and activity for each of its three activity cost pools.

The annual production and sales level of Product A is 18,188 units, and the annual production and sales level of Product B is 31,652 units. The approximate overhead cost per unit of Product B under activity-based costing is

a. $2.02. c. $12.87. b. $5.00. d. $22.40. 5. A company uses activity-based costing to determine the costs

of its two products: A and B. The budgeted cost and activity for each of the company’s three activity cost pools follow.

The activity rate under the activity-based costing method for Activity 3 is

a. $4.00. c. $18.00. b. $8.59. d. $20.00.

Budgeted Budgeted Activity Activity Overhead Cost Pool Cost Product A Product B Total

Activity 1 $ 80,000 200 800 1,000

Activity 2 58,400 1,000 500 1,500

Activity 3 360,000 600 5,400 6,000

Activity Budgeted Budgeted Activity

Cost Pool Cost Product A Product B Total

Activity 1 $19,800 800 300 1,100

Activity 2 16,000 2,200 1,800 4,000

Activity 3 14,000 400 300 700

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; Under traditional costing methods, overhead costs are allocated to products on the basis of some measure of volume such as direct labor hours or machine hours. This results in much of the over- head cost being allocated to high-volume products. In contrast,

under activity-based costing, some overhead costs are allocated on the basis of batch-level or product-level activities. This change in allocation bases results in shifting overhead costs from high- volume products to low-volume products.

Good quality

Poor quality

⎫ ⎬ ⎭

⎫ ⎪ ⎬ ⎪ ⎭

678 Chapter 17 Activity-Based Costing and Analysis

2. d; Generally, an activity-based costing system is more difficult to implement and maintain than a traditional costing system (thus answer a is false). Instead of eliminating waste by allocating costs to products that waste resources, activity-based management is a management approach that focuses on managing activities as a means of eliminating waste and reducing delays and defects (thus answer b is false). Instead of using a single allocation base (such as direct labor hours), activity-based costing uses a number of allocation bases for assigning costs to products (thus answer c is false). Answer d is true.

3. d; Batch-level activities are activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch. Further, the amount of resources consumed depends on the number of batches rather than on the number of units in the batch. Worker recreational facilities relate to the organization as a whole rather than to specific batches and, as such, are not considered to be batch level. On the other hand, purchase order processing, setting up equipment, and the clerical activities described are activities that are performed each time a batch of goods is handled or processed, and, as such, are batch- level activities.

4. c;

(A) (B) (A × B) Activity Rate Overhead (Budgeted overhead Cost

Activity cost ÷ Budgeted Actual Applied to Cost Pools activity) Activity Production

Activity 1 . . . . . ($80,000 ÷ 1,000) = $80 .00 800 $ 64,000 Activity 2 . . . . . ($58,400 ÷ 1,500) = $38 .93* 500 19,465 Activity 3 . . . . . ($360,000 ÷ 6,000) = $60 .00 5,400 324,000 Total overhead cost for Product B . . . . . . . . . . . . . . . . . . . . . . . . . $407,465

Number of units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ÷ 31,652 Overhead cost per unit of Product B . . . . . . . . . . . . . . . . . . . . . . . $ 12 .87*

*Rounded

5. d; The activity rate for Activity 3 is determined as follows: Budgeted cost ÷ Budgeted activity = Activity rate

$14,000 ÷ 700 = $20

Icon denotes assignments that involve decision making.

1. Why are overhead costs allocated to products and not traced to products as direct materials and direct labor are?

2. What are three common methods of assigning overhead costs to a product?

3. Why are direct labor hours and machine hours commonly used as the bases for overhead allocation?

4. What are the advantages of using a single plantwide over- head rate?

5. The usefulness of a single plantwide overhead rate is based on two assumptions. What are those assumptions?

6. What is a cost object? 7. Explain why a single plantwide overhead rate can dis-

tort the cost of a particular product. 8. Why are multiple departmental overhead rates more ac-

curate for product costing than a single plantwide overhead rate?

9. In what way are departmental overhead rates similar to a single plantwide overhead rate? How are they different?

10. Why is overhead allocation under ABC usually more accu- rate than either the plantwide overhead allocation method or the departmental overhead allocation method?

11. Google reports costs in financial state- ments. If plantwide overhead rates are al- lowed for reporting costs to external users, why might a company choose to use a more complicated and more ex- pensive method for assigning overhead costs to products?

12. What is the first step in applying activity-based costing? 13. What is an activity cost driver? 14. Apple’s production requires activities. What

are value-added activities? 15. What are the four activity levels associated with activity-

based costing? Define each. 16. Samsung is a manufacturer.

“Activity-based costing is only useful for manufacturing companies.” Is this a true statement? Explain.

17. Apple must assign overhead costs to its products. Activity-based costing is generally considered more accurate than other methods of assigning overhead. If this is so, why don’t all manufacturing compa- nies use it?

18. Toyota embraces lean techniques, including lean account- ing. What are the key components of lean accounting?

Discussion Questions

GOOGLE

APPLE

APPLE

Samsung

QUICK STUDY

QS 17-1 Overhead cost allocation methods

C1

In the blank next to each of the following terms, place the letter A through D that corresponds to the description of that term. Some letters are used more than once.

1. Activity-based costing 2. Plantwide overhead rate method 3. Departmental overhead rate method

A. Uses more than one rate to allocate overhead costs to products.

B. Uses only volume-based measures such as direct labor hours to allocate overhead costs to products.

C. Typically uses the most overhead allocation rates. D. Focuses on the costs of carrying out activities.

Chapter 17 Activity-Based Costing and Analysis 679

1. Which costing method assumes all products use overhead costs in the same proportions? a. Activity-based costing c. Departmental overhead rate method b. Plantwide overhead rate method d. All cost allocation methods

2. Which of the following would usually not be used in computing plantwide overhead rates? a. Direct labor hours c. Direct labor dollars b. Number of quality inspections d. Machine hours

3. With ABC, overhead costs should be traced to which cost object first? a. Units of product c. Activities b. Departments d. Product batches

QS 17-2 Cost allocation methods

C1

QS 17-3 Costing terminology

C2

In the blank next to the following terms, place the letter A through D that corresponds to the best descrip- tion of that term.

1. Activity 2. Activity driver 3. Cost object 4. Cost pool

A. Measurement associated with an activity. B. A group of costs that have the same activity drivers. C. Anything to which costs will be assigned. D. A task that causes a cost to be incurred.

Classify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) for a manufacturer of organic juices. 1. Cutting fruit 4. Receiving fruit shipments 2. Developing new types of juice 5. Cleaning blending machines 3. Blending fruit into juice 6. Reducing water usage

QS 17-4 Identifying activity levels

C3

Classify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) for a manufacturer of trail mix. 1. Roasting peanuts 4. Providing utilities for factory 2. Cleaning roasting machines 5. Calibrating mixing machines 3. Sampling product quality 6. Reducing electricity usage

QS 17-5 Identifying activity levels

C3

QS 17-6 Advantages of plantwide and departmental rate methods

A1

Which of the following are advantages of the plantwide and departmental overhead rate methods? Indicate advantages with an A and disadvantages with a D. 1. They are based on readily available information. 2. They can be used for external financial reporting. 3. Overhead costs are too complex to be explained by only one factor. 4. They violate GAAP. 5. They are easy to implement.

QS 17-7 Multiple choice overhead questions

A2

1. If management wants the most accurate product cost, which of the following costing methods should be used? a. Volume-based costing using departmental overhead rates b. Volume-based costing using a plantwide overhead rate c. Normal costing using a plantwide overhead rate d. Activity-based costing

2. Which costing method tends to overstate the cost of high-volume products? a. Traditional volume-based costing c. Job order costing b. Activity-based costing d. Differential costing

3. Disadvantages of activity-based costing include a. It is not acceptable under GAAP c. It can be used in activity-based for external reporting. management. b. It can be costly to implement. d. Both a. and b.

680 Chapter 17 Activity-Based Costing and Analysis

QS 17-8 Costs of quality

A2

A list of activities that generate quality costs is provided below. For each activity, indicate whether it relates to a prevention (P), appraisal (A), internal failure (I), or external failure (E) activity. 1. Inspecting raw materials 2. Training workers in quality techniques 3. Collecting data on a manufacturing

process 4. Overtime labor to rework products

5. Cost of additional materials to rework a product

6. Inspecting finished goods inventory 7. Scrapping defective goods 8. Lost sales due to customer dissatisfaction

QS 17-9 Plantwide rate method

P1

A manufacturer uses machine hours to assign overhead costs to products. Budgeted information for the next year follows. Compute the plantwide overhead rate for the next year based on machine hours.

Budgeted factory overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . $544,000

Budgeted machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,400

QS 17-11 Computing departmental overhead rates P2

Refer to the information in QS 17-10. What is the company’s Assembly department overhead rate using direct labor hours?

QS 17-12 Computing departmental overhead rates P2

Refer to the information in QS 17-10. What is the company’s Finishing department overhead rate using machine hours?

QS 17-10 Computing plantwide overhead rates

P1

Rafner Manufacturing identified the following budgeted data in its two production departments.

Assembly Finishing

Manufacturing overhead costs . . . . . . . . . . . . $1,200,000 $600,000

Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . 12,000 DLH 20,000 DLH

Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 MH 16,000 MH

1. What is the company’s single plantwide overhead rate based on direct labor hours? 2. What is the company’s single plantwide overhead rate based on machine hours? (Round your answer

to two decimal places.)

QS 17-14 Assigning service costs using ABC

P3

Aziz Company sells two types of products, basic and deluxe. The company provides technical support for users of its products at an expected cost of $250,000 per year. The company expects to process 10,000 customer service calls per year. 1. Determine the company’s cost of technical support per customer service call. 2. During the month of January, Aziz received 550 calls for customer service on its deluxe model and

250 calls for customer service on its basic model. Assign technical support costs to each model using activity-based costing (ABC).

QS 17-13 Computing activity rates

P3

A manufacturer uses activity-based costing to assign overhead costs to products. Budgeted cost informa- tion for selected activities for next year follows. Form two cost pools and compute activity rates for each of the cost pools.

Activity Expected Cost Cost Driver Expected Usage of Cost Driver

Purchasing . . . . . . . . . . . . . . . . $135,000 Purchase orders 4,500 purchase orders

Cleaning factory . . . . . . . . . . . . 32,000 Square feet 5,000 square feet

Providing utilities . . . . . . . . . . . 65,000 Square feet 5,000 square feet

Chapter 17 Activity-Based Costing and Analysis 681

QS 17-15 Computing activity rates

P3

A company uses activity-based costing to determine the costs of its three products: A, B, and C. The bud- geted cost and cost driver activity for each of the company’s three activity cost pools follow. Compute the activity rates for each of the company’s three activities.

Budgeted Activity of Cost Driver

Activity Cost Pools Budgeted Cost Product A Product B Product C

Activity 1 . . . . . . . . . . . . . . . . . . . . . $140,000 20,000 9,000 6,000

Activity 2 . . . . . . . . . . . . . . . . . . . . . $ 90,000 8,000 15,000 7,000

Activity 3 . . . . . . . . . . . . . . . . . . . . . $ 82,000 1,625 1,000 2,500

Exercise 17-2 Classifying activities

C3

Following are activities in providing medical services at Healthsmart Clinic. A. Registering patients E. Ordering medical equipment B. Cleaning beds F. Heating the clinic C. Stocking examination rooms G. Providing security services D. Washing linens H. Filling prescriptions Classify each activity as unit level (U), batch level (B), service level (S), or facility level (F).

A manufacturer uses activity-based costing to assign overhead costs to products. In the coming year, it expects to incur $825,000 of costs to dispose of 3,300 tons of hazardous waste. 1. Compute the company’s cost of hazardous waste disposal per ton. 2. During the year, the company disposes of 5 tons of hazardous waste in the completion of Job 125.

Assign hazardous waste disposal cost to Job 125 using activity-based costing.

QS 17-16 Activity-based costing

P3

EXERCISES

Exercise 17-1 Identifying activity levels

C3

Identify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) to indicate the way each is incurred with respect to production. 1. Paying real estate taxes on the

factory building 2. Attaching labels to collars of shirts 3. Redesigning a bicycle seat 4. Cleaning the Assembly department

5. Polishing gold wedding rings 6. Mixing bread dough in a commercial bakery 7. Sampling cookies to determine quality 8. Recycling hazardous waste 9. Reducing greenhouse gas emissions

Exercise 17-4 Computing overhead rates under ABC P3

Refer to the information in Exercise 17-3. Compute the activity rate for each activity, assuming the com- pany uses activity-based costing.

Exercise 17-3 Computing plantwide overhead rates

P1

Xie Company identified the following activities, costs, and activity drivers for this year. The company manufactures two types of go-karts: deluxe and basic.

Activity Expected Costs Expected Activity

Handling materials . . . . . . . . . . . . . . . . . . . $625,000 100,000 parts

Inspecting product . . . . . . . . . . . . . . . . . . . 900,000 1,500 batches

Processing purchase orders . . . . . . . . . . . . 105,000 700 orders

Paying suppliers . . . . . . . . . . . . . . . . . . . . . 175,000 500 invoices

Insuring the factory . . . . . . . . . . . . . . . . . . . 300,000 40,000 square feet

Designing packaging . . . . . . . . . . . . . . . . . 75,000 2 models

Required

1. Compute a single plantwide overhead rate for the year, assuming that the company assigns overhead based on 125,000 budgeted direct labor hours.

2. In January of this year, the deluxe model required 2,500 direct labor hours and the basic model required 6,000 direct labor hours. Assign overhead costs to each model using the single plantwide overhead rate.

682 Chapter 17 Activity-Based Costing and Analysis

Exercise 17-7 Departmental overhead rates

P2

Refer to the information in Exercise 17-6.

Required

1. Compute a departmental overhead rate for the Molding department based on machine hours and a department overhead rate for the Trimming department based on direct labor hours.

2. Determine the total overhead cost assigned to each product line using the departmental overhead rates from requirement 2.

3. Determine the overhead cost per unit for each product line using the departmental rate.

Exercise 17-8 Using the plantwide overhead rate to assess prices P1

Way Cool produces two different models of air conditioners. The company produces the mechanical sys- tems in its Components department. The mechanical systems are combined with the housing assembly in its Finishing department. The activities, costs, and drivers associated with these two manufacturing pro- cesses and the production support process follow.

Exercise 17-5 Assigning costs using ABC

P3

Refer to the information in Exercise 17-3. Assume that the following information is available for the com- pany’s two products for the first quarter of this year.

Deluxe Model Basic Model

Production volume . . . . . . . . . . . . 10,000 units 30,000 units

Parts required . . . . . . . . . . . . . . . . 20,000 parts 30,000 parts

Batches made . . . . . . . . . . . . . . . . 250 batches 100 batches

Purchase orders . . . . . . . . . . . . . . 50 orders 20 orders

Invoices . . . . . . . . . . . . . . . . . . . . 50 invoices 10 invoices

Space occupied . . . . . . . . . . . . . . 10,000 square feet 7,000 square feet

Models . . . . . . . . . . . . . . . . . . . . . . 1 model 1 model

Required

Compute activity rates for each activity and assign overhead costs to each product model using activity- based costing (ABC). What is the overhead cost per unit of each model?

Exercise 17-6 Plantwide overhead rate

P1

Textra Plastics produces parts for a variety of small machine manufacturers. Most products go through two operations, molding and trimming, before they are ready for packaging. Expected costs and activities for the Molding department and for the Trimming department for this year follow.

Molding Trimming

Direct labor hours . . . . . . . . . . . . . . . . . . . . 52,000 DLH 48,000 DLH

Machine hours . . . . . . . . . . . . . . . . . . . . . . 30,500 MH 3,600 MH

Overhead costs . . . . . . . . . . . . . . . . . . . . . . $730,000 $590,000

Data for two special-order parts to be manufactured by the company in this year follow.

Required

1. Compute the plantwide overhead rate using direct labor hours as the base. 2. Determine the overhead cost assigned to each product line using the plantwide rate computed in

requirement 1.

Part A27C Part X82B

Number of units . . . . . . . . . . . . . . . . . . . . . . 9,800 units 54,500 units

Machine hours: Molding . . . . . . . . . . . . . . . 5,100 MH 1,020 MH

Trimming . . . . . . . . . . . . . . 2,600 MH 650 MH

Direct labor hours: Molding . . . . . . . . . . . . . 5,500 DLH 2,150 DLH

Trimming . . . . . . . . . . . . 700 DLH 3,500 DLH

Chapter 17 Activity-Based Costing and Analysis 683

Additional production information concerning its two product lines follows.

Process Activity Overhead Cost Driver Quantity

Components Changeover $ 500,000 Number of batches 800 Machining 279,000 Machine hours 6,000 Setups 225,000 Number of setups 120 $1,004,000

Finishing Welding $ 180,300 Welding hours 3,000 Inspecting 210,000 Number of inspections 700 Rework 75,000 Rework orders 300 $ 465,300

Support Purchasing $ 135,000 Purchase orders 450 Providing space 32,000 Number of units 5,000 Providing utilities 65,000 Number of units 5,000 $ 232,000

Model 145 Model 212

Units produced . . . . . . . . . . . . . . . . . . 1,500 3,500 Welding hours . . . . . . . . . . . . . . . . . . . 800 2,200 Batches . . . . . . . . . . . . . . . . . . . . . . . 400 400 Number of inspections . . . . . . . . . . . . 400 300 Machine hours . . . . . . . . . . . . . . . . . . 1,800 4,200 Setups . . . . . . . . . . . . . . . . . . . . . . . . 60 60 Rework orders . . . . . . . . . . . . . . . . . . 160 140 Purchase orders . . . . . . . . . . . . . . . . . 300 150

Exercise 17-9 Using departmental overhead rates to assess prices

P2

Refer to the information in Exercise 17-8 to answer the following requirements.

Required

1. Determine departmental overhead rates and compute the overhead cost per unit for each product line. Base your overhead assignment for the Components department on machine hours. Use welding hours to assign overhead costs to the Finishing department. Assign costs to the Support department based on number of purchase orders.

2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per unit are $250 for Model 145 and $180 for Model 212.

3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the profit or loss per unit for each model.

Check (3) Model 212, $(20.38) per unit loss

Required

1. Using a plantwide overhead rate based on machine hours, compute the overhead cost per unit for each product line.

2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per unit are $250 for Model 145 and $180 for Model 212.

3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the profit or loss per unit for each model.

Check (3) Model 212, $(40.26) per unit loss

Exercise 17-10 Assigning overhead costs using the plantwide rate and departmental rate methods

P1 P2

Laval produces lamps and home lighting fixtures. Its most popular product is a brushed aluminum desk lamp. This lamp is made from components shaped in the Fabricating department and assembled in the Assembly department. Information related to the 35,000 desk lamps produced annually follows.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 Direct labor: Fabricating department (7,000 DLH × $20 per DLH) . . . . . . . . . . . . . . . . . . . . . . . . $140,000 Assembly department (16,000 DLH × $29 per DLH) . . . . . . . . . . . . . . . . . . . . . . . . $464,000 Machine hours: Fabricating department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,040 MH Assembly department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 MH

684 Chapter 17 Activity-Based Costing and Analysis

Expected overhead cost and related data for the two production departments follow.

Fabricating Assembly

Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 DLH 125,000 DLH

Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 MH 62,500 MH

Overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $200,000

Required

1. Determine the plantwide overhead rate for Laval using direct labor hours as a base. 2. Determine the total manufacturing cost per unit for the aluminum desk lamp using the plantwide over-

head rate. 3. Compute departmental overhead rates based on machine hours in the Fabricating department and

direct labor hours in the Assembly department. 4. Use departmental overhead rates from requirement 3 to determine the total manufacturing cost per unit

for the aluminum desk lamps.

Check (2) $26.90 per unit

(4) $27.60 per unit

Exercise 17-11 Using ABC to assess prices

P3

Refer to the information in Exercise 17-8 to answer the following requirements.

Required

1. Using ABC, compute the overhead cost per unit for each product line. 2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per

unit are $250 for Model 145 and $180 for Model 212. 3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the

profit or loss per unit for each model. Check (3) Model 212, $34.88 per unit profit

Exercise 17-12 Using ABC for strategic decisions

P1 P3

Consider the following data for two products of Gitano Manufacturing.

Required

1. Using direct labor hours as the basis for assigning overhead costs, determine the total production cost per unit for each product line.

2. If the market price for Product A is $20 and the market price for Product B is $60, determine the profit or loss per unit for each product. Comment on the results.

3. Consider the following additional information about these two product lines. If ABC is used for assigning overhead costs to products, what is the cost per unit for Product A and for Product B?

Check (2) Product B, $26.10 per unit profit

Product A Product B

Number of setups required for production . . . . . . . . . . . . . . . 10 setups 12 setups

Number of parts required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 part/unit 3 parts/unit

Inspection hours required . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 hours 210 hours

4. Determine the profit or loss per unit for each product. Should this information influence company strategy (yes or no)?

(4) Product B, $(24.60) per unit loss

Overhead Cost Product A Product B

Number of units produced . . . . . . . . . . . . . . . . . . . . . 10,000 units 2,000 units

Direct labor cost (@ $24 per DLH) . . . . . . . . . . . . . . . 0 .20 DLH per unit 0 .25 DLH per unit

Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit $3 per unit

Activity: Machine setup . . . . . . . . . . . . . . . . . . . . . . . $121,000

Materials handling . . . . . . . . . . . . . . . . . . . . 48,000

Quality control inspections . . . . . . . . . . . . . . 80,000

$249,000

Chapter 17 Activity-Based Costing and Analysis 685

Exercise 17-13 Comparing costs under ABC to traditional plantwide overhead rate

P1 P3

Smythe Co. makes furniture. The following data are taken from its production plans for the year.

Chairs Tables

Expected production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211,000 units 17,000 units

Direct labor hours required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254,000 DLH 16,400 DLH

Hazardous waste disposed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 pounds 800 pounds

Check (2) Tables, $29.65 per unit

Required

1. Determine the hazardous waste disposal cost per unit for chairs and for tables if costs are assigned using a single plantwide overhead rate based on direct labor hours.

2. Determine hazardous waste disposal costs per unit for chairs and for tables if costs are assigned based on the number of pounds disposed of.

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,870,000

Hazardous waste disposal costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630,000

Exercise 17-14 Activity-based costing and overhead cost allocation

P3

The following is taken from Ronda Co.’s internal records of its factory with two production departments. The cost driver for indirect labor and supplies is direct labor costs, and the cost driver for the remaining overhead items is number of hours of machine use. Compute the total amount of overhead cost allocated to Department 1 using activity-based costing.

Direct Labor Machine Use Hours

Department 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,800 2,000

Department 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,200 1,200

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000 3,200

Factory overhead costs Rent and utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,200

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,400

General office expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Depreciation — Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600

Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,200 Check Dept. 1 allocation, $16,700

Exercise 17-15 Activity-based costing rates and allocations

P3

A company has two products: standard and deluxe. The company expects to produce 36,375 standard units and 62,240 deluxe units. It uses activity-based costing and has prepared the following analysis showing budgeted cost and cost driver activity for each of its three activity cost pools.

Budgeted Activity of Cost Driver

Activity Cost Pool Budgeted Cost Standard Deluxe

Activity 1 . . . . . . . . . . . . . . . . . . . . . $93,000 2,500 5,250

Activity 2 . . . . . . . . . . . . . . . . . . . . . $92,000 4,500 5,500

Activity 3 . . . . . . . . . . . . . . . . . . . . . $87,000 3,000 2,800

Required

1. Compute overhead rates for each of the three activities. 2. What is the expected overhead cost per unit for the standard units? 3. What is the expected overhead cost per unit for the deluxe units?

686 Chapter 17 Activity-Based Costing and Analysis

Exercise 17-16 Using ABC in a service company

P3

Cardiff and Delp is an architectural firm that provides services for residential construction projects. The following data pertain to a recent reporting period.

Check (2) $150,200

Required

1. Using ABC, compute the firm’s activity overhead rates. Form activity cost pools where appropriate. 2. Assign costs to a 9,200-square-foot job that requires 450 contact hours, 340 design hours, and

200 days to complete.

Activities Costs

Design department: Client consultation . . . . . . . . . . . . . . . . . . . . . . 1,500 contact hours $270,000

Drawings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 design hours 115,000

Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 square feet 30,000

Project management department: Supervision . . . . . . . . . . . . . . . . 600 days $120,000

Billing . . . . . . . . . . . . . . . . . . . . . 8 jobs 10,000

Collections . . . . . . . . . . . . . . . . . 8 jobs 12,000

Exercise 17-17 Activity-based costing

P3

She also has collected the following information about the cost drivers for each category (cost pool) and the amount of each driver used by the two product lines.

Glassworks Inc. produces two types of glass shelving, rounded edge and squared edge, on the same production line. For the current period, the company reports the following data.

Rounded Edge Squared Edge Total

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000 $ 43,200 $ 62,200

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,200 23,800 36,000

Overhead (300% of direct labor cost) . . . . . . . . . . . 36,600 71,400 108,000

Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $67,800 $138,400 $206,200

Quantity produced . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 ft . 14,100 ft .

Average cost per ft . (rounded) . . . . . . . . . . . . . . . . . $ 6 .46 $ 9 .82

Glassworks’s controller wishes to apply activity-based costing (ABC) to allocate the $108,000 of over- head costs incurred by the two product lines to see whether cost per foot would change markedly from that reported above. She has collected the following information.

Overhead Cost Category (Activity Cost Pool) Cost

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,400

Depreciation of machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,600

Assembly line preparation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000

Total overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000

Overhead Cost Category Usage

(Activity Cost Pool) Driver Rounded Edge Squared Edge Total

Supervision . . . . . . . . . . . . . . . . . . . . Direct labor cost ($) $12,200 $23,800 $36,000

Depreciation of machinery . . . . . . . . Machine hours 500 hours 1,500 hours 2,000 hours

Assembly line preparation . . . . . . . . . Setups (number) 40 times 210 times 250 times

Required

1. Assign these three overhead cost pools to each of the two products using ABC. 2. Determine average cost per foot for each of the two products using ABC.

Check (2) Rounded edge, $5.19; Squared edge, $10.76

Chapter 17 Activity-Based Costing and Analysis 687

Exercise 17-18 Activity-based costing

P3

Surgery Center is an outpatient surgical clinic that was profitable for many years, but Medicare has cut its reimbursements by as much as 40%. As a result, the clinic wants to better understand its costs. It decides to prepare an activity-based cost analysis, including an estimate of the average cost of both general surgery and orthopedic surgery. The clinic’s three activity cost pools and their cost drivers follow.

Activity Cost Pool Cost Cost Driver Driver Quantity

Professional salaries . . . . . . . . . . . . . . . . . . . $1,600,000 Professional hours 10,000 Patient services and supplies . . . . . . . . . . . 27,000 Number of patients 600 Building cost . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Square feet 1,500

Service Hours Square Feet* Patients

General surgery . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 600 400 Orthopedic surgery . . . . . . . . . . . . . . . . . . . . . . . . 7,500 900 200

*Orthopedic surgery requires more space for patients, supplies, and equipment.

The two main surgical units and their related data follow.

Check (2) Average cost of General (Orthopedic) surgery, $1,195 ($6,495) per patient

Required

1. Compute the cost per cost driver for each of the three activity cost pools. 2. Use the results from part 1 to allocate costs to both the General surgery and the Orthopedic surgery

units. Compute total cost and average cost per patient for both the General surgery and the Orthopedic surgery units.

PROBLEM SET A

Problem 17-1A Comparing costs using ABC with the plantwide overhead rate

A1 A2 P1 P3

The following data are for the two products produced by Tadros Company.

The company’s direct labor rate is $20 per direct labor hour (DLH). Additional information follows.

Product A Product B

Direct materials . . . . . . . . . . . . . . . . . . . . $15 per unit $24 per unit Direct labor hours . . . . . . . . . . . . . . . . . . 0 .3 DLH per unit 1 .6 DLH per unit Machine hours . . . . . . . . . . . . . . . . . . . . 0 .1 MH per unit 1 .2 MH per unit Batches . . . . . . . . . . . . . . . . . . . . . . . . . . 125 batches 225 batches Volume . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 units 2,000 units Engineering modifications . . . . . . . . . . . 12 modifications 58 modifications Number of customers . . . . . . . . . . . . . . . 500 customers 400 customers Market price . . . . . . . . . . . . . . . . . . . . . . $30 per unit $120 per unit

Costs Driver

Indirect manufacturing Engineering support . . . . . . . . . . . $24,500 Engineering modifications Electricity . . . . . . . . . . . . . . . . . . . . 34,000 Machine hours Setup costs . . . . . . . . . . . . . . . . . . 52,500 Batches Nonmanufacturing Customer service . . . . . . . . . . . . . . 81,000 Number of customers

Required

1. Compute the manufacturing cost per unit using the plantwide overhead rate based on direct labor hours. What is the gross profit per unit?

2. How much gross profit is generated by each customer of Product A using the plantwide overhead rate? How much gross profit is generated by each customer of Product B using the plantwide overhead rate?

3. What is the cost of providing customer service to each customer? 4. Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit

per unit? 5. How much gross profit is generated by each customer of Product A using ABC? How much gross profit

is generated by each customer of Product B using ABC? Is the gross profit per customer adequate? Is the gross profit per customer for each of these products greater than the cost of providing customer service?

Check (1) Product A, $26.37 per unit cost

(3) Product A, $24.30 per unit cost

688 Chapter 17 Activity-Based Costing and Analysis

Problem 17-2A Assessing impacts of using a plantwide overhead rate versus ABC

A1 A2

Xylon Company manufactures custom-made furniture for its local market and produces a line of home furnishings sold in retail stores across the country. The company uses traditional volume-based methods of assigning direct materials and direct labor to its product lines. Overhead has always been assigned by using a plantwide overhead rate based on direct labor hours. In the past few years, management has seen its line of retail products continue to sell at high volumes, but competition has forced it to lower prices on these items. The prices are declining to a level close to its cost of production. Meanwhile, its custom-made furniture is in high demand, and customers have commented on its favor- able (lower) prices compared to its competitors. Management is considering dropping its line of retail products and devoting all of its resources to custom-made furniture.

Required

1. What reasons could explain why competitors are forcing the company to lower prices on its high- volume retail products?

2. Why do you believe the company charges less for custom-order products than its competitors? 3. Does a company’s costing method have any effect on its pricing decisions? Explain. 4. Aside from the differences in volume of output, what production differences do you believe exist

between making custom-order furniture and mass-market furnishings? 5. What information might the company obtain from using ABC that it might not obtain using volume-

based costing methods?

Problem 17-3A Applying activity-based costing

C3 A1 A2 P1 P3

Craft Pro Machining produces machine tools for the construction industry. The following details about overhead costs were taken from its company records.

Production Activity Indirect Labor Indirect Materials Other Overhead

Grinding . . . . . . . . . . . . . . . . . . . . . . . . $320,000

Polishing . . . . . . . . . . . . . . . . . . . . . . . $135,000

Product modification . . . . . . . . . . . . . 600,000

Providing power . . . . . . . . . . . . . . . . . $255,000

System calibration . . . . . . . . . . . . . . . 500,000

Additional information on the drivers for its production activities follows.

Required

1. Classify each activity as unit level, batch level, product level, or facility level. 2. Compute the activity overhead rates using ABC. Combine the grinding and polishing activities into a

single cost pool. 3. Determine overhead costs to assign to the following jobs using ABC.

Job 3175 Job 4286

Number of units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 units 2,500 units

Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 MH 5,500 MH

Engineering hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 eng . hours 32 eng . hours

Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 batches 90 batches

Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 DLH 4,375 DLH

Grinding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 machine hours

Polishing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 machine hours

Product modification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 engineering hours

Providing power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 direct labor hours

System calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 batches

4. What is the overhead cost per unit for Job 3175? What is the overhead cost per unit for Job 4286? 5. If the company uses a plantwide overhead rate based on direct labor hours, what is the overhead cost

for each unit of Job 3175? Of Job 4286? 6. Compare the overhead costs per unit computed in requirements 4 and 5 for each job. Which method

more accurately assigns overhead costs?

Check (4) Job 3175, $373.25 per unit

Chapter 17 Activity-Based Costing and Analysis 689

Problem 17-4A Evaluating product line costs and prices using ABC

P3

Bright Day Company produces two beverages, Hi-Voltage and EasySlim. Data about these products follow.

Hi-Voltage EasySlim

Production volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 bottles 180,000 bottles

Liquid materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 gallons 37,000 gallons

Dry materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620 pounds 12,000 pounds

Bottles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 bottles 180,000 bottles

Labels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 labels per bottle 1 label per bottle

Machine setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 setups 300 setups

Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 MH 3,750 MH

Additional data from its two production departments follow.

Required

1. Determine the cost of each product line using ABC. 2. What is the cost per bottle of Hi-Voltage? What is the cost per bottle of EasySlim? Hint: Your answer

should draw on the total cost for each product line computed in requirement 1. 3. If Hi-Voltage sells for $3.75 per bottle, how much profit does the company earn per bottle of Hi-Voltage

that it sells? 4. What is the minimum price that the company should set per bottle of EasySlim?

Check (3) $2.22 profit per bottle

Problem 17-5A Pricing analysis with ABC and a plantwide overhead rate

A1 A2 P1 P3

Sara’s Salsa Company produces its condiments in two types: Extra Fine for restaurant customers and Family Style for home use. Salsa is prepared in Department 1 and packaged in Department 2. The activi- ties, overhead costs, and drivers associated with these two manufacturing processes and the company’s production support activities follow.

Process Activity Overhead Cost Driver Quantity

Department 1 Mixing $ 4,500 Machine hours 1,500 Cooking 11,250 Machine hours 1,500

Product testing 112,500 Batches 600

$128,250

Department 2 Machine calibration $250,000 Production runs 400 Labeling 12,000 Cases of output 120,000

Defects 6,000 Cases of output 120,000

$268,000

Support Recipe formulation $ 90,000 Focus groups 45 Heat, lights, and water 27,000 Machine hours 1,500

Materials handling 65,000 Container types 8

$182,000

Department Driver Cost

Mixing department: Liquid materials . . . . . . . . . . . . . . . . . . . Gallons $ 2,304

Dry materials . . . . . . . . . . . . . . . . . . . . . Pounds 6,941

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . Machine hours 1,422

Bottling department: Bottles . . . . . . . . . . . . . . . . . . . . . . . . . Units $77,000

Labeling . . . . . . . . . . . . . . . . . . . . . . . . Labels per bottle 6,525

Machine setup . . . . . . . . . . . . . . . . . . . Setups 20,000

690 Chapter 17 Activity-Based Costing and Analysis

Additional production information about its two product lines follows.

Extra Fine Family Style

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 cases 100,000 cases

Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 batches 400 batches

Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . 500 MH 1,000 MH

Focus groups . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 groups 15 groups

Container types . . . . . . . . . . . . . . . . . . . . . . . . . . 5 containers 3 containers

Production runs . . . . . . . . . . . . . . . . . . . . . . . . . . 200 runs 200 runs

Check (2) Cost per case: Extra Fine, $10.82; Family Style, $9.82

(4) Cost per case: Extra Fine, $20.02; Family Style, $7.98

Required

1. Using a plantwide overhead rate based on cases, compute the overhead cost that is assigned to each case of Extra Fine Salsa and each case of Family Style Salsa.

2. Using the plantwide overhead rate, determine the total cost per case for the two products if the direct materials and direct labor cost is $6 per case of Extra Fine and $5 per case of Family Style.

3. If the market price of Extra Fine Salsa is $18 per case and the market price of Family Style Salsa is $9 per case, determine the gross profit per case for each product. Do both products have positive gross profits?

4. Using ABC, compute the total cost per case for each product type if the direct labor and direct materi- als cost is $6 per case of Extra Fine and $5 per case of Family Style.

5. If the market price is $18 per case of Extra Fine and $9 per case of Family Style, determine the gross profit per case for each product. Using ABC, is Extra Fine Salsa profitable?

PROBLEM SET B

Problem 17-1B Comparing costs using ABC with the plantwide overhead rate

A1 A2 P1 P3

The company’s direct labor rate is $20 per direct labor hour (DLH). Additional information follows.

Wade Company makes two distinct products, with the following information available for each.

Standard Deluxe

Direct materials . . . . . . . . . . . . . . . . . . . $4 per unit $8 per unit

Direct labor hours . . . . . . . . . . . . . . . . . 4 DLH per unit 5 DLH per unit

Machine hours . . . . . . . . . . . . . . . . . . . . 3 MH per unit 3 MH per unit

Batches . . . . . . . . . . . . . . . . . . . . . . . . . 175 batches 75 batches

Volume . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 units 10,000 units

Engineering modifications . . . . . . . . . . . 50 modifications 25 modifications

Number of customers . . . . . . . . . . . . . . . 1,000 customers 1,000 customers

Market price . . . . . . . . . . . . . . . . . . . . . . $92 per unit $125 per unit

Costs Driver

Indirect manufacturing

Engineering support . . . . . . . . . . . . . $ 56,250 Engineering modifications

Electricity . . . . . . . . . . . . . . . . . . . . . . 112,500 Machine hours

Setup costs . . . . . . . . . . . . . . . . . . . . . 41,250 Batches

Nonmanufacturing

Customer service . . . . . . . . . . . . . . . . 250,000 Number of customers

Required

1. Compute the manufacturing cost per unit using the plantwide overhead rate based on machine hours. What is the gross profit per unit?

2. How much gross profit is generated by each customer of the standard product using the plantwide overhead rate? How much gross profit is generated by each customer of the deluxe product using the plantwide overhead rate? What is the cost of providing customer service to each customer? What information is provided by this comparison?

3. Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit per unit?

Check (1) Gross profit per unit: Standard, $3.80; Deluxe, $12.80

(3) Gross profit per unit: Standard, $4.09; Deluxe, $11.64

Chapter 17 Activity-Based Costing and Analysis 691

4. How much gross profit is generated by each customer of the standard product using ABC? How much gross profit is generated by each customer of the deluxe product using ABC? Is the gross profit per customer adequate?

5. Which method of product costing gives better information to managers of this company? Explain.

Problem 17-2B Assessing impacts of using a plantwide overhead rate versus ABC

A1 A2

Midwest Paper produces cardboard boxes. The boxes require designing, cutting, and printing. (The boxes are shipped flat, and customers fold them as necessary.) Midwest has a reputation for providing high- quality products and excellent service to customers, who are major U.S. manufacturers. Costs are assigned to products based on the number of machine hours required to produce them. Three years ago, a new marketing executive was hired. She suggested the company offer custom design and manufacturing services to small specialty manufacturers. These customers required boxes for their products and were eager to have Midwest as a supplier. Within one year, Midwest found that it was so busy with orders from small customers, it had trouble supplying boxes to all its customers on a timely basis. Large, long-time customers began to complain about slow service, and several took their business else- where. Within another 18 months, Midwest was in financial distress with a backlog of orders to be filled.

Required

1. What do you believe are the major costs of making boxes? How are those costs related to the volume of boxes produced?

2. How did Midwest’s new customers differ from its previous customers? 3. Would the unit cost to produce a box for new customers be different from the unit cost to produce a

box for its previous customers? Explain. 4. Could Midwest’s fate have been different if it had used ABC for determining the cost of its boxes? 5. What information would have been available with ABC that might have been overlooked using a tra-

ditional volume-based costing method?

Problem 17-3B Applying activity-based costing

C3 A1 A2 P1 P3

Ryan Foods produces gourmet gift baskets that it distributes online as well as from its small retail store. The following details about overhead costs are taken from its records.

Production Activity Indirect Labor Indirect Materials Other Overhead

Wrapping . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $200,000 Assembling . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 Product design . . . . . . . . . . . . . . . . . . . . . . 180,000 Quality inspection . . . . . . . . . . . . . . . . . . . 100,000 Cooking . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 120,000

Additional information on the drivers for its production activities follows.

Wrapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units Assembling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 direct labor hours Product design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 design hours Quality inspection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 direct labor hours Cooking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 batches

Required

1. Classify each activity as unit level, batch level, product level, or facility level. 2. Compute the activity overhead rates using ABC. Combine the assembling and quality inspection

activities into a single cost pool. 3. Determine the overhead costs to assign to the following jobs using ABC.

Holiday Basket Executive Basket

Number of units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 units 1,000 units Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 DLH 500 DLH Design hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 design hours 40 design hours Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 batches 200 batches

[continued on next page]

692 Chapter 17 Activity-Based Costing and Analysis

4. What is the overhead cost per unit for the Holiday Basket? What is the overhead cost per unit for the Executive Basket?

5. If the company used a plantwide overhead rate based on direct labor hours, what would be the over- head cost for each Holiday Basket unit? What would be the overhead cost for each Executive Basket unit if a single plantwide overhead rate were used?

6. Compare the costs per unit computed in requirements 4 and 5 for each job. Which cost assignment method provides the most accurate cost? Explain.

Check (4) Holiday Basket, $14.25 per unit

(5) Holiday Basket, $18.13 per unit

Problem 17-4B Evaluating product line costs and prices using ABC

P3

Mathwerks produces two electronic, handheld educational games: Fun with Fractions and Count Calculus. Data on these products follow.

Fun with Fractions Count Calculus

Production volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 units 10,000 units Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 parts 100,000 parts Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 DLH 2,000 DLH Packaging materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 boxes 10,000 boxes Shipping cartons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 units per carton 25 units per carton Machine setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 setups 52 setups Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 MH 2,000 MH

Additional data from its two production departments follow.

Department Driver Cost

Assembly department: Component cost . . . . . . . . . . . . . . . . . . . . . Parts $495,000 Assembly labor . . . . . . . . . . . . . . . . . . . . . . Direct labor hours 244,800 Maintenance . . . . . . . . . . . . . . . . . . . . . . . Machine hours 100,800 Wrapping department: Packaging materials . . . . . . . . . . . . . . . . . . Boxes $460,800 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . Cartons 27,360 Machine setup . . . . . . . . . . . . . . . . . . . . . . Setups 187,200

Required

1. Using ABC, determine the cost of each product line. 2. What is the cost per unit of Fun with Fractions? What is the cost per unit of Count Calculus? 3. If Count Calculus sells for $59.95 per unit, how much profit does the company earn per unit of Count

Calculus sold? 4. What is the minimum price that the company should set per unit of Fun with Fractions? Explain.

Check (3) $32.37 profit per unit

Problem 17-5B Pricing analysis with ABC and a plantwide overhead rate

A1 A2 P1 P3

Tent Pro produces two lines of tents sold to outdoor enthusiasts. The tents are cut to specifications in Department A. In Department B, the tents are sewn and folded. The activities, costs, and drivers associ- ated with these two manufacturing processes and the company’s production support activities follow.

Process Activity Overhead Cost Driver Quantity

Department A Pattern alignment $ 64,400 Batches 560 Cutting 50,430 Machine hours 12,300 Moving product 100,800 Moves 2,400

$215,630

Department B Sewing $327,600 Direct labor hours 4,200 Inspecting 24,000 Inspections 600 Folding 47,880 Units 22,800 $399,480

Support Design $280,000 Modification orders 280 Providing space 51,600 Square feet 8,600 Materials handling 184,000 Square yards 920,000 $515,600

[continued from previous page]

Chapter 17 Activity-Based Costing and Analysis 693

Additional production information on the two lines of tents follows.

Pup Tent Pop-up Tent

Units produced . . . . . . . . . . . . . . . . . . 15,200 units 7,600 units

Moves . . . . . . . . . . . . . . . . . . . . . . . . . 800 moves 1,600 moves

Batches . . . . . . . . . . . . . . . . . . . . . . . . 140 batches 420 batches

Number of inspections . . . . . . . . . . . . 240 inspections 360 inspections

Machine hours . . . . . . . . . . . . . . . . . . 7,000 MH 5,300 MH

Direct labor hours . . . . . . . . . . . . . . . . 2,600 DLH 1,600 DLH

Modification orders . . . . . . . . . . . . . . 70 modification orders 210 modification orders

Space occupied . . . . . . . . . . . . . . . . . 4,300 square feet 4,300 square feet

Material required . . . . . . . . . . . . . . . . 450,000 square yards 470,000 square yards

Required

1. Using a plantwide overhead rate based on direct labor hours, compute the overhead cost that is assigned to each pup tent and each pop-up tent.

2. Using the plantwide overhead rate, determine the total cost per unit for the two products if the direct materials and direct labor cost is $25 per pup tent and $32 per pop-up tent.

3. If the market price of the pup tent is $65 and the market price of the pop-up tent is $200, determine the gross profit per unit for each tent. What might management conclude about the pup tent?

4. Using ABC, compute the total cost per unit for each tent if the direct labor and direct materials cost is $25 per pup tent and $32 per pop-up tent.

5. If the market price is $65 per pup tent and $200 per pop-up tent, determine the gross profit per unit for each tent. Comment on the results.

6. Would your pricing analysis be improved if the company used, instead of ABC, departmental rates determined using machine hours in Department A and direct labor hours in Department B? Explain.

Check (4) Pup tent, $58.46 per unit cost

SERIAL PROBLEM Business Solutions

P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 17 After reading an article about activity-based costing in a trade journal for the furniture industry, Santana Rey wondered if it was time to critically analyze overhead costs at Business Solutions. In a recent month, Santana found that setup costs, inspection costs, and utility costs made up most of its overhead. Additional information about overhead follows.

©Alexander Image/Shutterstock

Activity Cost Driver

Setting up machines . . . . . . . . . . . . . . $20,000 25 batches

Inspecting components . . . . . . . . . . . $ 7,500 5,000 parts

Providing utilities . . . . . . . . . . . . . . . . $10,000 5,000 machine hours

Required

1. Classify each of its three overhead activities as unit level, batch level, product level, or facility level. 2. What is the total cost of Job 615 if Business Solutions applies overhead at 50% of direct labor cost? 3. What is the total cost of Job 615 if Business Solutions uses activity-based costing? 4. Which approach to assigning overhead gives a better representation of the costs incurred to produce

Job 615? Explain.

Overhead has been applied to output at a rate of 50% of direct labor costs. The following data pertain to Job 615.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,500

Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 batches

Number of parts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 parts

Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 machine hours

694 Chapter 17 Activity-Based Costing and Analysis

ETHICS CHALLENGE C3 A2

BTN 17-1 In conducting interviews and observing factory operations to implement an activity-based cost- ing system, you determine that several activities are unnecessary or redundant. For example, warehouse personnel were inspecting purchased components as they were received at the loading dock. Later that day, the components were inspected again on the shop floor before being installed in the final product. Both of these activities caused costs to be incurred but were not adding value to the product. If you include this observation in your report, one or more employees who perform inspections will likely lose their jobs.

Required

1. As a plant employee, what is your responsibility to report your findings to superiors? 2. Should you attempt to determine if the redundancy is justified? Explain. 3. What is your responsibility to the employees whose jobs will likely be lost because of your report? 4. What facts should you consider before making your decision to report or not?

Beyond the Numbers

COMPANY ANALYSIS P3

Accounting Analysis

AA 17-1 Apple reports the following net sales (in $ millions) by product line in its fiscal-year 2017 annual report.

APPLE

APPLE GOOGLE

AA 17-2 The ratio of costs to revenues can indicate opportunities for activity-based costing to increase efficiency and reduce costs. Refer to Apple’s and Google’s 2017 income statements in Appendix A to answer the following.

Required

1. For Apple, compute the ratio of costs (titled as cost of sales plus operating expenses) to net sales for 2017.

2. For Google, compute the ratio of costs (titled as total costs and expenses) to revenues for 2017. 3. Which company has the higher ratio of costs to revenues for 2017?

COMPARATIVE ANALYSIS P3

AA 17-3 The ratio of costs to revenues can indicate opportunities for activity-based costing to increase effi- ciency and reduce costs. Refer to Samsung’s financial statements in Appendix A to answer the following.

Required

1. Compute the ratio of costs (titled as cost of sales plus selling and administrative expenses) to revenue for 2017.

2. Compute the ratio of costs (titled as cost of sales plus selling and administrative expenses) to revenue for 2016.

3. Was Samsung’s ratio of costs to revenues higher in 2017 or 2016?

GLOBAL ANALYSIS P3

Samsung

Product line 2017 Sales 2016 Sales

iPhone . . . . . . . . . . . . . . . . . . . . . . . . . $141,319 $136,700

iPad . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,222 20,628

Mac . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,850 22,831

Services . . . . . . . . . . . . . . . . . . . . . . . . 29,980 24,348

Other . . . . . . . . . . . . . . . . . . . . . . . . . . 12,863 11,132

Required

1. If Apple assigns overhead costs to product lines based on sales, which product line would be assigned the highest amount of overhead costs for 2017?

2. If Apple assigns overhead costs to product lines based on sales, which product line would be assigned the lowest amount of overhead costs for 2017?

3. Which of Apple’s product lines had the largest percentage increase in sales from 2016 to 2017?

Chapter 17 Activity-Based Costing and Analysis 695

BTN 17-2 The chief executive officer (CEO) of your company recently returned from a luncheon meeting where activity-based costing was presented and discussed. Though her background is not in accounting, she has worked for the company for 15 years and is thoroughly familiar with its operations. Her impres- sion of the presentation about ABC was that it was just another way of dividing up total overhead cost and that the total would still be the same “no matter how you sliced it.”

Required

Write a memorandum to the CEO, no more than one page, explaining how ABC is different from tradi- tional volume-based costing methods. Also identify its advantages and disadvantages vis-à-vis traditional methods. Be sure it is written to be understandable to someone who is not an accountant.

COMMUNICATING IN PRACTICE A2

BTN 17-3 Accounting professionals who work for private companies often obtain the Certified Management Accountant (CMA) designation to indicate their proficiency in several business areas in addition to managerial accounting. The CMA examination is administered by the Institute of Management Accountants (IMA).

Required

Go to the IMA website (IMAnet.org) and determine which parts of the CMA exam likely cover activity- based costing. A person planning to become a CMA should take what college coursework?

TAKING IT TO THE NET A2

BTN 17-4 Observe the operations at your favorite fast-food restaurant.

Required

1. How many people does it take to fill a typical order of a sandwich, beverage, and one side order? 2. Describe the activities involved in its food service process. 3. What costs are related to each activity identified in requirement 2?

TEAMWORK IN ACTION C2 C3

BTN 17-5 Sycamore Brewing brews many varieties of beer. Company founders Sarah Taylor Brigham and Justin Brigham know that financial success depends on cost control as well as revenue generation.

Required

1. If Sycamore Brewing wanted to expand its product line to include whiskey, what activities would it need to perform that are not required for its current product lines?

2. Related to part 1, should the additional overhead costs related to new product lines be shared by exist- ing product lines? Explain your reasoning.

ENTREPRENEURIAL DECISION C3

BTN 17-6 Visit and observe the processes of three different fast-food restaurants—these visits can be done as individuals or as teams. The objective of activity-based costing is to accurately assign costs to products and to improve operational efficiency.

Required

1. Individuals (or teams) can be assigned to each of three different fast-food establishments. Make a list of the activities required to process an order of a sandwich, beverage, and one side order at each res- taurant. Record the time required for each process, from placing the order to receiving the completed order.

2. What activities do the three establishments have in common? What activities are different across the establishments?

3. Is the number of activities related to the time required to process an order? Is the number of activities related to the price charged to customers? Explain both.

4. Make recommendations for improving the processes you observe. Would your recommendations increase or decrease the cost of operations?

HITTING THE ROAD C2 C3

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Describe different types of cost behavior

in relation to production and sales volume.

C2 Describe several applications of cost- volume-profit analysis.

ANALYTICAL A1 Compute the contribution margin and

describe what it reveals about a company’s cost structure.

P3 Interpret a CVP chart and graph costs and sales for a single-product company.

P4 Compute the break-even point for a multiproduct company.

P5 Appendix 18B—Compute unit cost and income under both absorption and variable costing.

A2 Analyze changes in sales using the degree of operating leverage.

PROCEDURAL P1 Determine cost estimates using the

scatter diagram, high-low, and regression methods of estimating costs.

P2 Compute the break-even point for a single-product company.

Chapter Preview

18 Cost Behavior and Cost-Volume-Profit Analysis

MEASURING COST

BEHAVIOR

P1 Scatter diagrams High-low method

Regression

Comparing cost estimation methods

CONTRIBUTION MARGIN AND BREAK-EVEN

A1 Contribution margin P2 Break-even P3 Cost-volume-profit

chart

Impact of estimates on break-even

APPLYING COST- VOLUME-PROFIT

ANALYSIS

C2 Margin of safety Income from sales and costs

Sales for target income

Strategizing

P4 Sales mix

A2 Operating leverage

IDENTIFYING COST

BEHAVIOR

C1 Fixed costs Variable costs

Graphing costs

Mixed costs

Step-wise costs

Curvilinear costs

NTK 18-1 NTK 18-2 NTK 18-3 NTK 18-4, 18-5

697

“Sell it, don’t tell it”—Nailah Ellis-Brown

Profitabili-Tea

DETROIT, MI—Nailah Ellis-Brown’s great-grandfather immigrated to the United States from Jamaica in the early 1900s with, among other possessions, a prized family recipe for hibiscus tea. Nailah recalls her great-grandfather’s command: “This rec- ipe is to be sold, not told.” This is exactly what her company, Ellis Island Tropical Tea (Ellisislandtea.com), does today.

Nailah started small, making tea in her mother’s basement and selling it out of the trunk of her car. “Everything from day one has been trial and error,” Nailah recalls.

In addition to production, packaging, and distribution, Nailah must measure and control costs. Concepts of fixed and variable costs, and how to control them to break even and make profits, are critical for her start-up. “Because our sales volume was low,” explains Nailah, “we had to set our price too high to cover costs.”

With a corrected lower selling price, Nailah recently landed distribution contracts with several major airports and Sam’s Club. This will increase sales and enable her company to re- cover its fixed costs.

To meet higher expected sales volume, Nailah needed a new production facility, which increased fixed costs. Understanding relations between costs, volume, and profit, called CVP analysis, helps guide her decisions. Further, con- tribution margin income statements and CVP analysis help her predict the effects of different selling prices and costs on profits.

Nailah advises entrepreneurs to find a niche and be persis- tent. “Ours is the only Jamaican sweet tea on the market . . . quitting is not an option.”

Sources: Ellisislandtea website, January 2019; Blackenterprise.com, January 4, 2016; ModelDmedia.com, October 10, 2016; MSNBC.com video interview, June 9, 2017; Youtube.com video, youtube.com/watch?v=dSWVMVZoLL4

©Ellis Infinity, LLC

Planning a company’s future activities is crucial to successful management. Managers use cost- volume-profit (CVP) analysis to predict how changes in costs and sales levels affect profit. CVP analysis requires four inputs, as shown in Exhibit 18.1.

IDENTIFYING COST BEHAVIOR

Number of units sold

Sales price per unit

Variable costs per unit

Fixed costs (total)

Rydell Company Income Statement

For Period Ended

Sales price per unit × Number of units sold − Variable costs per unit × Number of units sold − Fixed costs = Pretax income (profit)

EXHIBIT 18.1 Inputs for CVP Analysis

Using these four inputs, managers apply CVP analysis to answer questions such as: How many units must we sell to break even? How much will income increase if we install a new machine to reduce labor costs? What is the change in income if selling prices decline and sales volume increases? How will income change if we change the sales mix of our products or services? What sales volume is needed to earn a target income?

This chapter uses Rydell, a football manufacturer, to explain CVP analysis. We first review cost classifications like fixed and variable costs, and then we show methods for measuring these costs.

698 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

The concept of relevant range is important to classifying costs for CVP analysis. The rel- evant range of operations is the normal operating range for a business. Except for unusually good or bad times, management plans for operations within a range of volume neither close to zero nor at maximum capacity. The relevant range excludes extremely high or low operating levels that are unlikely to occur. CVP analysis requires management to classify costs as either fixed or variable with respect to production or sales volume, within the relevant range of operations.

Fixed Costs Fixed costs do not change when the volume of activity changes (within a relevant range). For example, $32,000 in monthly rent paid for a factory building remains the same whether the fac- tory operates with a single eight-hour shift or around the clock with three shifts. This means that rent cost is the same each month at any level of output from zero to the plant’s full productive capacity.

Though the total amount of fixed cost does not change as volume changes, fixed cost per unit of output decreases as volume increases. For instance, if 200 units are produced when monthly rent is $32,000, the average rent cost per unit is $160 (computed as $32,000/200 units). When production increases to 1,000 units per month, the average rent cost per unit decreases to $32 (computed as $32,000∕1,000 units).

Variable Costs Variable costs change in proportion to changes in volume of activity. Direct materials cost is one example of a variable cost. If one unit of product requires materials costing $20, total mate- rials costs are $200 when 10 units are manufactured, $400 for 20 units, and so on. While the total amount of variable cost changes with the level of production, variable cost per unit remains constant as volume changes.

Graphing Fixed and Variable Costs against Volume When production volume and costs are graphed, units of product are usually plotted on the horizontal axis and dollars of cost are plotted on the vertical axis. The upper graph in Exhibit 18.2 shows the relation between total fixed costs and volume, and the relation between total variable costs and volume. Total fixed costs of $32,000 remain the same at all production levels up to the company’s monthly capacity of 2,000 units. Total variable costs increase by $20 per unit for each additional unit produced. When variable costs are plotted on a graph of cost and volume, they appear as an upward-sloping straight line starting at the zero cost level.

The lower graph in Exhibit 18.2 shows that fixed costs per unit decrease as production increases. This drop in per unit costs as production increases is known as economies of scale. This lower graph also shows that variable costs per unit remain constant as production levels change.

Mixed Costs Are all costs either fixed or variable? No. Mixed costs include both fixed and variable cost components. For example, compensation for sales representatives often includes a fixed monthly salary and a variable commission based on sales. Utilities can also be considered a mixed cost; even if no units are produced, it is not likely a manufacturing plant will use no electricity or water. Like a fixed cost, a mixed cost is greater than zero when volume is zero; but unlike a fixed cost, it increases steadily in proportion to increases in volume.

Graphing Mixed Costs against Volume The total cost line in the top graph in Exhibit 18.2 starts on the vertical axis at the $32,000 fixed cost point. At the zero volume level, total cost equals the fixed costs. As the volume of activity increases, the total cost line increases at an

C1 Describe different types of cost behavior in relation to production and sales volume.

Point: Fixed costs stay constant in total but decrease per unit as more units are produced. Variable costs vary in total but are fixed per unit as production changes.

To ta

l c os

t

Volume

Total fixed costs

Volume

Total variable costs

To ta

l c os

t

Volume

To ta

l c os

t

Total mixed costs

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 699

Units Total Fixed Total Variable Produced Costs Costs

0 $32,000 $ 0

200 32,000 4,000

400 32,000 8,000 ⋮ ⋮ ⋮ 1,800 32,000 36,000

2,000 32,000 40,000

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

10,000

20,000

30,000

40,000

50,000

60,000

$80,000

70,000

Volume (Units)

C os

t

Monthly Capacity

Total Costs = $32,000 + $20 per Unit

Variable Costs = $20 per Unit

Fixed Costs = $32,000

Relation of Total Fixed Costs and Total Variable Costs to Volume

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

20

40

60

80

100

120

160

180

$200

140

Volume (Units)

C os

t p er

u ni

t

Relation of Per Unit Fixed Costs and Per Unit Variable Costs to Volume

Total Cost per Unit

Fixed Costs

per Unit

Variable Costs per Unit

Units Per Unit Per Unit Produced Fixed Costs Variable Costs

1 $32,000 $20

200 160 20

400 80 20 ⋮ ⋮ ⋮ 2,000 16 20

EXHIBIT 18.2 Relations of Total and Per Unit Costs to Volume

amount equal to the variable cost per unit. This total cost line is a “mixed cost”—and it is high- est when the volume of activity is at 2,000 units (the end point of the relevant range). In CVP analysis, mixed costs should be separated into fixed and variable components. The fixed com- ponent is added to other fixed costs, and the variable component is added to other variable costs. We show how to separate costs later in this chapter.

Below are examples of fixed, variable, and mixed costs for a manufacturer of footballs.

Fixed Costs Variable Costs Mixed Costs

∙ Rent ∙ Direct materials ∙ Electricity ∙ Depreciation* ∙ Direct labor ∙ Water ∙ Property taxes ∙ Shipping ∙ Sales rep (salary plus commission) ∙ Supervisor salaries ∙ Packaging ∙ Natural gas ∙ Office salaries ∙ Indirect materials ∙ Maintenance

*Computed using a method other than units-of-production depreciation.

To make line charts in Excel: Enter data Select: Insert Charts All Charts Line

Step-wise Costs A step-wise cost (or stair-step cost) reflects a step pattern in costs. Salaries of production super- visors are fixed within a relevant range of the current production volume. However, if produc- tion volume expands greatly (for example, with the addition of another shift), more supervisors

700 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

must be hired. This means that the total cost for supervisory salaries steps up by a lump-sum amount. Similarly, if production volume takes another large step up, supervisory salaries will increase by another lump sum.

Graphing Step-Wise Costs against Volume This behavior is graphed in Exhibit 18.3. See how the step-wise cost line is flat within each relevant range.

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

20,000

40,000

60,000

$80,000

Volume (Units)

C os

t

Step-wise Cost

Curvilinear Cost

Monthly Capacity

EXHIBIT 18.3 Step-wise and Curvilinear Costs

Curvilinear Costs Curvilinear costs increase as volume increases, but at a nonconstant rate. The curved line in Exhibit 18.3 shows a curvilinear cost beginning at zero (when production is zero) and increas- ing at different rates as volume increases.

Graphing Curvilinear Costs against Volume One example of a curvilinear cost is total direct labor cost. At low levels of production, employees can specialize in certain tasks. This effi- ciency results in a flatter slope in the curvilinear cost graph at lower levels of production in Exhibit 18.3. At some point, adding more employees creates inefficiencies (they get in each other’s way or do not have special skills). This inefficiency is reflected in a steeper slope at higher levels of production in the curvilinear cost graph in Exhibit 18.3.

In CVP analysis, step-wise costs are usually treated as either fixed or variable costs. Curvilinear costs are typically treated as variable costs, and thus remain constant per unit. These treatments involve manager judgment and depend on the width of the relevant range and the expected volume.

Determine whether each of the following is best described as a fixed, variable, mixed, step-wise, or curvi- linear cost as the number of product units changes.

Classifying Costs

NEED-TO-KNOW 18-1

C1

Do More: QS 18-1, QS 18-2, E 18-1, E 18-2, E 18-3

Solution

a. variable b. fixed c. mixed d. fixed* e. curvilinear

*If more shifts are added, then supervisory salaries behave like a step-wise cost with respect to the number of shifts.

Type of Cost

Rubber used to manufacture tennis balls . . a. Depreciation (straight-line method). . . . . . . b. Electricity usage . . . . . . . . . . . . . . . . . . . . . . c.

Type of Cost

Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . d. A salesperson’s commission is 7% for sales of up to $100,000 and 10% of sales for sales above $100,000. . . . e.

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 701

Identifying and measuring cost behavior require analysis and judgment. A key part of this process is to classify costs as either fixed or variable, which often requires analysis of past cost behavior. A goal of classifying costs is to develop a cost equation. The cost equation expresses total costs as a function of total fixed costs plus variable cost per unit. Three methods are commonly used: Scatter diagram High-low method Regression

Each method is explained using the unit and cost data shown in Exhibit 18.4, which are from a start-up company that uses units produced as the activity base in estimating cost behavior.

MEASURING COST BEHAVIOR P1 Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs.

EXHIBIT 18.4 Data for Estimating Cost Behavior

Month Units Produced Total Cost

January . . . . . . . . . . 27,500 $21,500

February . . . . . . . . . 22,500 20,500

March . . . . . . . . . . . 25,000 25,000

April . . . . . . . . . . . . . 35,000 21,500

May . . . . . . . . . . . . . 47,500 25,500

June. . . . . . . . . . . . . 17,500 18,500

Month Units Produced Total Cost

July . . . . . . . . . . . . . 30,000 $23,500

August . . . . . . . . . . . 52,500 28,500

September . . . . . . . 37,500 26,000

October . . . . . . . . . . 62,500 29,000

November . . . . . . . . 67,500 31,000

December . . . . . . . . 57,500 26,000

Scatter Diagram A scatter diagram is a graph of unit volume and cost data. Units are plotted on the horizontal axis and costs are plotted on the vertical axis. Each point on a scatter diagram reflects the cost and number of units for a prior period. In Exhibit 18.5, the prior 12 months’ costs and units are graphed. Each point reflects total costs incurred and units produced in that month. For instance, the point labeled March shows units produced of 25,000 and costs of $25,000. Appendix 18A shows how to create a scatter diagram using Excel.

0 0

10,000 20,000 40,00030,000 70,000 80,00060,00050,000

5,000

10,000

15,000

20,000

25,000

30,000

$40,000

35,000

Volume (Units)

C os

t

March

Estimated Line of Cost Behavior

Estimated Fixed Cost Component, $17,000

EXHIBIT 18.5 Scatter Diagram

The scatter diagram is useful for identifying extreme data points (“outliers”) and for visually classifying costs. Outliers might be due to data errors, which must be corrected before comput- ing variable and fixed costs. If there is no obvious visual relation between costs and the selected activity base, management should consider whether there is a better activity base. The scatter diagram in Exhibit 18.5 suggests there are no outliers in these data and that total costs increase with the number of units produced. Appendix 18A shows how to use a scatter diagram to esti- mate fixed and variable costs.

The estimated line of cost behavior is drawn on a scatter diagram to reflect the relation between cost and unit volume. This line best visually “fits” the points in a scatter diagram. Fit- ting this line is done with spreadsheet software, as we illustrate in Appendix 18A. The line in Exhibit 18.5 reflects a mixed cost. We next discuss two approaches to estimating the fixed and variable cost components of this mixed cost.

Point: Outliers are points that are far from the line of best fit.

702 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

High-Low Method The high-low method uses just two points to estimate the cost equation: the highest and lowest volume levels. The high-low method follows three steps.

Step 1: Identify the highest and lowest volume levels. These might not be the highest or lowest levels of costs. Step 2: Compute the slope (variable cost per unit) using the high and low volume levels. Step 3: Compute the total fixed costs by computing the total variable cost at either the high or low volume level, and then subtracting that amount from the total cost at that volume level.

We illustrate the high-low method next.

Step 1: In our case, the lowest number of units is 17,500 and the highest is 67,500. The costs corresponding to these unit volumes are $18,500 and $31,000, respectively (see the data in Exhibit 18.4). Step 2: The variable cost per unit is calculated using a simple formula: change in cost divided by the change in units. Using the data from the high and low unit volumes, this results in a slope, or estimated variable cost per unit, of $0.25 as computed in Exhibit 18.6.

EXHIBIT 18.6 Variable Cost per Unit— High-Low Method

Change in cost Change in units

= $31,000 − $18,500 67,500 − 17,500

= $12,500 50,000

= $0.25 per unit

EXHIBIT 18.7 Determining Fixed Costs— High-Low Method

Total cost = Fixed cost + (Variable cost per unit × Units) $31,000 = Fixed cost + ($0.25 per unit × 67,500 units) $31,000 = Fixed cost + $16,875

$14,125 = Fixed cost

Step 3: To estimate the fixed cost for the high-low method, we know that total cost equals fixed cost plus variable cost per unit times the number of units. Then we pick either the high or low volume point to determine the fixed cost. This computation is shown in Exhibit 18.7—where we use the high point (67,500 units) in determining the fixed cost of $14,125. (Use of the low vol- ume point yields the same fixed cost estimate.)

Thus, the cost equation from the high-low method is $14,125 plus $0.25 per unit produced. A weakness of the high-low method is that it ignores all data points except the highest and lowest volume levels.

Regression Least-squares regression, or simply regression, is a statistical method for identifying cost behavior. We use the cost equation estimated from this method but leave the computational details for advanced courses. Computations for least-squares regression are readily done using most spreadsheet programs or calculators. We illustrate this using Excel in Appendix 18A. Using least-squares regression, the cost equation for the data presented in Exhibit 18.4 is $16,688 plus $0.20 per unit produced; that is, the fixed cost is estimated as $16,688 and the variable cost at $0.20 per unit.

Comparing Cost Estimation Methods Different cost estimation methods result in different estimates of fixed and variable costs, as summarized in Exhibit 18.8. Estimates from the high-low method use only two sets of values corresponding to the lowest and highest unit volumes. Sometimes these two activity levels do not reflect the more usual conditions likely to recur. Estimates from least-squares regression use a statistical technique and all available data points.

Example: Using information from Exhibit 18.7, what is the amount of fixed cost at the low level of volume? Answer: $14,125, computed as $18,500 − ($0.25 × 17,500 units).

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 703

These methods use past data. Thus, cost estimates resulting from these methods are only as good as the data used. Managers must establish that the data are reliable. If the data are reliable, the use of more data points, as in the regression method, should yield more accurate estimates than the high-low method. However, the high-low method is easier to apply and thus might be useful for obtaining a quick cost equation estimate.

EXHIBIT 18.8 Comparison of Cost Estimation Methods

Estimation Method Fixed Cost Variable Cost

High-low . . . . . . . . . . . . . . . . . . . . . . . . . $14,125 $0.25 per unit

Regression . . . . . . . . . . . . . . . . . . . . . . . 16,688 0.20 per unit

This section explains contribution margin, a key measure in CVP analysis. We also discuss break-even analysis, an important special case of CVP analysis.

Contribution Margin and Its Measures After classifying costs as fixed or variable, we can compute contribution margin, which equals total sales minus total variable costs. Contribution margin contributes to covering fixed costs and generating profits. Contribution margin per unit, or unit contribution margin, is the amount by which a product’s unit selling price exceeds its variable cost per unit. Exhibit 18.9 shows the formula for contribution margin per unit.

A1 Compute the contribution margin and describe what it reveals about a company’s cost structure.

CONTRIBUTION MARGIN AND BREAK-EVEN ANALYSIS

EXHIBIT 18.9 Contribution Margin per Unit

Contribution margin = Selling price per unit − Total variable cost per unit per unit

Contribution margin ratio is the percent of a unit’s selling price that exceeds total unit vari- able cost. It is interpreted as the percent of each sales dollar that remains after deducting the unit variable cost. Exhibit 18.10 shows the formula for contribution margin ratio.

EXHIBIT 18.10 Contribution Margin RatioContribution margin ratio =

Contribution margin per unit Selling price per unit

Using the information below, apply the high-low method to determine the cost equation (total fixed costs plus variable costs per unit).

High-Low Method

NEED-TO-KNOW 18-2

P1

Do More: QS 18-3, E 18-6

Volume Units Produced Total Cost

Highest . . . . . . . . . . . . . 4,000 $17,000

Lowest. . . . . . . . . . . . . . 1,600 9,800

Solution

The variable cost per unit is computed as: [$17,000 − $9,800]∕[4,000 units − 1,600 units] = $3 per unit. Total fixed costs using the lowest activity level are computed from the following equation: $9,800 = Fixed costs + ($3 × 1,600 units); thus, fixed costs = $5,000. This implies the cost equation is $5,000 plus $3 per unit produced. We can prove the accuracy of this cost equation at either the highest or lowest point shown here.

Highest point: Lowest point: Total cost = $5,000 + ($3 per unit × 4,000 units) Total cost = $5,000 + ($3 per unit × 1,600 units) = $5,000 + $12,000 = $5,000 + $4,800 = $17,000 = $9,800

704 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

To illustrate contribution margin, consider Rydell, which sells footballs for $100 each and incurs variable costs of $70 per football sold. Its fixed costs are $24,000 per month with monthly capacity of 1,800 units (footballs). Rydell’s contribution margin per unit is $30, and its contri- bution ratio is 30%, computed as follows.

Selling price per unit. . . . . . . . . . . . . . . . . . . . $100

Variable cost per unit . . . . . . . . . . . . . . . . . . . 70

Contribution margin per unit . . . . . . . . . . . . . $ 30

Contribution margin ratio ($30/$100) . . . . . . 30%

At a selling price of $100 per football, Rydell covers its per unit variable costs and makes $30 per unit to contribute to fixed costs and profit. Rydell’s contribution margin ratio is 30%, computed as $30∕$100. A contribution margin ratio of 30% implies that for each $1 in sales, Rydell has $0.30 that contributes to fixed cost and profit. Next we show how to use these con- tribution margin measures in break-even analysis.

Break-Even Point The break-even point is the sales level at which total sales equal total costs and a company neither earns a profit nor incurs a loss. Break-even applies to nearly all organizations, activities, and events. A key concern when launching a project is whether it will break even—that is, whether sales will at least cover total costs. The break-even point can be expressed in either units or dollars of sales. To illustrate break-even analysis, let’s again look at Rydell, which sells footballs for $100 per unit and incurs $70 of variable costs per unit sold. Its fixed costs are $24,000 per month. Three different methods are used to find the break-even point. Formula method Contribution margin income statement Cost-volume-profit chart

Formula Method We compute the break-even point using the formula in Exhibit 18.11. This formula uses the contribution margin per unit (calculated above), which for Rydell is $30 ($100 − $70). The break-even sales volume in units follows.

P2 Compute the break-even point for a single-product company.

Point: Selling prices and variable costs are usually expressed in per unit amounts. Fixed costs are usu- ally expressed in total amounts.

Sales Manager You can accept only one of two customer orders due to limited capacity. The first order is for 100 units with a contribution margin ratio of 60% and a selling price of $1,000 per unit. The second order is for 500 units with a contribution margin ratio of 20% and a selling price of $800 per unit. Incremental fixed costs are the same for both orders. Which order do you accept? ■ Answer: You must compute the total contribution margin for each order. Total contribution margin is $60,000 ($600 per unit × 100 units) and $80,000 ($160 per unit × 500 units) for the two orders, respectively. The second order provides the largest return in absolute dollars and is the order you would accept. Another factor to consider in your selection is the potential for a long-term relationship with these customers including repeat sales and growth.

Decision Maker

©Darren Greenwood/Design Pics

EXHIBIT 18.11 Formula for Computing Break-Even Sales (in Units)

Break-even point in units = Fixed costs

Contribution margin per unit = $24,000∕$30 = 800 units per month

If Rydell sells 800 units, its profit will be zero. Profit increases or decreases by $30 for every unit sold above or below that break-even point; for example, if Rydell sells 801 units, profit will equal $30. We also can calculate the break-even point in dollars. Also called break-even sales dollars, it uses the contribution margin ratio to determine the required sales dollars

Point: Even if a company operates at a level above its break-even point, management may decide to stop operating because it is not earning a reasonable return on investment.

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 705

needed for the company to break even. Exhibit 18.12 shows the formula and Rydell’s break- even point in dollars.

EXHIBIT 18.12 Formula for Computing Break-Even Sales (in Dollars)

Break-even point in dollars = Fixed costs

Contribution margin ratio = $24,000∕30% = $24,000∕0.30 = $80,000 of monthly sales

Contribution Margin Income Statement Method The center of Exhibit 18.13 shows the general format of a contribution margin income statement. It differs in format from a traditional income statement in two ways. First, it separately classifies costs and expenses as variable or fixed. A traditional income statement classifies costs as product or period. Second, it reports contribution margin (Sales − Variable costs). A traditional income statement reports gross profit (Sales – Cost of sales), as shown at the left of Exhibit 18.13.

The right side of Exhibit 18.13 uses this format to find the break-even point for Rydell. To use this method, set income equal to zero and work up the income statement to find sales. At the break-even point, Rydell’s contribution margin must exactly equal its fixed costs of $24,000. For Rydell’s contribution margin to equal $24,000, it must sell 800 units ($24,000/$30). The resulting contribution margin income statement shows that the $80,000 revenue from sales of 800 units exactly equals the sum of variable and fixed costs.

EXHIBIT 18.13 Contribution Margin Income Statement for Break-Even Sales

Hudson Co. predicts fixed costs of $400,000 for 2019. Its one product sells for $170 per unit, and it incurs variable costs of $150 per unit. The company predicts total sales of 25,000 units for 2019. 1. Compute the contribution margin per unit. 2. Compute the break-even point (in units) using the formula method. 3. Prepare a contribution margin income statement at the break-even point.

Solution

1. Contribution margin per unit = $170 − $150 = $20

2. Break-even point = $400,000∕$20 = 20,000 units

Contribution Margin and Break-Even Point

NEED-TO-KNOW 18-3

A1 P2

Do More: QS 18-5, QS 18-6, QS 18-10, E 18-8, E 18-9,

E 18-16

Contribution Margin Income Statement (at Break-Even) For Year Ended December 31, 2019

Sales (20,000 units at $170 each). . . . . . . . . . . . $3,400,000

Variable costs (20,000 units at $150 each) . . . . 3,000,000

Contribution margin (20,000 units at $20 each) . . 400,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Income (pretax). . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

3.

Income Statement (Traditional)

Sales. . . . . . . . . . . . . . . . . . . . . $#

Cost of sales . . . . . . . . . . . . . . #

Gross profit . . . . . . . . . . . . . . . #

Selling and admin. . . . . . . . . . #

Income (pretax). . . . . . . . . . . . $#

Contribution Margin Income Statement (at Break-Even) For Month Ended January 31, 2019

Sales (800 units at $100 each) . . . . . . . . . . . . . . . . $80,000

Variable costs (800 units at $70 each) . . . . . . . . . . 56,000

Contribution margin (800 units at $30 each) . . . 24,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Income (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Contribution Margin Income Statement Format

Sales

− Variable costs Contribution margin

− Fixed costs Income (pretax)

Product costs (some fixed, some variable)

Period costs (some fixed, some variable)

Some product costs, some period costs

706 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

$180,000

Volume (Number of units produced)

D ol

la rs

Break-Even Point (sales of 800 units or $80,000)

Loss Area Profit Area

Total Costs

Total Sales 2

1

EXHIBIT 18.14 Cost-Volume-Profit Chart

Cost-Volume-Profit Chart A third way to find the break-even point is to examine a cost-volume-profit (CVP) chart (break-even chart). Exhibit 18.14 shows Rydell’s CVP chart. In a CVP chart, the horizontal axis is the number of units produced and sold, and the vertical axis is dollars of sales and costs. The lines in the chart show both sales and costs at different output levels.

A CVP chart shows two key lines.

1 Total costs. This line starts at the fixed costs level on the vertical axis ($24,000 for Rydell). The slope of this line is the variable cost per unit ($70 per unit for Rydell).

2 Total sales. This line starts at zero on the vertical axis (zero units and zero dollars of sales). The slope of this line equals the selling price per unit ($100 per unit for Rydell). This line must not extend beyond the company’s productive capacity.

The CVP chart provides several key observations.

1. Break-even point, where the total cost line and total sales line intersect—at 800 units, or $80,000, for Rydell.

2. Profit or loss expected, measured as the vertical distance between the sales line and the total cost line at any level of units sold (a loss is to the left of the break-even point, a profit is to the right). As the number of units sold increases, the loss area decreases and the profit area increases.

3. Maximum productive capacity, which is 1,800 units (the last point on the CVP chart). At this point Rydell expects sales of $180,000 and its largest profit.

We show how to prepare a CVP chart in Appendix 18C.

P3 Interpret a CVP chart and graph costs and sales for a single-product company.

Point: CVP analysis is often based on sales volume, using either units sold or dollar sales. Other output measures, such as the number of units produced, also can be used.

EXHIBIT 18.15 Alternative Estimates for Break-Even Analysis

Selling Price Variable Cost Total Fixed per Unit per Unit Costs

Optimistic. . . . . . . . . . . . $105 $68 $21,000

Most likely . . . . . . . . . . . 100 70 24,000

Pessimistic . . . . . . . . . . . 95 72 27,000

Changes in Estimates CVP analysis uses estimates, and knowing how changes in those estimates impact break-even is useful. For example, a manager might form three estimates for each of the inputs of break-even: optimistic, most likely, and pessimistic. Then ranges of break-even points in units can be com- puted using any of the three methods shown above. To illustrate, assume Rydell’s managers provide the estimates in Exhibit 18.15.

Example: In Exhibit 18.14, the sales line intersects the cost line at 800 units. At what point would the two lines intersect if selling price is increased to $120 per unit? Answer: $24,000/($120 − $70) = 480 units

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 707

If, for example, Rydell’s managers believe they can raise the selling price of a football to $105, without any change in unit variable or total fixed costs, then the revised contribution margin per football is $35 ($105 − $70), and the revised break-even in units follows in Exhibit 18.16.

EXHIBIT 18.16 Revised Break-Even in Units

Revised break-even point in units =

$24,000 $35 = 686 units (rounded)

Repeating this calculation using each of the other eight separate estimates above (keeping other estimates unchanged from their original amounts), and graphing the results, yields the three graphs in Exhibit 18.17.

500

800 850 900 950

1,000

750 700 650 600 550

B re

ak -E

ve n

(U ni

ts )

$94 $96 $98 $100 $102 $104 Price (per unit)

Impact of Price Changes on Break-Even in Units

(A)

$106 $73$71 $72 740

860

880

840

820

800

780

760B re

ak -E

ve n

(U ni

ts )

$67 $68 $69 $70 Variable Cost (per unit)

Impact of Changes in Variable Cost on Break-Even in Units

(B)

800

850

900

950

750

700

650

600

B re

ak -E

ve n

(U ni

ts )

Total Dollars of Fixed Costs (’000s)

Impact of Changes in Fixed Costs on Break-Even in Units

(C)

$15 $18 $21 $24 $27 $30

EXHIBIT 18.17 Break-Even Points for Alternative Estimates

These graphs show how changes in selling prices, variable costs, and fixed costs impact break- even. When selling prices can be increased without impacting unit variable costs or total fixed costs, break-even decreases (graph A). When competition reduces selling prices and the com- pany cannot reduce costs, break-even increases (graph A). Increases in either variable (graph B) or fixed costs (graph C), if they cannot be passed on to customers via higher selling prices, will increase break-even. If costs can be reduced and selling prices held constant, the break-even point decreases.

Point: This analysis changed only one estimate at a time; managers can examine how combinations of changes in estimates impact break-even.

Supervisor Your team is conducting a CVP analysis for a new product. Different sales projections have different incomes. One member suggests picking numbers yielding favorable income because any estimate is “as good as any other.” Another member suggests dropping unfavorable data points for cost estimation. What do you do? ■ Answer: Your dilemma is whether to go along with the suggestions to “manage” the numbers to make the project look like it will achieve sufficient profits. You should not follow these suggestions. People will be affected negatively if you manage the predicted numbers and the project eventually is unprofitable. Moreover, if it does fail, an investigation would likely reveal that data in the proposal were “fixed” to make the project look good. One way to deal with this dilemma is to prepare several analyses showing results under different assumptions and then let senior management make the decision.

Decision Ethics

©Caiaimage/Glow Images

Managers consider many strategies in planning business operations. Cost-volume-profit analy- sis is useful in evaluating the likely effects of these strategies.

Margin of Safety All companies desire results in excess of break-even. The excess of expected sales over the break-even sales level is called margin of safety, the amount that sales can drop before the com- pany incurs a loss. It often is expressed in dollars or as a percent of the expected sales level.

C2 Describe several applications of cost- volume-profit analysis.

APPLYING COST-VOLUME-PROFIT ANALYSIS

708 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

To illustrate, Rydell’s break-even point in dollars is $80,000. If its expected sales are $100,000, the margin of safety is $20,000 ($100,000 − $80,000). As a percent, the margin of safety is 20% of expected sales, as shown in Exhibit 18.18.

EXHIBIT 18.18 Computing Margin of Safety (in Percent)

Margin of safety (in percent) = Expected sales − Break-even sales

Expected sales

= $100,000 − $80,000

$100,000 = $20,000/$100,000 = 20%

Management must assess whether the margin of safety is adequate in light of factors such as sales variability, competition, consumer tastes, and economic conditions.

Computing Income from Sales and Costs Managers often use contribution margin income statements to forecast future sales or income. Exhibit 18.19 shows the key variables in CVP analysis—sales, variable costs, contribution mar- gin, and fixed costs—and their relations to income (pretax). To answer the question “What is the predicted income from a predicted level of sales?” we work our way down this income state- ment to compute income.

Contribution Margin Income Statement Sales

− Variable costs Contribution margin

− Fixed costs Income (pretax)To find income

To find sales EXHIBIT 18.19 Income Relations in CVP Analysis

EXHIBIT 18.20 Computing Expected Pretax Income from Expected Sales

Contribution Margin Income Statement (Pretax) For Month Ended January 31, 2019

Sales (1,500 units at $100 each) . . . . . . . . . . . . . . . . . . . $150,000

Variable costs (1,500 units at $70 each) . . . . . . . . . . . . . 105,000

Contribution margin (1,500 units at $30 each) . . . . . . . . 45,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Income (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

Computing After-Tax Income To find the amount of after-tax income from selling 1,500 units, management uses the tax rate. Assume that the tax rate is 25%. Then we can prepare a projected after-tax income statement, shown in Exhibit 18.21. After-tax income can also be computed as Pretax income × (1 − Tax rate).

To illustrate, assume Rydell’s management expects to sell 1,500 units in January 2019. What is the amount of income if this sales level is achieved? We first compute dollar sales, and then use the format in Exhibit 18.19 to compute Rydell’s expected income in Exhibit 18.20. This $21,000 income amount can also be computed as (Units sold × Contribution margin per unit) − Fixed costs, or (1,500 × $30) − $24,000. The $21,000 income is pretax.

Point: 1,500 units of sales is 700 units above Rydell’s break-even point. Income can also be com- puted as 700 units × $30 contri- bution margin per unit.

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 709

EXHIBIT 18.21 Computing Expected After-Tax Income from Expected Sales

Contribution Margin Income Statement (After-Tax) For Month Ended January 31, 2019

Sales (1,500 units at $100 each) . . . . . . . . . . . . . . . . . . . $150,000

Variable costs (1,500 units at $70 each) . . . . . . . . . . . . . 105,000

Contribution margin (1,500 units at $30 each) . . . . . . . . 45,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Income taxes ($21,000 × 25%) . . . . . . . . . . . . . . . . . . . . 5,250 Net income (after tax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,750 Point: Pretax income

= $15,750∕(1 − 0.25), or $21,000.

Management then assesses whether this income is an adequate return on assets invested. Management will also consider whether sales and income can be increased by changing prices or reducing costs. CVP analysis is good for addressing these kinds of “what-if” questions.

Computing Sales for a Target Income Many companies’ annual plans are based on income targets (sometimes called bud- gets). Rydell’s goal for this year is to increase income by 10% over the prior year. CVP analysis helps to determine the sales level needed to achieve the target income. Planning for the year is then based on this level.

We use the formula in Exhibit 18.22 to compute sales for a target income (pretax). To illustrate, Rydell has monthly fixed costs of $24,000 and a 30% contribution margin ratio. Assume that it sets a target monthly income of $12,000. Using the formula in Exhibit 18.22, we find that Rydell needs $120,000 of sales to produce a $12,000 pretax target income.

“How many units must we sell to earn $50,000?”

Dollar sales at target income =

Fixed costs +

Target income (pretax)

Contribution margin ratio

= $24,000 + $12,000

30% = $120,000

EXHIBIT 18.22 Computing Sales (Dollars) for a Target Income

Point: Break-even is a special case of the formulas in Exhibits 18.22 and 18.23; simply set target income to $0, and the formulas reduce to those in Exhibits 18.11 and 18.12.

Alternatively, we can compute unit sales instead of dollar sales. To do this, use contribu- tion margin per unit. Exhibit 18.23 illustrates this for Rydell. The two computations in Exhibits 18.22 and 18.23 are equivalent because sales of 1,200 units at $100 sales price per unit equal $120,000 of sales.

Unit sales at target income =

Fixed costs +

Target income (pretax)

Contribution margin per unit

= $24,000 + $12,000

$30 = 1,200 units

EXHIBIT 18.23 Computing Sales (Units) for a Target Income

We can also use the contribution margin income statement approach to compute sales for a target income in two steps.

710 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Step 1: Insert the fixed costs ($24,000) and the target profit level ($12,000) into a contribution margin income statement, as shown in Exhibit 18.24. To cover its fixed costs of $24,000 and yield target income of $12,000, Rydell must generate a contribution margin of $36,000 (com- puted as $24,000 plus $12,000). Step 2: Enter $36,000 in the contribution margin row as step 2. With a contribution margin ratio of 30%, sales must be $120,000, computed as $36,000∕0.30, to yield a contribution margin of $36,000. We enter $120,000 in the sales row of the contribution margin income statement and solve for variable costs of $84,000 (computed as $120,000 − $36,000). At a selling price of $100 per unit, Rydell must sell 1,200 units ($120,000∕$100) to earn a target income of $12,000.

Evaluating Strategies Earlier we showed how changing one of the estimates in a CVP analysis impacts break-even. We can also examine strategies that impact several estimates in the CVP analysis. For instance, we might want to know what happens to income if we automate a currently manual process. We can use sensitivity analysis to predict income if we can describe how these changes affect a company’s fixed costs, variable costs, selling price, and volume. CVP analyses based on

A manufacturer predicts fixed costs of $502,000 for the next year. Its one product sells for $180 per unit, and it incurs variable costs of $126 per unit. Its target (pretax) income is $200,000. 1. Compute the contribution margin ratio. 2. Compute the dollar sales needed to yield the target income. 3. Compute the unit sales needed to yield the target income. 4. Assume break-even sales of 9,296 units. Compute the margin of safety (in dollars) if the company

expects to sell 10,000 units.

Solution

1. Contribution margin ratio = [$180 − $126]∕$180 = 30% 2. Dollar sales at target income = [$502,000 + $200,000]∕0.30 = $2,340,000 3. Unit sales at target income = [$502,000 + $200,000]∕[$180 − $126] = 13,000 units 4. Margin of safety = (10,000 × $180) − (9,296 × $180) = $126,720

A1 C2

Contribution Margin, Target Income, and Margin of Safety

NEED-TO-KNOW 18-4

Do More: QS 18-9, QS 18-11, QS 18-13, E 18-12, E 18-17

Mic Drop Concert promotion is a risky and low-margin business. A recent Ariana Grande tour grossed nearly $70 million in ticket revenue. How much went to the promoter? After paying taxes, fixed costs of each venue (venue staff, electricity, security, insurance), and Ariana’s share of ticket revenues, the promoter might have about $9 million to apply against its own fixed costs. Live Nation, Ariana’s promoter, recently posted a small profit after several succes- sive years of not breaking even. ■

Decision Insight

©Dave Hogan for One Love Manchester/Getty Images

EXHIBIT 18.24 Using the Contribution Margin Income Statement to Find Target Sales

Contribution Margin Income Statement For Month Ended January 31, 2019

Step 1 Step 2 Sales . . . . . . . . . . . . . . . . . . . . ? $120,000

Variable costs . . . . . . . . . . . . . ? 84,000

Contribution margin . . . . . . . . ? 36,000

Fixed costs . . . . . . . . . . . . . . .  24,000 24,000

Target income . . . . . . . . . . . . . $12,000 $ 12,000

$36,000∕0.30$24,000 + $12,000

To find sales

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 711

different estimates can be useful to management in planning business strategy. We provide some examples.

Buy a Productive Asset A new machine would increase monthly fixed costs from $24,000 to $30,000 and decrease variable costs by $10 per unit (from $70 per unit to $60 per unit). Rydell’s break-even point in dollars is currently $80,000. How would the new machine affect Rydell’s break-even point in dollars? If Rydell maintains its selling price of $100 per unit, its contribution margin per unit will increase to $40—computed as $100 per unit minus the (new) variable costs of $60 per unit. With this new machine, the revised contribution margin ratio per unit is 40% (computed as $40∕$100). Rydell’s revised break-even point in dollars would be $75,000, as computed in Exhibit 18.25. The new machine would lower Rydell’s break- even point by $5,000, or 50 units, per month. The revised margin of safety increases to 25%, computed as ($100,000 − $75,000)∕$100,000.

Increase Advertising Expense Instead of buying a new machine, Rydell’s adver- tising manager suggests increasing advertising. She believes that an increase of $3,000 in the monthly advertising budget will increase sales by $25,000 per month (at a selling price of $100 per unit). The contribution margin will continue to be $30 per unit. Exhibit 18.8 showed the company’s margin of safety was 20% when Rydell’s expected sales level was $100,000. With the advertising campaign, Rydell’s revised break-even point in dollars is $90,000, as computed in Exhibit 18.26.

Revised break-even point in dollars =

Revised fixed costs Revised contribution margin ratio =

$30,000 40% = $75,000

EXHIBIT 18.25 Revised Break-Even

Revised break-even point in dollars =

Revised fixed costs Revised contribution margin ratio =

$27,000 30% = $90,000

EXHIBIT 18.26 Revised Break-Even (in Dollars)

The revised margin of safety is computed in Exhibit 18.27. Without considering other fac- tors, the advertising campaign would increase Rydell’s margin of safety from 20% to 28%.

EXHIBIT 18.27 Revised Margin of Safety (in Percent)

Revised margin of safety (in percent) = Expected sales − Break-even sales

Expected sales

= $125,000 − $90,000

$125,000 = 28%

Sales Mix and Break-Even Many companies sell multiple products or services, and we can modify CVP analysis for these cases. An important assumption in a multiproduct setting is that the sales mix of different prod- ucts is known and remains constant during the planning period. Sales mix is the ratio (propor- tion) of the sales volumes for the various products. For instance, if a company normally sells 10,000 footballs, 5,000 softballs, and 4,000 basketballs per month, its sales mix can be expressed as 10:5:4 for footballs, softballs, and basketballs.

When companies sell more than one product or service, we estimate the break-even point by using a composite unit, which summarizes the sales mix and contribution margins of each product. Multiproduct CVP analysis treats this composite unit as a single product. To illustrate, let’s look at Hair-Today, a styling salon that offers three cuts: basic, ultra, and budget in the ratio of 4 basic cuts to 2 ultra cuts to 1 budget cut (expressed as 4:2:1). Management wants to esti- mate its break-even point for next year. Unit selling prices for these three cuts are basic, $20;

P4 Compute the break-even point for a multiproduct company.

©Sergey Novikov/Shutterstock

712 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

ultra, $32; and budget, $16. Unit variable costs for these three cuts are basic, $13; ultra, $18; and budget, $8. Using the 4:2:1 sales mix, the selling price and variable costs of a composite unit of the three products are computed as follows.

Selling price per composite unit 4 units of basic @ $20 per unit. . . . . . . . . . . . . $ 80

2 units of ultra @ $32 per unit . . . . . . . . . . . . . 64

1 unit of budget @ $16 per unit . . . . . . . . . . . . 16

Selling price of a composite unit . . . . . . . . . . . $160

Variable costs per composite unit 4 units of basic @ $13 per unit. . . . . . . . . . . . . . . $52

2 units of ultra @ $18 per unit . . . . . . . . . . . . . . . 36

1 unit of budget @ $8 per unit . . . . . . . . . . . . . . . 8

Variable costs of a composite unit. . . . . . . . . . . . $96

We compute the contribution margin for a composite unit using essentially the same formula used earlier (see Exhibit 18.9), as shown in Exhibit 18.28.

EXHIBIT 18.28 Contribution Margin per Composite Unit

Contribution margin = Selling price – Variable cost per composite unit per composite unit per composite unit $64 = $160 – $96

Assuming Hair-Today’s fixed costs are $192,000 per year, we compute its break-even point in composite units in Exhibit 18.29.

Break-even point in composite units = Fixed costs

Contribution margin per composite unit

= $192,000

$64 = 3,000 composite units

EXHIBIT 18.29 Break-Even Point in Composite Units

Basic: 4 × 3,000 . . . . . . . . . . 12,000 units Ultra: 2 × 3,000 . . . . . . . . . . 6,000 units Budget: 1 × 3,000 . . . . . . . . . . 3,000 units 7 × 3,000 . . . . . . . . . . 21,000 units

This computation implies that Hair-Today breaks even when it sells 3,000 composite units. Each composite unit represents seven haircuts. To determine how many units of each product it must sell to break even, we use the expected sales mix of 4:2:1 and multiply the number of units of each product in the composite by 3,000, as follows.

Point: The break-even point in dollars for Exhibit 18.29 is $192,000∕($64∕$160) = $480,000.

Exhibit 18.30 verifies that with this sales mix and unit sales computed above, Hair-Today would break even.

EXHIBIT 18.30 Multiproduct Break-Even Income

Basic Ultra Budget Total

Contribution margin Basic (12,000 @ $7). . . . . . . . . . . . . . $84,000 Ultra (6,000 @ $14) . . . . . . . . . . . . . . $84,000 Budget (3,000 @ $8) . . . . . . . . . . . . . $24,000 Total contribution margin. . . . . . . . . . $192,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . 192,000 Net income . . . . . . . . . . . . . . . . . . . . . . . $ 0

If the sales mix changes, the break-even point will likely change. For example, if Hair-Today sells more ultra cuts and fewer basic cuts, its break-even point will decrease. We can vary the sales mix to see what happens under alternative strategies.

For companies that sell many different products, multiproduct break-even computations can become hard. Amazon, for example, sells over 200 million different products. In such cases,

Point: Enterprise resource plan- ning (ERP) systems can quickly generate multiproduct break-even analyses.

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 713

managers can group these products into departments (such as clothing, sporting goods, music) and compute department contribution margins. The department contribution margins and the sales mix can be used as we illustrate in this section.

Entrepreneur CVP analysis indicates that your start-up will break even with the current sales mix and price levels. You have a target income in mind. What analysis might you perform to assess the likelihood of achieving this income? ■ Answer: First compute the level of sales to achieve the desired net income. Then conduct sensitivity analysis by varying the price, sales mix, and cost estimates to assess the possibility of reaching the target sales level. For instance, you might have to pursue aggressive marketing strategies to push the high-margin products, you might have to cut prices to increase sales and profits, or another strategy might emerge.

Decision Maker

Assumptions in Cost-Volume-Profit Analysis CVP analysis relies on several assumptions: Costs can be classified as variable or fixed. Costs are linear within the relevant range. All units produced are sold (inventory levels do not change). Sales mix is constant.

If costs and sales differ from these assumptions, the results of CVP analysis can be less useful. Managers understand that CVP analysis gives approximate answers to questions and enables them to make rough estimates about the future.

The sales mix of a company’s two products, X and Y, is 2:1. Unit variable costs for both products are $2, and unit selling prices are $5 for X and $4 for Y. The company has $640,000 of fixed costs. 1. What is the contribution margin per composite unit? 2. What is the break-even point in composite units? 3. How many units of X and how many units of Y will be sold at the break-even point?

Solution

1.

Selling price of a composite unit 2 units of X @ $5 per unit. . . . . . . . . . . . . . . . . . . $10

1 unit of Y @ $4 per unit. . . . . . . . . . . . . . . . . . . . 4

Selling price of a composite unit . . . . . . . . . . . . . $14

Variable costs of a composite unit 2 units of X @ $2 per unit. . . . . . . . . . . . . . . . . . . $4

1 unit of Y @ $2 per unit. . . . . . . . . . . . . . . . . . . . 2

Variable costs of a composite unit . . . . . . . . . . . . $6

Contribution Margin and Break-Even Point, Composite Units

NEED-TO-KNOW 18-5

P4

Do More: QS 18-14, E 18-22, E 18-23

Therefore, the contribution margin per composite unit is $8. 2. The break-even point in composite units = $640,000∕$8 = 80,000 units. 3. At break-even, the company will sell 160,000 units (80,000 × 2) of X and 80,000 units of Y (80,000 × 1).

Manufacturers try to increase the sustainability of their materials and packaging. Nike recently reengi- neered its shoeboxes to use 30% less material. These lighter shoeboxes can be shipped in cartons that are 20% lighter. Nike also now uses recycled polyester in much of its clothing. The company estimates it has reused the equivalent of over 2 billion plastic bottles in recent years.

These and other sustainability initiatives impact both variable and fixed costs and CVP analysis. Consider Rydell, the football manufacturer illustrated in this chapter. Rydell expects to sell 1,500 footballs per month, at a price of $100 per unit. Variable costs are $70 per unit and monthly fixed costs are $24,000. Rydell is considering using some recycled materials. This would add $1,160 in fixed costs per month and

SUSTAINABILITY AND ACCOUNTING

714 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

reduce variable costs by $4 per unit. Management wants to know how this initiative would impact the company’s break-even point, margin of safety, and forecasted income. Relevant calculations follow.

Revised break-even point in units =

Revised fixed costs Revised contribution margin

= $25,160

$34 = 740 units

Revised margin of safety =

Expected sales − Break-even sales Expected sales

= $150,000 − $74,000

$150,000 = 50.7%

Revised forecasted income = (Units sold × Contribution margin per unit) − Fixed costs

= (1,500 × $34) − $25,160 = $25,840

Before Initiative

Break-even 800 units Margin of safety 20% Forecasted income $21,000

Nailah Ellis-Brown, founder of this chapter’s featured company, Ellis Island Tropical Tea, focuses on the “people” aspect of the triple bottom line. For her, that means doing what she can to help the people of Detroit recover from the hardships caused by the decline of the auto industry. “My passion is for [Michigan] natives,” exclaims Nailah, “many of whom happen to be black.”©Ellis Infinity, LLC

Degree of Operating LeverageDecision Analysis

CVP analysis is especially useful when management wishes to predict outcomes of alternative strategies. These strategies can involve changes in selling prices, fixed costs, variable costs, sales volume, and prod- uct mix. Managers are interested in seeing the effects of changes in some or all of these factors. Managers try to get maximum benefits from their fixed costs. Managers want to use 100% of their capacity so that fixed costs are spread over the largest number of units. This would decrease fixed cost per unit and increase income. The extent, or relative size, of fixed costs in the total cost structure is known as operating leverage. Companies having a higher proportion of fixed costs in their total cost structure have higher operating leverage. An example is a company that automates its processes instead of using direct labor, increasing its fixed costs and lowering its variable costs. A useful managerial measure to assess the effect of changes in the level of sales on income is the degree of operating leverage (DOL), calculated as shown in Exhibit 18.31.

A2 Analyze changes in sales using the degree of operating leverage.

DOL = Total contribution margin (in dollars)∕Pretax incomeEXHIBIT 18.31 Degree of Operating Leverage

Rydell Company

Sales (1,200 × $100) . . . . . . . . . . . . . . . . . . $120,000 Variable costs (1,200 × $70) . . . . . . . . . . . . 84,000 Contribution margin . . . . . . . . . . . . . . . . . . 36,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Income (pretax) . . . . . . . . . . . . . . . . . . . . . . $ 12,000

To illustrate, assume Rydell Company sells 1,200 footballs. At this sales level, its contribution margin (in dollars) and pretax income are computed as

Rydell’s degree of operating leverage (DOL) is then computed as shown in Exhibit 18.32.

EXHIBIT 18.32 Rydell’s Degree of Operating Leverage

DOL = Total contribution margin (in dollars)∕Pretax income DOL = $36,000∕$12,000 = 3.0

We then can use DOL to predict the effect of changes in the level of sales on pretax income. For example, if Rydell expects sales can either increase or decrease by 10%, and these changes would be within Rydell’s relevant range, we can compute the change in pretax income using DOL, as shown in Exhibit 18.33.

Change in income (%) = DOL × Change in sales (%) = 3.0 × 10% = 30%

EXHIBIT 18.33 Impact of Change in Sales on Income

COMPREHENSIVE

Break-Even, CVP Chart, and Sales for Target Income

NEED-TO-KNOW 18-6

Thus, if Rydell’s sales increase by 10%, its income will increase by $3,600 (computed as $12,000 × 30%), to $15,600. If, instead, Rydell’s sales decrease by 10%, its net income will decrease by $3,600, to $8,400. We can prove these results with contribution margin income statements, as shown below.

Sales Increase Sales Decrease Current by 10% by 10%

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $132,000 $108,000

Variable costs . . . . . . . . . . . . . . . . . . . . 84,000 92,400 75,600

Contribution margin . . . . . . . . . . . . . . . $ 36,000 $ 39,600 $ 32,400

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . 24,000 24,000 24,000

Target (pretax) income . . . . . . . . . . . . . $ 12,000 $ 15,600 $ 8,400

Sport Caps Co. manufactures and sells caps for different sporting events. The fixed costs of operating the company are $150,000 per month, and variable costs are $5 per cap. The caps are sold for $8 per unit. The production capacity is 100,000 caps per month.

Required

1. Use the formulas in the chapter to compute the following: a. Contribution margin per cap. b. Break-even point in terms of the number of caps produced and sold. c. Amount of income at 30,000 caps sold per month (ignore taxes). d. Amount of income at 85,000 caps sold per month (ignore taxes). e. Number of caps to be produced and sold to provide $60,000 of income (pretax). 2. Draw a CVP chart for the company, showing cap output on the horizontal axis. Identify (a) the break-

even point and (b) the amount of pretax income when the level of cap production is 70,000. 3. Use the formulas in the chapter to compute the a. Contribution margin ratio. b. Break-even point in terms of sales dollars. c. Amount of income at $250,000 of sales per month (ignore taxes). d. Amount of income at $600,000 of sales per month (ignore taxes). e. Dollars of sales needed to provide $60,000 of pretax income.

PLANNING THE SOLUTION Identify the formulas in the chapter for the required items expressed in units and solve them using the

data given in the problem. Draw a CVP chart that reflects the facts in the problem. The horizontal axis should plot the volume in

units up to 100,000, and the vertical axis should plot the total dollars up to $800,000. Plot the total cost line as upward sloping, starting at the fixed cost level ($150,000) on the vertical axis and increasing until it reaches $650,000 at the maximum volume of 100,000 units. Verify that the break-even point (where the two lines cross) equals the amount you computed in part 1.

Identify the formulas in the chapter for the required items expressed in dollars and solve them using the data given in the problem.

SOLUTION 1. a. Contribution margin per cap = Selling price per unit − Variable cost per unit = $8 − $5 = $3

b. Break-even point in caps = Fixed costs

Contribution margin per cap =

$150,000 $3

= 50,000 caps

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 715

716 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

c. Income at 30,000 caps sold = (Units × Contribution margin per unit) − Fixed costs = (30,000 × $3) − $150,000 = $(60,000) loss

d. Income at 85,000 caps sold = (Units × Contribution margin per unit) − Fixed costs = (85,000 × $3) − $150,000 = $105,000 profit

e. Units needed for $60,000 income = Fixed costs + Target income Contribution margin per cap

= $150,000 + $60,000

$3 = 70,000 caps

2. CVP chart.

0 25,000 50,000 75,000 0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

$800,000

Volume (Units)

D ol

la rs

Break-Even Point

100,000

Profit at 70,000 Units

Monthly Capacity

Total Costs

Total Sales

3. a. Contribution margin ratio = Contribution margin per unit

Selling price per unit =

$3 $8

= 0.375 or 37.5%

b. Break-even point in dollars = Fixed costs

Contribution margin ratio =

$150,000 37.5%

= $400,000

c. Income at sales of $250,000 = (Sales × Contribution margin ratio) − Fixed costs = ($250,000 × 37.5%) − $150,000 = $(56,250) loss

d. Income at sales of $600,000 = (Sales × Contribution margin ratio) − Fixed costs = ($600,000 × 37.5%) − $150,000 = $75,000 income

e. Dollars of sales to yield $60,000 pretax income

= Fixed costs + Target pretax income

Contribution margin ratio

= $150,000 + $60,000

37.5% = $560,000

APPENDIX

Using Excel for Cost Estimation18A Microsoft Excel® and other spreadsheet software can be used to perform least-squares regressions to iden- tify cost behavior. In Excel, the INTERCEPT and SLOPE functions are used. The following screen shot reports the data from Exhibit 18.4 in cells Al through C13 and shows the cell contents to find the intercept (cell B15) and slope (cell B16). Cell B15 uses Excel to find the intercept from a least-squares regression of total cost (shown as C2:C13 in cell B15) on units produced (shown as B2:B13 in cell B15). Spreadsheet software is useful in understanding cost behavior when many data points (such as monthly total costs and units produced) are available.

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 717

Variable cost is $0.32 per unit. Thus, the cost equation that management will use to estimate costs for dif- ferent unit levels is $17,000 plus $0.32 per unit produced.

27,500 22,500 25,000 35,000 47,500 17,500

30,000 52,500 37,500 62,500 67,500 57,500

$2 1,500

Result $16,688.24 $ 0.1995

20,500 25,000 21,500 25,500 18,500 23,500 28,500 26,000 29,000 31,000 26,000

A B C

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Month Units Produced Total Cost

January February March April May June July August September October November December

Intercept Slope

=INTERCEPT(C2:C13, B2:B13) =SLOPE(C2:C13, B2:B13)

Excel can also be used to create scatter diagrams such as that in Exhibit 18.5. In contrast to visually drawing a line that “fits” the data, Excel more precisely fits the line. To draw a scatter diagram with a line of fit, follow these steps:

1. Highlight the data cells you wish to diagram; in this example, start from cell C13 and highlight through cell B2.

2. Then select “Insert” and “Scatter” from the drop-down menus. Selecting the chart type in the upper left corner of the choices under “Scatter” will produce a diagram that looks like that in Exhibit 18.5, without a line of fit.

3. To add a line of fit (also called a trend line), select “Design,” “Add Chart Element,” “Trendline,” and “Linear” from the drop-down menus. This will produce a diagram that looks like that in Exhibit 18.5, including the line of fit.

The line drawn in Exhibit 18.5 intersects the vertical axis at approximately $17,000, which represents an estimate of fixed costs. To compute an esti- mated variable cost per unit, select any two levels of output and compute a slope as in the high-low method. Using 0 and 25,000 units as the two activity points, the slope is

Point: The intercept function solves for total fixed costs. The slope function solves for the variable cost per unit.

Change in cost Change in units

= $25,000 − $17,000

25,000 − 0 =

$8,000 25,000

= $0.32 per unit

APPENDIX

Variable Costing and Performance Reporting 18B This chapter showed the usefulness of contribution margin, or selling price minus variable costs, in CVP analysis. The contribution margin income statement introduced in this chapter is also known as a variable costing income statement. In variable costing, only costs that change in total with changes in production levels are included in product costs. These costs include direct materials, direct labor, and variable over- head costs. Thus, under variable costing, fixed overhead costs are excluded from product costs and instead are expensed in the period incurred. As we showed in this chapter, a variable costing approach can be useful in many managerial analyses and decisions. The variable costing method is not allowed, however, for external financial reporting. Instead, GAAP requires absorption costing. Under absorption costing, product costs include direct materials, direct la- bor, and all overhead, both variable and fixed. Thus, under absorption costing, fixed overhead costs are expensed when the goods are sold. Managers can use variable costing information for internal decision making, but they must use absorption costing for external reporting purposes.

Computing Unit Cost To illustrate the difference between absorption costing and variable costing, let’s consider the product cost data in Exhibit 18B.1 from IceAge, a skate manufacturer.

P5 Compute unit cost and income under both absorption and variable costing.

Direct materials cost. . . . . . . . . . . . . . . . $4 per unit

Direct labor cost . . . . . . . . . . . . . . . . . . . $8 per unit

Expected units produced . . . . . . . . . . . . 60,000 units

Overhead cost (per year)

Variable overhead cost . . . . . . . . . . . $180,000

Fixed overhead cost. . . . . . . . . . . . . . 600,000

Total overhead cost . . . . . . . . . . . . . . $780,000

EXHIBIT 18B.1 Summary Product Cost Data

718 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Income Reporting The prior section showed how the different treatment of fixed overhead costs leads to different product costs per unit under absorption and variable costing. This section shows the implications of this difference for income reporting. To illustrate the income reporting implications, we return to IceAge Company. Below are the manufac- turing cost data for IceAge as well as additional data on selling and administrative expenses. Assume that IceAge began year 2019 with no units in inventory. During 2019, IceAge produced 60,000 units and sold 40,000 units at $40 each, leaving 20,000 units in ending inventory. Using the information above, we prepare income statements for IceAge both under absorption costing and under variable costing. Under variable costing, expenses are grouped according to cost

Using the product cost data, Exhibit 18B.2 shows the product cost per unit computations for both absorp- tion and variable costing. These computations are shown both in a tabular format (left side of exhibit) and a visual format (right side of exhibit). For absorption costing, the product cost per unit is $25, which con- sists of $4 in direct materials, $8 in direct labor, $3 in variable overhead ($180,000∕60,000 units), and $10 in fixed overhead ($600,000∕60,000 units). For variable costing, the product cost per unit is $15, which consists of $4 in direct materials, $8 in direct labor, and $3 in variable overhead. Fixed overhead costs of $600,000 are treated as a period cost and are recorded as expense in the period incurred. The difference between the two costing methods is the ex- clusion of fixed overhead from product costs for variable costing.

Product Cost per Unit

Absorption Variable Costing Costing

Direct materials. . . . . . . . . . . . $ 4 $ 4

Direct labor . . . . . . . . . . . . . . . 8 8

Overhead costs

Variable overhead . . . . . . . 3 3

Fixed overhead . . . . . . . . . 10 Total product cost per unit . . . $25 $15

Product Costs

Absorption Costing

$25 per unit

$4 DM

$8 DL

$3 VOH

$10 FOH Period Expenses $600,000

Variable Costing

Product Costs $15 per unit

EXHIBIT 18B.2 Unit Cost Computation

A manufacturer reports the following data.

P5

Computing Product Cost per Unit

NEED-TO-KNOW 18-7

Do More: QS 18-17, QS 18-18, QS 18-19, QS 18-20, E 18-26

Direct materials cost. . . . . . . . . . . . . . . . $6 per unit Variable overhead . . . . . . . . . . $220,000 per year

Direct labor cost . . . . . . . . . . . . . . . . . . . $14 per unit Fixed overhead. . . . . . . . . . . . . $680,000 per year

Expected units produced . . . . . . . . . . . . 20,000 units

Per Unit Costs (1) Absorption Costing (2) Variable Costing

Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6 $ 6

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 14

Variable overhead ($220,000∕20,000) . . . . . . . . . . . 11 11 Fixed overhead ($680,000∕20,000)* . . . . . . . . . . . . . 34 Total product cost per unit . . . . . . . . . . . . . . . . . . . . . . $65 $31

*Not included in product costs under variable costing.

1. Compute the total product cost per unit under absorption costing. 2. Compute the total product cost per unit under variable costing.

Solution

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 719

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2019

Sales* (40,000 × $40) . . . . . . . . . . . . . . . . . . $1,600,000 Cost of goods sold (40,000 × $25†) . . . . . . . 1,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Selling and administrative expenses [$200,000 + (40,000 × $2)] . . . . . . . . . . 280,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000

*Units produced equal 60,000; units sold equal 40,000. †$4 DM + $8 DL + $3 VOH + $10 FOH. ‡$4 DM + $8 DL + $3 VOH.

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2019

Sales* (40,000 × $40) . . . . . . . . . . . $1,600,000 Variable expenses

Variable production costs (40,000 × $15‡) . . . . . . . . . . . $600,000 Variable selling and administrative expenses (40,000 × $2). . . . . 80,000 680,000 Contribution margin. . . . . . . . . . . . . 920,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . 600,000

Fixed selling and administrative expense. . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . . . . $ 120,000

EXHIBIT 18B.3 Income under Absorption or Variable Costing

The income statements reveal that for 2019, income is $320,000 under absorption costing. Under vari- able costing, income is $120,000, which is $200,000 less than under absorption costing. This $200,000 difference is due to the different treatment of fixed overhead under the two costing methods. Because variable costing expenses fixed manufacturing overhead (FOH) based on the number of units produced (60,000 × $10), and absorption costing expenses FOH based on the number of units sold (40,000 × $10), net income is lower under variable costing by $200,000 (20,000 units × $10). Under variable costing, the entire $600,000 fixed overhead cost is treated as an expense in computing 2019 income. Under absorption costing, the fixed overhead cost is allocated to each unit of product at the rate of $10 per unit (from Exhibit 18B.2). When production exceeds sales by 20,000 units (60,000 versus 40,000), the $200,000 ($10 × 20,000 units) of fixed overhead cost allocated to these 20,000 units is in- cluded in the cost of ending inventory. This means that $200,000 of fixed overhead cost incurred in 2019 is not expensed until future years under absorption costing, when it is reported in cost of goods sold as those products are sold. Consequently, income for 2019 under absorption costing is $200,000 higher than income under variable costing. Even though sales (of 40,000 units) and the number of units produced (totaling 60,000) are the same under both costing methods, net income differs greatly due to the treatment of fixed overhead.

Converting Income under Variable Costing to Income under Absorption Costing In 2019, IceAge produced 20,000 more units than it sold. Those 20,000 units remaining in ending inventory will be sold in future years. When those units are sold, the $200,000 of fixed overhead costs attached to them will be expensed, resulting in lower income under the absorption costing method. This leads to a simple way to convert income under variable costing to income under absorption costing:

©Toshifumi Kitamura/AFP/Getty Images

Income under absorption costing =

Income under variable costing +

Fixed overhead cost in ending inventory −

Fixed overhead cost in beginning inventory

For example, assume IceAge produces 60,000 units and sells 80,000 units in 2020, and reports income under variable costing of $1,040,000. Income under absorption costing is then computed as

Income under absorption costing = $1,040,000 + $0 − $200,000 = $840,000

behavior—variable or fixed, and production or nonproduction. Under the traditional format of absorption costing, expenses are grouped by function but not separated into variable and fixed components.

Units Produced Exceed Units Sold Exhibit 18B.3 shows absorption costing and variable costing income statements. In 2019, 60,000 units were produced, but only 40,000 units were sold, which means 20,000 units remain in ending inventory.

720 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Differences in income between variable and absorption costing are summarized below.

< <

< Absorption costing < Variable costing $840,000 < $1,040,000

80,000 pairs60,000 pairs

Production

>>

> Income under

Absorption costing > Variable costing $320,000 > $120,000

Sales 40,000 pairs60,000 pairs

2019

2020

APPENDIX

Preparing a CVP Chart18C Here are the data to prepare a CVP chart in Excel for Rydell. To draw a CVP chart as shown in Exhibit 18.14, follow these steps.

1. Highlight cells containing the data to graph, in this case B2:C10. 2. Select Insert>Charts>All Charts>Line, then select the first of the line

chart choices.

These steps produce the chart in Exhibit 18.14, but without the formatting and labeling.

$ 20,000 40,000 60,000 80,000

100,000 120,000 140,000 160,000 180,000

$ 38,000 52,000 66,000 80,000 94,000

108,000 122,000 136,000 150,000

A B C

Units Sales Total Cost

200 1 2 3 4 5 6 7 8 9 10

400 600 800

1,000 1,200 1,400 1,600 1,800

COST BEHAVIOR Fixed costs: Do not change in total as volume changes. Variable costs: Change proportionately with volume. Mixed costs: Include both fixed and variable components. Step-wise costs: Step pattern, but fixed within each relevant range. Relevant range: Normal operating range; neither near zero nor maximum.

MEASURING COST BEHAVIOR Cost equation: Fixed costs + Variable cost per unit High-low method: Estimates a cost equation using high and low activity.

Variable cost per unit =

High cost − Low cost High volume − Low volume

Fixed costs in total = Total cost – (Variable cost per unit × # of units) Regression method: Statistical method using all data.

Summary: Cheat Sheet

CONTRIBUTION MARGIN

Contribution margin = Selling price per unit − Total variable cost per unit per unit

Contribution margin ratio = Contribution margin per unit

Selling price per unit

Contribution Margin Income Statement Format

Sales

− Variable costs Contribution margin

− Fixed costs Income (pretax)

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 721

BREAK-EVEN POINT

APPLYING CVP Margin of safety: Amount that sales can drop before company incurs a loss.

Break-even point in units = Fixed costs

Contribution margin per unit

Break-even point in dollars = Fixed costs

Contribution margin ratio

Margin of safety (in percent) = Expected sales − Break-even sales

Expected sales

Dollar sales at target income =

Fixed costs +

Target income (pretax)

Contribution margin ratio

Unit sales at target income =

Fixed costs +

Target income (pretax)

Contribution margin per unit

Contribution margin = Selling price – Variable cost per composite unit per composite unit per composite unit

Break-even point in composite units =

Fixed costs Contribution margin per composite unit

OPERATING LEVERAGE Operating leverage (DOL): Degree of fixed costs in the cost structure. More fixed costs means More leverage.

DOL = Total contribution margin (in dollars)∕Pretax income

Change in income (%) = DOL × Change in sales (%)

VARIABLE COSTING

Income under absorption costing =

Income under variable costing +

Fixed overhead cost in ending inventory −

Fixed overhead cost in beginning inventory

Absorption costing (707) Break-even point (704) Composite unit (711) Contribution margin (703) Contribution margin per unit (703) Contribution margin ratio (703) Cost-volume-profit (CVP) analysis (697) Cost-volume-profit (CVP) chart (706)

Curvilinear cost (700) Degree of operating leverage (DOL) (714) Estimated line of cost behavior (701) High-low method (702) Least-squares regression (702) Margin of safety (707) Mixed cost (698) Operating leverage (714)

Relevant range of operations (698) Sales mix (711) Scatter diagram (701) Step-wise cost (699) Variable costing (717) Variable costing income statement (717)

Key Terms

SALES MIX Sales mix: Ratio of sales volumes for various products. Price (or variable) cost per composite unit: # product 1 × $ per unit of product 1 + # product 2 × $ per unit of product 2 + # product 3 × $ per unit of product 3 = Price (or variable) cost per composite unit

Multiple Choice Quiz

1. A company’s only product sells for $150 per unit. Its vari- able costs per unit are $100, and its fixed costs total $75,000. What is its contribution margin per unit? a. $50 c. $100 e. $25 b. $250 d. $150

2. Using information from question 1, what is the company’s contribution margin ratio? a. 662⁄3% c. 50% e. 331⁄3% b. 100% d. 0%

3. Using information from question 1, what is the company’s break-even point in units? a. 500 units c. 1,500 units e. 1,000 units b. 750 units d. 3,000 units

4. A company’s forecasted sales are $300,000 and its sales at break-even are $180,000. Its margin of safety in dollars is a. $180,000. c. $480,000. e. $300,000. b. $120,000. d. $60,000.

5. A product sells for $400 per unit and its variable costs per unit are $260. The company’s fixed costs are $840,000. If the company desires $70,000 pretax income, what is the re- quired dollar sales? a. $2,400,000 c. $2,600,000 e. $1,400,000 b. $200,000 d. $2,275,000

722 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

A,B,C Superscript letter A, B, or C denotes assignments based on Appendix 18A, 18B, or 18C.

Icon denotes assignments that involve decision making.

1. What is a variable cost? Identify two variable costs. 2. When output volume increases, do variable costs per

unit increase, decrease, or stay the same within the relevant range of activity? Explain.

3. When output volume increases, do fixed costs per unit increase, decrease, or stay the same within the relevant range of activity? Explain.

4. How is cost-volume-profit analysis useful? 5. How do step-wise costs and curvilinear costs differ? 6. Describe the contribution margin ratio in layperson’s terms. 7. Define and explain the contribution margin ratio. 8. Define and describe contribution margin per unit. 9. In performing CVP analysis for a manufacturing company,

what simplifying assumption is usually made about the vol- ume of production and the volume of sales?

10. What two arguments tend to justify classifying all costs as either fixed or variable even though individual costs might not behave exactly as classified?

11. How does assuming that operating activity occurs within a relevant range affect cost-volume-profit analysis?

12. List three methods to measure cost behavior. 13. How is a scatter diagram used to identify and measure the

behavior of a company’s costs? 14. In cost-volume-profit analysis, what is the estimated profit

at the break-even point? 15. Assume that a straight line on a CVP chart intersects

the vertical axis at the level of fixed costs and has a positive

slope that rises with each additional unit of volume by the amount of the variable costs per unit. What does this line represent?

16. Google has both fixed and variable costs. Why are fixed costs depicted as a horizontal line on a CVP chart?

17. Each of two similar companies has sales of $20,000 and total costs of $15,000 for a month. Company A’s total costs include $10,000 of variable costs and $5,000 of fixed costs. If Company B’s total costs include $4,000 of variable costs and $11,000 of fixed costs, which company will enjoy more profit if sales double?

18. of reflects expected sales in excess of the level of break-even sales.

19. Apple produces tablet computers. Identify some of the variable and fixed product costs as- sociated with that production. Hint: Limit costs to product costs.

20. Should Apple use single-product or multi- product break-even analysis? Explain.

21. Samsung is thinking of expanding sales of its most popular smartphone model by 65%. Should we expect its variable and fixed costs for this model to stay within the relevant range? Explain.

22.B Google uses variable costing for several business decisions. How can variable cost- ing income be converted to absorption costing income?

Discussion Questions

GOOGLE

GOOGLE

APPLE

APPLE

Samsung

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a; $150 − $100 = $50 2. e; ($150 − $100)∕$150 = 331⁄3% 3. c; $75,000∕$50 CM per unit = 1,500 units

4. b; $300,000 − $180,000 = $120,000 5. c; Contribution margin ratio = ($400 − $260)∕$400 = 0.35 Targeted sales = ($840,000 + $70,000)∕0.35 = $2,600,000

QUICK STUDY

QS 18-1 Cost behavior identification

C1

Listed here are four series of separate costs measured at various volume levels. Examine each series and identify whether it is best described as a fixed, variable, step-wise, or curvilinear cost. Hint: It can help to graph each cost series.

Volume (Units) Series 1 Series 2 Series 3 Series 4

0 . . . . . . . . . . . . $ 0 $450 $ 800 $100

100 . . . . . . . . . . . . 800 450 800 105

200 . . . . . . . . . . . . 1,600 450 800 120

300 . . . . . . . . . . . . 2,400 450 1,600 145

400 . . . . . . . . . . . . 3,200 450 1,600 190

500 . . . . . . . . . . . . 4,000 450 2,400 250

600 . . . . . . . . . . . . 4,800 450 2,400 320

Excel: Enter data Select: Insert Charts All Charts Line

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 723

The following information is available for a company’s maintenance cost over the last seven months. Using the high-low method, estimate both the fixed and variable components of its maintenance cost.

QS 18-3 Cost behavior estimation— high-low method

P1Month Units Produced Maintenance Cost

June. . . . . . . . . . . . . . . . 90 $5,450

July . . . . . . . . . . . . . . . . 180 6,900

August . . . . . . . . . . . . . . 120 5,100

September . . . . . . . . . . 150 6,000

October . . . . . . . . . . . . . 210 6,900

November . . . . . . . . . . . 240 8,100

December . . . . . . . . . . . 60 3,600

This scatter diagram reflects past units produced and their corresponding maintenance costs. QS 18-4 Interpreting a scatter diagram

P1

0

$12,000

10,000

8,000

6,000

4,000

2,000M ai

nt en

an ce

C os

ts

0 1,000 2,000 Units Produced

3,000 4,000 5,000

1. Review the scatter diagram and classify these costs as either fixed, variable, or mixed. 2. If 3,000 units are produced, are maintenance costs expected to be greater than $6,000?

Determine whether each of the following is best described as a fixed, variable, or mixed cost with respect to product units.

1. Rubber used to manufacture athletic shoes. 2. Maintenance of factory machinery. 3. Packaging expense. 4. Wages of an assembly-line worker paid

on the basis of acceptable units produced.

QS 18-2 Cost behavior identification

C1 5. Factory supervisor’s salary. 6. Taxes on factory building. 7. Depreciation expense of warehouse.

Compute the contribution margin ratio using the following data: sales, $5,000; total variable cost, $3,000. QS 18-5 Contribution margin ratio A1

QS 18-6 Contribution margin per unit and break-even units

P2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Determine the (1) contribution margin per unit and (2) break-even point in units.

QS 18-7 Assumptions in CVP analysis

C2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. How will the break-even point in units change in response to each of the following independent changes in selling price per unit, variable cost per unit, or total fixed costs? Use I for increase and D for decrease. (It is not necessary to compute new break-even points.)

Change Break-Even in Units will:

1. Total fixed costs to $190,000 . . . . . . . . . .

2. Variable costs to $34 per unit . . . . . . . . . .

3. Selling price per unit to $80 . . . . . . . . . . .

Change Break-Even in Units will:

4. Variable costs to $67 per unit . . . . . . . . . .

5. Total fixed costs to $150,000 . . . . . . . . . .

6. Selling price per unit to $120 . . . . . . . . . .

724 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

QS 18-9 CVP analysis and target income C2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Compute the units of product that must be sold to earn pretax income of $200,000. (Round to the nearest whole unit.)

QS 18-10 Computing break-even

P2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. Determine the break-even point in units.

QS 18-11 Margin of safety C2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. If the company expects sales of 10,000 units, compute its margin of safety (a) in dollars and (b) as a percent of expected sales.

QS 18-12 Contribution margin income statement P2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. The company expects sales of 10,000 units. Prepare a contribution margin income state- ment for the year ended December 31, 2019.

QS 18-13 Target income C2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. Compute the level of sales in units needed to produce a target (pretax) income of $118,000.

QS 18-14 Sales mix and break-even

P4

US-Mobile manufactures and sells two products, tablet computers and smartphones, in the ratio of 5:3. Fixed costs are $105,000, and the contribution margin per composite unit is $125. What number of each type of product is sold at the break-even point?

QS 18-15C CVP chart P3

Corme Company expects sales of $34 million (400,000 units). The company’s total fixed costs are $17.5 million and its variable costs are $35 per unit. Prepare a CVP chart from this information.

QS 18-8 Contribution margin ratio and break-even dollars P2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Determine the (1) contribution margin ratio and (2) break-even point in dollars.

Singh Co. reports a contribution margin of $960,000 and fixed costs of $720,000. (1) Compute the company’s degree of operating leverage. (2) If sales increase by 15%, what amount of income will Singh Co. expect?

QS 18-16 Operating leverage analysis A2

Refer to Vijay Company’s data in QS 18-17. Compute its product cost per unit under variable costing.QS 18-18B Computing unit cost under variable costing P5

Vijay Company reports the following information regarding its production costs. Compute its product cost per unit under absorption costing.

QS 18-17B Computing unit cost under absorption costing P5

Direct materials. . . . . . . . . . . . . . . . . . . . . $10 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . $20 per unit

Units produced . . . . . . . . . . . . . . . . . . . . . 20,000 units

Overhead costs for the year

Variable overhead . . . . . . . . . . . . . . . . $10 per unit

Fixed overhead. . . . . . . . . . . . . . . . . . . $160,000

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000, and fixed selling and administrative costs are $65,200. The company also reports the following per unit costs for the year. Prepare an income statement under variable costing.

QS 18-19B Variable costing income statement

P5

Variable production costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . $25

Variable selling and administrative expenses. . . . . . . . . . . . 2

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 725

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000, and fixed selling and administrative costs are $65,200. The company also reports the following per unit costs for the year. Prepare an income statement under absorption costing.

QS 18-20B Absorption costing income statement

P5

Variable production costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . $25

Variable selling and administrative expenses. . . . . . . . . . . . 2

A recent income statement for BMW reports the following (in € millions). Assume 75% of the cost of sales and 75% of the selling and administrative costs are variable costs, and the remaining 25% of each is fixed. Compute the contribution margin (in € millions). (Round computations using percentages to the nearest whole euro.)

QS 18-21 Contribution margin

A1

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . €92,175

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,043

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . 8,633

C os

ts

Volume VolumeVolume Volume Volume

C os

ts

C os

ts

C os

ts

2.1. 4.3. 5.

C os

ts

EXERCISES

Exercise 18-1 Cost behavior in graphs

C1

Following are five graphs representing various cost behaviors. (1) Identify whether the cost behavior in each graph is mixed, step-wise, fixed, variable, or curvilinear. (2) Identify the graph (by number) that best illustrates each cost behavior: (a) Factory policy requires one supervisor for every 30 factory workers; (b) real estate taxes on factory; (c) electricity charge that includes the standard monthly charge plus a charge for each kilowatt hour; (d) commissions to salespersons; and (e) costs of hourly paid workers that provide substantial gains in efficiency when a few workers are added but gradually smaller gains in effi- ciency when more workers are added.

The left column lists several cost classifications. The right column presents short definitions of those costs. In the blank space beside each of the numbers in the right column, write the letter of the cost best described by the definition. A. Total cost B. Mixed cost C. Variable cost D. Curvilinear cost E. Step-wise cost F. Fixed cost

Exercise 18-2 Cost behavior defined

C1 1. This cost is the combined amount of all the other costs. 2. This cost remains constant over a limited range of volume;

when it reaches the end of its limited range, it changes by a lump sum and remains at that level until it exceeds another lim- ited range.

3. This cost has a component that remains the same over all volume levels and another component that increases in direct proportion to increases in volume.

4. This cost increases when volume increases, but the increase is not constant for each unit produced.

5. This cost remains constant over all volume levels within the productive capacity for the planning period.

6. This cost increases in direct proportion to increases in volume; its amount is constant for each unit produced.

726 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

A company reports the following information about its unit sales and its cost of sales. Each unit sells for $500. Use these data to prepare a scatter diagram. Draw an estimated line of cost behavior and determine whether the cost appears to be variable, fixed, or mixed.

Exercise 18-4A Measurement of cost behavior using a scatter diagram

P1 Period Unit Sales Cost of Sales

1 . . . . . . . . . . . . . . . 22,500 $15,150

2 . . . . . . . . . . . . . . . 17,250 11,250

3 . . . . . . . . . . . . . . . 15,750 10,500

Period Unit Sales Cost of Sales

4 . . . . . . . . . . . . . . . 11,250 $ 8,250

5 . . . . . . . . . . . . . . . 13,500 9,000

6 . . . . . . . . . . . . . . . 18,750 14,250

Use the following information about unit sales and total cost of sales to prepare a scatter diagram. Draw a cost line that reflects the behavior displayed by this cost. Determine whether the cost is variable, step- wise, fixed, mixed, or curvilinear.

Exercise 18-5A Scatter diagram and measurement of cost behavior

P1 Period Unit Sales Cost of Sales Period Unit Sales Cost of Sales

1 . . . . . . . . . . . . . . . . 760 $590 9 . . . . . . . . . . . . . . . . . 580 $390

2 . . . . . . . . . . . . . . . . 800 560 10 . . . . . . . . . . . . . . . . . 320 240

3 . . . . . . . . . . . . . . . . 200 230 11 . . . . . . . . . . . . . . . . . 240 230

4 . . . . . . . . . . . . . . . . 400 400 12 . . . . . . . . . . . . . . . . . 720 550

5 . . . . . . . . . . . . . . . . 480 390 13 . . . . . . . . . . . . . . . . . 280 260

6 . . . . . . . . . . . . . . . . 620 550 14 . . . . . . . . . . . . . . . . . 440 410

7 . . . . . . . . . . . . . . . . 680 590 15 . . . . . . . . . . . . . . . . . 380 260

8 . . . . . . . . . . . . . . . . 540 430

Exercise 18-3 Cost behavior identification

C1

Following are five series of costs A through E measured at various volume levels. Identify each series as either fixed, variable, mixed, step-wise, or curvilinear.

A B C D E F

1 2 3 4 5 6 7

0 400 800

1,200 1,600 2,000 2,400

Volume (Units) $2,500

3,100 3,700 4,300 4,900 5,500 6,100

Series B Series D $5,000

5,000 5,000 5,000 5,000 5,000 5,000

Series ESeries CSeries A 0

3,600 7,200

10,800 14,400 18,000 21,600

$ 0 6,000 6,600 7,200 8,200 9,600

13,500

$ $1,000 1,000 2,000 2,000 3,000 3,000 4,000

Excel: Enter data Select: Insert Charts All Charts Line

Felix & Co. reports the following information about its units produced and total costs. Estimate total costs if 3,000 units are produced. Use the high-low method to estimate the fixed and variable components of total costs.

Exercise 18-6 Cost behavior estimation—scatter diagram and high-low

P1 Period Units Produced Total Costs Period Units Produced Total Costs

1 . . . . . . . . . . . . . . . . 0 $2,500 6 . . . . . . . . . . . . . . . . . 2,000 $5,500

2 . . . . . . . . . . . . . . . . 400 3,100 7 . . . . . . . . . . . . . . . . . 2,400 6,100

3 . . . . . . . . . . . . . . . . 800 3,700 8 . . . . . . . . . . . . . . . . . 2,800 6,700

4 . . . . . . . . . . . . . . . . 1,200 4,300 9 . . . . . . . . . . . . . . . . . 3,200 7,300

5 . . . . . . . . . . . . . . . . 1,600 4,900 10 . . . . . . . . . . . . . . . . . 3,600 7,900

Refer to the information from Exercise 18-6. Use spreadsheet software to use ordinary least-squares re- gression to estimate the cost equation, including fixed and variable cost amounts.

Exercise 18-7A Measurement of cost behavior using regression P1

A jeans maker is designing a new line of jeans called Slims. The jeans will sell for $205 per pair and cost $164 per pair in variable costs to make. 1. Compute the contribution margin per pair. 2. Compute the contribution margin ratio. 3. Describe what the contribution margin ratio reveals about this new jeans line.

Exercise 18-8 Contribution margin

A1

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 727

Exercise 18-9 Contribution margin and break-even P2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. Use this information to compute the company’s (a) contribution margin, (b) contribution margin ratio, (c) break-even point in units, and (d) break-even point in dollars of sales.

Exercise 18-10C CVP chart P3

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. Prepare a CVP chart for the company.

Exercise 18-11 Income reporting and break-even analysis

P2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. 1. Prepare a contribution margin income statement for Blanchard Company showing sales, variable

costs, and fixed costs at the break-even point. 2. If the company’s fixed costs increase by $135,000, what amount of sales (in dollars) is needed to break

even?

Exercise 18-12 Computing sales to achieve target income C2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. Management targets an annual pretax income of $1,012,500. Assume that fixed costs remain at $562,500. Compute the (1) unit sales to earn the target income and (2) dollar sales to earn the target income.

Exercise 18-14 Predicting sales and variable costs using contribution margin C2

Bloom Company management predicts that it will incur fixed costs of $160,000 and earn pretax income of $164,000 in the next period. Its expected contribution margin ratio is 25%. Use this information to compute the amounts of (1) total dollar sales and (2) total variable costs.

Exercise 18-15 Computing variable and fixed costs C2

Harrison Co. expects to sell 200,000 units of its product next year, which would generate total sales of $17 million. Management predicts that pretax net income for next year will be $1,250,000 and that the contribution margin per unit will be $25. Use this information to compute next year’s total expected (a) variable costs and (b) fixed costs.

Exercise 18-17 Target income and margin of safety (in dollars)

C2

Refer to the information in Exercise 18-16. 1. Assume Hudson Co. has a target pretax income of $162,000 for 2020. What amount of sales (in dol-

lars) is needed to produce this target income? 2. If Hudson achieves its target pretax income for 2020, what is its margin of safety (in percent)? (Round

to one decimal place.)

Exercise 18-13 Forecasted income statement

C2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. The sales manager predicts that annual sales of the company’s product will soon reach 40,000 units and its price will increase to $200 per unit. According to the production manager, variable costs are expected to increase to $140 per unit, but fixed costs will remain at $562,500. The income tax rate is 20%. What amounts of pretax and after-tax income can the company expect to earn from these predicted changes? Hint: Prepare a forecasted contri- bution margin income statement as in Exhibit 18.21.

Exercise 18-16 Break-even

P2

Hudson Co. reports the contribution margin income statement for 2019 below. Using this information, compute Hudson Co.’s (1) break-even point in units and (2) break-even point in sales dollars.

Contribution Margin Income Statement For Year Ended December 31, 2019

Sales (9,600 units at $225 each) . . . . . . . . . . . . . . . . . . . . $2,160,000

Variable costs (9,600 units at $180 each). . . . . . . . . . . . . 1,728,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324,000

Pretax income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 108,000

728 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Exercise 18-18 Evaluating strategies

C2

Refer to the information in Exercise 18-16. Assume the company is considering investing in a new ma- chine that will increase its fixed costs by $40,500 per year and decrease its variable costs by $9 per unit. Prepare a forecasted contribution margin income statement for 2020 assuming the company purchases this machine.

Exercise 18-19 Evaluating strategies C2

Refer to the information in Exercise 18-16. If the company raises its selling price to $240 per unit, com- pute its (1) contribution margin per unit, (2) contribution margin ratio, (3) break-even point in units, and (4) break-even point in sales dollars.

Exercise 18-20 Evaluating strategies C2

Refer to the information in Exercise 18-16. The marketing manager believes that increasing advertising costs by $81,000 in 2020 will increase the company’s sales volume to 11,000 units. Prepare a forecasted contribu- tion margin income statement for 2020 assuming the company incurs the additional advertising costs.

Exercise 18-21 Predicting unit and dollar sales C2

Nombre Company management predicts $390,000 of variable costs, $430,000 of fixed costs, and a pretax income of $155,000 in the next period. Management also predicts that the contribution margin per unit will be $9. Use this information to compute the (1) total expected dollar sales for next period and (2) num- ber of units expected to be sold next period.

Exercise 18-22 CVP analysis using composite units

P4

Handy Home sells windows and doors in the ratio of 8:2 (windows:doors). The selling price of each win- dow is $200 and of each door is $500. The variable cost of a window is $125 and of a door is $350. Fixed costs are $900,000. Use this information to determine the (1) selling price per composite unit, (2) variable costs per composite unit, (3) break-even point in composite units, and (4) number of units of each product that will be sold at the break-even point.

Exercise 18-23 CVP analysis using composite units

P4

R&R Tax Service offers tax and consulting services to individuals and small businesses. Data for fees and costs of three types of tax returns follow. R&R provides services in the ratio of 5:3:2 (easy, moderate, business). Fixed costs total $18,000 for the tax season. Use this information to determine the (1) selling price per composite unit, (2) variable costs per composite unit, (3) break-even point in composite units, and (4) number of units of each product that will be sold at the break-even point.

Type of Return Fee Charged Variable Cost per Return

Easy (Form 1040EZ) . . . . . . . . . . . . . . $ 50 $ 30

Moderate (Form 1040) . . . . . . . . . . . 125 75

Business . . . . . . . . . . . . . . . . . . . . . . . 275 100

Exercise 18-24 Operating leverage computed and applied

A2

Company A is a manufacturer with sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with service revenues of $4,500,000 and a 25% contri- bution margin. Its fixed costs equal $375,000. Compute the degree of operating leverage (DOL) for each company. Which company benefits more from a 20% increase in sales?

Refer to the information in Exercise 18-16. 1. Compute the company’s degree of operating leverage for 2019. 2. If sales decrease by 5% in 2020, what will be the company’s pretax income? 3. Assume sales for 2020 decrease by 5%. Prepare a contribution margin income statement for 2020.

Exercise 18-25 Degree of operating leverage

A2

A manufacturer reports the information below for three recent years. Compute income for each of the three years using absorption costing.

Exercise 18-26B Computing absorption costing income

P5 Year 1 Year 2 Year 3 Variable costing income . . . . . . . . . . . . . . . . . . . . . . . . $110,000 $114,400 $118,950

Beginning finished goods inventory (units) . . . . . . . . . 0 1,200 700

Ending finished goods inventory (units) . . . . . . . . . . . . 1,200 700 800

Fixed manufacturing overhead per unit . . . . . . . . . . . . $2.50 $2.50 $2.50

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 729

Use the amounts shown on the contribution margin income statements below to compute the missing amounts denoted by letters a through n.

Exercise 18-27 Contribution margin income statement

A1 Company A Company B

Number of units sold . . . . . . . . . . . . . . . . . . . a 1,975

Total Per unit Total Per unit

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $208,000 $65 h i

Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . 150,400 b $39,500 j

Contribution margin . . . . . . . . . . . . . . . . . . . . c d 43,450 k

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . e f 19,750 l

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 46,400 g m n

Required

1. Prepare a contribution margin income statement for the year. 2. Compute its contribution margin per unit and its contribution margin ratio.

Analysis Component

3. For each dollar of sales, how much is left to cover fixed costs and contribute to operating income?

Check (1) Net income, $101,250

PROBLEM SET A

Problem 18-1A Contribution margin income statement and contribution margin ratio

A1

The following costs result from the production and sale of 1,000 drum sets manufactured by Tight Drums Company for the year ended December 31, 2019. The drum sets sell for $500 each. The company has a 25% income tax rate.

Variable production costs

Plastic for casing . . . . . . . . . . . . . . . . . . . . . . $17,000

Wages of assembly workers . . . . . . . . . . . . . 82,000

Drum stands . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Variable selling costs

Sales commissions. . . . . . . . . . . . . . . . . . . . . 15,000

Fixed manufacturing costs

Taxes on factory . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Factory maintenance . . . . . . . . . . . . . . . . . . . 10,000

Factory machinery depreciation . . . . . . . . . . 40,000

Fixed selling and administrative costs

Lease of equipment for sales staff. . . . . . . . . 10,000

Accounting staff salaries . . . . . . . . . . . . . . . . 35,000

Administrative management salaries. . . . . . . 125,000

Problem 18-2A Cost behavior estimation— high-low

P1

Alden Co.’s monthly unit sales and total cost data for its operating activities of the past year follow. Management wants to use these data to predict future fixed and variable costs.

Month Units Sold Total Cost Month Units Sold Total Cost

1 . . . . . . . . . . . . . . 320,000 $160,000 7 . . . . . . . . . . . . . 340,000 $220,000

2 . . . . . . . . . . . . . . 160,000 100,000 8 . . . . . . . . . . . . . 280,000 160,000

3 . . . . . . . . . . . . . . 280,000 220,000 9 . . . . . . . . . . . . . 80,000 64,000

4 . . . . . . . . . . . . . . 200,000 100,000 10 . . . . . . . . . . . . . 160,000 140,000

5 . . . . . . . . . . . . . . 300,000 230,000 11 . . . . . . . . . . . . . 100,000 100,000

6 . . . . . . . . . . . . . . 200,000 120,000 12 . . . . . . . . . . . . . 110,000 80,000

Required

1. Estimate both the variable costs per unit and the total monthly fixed costs using the high-low method. 2. Use the results from part 1 to predict future total costs when sales volume is (a) 200,000 units and

(b) 300,000 units.

730 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Contribution Margin Income Statement For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (50,000)

Problem 18-4A Break-even analysis; income targeting and forecasting

C2 A1 P2

Astro Co. sold 20,000 units of its only product and incurred a $50,000 loss (ignoring taxes) for the current year, as shown here. During a planning session for year 2020’s activities, the production manager notes that variable costs can be reduced 50% by installing a machine that automates several operations. To obtain these savings, the company must increase its annual fixed costs by $200,000. The maximum output capacity of the company is 40,000 units per year.

Required

1. Compute the break-even point in dollar sales for 2019. 2. Compute the predicted break-even point in dollar sales for 2020 assuming the machine is installed and

there is no change in the unit selling price. 3. Prepare a forecasted contribution margin income statement for 2020 that shows the expected results

with the machine installed. Assume that the unit selling price and the number of units sold will not change, and no income taxes will be due.

4. Compute the sales level required in both dollars and units to earn $200,000 of target pretax income in 2020 with the machine installed and no change in unit sales price. Round answers to whole dollars and whole units.

5. Prepare a forecasted contribution margin income statement that shows the results at the sales level computed in part 4. Assume no income taxes will be due.

Check (3) Net income, $150,000

(4) Required sales, $1,083,333 or 21,667 units (both rounded)

Problem 18-5A Break-even analysis, different cost structures, and income calculations

C2 A1 P4

Henna Co. produces and sells two products, T and O. It manufactures these products in separate factories and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

Product T Product O

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000 $2,000,000

Variable costs . . . . . . . . . . . . . . . . . . . . . 1,600,000 250,000

Contribution margin . . . . . . . . . . . . . . . . 400,000 1,750,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . 125,000 1,475,000

Income before taxes. . . . . . . . . . . . . . . . 275,000 275,000

Income taxes (32% rate). . . . . . . . . . . . . 88,000 88,000

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 187,000 $ 187,000

Problem 18-3A Break-even analysis

P2 P3

Praveen Co. manufactures and markets a number of rope products. Management is considering the future of Product XT, a special rope for hang gliding, that has not been as profitable as planned. Since Product XT is manufactured and marketed independently of the other products, its total costs can be precisely measured. Next year’s plans call for a $200 selling price per 100 yards of XT rope. Its fixed costs for the year are expected to be $270,000, up to a maximum capacity of 700,000 yards of rope. Forecasted variable costs are $140 per 100 yards of XT rope.

Required

1. Estimate Product XT’s break-even point in terms of (a) sales units and (b) sales dollars. 2. Prepare a contribution margin income statement showing sales, variable costs, and fixed costs for

Product XT at the break-even point.

Check (1a) Break-even sales, 4,500 units

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 731

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to whole dollars.) 2. Assume that the company expects sales of each product to decline to 30,000 units next year with no

change in unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as just shown with columns for each of the two products (assume a 32% tax rate). Also, assume that any loss before taxes yields a 32% tax benefit.

3. Assume that the company expects sales of each product to increase to 60,000 units next year with no change in unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement shown with columns for each of the two products (assume a 32% tax rate).

Analysis Component

4. If sales greatly decrease, which product would experience a greater decrease in net income?

Check (2) After-tax income: T, $78,200; O, $(289,000)

(3) After-tax income: T, $241,400; O, $425,000

Problem 18-6A Analysis of price, cost, and volume changes for contribution margin and net income

A1 P2

This year Burchard Company sold 40,000 units of its only product for $25 per unit. Manufacturing and selling the product required $200,000 of fixed manufacturing costs and $325,000 of fixed selling and administrative costs. Its per unit variable costs follow.

Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8.00

Direct labor (paid on the basis of completed units) . . . . 5.00

Variable overhead costs. . . . . . . . . . . . . . . . . . . $1.00

Variable selling and administrative costs . . . . . 0.50

Next year the company will use a new material, which will reduce material costs by 50% and direct labor costs by 60% and will not affect product quality or marketability. Management is considering an increase in the unit selling price to reduce the number of units sold because the factory’s output is nearing its annual output capacity of 45,000 units. Two plans are being considered. Under plan 1, the company will keep the selling price at the current level and sell the same volume as last year. This plan will increase income because of the reduced costs from using the new material. Under plan 2, the company will increase the selling price by 20%. This plan will decrease unit sales volume by 10%. Under both plans, the total fixed costs and the variable costs per unit for overhead and for selling and administrative costs will remain the same.

Required

1. Compute the break-even point in dollar sales for (a) plan 1 and (b) plan 2. 2. Prepare a forecasted contribution margin income statement with two columns showing the expected

results of plan 1 and plan 2. The statements should report sales, total variable costs, contribution mar- gin, total fixed costs, income before taxes, income taxes (30% rate), and net income.

Check (1) Break-even: Plan 1, $750,000; Plan 2, $700,000 (2) Net income: Plan 1, $122,500; Plan 2, $199,500

Problem 18-7A Break-even analysis with composite units

P4

Patriot Co. manufactures and sells three products: red, white, and blue. Their unit selling prices are red, $20; white, $35; and blue, $65. The per unit variable costs to manufacture and sell these products are red, $12; white, $22; and blue, $50. Their sales mix is reflected in a ratio of 5:4:2 (red:white:blue). Annual fixed costs shared by all three products are $250,000. One type of raw material has been used to manufac- ture all three products. The company has developed a new material of equal quality for less cost. The new material would reduce variable costs per unit as follows: red, by $6; white, by $12; and blue, by $10. However, the new material requires new equipment, which will increase annual fixed costs by $50,000. (Round answers to whole composite units.)

Required

1. If the company continues to use the old material, determine its break-even point in both sales units and sales dollars of each individual product.

2. If the company uses the new material, determine its new break-even point in both sales units and sales dollars of each individual product.

Check (1) Old plan break- even, 2,050 composite units (rounded)

732 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Problem 18-2B Cost behavior estimation— high-low

P1

Sun Co.’s monthly unit sales and total cost data for its operating activities of the past year follow. Management wants to use these data to predict future fixed and variable costs. (Dollar and unit amounts are in thousands.)

Required

1. Estimate both the variable costs per unit and the total monthly fixed costs using the high-low method. 2. Use the results from part 1 to predict future total costs when sales volume is (a) 100 units and (b) 170

units.

Month Units Sold Total Cost Month Units Sold Total Cost

1 . . . . . . . . . . . . . . 195 $ 97 7 . . . . . . . . . . . . . 145 $ 93

2 . . . . . . . . . . . . . . 125 87 8 . . . . . . . . . . . . . 185 105

3 . . . . . . . . . . . . . . 105 73 9 . . . . . . . . . . . . . 135 85

4 . . . . . . . . . . . . . . 155 89 10 . . . . . . . . . . . . . 85 58

5 . . . . . . . . . . . . . . 95 81 11 . . . . . . . . . . . . . 175 95

6 . . . . . . . . . . . . . . 215 110 12 . . . . . . . . . . . . . 115 79

Problem 18-3B Break-even analysis

P2 P3

Hip-Hop Co. manufactures and markets several products. Management is considering the future of one product, electronic keyboards, that has not been as profitable as planned. Since this product is manufac- tured and marketed independently of the other products, its total costs can be precisely measured. Next year’s plans call for a $350 selling price per unit. The fixed costs for the year are expected to be $42,000, up to a maximum capacity of 700 units. Forecasted variable costs are $210 per unit.

Required

1. Estimate the keyboards’ break-even point in terms of (a) sales units and (b) sales dollars. 2. Prepare a contribution margin income statement showing sales, variable costs, and fixed costs for

keyboards at the break-even point. 3. Prepare a CVP chart for keyboards like that in Exhibit 18.14. Use 700 keyboards as the maximum

number of sales units on the horizontal axis of the graph and $250,000 as the maximum dollar amount on the vertical axis.

Check (1) Break-even sales, 300 units

Required

1. Prepare a contribution margin income statement for the year. 2. Compute its contribution margin per unit and its contribution margin ratio.

Analysis Component

3. Interpret the contribution margin and contribution margin ratio from part 2.

Check (1) Net income, $6,135

PROBLEM SET B

Problem 18-1B Contribution margin income statement and contribution margin ratio

A1

The following costs result from the production and sale of 12,000 CD sets manufactured by Gilmore Company for the year ended December 31, 2019. The CD sets sell for $18 each. The company has a 25% income tax rate.

Variable manufacturing costs

Plastic for CD sets . . . . . . . . . . . . . . . . . . . . . $ 1,500

Wages of assembly workers . . . . . . . . . . . . . 30,000

Labeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Variable selling costs

Sales commissions. . . . . . . . . . . . . . . . . . . . . 6,000

Fixed manufacturing costs

Rent on factory . . . . . . . . . . . . . . . . . . . . . . . . $ 6,750

Factory cleaning service. . . . . . . . . . . . . . . . . 4,520

Factory machinery depreciation . . . . . . . . . . 20,000

Fixed selling and administrative costs

Lease of office equipment . . . . . . . . . . . . . . . 1,050

Systems staff salaries . . . . . . . . . . . . . . . . . . . 15,000

Administrative management salaries. . . . . . . 120,000

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 733

Problem 18-4B Break-even analysis; income targeting and forecasting

C2 A1 P2

Contribution Margin Income Statement For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750,000 Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (50,000)

Rivera Co. sold 20,000 units of its only product and incurred a $50,000 loss (ignoring taxes) for the cur- rent year, as shown here. During a planning session for year 2020’s activities, the production manager notes that variable costs can be reduced 50% by installing a machine that automates several operations. To obtain these savings, the company must increase its annual fixed costs by $150,000. The maximum output capacity of the company is 40,000 units per year.

Required

1. Compute the break-even point in dollar sales for 2019. 2. Compute the predicted break-even point in dollar sales for 2020 assuming the machine is installed and

no change occurs in the unit selling price. (Round the change in variable costs to a whole number.) 3. Prepare a forecasted contribution margin income statement for 2020 that shows the expected results

with the machine installed. Assume that the unit selling price and the number of units sold will not change, and no income taxes will be due.

4. Compute the sales level required in both dollars and units to earn $200,000 of target pretax income in 2020 with the machine installed and no change in unit sales price. (Round answers to whole dollars and whole units.)

5. Prepare a forecasted contribution margin income statement that shows the results at the sales level computed in part 4. Assume no income taxes will be due.

Check (3) Net income, $100,000

(4) Required sales, $916,667 or 24,445 units (both rounded)

Stam Co. produces and sells two products, BB and TT. It manufactures these products in separate factories and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

Problem 18-5B Break-even analysis, different cost structures, and income calculations

C2 A1 P4 Product BB Product TT

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $800,000

Variable costs . . . . . . . . . . . . . . . . . . . . . 560,000 100,000

Contribution margin . . . . . . . . . . . . . . . . 240,000 700,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . 100,000 560,000

Income before taxes. . . . . . . . . . . . . . . . 140,000 140,000

Income taxes (32% rate). . . . . . . . . . . . . 44,800 44,800

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 95,200 $ 95,200

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to the next whole dollar.) 2. Assume that the company expects sales of each product to decline to 33,000 units next year with no

change in the unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as shown here with columns for each of the two products (assume a 32% tax rate and that any loss before taxes yields a 32% tax benefit).

3. Assume that the company expects sales of each product to increase to 64,000 units next year with no change in the unit selling prices. Prepare forecasted financial results for next year following the format of the contribution margin income statement as shown here with columns for each of the two products (assume a 32% tax rate).

Analysis Component

4. If sales greatly increase, which product would experience a greater increase in profit? Explain. 5. Describe some factors that might have created the different cost structures for these two products.

Check (2) After-tax income: BB, $39,712; TT, $(66,640)

(3) After-tax income: BB, $140,896; TT, $228,480

734 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Problem 18-7B Break-even analysis with composite units

P4

Milano Co. manufactures and sells three products: product 1, product 2, and product 3. Their unit selling prices are product 1, $40; product 2, $30; and product 3, $20. The per unit variable costs to manufacture and sell these products are product 1, $30; product 2, $15; and product 3, $8. Their sales mix is reflected in a ratio of 6:4:2. Annual fixed costs shared by all three products are $270,000. One type of raw material has been used to manufacture products 1 and 2. The company has developed a new material of equal quality for less cost. The new material would reduce variable costs per unit as follows: product 1 by $10 and product 2 by $5. However, the new material requires new equipment, which will increase annual fixed costs by $50,000.

Required

1. If the company continues to use the old material, determine its break-even point in both sales units and sales dollars of each individual product.

2. If the company uses the new material, determine its new break-even point in both sales units and sales dollars of each individual product. (Round to the next whole unit.)

Analysis Component

3. What insight does this analysis offer management for long-term planning?

Check (1) Old plan break- even, 1,875 composite units

SERIAL PROBLEM Business Solutions P4

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 18 Business Solutions sells upscale modular desk units and office chairs in the ratio of 3:2 (desk unit:chair). The selling prices are $1,250 per desk unit and $500 per chair. The variable costs are $750 per desk unit and $250 per chair. Fixed costs are $120,000.

Required

1. Compute the selling price per composite unit. 2. Compute the variable costs per composite unit. 3. Compute the break-even point in composite units. 4. Compute the number of units of each product that would be sold at the break-even point.

©Alexander Image/Shutterstock

Check (3) 60 composite units

This year Best Company earned a disappointing 5.6% after-tax return on sales (net income/sales) from marketing 100,000 units of its only product. The company buys its product in bulk and repackages it for resale at the price of $20 per unit. Best incurred the following costs this year.

Problem 18-6B Analysis of price, cost, and volume changes for contribution margin and net income

A1 P2 Total variable unit costs . . . . . . . . . . . . . . . . . . . . $800,000

Total variable packaging costs. . . . . . . . . . . . . . . $100,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . $950,000

Income tax rate. . . . . . . . . . . . . . . . . . . 25%

The marketing manager claims that next year’s results will be the same as this year’s unless some changes are made. The manager predicts the company can increase the number of units sold by 80% if it reduces the selling price by 20% and upgrades the packaging. This change would increase variable packaging costs by 20%. Increased sales would allow the company to take advantage of a 25% quantity purchase discount on the cost of the bulk product. Neither the packaging change nor the volume discount would affect fixed costs, which provide an annual output capacity of 200,000 units.

Required

1. Compute the break-even point in dollar sales under the (a) existing business strategy and (b) new strat- egy that alters both unit selling price and variable costs. (Round answers to the next whole dollar.)

2. Prepare a forecasted contribution margin income statement with two columns showing the expected results of (a) the existing strategy and (b) changing to the new strategy. The statements should report sales, total variable costs (unit and packaging), contribution margin, fixed costs, income before taxes, income taxes, and net income. Also determine the after-tax return on sales for these two strategies.

Check (1b) Break-even sales for new strategy, $1,727,273 (rounded) (2) Net income: Existing strategy, $112,500; new strategy, $475,500

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 735

COMPANY ANALYSIS P2

Accounting Analysis

AA 18-1 Apple offers extended service contracts that provide repair coverage for its products. Assume Apple charges $160 to repair an iPhone screen and $400 for other repairs. Services are provided in a ratio of 2 screens to 1 other repair (2:1). Variable costs are 40% of selling price for iPhone screen repairs and 48% of selling price for other repairs. Assume fixed costs are $2 billion per year for the repair services department.

Required

1. Compute the selling price per composite unit for Apple’s repair services. 2. Compute the variable cost per composite unit for Apple’s repair services. 3. How many composite units must Apple’s repair services department sell each year to break even? 4. At the break-even level, how many screen repairs and other repairs will Apple complete each year?

APPLE

Required

1. Compute each company’s break-even point in unit sales. (Each company sells many devices at many different selling prices, and each has its own variable costs. This assignment assumes an average sell- ing price per unit and an average cost per item.)

2. If unit sales were to decline, which company would experience the larger decline in operating profit?

AA 18-2 Both Apple and Google sell electronic devices, and each of these companies has a different product mix. Assume the following data are available for both companies.

COMPARATIVE ANALYSIS A2 P2

Apple Google

Average selling price per unit sold . . . . . . . . . . . . $550 per unit $470 per unit

Average variable cost per unit sold . . . . . . . . . . . . $250 per unit $270 per unit

Total fixed costs ($ millions) . . . . . . . . . . . . . . . . . . $36,000 $10,000

ETHICS CHALLENGE C1

BTN 18-1 Labor costs of an auto repair mechanic are seldom based on actual hours worked. Instead, this labor cost is based on an industry average of time estimated to complete a repair job. This means a cus- tomer can pay, for example, $120 for two hours of work on a car when the actual time worked was only one hour. Many experienced mechanics can complete repair jobs faster than the industry average. Assume that you are asked to complete such a survey for a repair center. The survey calls for objective input, and many questions require detailed cost data and analysis. The mechanics and owners know you have the survey and encourage you to complete it in a way that increases the average billable hours for repair work.

Required

Write a one-page memorandum to the mechanics and owners that describes the direct labor analysis you will undertake in completing this survey.

Beyond the Numbers

GOOGLE APPLE

Samsung Apple

Selling price per unit. . . . . . . . . . . . . . . . . . . . . . . . $720 $650

Variable cost per unit . . . . . . . . . . . . . . . . . . . . . . . 288 221

AA 18-3 Both Samsung and Apple sell smartphones. Assume the following data are available for a popular smartphone model of each company.

GLOBAL ANALYSIS A1

Samsung

Required

1. Compute the contribution margin ratio for each model. 2. Based on contribution margin ratio, which company’s smartphone sales contribute more to covering

fixed costs?

APPLE

736 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

BTN 18-4 A local movie theater owner explains to you that ticket sales on weekends and evenings are strong, but attendance during the weekdays, Monday through Thursday, is poor. The owner proposes to offer a contract to the local grade school to show educational materials at the theater for a set charge per student during school hours. The owner asks your help to prepare a CVP analysis listing the cost and sales projections for the proposal. The owner must propose to the school’s administration a charge per child. At a minimum, the charge per child needs to be sufficient for the theater to break even.

Required

Your team is to prepare two separate lists of questions that enable you to complete a reliable CVP analysis of this situation. One list is to be answered by the school’s administration, the other by the owner of the movie theater.

TEAMWORK IN ACTION C2

BTN 18-5 Ellis Island Tropical Tea, launched by entrepreneur Nailah Ellis-Brown as described in this chapter’s opener, makes Jamaican sweet tea from all-natural ingredients.

Required

1. Identify at least two fixed costs that do not change regardless of how much tea Nailah’s company sells. 2. Ellis Island Tropical Tea is growing. How could overly optimistic sales estimates hurt Nailah’s business? 3. Explain how cost-volume-profit analysis can help Nailah manage her company.

ENTREPRENEURIAL DECISION C1 A1

BTN 18-2 Several important assumptions underlie CVP analysis. Assumptions often help simplify and focus our analysis of sales and costs. A common application of CVP analysis is as a tool to forecast sales, costs, and income.

Required

Assume that you are actively searching for a job. Prepare a half-page report identifying (1) three assump- tions relating to your expected revenue (salary) and (2) three assumptions relating to your expected costs for the first year of your new job. Be prepared to discuss your assumptions in class.

COMMUNICATING IN PRACTICE C2

BTN 18-3 Access and review the entrepreneurial information at Bizfilings (bizfilings.com). Search for New Business Cash Needs Checklist and review the resulting material.

Required

Write a half-page report that describes the information and resources available to help the owner of a start- up business control and monitor its cash flows and costs.

TAKING IT TO THE NET C1

BTN 18-6 Multiproduct break-even analysis is often viewed differently when actually applied in practice. You are to visit a local fast-food restaurant and count the number of items on the menu. To apply multi- product break-even analysis to the restaurant, similar menu items must often be fit into groups. A reason- able approach is to classify menu items into approximately five groups. We then estimate average selling price and average variable cost to compute average contribution margin. (Hint: For fast-food restaurants, the highest contribution margin is with its beverages, at about 90%.)

HITTING THE ROAD P4

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 737

Required

1. Prepare a one-year multiproduct break-even analysis for the restaurant you visit. Begin by establishing groups. Next, estimate each group’s volume and contribution margin. These estimates are necessary to compute each group’s contribution margin. Assume that annual fixed costs in total are $500,000 per year. (Hint: You must develop your own estimates on volume and contribution margin for each group to obtain the break-even point and sales.)

2. Prepare a one-page report on the results of your analysis. Comment on the volume of sales necessary to break even at a fast-food restaurant.

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Learning Objectives

CONCEPTUAL C1 Describe how absorption costing can

result in overproduction.

ANALYTICAL A1 Use variable costing in pricing special

orders.

P3 Convert income under variable costing to the absorption cost basis.

P4 Determine product selling price based on absorption costing.

PROCEDURAL P1 Compute unit cost under both

absorption and variable costing.

P2 Prepare and analyze an income statement using absorption costing and using variable costing.

Chapter Preview

19 Variable Costing and Analysis

COMPARING VARIABLE AND ABSORPTION COSTING

C1 Planning production P4 Setting prices

Controlling costs

CVP analysis

Variable costing for services

A1 Pricing special orders

VARIABLE COSTING AND ABSORPTION COSTING

Variable costing

Absorption costing

P1 Computing unit cost

NTK 19-3NTK 19-1 NTK 19-2

INCOME REPORTING IMPLICATIONS

P2 Production equals sales Production exceeds sales

Production less than sales

Income reporting

P3 Converting income

739

“Make your dream reality”—Shay Doyon

Ray of Light

LACONIA, NH—Lifelong Northeasterners David and Shay Doyon were looking for a change. “I always had a dream and passion of owning an inn,” recalls Shay. “I love the cozy, quaint feeling that emanates from a country inn.” After a stay at the Lantern Inn B&B (lanterninnbb.com), they bought it.

David and Shay faced challenges in making their dream a reality. “We are first-time operators of a bed and breakfast,” ex- plains David. The couple used accounting concepts to develop their business plan and set up an accounting system to mea- sure, track, and report on profits and cash flows.

David and Shay’s understanding of variable and fixed costs allows them to compute the break-even number of rooms they must rent to cover fixed costs. David and Shay set their prices to cover their costs using a market analysis of going rates in the area. This approach is common in competitive industries like hospitality.

The owners also provide special offers to veterans and par- ties who wish to rent the entire inn. In these cases, the owners focus on variable costs and incremental fixed costs.

Shay advises aspiring entrepreneurs to “pursue your dream and work hard!” David adds: “An understanding of accounting helps in starting and running your business.”

Sources: Lantern Inn B&B website, January 2019; correspondence with David Doyon, March 2018

©Lantern Inn

This chapter illustrates and compares two costing methods. Variable costing, where direct materials, direct labor, and variable overhead costs are in-

cluded in product costs. This method is useful for many managerial decisions, but it cannot be used for external financial reporting.

Absorption costing, where direct materials, direct labor, and both variable and fixed over- head costs are included in product costs. This method is required for external financial re- porting under U.S. GAAP, but it can result in misleading product cost information and poor managerial decisions.

Exhibit 19.1 compares the absorption and variable costing methods. Both methods include direct materials, direct labor, and variable overhead in product costs. The key difference between the methods lies in their treatment of fixed overhead costs—such costs are included in product costs under absorption costing but included in period expenses under variable costing. Product costs are included in inventory until the goods are sold, at which time they are included in cost of goods sold. Period expenses are reported as expenses immediately in the period in which they are incurred.

INTRODUCING VARIABLE COSTING AND ABSORPTION COSTING

Point: Under variable costing, fixed overhead is expensed at the time the units are produced. Under absorption costing, fixed overhead is expensed at the time the units are sold (as a component of cost of goods sold).

Product Costs

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead Period Expenses

Variable Costing

Product Costs

EXHIBIT 19.1 Absorption Costing versus Variable Costing

740 Chapter 19 Variable Costing and Analysis

Exhibit 19.1 helps us understand when the absorption and variable costing methods will yield different income amounts. Differences in income resulting from the alternative costing methods will be small when Fixed overhead is a small percentage of total manufacturing costs. Inventory levels are low. As more companies adopt lean techniques, including just-in-time

manufacturing, inventory levels fall. Lower inventory levels reduce income differences be- tween absorption and variable costing.

Inventory turnover is rapid. The more quickly inventory turns over, the more product costs are included in cost of goods sold relative to the product costs that remain in inventory.

The period of analysis is long. Different costing methods might yield very different income numbers over a quarter or year, but these differences will decrease as income is compared over longer periods.

Computing Unit Product Cost To illustrate the difference between absorption costing and variable costing, consider the prod- uct cost data in Exhibit 19.2 from IceAge, a skate manufacturer.

P1 Compute unit cost under both absorption and variable costing.

EXHIBIT 19.2 Summary Product Cost Data

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $4 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8 per unit

Expected units produced (per year) . . . . . . . . . . . 60,000 units

Variable overhead . . . . . . . . . . . $3 per unit

Fixed overhead . . . . . . . . . . . . . $600,000 per year

Using these product cost data, Exhibit 19.3 shows the product cost per unit computations for both absorption and variable costing. These computations are shown both in a visual format and a tabular format. For absorption costing, the product cost per unit is $25, which consists of $4 in direct

materials, $8 in direct labor, $3 in variable overhead, and $10 in fixed overhead ($600,000∕60,000 units).

For variable costing, the product cost per unit is $15, which consists of $4 in direct materials, $8 in direct labor, and $3 in variable overhead. Fixed overhead costs of $600,000 are treated as a period cost and are recorded as expense in the period incurred. The difference between the two costing methods is the exclusion of fixed overhead from product costs for variable costing.

©Karl Weatherly/Corbis/Getty Images

Product Cost per Unit

Absorption Variable Costing Costing

Direct materials . . . . . . . . . . . . . . . . . . . . . . $ 4 $ 4

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . 8 8

Overhead costs

Variable overhead . . . . . . . . . . . . . . . . . 3 3

Fixed overhead . . . . . . . . . . . . . . . . . . . 10 — Total product cost per unit . . . . . . . . . . . . . $25 $15

Product Costs

Absorption Costing

$25 per unit

$4 DM

$8 DL

$3 VOH

$10 FOH Period Expenses $600,000

Variable Costing

Product Costs

$ 15 per unit

EXHIBIT 19.3 Unit Cost Computation

A manufacturer reports the following data.

Computing Product Cost per Unit

NEED-TO-KNOW 19-1

P1

Direct materials cost . . . . . . . . . . . . . . . $6 per unit Variable overhead . . . . . . . . . . . . . $11 per unit

Direct labor cost . . . . . . . . . . . . . . . . . . . $14 per unit Fixed overhead . . . . . . . . . . . . . . . $680,000 per year

Expected units produced . . . . . . . . . . . 20,000 units

1. Compute the total product cost per unit under absorption costing. 2. Compute the total product cost per unit under variable costing.

Chapter 19 Variable Costing and Analysis 741

Solution

Do More: QS 19-1, QS 19-2, E 19-1, E 19-2

Per Unit Costs (1) Absorption Costing (2) Variable Costing

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6 $ 6

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 14

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 11

Fixed overhead ($680,000∕20,000)* . . . . . . . . . . . . . 34 — Total product cost per unit . . . . . . . . . . . . . . . . . . . . . $65 $31

*Not included in product costs under variable costing.

The different treatment of fixed overhead costs leads to different product costs per unit under absorption and variable costing. This section shows how this impacts income reporting.

Below are data for IceAge Company. Assume IceAge’s variable costs per unit are constant and its annual fixed costs do not change during the three-year period 2017 through 2019.

INCOME REPORTING IMPLICATIONS P2 Prepare and analyze an income statement using absorption costing and using variable costing.

Sales and production information for IceAge follows. Its sales price was a constant $40 per unit over this time period. Units produced equal those sold for 2017, exceed those sold for 2018, and are less than those sold for 2019. IceAge began 2017 with no units in beginning inventory.

Manufacturing Costs Selling and Administrative Expenses

Direct materials . . . . . . . . . . . . . . . . . $4 per unit Variable . . . . . . . . . . . . . . . . . . . . . . . $2 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . $8 per unit Fixed . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 per year

Variable overhead . . . . . . . . . . . . . . . $3 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . $600,000 per year

Units Produced Units Sold Units in Ending Inventory

2017 . . . . . . . . . . 60,000 60,000 0

2018 . . . . . . . . . . 60,000 40,000 20,000

2019 . . . . . . . . . . 60,000 80,000 0

We prepare income statements for IceAge under absorption costing and under variable costing. We consider three different cases: when units produced are equal to, exceed, or are less than units sold. In general, income differs between the costing methods when inventory levels change. Inventory levels change when units produced do not equal units sold.

Units Produced Equal Units Sold Exhibit 19.4 presents the 2017 income statement for both costing methods (2018 and 2019 state- ments will follow). The income statement under variable costing (on the right) is a contribution margin income statement. Contribution margin is the excess of sales over variable costs. This margin contributes to cover- ing all fixed costs and earning income. In the absorption costing income statement, expenses are not separated into variable and fixed components.

Exhibit 19.4 reveals that reported income is identical under absorption costing and variable costing when the number of units produced equals the number of units sold. Because variable costing expenses the same amount

Production =

==

= Income under

2017

60,000 pairs60,000 pairs Absorption costing = Variable costing $580,000 = $580,000

SalesP d iProduction 60 000 i60,000 pairs, p

S l=== Sales 60 000 i

=

==

=

= 60,000 pairs

==

, p

742 Chapter 19 Variable Costing and Analysis

of fixed overhead cost ($600,000) that absorption costing includes in cost of goods sold ($600,000 = 60,000 units × $10 fixed overhead per unit), net income is the same under either method when units produced equal units sold.

Exhibit 19.5 reorganizes the information from Exhibit 19.4 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. In this year, there are no units in ending inventory, so the finished goods inventory is $0 under both methods. When units produced equal units sold, there is no difference in total expenses reported on the income statement. Yet, there is a difference in what categories receive those costs. Absorption costing assigns $1,500,000 to cost of goods sold compared to $900,000 for variable costing. The $600,000 difference is a period cost for variable costing.

EXHIBIT 19.4 Income for 2017—Quantity Produced Equals Quantity Sold*

Point: Contribution margin (Sales − Variable expenses) is different from gross margin (Sales − Cost of sales).

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2017

Sales* (60,000 × $40) . . . . . . . . . $2,400,000 Variable expenses

Variable production costs (60,000 × $15‡) . . . . . . . . . . $900,000 Variable selling and administrative expenses (60,000 × $2) . . . . . 120,000 1,020,000 Contribution margin . . . . . . . . . . . . 1,380,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . 600,000

Fixed selling and administrative expenses . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2017

Sales* (60,000 × $40) . . . . . . . . . . . . . . . . $2,400,000 Cost of goods sold (60,000 × $25†) . . . . . . . 1,500,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . 900,000

Selling and administrative expenses [$200,000 + (60,000 × $2)] . . . . . . . . . 320,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 580,000

*Units produced equal 60,000; units sold equal 60,000. †($4 DM + $8 DL + $3 VOH + $10 FOH) ‡($4 DM + $8 DL + $3 VOH)

A performance report that excludes fixed expenses and net income is a contribution margin report. Its bottom line is contribution margin .

Point: Contribution margin income statements prepared under variable costing are useful in performing cost-volume-profit analyses.

EXHIBIT 19.5 Production Cost Assignment for 2017

Absorption Costing For Year 2017

Beginning finished goods inventory . . . . . . . . . $ 0

Cost of goods manufactured

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $240,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Variable manufacturing overhead . . . . . . . . . 180,000

Fixed manufacturing overhead . . . . . . . . . . . 600,000 1,500,000

Cost of goods available for sale . . . . . . . . . . 1,500,000

Less: Ending finished goods inventory . . . . . . 0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . $1,500,000

Income statement

Balance sheet

Variable Costing For Year 2017

Beginning finished goods inventory . . . . . . . . . $ 0

Cost of goods manufactured

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $240,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Variable manufacturing overhead . . . . . . . . . 180,000

Fixed manufacturing overhead . . . . . . . . . . . 0 900,000

Cost of goods available for sale . . . . . . . . . . 900,000

Less: Ending finished goods inventory . . . . . . 0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 900,000

Period costs

Fixed manufacturing overhead . . . . . . . . . . . 600,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000

Income statementBalance sheet

(Absorption) FG Inventory

Beg. 0 COGM 1,500,000 1,500,000 COGS

End. 0 (Variable) FG Inventory

Beg. 0 COGM 900,000 900,000 COGS

End. 0

©Steve Mason/Getty Images

Manufacturing Margin Some managers compute manufacturing margin (also called production margin), which is sales less variable production costs. Some managers also require that internal income statements show this amount to highlight the impact of variable product costs on income. The contribution margin section of IceAge’s variable cost- ing income statement would appear as here (compare this to Exhibit 19.4).

Sales . . . . . . . . . . . . . . . . . . . . . . $2,400,000 Variable production costs . . . . . 900,000 Manufacturing margin . . . . . . . . 1,500,000 Variable selling & admin . exp . . . 120,000 Contribution margin . . . . . . . . . . $1,380,000 ■

Decision Insight

Chapter 19 Variable Costing and Analysis 743

Units Produced Exceed Units Sold Exhibit 19.6 shows absorption costing and variable costing income statements for 2018. In 2018, 60,000 units were produced, which is the same as in 2017. However, only 40,000 units were sold, which means 20,000 units remain in ending inventory.

For 2018, income is $320,000 under absorption costing. Under variable costing income is $120,000. The cause of this $200,000 income difference is the different treatment of fixed over- head. Because variable costing expenses the $600,000 of fixed manufacturing overhead (FOH) as a period cost, and absorption costing expenses FOH based on the number of units sold (40,000 × $10), net income is lower under variable costing by $200,000 (20,000 units × $10).

Production >

>>

> Income under

2018

Absorption costing > Variable costing $320,000 > $120,000

Sales 40,000 pairs60,000 pairs

EXHIBIT 19.6 Income for 2018—Quantity Produced Exceeds Quantity Sold

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2018

Sales* (40,000 × $40) . . . . . . . . . . . . . . . . . . $1,600,000 Cost of goods sold (40,000 × $25†) . . . . . . . 1,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Selling and administrative expenses [$200,000 + (40,000 × $2)] . . . . . . . . . . 280,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000

*Units produced equal 60,000; units sold equal 40,000. †($4 DM + $8 DL + $3 VOH + $10 FOH) ‡($4 DM + $8 DL + $3 VOH)

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2018

Sales* (40,000 × $40) . . . . . . . . . . . $1,600,000 Variable expenses

Variable production costs (40,000 × $15‡) . . . . . . . . . . . $600,000 Variable selling and administrative expenses (40,000 × $2) . . . . . . 80,000 680,000 Contribution margin . . . . . . . . . . . . . 920,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . 600,000

Fixed selling and administrative expenses . . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . . . $ 120,000

Exhibit 19.7 reorganizes the information from Exhibit 19.6 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When units pro- duced exceed units sold, there is a difference in total expenses. Under absorption costing, cost of goods sold of $1,000,000 is $200,000 lower than the total expenses ($1,200,000) under variable costing. As a result, income (and ending finished goods inventory) under absorption costing is $200,000 greater than under variable costing because of the fixed overhead cost included in ending

Variable Costing For Year 2018

Beginning finished goods inventory . . . . . . . . $ 0

Cost of goods manufactured

Direct materials . . . . . . . . . . . . . . . . . . . . . . $240,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Variable manufacturing overhead . . . . . . . . 180,000

Fixed manufacturing overhead . . . . . . . . . . 0 900,000

Cost of goods available for sale . . . . . . . . . 900,000

Less: Ending finished goods inventory . . . . . 300,000†

Cost of goods sold . . . . . . . . . . . . . . . . . . . . 600,000

Period costs

Fixed manufacturing overhead . . . . . . . . . . 600,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000

Absorption Costing For Year 2018

Beginning finished goods inventory . . . . . . . . . $ 0

Cost of goods manufactured

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $240,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Variable manufacturing overhead . . . . . . . . . 180,000

Fixed manufacturing overhead . . . . . . . . . . . 600,000 1,500,000

Cost of goods available for sale . . . . . . . . . . 1,500,000

Less: Ending finished goods inventory . . . . . . 500,000*

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . $1,000,000

*20,000 units × $25 per unit †20,000 units × $15 per unit

Income statement

Balance sheet

(Absorption) FG Inventory

Beg. 0 COGM 1,500,000 1,000,000 COGS

End. 500,000

(Variable) FG Inventory

Beg. 0 COGM 900,000 600,000 COGS

End. 300,000

Income statement

Balance sheet

EXHIBIT 19.7 Production Cost Assignment for 2018

744 Chapter 19 Variable Costing and Analysis

inventory (asset) under absorption costing. This $200,000 of fixed overhead cost will be reported in cost of goods sold in future years (under absorption costing) as those products are sold.

Units Produced Are Less Than Units Sold Exhibit 19.8 shows absorption costing and variable costing income statements for 2019. In 2019, IceAge produced 60,000 units and sold 80,000 units. Thus, IceAge produced 20,000 units fewer than it sold. This means IceAge

sold all that it produced during the period, and it sold all of its beginning finished goods inventory. IceAge’s income is $840,000 under absorption costing, but it is $1,040,000 under variable costing.

Production <

<<

< Income under

2019

Absorption costing < Variable costing $840,000 < $1,040,000

Sales 80,000 pairs60,000 pairs

Point: IceAge can sell more units than it produced in 2019 because of inventory carried over from 2018.

EXHIBIT 19.8 Income for 2019—Quantity Produced Is Less Than Quantity Sold

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2019

Sales* (80,000 × $40) . . . . . . . . . . . . $ 3,200,000 Variable expenses

Variable production costs (80,000 × $15‡) . . . . . . . . . . . . $1,200,000 Variable selling and administrative expenses (80,000 × $2) . . . . . . 160,000 1,360,000 Contribution margin . . . . . . . . . . . . . . 1,840,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . 600,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . . . . $1,040,000

*Units produced equal 60,000; units sold equal 80,000. †($4 DM + $8 DL + $3 VOH + $10 FOH) ‡($4 DM + $8 DL + $3 VOH)

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2019

Sales* (80,000 × $40) . . . . . . . . . . . . . . . . . . $3,200,000 Cost of goods sold (80,000 × $25†) . . . . . . 2,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000

Selling and administrative expenses [$200,000 + (80,000 × $2)] . . . . . . . . . . 360,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 840,000

This $200,000 income difference is due to the treatment of fixed overhead (FOH). Beginning inventory in 2019 under absorption costing included $200,000 of fixed overhead cost incurred in 2018, which is assigned to cost of goods sold in 2019 under absorption costing. Because absorption costing expenses FOH based on the number of units sold (80,000), net income is higher under variable costing by $200,000 (20,000 units × $10).

Exhibit 19.9 reorganizes the information from Exhibit 19.8 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quan- tity produced is less than quantity sold, there is a difference in total costs assigned.

Absorption Costing For Year 2019

Beginning finished goods inventory . . . . . . . . . $ 500,000*

Cost of goods manufactured

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $240,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Variable manufacturing overhead . . . . . . . . . 180,000

Fixed manufacturing overhead . . . . . . . . . . . 600,000 1,500,000

Cost of goods available for sale . . . . . . . . . . 2,000,000

Less: Ending finished goods inventory . . . . . . 0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . $2,000,000

Variable Costing For Year 2019

Beginning finished goods inventory . . . . . . . . . $ 300,000†

Cost of goods manufactured

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $240,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Variable manufacturing overhead . . . . . . . . . 180,000

Fixed manufacturing overhead . . . . . . . . . . . 0 900,000

Cost of goods available for sale . . . . . . . . . . 1,200,000

Less: Ending finished goods inventory . . . . . . 0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 1,200,000

Period costs

Fixed manufacturing overhead . . . . . . . . . . . 600,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000

*20,000 units × $25 per unit †20,000 units × $15 per unit

Income statement

Balance sheet

Income statement

Balance sheet

(Absorption) FG Inventory

Beg. 500,000 COGM 1,500,000 2,000,000 COGS End. 0

(Variable) FG Inventory

Beg. 300,000 COGM 900,000 1,200,000 COGS End. 0

EXHIBIT 19.9 Production Cost Assignment for 2019

Chapter 19 Variable Costing and Analysis 745

Specifically, beginning inventory in 2019 under absorption costing was $500,000 (20,000 units × $25), whereas it was only $300,000 (20,000 units × $15) under variable costing. Conse- quently, when that inventory is sold in 2019, that $200,000 difference in inventory is included in cost of goods sold under absorption costing. Thus, the 2019 income under absorption costing is $200,000 less than the income under variable costing.

Summarizing Income Reporting IceAge’s income reported under both variable costing and absorption costing for the years 2017 through 2019 is summarized in Exhibit 19.10. Total income is $1,740,000 for this time period for both methods. Further, income under absorption costing and income under variable costing differ whenever the quantity produced and the quantity sold differ. These dif- ferences in income are due to the different timing with which fixed overhead costs are reported in income under the two methods. Specifically, income under absorption costing is higher when more units are produced than are sold and is lower when fewer units are pro- duced than are sold.

FG Inventory Income Effect

No change No difference

Increases Absorption > Variable Decreases Variable > Absorption

Units Units Income under Income under Income Produced Sold Absorption Costing Variable Costing Differences

2017 . . . . . . . . . . 60,000 60,000 $ 580,000 $ 580,000 $ 0 2018 . . . . . . . . . . 60,000 40,000 320,000 120,000 200,000 2019 . . . . . . . . . . 60,000 80,000 840,000 1,040,000 (200,000) Totals . . . . . . . . . 180,000 180,000 $1,740,000 $1,740,000 $ 0

EXHIBIT 19.10 Summary of Income Reporting

For IceAge, the total number of units produced over 2017–2019 exactly equals the number of units sold over that period. This means that the difference between absorption costing income and variable costing income for the total three-year period is zero. In reality, production and sales quantities rarely exactly equal each other over such a short period of time. We normally see differences in income for these two methods extending over several years.

Point: In our illustration the company produces the same number of units (60,000) each year. We provide an example with varying yearly production levels in Need-to-Know 19-4 at the end of the chapter.

ZBest Mfg. reports the following data for 2019.

Computing Income under Absorption and Variable Costing

NEED-TO-KNOW 19-2

P2

1. Prepare an income statement for 2019 under absorption costing. 2. Prepare an income statement for 2019 under variable costing.

Solution

Direct materials cost . . . . . . . . $6 per unit Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units Direct labor cost . . . . . . . . . . . $11 per unit Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 units Variable overhead cost . . . . . $3 per unit Variable selling and administrative expenses . . . . . $2 per unit Fixed overhead . . . . . . . . . . . $680,000 per year Fixed selling and administrative expenses . . . . . . . $112,000 per year Sales price . . . . . . . . . . . . . . . . $80 per unit

ZBEST MFG. Income Statement (Variable Costing) For Year Ended December 31, 2019

Sales (14,000 × $80) . . . . . . . . . . . . . $1,120,000 Variable expenses

Variable production costs (14,000 × $20†) . . . . . . . . . . . . $280,000 Variable selling and admin . expenses‡ . . . . . . . . . . . 28,000 308,000

Contribution margin . . . . . . . . . . . . . . 812,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . 680,000

Fixed selling and admin . expenses . . . . . . . . . . . . . . . . . 112,000 792,000

Net income . . . . . . . . . . . . . . . . . . . . . $ 20,000

* $6 DM + $11 DL + $3 VOH + $34 FOH ($680,000∕20,000) †$6 DM + $11 DL + $3 VOH ‡14,000 × $2 per unit

ZBEST MFG. Income Statement (Absorption Costing)

For Year Ended December 31, 2019

Sales (14,000 × $80) . . . . . . . . . . . . . . . . . . . $1,120,000 Cost of goods sold (14,000 × $54*) . . . . . . . 756,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . 364,000

Selling and admin . expenses [$112,000 + (14,000 × $2)] . . . . . . . . . . . 140,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 224,000

The difference in income between the two methods ($204,000) can be computed as the 6,000 units added to ending inventory × $34 FOH per unit .

Do More: QS 19-3, QS 19-4, E 19-3, E 19-4, E 19-5

746 Chapter 19 Variable Costing and Analysis

C1 Describe how absorption costing can result in overproduction.

P3 Convert income under variable costing to the absorption cost basis.

Converting Income under Variable Costing to Absorption Costing Companies can use variable costing for internal reporting and business decisions, but they must use absorption costing for external reporting and tax reporting. For companies concerned about maintaining two costing systems, we can readily convert reports under variable costing to those using absorption costing.

Income under variable costing is restated to that under absorption costing by adding the fixed overhead cost in ending inventory and subtracting the fixed overhead cost in beginning inventory. Exhibit 19.11 shows the formula for this calculation.

Income under = Income under + Fixed overhead cost − Fixed overhead cost absorption costing variable costing in ending inventory* in beginning inventory* *Under absorption costing.

EXHIBIT 19.11 Formula to Convert Variable Costing Income to Absorption Costing

Exhibit 19.12 shows the computations of absorption costing income. To restate variable costing income to absorption costing income for 2018, add back the fixed overhead cost deferred in (ending) inventory. To restate variable costing income to absorption costing income for 2019, deduct the fixed overhead cost recognized from (beginning) inventory, which was incurred in 2018 but expensed in the 2019 cost of goods sold when the inventory was sold.

2017 2018 2019

Variable costing income (Exhibit 19 .10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,000 $120,000 $1,040,000

Add: Fixed overhead cost deferred in ending inventory (20,000 × $10) . . . . . . . . . . 0 200,000 0 Less: Fixed overhead cost recognized from beginning inventory (20,000 × $10) . . . . . 0 0 (200,000) Absorption costing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,000 $320,000 $ 840,000

EXHIBIT 19.12 Converting Variable Costing Income to Absorption Costing Income

This section compares the roles of absorption and variable costing in the following decisions. Planning production Controlling costs Setting prices Cost-volume-profit analysis

Planning Production Many companies link manager bonuses to income computed under absorption costing because this is how income is reported to shareholders (per GAAP). This can lead some managers to produce excess inventory, as we show next.

To illustrate how a reward system can lead to overproduction under absorption costing, let’s use IceAge’s 2017 data with one change: its manager decides to produce 100,000 units instead of 60,000. Because only 60,000 units are sold, the 40,000 units of excess production will be stored in ending finished goods inventory.

The left side of Exhibit 19.13 shows the product cost per unit under absorption costing when 60,000 units are produced (same as Exhibit 19.3). The right side shows product cost per unit when 100,000 units are produced.

Total product cost per unit is $4 less when 100,000 units are produced. This is because the company is spreading the $600,000 fixed overhead cost over 40,000 more units when 100,000 units are produced than when 60,000 units are produced.

COMPARING VARIABLE COSTING AND ABSORPTION COSTING

Chapter 19 Variable Costing and Analysis 747

The $4 per unit difference in product cost impacts income reporting. Exhibit 19.14 presents the 2017 income statement under absorption costing for the two alternative production levels.

Absorption Costing Absorption Costing When 60,000 Units Are Produced When 100,000 Units Are Produced

Per Unit Per Unit Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4 Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . 3 Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . 3

Total variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Total variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Fixed overhead ($600,000/60,000 units) . . . . . . 10 Fixed overhead ($600,000/100,000 units) . . . . . 6

Total product cost . . . . . . . . . . . . . . . . . . . . . . . $25 Total product cost . . . . . . . . . . . . . . . . . . . . . . . . $21

EXHIBIT 19.13 Unit Cost under Absorption Costing for Different Production Levels

EXHIBIT 19.14 Income under Absorption Costing for Different Production Levels

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2017 [60,000 Units Produced; 60,000 Units Sold]

Sales (60,000 × $40) . . . . . . . . . . . . . . . . . . . $2,400,000 Cost of goods sold (60,000 × $25) . . . . . . . . . . 1,500,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Selling and administrative expenses

Variable (60,000 × $2) . . . . . $120,000 Fixed . . . . . . . . . . . . . . . . . . . . 200,000 320,000

Net income . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2017 [100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 × $40) . . . . . . . . . . . . . . . . . . . $2,400,000 Cost of goods sold (60,000 × $21) . . . . . . . . 1,260,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . 1,140,000

Selling and administrative expenses

Variable (60,000 × $2) . . . . $120,000 Fixed . . . . . . . . . . . . . . . . . . . 200,000 320,000

Net income . . . . . . . . . . . . . . . $ 820,000

Common sense suggests that because the company’s variable cost per unit, total fixed costs, and sales are identical in both cases, merely producing more units and creating excess ending inventory should not increase income. Yet, income under absorption costing is $240,000 greater if IceAge produces 40,000 more units than necessary and builds up ending inventory. The rea- son is that $240,000 of fixed overhead (40,000 units × $6) is assigned to ending inventory instead of being expensed as cost of goods sold in 2017. This shows that under absorption cost- ing, a manager can increase income just by producing more and disregarding whether the excess units can be sold or not. This incentive problem encourages inventory buildup, which leads to increased costs in storage, financing, and obsolescence. If the excess inventory is never sold, it will be disposed of at a loss.

The manager incentive problem is avoided when income is measured using variable costing. To illustrate, Exhibit 19.15 reports income under variable costing for the same production levels used in Exhibit 19.14. This demonstrates that managers cannot increase income under variable costing by merely increasing production without increasing sales.

Reported income under variable costing is not affected by production level changes because all fixed production costs are expensed in the year when incurred. Under variable costing, com- panies increase income by selling more units, not by producing excess inventory.

Production Manager Your company produces and sells MP3 players. Due to competition, your company projects sales to be 35% less than last year. The CEO is concerned that top executives won’t receive bonuses because of the expected sales decrease. The controller suggests that if the company produces as many units as last year, reported income might achieve the level for bonuses to be paid. Should your company produce excess inventory to maintain income? What ethical issues arise? ■ Answer: Under absorption costing, fixed overhead costs are spread over all units produced. Thus, fixed cost for each unit will be lower if more units are produced. This means the company can increase income by producing excess units even if sales remain constant. But excess inventory leads to increased financing cost and obsolescence. Also, producing excess inventory to meet income levels for bonuses harms company owners and is unethical. You must discuss this with the appropriate managers.

Decision Ethics

748 Chapter 19 Variable Costing and Analysis

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2017

[60,000 Units Produced; 60,000 Units Sold]

Sales (60,000 × $40) . . . . . . . . . $2,400,000 Variable expenses

Variable production costs (60,000 × $15) . . . . . . . . . . $900,000 Variable selling and administrative expenses (60,000 × $2) . . . . . . . . . . . 120,000 1,020,000 Contribution margin . . . . . . . . . . . 1,380,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . 600,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2017

[100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 × $40) . . . . . . . . . . $2,400,000 Variable expenses

Variable production costs (60,000 × $15) . . . . . . . . . . $900,000 Variable selling and administrative expenses (60,000 × $2) . . . . . . . . . . . 120,000 1,020,000 Contribution margin . . . . . . . . . . . 1,380,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . 600,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . $ 580,000

EXHIBIT 19.15 Income under Variable Costing for Different Production Levels

P4 Determine product selling price based on absorption costing.

Setting Prices Over the long run, prices must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to owners. For this purpose, absorption cost information is useful because it reflects the full costs that sales must exceed for the company to be profitable. We can use a three-step process to determine product selling prices.

Step 1: Determine the product cost per unit using absorption costing. Step 2: Determine the target markup on product cost per unit. Step 3: Add the target markup to the product cost to find the target selling price.

To illustrate, consider IceAge. Under absorption costing, its product cost is $25 per unit (from Exhibit 19.3). IceAge’s management must then determine a target markup on this product cost. This target markup could be based on industry averages, prices that have been charged in the past, or other information. In addition, this markup must be set high enough to cover selling and administrative expenses (both variable and fixed) that are excluded from product costs. Assume IceAge targets a markup of 60% of absorption cost. With that information, the company computes a target selling price as in Exhibit 19.16.

Step 1 Absorption cost per unit (from Exhibit 19 .3) . . . . . . . . . . . . . . . $25 Step 2 Target markup per unit ($25 × 60%) . . . . . . . . . . . . . . . . . . . . . 15 Step 3 Target selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40

EXHIBIT 19.16 Determining Selling Price with Absorption Costing

IceAge can use this target selling price as a starting point in setting prices. Management must also consider the level of competition in its industry and customer preferences. If customers are not willing to pay $40 per unit, IceAge must either lower its target markup or find ways to reduce its costs.

While absorption cost information is useful in setting long-run prices, it can lead to mislead- ing decisions in analyzing special orders. We show how variable cost information can be used to analyze special-order decisions in the Decision Analysis at the end of the chapter.

Controlling Costs An effective management practice is to hold managers responsible only for their controllable costs. A cost is controllable if a manager can determine or greatly affect the amount incurred.

Chapter 19 Variable Costing and Analysis 749

Uncontrollable costs are not within the manager’s influence. In general, variable production costs and fixed production costs are controlled at different levels of management. Variable production costs, like direct materials and direct labor, are controlled by the produc-

tion supervisor. Fixed costs related to production capacity, like depreciation, are controlled by higher-level

managers who make decisions to change factory size or add new machines. Income statements that separately report variable and fixed costs, as is done in the contribu-

tion format used in variable costing, are more useful for controlling costs. Because absorption costing does not separate variable from fixed costs, it is less useful in evaluating the effective- ness of cost control by different levels of managers.

Internal Auditor Your company uses absorption costing. Management is disappointed because its external audi- tors are requiring it to write off an inventory amount because it exceeds what the company could reasonably sell in the foreseeable future. Why would management produce more than it sells? Why would management be disap- pointed about the write-off? ■ Answer: If bonuses are tied to income, managers have incentives to increase income for personal gain. If absorp- tion costing is used to determine income, management can reduce current-period expenses (and raise income) with overproduction, which shifts fixed production costs to future periods. This decision fails to consider whether there is a viable market for all units that are produced. If there is not, an auditor can conclude that the inventory does not have “future economic value” and pressure management to write it off. Such a write-off reduces income by the cost of the excess inventory.

Decision Maker

CVP Analysis The previous chapter discussed cost-volume-profit (CVP) analysis for making managerial deci- sions. If the income statement is prepared under variable costing and presented in the contribu- tion format, the data for CVP analysis are readily available.

Using the variable costing income statement from the left side of Exhibit 19.15, IceAge com- putes its break-even point as follows.

Break-even (in units) =

Fixed costs Contribution margin per unit =

$800,000 $23* = 34,783 (rounded)

*Total contribution margin/Units produced = $1,380,000/60,000

If the income statement is prepared under absorption costing, the data needed for CVP analy- sis are not readily available. Thus, we must reclassify cost data in order to conduct CVP analysis if absorption costing is used.

Variable Costing for Service Firms Variable costing also applies to service companies. Because service companies do not produce inventory, the differences in income from absorption and variable costing shown for a manufac- turer do not apply. Still, a focus on variable costs can be useful in managerial decisions for ser- vice firms. One example is a hotel receiving an offer to reserve a large block of rooms at a discounted price. Another example is “special-order” pricing for airlines when they sell tickets shortly before a flight at deeply discounted prices. If the discounted price exceeds variable costs, such sales increase contribution margin and net income.

For example, BlueSky provides charter airline services. Its variable costing income for 2019 is shown in Exhibit 19.17. Based on an activity level of 120 flights (60% of its capacity), BlueSky’s variable cost per flight is $30,000, computed as $3,600,000/120. BlueSky’s normal price is $50,000 per flight. A community group has offered BlueSky $35,000 to fly its members to Washington, D.C. In making its decision, BlueSky should ignore allocated fixed costs. If fixed costs will not increase from accepting this charter flight, the company’s expected contri- bution margin from the special offer is

Revenue from charter flight . . . . . . . . . . . . . . . . $35,000

Variable costs of charter flight . . . . . . . . . . . . . . 30,000

Contribution margin of charter flight . . . . . . . . . $ 5,000

750 Chapter 19 Variable Costing and Analysis

BlueSky should accept the charter-flight offer, as it provides a contribution margin of $5,000. An incorrect analysis based on absorption costing might lead management to reject the offer.

Income Statement (Variable Costing) For Year Ended December 31, 2019

Revenue (120 flights) . . . . . . . . . . . . . . . . . . $6,000,000

Variable expenses

Wages, salaries, and benefits . . . . . . . . . $1,920,000

Fuel and oil . . . . . . . . . . . . . . . . . . . . . . . . 1,080,000

Food and beverages . . . . . . . . . . . . . . . . 600,000 3,600,000

Contribution margin . . . . . . . . . . . . . . . . . . . 2,400,000

Fixed expenses

Depreciation . . . . . . . . . . . . . . . . . . . . . . . 300,000

Rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 720,000

Operating income . . . . . . . . . . . . . . . . . . . . . $1,680,000

EXHIBIT 19.17 Variable Costing Income Statement for Service Provider

Part 1. A manufacturer’s absorption cost per unit is $60. Compute the target selling price per unit if a 30% markup is targeted.

Solution Setting Prices

NEED-TO-KNOW 19-3

P4

Do More: QS 19-18, E 19-13, E 19-14, E 19-15

Do More: QS 19-17, E 19-11

Part 2. A hotel rents its 200 luxury suites at a rate of $500 per night per suite. The hotel’s cost per night per suite is $400, consisting of

Absorption cost per unit . . . . . . . . . . . . . . . . . . . $60

Target markup per unit ($60 × 30%) . . . . . . . . . 18 Target selling price per unit . . . . . . . . . . . . . . . . $78

Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160

Fixed costs (allocated) . . . . . . . . . . . . . . . . . . . . . 240

Total cost per night per suite . . . . . . . . . . . . . . . . $400

The hotel’s manager has received an offer to reserve a block of 40 suites for $250 per suite per night dur- ing the hotel’s off-season, when it has many available suites. Determine whether the offer should be ac- cepted or rejected.

Solution

The allocated fixed costs should be ignored. Because the offer price of $250 per suite is greater than the variable costs of $160 per suite, the offer should be accepted.

Considering Special Offers

A1

This chapter showed alternative ways to compute income. When businesses consider the effects of their operations on the environment, more ways to measure income emerge.

For example, PUMA, a maker of athletic shoes and apparel, developed an environmental profit and loss (EP&L) account, also called EP&L report, which is a listing in monetary terms of the impact on human welfare from PUMA’s business activities. In this report, profit is the monetary value of activities that benefit the environment and loss is the monetary value of activities that harm the environment. While many companies measure and attempt to reduce their water usage, carbon emissions, and waste, PUMA takes the next step by putting environmental impacts into monetary terms.

SUSTAINABILITY AND ACCOUNTING

Chapter 19 Variable Costing and Analysis 751

EXHIBIT 19.18 Environmental Profit and Loss Report

Environmental Profit and Loss (in € millions)

Environmental profits . . . . . . . . . . . € 0 Environmental losses Water use . . . . . . . . . . . . . . . . . . . €47 Carbon emissions . . . . . . . . . . . . 47 Land use . . . . . . . . . . . . . . . . . . . 37 Air pollution . . . . . . . . . . . . . . . . . 11 Waste . . . . . . . . . . . . . . . . . . . . . . 3 145 Net environmental loss . . . . . . . . . . €145

Putting environmental impacts into monetary terms enables companies to better grasp the effects of their activities. PUMA’s €145 million net environmental loss from Exhibit 19.18, although not included in comput- ing GAAP net income, was over 70% of net income for that year. In addition, over 85% of the company’s environmental costs are from suppliers and processors at early stages of the company’s supply chain, and roughly 66% of its environmental costs are from its footwear division. The EP&L report enables managers to develop strategies that are likely to have the greatest impact in reducing environmental costs.

Lantern Inn B&B, this chapter’s opening company, advocates the importance of small, local busi- nesses for sustainable communities. David Doyon, co-owner of Lantern Inn, agrees that “small businesses are the largest employer nationally, and local business have less environmental impact.” “We buy locally,” explains co-owner Shay Doyon, thus reducing transportation costs, habitat loss, and pollution. ©Lantern Inn

Pricing Special Orders Decision Analysis

Over the long run, prices must cover all fixed and variable costs. Over the short run, however, fixed produc- tion costs such as the cost to maintain plant capacity do not change with changes in production levels. With excess capacity, increases in production levels would increase variable production costs, but not fixed costs. This implies that while managers try to maintain the long-run price on existing orders, which covers all pro- duction costs, managers should accept special orders provided the special-order price exceeds variable cost. To illustrate, let’s return to the data of IceAge Company. Recall that its variable production cost per unit is $15 and its total production cost per unit is $25 (at a production level of 60,000 units). Assume that it receives a special order for 1,000 pairs of skates at an offer price of $22 per pair from a foreign skating school. This special order will not affect IceAge’s regular sales, and its plant has excess capacity to fill the order. Using absorption costing information, cost is $25 per unit and the special-order price is $22 per unit. These data might suggest that management should reject the order as it would lose $3,000, computed as 1,000 units at $3 loss per pair ($22 − $25). However, closer analysis suggests that this order should be accepted. The $22 order price exceeds the $15 variable cost of the product. Specifically, Exhibit 19.19 reveals that the incremental revenue from accepting the order is $22,000 (1,000 units at $22 per unit), whereas the incremental production cost of the order is $15,000 (1,000 units at $15 per unit) and the incremental variable selling and administrative cost is $2,000 (1,000 units at $2 per unit). Thus, both contribution margin and net income would increase by $5,000 from accepting the order. Variable costing reveals this profitable opportunity, while absorption costing hides it.

A1 Use variable costing in pricing special orders.

Point: Total cost per unit is com- puted under absorption costing.

Point: Use of relevant costs in special-order and other manage- rial decisions is covered more ex- tensively in a later chapter.

Reject Special Order Accept Special Order

Incremental sales . . . . . . . . . . . $0 Incremental sales (1,000 × $22) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22,000 Incremental costs . . . . . . . . . . 0 Incremental costs

Variable production cost (1,000 × $15) . . . . . . . . . . . . . . . . . . . . 15,000 Variable selling and admin . expense (1,000 × $2) . . . . . . . . . . . 2,000 Incremental income . . . . . . . . . $0 Incremental income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

EXHIBIT 19.19 Computing Incremental Income for a Special Order

The reason for increased income from accepting the special order lies in the different behavior of vari- able and fixed production costs. If the order is rejected, only variable costs are saved. Fixed costs, how- ever, do not change in the short run regardless of rejecting or accepting this order. Because incremental revenue from the order exceeds incremental costs (only variable costs in this case), accepting the special order increases company income.

Point: Fixed overhead costs won’t increase when these additional units are sold because the company already has excess capacity. 

Exhibit 19.18 shows one form of an EP&L report for PUMA. In this year, PUMA reported no profits from activities that benefited the environment, but it did report losses (costs) of several activities that harmed the environment.

752 Chapter 19 Variable Costing and Analysis

Navaroli Company began operations on January 5, 2018. Cost and sales information for its first two cal- endar years of operations are summarized below.

COMPREHENSIVE

Variable and Absorption Costing

NEED-TO-KNOW 19-4

Manufacturing costs Production and sales data

Direct materials . . . . . . . . . . . . . . . . . . . . . . $80 per unit Units produced, 2018 . . . . . . . . . . . . . . 200,000 units

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $120 per unit Units sold, 2018 . . . . . . . . . . . . . . . . . . . 140,000 units

Factory overhead costs Units in ending inventory, 2018 . . . . . . . 60,000 units

Variable overhead . . . . . . . . . . . . . . . . . . $30 per unit Units produced, 2019 . . . . . . . . . . . . . . 80,000 units

Fixed overhead (per year) . . . . . . . . . . . . $14,000,000 Units sold, 2019 . . . . . . . . . . . . . . . . . . . 140,000 units

Nonmanufacturing costs Units in ending inventory, 2019 . . . . . . . 0 units

Variable selling and administrative . . . . . . . $10 per unit Sales price per unit . . . . . . . . . . . . . . . . . $600 per unit

Fixed selling and administrative . . . . . . . . . $ 8,000,000

Required

1. Prepare an income statement for the company for 2018 under absorption costing. 2. Prepare an income statement for the company for 2018 under variable costing. 3. Explain the source(s) of the difference in reported income for 2018 under the two costing methods. 4. Prepare an income statement for the company for 2019 under absorption costing. 5. Prepare an income statement for the company for 2019 under variable costing. 6. Prepare a schedule to convert variable costing income to absorption costing income for each of the

years 2018 and 2019. Use the format in Exhibit 19.12.

PLANNING THE SOLUTION Set up a table to compute the product cost per unit under the two costing methods (refer to Exhibit 19.3). Prepare income statements under the two costing methods (refer to Exhibit 19.6). Consider differences in the treatment of fixed overhead costs for the income statement to answer

requirements 3 and 6.

SOLUTION Before the income statement for 2018 is prepared, unit costs for 2018 are computed under the two costing methods as follows.

Product Cost per Unit Absorption Costing Variable Costing

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $ 80 $ 80

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 120

Overhead

Variable overhead . . . . . . . . . . . . . . . . . . . . 30 30

Fixed overhead* . . . . . . . . . . . . . . . . . . . . . 70 —

Total product cost per unit . . . . . . . . . . . . . . . $300 $230

*Fixed overhead per unit = $14,000,000 ÷ 200,000 units = $70 per unit.

1. Absorption costing income statement for 2018.

Income Statement (Absorption Costing) For Year Ended December 31, 2018

Sales (140,000 × $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Cost of goods sold (140,000 × $300) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000,000

Selling and administrative expenses ($1,400,000 + $8,000,000) . . . . . . . . . . . . . 9,400,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,600,000

Chapter 19 Variable Costing and Analysis 753

2. Variable costing income statement for 2018.

Income Statement (Variable Costing) For Year Ended December 31, 2018

Sales (140,000 × $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Variable expenses

Variable production costs (140,000 × $230) . . . . . . . . . . . . . . $32,200,000 Variable selling and administrative costs . . . . . . . . . . . . . . . . . 1,400,000 33,600,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000

Fixed selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 22,000,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000

3. Income under absorption costing is $4,200,000 more than that under variable costing even though sales are identical for each. This difference is due to the different treatment of fixed overhead cost. Under variable costing, the entire $14,000,000 of fixed overhead is expensed on the 2018 income statement. However, under absorption costing, $70 of fixed overhead cost is allocated to each of the 200,000 units produced. Because there were 60,000 units unsold at year-end, $4,200,000 (60,000 units × $70 per unit) of fixed overhead cost allocated to these units will be carried on its balance sheet in ending inven- tory. Consequently, reported income under absorption costing is $4,200,000 higher than variable cost- ing income for the current period.

Before the income statement for 2019 is prepared, product cost per unit in 2019 is computed under the two costing methods as follows.

*Fixed overhead per unit = $14,000,000∕80,000 units = $175 per unit.

Product Cost per Unit Absorption Costing Variable Costing

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $ 80 $ 80

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 120

Overhead

Variable overhead . . . . . . . . . . . . . . . . . . . . 30 30

Fixed overhead* . . . . . . . . . . . . . . . . . . . . . 175

Total product cost per unit . . . . . . . . . . . . . . . $405 $230

4. Absorption costing income statement for 2019.

Income Statement (Absorption Costing) For Year Ended December 31, 2019

Sales (140,000 × $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Cost of goods sold

From beginning inventory (60,000 × $300) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000,000 Produced during the year (80,000 × $405) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,400,000 50,400,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,600,000

Selling and administrative expenses ($1,400,000 + $8,000,000) . . . . . . . . . . . . . . 9,400,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,200,000

754 Chapter 19 Variable Costing and Analysis

5. Variable costing income statement for 2019.

6. Conversion of variable costing income to absorption costing income.

2018 2019

Variable costing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000 $28,400,000

Add: Fixed overhead cost deferred in ending inventory (60,000 × $70) . . . . . . . . . . . . . . . . . . . 4,200,000 0 Less: Fixed overhead cost recognized from beginning inventory (60,000 × $70) . . . . . . . . . . . . . . 0 (4,200,000) Absorption costing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,600,000 $24,200,000

Point: Total income over the two years equals $56,800,000 under both costing methods. This is because the total number of units produced over these two years equals the total number of units sold over these two years.

Income Statement (Variable Costing) For Year Ended December 31, 2019

Sales (140,000 × $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Variable expenses

Variable product costs (140,000 × $230) . . . . . . . . . . . . . . . . . $32,200,000 Variable selling and administrative costs . . . . . . . . . . . . . . . . . 1,400,000 33,600,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000

Fixed selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 22,000,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000

ABSORPTION AND VARIABLE COSTING Absorption costing: Fixed overhead part of product costs. Variable costing: Fixed overhead part of period expenses.

INCOME REPORTING General rule—When inventory levels change: Absorption costing income ≠ Variable costing income. ∙ Production = Sales → Inventory unchanged

Absorption income = Variable income See Exhibit 19.4 ∙ Production > Sales → Inventory increases

Absorption income > Variable income See Exhibit 19.6 ∙ Production < Sales → Inventory decreases

Absorption income < Variable income See Exhibit 19.8

CONVERT INCOME: VARIABLE TO ABSORPTION

Summary: Cheat Sheet

SETTING PRICE WITH ABSORPTION COSTING

INCOME STATEMENT FORMATS

Product Costs

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead Period Expenses

Variable Costing

Product Costs

Target price =

Absorption cost per unit +

Target markup per unit

Income Statement (Variable Costing)

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $#

Variable expenses

Variable production costs . . . . . . . . . . . . . $#

Variable selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . # #

Contribution margin . . . . . . . . . . . . . . . . . . . #

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . #

Fixed selling and administrative expenses . . . . . . . . . . . # #

Net income . . . . . . . . . . . . . . . . . . . . . . . . . $#

Income Statement (Absorption Costing)

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $#

Cost of goods sold . . . . . . . . . . . . . . . . . . . #

Gross margin . . . . . . . . . . . . . . . . . . . . . . . #

Selling and administrative expenses . . . . . #

Net income . . . . . . . . . . . . . . . . . . . . . . . . $#

Formats Applied: Absorption costing required for external reporting under GAAP. Variable costing useful for planning production, controlling costs, CVP analysis, and analyzing special orders.

SPECIAL ORDER ACCEPT if: Price > Variable costs + Incremental fixed costs.

Income under = Income under + Fixed overhead cost − Fixed overhead cost absorption costing variable costing in ending inventory* in beginning inventory* *Under absorption costing.

Chapter 19 Variable Costing and Analysis 755

Icon denotes assignments that involve decision making.

1. What costs are normally included in product costs under variable costing?

2. What costs are normally included in product costs under absorption costing?

3. When units produced exceed units sold for a reporting period, would income under variable costing be greater than, equal to, or less than income under absorption cost- ing? Explain.

4. Describe how the following items are computed: (a) gross margin and (b) contribution margin.

5. How can absorption costing lead to incorrect short-run pricing decisions?

6. What conditions must exist to achieve accurate short-run pricing decisions using variable costing?

7. Describe the usefulness of variable costing for control- ling company costs.

Discussion Questions

Multiple Choice Quiz

Answer questions 1 and 2 using the following data.

1. Product cost per unit under absorption costing is a. $11. c. $14. e. $16. b. $12. d. $15.

2. Product cost per unit under variable costing is a. $11. c. $14. e. $16. b. $12. d. $15.

3. Under variable costing, which costs are included in product cost? a. All variable product costs, including direct materials,

direct labor, and variable overhead.

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . $3 per unit

Variable selling and administrative . . . . . . . . . . . . $1 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000 total

Fixed selling and administrative . . . . . . . . . . . . . . . . $1,000 total

b. All variable and fixed allocations of product costs, in- cluding direct materials, direct labor, and both variable and fixed overhead.

c. All variable product costs except for variable overhead. d. All variable and fixed allocations of product costs, ex-

cept for both variable and fixed overhead. 4. The difference between product cost per unit under absorp-

tion costing as compared to that under variable costing is a. Direct materials and direct labor. b. Fixed and variable portions of overhead. c. Fixed overhead only. d. Variable overhead only.

5. When production exceeds sales, which of the following is true? a. No change occurs to inventories for either absorption

costing or variable costing methods. b. Use of absorption costing produces a higher net income

than the use of variable costing. c. Use of absorption costing produces a lower net income

than the use of variable costing. d. Use of absorption costing causes inventory value to de-

crease more than it would through the use of variable costing.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $14, computed as $3 + $5 + $3 + ($3,000∕1,000 units). 2. a; $11, computed as $3 + $5 + $3 (consisting of all variable

product costs).

3. a 4. c 5. b

Absorption costing (also called full costing) (739)

Contribution format (749) Contribution margin income

statement (741) Controllable costs (748)

Environmental profit and loss (EP&L) account (750)

Fixed overhead cost deferred in inventory (746)

Fixed overhead cost recognized from inventory (746)

Manufacturing margin (742) Uncontrollable costs (749) Variable costing (also called direct or

marginal costing) (739)

Key Terms

756 Chapter 19 Variable Costing and Analysis

8. Describe how use of absorption costing in determining income can lead to overproduction and a buildup of inventory. Explain how variable costing can avoid this same problem.

9. What are the major limitations of variable costing? 10. Google uses variable costing for several

business decisions. How can variable cost- ing income statements be converted to absorption costing?

11. Explain how contribution margin analysis is useful for managerial decisions and performance evaluations.

12. Samsung’s managers rely on reports of variable costs. How can variable costing

reports prepared using the contribution margin format help managers in computing break-even volume in units?

13. Assume that Apple has received a spe- cial order from a retailer for 1,000 specially outfitted iPads. This is a one-time order, which will not require any additional capacity or fixed costs. What should Apple consider when determining a selling price for these iPads?

14. How can Samsung use variable cost- ing to help better understand its opera- tions and to make better pricing decisions?

GOOGLE

Samsung

APPLE

Samsung

QUICK STUDY

QS 19-1 Computing unit cost under absorption costing

P1

Vijay Company reports the following information regarding its production costs. Compute its product cost per unit under absorption costing.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $10 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . $10 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 (per year)

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

QS 19-2 Computing unit cost under variable costing P1

Refer to Vijay Company’s data in QS 19-1. Compute its product cost per unit under variable costing.

QS 19-3 Variable costing income statement

P2

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000, and fixed selling and administrative costs are $65,200. The company also reports the following per unit variable costs for the year. Prepare an income statement under variable costing.

Variable product costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25 .00

Variable selling and administrative expenses . . . . . . . . . . . . 2 .00

QS 19-4 Absorption costing income statement

P2

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000, and fixed selling and administrative costs are $65,200. The company also reports the following per unit variable costs for the year. Prepare an income statement under absorption costing.

Variable product costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25 .00

Variable selling and administrative expenses . . . . . . . . . . . . 2 .00

Ramort Company reports the following cost data for its single product. The company regularly sells 20,000 units of its product at a price of $60 per unit. Compute gross margin under absorption costing.

QS 19-5 Absorption costing and gross margin

P2 Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12 per unit

Overhead costs: Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 per unit

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000 (per year)

Selling and administrative costs: Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $65,200 (per year)

Normal production level (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Chapter 19 Variable Costing and Analysis 757

Refer to the information about Ramort Company in QS 19-5. If Ramort doubles its production to 40,000 units while sales remain at the current 20,000-unit level, by how much would the company’s gross margin increase or decrease under absorption costing?

QS 19-6 Absorption costing and gross margin P2

Refer to the information about Ramort Company in QS 19-5. Compute contribution margin under variable costing.

QS 19-7 Variable costing and contribution margin P2

Refer to the information about Ramort Company in QS 19-5. If Ramort doubles its production to 40,000 units while sales remain at the current 20,000-unit level, would the company’s contribution margin increase or decrease under variable costing?

QS 19-8 Variable costing and contribution margin P2

QS 19-9 Computing manufacturing margin P2

D’Souza Company sold 10,000 units of its product at a price of $80 per unit. Total variable cost is $50 per unit, consisting of $40 in variable production cost and $10 in variable selling and administrative cost. Compute the manufacturing (production) margin for the company under variable costing.

QS 19-10 Computing contribution margin P2

D’Souza Company sold 10,000 units of its product at a price of $80 per unit. Total variable cost is $50 per unit, consisting of $40 in variable production cost and $10 in variable selling and administrative cost. Compute the contribution margin.

1. Convert this company’s variable costing income statement to an absorption costing income statement. 2. Fill in the blanks: The dollar difference in variable costing income and absorption costing income =

units × fixed overhead per unit.

Diaz Company reports the following variable costing income statement for its single product. This com- pany’s sales totaled 50,000 units, but its production was 80,000 units. It had no beginning finished goods inventory for the current period.

Income Statement (Variable Costing)

Sales (50,000 units × $60 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000 Variable expenses

Variable manufacturing expense (50,000 units × $28 per unit) . . . . . . . . . . . . . . . . . . 1,400,000 Variable selling and admin . expense (50,000 units × $5 per unit) . . . . . . . . . . . . . . . . 250,000 Total variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,650,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,350,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000

Total fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 870,000

QS 19-11 Converting variable costing income to absorption costing

P3

QS 19-12 Converting variable costing income to absorption costing income P3

Ming Company had net income of $772,200 based on variable costing. Beginning and ending inventories were 7,800 units and 5,200 units, respectively. Assume the fixed overhead per unit was $3.00 for both the beginning and ending inventory. What is net income under absorption costing?

QS 19-13 Converting variable costing income to absorption costing income P3

Mortech had net income of $250,000 based on variable costing. Beginning and ending inventories were 50,000 units and 48,000 units, respectively. Assume the fixed overhead per unit was $0.75 for both the beginning and ending inventory. What is net income under absorption costing?

QS 19-14 Converting variable costing income to absorption costing income P3

Hong Co. had net income of $386,100 under variable costing. Beginning and ending inventories were 2,600 units and 3,900 units, respectively. Fixed overhead cost was $4.00 per unit for both the beginning and ending inventory. What is net income under absorption costing?

758 Chapter 19 Variable Costing and Analysis

QS 19-15 Converting variable costing income to absorption costing income P3

E-Com had net income of $130,000 under variable costing. Beginning and ending inventories were 1,200 units and 4,900 units, respectively. Fixed overhead cost was $2.50 per unit for both the beginning and end- ing inventory. What is net income under absorption costing?

QS 19-16 Absorption costing and overproduction

C1

1. Compute the company’s total product cost per unit under absorption costing if 12,500 units had been produced.

2. Fill in the blank with increase or decrease: If production is greater than sales, cost of goods sold under absorption costing will .

Under absorption costing, a company had the following per unit costs when 10,000 units were produced.

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Total variable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Fixed overhead ($50,000/10,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Total product cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14

QS 19-17 Absorption costing and product pricing

P4

A manufacturer reports the following information on its product. Compute the target selling price per unit under absorption costing.

Direct materials cost . . . . . . . . . . . . . . . . . . . $50 per unit

Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . $12 per unit

Variable overhead cost . . . . . . . . . . . . . . . . . $6 per unit

Fixed overhead cost . . . . . . . . . . . . . . . . . . . . $2 per unit

Target markup . . . . . . . . . . . . . . . . . . . . . . . . 40%

Li Company produces a product that sells for $84 per unit. A customer contacts Li and offers to purchase 2,000 units of its product at a price of $68 per unit. Variable production costs with this order would be $30 per unit, and variable selling expenses would be $18 per unit. Assume that this special order would not require any additional fixed costs and that Li has sufficient capacity to produce the product without affect- ing regular sales. Should Li accept this special order?

QS 19-18 Special-order pricing

A1

Refer to the information in QS 19-16. The company sells its product for $50 per unit. Due to new regula- tions, the company must now incur $2 per unit of hazardous waste disposal costs and $8,500 per year of fixed hazardous waste disposal costs. Compute the contribution margin per unit, including hazardous waste disposal costs.

QS 19-19 Sustainability and product costing P1

Refer to the information in QS 19-16. The company sells its product for $50 per unit. Due to new regula- tions, the company must now incur $2 per unit of hazardous waste disposal costs and $8,500 per year of fixed hazardous waste disposal costs. Compute the company’s break-even point (in units), including haz- ardous waste disposal costs.

QS 19-20 Sustainability and product costing P1

EXERCISES

Exercise 19-1 Computing unit and inventory costs under absorption costing

P1

Trio Company reports the following information for the current year, which is its first year of operations.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 per year

Units produced this year . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Units sold this year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 units

Ending finished goods inventory in units . . . . . . . . . . . . . . . 6,000 units

Chapter 19 Variable Costing and Analysis 759

1. Compute the product cost per unit using absorption costing. 2. Determine the cost of ending finished goods inventory using absorption costing. 3. Determine the cost of goods sold using absorption costing.

Check (1) Absorption cost per unit, $43

Exercise 19-2 Computing unit and inventory costs under variable costing P1

Refer to the information in Exercise 19-1. Assume instead that Trio Company uses variable costing. 1. Compute the product cost per unit using variable costing. 2. Determine the cost of ending finished goods inventory using variable costing. 3. Determine the cost of goods sold using variable costing.

Check (1) Variable cost per unit, $35

Sims Company, a manufacturer of tablet computers, began operations on January 1, 2019. Its cost and sales information for this year follows.

Manufacturing costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60 per unit

Overhead costs

Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30 per unit

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,000,000 (per year)

Selling and administrative costs for the year

Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $770,000

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,250,000

Production and sales for the year

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 units

Sales price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . $350 per unit

Exercise 19-3 Income reporting under absorption costing and variable costing

P2

1. Prepare an income statement for the year using variable costing. 2. Prepare an income statement for the year using absorption costing.

Check (1) Variable costing income, $3,380,000

Kenzi Kayaking, a manufacturer of kayaks, began operations this year. During this first year, the company produced 1,050 kayaks and sold 800 at a price of $1,050 each. At this first year-end, the company reported the following income statement information using absorption costing.

Sales (800 × $1,050) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $840,000 Cost of goods sold (800 × $500) . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . 230,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000

Exercise 19-4 Variable costing income statement

P2

Additional Information

a. Product cost per kayak totals $500, which consists of $400 in variable production cost and $100 in fixed production cost—the latter amount is based on $105,000 of fixed production costs allocated to the 1,050 kayaks produced.

b. The $230,000 in selling and administrative expenses consists of $75,000 that is variable and $155,000 that is fixed.

Required

1. Prepare an income statement for the current year under variable costing. 2. Fill in the blanks: The dollar difference in variable costing income and absorption costing income =

units × fixed overhead per unit.

760 Chapter 19 Variable Costing and Analysis

Polarix is a retailer of ATVs (all-terrain vehicles) and accessories. An income statement for its Consumer ATV department for the current year follows. ATVs sell for $3,800 each. Variable selling expenses are $270 per ATV. The remaining selling expenses are fixed. Administrative expenses are 40% variable and 60% fixed. The company does not manufacture its own ATVs; it purchases them from a supplier for $1,830 each.

Exercise 19-8 Contribution margin format income statement

P2

Exercise 19-5 Absorption costing and variable costing income statements

P2

Rey Company’s single product sells at a price of $216 per unit. Data for its single product for its first year of operations follow. Prepare an income statement for the year assuming (a) absorption costing and (b) variable costing.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28 per unit

Overhead costs: Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6 per unit

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 per year

Selling and administrative expenses: Variable . . . . . . . . . . . . . . . . . $18 per unit

Fixed . . . . . . . . . . . . . . . . . . . $200,000 per year

Units produced (and sold) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Oak Mart, a producer of solid oak tables, reports the following data from its second year of business.

1. Prepare the current-year income statement for the company using variable costing. 2. Prepare the current-year income statement for the company using absorption costing. 3. Fill in the blanks: The dollar difference in variable costing income and absorption costing income =

units × fixed overhead per unit.

Check (2) Absorption costing income, $8,749,000

Sales price per unit . . . . . . . . . . . . . . . . . . $320 per unit

Units produced this year . . . . . . . . . . . . . 115,000 units

Units sold this year . . . . . . . . . . . . . . . . . . 118,000 units

Units in beginning-year inventory . . . . . . 3,000 units

Beginning inventory costs

Variable (3,000 units × $135) . . . . . . . $405,000 Fixed (3,000 units × $80) . . . . . . . . . . 240,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . $645,000

Manufacturing costs this year

Direct materials . . . . . . . . . . . . . . . . . . . . . . $40 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $62 per unit

Overhead costs this year

Variable overhead . . . . . . . . . . . . . . . . . . $3,220,000

Fixed overhead . . . . . . . . . . . . . . . . . . . . $7,400,000

Selling and administrative costs this year

Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,416,000

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,600,000

Exercise 19-7 Income reporting under absorption costing and variable costing

P2

1. Prepare this company’s income statement for its first month of operations under absorption costing. 2. Fill in the blanks: The dollar difference in variable costing income and absorption costing income =

units × fixed overhead per unit.

Hayek Bikes prepares the income statement under variable costing for its managerial reports, and it pre- pares the income statement under absorption costing for external reporting. For its first month of opera- tions, 375 bikes were produced and 225 were sold; this left 150 bikes in ending inventory. The income statement information under variable costing follows.

Exercise 19-6 Absorption costing income statement

P2

Sales (225 × $1,600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 Variable product cost (225 × $625) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,625 Variable selling and administrative expenses (225 × $65) . . . . . . . . . . . . . . . 14,625 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204,750

Fixed overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,250

Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 73,500

Chapter 19 Variable Costing and Analysis 761

Income Statement—Consumer ATV Department For Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $646,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311,100

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334,900

Operating expenses: Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . $135,000

Administrative expenses . . . . . . . . . . . . . . . . . . 59,500 194,500

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,400

1. Prepare an income statement for the current year using the contribution margin format. 2. For each ATV sold during this year, what is the contribution toward covering fixed expenses and earn-

ing income? Check (2) $1,560

Exercise 19-10 Computing absorption costing income

P3

A manufacturer reports the information below for three recent years. Compute income for each of the three years using absorption costing.

Year 1 Year 2 Year 3

Variable costing income . . . . . . . . . . . . . . . . . . . . . . . . . $110,000 $114,400 $118,950

Beginning finished goods inventory (units) . . . . . . . . . . 0 1,200 700

Ending finished goods inventory (units) . . . . . . . . . . . . 1,200 700 800

Fixed manufacturing overhead per unit . . . . . . . . . . . . $2 .50 $2 .50 $2 .50

Exercise 19-9 Income statement under absorption costing and variable costing

P1 P2

Cool Sky reports the following costing data on its product for its first year of operations. During this first year, the company produced 44,000 units and sold 36,000 units at a price of $140 per unit.

1. Assume the company uses absorption costing. a. Determine its product cost per unit. b. Prepare its income statement for the year under absorption costing. 2. Assume the company uses variable costing. a. Determine its product cost per unit. b. Prepare its income statement for the year under variable costing.

Check (1a) Absorption cost per unit, $102

(2a) Variable cost per unit, $90

Manufacturing costs

Direct materials per unit . . . . . . . . . . . . . . . . . . . . . . . $60

Direct labor per unit . . . . . . . . . . . . . . . . . . . . . . . . . . $22

Variable overhead per unit . . . . . . . . . . . . . . . . . . . . . $8

Fixed overhead for the year . . . . . . . . . . . . . . . . . . . . $528,000

Selling and administrative costs

Variable selling and administrative cost per unit . . . . $11

Fixed selling and administrative cost per year . . . . . $105,000

Exercise 19-11 Absorption costing and product pricing

P4

Sirhuds Inc., a maker of smartwatches, reports the information below on its product. The company uses absorption costing and has a target markup of 40% of absorption cost per unit. Compute the target selling price per unit under absorption costing.

Direct materials cost . . . . $100 per unit

Direct labor cost . . . . . . . . $30 per unit

Variable overhead cost . . $8 per unit

Fixed overhead cost . . . . . $600,000 per year

Variable selling and administrative expenses . . $3 per unit

Fixed selling and administrative expenses . . . $120,000 per year

Expected production (and sales) . . . . . . . . . . . . 50,000 units per year

762 Chapter 19 Variable Costing and Analysis

The hotel manager receives an offer to hold the Junior States of America (JSA) convention at the hotel in February, which is the hotel’s low season with an occupancy rate of under 45%. JSA would reserve 100 rooms for four nights if the hotel could offer a 50% discount, or a rate of $150 per night. The hotel man- ager is inclined to reject the offer because the cost per room per night is $165. Should the offer from JSA be accepted or rejected? What is the contribution margin from accepting the offer?

Empire Plaza Hotel is a hotel with 400 rooms. Its regular room rate is $300 per night per room. The hotel’s cost is $165 per night per room and consists of the following.

Exercise 19-14 Analyzing variable cost for a special order

A1 Variable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40 Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

Total cost per night per room . . . . . . . . . . . . . . . . . $165

The hotel manager receives an offer to hold the local Bikers’ Club annual meeting at the hotel in March, which is the hotel’s low season with an occupancy rate of under 50%. The Bikers’ Club would reserve 50 suites for three nights if the hotel could offer a 50% discount, or a rate of $125 per night. The hotel manager is inclined to reject the offer because the cost per suite per night is $140. Prepare an analysis of this offer for the hotel manager. Should the offer from the Bikers’ Club be accepted or rejected? What is the contribution margin from accepting the offer?

Grand Garden is a hotel with 150 suites. Its regular suite rate is $250 per night per suite. The hotel’s cost per night is $140 per suite and consists of the following.

Exercise 19-13 Analyzing variable cost for a special order

A1 Variable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30 Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Total cost per night per suite . . . . . . . . . . . . . . . . . . $140

MidCoast Airlines provides charter airplane services. In October of this year, the company is operat- ing at 60% of its capacity when it receives a bid from the local community college. The college is or- ganizing a Washington, D.C., trip for its international student group. The college budgeted only $30,000 for round-trip airfare. MidCoast Airlines normally charges between $50,000 and $60,000 for such service. MidCoast determines its cost for the round-trip flight to Washington to be $44,000, which consists of the following.

Variable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000

Fixed cost (allocated) . . . . . . . . . . . . . . . . . . . . . 29,000

Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,000

Exercise 19-15 Analyzing variable cost for a special order

A1

Although the manager at MidCoast supports the college’s educational efforts, she cannot justify accepting the $30,000 bid for the trip given the projected $14,000 loss. Still, she decides to consult with you, an in- dependent financial consultant. Should the airline accept the bid from the college? What is the contribu- tion margin from accepting the offer?

Exercise 19-12 Absorption costing and overproduction

C1

Jacquie Inc. reports the following annual cost data for its single product.

If Jacquie increases its production to 80,000 units, while sales remain at the current 60,000-unit level, by how much would the company’s gross margin increase or decrease under absorption costing? Assume the company has idle capacity to double current production.

Normal production and sales level . . . . . . . . . 60,000 units

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56 .00 per unit

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . $9 .00 per unit

Direct labor . . . . . . . . . . . . . . . $6 .50 per unit

Variable overhead . . . . . . . . . . $11 .00 per unit

Fixed overhead . . . . . . . . . . . . $720,000 in total

Chapter 19 Variable Costing and Analysis 763

A recent annual report for Nike reports the following operating income for its United States and China geographic segments.

Exercise 19-16 Analyzing income growth

P2

Required

1. Is operating income growing faster in the United States or in the China segment? 2. Is the difference in operating income growth due to the use of different costing methods (absorption or

variable costing) in the two geographic segments?

$ millions 2017 2016

United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,875 $3,763

China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,507 1,372

PROBLEM SET A

Problem 19-1A Variable costing income statement and conversion to absorption costing income (two consecutive years)

P2 P3

Dowell Company produces a single product. Its income statements under absorption costing for its first two years of operation follow.

Additional Information

a. Sales and production data for these first two years follow.

b. Variable cost per unit and total fixed costs are unchanged during 2018 and 2019. The company’s $31 per unit product cost consists of the following.

c. Selling and administrative expenses consist of the following.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Fixed overhead ($300,000∕30,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Total product cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31

2018 2019

Variable selling and administrative expenses ($2 .50 per unit) . . . . . . . $ 50,000 $100,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . 240,000 240,000

Total selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . $290,000 $340,000

Required

1. Prepare income statements for the company for each of its first two years under variable costing. 2. Prepare a table as in Exhibit 19.12 to convert variable costing income to absorption costing income for

both 2018 and 2019.

Check (1) 2018 net loss, $(90,000)

2018 2019

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 30,000

Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 40,000

2018 2019

Sales ($46 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $920,000 $1,840,000

Cost of goods sold ($31 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620,000 1,240,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 600,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 290,000 340,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000 $ 260,000

764 Chapter 19 Variable Costing and Analysis

Additional Information

a. Selling and administrative expenses consist of $350,000 in annual fixed expenses and $2.25 per unit in variable selling and administrative expenses.

b. The company’s product cost of $30 per unit is computed as follows.

Problem 19-2A Variable costing income statement and conversion to absorption costing income

P2 P3

Trez Company began operations this year. During this first year, the company produced 100,000 units and sold 80,000 units. The absorption costing income statement for this year follows.

Sales (80,000 units × $50 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000 Cost of goods sold

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Cost of goods manufactured (100,000 units × $30 per unit) . . . . . . . . . . . . . . . . 3,000,000 Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000

Ending inventory (20,000 × $30) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,070,000

Required

1. Prepare an income statement for the company under variable costing. 2. Fill in the blanks: The dollar difference in variable costing income and absorption costing income =

________ units × _______ fixed overhead per unit.

Blazer Chemical produces and sells an ice-melting granular used on roadways and sidewalks in winter. It annually produces and sells about 100 tons of its granular. In its nine-year history, the company has never reported a net loss. However, because of this year’s unusually mild winter, projected demand for its prod- uct is only 60 tons. Based on its predicted production and sales of 60 tons, the company projects the fol- lowing income statement (under absorption costing).

Its product cost information follows and consists mainly of fixed cost because of its automated production process requiring expensive equipment.

Sales (60 tons at $21,000 per ton) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,260,000

Cost of goods sold (60 tons at $16,000 per ton) . . . . . . . . . . . . . . . . . . . . . . . . 960,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318,600

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (18,600)

Variable direct labor and material costs per ton . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,500

Fixed cost per ton ($750,000 ÷ 60 tons) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 Total product cost per ton . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000

Selling and administrative expenses consist of variable selling and administrative expenses of $310 per ton and fixed selling and administrative expenses of $300,000 per year. The company’s president is con- cerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The operations manager mentions that because the company has large storage capacity, it can report a net income by keeping its production at the usual 100-ton level even though it expects to sell only 60 tons. The president is puzzled by the suggestion that the company can report income by producing more with- out increasing sales.

Problem 19-3A Income reporting, absorption costing, and managerial ethics

C1 P2

Direct materials . . . . . . . . . . . . . . . . . . $5 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . $14 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit

Fixed overhead ($900,000∕100,000 units) . . . . . $9 per unit

Chapter 19 Variable Costing and Analysis 765

Required

1. Prepare an income statement (using absorption costing) based on production of 100 tons and sales of 60 tons.

2. By how much does net income increase by producing 100 tons and storing 40 tons in inventory?

PROBLEM SET B

Problem 19-1B Variable costing income statement and conversion to absorption costing income (two consecutive years)

P2 P3

Azule Company produces a single product. Its income statements under absorption costing for its first two years of operation follow.

Additional Information

a. Sales and production data for these first two years follow.

b. Its variable cost per unit and total fixed costs are unchanged during 2018 and 2019. Its $26 per unit product cost consists of the following.

c. Its selling and administrative expenses consist of the following.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Fixed overhead ($480,000∕60,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Total product cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26

2018 2019

Variable selling and administrative expenses ($3 per unit) . . . . . . . . . . . $165,000 $195,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . 300,000 300,000

Total selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . $465,000 $495,000

Required

1. Prepare this company’s income statements under variable costing for each of its first two years. 2. Explain any difference between the absorption costing income and the variable costing income for

these two years.

Check (1) 2018 net loss, $(10,000)

2018 2019

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 60,000

Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 65,000

2018 2019

Sales ($35 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,925,000 $2,275,000

Cost of goods sold ($26 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,430,000 1,690,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495,000 585,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 465,000 495,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 90,000

Problem 19-2B Variable costing income statement and conversion to absorption costing income

P2 P3

E’Lonte Company began operations this year. During this first year, the company produced 300,000 units and sold 250,000 units. Its income statement under absorption costing for this year follows.

Sales (250,000 units × $18 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,500,000 Cost of goods sold

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Cost of goods manufactured (300,000 units × $7 .50 per unit) . . . . . . . . . . . . . . 2,250,000 Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,250,000

Ending inventory (50,000 × $7 .50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,875,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 425,000

766 Chapter 19 Variable Costing and Analysis

Additional Information

a. Selling and administrative expenses consist of $1,200,000 in annual fixed expenses and $4 per unit in variable selling and administrative expenses.

b. The company’s product cost of $7.50 per unit is computed as follows.

Required

1. Prepare the company’s income statement under variable costing. 2. Explain any difference between the company’s income under variable costing (from part 1) and the

income reported above.

Its product cost information follows and consists mainly of fixed production cost because of its automated production process requiring expensive equipment.

Sales (250,000 lbs . at $8 per lb .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

Cost of goods sold (250,000 lbs . at $6 .80 per lb .) . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (150,000)

Variable direct labor and materials costs per pound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2 .00

Fixed production cost per pound ($1,200,000∕250,000 lbs .) . . . . . . . . . . . . . . . . . . . . . . 4 .80 Total product cost per pound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6 .80

Chem-Melt produces and sells an ice-melting granular used on roadways and sidewalks in winter. The company annually produces and sells about 300,000 pounds of its granular. In its 10-year history, the company has never reported a net loss. Because of this year’s unusually mild winter, projected demand for its product is only 250,000 pounds. Based on its predicted production and sales of 250,000 pounds, the company projects the following income statement under absorption costing.

Problem 19-3B Income reporting, absorption costing, and managerial ethics

C1 P2

The company’s selling and administrative expenses are all fixed. The president is concerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The controller suggests that because the company has large storage capacity, it can report a net income by keeping its production at the usual 300,000-pound level even though it expects to sell only 250,000 pounds. The president is puzzled by the suggestion that the company can report a profit by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 300,000 pounds and storing the excess production in inventory? Prepare an income statement (using absorption costing) based on production of 300,000 pounds and sales of 250,000 pounds.

2. Should the company produce 300,000 pounds given that projected demand is 250,000 pounds? Explain, and also refer to any ethical implications of such a managerial decision.

SERIAL PROBLEM Business Solutions

P2 P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 19 Santana Rey expects sales of Business Solutions’s line of computer workstation furniture to equal 300 workstations (at a sales price of $3,000 each) for 2019. The workstations’ manufacturing costs include the following.

Direct materials . . . . . . . . . . . . $2 .00 per unit

Direct labor . . . . . . . . . . . . . . . $2 .40 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1 .60 per unit

Fixed overhead ($450,000∕300,000 units) . . . . . . . . $1 .50 per unit

Chapter 19 Variable Costing and Analysis 767

The selling expenses related to these workstations follow.

Santana is considering how many workstations to produce in 2019. She is confident that she will be able to sell any workstations in her 2019 ending inventory during 2020. However, Santana does not want to overproduce as she does not have sufficient storage space for many more workstations.

Required

For parts 1 and 2, assume 300 workstations are sold. 1. Compute Business Solutions’s absorption costing income assuming a. 300 workstations are produced. b. 320 workstations are produced. 2. Compute Business Solutions’s variable costing income assuming a. 300 workstations are produced. b. 320 workstations are produced. 3. For parts 1 and 2, which costing method, absorption or variable, yields the higher net income when

320 workstations are produced and 300 are sold?

©Alexander Image/Shutterstock

COMPANY ANALYSIS P2

Accounting Analysis

AA 19-1 Review Apple’s income statement in Appendix A for the year ending September 30, 2017, and identify its net income for 2017. 1. Is Apple’s net income prepared using absorption costing or variable costing? 2. Review Apple’s balance sheet data in Appendix A as of September 30, 2017, and September 24, 2016.

What amounts (in $ millions) does Apple report for inventory at each of these balance sheet dates? 3. Assume Apple’s fixed overhead costs equal 10% of the total reported inventory cost at each of these

two balance sheet dates. Compute Apple’s 2017 net income under variable costing. Hint: Refer to Exhibit 19.11.

APPLE

AA 19-2 Apple’s and Google’s ending inventory amounts (in $ millions) are shown below: COMPARATIVE ANALYSIS P2

APPLE GOOGLE

Apple Google

2017 2016 2017 2016

Ending inventory . . . . . . . . . . . . $4,855 $2,132 $749 $268

Required

1. Assume Apple uses variable costing for some of its internal reports. For 2017, would net income based on variable costing be higher, lower, or no different from net income based on absorption costing?

2. Assume Google uses variable costing for some of its internal reports. For 2017, would net income based on variable costing be higher, lower, or no different from net income based on absorption costing?

3. Assume both companies are considering implementing just-in-time (JIT) inventory systems. After implementing JIT systems, would differences in income between absorption costing and variable costing be more likely to increase or to decrease?

Direct materials . . . . . . . . . . . . $800 per unit

Direct labor . . . . . . . . . . . . . . . $400 per unit

Variable overhead . . . . . . . . . $100 per unit

Fixed overhead . . . . . . . . . . . . $24,000 per year

Variable selling expenses . . . . $50 per unit Fixed selling expenses . . . . . . $4,000 per year

768 Chapter 19 Variable Costing and Analysis

ETHICS CHALLENGE C1

BTN 19-1 FDP Company produces a variety of home security products. Gary Price, the company’s pres- ident, is concerned with the fourth-quarter market demand for the company’s products. Unless something is done in the last two months of the year, the company is likely to miss its earnings expectation of Wall Street analysts. Price still remembers when FDP’s earnings were below analysts’ expectation by two cents a share three years ago and the company’s share price fell 19% the day earnings were announced. In a recent meeting, Price told his top management that something must be done quickly. One proposal by the marketing vice president was to give a deep discount to the company’s major customers to increase the company’s sales in the fourth quarter. The company controller pointed out that while the discount could increase sales, it may not help the bottom line; to the contrary, it could lower income. The controller said, “Since we have enough storage capacity, we might simply increase our production in the fourth quarter to increase our reported profit.”

Required

1. Gary Price is not sure how the increase in production without a corresponding increase in sales could help boost the company’s income. Explain to Price how reported income varies with respect to pro- duction level.

2. Is there an ethical concern in this situation? If so, which parties are affected? Explain.

Beyond the Numbers

AA 19-3 Review Samsung’s income statement in Appendix A for the year ending December, 31 2017, and identify its net income for 2017. 1. Review Samsung’s balance sheet data in Appendix A as of December 31, 2017, and December 31, 2016.

What amounts (in ₩ millions) does Samsung report for inventory at each of these balance sheet dates? 2. Assume Samsung uses absorption costing for financial reporting and its fixed overhead costs equal

10% of the total reported inventory cost at each of these two balance sheet dates. Compute Samsung’s 2017 net income under variable costing. Hint: Refer to Exhibit 19.11.

GLOBAL ANALYSIS P3

Samsung

BTN 19-3 This chapter discussed the variable costing method and how to use variable costing informa- tion to make various business decisions. We also can find several websites on variable costing and its business applications.

Required

1. Review the website of Value Based Management at ValueBasedManagement.net. Identify and read the page on the topic of variable costing (valuebasedmanagement.net/methodsvariablecosting.html).

2. What other phrases are used in practice for variable costing? 3. According to this website, what are the consequences of variable costing for profit calculation?

TAKING IT TO THE NET P2

BTN 19-4 This chapter identified several decision contexts in which managers use product cost information.

Required

Break into teams and identify at least one specific decision context in which absorption costing informa- tion is more relevant than variable costing information and at least one decision context in which variable costing information is more relevant than absorption costing. Be prepared to discuss your answers in class.

TEAMWORK IN ACTION P4

BTN 19-2 Mertz Chemical has three divisions. Its consumer product division faces strong competition from companies overseas. During its recent teleconference, Ryan Peterson, the consumer product division manager, reported that his division’s sales for the current year were below its break-even point. However, when the division’s annual reports were received, Billie Mertz, the company president, was surprised that the consumer product division actually reported a profit of $264,000. How could this be possible?

Required

Assume that you work in the corporate controller’s office. Write a half-page memorandum to the president explaining how the division can report income even if its sales are below the break-even point.

COMMUNICATING IN PRACTICE P3

Chapter 19 Variable Costing and Analysis 769

BTN 19-5 Lantern Inn is a bed and breakfast operated by Shay and David Doyon.

Required

Shay and David use variable costing to make business decisions. If Shay and David used absorption cost- ing, would we expect the company’s income to be more than, less than, or about the same as its income measured under variable costing? Explain.

ENTREPRENEURIAL DECISION P3

BTN 19-6 Visit a local hotel and observe its daily operating activities. The costs associated with some of its activities are variable while others are fixed with respect to occupancy levels.

Required

1. List costs that are likely variable for the hotel. 2. List costs that are likely fixed for the hotel. 3. Using your lists from parts 1 and 2, which type of costs (fixed or variable) is likely to be larger (in

dollars)? 4. Based on your observations and the answers to parts 1 through 3, explain why many hotels offer dis-

counts as high as 50% or more during their low occupancy season.

HITTING THE ROAD A1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Describe the benefits of budgeting.

ANALYTICAL A1 Analyze expense planning using

activity-based budgeting.

P3 Prepare budgeted financial statements.

P4 Appendix 20A—Prepare each component of a master budget—for a merchandising company.

PROCEDURAL P1 Prepare the operating budgets of a master

budget—for a manufacturing company.

P2 Prepare a cash budget—for a manufacturing company.

Chapter Preview

20 Master Budgets and Performance Planning

OPERATING BUDGETS

P1 Prepare operating budgets, including

Sales

Production

Direct materials

Direct labor

Overhead

Selling expenses

General expenses

INVESTING AND FINANCING BUDGETS

Capital expenditures budget

P2 Cash budget

BUDGETED FINANCIAL

STATEMENTS

P3 Budgeted income statement

Budgeted balance sheet

Master budget

Service companies

A1 Activity-based budgeting

P4 Appendix: Merchandiser budgeting

BUDGET PROCESS AND

ADMINISTRATION

C1 Budgeting process Benefits of budgeting

Human behavior

Reporting and timing

Master budget components

NTK 20-1 NTK 20-2, 20-3, 20-4 NTK 20-5 NTK 20-6, 20-8

771

“We make juice from misfits”—Anna Yang

Crushing It

WASHINGTON, DC—Billions of pounds of edible food—from discarded fruits and vegetables from retailers to scraps of pre- cut goods from food processors—are wasted each year. Seizing a delicious opportunity, college students Anna Yang and Phil Wong started by repurposing these unwanted raw materials into cold-pressed juices.

Starting with a borrowed blender and a few discarded peaches, Anna and Phil’s vision to reduce waste turned into a company, Misfit Juicery (Misfitjuicery.com). “We had never started a company,” admits Phil. “We were complete amateurs, selling juice out of mason jars.”

Misfit obtains ingredients from local farmers, national food distributors, and fresh-cut producers. “We attack the issue all along the supply chain,” explains Anna. Their sup- ply chain strategy requires them to budget the cost of their fruit and vegetable purchases. They must also track costs of storing these perishable raw materials. Anna and Phil also budget for direct labor costs of several full- and part-time employees.

In explaining budgets, Anna says “our company changes on a day-to-day basis.” Rapid change and many unknowns make sales forecasts difficult. Anna knows that a good sales forecast is the cornerstone of a good budget. She also explains that all companies set budgets—manufacturers budget costs of direct materials, direct labor, and overhead, and service firms focus on direct labor budgets.

Misfit’s blend is working. It recently expanded into new mar- kets and products, added flavors, and moved into a larger pro- duction site. Anna proclaims, “We want to be THE food brand that squeezes inefficiencies from the supply chain.”

Sources: Misfit Juicery website, January 2019; DC Inno, October 18, 2016; ABC News interview, July 24, 2017; Bevnet, April 15, 2016; Vogue, October 26, 2016

©Misfit Juicery

Budgeting Process Managers must ensure that activities of employees and departments contribute to meeting the company’s overall goals. This requires coordination and budgeting. Budgeting, the process of planning future business actions and expressing them as formal plans, helps to achieve this coordination.

A budget is a formal statement of a company’s plans, expressed in monetary terms. Unlike long-term strategic plans, budgets typically cover shorter periods such as a month, quarter, or year. Budgets are useful in controlling operations. The budgetary control process, shown in Exhibit 20.1, refers to management’s use of budgets to see that planned objectives are met.

BUDGET PROCESS AND ADMINISTRATION

C1 Describe the benefits of budgeting.

OPTEL Fixed Budget Performance Report

Fixed Actual Budget Results Variances*

Sales (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 12,000

Sales (in dollars) . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $125,000 $25,000 F

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 10,000 13,000 3,000 U

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 20,000 5,000 U

Overhead

Factory supplies . . . . . . . . . . . . . . . . . . . . . . 2,000 2,100 100 U

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000 1,000 U

Depreciation— machinery . . . . . . . . . . . . . . 8,000 8,000 0

Supervisory salaries . . . . . . . . . . . . . . . . . . . 11,000 11,000 0

Selling expenses

Sales commissions . . . . . . . . . . . . . . . . . . . . . . 9,000 10,800 1,800 U

Shipping expenses . . . . . . . . . . . . . . . . . . . . . . 4,000 4,300 300 U

General and administrative expenses

O�ce supplies . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,200 200 U

Insurance expenses . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U

Depreciation— o�ce equipment. . . . . . . . . . . 7,000 7,000 0

Administrative salaries . . . . . . . . . . . . . . . . . . . 13,000 13,000 0

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 99,600 11,600 U

Income from operations . . . . . . . . . . . . . . . . . . . $ 12,000 $ 25,400 $13,400 F

* F = Favorable variance; U 5 Unfavorable variance.

EXHIBIT 20.1 Process of Budgetary Control

The budgetary control process involves at least four steps: (1) develop the budget from planned objectives, (2) compare actual results to budgeted amounts and analyze differences, (3) take corrective and strategic actions, and (4) establish new objectives and a new budget.

In this chapter we focus on the first step in the budgetary control process, developing a bud- get. In the next chapter we show how managers compare budgeted and actual amounts to guide corrective actions and make new plans.

772 Chapter 20 Master Budgets and Performance Planning

Benefits of Budgeting Budgets benefit the key managerial functions of planning and controlling. Plan A budget focuses on the future opportunities and threats to the organization. This

focus on the future is important because the daily pressures of operating an organization can divert management’s attention from planning. Budgeting makes managers devote time to plan for the future.

Control The control function requires management to evaluate (benchmark) operations against some norm. Since budgeted performance considers important company, industry, and economic factors, a comparison of actual to budgeted performance provides an effective monitoring and control system. This comparison assists management in identifying problems and taking corrective actions if necessary.

Coordinate Budgeting helps to coordinate activities so that all employees and departments understand and work toward the company’s overall goals.

Communicate Written budgets effectively communicate management’s specific action plans to all employees. When plans are not written down, conversations can lead to uncer- tainty and confusion among employees.

Motivate Budgets can be used to motivate employees. Budgeted performance levels can provide goals for employees to attain or even exceed. Many companies provide incentives, like cash bonuses, for employee performance that meets or exceeds budget goals.

Control

Coordinate

Motivate

Communicate

Budget

Plan

Budget Bonus Budgets are important in determining managers’ pay. A recent survey shows that 82% of large com- panies tie managers’ bonus payments to beating budget goals. For these companies, bonus payments are frequently more than 20% of total manager pay. ■

Decision Insight

Budget Strategy Most companies allocate dollars based on budgets submitted by department managers. These managers verify the numbers and monitor the budget. Managers must remember, however, that a budget is judged by its success in helping achieve the company’s mission. One analogy is that a hiker must know the route to properly plan a hike and monitor hiking progress. ■

Decision Insight

Budgeting and Human Behavior Budgets provide standards for evaluating performance and can affect employee attitudes. Bud- geted levels of performance must be realistic to avoid discouraging employees. Employees who will be evaluated should help prepare the budget to increase their commitment to it. For exam- ple, the sales department should be involved in developing sales estimates, while the production department should prepare its initial expense budget. This bottom-up process is usually more useful than a top-down approach in which top management passes down the budget without input. Performance evaluations must allow the affected employees to explain the reasons for apparent performance deficiencies, rather than assigning blame.

Budgeting has three important guidelines.

1. Employees affected by a budget should help prepare it (participatory budgeting). 2. Goals reflected in a budget should be challenging but attainable. 3. Evaluations offer opportunities to explain differences between actual and budgeted amounts.

Budgeting can be a positive motivating force when the guidelines are followed.

Potential Negative Outcomes of Budgeting Managers must be aware of potential negative out- comes of budgeting. Under participatory budgeting, some employees might understate sales bud- gets and overstate expense budgets to allow themselves a cushion, or budgetary slack, to aid in meeting targets. Sometimes, pressure to meet budgeted results leads employees to engage in unethical behavior or commit fraud. Finally, some employees might always spend their budgeted amounts, even on unnecessary items, to ensure their budgets aren’t reduced for the next period.

Example: Assume a company’s sales force receives a bonus when sales exceed the budgeted amount. How would this arrange- ment affect the participatory sales forecasts? Answer: Sales reps may understate their budgeted sales.

©Cultura RF/Getty Images

Chapter 20 Master Budgets and Performance Planning 773

Budget Reporting and Timing The budget period usually coincides with the company’s fiscal year. To provide specific guid- ance to help control operations, the annual budget usually is separated into quarterly or monthly budgets. These short-term budgets allow management to periodically evaluate performance and take corrective action.

The time required to prepare a budget can vary a lot. Large, complex organizations usually take longer to prepare their budgets than do smaller ones. This is because of the effort required to coordinate the different units (departments) within large organizations.

Many companies apply continuous budgeting by preparing rolling budgets. In continuous budgeting, a company continually revises its budgets as time passes. In a rolling budget, a com- pany revises its entire set of budgets by adding a new quarterly budget to replace the quarter that just elapsed. Thus, at any point in time, monthly or quarterly budgets are available for the next 12 months or four quarters. The rolling budget below shows rolling budgets prepared at the end of two consecutive periods. The first set (at top) is prepared in December 2018 and covers the four calendar quarters of 2019. In March 2019, the company prepares another rolling budget for the next four quarters through March 2020. This same process is repeated every three months. As a result, management is continuously planning ahead.

2019 2020

Rolling Budgets (Calendar Years and Quarters)

B ud

ge t P

re pa

ra tio

n D

at e

December 2018

March 2019

First Quarter

Second Quarter

Third Quarter

Fourth Quarter

Second Quarter

Third Quarter

Fourth Quarter

First Quarter

Budget Needs Many companies use zero-based budgeting, which requires all expenses to be justified for each new budget. Rather than using last period’s budgeted or actual amounts to determine this period’s budgets, manag- ers instead analyze each activity in the organization to see if it is necessary. Managers then budget for only those necessary activities. Made-from-scratch budgets can be useful in identifying waste and reducing costs. ■

Decision Insight

Master Budget Components A master budget is a formal, comprehensive plan for a company’s future. It contains several individual budgets that are linked together to form a coordinated plan. Exhibit 20.2 summarizes the master budgeting process. The master budgeting process typically begins with the sales bud- get and ends with a cash budget and budgeted financial statements. The master budget includes individual budgets for sales, production (or purchases), various expenses, capital expenditures, and cash.

Label each item below with a “B” if it describes a benefit of budgeting or a “Not B” if it describes a potential negative outcome of budgeting.

1. Budgets provide goals for employees to work toward. 2. Written budgets help communicate plans to all employees. 3. Some employees might understate sales targets in budgets. 4. A budget forces managers to spend time planning for the future. 5. Some employees might always spend budgeted amounts. 6. With rolling budgets, managers can continuously plan ahead.

Solution

1. B 2. B 3. Not B 4. B 5. Not B 6. B

Budgeting Benefits

NEED-TO-KNOW 20-1

C1

Do More: QS 20-1, QS 20-2

774 Chapter 20 Master Budgets and Performance Planning

The number and types of budgets included in a master budget depend on the company’s size and complexity. A manufacturer’s master budget should include, at a minimum, several operat- ing budgets (shown in yellow in Exhibit 20.2), a capital expenditures budget, and a cash budget. The capital expenditures budget summarizes the effects of investing activities on cash. The cash budget helps determine the company’s need for financing.

Managers often express the expected financial results of planned activities with a budgeted balance sheet and a budgeted income statement. Some budgets require the input of other budgets. For example, direct materials and direct labor budgets cannot be prepared until a production budget is prepared. A company cannot plan its produc- tion until it prepares a sales budget.

The rest of this chapter explains how Toronto Sticks Company (TSC), a manufac- turer of youth hockey sticks, prepares its budgets. Its master budget includes operating, capital expenditures, and cash budgets for each month in each quarter. It also includes a budgeted income statement for each quarter and a budgeted balance sheet as of the last

day of each quarter. We show how TSC prepares budgets for October, November, and December 2019. Exhibit 20.3 presents TSC’s balance sheet at the start of this budgeting period, which we refer to in preparing the component budgets.

Point: Merchandisers prepare merchandise purchase budgets instead of the production and manufacturing budgets in Exhibit 20.2.

Courtesy of JJW Images

P1 Prepare the operating bud- gets of a master budget—for a manufacturing company.

This section explains TSC’s preparation of operating budgets. Its operating budgets consist of the sales budget, production and manufacturing budgets, selling expense budget, and general and administrative expense budget. (Note: The preparation of merchandising budgets is described in this chapter’s appendix.)

OPERATING BUDGETS

EXHIBIT 20.3 Balance Sheet prior to the Budgeting Period

TORONTO STICKS COMPANY Balance Sheet

September 30, 2019

*Equipment is depreciated on a straight-line basis over 10 years (salvage value is $20,000).

Liabilities and Equity Liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . $ 7,060

Income taxes payable (due 10/31/2019) . . . . 20,000

Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 $ 37,060

Stockholders’ equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . 42,870 192,870

Total liabilities and equity . . . . . . . . . . . . . . . . . . $229,930

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . 25,200

Raw materials inventory (178 pounds @ $20) . . . 3,560

Finished goods inventory (1,010 units @ $17) . . 17,170

Equipment* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000

Less: Accumulated depreciation . . . . . . . . . . . . . . 36,000 164,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,930

Sales

Production

Direct laborDirect materials Factory overhead

Capital expenditures Selling expenses General & admin expensesCash

Budgeted financial statements

EXHIBIT 20.2 Master Budget Process for a Manufacturer

Operating budgets

Investing budgets

Financing budgets

Chapter 20 Master Budgets and Performance Planning 775

1,000 × $ 60

$60,000

800 × $ 60

$48,000

1,400 × $ 60

$84,000

3,200 × $ 60

$192,000

Budgeted sales (units) Selling price per unit Total budgeted sales (dollars)

1 2 3 4 5 6 7

A B C D E

TORONTO STICKS COMPANY Sales Budget

October 2019–December 2019 DecemberNovemberOctober Totals

EXHIBIT 20.4 Sales Budget

Production Budget A manufacturer prepares a production budget, which shows the number of units to be pro- duced in a period. The production budget is based on the budgeted unit sales from the sales budget, along with inventory considerations. Manufacturers often determine a certain amount of safety stock, a quantity of inventory that provides protection against lost sales caused by unful- filled demands from customers or delays in shipments from suppliers. Exhibit 20.5 shows how to compute the production required for a period. A production budget does not show costs; it is always expressed in units of product.

Entrepreneur You run a start-up that manufactures designer clothes. Business is seasonal, and fashions and designs quickly change. How do you prepare reliable annual sales budgets? ■ Answer: You face two issues. First, because fashions and designs frequently change, you cannot rely on previous budgets. You must carefully analyze the market to understand what designs are in vogue. This will help you plan the product mix and estimate demand. The second issue is the budgeting period. An annual sales budget may be unreliable because tastes can quickly change. Your might prepare monthly and quarterly sales budgets that you continuously monitor and revise.

Decision Maker

Budgeted ending inventory units Budgeted sales units+ Beginning finishedgoods inventoryunits–Units toproduce =

Required units for the period

EXHIBIT 20.5 Computing Production Requirements

Sales Budget The first step in preparing the master budget is the sales budget, which shows the planned sales units and the expected dollars from these sales. The sales budget is the starting point in the bud- geting process because plans for most departments are linked to sales.

The sales budget comes from a careful analysis of forecasted economic and market condi- tions, business capacity, and advertising plans. To illustrate, in September 2019, TSC sold 700 hockey sticks at $60 per unit. After considering sales predictions and market conditions, TSC prepares its sales budget for the next three months (see Exhibit 20.4). The sales budget in Exhibit 20.4 includes forecasts of both unit sales and unit prices. Some sales budgets are expressed only in total sales dollars, but most are more detailed and can include budgets for many different products, regions, departments, and sales representatives.

Operating Budgets

Sales Production Direct materials Direct labor Factory overhead Selling expenses General & administrative

After assessing the cost of keeping inventory along with the risk and cost of inventory short- ages, TSC decides that the number of units in its finished goods inventory at each month-end should equal 90% of next month’s predicted sales. For example, inventory at the end of October should equal 90% of budgeted November sales, and so on. This information, along with knowl- edge of 1,010 units in inventory at September 30 (see Exhibit 20.3), allows the company to prepare the production budget shown in Exhibit 20.6. The actual number of units of ending inventory at September 30 is not consistent with TSC’s policy. This is common, as sales fore- casts are uncertain and production can sometimes be disrupted.

Use three steps to complete the production budget.

1. Compute budgeted ending inventory based on the company’s inventory policy. 2. Add budgeted sales (from the sales budget). 3. Subtract beginning inventory.

Units of Finished Goods Inventory

Beg. inv. # Required Sales # prod. units #

End. inv. #

Example: Under a JIT system, how will sales in units differ from the number of units to produce? Answer: The two amounts are similar because future inventory should be near zero.

776 Chapter 20 Master Budgets and Performance Planning

The result is the required units to be produced for the period. The number of units to be pro- duced provides the basis for manufacturing budgets for the production costs of those units— direct materials, direct labor, and overhead.

EXHIBIT 20.6 Production Budget

Steps

Budgeted ending inventory + Budgeted sales – Beginning inventory = Units to produce

Next month’s budgeted sales (units) from sales budget* Ratio of inventory to future sales Budgeted ending inventory (units) Add: Budgeted sales (units) Required units of available production Deduct: Beginning inventory (units) Units to produce

1 2 3 4 5 6 7 8 9 10 11

A B C D

TORONTO STICKS COMPANY Production Budget

October 2019–December 2019 NovemberOctober December

800 × 90

720 1,000 1,720 1,010

710

%

1,400 × 90

1,260 800

2,060 720

1,340

% 900

× 90 810

1,400 2,210 1,260

950

%

*From sales budget (Exhibit 20.4); January budgeted sales of 900 units from next quarter’s sales budget. †October’s beginning inventory (1,010 units) is inconsistent with company policy.

Direct Materials Budget The direct materials budget shows the budgeted costs for direct materials that must be purchased to satisfy the budgeted production for the period. Whereas the production budget shows units to be produced, the direct materials budget translates the units to be produced into budgeted costs. (The same is true for the other two manufacturing budgets that we will discuss below—the direct labor budget and the factory overhead budget).

A direct materials budget requires the following inputs. 1 Number of units to produce (from the production budget). 2 Materials requirements per unit—How many units (pounds, gallons, etc.) of direct materials

go into each unit of finished product? 3 Budgeted ending inventory (in units) of direct materials—As with finished goods, most

companies maintain a safety stock of materials to ensure that production can continue. 4 Beginning inventory (in units) of direct materials. 5 Cost per unit of direct materials.

Just-in-Time Managers of just-in-time (JIT) inventory systems use sales budgets for short periods (often as few as one or two days) to order just enough merchandise or materials to satisfy the immediate sales demand. This keeps the amount of inventory to a minimum (or zero in an ideal situation). A JIT system minimizes the costs of maintaining inventory, but it is practical only if customers are content to order in advance or if managers can accurately determine short-term sales demand. Suppliers also must be able and willing to ship small quantities regularly and promptly. ■

Decision Insight

Point: Accurate estimates of future sales are crucial in a JIT system.

©Juanmonino/E+/Getty Images

A manufacturing company predicts sales of 220 units for May and 250 units for June. The company wants each month’s ending inventory to equal 30% of next month’s predicted unit sales. Beginning inventory for May is 66 units. Compute the company’s budgeted production in units for May.

Solution

Production Budget

NEED-TO-KNOW 20-2

P1

Production Budget (May) Units

Budgeted ending inventory for May (250 × 30%) . . . . . . . . . . . . 75 Plus: Budgeted sales for May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

Required units of available production . . . . . . . . . . . . . . . . . . . . . 295

Less: Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (66)

Total units to be produced during May . . . . . . . . . . . . . . . . . . . . . 229

Do More: QS 20-12, QS 20-16, QS 20-17, E 20-3, E 20-10,

E 20-11

Chapter 20 Master Budgets and Performance Planning 777

Materials (in pounds) to purchase are computed as follows.

Budgeted production

(units)

Materials required for each

unit (pounds)× Budgeted ending

materials inventory (pounds)+

Beginning materials

inventory (pounds)– Materials to be

purchased (pounds) =

Exhibit 20.7 shows the direct materials budget for TSC. 1 This budget begins with the budgeted production from the production budget. 2 Next, TSC needs to know the amount of direct materials needed for each of the units to

be produced—in this case, half a pound (0.5) of wood. With these two inputs we can compute the amount of direct materials needed for production. For example, to produce 710 hockey sticks in October, TSC will need 355 pounds of wood (710 units × 0.5 lbs. = 355 lbs.).

3 TSC wants a safety stock of direct materials in inventory at the end of each month to complete 50% of the budgeted units to be produced in the next month. Because TSC expects to produce 1,340 units in November, requiring 670 pounds of materials, it needs ending inventory of direct materials of 335 pounds (50% × 670) in inventory at the end of October. TSC’s total direct materials requirement for October is therefore 690 pounds (355 + 335).

4 TSC already has 178 pounds of direct materials in its beginning inventory (refer to Exhibit 20.3). TSC deducts this amount from the total materials requirements for the month. For October, the calculation is 690 pounds – 178 pounds = 512 pounds of direct materials to be purchased in October.

5 The direct materials budget next translates the pounds of direct materials to be purchased into budgeted costs. TSC estimates that the cost of direct materials will be $20 per pound over the quarter. At $20 per pound, purchasing 512 pounds of direct materials for October production will cost $10,240 (computed as $20 × 512). Similar calculations yield the cost of direct materials pur- chases for November ($11,450) and December ($9,700). (For December, assume the budgeted end- ing inventory of direct materials, based on January’s production requirements, is 247.5 pounds.)

If the company expects direct materials costs to change in the future, it can easily include changes in the direct materials budget. For example, if the price of wood jumps to $25 per pound in December—say, because a long-term contract with the supplier was about to expire— TSC could simply change December’s material price per pound in the direct materials budget.

Point: Most hockey sticks are composites of several raw materi- als, including wood, fiberglass, and graphite. We focus on one raw material for simplicity.

Units of Direct Materials

Beg. inv. Direct materials Direct materials to purchase required for prod.

End. inv.

EXHIBIT 20.7 Direct Materials Budget

Materials needed for production + Budgeted ending mtls. inventory − Beginning mtls. inventory = Materials to be purchased

Budgeted production units* Materials requirements per unit Materials needed for production (pounds) Add: Budgeted ending inventory (pounds) Total materials requirements (pounds) Deduct: Beginning inventory (pounds) Materials to be purchased (pounds)

Material price per pound Total cost of direct materials purchases

1 2 3 4

5 6 7 8 9 10 11 12 13 14

A B C D

TORONTO STICKS COMPANY Direct Materials Budget

October 2019–December 2019 NovemberOctober

710 × 0.5

355 335 690

$ 20 $10,240

(178) 512

(335)

1,340 × 0.5

670 237.5 907.5

572.5

$ 20 $11,450

December

(237.5)

950 × 0.5

475 247.5 722.5

485.0

$ 20 $9,700

*From production budget (Exhibit 20.6). †Computed from January 2020 production requirements, assumed to be 990 units. 990 units × 0.5 lbs. per unit × 50% safety stock = 247.5 lbs.

×50% ×50% 2 1

3

4

5

Direct Labor Budget The direct labor budget shows the budgeted costs for direct labor that will be needed to satisfy the budgeted production for the period. Because there is no “inventory” of labor, the direct labor budget is easier to prepare than the direct materials budget.

A direct labor budget requires the following inputs. 1 Number of units to produce (from the production budget). 2 Labor requirements per unit—direct labor hours for each unit of finished product. 3 Cost per direct labor hour. ©Monkey Business Images/Shutterstock

778 Chapter 20 Master Budgets and Performance Planning

Budgeted amount of direct labor cost is computed as follows.

Budgeted production

(units)

Direct labor required per unit (hours)× Direct labor costper hour (dollars)×Budgeted directlabor cost(dollars) =

TSC’s direct labor budget is shown in Exhibit 20.8. 1 The budgeted production units are from the production budget. 2 Fifteen minutes of labor time (a quarter of an hour) are required to produce one unit.

Compute budgeted direct labor hours by multiplying the budgeted production for each month by one-quarter (0.25) of an hour.

3 Labor is paid $12 per hour. Compute the total cost of direct labor by multiplying bud- geted labor hours by the labor rate of $12 per hour.

Estimated changes in direct labor costs can be easily included in the budgeting process. Com- panies thus can ensure the right amount of direct labor for periods in which production is expected to change or to take into account expected changes in direct labor rates.

Point: A quarter of an hour can be expressed as 0.25 hours (15 minutes/60 minutes = 0.25 hours).

EXHIBIT 20.8 Direct Labor Budget

Example: If TSC can reduce its direct labor requirements to 0.20 hours per unit by paying $14 per hour for more skilled workers, what is the total direct labor cost for December? Answer: $2,660.

Budgeted production (units)* Direct labor requirements per unit (hours) Total direct labor hours needed

Direct labor rate (per hour) Total cost of direct labor

1 2 3 4 5 6 7 8 9 10

A B C D

TORONTO STICKS COMPANY Direct Labor Budget

October 2019–December 2019 NovemberOctober December

710 × 0.25

177.5

$ 12 $2,130

1,340 × 0.25

335

$ 12 $4,020

950 × 0.25

237.5

$ 12 $2,850

*From production budget (Exhibit 20.6).

1 2

3

A manufacturing company budgets production of 800 units during June and 900 units during July. Each unit of finished goods requires 2 pounds of direct materials, at a cost of $8 per pound. The company maintains an inventory of direct materials equal to 10% of next month’s budgeted production. Beginning direct materials inventory for June is 160 pounds. Each finished unit requires 1 hour of direct labor at the rate of $14 per hour. Compute the budgeted (a) cost of direct materials purchases for June and (b) direct labor cost for June.

Solution

Direct Materials and Direct Labor Budgets

NEED-TO-KNOW 20-3

P1

Do More: QS 20-7, QS 20-8, QS 20-13, QS 20-14, E 20-4,

E 20-5, E 20-8

Direct Labor Budget (June)

Budgeted production (units) . . . . . . . . . . . . . . . 800

Labor requirements per unit (hours) . . . . . . . . . × 1 Total direct labor hours needed . . . . . . . . . . . . . 800

Labor rate (per hour) . . . . . . . . . . . . . . . . . . . . . $ 14

Direct labor cost (June) . . . . . . . . . . . . . . . . . . . $11,200

b. Direct Materials Budget (June)

Budgeted production (units) . . . . . . . . . . . . . . . . . . . . . . 800

Materials requirements per unit (lbs .) . . . . . . . . . . . . . . . × 2 Materials needed for production (lbs .) . . . . . . . . . . . . . . 1,600

Add: Budgeted ending inventory (lbs .) . . . . . . . . . . . . . . 180*

Total materials requirements (lbs .) . . . . . . . . . . . . . . . . . . 1,780

Less: Beginning inventory (lbs .) . . . . . . . . . . . . . . . . . . . . (160)

Materials to be purchased (lbs .) . . . . . . . . . . . . . . . . . . . . 1,620

Material price per pound . . . . . . . . . . . . . . . . . . . . . . . . . $ 8

Total cost of direct materials purchases . . . . . . . . . . . . . $12,960

*900 units × 2 lbs. per unit × 10% = 180 lbs.

a.

Factory Overhead Budget The factory overhead budget shows the budgeted costs for factory overhead that will be needed to complete the budgeted production for the period. TSC’s factory overhead budget is shown in Exhibit 20.9. TSC separates variable and fixed overhead costs in its overhead budget, as do many companies.

Chapter 20 Master Budgets and Performance Planning 779

Separating variable and fixed overhead costs enables companies to more closely estimate changes in overhead costs as production volume varies. TSC assigns the variable portion of overhead using a predetermined overhead rate of $2.50 per unit of production. This rate might be based on inputs such as direct materials costs, machine hours, direct labor hours, or other activity measures.

TSC’s fixed overhead consists entirely of depreciation on manufacturing equipment. From Exhibit 20.3, this is computed as $18,000 per year [($200,000 – $20,000)∕10 years], or $1,500 per month ($18,000∕12 months). This fixed overhead cost stays constant at $1,500 per month.

The budget in Exhibit 20.9 is in condensed form; most overhead budgets are more detailed, listing each overhead cost item. Overhead budgets also commonly include supervisor salaries, indirect materials, indirect labor, utilities, and maintenance of manufacturing equipment. We explain these more detailed overhead budgets in the next chapter.

Product Cost per Unit With the three manufacturing budgets (direct materials, direct labor, and factory overhead), we compute TSC’s budgeted product cost per unit. This amount is then used to prepare the: Cost of goods sold budget, which budgets the total manufacturing costs for the period. Budgeted income statement, which summarizes the expected income from budgeted activities.

For budgeting purposes, TSC assumes it will normally produce 3,000 units of product each quarter, yielding fixed overhead of $1.50 per unit (computed as $4,500∕3,000). TSC’s other product costs are all variable. Exhibit 20.10 summarizes the product cost per unit calculation. We use this total product cost per unit as a simplified budgeted cost of goods sold.

Point: Companies can use scatter diagrams, the high-low method, or regression analysis to classify over- head costs as fixed or variable.

Budgeted production (units)* Variable factory overhead rate Budgeted variable overhead Budgeted fixed overhead Budgeted total overhead

1 2 3 4 5 6 7 8 9

A B C D

TORONTO STICKS COMPANY Factory Overhead Budget

October 2019–December 2019 NovemberOctober December

710 × $ 2.50

1,775 1,500

$3,275

1,340 × $ 2.50

3,350 1,500

$4,850

950 × $ 2.50

2,375 1,500

$3,875

*From production budget (Exhibit 20.6).

EXHIBIT 20.9 Factory Overhead Budget

EXHIBIT 20.10 Product Cost per Unit

Product Cost Per Unit

Direct materials (½ pound of materials × $20 per pound of materials) . . . . . . . . . . . $10 .00 Direct labor (0 .25 hours of direct labor × $12 per hour of direct labor) . . . . . . . . . . . 3 .00 Variable overhead (from predetermined overhead rate) . . . . . . . . . . . . . . . . . . . . . . . 2 .50

Fixed overhead ($4,500 total fixed overhead per quarter/3,000 units of expected production per quarter) . . . . . . . . . . . . . . . . . 1 .50

Total product cost per unit* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17 .00

*Computed at the normal production level of 3,000 units per quarter. (Cost of goods sold budgets also can consider changing product costs, changing inventory levels, and different inventory cost flow assumptions. These issues are covered in advanced courses.)

Selling Expense Budget The selling expense budget is an estimate of the types and amounts of selling expenses expected during the budget period. It is usually prepared by the vice president of marketing or a sales manager. Budgeted selling expenses are based on the sales budget, plus a fixed amount of sales manager salaries.

TSC’s selling expense budget is in Exhibit 20.11. The firm’s selling expenses consist of com- missions paid to sales personnel and a $2,000 monthly salary paid to the sales manager. Sales commissions equal 10% of total sales and are paid in the month sales occur. Sales commissions

Cost of Goods Sold Budget

Budgeted sales units # × Product cost per unit $

= Budgeted COGS $

780 Chapter 20 Master Budgets and Performance Planning

vary with sales volume, but the sales manager’s salary is fixed. Other common selling expenses include advertising, delivery expenses, and marketing expenses.

General and Administrative Expense Budget The general and administrative expense budget plans the predicted operating expenses not included in the selling expenses or manufacturing budgets. The office manager responsible for general administration often is responsible for preparing the general and administrative expense budget.

Exhibit 20.12 shows TSC’s general and administrative expense budget. It includes salaries of $54,000 per year, or $4,500 per month (paid each month when they are earned). Insurance, taxes, and depreciation on nonmanufacturing assets are other common examples of general and administrative expenses.

Budgeted sales* Sales commission % Sales commissions Salary for sales manager Total selling expenses

1 2 3 4 5 6 7 8 9

A EB C D

TORONTO STICKS COMPANY Selling Expense Budget

October 2019–December 2019 DecemberNovember TotalsOctober

$48,000 × 10

4,800 2,000

$ 6,800

% $84,000

× 10 8,400 2,000

$ 10,400

% $192,000 × 10

19,200 6,000

$ 25,200

% $60,000 × 10

6,000 2,000

$ 8,000

%

*From sales budget (Exhibit 20.4).

EXHIBIT 20.11 Selling Expense Budget

Example: If TSC expects a 12% sales commission will result in budgeted sales of $220,000 for the quarter, what is the total amount of selling expenses for the quarter? Answer: $32,400.

Point: Some companies combine selling and general administrative expenses into a single budget.

Administrative salaries Total general and administrative expenses

1 2 3 4 5 6

A EB C D

TORONTO STICKS COMPANY General and Administrative Expense Budget

October 2019–December 2019 DecemberNovember TotalsOctober

$4,500 $4,500

$4,500 $4,500

$4,500 $4,500

$13,500 $13,500

EXHIBIT 20.12 General and Administrative Expense Budget

Example: In Exhibit 20.12, how would a rental agreement of $5,000 per month plus 1% of sales affect the general and ad- ministrative expense budget? (Budgeted sales are in Exhibit 20.4.) Answer: Rent expense: Oct. = $5,600; Nov. = $5,480; Dec. = $5,840; Total = $16,920; Revised total general and administrative expenses: Oct. = $10,100; Nov. = $9,980; Dec. = $10,340; Total = $30,420.

No Biz Like Snow Biz Ski resorts’ costs of making snow are in the mil- lions of dollars for equipment alone. Snowmaking involves spraying drop- lets of water into the air, causing them to freeze and come down as snow. Making snow can cost more than $2,000 an hour. Snowmaking accounts for 40–50 percent of the budgeted costs for many ski resorts. ■

Decision Insight

©Gail Shotlander/Getty Images

A manufacturing company budgets sales of $70,000 during July. It pays sales commissions of 5% of sales and also pays a sales manager a salary of $3,000 per month. Other monthly costs include depreciation on office equipment ($500), insurance expense ($200), advertising ($1,000), and an office manager salary of $2,500 per month. Compute the total (a) budgeted selling expense and (b) budgeted general and adminis- trative expense for July.

Solution

a. Total budgeted selling expense = ($70,000 × 5%) + $3,000 + $1,000 = $7,500 b. Total budgeted general and administrative expense = $500 + $200 + $2,500 = $3,200

Selling and General and Administrative Expense Budgets

NEED-TO-KNOW 20-4

P1

Do More: QS 20-5, QS 20-11

Chapter 20 Master Budgets and Performance Planning 781

Information from operating budgets is useful in preparing the capital expenditures budget—a key part of investing budgets.

Capital Expenditures Budget The capital expenditures budget shows dollar amounts estimated to be spent to purchase additional plant assets and any cash expected to be received from plant asset disposals. The capital expenditures budget shows the company’s expected investing activities in plant assets. It is usually prepared after the operating budgets. Because a company’s plant assets determine its productive capacity, this budget is affected by long-range plans for the busi- ness. The process of preparing other budgets can reveal that the company requires more (or less) plant assets.

TSC does not anticipate disposal of any plant assets through December, but it does plan to buy additional equipment for $25,000 cash near the end of December. This is the only budgeted capital expenditure from October through December. Thus, no separate budget is shown. TSC’s December 2019 cash budget will reflect this $25,000 planned expenditure.

Cash Budget A cash budget shows expected cash inflows and outflows during the budget period. Managing cash flows is vital for a firm’s success. Most companies set an amount of cash they require for operations. The cash budget is important because it helps the company meet this cash balance goal. If the cash budget indicates a potential cash shortfall, the company can prearrange loans to meet its obligations. If the cash budget indicates a potential cash windfall, the company can plan to pay off prior loans or make other investments. Exhibit 20.13 shows the general formula for the cash budget.

Investing Budgets Capital expenditures

P2 Prepare a cash budget—for a manufacturing company.

INVESTING AND FINANCING BUDGETS

Budgeted cash

receipts

Budgeted cash

payments

Preliminary cash

balance

Repay loans, buy securities

Loan Activity

Adequate

Too low

Increase short-term

loans

Beginning cash

balance + – =

EXHIBIT 20.13 General Formula for Cash Budget

When preparing a cash budget, add budgeted cash receipts to the beginning cash balance and subtract budgeted cash payments. If the preliminary cash balance is too low, additional cash requirements appear in the budget as planned increases from short-term loans. If the prelimi- nary cash balance exceeds the balance the company wants to maintain, the excess is used to repay loans (if any) or to acquire short-term investments.

Information for preparing the cash budget is taken mainly from the operating and capital expenditures budgets. Preparing the cash budget typically requires the preparation of other sup- porting schedules; we show the first of these, a schedule of cash receipts from sales, next.

Cash Receipts from Sales Managers use the sales budget and knowledge about how frequently customers pay on credit sales to budget monthly cash receipts. To illustrate, Exhibit 20.14 presents TSC’s schedule of budgeted cash receipts.

We begin with TSC’s budgeted sales (Exhibit 20.4). Analysis of past sales indicates that 40% of the firm’s sales are for cash. The remaining 60% are credit sales; these customers are expected to pay in full in the month following the sales. We now can compute the budgeted cash receipts from customers, as shown in Exhibit 20.14. October’s budgeted cash receipts consist of $24,000 from expected October cash sales ($60,000 × 40%) plus the anticipated collection of $25,200 of accounts receivable from the end of September.

Point: Budgeted cash collections can be impacted by transaction fees for credit or debit cards. Companies like Visa and American Express charge differ- ent credit card fees, and banks charge fees to use debit cards.

Financing Budgets Cash budgets

782 Chapter 20 Master Budgets and Performance Planning

Alternative Collection Timing The schedule above can be modified for alternative collec- tion timing and/or uncollectible accounts. For example, if TSC collects 80% of credit sales in the first month after sale, 20% of credit sales in the second month after sale, and all other as- sumptions are unchanged, budgeted cash receipts for December follow.

Sales* Less: Ending accounts receivable (60%) Cash receipts from Cash sales (40% of sales) Collections of prior month’s receivables Total cash receipts

1 2 3 4 5 6 7 8 9 10

A C D E

TORONTO STICKS COMPANY Schedule of Cash Receipts from Sales

October 2019–December 2019 NovemberOctoberSeptember December

$60,000 36,000

24,000 25,200

$49,200

$42,000 25,200†

$48,000 28,800

19,200 36,000

$55,200

$84,000 50,400

33,600 28,800

$62,400

B

*From sales budget (Exhibit 20.4). †Accounts receivable balance from September 30 balance sheet (Exhibit 20.3).

EXHIBIT 20.14 Computing Budgeted Cash Receipts from Sales

December budgeted cash receipts with alternative collection timing and uncollectible accounts

Cash receipts from December cash sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 33,600

Collections of November’s receivables ($48,000 × 95% × 60% × 80%) . . . . . . . . . . . . . . 21,888 Collections of October’s receivables ($60,000 × 95% × 60% × 20%) . . . . . . . . . . . . . . . . 6,840 Total cash receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $62,328

December budgeted cash receipts with alternative collection timing

Cash receipts from December cash sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 33,600

Collections of November’s receivables ($48,000 × 60% × 80%) . . . . . . . . . . . . . . . . . . . . 23,040 Collections of October’s receivables ($60,000 × 60% × 20%) . . . . . . . . . . . . . . . . . . . . . . 7,200 Total cash receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,840

Uncollectible Accounts Some companies consider uncollectible accounts in their cash bud- gets. To do so, multiply credit sales by (1 – % of uncollectible receivables). For example, if in addition to the alternative collection timing above TSC estimates that 5% of all credit sales will not be collected, it computes its December cash receipts as follows.

Cash Payments for Materials Managers use the beginning balance sheet (Exhibit 20.3) and the direct materials budget (Exhibit 20.7) to help prepare a schedule of cash payments for materials. Managers also must know how TSC purchases direct materials (pay cash or on account) and, for credit purchases, how quickly TSC pays. TSC’s materials purchases are entirely on account. It makes full payment during the month following its purchases. Using this information, the schedule of cash payments for materials is shown in Exhibit 20.15.

EXHIBIT 20.15 Computing Cash Payments for Materials Purchases

Materials purchases* Cash payments for Current month purchases (0%) Prior month purchases (100%) Total cash payments for direct materials

1 2 3 4 5 6 7 8 9

A B C D

TORONTO STICKS COMPANY Schedule of Cash Payments for Direct Materials

October 2019–December 2019 NovemberOctober December

$11,450

0 10,240

$10,240

$ 9,700

0 11,450

$11,450

$10,240

0 7,060

$ 7,060 †

*From direct materials budget (Exhibit 20.7). †Accounts Payable balance from September 30 balance sheet (Exhibit 20.3).

The schedule above can be modified for alternative payment timing. For example, if TSC paid for 20% of its purchases in the month of purchase and paid the remaining 80% of a month’s purchases in the following month, its cash payments in December would equal $11,100, com- puted as (20% × $9,700) plus (80% × $11,450).

Chapter 20 Master Budgets and Performance Planning 783

Preparing the Cash Budget The cash budget summarizes many other budgets in terms of their effects on cash. To prepare the cash budget, TSC’s managers use the budgets and other schedules listed below.

1. Cash receipts from sales (Exhibit 20.14). 2. Cash payments for direct materials (Exhibit 20.15). 3. Cash payments for direct labor (Exhibit 20.8). 4. Cash payments for overhead (Exhibit 20.9). 5. Cash payments for selling expenses (Exhibit 20.11). 6. Cash payments for general and administrative expenses (Exhibit 20.12).

The fixed overhead assigned to depreciation in the factory overhead budget (Exhibit 20.9) does not require a cash payment. Therefore, it is not included in the cash budget. Other types of fixed overhead—such as payments for property taxes and insurance—are included if they require cash payments.

Additional information is typically needed to prepare the cash budget. For TSC, this addi- tional information includes

1. Income taxes payable: $20,000, from the beginning balance sheet in Exhibit 20.3. 2. Expected dividend payments: TSC plans to pay $3,000 of cash dividends in the second

month of each quarter. 3. Loan activity: TSC wants to maintain a minimum cash balance of $20,000 at each

month-end. This is important, as it helps ensure TSC maintains enough cash to pay its bills as they come due. If TSC borrows cash, it must pay interest at the rate of 1% per month.

Exhibit 20.16 shows the full cash budget for TSC. The company begins October with $20,000 in cash. To this is added $49,200 in expected cash receipts from customers (from Exhibit 20.14). We next subtract expected cash payments for direct materials, direct labor, overhead, selling expenses, and general and administrative expenses. Income taxes of $20,000 were due as of the end of September 30, 2019, and payable in October. We next discuss TSC’s loan activity, includ- ing any interest payments.

$20,000 49,200 69,200

7,060 2,130 1,775

6,000 2,000 4,500

20,000

100

43,565 $25,635

5,635 $20,000 $ 4,365

$20,000 55,200 75,200

10,240 4,020 3,350 4,800 2,000 4,500

3,000

44

31,954 $ 43,246

4,365 $ 38,881 $ 0

$38,881 62,400 101,281

11,450 2,850 2,375 8,400 2,000 4,500

25,000 56,575

$ 44,706

$ 44,706 $ 0

Beginning cash balance Add: Cash receipts from customers (Exhibit 20.14) Total cash available Less: Cash payments for Direct materials (Exhibit 20.15) Direct labor (Exhibit 20.8) Variable overhead (Exhibit 20.9) Sales commissions (Exhibit 20.11) Sales salaries (Exhibit 20.11) General and administrative expenses (Exhibit 20.12) Income taxes payable (Exhibit 20.3) Dividends Interest on bank loan October ($10,000 × 1%)* November ($4,365 × 1%)† Purchase of equipment Total cash payments Preliminary cash balance Loan activity Additional loan from bank Repayment of loan to bank Ending cash balance Loan balance, end of month‡

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

A B C D

TORONTO STICKS COMPANY Cash Budget

October 2019–December 2019 DecemberNovemberOctober

*Beginning loan balance (note payable) from Exhibit 20.3. †Rounded to the nearest dollar. ‡Beginning loan balance + New loans – Loan repayments. For October: $10,000 – $5,635 = $4,365.

EXHIBIT 20.16 Cash Budget

Cash

Oct . 1 20,000 Receipts 49,200 43,565 Payments

Prelim . bal . 25,635 5,635 Repay loan

Oct . 31 20,000

784 Chapter 20 Master Budgets and Performance Planning

Loan Activity TSC’s bank promises additional loans at each month-end, if necessary, so that the company keeps a minimum cash balance of $20,000. If the cash balance exceeds $20,000 at month-end, TSC uses the excess to repay loans (if any) or buy short-term investments. If the cash balance is less than $20,000 at month-end, the bank loans TSC the difference.

Monthly interest on bank loans is computed as:

Cash paid for interest = Monthly interest rate (%) × Beginning loan balance

Using TSC’s interest rate of 1% per month, budgeted cash payments for interest follow.

Budgeted cash payments for interest Interest Rate Beginning Loan Balance Interest Cost October . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1% $10,000 $100

November . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 4,365 44

December . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 0

Exhibit 20.16 shows that the October 31 cash balance increases to $25,635 (before any loan- related activity). This amount is more than the $20,000 minimum. Thus, TSC will use the excess cash of $5,635 (computed as $25,635 – $20,000) to pay off a portion of its loan. At the end of November, TSC’s preliminary cash balance is sufficient to pay off its remaining loan balance.

Had TSC’s preliminary cash balance been below the $20,000 minimum in any month, TSC would have increased its loan from the bank so that the ending cash balance was $20,000. We show an example of this situation in Need-to-Know 20-7 at the end of this chapter.

Note Payable

10,000 Sep . 30 Repay 5,635

4,365 Oct . 31 Repay 4,365

0 Nov . 30

Cash Cushion Why do some companies maintain a minimum cash balance even when the budget shows extra cash is not needed? For example, Apple’s cash and short-term investments balance is over $70 billion. According to Apple’s CEO, Tim Cook, the cushion provides “flexibility and security,” important in navigating uncertain economic times. A cash cushion enables companies to jump on new ventures or acquisitions that may present themselves. The Boston Red Sox keep a cash cushion for its trades involving players with “cash considerations.” ■

Decision Insight

©Adam Glanzman/Getty Images

Part 1

Diaz Co. predicts sales of $80,000 for January and $90,000 for February. Seventy percent of Diaz’s sales are for cash, and the remaining 30% are credit sales. All credit sales are collected in the month after sale. January’s beginning accounts receivable balance is $20,000. Compute budgeted cash receipts for January and February.

Solution

Part 2

Use the following information to prepare a cash budget for the month ended January 31 for Garcia Company. The company requires a minimum $30,000 cash balance at the end of each month. Any pre- liminary cash balance above $30,000 is used to repay loans (if any). Garcia has a $2,000 loan outstanding at the beginning of January.

a. January 1 cash balance, $30,000 d. Budgeted cash payments for labor, $33,400 b. Cash receipts from sales, $132,000 e. Other budgeted cash expenses,* $8,200 c. Budgeted cash payments for materials, $63,500 f. Cash repayment of bank loan, $2,000 *Including loan interest for January.

Cash Budget

NEED-TO-KNOW 20-5

P2

Do More: QS 20-6, QS 20-10, QS 20-19, E 20-18

Budgeted Cash Receipts January February

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $90,000

Less: Ending accounts receivable (30%) . . . . . . . . . . . . . . . . . . 24,000 27,000

Cash receipts from

Cash sales (70% of sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,000 63,000

Collections of prior month’s receivables . . . . . . . . . . . . . . . . 20,000 24,000

Total cash receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $76,000 $87,000

Solution

Cash Budget For Month Ended January 31

Beginning cash balance . . . . . . . . . . . . . . . . . . . $ 30,000 Add: Cash receipts from sales . . . . . . . . . . . . . . . 132,000 Total cash available . . . . . . . . . . . . . . . . . . . . . . . $162,000 Less: Cash payments for Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 63,500 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,400 Other cash expenses . . . . . . . . . . . . . . . . . . . . 8,200 Total cash payments . . . . . . . . . . . . . . . . . . . . 105,100 Preliminary cash balance . . . . . . . . . . . . . . . . . $ 56,900 Loan activity: Repayment of loan to bank . . . . . . . . . . . . . . . 2,000 Ending cash balance . . . . . . . . . . . . . . . . . . . . . . . $ 54,900

Loan balance, end of month . . . . . . . . . . . . . . . . $ 0 Do More: QS 20-24, E 20-17, E 20-21, E 20-22

Chapter 20 Master Budgets and Performance Planning 785

One of the final steps in the budgeting process is summarizing the financial statement effects. We next illustrate TSC’s budgeted income statement and budgeted balance sheet.

Budgeted Income Statement The budgeted income statement shows predicted amounts of sales and expenses for the budget period. It summarizes the predicted income effects of the budgeted activities. Information to prepare a budgeted income statement is primarily taken from already-prepared budgets. The volume of information summarized in the budgeted income statement is so large for some com- panies that they often use spreadsheets to accumulate the budgeted transactions and classify them by their effects on income.

We condense TSC’s budgeted income statement and show it in Exhibit 20.17. All informa- tion in this exhibit is taken from the component budgets we’ve examined in this chapter. Also, we now can predict the amount of income tax expense for the quarter, computed as 40% of the budgeted pretax income. For TSC, these taxes are not payable until January 31, 2020. Thus, these taxes are not shown on the October–December 2019 cash budget in Exhibit 20.16, but they are included on the December 31, 2019, balance sheet (shown next).

BUDGETED FINANCIAL STATEMENTS P3 Prepare budgeted financial statements.

Budgeted Financial Statements Income statement Balance sheet

Point: Lenders often require po- tential borrowers to provide cash budgets, budgeted income state- ments, and budgeted balance sheets, as well as data on past performance.

TORONTO STICKS COMPANY Budgeted Income Statement

For Three Months Ended December 31, 2019

Sales (Exhibit 20 .4, 3,200 units @ $60) . . . . . . . . . . . . . $192,000 Cost of goods sold (3,200 units @ $17)* . . . . . . . . . . . . . 54,400 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,600 Operating expenses Sales commissions (Exhibit 20 .11) . . . . . . . . . . . . . . . $19,200 Sales salaries (Exhibit 20 .11) . . . . . . . . . . . . . . . . . . . 6,000 Administrative salaries (Exhibit 20 .12) . . . . . . . . . . . . 13,500 Interest expense (Exhibit 20 .16) . . . . . . . . . . . . . . . . . 144 38,844 Income before income taxes . . . . . . . . . . . . . . . . . . . . . . 98,756 Income tax expense ($98,756 × 40%)† . . . . . . . . . . . . . 39,502 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 59,254

*$17 product cost per unit from Exhibit 20.10. †Rounded to the nearest dollar.

EXHIBIT 20.17 Budgeted Income Statement

786 Chapter 20 Master Budgets and Performance Planning

Budgeted Balance Sheet The final step in preparing the master budget is summarizing the company’s predicted financial position. The budgeted balance sheet shows predicted amounts for the company’s assets, liabili- ties, and equity as of the end of the budget period. TSC’s budgeted balance sheet in Exhibit 20.18 is prepared using information from the other budgets. The sources of amounts are reported in the notes to the budgeted balance sheet.

Retained Earnings

42,870 Sep . 30 59,254 Net income Dividends 3,000

99,124 Dec . 31

EXHIBIT 20.18 Budgeted Balance Sheet

TORONTO STICKS COMPANY Budgeted Balance Sheet

December 31, 2019

Assets Casha . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,706

Accounts receivableb . . . . . . . . . . . . 50,400

Raw materials inventoryc . . . . . . . . . 4,950

Finished goods inventoryd . . . . . . . . 13,770

Equipmente . . . . . . . . . . . . . . . . . . . . $225,000

Less: Accumulated depreciationf . . . 40,500 184,500

Total assets . . . . . . . . . . . . . . . . . . . . $298,326

Liabilities and Equity Liabilities

Accounts payableg . . . . . . . $ 9,700

Income taxes payableh . . . 39,502 $ 49,202

Stockholders’ equity

Common stocki . . . . . . . . . . 150,000

Retained earningsj . . . . . . . 99,124 249,124

Total liabilities and equity . . . . $298,326

a Ending balance for December from the cash budget (in Exhibit 20.16). b 60% of $84,000 sales budgeted for December from the sales budget (in Exhibit 20.4). c 247.5 pounds of raw materials in budgeted ending inventory at the budgeted cost of $20 per pound (direct materials budget,

Exhibit 20.7). d 810 units in budgeted finished goods inventory (Exhibit 20.6) at the budgeted cost of $17 per unit (Exhibit 20.10). e September 30 balance of $200,000 from the beginning balance sheet in Exhibit 20.3 plus $25,000 cost of new equipment

from the cash budget in Exhibit 20.16. f September 30 balance of $36,000 from the beginning balance sheet in Exhibit 20.3 plus $4,500 depreciation expense from the factory overhead budget in Exhibit 20.9.

g Budgeted cost of materials purchases for December from Exhibit 20.7, to be paid in January. h Income tax expense from the budgeted income statement for the fourth quarter in Exhibit 20.17, to be paid in January. i Unchanged from the beginning balance sheet in Exhibit 20.3. j September 30 balance of $42,870 from the beginning balance sheet in Exhibit 20.3 plus budgeted net income of $59,254 from the budgeted income statement in Exhibit 20.17 minus budgeted cash dividends of $3,000 from the cash budget in Exhibit 20.16.

Using the Master Budget Managers use the master budget in several ways. Sensitivity analysis—Technologies like Excel and enterprise resource planning (ERP) sys-

tems enable managers to quickly get alternative master budgets under different assumptions, allowing them to better plan for and adapt to changing conditions.

Planning—Any stage in the master budgeting process might show results that require new plans. For example, an early version of the cash budget might show too little cash unless payments are reduced. A budgeted income statement might show income below its target, or a budgeted balance sheet might show too much debt from planned equip- ment purchases. Management can change its plans to aim for better results.

Controlling—Managers compare actual results to budgeted results. Differences be- tween actual and budgeted results are called variances. Managers examine variances to identify areas to improve and take corrective action.

Budgeting for Service Companies Service providers also use master budgets; however, because they do not manufacture goods and hold no inventory, they typically need fewer operating budgets than manufacturers do. Exhibit 20.19 shows the master budget process for a service provider.

Exhibit 20.19 shows that service providers do not prepare production, direct materials, or factory overhead budgets. In addition, because many services such as accounting, banking, and

HOCKEY DEN Cash Budget

October November December

Beginning cash balance . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 20,000 $ 22,272

Cash receipts from customers . . . . . .. . . . . . . . . . . . . 82,000 92,000 104,000

Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,000 112,000 126,272

Cash payments

Payments for merchandise . . . . . . . . . . . . . . . . . . . . . . 58,200 49,200 80,400

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 8,000 14,000

Salaries

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000 2,000

Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 4,500 4,500

Income taxes payable . . . . . . . . . . . . . . . . . . . . . .. . .. . . 20,000

Dividends ($150,000 × 2%) . . . . . . . . . . . . . . . . . . . . . 3,000 Interest on bank loan

000,01$(rebotcO × 1%) . . . . . . . . . . . . . . . . . . . . 100 008,22(rebmevoN × 1%) . . . . . . . . . . . . . . . . . . . 228

Purchase of equipment . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total cash payments . . . . . . . . . . . . . . . . . . . . . . . . . . 94,800 66,928 125,900

Preliminary cash balance . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200 $ 45,072 $ 372

Loan activity

Additional loan from bank . . . . . . . . . . . . . . . . . . . . . . . . . 12,800 19,628

Repayment of loan to bank . . . . . . . . . . . . . . . . . . . . . . . . 22,800

Ending cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 22,272 $ 20,000

Loan balance, end of month . . . . . . . . . . . . . . . . . . . . . . . $ 22,800 $ 0 $ 19,628

$

Chapter 20 Master Budgets and Performance Planning 787

Activity-Based Budgeting Decision Analysis

Activity-based budgeting (ABB) is a budget system based on expected activities. Knowledge of expected activities and their levels for the budget period enables management to plan for resources required to per- form the activities. Exhibit 20.21 contrasts a traditional budget with an activity-based budget for a company’s accounting department. With a traditional budget, management often makes across-the-board budget cuts or increases. For example, management might decide that each of the line items in the traditional budget must be cut by 5%. This might not be a good strategic decision. ABB requires management to list activities performed by, say, the accounting department, such as auditing, tax reporting, financial reporting, and cost accounting. By focusing on the relation between activities and costs, management can attempt to reduce costs by eliminating non-value-added activities.

landscaping are labor-intensive, the direct labor budget is important. If an accounting firm greatly underestimates the hours needed to complete an audit, it might charge too low a price. If the accounting firm greatly overestimates the hours needed, it might bid too high a price (and lose jobs) or incur excessive labor costs. Either way, the firm’s profits can suffer if its direct labor budget is unrealistic.

Budgets translate an organization’s strategic goals into dollar terms. When deciding on strategic goals, managers must consider their effects on budgets. Johnson & Johnson, a large manufacturer of pharma- ceuticals, medical devices, and consumer health products, sets goals for both profits and sustainable prac- tices. A recent company sustainability report discusses several sustainability goals and strategies, including some shown in Exhibit 20.20.

EXHIBIT 20.20 Sustainability Goals and Strategies

Sustainability Goal Strategy to Achieve Goal

Reduce waste by 10% . . . . . . . . . . . . Purchase pulping machine to grind and recycle packaging .

Reduce CO2 emissions by 20% . . . . . Purchase hybrid vehicles .

Reduce water usage by 10% . . . . . . . Update plumbing, install water recovery systems, employee training .

Several of the company’s strategies involve asset purchases that will impact the capital expenditures bud- get. Additional employee training will impact the overhead budget. By reducing waste, increasing recy- cling, and reducing water usage, the company hopes to reduce some of the costs reflected in the direct materials and overhead budgets. Company managers periodically evaluate performance with respect to these goals and make any necessary adjustments to budgets.

Misfit Juicery, this chapter’s feature company, “is a company fighting food waste with juice,” accord- ing to co-founder Phil Wong. The company’s focus on repurposing “misfits” extends to its labor force, which includes chronically underemployed groups like the homeless. “Yes, we make delicious juice,” says co-founder Anna Yang, “but our mission is to fix waste!” ©Misfit Juicery

A1 Analyze expense planning using activity- based budgeting.

SUSTAINABILITY AND ACCOUNTING

Sales

Direct labor

Capital expenditures Selling expenses General & admin expensesCash

Budgeted financial statements

EXHIBIT 20.19 Master Budget Process for a Service Company

Operating budgets

Investing budgets

Financing budgets

Payne Company’s management asks you to prepare its master budget using the following information. The budget is to cover the months of April, May, and June of 2019.

COMPREHENSIVE 1

Master Budget— Manufacturer

NEED-TO-KNOW 20-6

PAYNE COMPANY Balance Sheet

March 31, 2019

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000

Accounts receivable . . . . . . . . . . . . . . . . 175,000

Raw materials inventory . . . . . . . . . . . . . 30,798*

Finished goods inventory . . . . . . . . . . . . 96,600†

Total current assets . . . . . . . . . . . . . . . . . $352,398

Equipment . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Less: Accumulated depreciation . . . . . . (90,000)

Equipment, net . . . . . . . . . . . . . . . . . . . . 390,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . $742,398

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . $ 63,818

Short-term notes payable . . . . . . . . 12,000

Total current liabilities . . . . . . . . . . . $ 75,818

Long-term note payable . . . . . . . . . . 200,000

Total liabilities . . . . . . . . . . . . . . . . . . 275,818

Common stock . . . . . . . . . . . . . . . . . 435,000

Retained earnings . . . . . . . . . . . . . . . 31,580

Total stockholders’ equity . . . . . . . . 466,580

Total liabilities and equity . . . . . . . . . $742,398

*2,425 pounds @ $12.70 per pound, rounded to nearest whole dollar. †8,400 units @ $11.50 per unit.

Additional Information

a. Sales for March total 10,000 units. Expected sales (in units) are 10,500 (April), 9,500 (May), 10,000 (June), and 10,500 (July). The product’s selling price is $25 per unit.

b. Company policy calls for a given month’s ending finished goods inventory to equal 80% of the next month’s expected unit sales. The March 31 finished goods inventory is 8,400 units, which complies with the policy. The product’s manufacturing cost is $11.50 per unit, including per unit costs of $6.35 for materials (0.5 lbs. at $12.70 per lb.), $3.75 for direct labor (0.25 hour × $15 direct labor rate per hour), $0.90 for variable overhead, and $0.50 for fixed overhead. Fixed overhead consists entirely of $5,000 of monthly depreciation expense. Company policy also calls for a given month’s ending raw materials inventory to equal 50% of next month’s expected materials needed for production. The March 31 inventory is 2,425 units of materials, which complies with the policy. The company expects to have 2,100 units of materials inventory on June 30.

c. Sales representatives’ commissions are 12% of sales and are paid in the month of the sales. The sales manager’s monthly salary will be $3,500 in April and $4,000 per month thereafter.

d. Monthly general and administrative expenses include $8,000 administrative salaries and 0.9% monthly interest on the long-term note payable.

e. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are collected in full in the month following the sale (none are collected in the month of the sale).

788 Chapter 20 Master Budgets and Performance Planning

EXHIBIT 20.21 Activity-Based Budgeting versus Traditional Budgeting (for an accounting department)

Traditional Budget Activity-Based Budget

Salaries . . . . . . . . . . . . . . . . . . . . . . $152,000 Auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,000

Supplies . . . . . . . . . . . . . . . . . . . . . . 22,000 Tax reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,000

Depreciation . . . . . . . . . . . . . . . . . . 36,000 Financial reporting . . . . . . . . . . . . . . . . . . . . . . . . 63,000

Utilities . . . . . . . . . . . . . . . . . . . . . . 14,000 Cost accounting . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . $224,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $224,000

Environmental Manager You hold the new position of Sustainability Manager for a chemical company. You are asked to develop a budget for your job and identify job responsibilities. How do you proceed? ■ Answer: You are unlikely to have data on this new position to use in preparing your budget. In this situation, you can use activity-based budgeting. This requires developing a list of activities to conduct, the resources required to perform these activities, and the expenses associated with these resources. You should challenge yourself to be absolutely certain that the listed activities are necessary and that the listed resources are required.

Decision Maker

Chapter 20 Master Budgets and Performance Planning 789

f. All direct materials purchases are on credit, and no payables arise from any other transactions. One month’s purchases are fully paid in the next month. Materials cost $12.70 per pound.

g. The minimum ending cash balance for all months is $50,000. If necessary, the company borrows enough cash using a short-term note to reach the minimum. Short-term notes require an interest pay- ment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the mini- mum, the excess will be applied to repaying the short-term notes payable balance.

h. Dividends of $100,000 are to be declared and paid in May. i. No cash payments for income taxes are to be made during the second calendar quarter. Income taxes

will be assessed at 35% in the quarter. j. Equipment purchases of $55,000 are scheduled for June.

Required

Prepare the following budgets and other financial information as required. 1. Sales budget, including budgeted sales for July. 2. Production budget. 3. Direct materials budget. Round costs of materials

purchases to the nearest dollar. 4. Direct labor budget. 5. Factory overhead budget. 6. Selling expense budget. 7. General and administrative expense budget.

8. Expected cash receipts from customers and the expected June 30 bal- ance of accounts receivable.

9. Expected cash payments for purchases and the expected June 30 bal- ance of accounts payable.

10. Cash budget. 11. Budgeted income statement, budgeted statement of retained earnings,

and budgeted balance sheet.

SOLUTION 1.

10,500 × $ 25

$262,500

9,500 × $ 25

$237,500

10,000 × $ 25

$250,000 $750,000

Projected unit sales Selling price per unit Projected sales

1 2 3 4

A B C D E JuneMayAprilSales Budget Quarter

2.

9,500 × 80

7,600 10,500 18,100 8,400 9,700

% Next period’s unit sales (part I) Ending inventory percent Desired ending inventory Current period's unit sales (part I) Required units of available production Less: Beginning inventory Total units to be produced

1 2 3 4 5 6 7 8

A B C D E

JuneMayAprilProduction Budget Quarter 10,000

× 80 8,000 9,500

17,500 7,600 9,900

%

30,000

10,500 × 80

8,400 10,000 18,400 8,000

10,400

%

3.

9,700 × 0.5

4,850 2,475 7,325 2,425 4,900

$ 12.70 $62,230

10,400 × 0.5

5,200 2,100 7,300 2,600 4,700

$ 12.70 $59,690

Budgeted production (units) (part 2) Materials requirements per unit (pounds) Materials needed for production (pounds) Add: Budgeted ending inventory (pounds) Total material requirements (pounds) Deduct: Beginning inventory (pounds) Materials to be purchased (pounds)

Materials price per pound Total cost of direct materials purchases

1 2 3 4 5 6 7 8 9 10 11

A B C D JuneMayAprilDirect Materials Budget

9,900 × 0.5

4,950 2,600 7,550 2,475 5,075

$ 12.70 $64,453 *

*Rounded to nearest dollar.

4.

9,700 × 0.25

2,425

$ 15 $36,375

9,900 × 0.25

2,475

$ 15 $37,125

10,400 × 0.25

2,600

$ 15 $39,000

Budgeted production (units) (part 2) Labor requirements per unit (hours) Total labor hours needed

Labor rate (per hour) Total direct labor cost

1 2 3 4 5 6 7

A B C D JuneMayAprilDirect Labor Budget

790 Chapter 20 Master Budgets and Performance Planning

5.

9,700 × $ 0.90

8,730 5,000

$13,730

9,900 × $ 0.90

8,910 5,000

$13,910

10,400 × $ 0.90

9,360 5,000

$14,360

Budgeted production (units) (part 2) Variable factory overhead rate Budgeted variable overhead Budgeted fixed overhead Budgeted total overhead

1 2 3 4 5 6

A B C D JuneMayAprilFactory Overhead Budget

6.

$262,500 × 12

31,500 3,500

$ 35,000

% $237,500 × 12

28,500 4,000

$ 32,500

% $250,000 × 12

30,000 4,000

$ 34,000

% $750,000 × 12

90,000 11,500

$101,500

% Budgeted sales (part 1) Commission % Sales commissions Manager’s salary Budgeted selling expenses

1 2 3 4 5 6

A B C D E JuneMayAprilSelling Expense Budget Quarter

7.

$8,000 1,800

$9,800

$8,000 1,800

$9,800

$8,000 1,800

$9,800

$24,000 5,400

$29,400

Administrative salaries Interest on long-term note payable (0.9% × $200,000) Budgeted general and administrative expenses

1 2 3 4 5

A B C D E

JuneMayAprilGeneral and Administrative Expense Budget Quarter

8.

$262,500 $ 183,750

$ 78,750 175,000

$ 253,750 *

*Accounts Receivable balance from March 31 balance sheet.

$237,500 $ 166,250

$ 7 1,250 183,750

$255,000

$250,000 $ 175,000

$ 75,000 166,250

$ 241,250

Budgeted sales (part 1) Ending accounts receivable (70%) Cash receipts Cash sales (30% of budgeted sales) Collections of prior month’s receivables Total cash to be collected

1 2 3 4 5 6 7

A B C D JuneMayAprilSchedule of Cash Receipts

$225,000 525,000

$750,000

E Quarter

9.

*Accounts Payable balance from March 31 balance sheet.

$190,501 Cash payments (equal to prior month’s materials purchases) Expected June 30 balance of accounts payable (June purchases)

1 2 3 4 5

A E

$64,453

$59,690

D

June

$62,230

C

May

$63,818*

B

AprilSchedule of Cash Payments for Materials Quarter

10.

$ 50,000 253,750 303,750

63,818 36,375

8,730 31,500

3,500 8,000

1,800

120

153,843 $149,907

12,000 $137,907 $ 0

$137,907 255,000 392,907

62,230 37,125 8,910

28,500

4,000 8,000

100,000 1,800

250,565 $142,342

0 $142,342 $ 0

$142,342 241,250 383,592

64,453 39,000

9,360 30,000

4,000 8,000

1,800

55,000 211,613

$ 171,979

0 $ 171,979 $ 0

Beginning cash balance Add: Cash receipts from customers (part 8) Total cash available Less: Cash payments for Direct materials (part 9) Direct labor (part 4) Variable overhead (part 5) Sales commissions (part 6) Salaries Sales (part 6) Administrative (part 7) Dividends Interest on long-term note (part 7) Interest on bank loan October ($12,000 × 1%) Purchase of equipment Total cash payments Loan activity: Preliminary cash balance Additional loan from bank Repayment of loan to bank Ending cash balance Loan balance, end of month

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

A B C D

JuneMayAprilCash Budget

Chapter 20 Master Budgets and Performance Planning 791

11.

PAYNE COMPANY Budgeted Statement of Retained Earnings

For Quarter Ended June 30, 2019

Retained earnings, March 31, 2019 . . . . . . . . . . . . $ 31,580

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,087

209,667

Less: Cash dividends (part 10) . . . . . . . . . . . . . . . . . 100,000

Retained earnings, June 30, 2019 . . . . . . . . . . . . . $109,667

PAYNE COMPANY Budgeted Income Statement

For Quarter Ended June 30, 2019

Sales (part 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750,000

Cost of goods sold (30,000 units @ $11 .50) . . . . . . . . . . 345,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405,000

Operating expenses

Sales commissions (part 6) . . . . . . . . . . . . . . . . . . . . . . $90,000

Sales salaries (part 6) . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Administrative salaries (part 7) . . . . . . . . . . . . . . . . . . . 24,000

Interest on long-term note (part 7) . . . . . . . . . . . . . . . . 5,400

Interest on short-term notes (part 10) . . . . . . . . . . . . . 120

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 131,020

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . 273,980

Income taxes ($273,980 × 35%) . . . . . . . . . . . . . . . . . . . 95,893 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $178,087

*Plus $1 rounding difference.

PAYNE COMPANY Budgeted Balance Sheet

June 30, 2019

Assets Cash (part 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $171,979

Accounts receivable (part 8) . . . . . . . . . . . . . . . . . . . . . . . . 175,000

Raw materials inventory (2,100 pounds @ $12 .70)* . . . . . 26,671

Finished goods inventory (8,400 units @ $11 .50) . . . . . . . 96,600

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $470,250

Equipment (Mar . 31 bal . plus purchase) . . . . . . . . . . . . . . . 535,000

Less: Accumulated depreciation (Mar . 31 bal . plus depreciation expense) . . . . . . . . . . . . 105,000 430,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900,250

Liabilities and Equity Accounts payable (part 9) . . . . . . . . . . . . . . . $ 59,690

Income taxes payable . . . . . . . . . . . . . . . . . . 95,893

Total current liabilities . . . . . . . . . . . . . . . . . $155,583

Long-term note payable (Mar . 31 bal .) . . . . 200,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . 355,583

Common stock (Mar . 31 bal .) . . . . . . . . . . . . 435,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . 109,667

Total stockholders’ equity . . . . . . . . . . . . . . . 544,667

Total liabilities and equity . . . . . . . . . . . . . . . $900,250

Wild Wood Company’s management asks you to prepare its master budget using the following informa- tion. The budget is to cover the months of April, May, and June of 2019. Wild Wood is a merchandiser.

COMPREHENSIVE 2

Master Budget— Merchandiser

NEED-TO-KNOW 20-7

WILD WOOD COMPANY Balance Sheet

March 31, 2019

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 175,000

Merchandise inventory (8,400 units × $15) . . . . . . 126,000 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . 351,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Less: Accumulated depreciation . . . . . . . . . . . . . . (90,000)

Equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $741,000

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . $156,000

Short-term notes payable . . . . . . . . 12,000

Total current liabilities . . . . . . . . . . . 168,000

Long-term note payable . . . . . . . . . 200,000

Total liabilities . . . . . . . . . . . . . . . . . . 368,000

Common stock . . . . . . . . . . . . . . . . . 235,000

Retained earnings . . . . . . . . . . . . . . 138,000

Total stockholders’ equity . . . . . . . . 373,000

Total liabilities and equity . . . . . . . . $741,000

Additional Information

a. Sales for March total 10,000 units. Each month’s sales are expected to exceed the prior month’s results by 5%. The product’s selling price is $25 per unit.

b. Company policy calls for a given month’s ending inventory to equal 80% of the next month’s expected unit sales. The March 31 inventory is 8,400 units, which complies with the policy. The purchase price is $15 per unit.

792 Chapter 20 Master Budgets and Performance Planning

c. Sales representatives’ commissions are 12.5% of sales and are paid in the month of the sales. The sales manager’s monthly salary will be $3,500 in April and $4,000 per month thereafter.

d. Monthly general and administrative expenses include $8,000 administrative salaries, $5,000 deprecia- tion, and 0.9% monthly interest on the long-term note payable.

e. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are collected in full in the month following the sale (none are collected in the month of the sale).

f. All merchandise purchases are on credit, and no payables arise from any other transactions. One month’s purchases are fully paid in the next month.

g. The minimum ending cash balance for all months is $50,000. If necessary, the company borrows enough cash using a short-term note to reach the minimum. Short-term notes require an interest pay- ment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the mini- mum, the excess will be applied to repaying the short-term notes payable balance.

h. Dividends of $100,000 are to be declared and paid in May. i. No cash payments for income taxes are to be made during the second calendar quarter. Income taxes

will be assessed at 35% in the quarter. j. Equipment purchases of $55,000 are scheduled for June.

Required

Prepare the following budgets and other financial information as required. 1. Sales budget, including budgeted sales for July. 2. Purchases budget. 3. Selling expense budget. 4. General and administrative expense budget. 5. Expected cash receipts from customers and the expected June 30 balance of accounts receivable. 6. Expected cash payments for purchases and the expected June 30 balance of accounts payable. 7. Cash budget. 8. Budgeted income statement, budgeted statement of retained earnings, and budgeted balance sheet.

PLANNING THE SOLUTION The sales budget shows expected sales for each month in the quarter. Start by multiplying March sales

by 105% and then do the same for the remaining months. July’s sales are needed for the purchases budget. To complete the budget, multiply the expected unit sales by the selling price of $25 per unit.

Use these results and the 80% inventory policy to budget the size of ending inventory for April, May, and June. Add the budgeted sales to these numbers and subtract the actual or expected beginning inventory for each month. The result is the number of units to be purchased each month. Multiply these numbers by the per unit cost of $15. Find the budgeted cost of goods sold by multiplying the unit sales in each month by the $15 cost per unit. Compute the cost of the June 30 ending inventory by multiply- ing the expected units available at that date by the $15 cost per unit.

The selling expense budget has only two items. Find the amount of the sales representatives’ commis- sions by multiplying the expected dollar sales in each month by the 12.5% commission rate. Then include the sales manager’s salary of $3,500 in April and $4,000 in May and June.

The general and administrative expense budget should show three items. Administrative salaries are fixed at $8,000 per month, and depreciation is $5,000 per month. Budget the monthly interest expense on the long-term note by multiplying its $200,000 balance by the 0.9% monthly interest rate.

Determine the amounts of cash sales in each month by multiplying the budgeted sales by 30%. Add to this amount the credit sales of the prior month (computed as 70% of prior month’s sales). April’s cash receipts from collecting receivables equals the March 31 balance of $175,000. The expected June 30 accounts receivable balance equals 70% of June’s total budgeted sales.

Determine expected cash payments on accounts payable for each month by making them equal to the merchandise purchases in the prior month. The payments for April equal the March 31 balance of accounts payable shown on the beginning balance sheet. The June 30 balance of accounts payable equals merchandise purchases for June.

Prepare the cash budget by combining the given information and the amounts of cash receipts and cash pay- ments on account that you computed. Complete the cash budget for each month by either borrowing enough to raise the preliminary balance to the minimum or paying off short-term debt as much as the balance allows without falling below the minimum. Show the ending balance of the short-term note in the budget.

Prepare the budgeted income statement by combining the budgeted items for all three months. Determine the income before income taxes and multiply it by the 35% rate to find the quarter’s income tax expense.

Chapter 20 Master Budgets and Performance Planning 793

The budgeted statement of retained earnings should show the March 31 balance plus the quarter’s net income minus the quarter’s dividends.

The budgeted balance sheet includes updated balances for all items that appear in the beginning bal- ance sheet and an additional liability for unpaid income taxes. Amounts for all asset, liability, and equity accounts can be found either in the budgets, in other calculations, or by adding amounts found there to the beginning balances.

SOLUTION 1.

10,000 500

10,500

10,500 525

11,025

11,025 551

11,576

11,576 579

12,155

Prior period’s unit sales Plus 5% growth* Projected unit sales

*Rounded to nearest whole unit.

1 2 3 4

A B C D E JuneMayAprilCalculation of Unit Sales July

10,500 × $ 25

$262,500

11,025 × $ 25

$275,625

11,576 × $ 25

$289,400

$827,525

Projected unit sales Selling price per unit Projected sales

1 2 3 4

A B C D E JuneMayAprilSales Budget Quarter

3.

$262,500 × 12.5

32,813 3,500

$ 36,313

% Budgeted sales (part 1) Commission % Sales commissions* Manager’s salary Budgeted selling expenses*

1 2 3 4 5 6

A B C D E JuneMayAprilSelling Expense Budget Quarter

$275,625 × 12.5

34,453 4,000

$ 38,453

% $289,400 × 12.5

36,175 4,000

$ 40,175

% $827,525 × 12.5 103,441 11,500

$ 114,941

%

*Rounded to the nearest dollar.

2.

11,025 × 80

8,820 10,500 19,320 8,400

10,920 × $ 15

$163,800

%

$516,375

Next period’s unit sales (part 1) Ending inventory percent Desired ending inventory (units) Add: Current period’s unit sales (part 1) Units to be available Less: Beginning inventory (units) Units to be purchased Budgeted cost per unit Budgeted purchases

1 2 3 4 5 6 7 8 9 10

A B C D E MayAprilPurchases Budget Quarter 11,576

× 80 9,261

11,025 20,286

8,820 11,466

× $ 15 $171,990

%

June 12,155

× 80 9,724 11,576

21,300 9,261

12,039 × $ 15

$180,585

%

4.

$ 8,000 5,000 1,800

$14,800

Administrative salaries Depreciation Interest on long-term note payable (0.9% × $200,000) Budgeted expenses

1 2 3 4 5

A B C D E JuneMayAprilGeneral and Administrative Expense Budget Quarter

$ 8,000 5,000 1,800

$14,800

$ 8,000 5,000 1,800

$14,800

$24,000 15,000 5,400

$44,400

5.

$262,500 $ 183,750

$ 78,750

175,000 $ 253,750

*

$275,625 $ 192,938

$ 82,687

183,750 $266,437

$289,400 $202,580

$ 86,820

192,938 $ 279,758

$248,257

551,688 $799,945

Budgeted sales (part 1) Ending accounts receivable (70% of sales) Cash receipts Cash sales (30% of budgeted sales) Collections of prior month’s receivables Total cash to be collected

1 2 3 4 5 6 7

1 2 3 4 5 6 7

AA BB CC DD EE JuneMayAprilSchedule of Cash Receipts from Sales Quarter

*March 31 Accounts Receivable balance (from balance sheet).

6.

$156,000*

$163,800

$171,990

$180,585

$491,790

Cash payments (equal to prior month’s purchases) Expected June 30 balance of accounts payable (part 2, June purchases)

1 2 3 4 5

A B C D E JuneMayAprilSchedule of Cash Payments to Suppliers Quarter

*March 31 Accounts Payable balance (from balance sheet).

794 Chapter 20 Master Budgets and Performance Planning

7.

Beginning cash balance Add: Cash receipts (part 5) Total cash available Less: Cash payments for Merchandise (part 6) Sales commissions (part 3) Salaries Sales (part 3) Administrative (part 4) Interest on long-term note (part 4) Dividends Equipment purchase Interest on short-term notes April ($12,000 × 1%) June ($6,099 × 1%) Total cash payments Preliminary balance Loan activity Additional loan Loan repayment Ending cash balance Ending short-term notes payable balance

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

A B C D

JuneMayAprilCash Budget $ 89,517

266,437 355,954

163,800 34,453

4,000 8,000 1,800

100,000

312,053 43,901

6,099

$ 50,000 $ 6,099

$ 50,000 279,758 329,758

171,990 36,175

4,000 8,000 1,800

55,000

61

277,026 52,732

$ 50,000 $ 3,367

(2,732)

$ 50,000 253,750 303,750

156,000 32,813

3,500 8,000 1,800

120

202,233 101,517

$ 89,517 $ 0

(12,000)

8. WILD WOOD COMPANY

Budgeted Income Statement For Quarter Ended June 30, 2019

Sales (part 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $827,525 Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496,515 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331,010 Operating expenses Sales commissions (part 3) . . . . . . . . . . . . . . . . . . . . $103,441 Sales salaries (part 3) . . . . . . . . . . . . . . . . . . . . . . . . 11,500 Administrative salaries (part 4) . . . . . . . . . . . . . . . . . 24,000 Depreciation (part 4) . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Interest on long-term note (part 4) . . . . . . . . . . . . . . 5,400 Interest on short-term note (part 7) . . . . . . . . . . . . . 181 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . 159,522 Income before income taxes . . . . . . . . . . . . . . . . . . . . . 171,488 Income taxes (35%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,021 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $111,467

*33,101 units sold @ $15 per unit.

WILD WOOD COMPANY Budgeted Statement of Retained Earnings

For Quarter Ended June 30, 2019

Beginning retained earnings (Mar . 31 bal .) . . . . . . . $138,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,467 249,467 Less: Cash dividends (part 7) . . . . . . . . . . . . . . . . . . 100,000 Ending retained earnings . . . . . . . . . . . . . . . . . . . . . $149,467

WILD WOOD COMPANY Budgeted Balance Sheet

June 30, 2019

Assets Cash (part 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 Accounts receivable (part 5) . . . . . . . . . . . . . . . . . 202,580 Inventory (9,724 units @ $15 each) . . . . . . . . . . . 145,860 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . $398,440

Equipment (Mar . 31 bal . plus purchase) . . . . . . . . 535,000 Less: Accumulated depreciation (Mar . 31 bal . plus depreciation expense) . . . . . 105,000 430,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $828,440

Liabilities and Equity Accounts payable (part 6) . . . . . . . . . . . . . . . . $180,585 Short-term notes payable (part 7) . . . . . . . . . . 3,367 Income taxes payable . . . . . . . . . . . . . . . . . . . 60,021 Total current liabilities . . . . . . . . . . . . . . . . . . . $243,973 Long-term note payable (Mar . 31 bal .) . . . . . . 200,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 443,973 Common stock (Mar . 31 bal .) . . . . . . . . . . . . . 235,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . 149,467 Total stockholders’ equity . . . . . . . . . . . . . . . . 384,467 Total liabilities and equity . . . . . . . . . . . . . . . . $828,440

Chapter 20 Master Budgets and Performance Planning 795

Preparing the Merchandise Purchases Budget A merchandiser usually expresses a merchandise purchases budget in both units and dollars. Exhibit 20A.2 shows the general layout for this budget in equation form. If this formula is expressed in units and only one product is involved, we can compute the number of dollars of inventory to be purchased for the budget by multiplying the units to be purchased by the cost per unit.

APPENDIX

Merchandise Purchases Budget 20A Exhibit 20A.1 shows the master budget sequence for a merchandiser. Unlike a manufacturing company, a merchandiser must prepare a merchandise purchases budget rather than a production budget. In addition, a merchandiser does not prepare direct materials, direct labor, or factory overhead budgets. In this appen- dix we show the merchandise purchases budget for Hockey Den (HD), a retailer of hockey sticks.

EXHIBIT 20A.3 Merchandise Purchases Budget

Sales

Purchases

Capital expenditures Cash

Budgeted financial statements

Selling expenses General & admin expenses

Operating budgets

Investing budgets

Financing budgets

EXHIBIT 20A.1 Master Budget Sequence—Merchandiser

Budgeted ending merchandise

inventory + Budgeted salesfor the period – Budgeted beginning

merchandise inventory

Merchandise inventory to be

purchased = EXHIBIT 20A.2 General Formula for Merchandise Purchases Budget

P4 Prepare each component of a master budget—for a merchandising company.

A merchandise purchases budget requires the following inputs.

1 Sales budget (in units). 2 Budgeted ending inventory (in units). 3 Cost per unit.

1 Toronto Sticks Company is an exclusive supplier of hockey sticks to HD, meaning that the com- panies use the same budgeted sales figures in preparing budgets. Thus, HD predicts unit sales as follows: October, 1,000; November, 800; December, 1,400; and January, 900. 2 After considering the costs of keeping inventory and inventory shortages, HD set a policy that end- ing inventory (in units) should equal 90% of next month’s predicted sales. For example, inventory at the end of October should equal 90% of November’s budgeted sales. 3 Finally, HD expects the per unit purchase cost of $60 to remain unchanged through the budgeting period. This information, along with knowledge of 1,010 units in inventory at September 30 (given), allows the company to prepare the merchandise purchases budget shown in Exhibit 20A.3.

Next month’s budgeted sales (units) Ratio of inventory to future sales Budgeted ending inventory (units) Add: Budgeted sales (units) Required units of available merchandise Deduct: Beginning inventory (units) Total units to be purchased

Budgeted cost per unit Budgeted cost of merchandise purchases

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

A B C D

HOCKEY DEN Merchandise Purchases Budget October 2019–December 2019

NovemberOctober December 800

× 90 720

1,000 1,720 1,010

710

$ 60 $42,600

*

% % 1,400

× 90 1,260

800 2,060

720 1,340

$ 60 $80,400

% 900

× 90 810

1,400 2,210 1,260

950

$ 60 $57,000

*Does not comply with company policy.

1

2

3

Units to Purchase

Budgeted ending inventory + Budgeted sales – Beginning inventory

= Units to be purchased

796 Chapter 20 Master Budgets and Performance Planning

The first three lines of HD’s merchandise purchases budget determine the required ending inventories (in units). Budgeted unit sales are then added to the desired ending inventory to give the required units of available merchandise. We then subtract beginning inventory to determine the budgeted number of units to be purchased. The last line is the budgeted cost of the purchases, computed by multiplying the number of units to be purchased by the predicted cost per unit.

Other Master Budget Differences—Merchandiser vs. Manufacturer In addition to preparing a purchases budget instead of production, direct materials, direct labor, and overhead budgets, other key differences in master budgets for merchandisers include:

Depreciation expense is included in the general and administrative expense budget of the merchan- diser. For the manufacturer, depreciation on manufacturing assets is included in the factory overhead budget and treated as a product cost.

The budgeted balance sheet for the merchandiser will report only one asset for inventory. The balance sheet for the manufacturer will typically report three inventory assets: raw materials, work in process, and finished goods.

See Need-to-Know 20-7 for illustration of a complete master budget, including budgeted financial state- ments, for a merchandising company.

In preparing monthly budgets for the third quarter, a company budgeted sales of 120 units for July and 140 units for August. Management wants each month’s ending inventory to be 60% of next month’s sales. The June 30 inventory consists of 72 units. How many units should be purchased in July?

Solution P4

Merchandise Purchases Budget

NEED-TO-KNOW 20-8

Do More: QS 20-28, QS 20-29, QS 20-30, E 20-24

Merchandise Purchases Budget July

Next month’s budgeted sales (units) . . . . . . . . . . . . . . . . 140 Ratio of inventory to future sales . . . . . . . . . . . . . . . . . . . × 60% Budgeted ending inventory (units) . . . . . . . . . . . . . . . . . . 84 Add: Budgeted sales (units) . . . . . . . . . . . . . . . . . . . . . . . +120 Required units of available merchandise . . . . . . . . . . . . 204 Deduct: Beginning inventory (units) . . . . . . . . . . . . . . . . – 72 Units to be purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

BUDGET PROCESS Budget: Statement of plans, in monetary terms.

PRODUCTION BUDGET

BUDGETING BENEFITS Plan, control, coordinate, communicate, and motivate.

Summary: Cheat Sheet

OPTEL Fixed Budget Performance Report

Fixed Actual Budget Results Variances*

Sales (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 12,000

Sales (in dollars) . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $125,000 $25,000 F

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 10,000 13,000 3,000 U

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 20,000 5,000 U

Overhead

Factory supplies . . . . . . . . . . . . . . . . . . . . . . 2,000 2,100 100 U

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000 1,000 U

Depreciation— machinery . . . . . . . . . . . . . . 8,000 8,000 0

Supervisory salaries . . . . . . . . . . . . . . . . . . . 11,000 11,000 0

Selling expenses

Sales commissions . . . . . . . . . . . . . . . . . . . . . . 9,000 10,800 1,800 U

Shipping expenses . . . . . . . . . . . . . . . . . . . . . . 4,000 4,300 300 U

General and administrative expenses

O�ce supplies . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,200 200 U

Insurance expenses . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U

Depreciation— o�ce equipment. . . . . . . . . . . 7,000 7,000 0

Administrative salaries . . . . . . . . . . . . . . . . . . . 13,000 13,000 0

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 99,600 11,600 U

Income from operations . . . . . . . . . . . . . . . . . . . $ 12,000 $ 25,400 $13,400 F

* F = Favorable variance; U 5 Unfavorable variance.

MASTER BUDGET COMPONENTS Sales

Production

Direct laborDirect materials Factory overhead

Capital expenditures Selling expenses General & admin expensesCash

Budgeted financial statements

Operating budgets

Investing budgets

Financing budgets

Budgeted sales $ = Budgeted sales in units × Selling price per unit

Budgeted ending inventory units

Budgeted sales units+ Beginning finishedgoods inventoryunits–Units toproduce = Required units for the period

Next month’s budgeted sales (units) from sales budget . . . . . . . . . . 800 Ratio of inventory to future sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . × 90% Budgeted ending inventory (units) . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 Add: Budgeted sales (units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Required units of available production . . . . . . . . . . . . . . . . . . . . . . . 1,720 Deduct: Beginning inventory (units) . . . . . . . . . . . . . . . . . . . . . . . . . (1,010) Units to be produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710

Budgeted production units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710 Materials requirements per unit . . . . . . . . . . . . . . . . . . . . . . . . . . × 0 .5 Materials needed for production (pounds) . . . . . . . . . . . . . . . . . . 355 Add: Budgeted ending inventory (pounds) . . . . . . . . . . . . . . . . . 335 Total materials requirements (pounds) . . . . . . . . . . . . . . . . . . . . . 690 Deduct: Beginning inventory (pounds) . . . . . . . . . . . . . . . . . . . . (178) Materials to be purchased (pounds) . . . . . . . . . . . . . . . . . . . . . . . 512

Material price per pound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20 Total cost of direct materials purchases . . . . . . . . . . . . . . . . . . . . $10,240

DIRECT MATERIALS BUDGET Budgeted production

(units)

Materials required for each

unit (pounds)× Budgeted ending

materials inventory (pounds)+

Beginning materials

inventory (pounds)– Materials to be

purchased (pounds) =

Chapter 20 Master Budgets and Performance Planning 797

DIRECT LABOR BUDGET

OVERHEAD BUDGET

Budgeted production

(units)

Direct labor required per unit (hours)× Direct labor costper hour (dollars)×Budgeted directlabor cost(dollars) =

Budgeted production (units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710 Direct labor requirements per unit (hours) . . . . . . . . . . . . . . . . . . . . × 0 .25 Total direct labor hours needed . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 .5

Direct labor rate (per hour) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12 Total cost of direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,130

Budgeted production (units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710 Variable factory overhead rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . × $ 2 .50 Budgeted variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,775 Budgeted fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500 Budgeted total overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,275

CASH BUDGET

Budgeted cash

receipts

Budgeted cash

payments

Preliminary cash

balance

Repay loans, buy securities

Loan Activity

Adequate

Too low

Increase short-term

loans

Beginning cash

balance + – =

Activity-based budgeting (ABB) (781) Budget (771) Budgetary control (771) Budgeted balance sheet (786) Budgeted income statement (785) Budgeting (771) Capital expenditures budget (781) Cash budget (781)

Continuous budgeting (773) Cost of goods sold budget (779) Direct labor budget (777) Direct materials budget (776) Factory overhead budget (778) General and administrative expense

budget (780) Master budget (773)

Merchandise purchases budget (795) Production budget (775) Rolling budget (773) Safety stock (775) Sales budget (775) Selling expense budget (779) Zero-based budgeting (773)

Key Terms

Multiple Choice Quiz

1. A plan that reports the units of merchandise to be produced by a manufacturing company during the budget period is called a a. Capital expenditures budget. b. Cash budget. c. Production budget. d. Manufacturing budget. e. Sales budget.

2.A A hardware store has budgeted sales of $36,000 for its power tool department in July. Management wants to have $7,000 in power tool inventory at the end of July. Its beginning in- ventory of power tools is expected to be $6,000. What is the budgeted dollar amount of merchandise purchases? a. $36,000 c. $42,000 e. $37,000 b. $43,000 d. $35,000

3. A store has the following budgeted sales for the next three months.

Cash sales are 25% of total sales and all credit sales are ex- pected to be collected in the month following the sale. The total amount of cash expected to be received from custom- ers in September is a. $240,000. c. $60,000. e. $220,000. b. $225,000. d. $165,000.

July August September

Budgeted sales . . . . . . . . . $180,000 $220,000 $240,000

MERCHANDISE PURCHASES BUDGET Budgeted ending

merchandise inventory + Budgeted salesfor the period –

Budgeted beginning merchandise

inventory

Merchandise inventory to be

purchased =

$20,000 49,200 69,200

$ 7,060 2,130 1,775

12,500 20,000

0 100

0 43,565

$25,635

(5,635 $20,000

Beginning cash balance Add: Cash receipts from customers Total cash available Less: Cash payments for Direct materials Direct labor Overhead Selling and general admin. expenses Income taxes payable Dividends Interest on bank loan Purchase of equipment Total cash payments Preliminary cash balance Loan activity Additional loan or repayment of loan Ending cash balance

Cash Budget

)

798 Chapter 20 Master Budgets and Performance Planning

A Superscript letter A denotes assignments based on Appendix 20A, which relates to budgets for merchandising companies.

Icon denotes assignments that involve decision making.

1. Identify at least three benefits of budgeting in helping managers plan and control a business.

2. How does a budget benefit management in its control function? 3. What is the benefit of continuous budgeting? 4. Identify three usual time horizons for short-term planning

and budgets. 5. Why should each department participate in preparing

its own budget? 6. How does budgeting help management coordinate and

plan business activities? 7. Why is the sales budget so important to the budgeting

process? 8. What is a selling expense budget? What is a capital expen-

ditures budget? 9. Identify at least two potential negative outcomes of budgeting. 10. Google prepares a cash budget. What is a

cash budget? Why must operating budgets and the capital expenditures budget be prepared before the cash budget?

11. Apple regularly uses budgets. What is the dif- ference between a production budget and a manufacturing budget?

12. Would a manager of an Apple retail store participate more in budgeting than a manager at the corporate offices? Explain.

13. Does the manager of a Samsung dis- tribution center participate in long-term budgeting? Explain.

14. Assume that Samsung’s consumer electronics division is charged with pre- paring a master budget. Identify the participants—for ex- ample, the sales manager for the sales budget—and describe the information each person provides in preparing the mas- ter budget.

15. Coca-Cola recently redesigned its bottle to reduce its use of glass, thus lowering its bottle’s weight and CO2 emis- sions. Which budgets in the company’s master budget will this redesign impact?

16. Activity-based budgeting is a budget system based on ex- pected activities. Describe activity-based budgeting, and explain its preparation of budgets. How does activity-based budgeting differ from traditional budgeting?

Discussion Questions

GOOGLE

APPLE

APPLE

Samsung

Samsung

4. A plan that shows the expected cash inflows and cash out- flows during the budget period, including receipts from loans needed to maintain a minimum cash balance and re- payments of such loans, is called a. A rolling budget. d. A cash budget. b. An income statement. e. An operating budget. c. A balance sheet.

5. The following sales are predicted for a company’s next four months.

Each month’s ending inventory of finished goods should be 30% of the next month’s sales. The budgeted production of units for May is a. 572 units. c. 548 units. e. 180 units. b. 560 units. d. 600 units.

April May June July

Unit sales . . . . . . . . . . . . 480 560 600 480

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c 2. e; Budgeted purchases = $36,000 + $7,000 – $6,000 = $37,000 3. b; Cash collected = 25% of September sales + 75% of August

sales = (0.25 × $240,000) + (0.75 × $220,000) = $225,000

4. d 5. a; 560 units + (0.30 × 600 units) – (0.30 × 560 units) = 572 units

QUICK STUDY

QS 20-1 Budget motivation

C1

For each of the following items 1 through 5, indicate yes if the item is an important budgeting guideline or no if it is not.

1. Employees should have the opportunity to explain differences from budgeted amounts. 2. Budgets should include budgetary slack. 3. Employees impacted by a budget should be consulted when it is prepared. 4. Goals in a budget should be set low so targets can be reached. 5. Budgetary goals should be attainable.

Chapter 20 Master Budgets and Performance Planning 799

For each of the following items 1 through 6, indicate yes if it describes a potential benefit of budgeting or no if it describes a potential negative outcome of budgeting.

1. Budgets help coordinate activities across departments. 2. Budgets are useful in assigning blame for unexpected results. 3. A budget forces managers to spend time planning for the future. 4. Some employees might overstate expenses in budgets. 5. Budgets can lead to excessive pressure to meet budgeted results. 6. Budgets can provide incentives for good performance.

QS 20-2 Budgeting benefits

C1

Zahn Co. predicts sales of 220 units in May and 240 units in June. Each month’s ending inventory should be 25% of the next month’s sales. The April 30 ending finished goods inventory is 55 units. Compute budgeted production (in units) for May.

QS 20-3 Production budget P1

Grace manufactures and sells miniature digital cameras for $250 each. 1,000 units were sold in May, and management forecasts 4% growth in unit sales each month. Determine (a) the number of units of camera sales and (b) the dollar amount of camera sales for the month of June.

QS 20-4 Sales budget P1

Liza’s predicts sales of $40,000 for May and $52,000 for June. Assume 60% of Liza’s sales are for cash. The remaining 40% are credit sales; credit customers pay in the month following the sale. Compute the budgeted cash receipts for June.

QS 20-6 Cash budget P2

Zilly Co. predicts sales of $400,000 for June. Zilly pays a sales manager a monthly salary of $6,000 and a commission of 8% of that month’s sales dollars. Prepare a selling expense budget for the month of June.

QS 20-5 Selling expense budget P1

Zortek Corp. budgets production of 400 units in January and 200 units in February. Each finished unit requires five pounds of raw material Z, which costs $2 per pound. Each month’s ending inventory of raw materials should be 40% of the following month’s budgeted production. The January 1 raw materials in- ventory has 130 pounds of Z. Prepare a direct materials budget for January.

QS 20-7 Manufacturing: Direct materials budget P1

Tora Co. plans to produce 1,020 units in July. Each unit requires two hours of direct labor. The direct labor rate is $20 per hour. Prepare a direct labor budget for July.

QS 20-8 Manufacturing: Direct labor budget P1

Scora, Inc., is preparing its master budget for the quarter ending March 31. It sells a single product for $50 per unit. Budgeted sales for the next three months follow. Prepare a sales budget for the months of January, February, and March.

QS 20-9 Sales budget

P1

January February March

Sales in units . . . . . . . . . . 1,200 2,000 1,600

X-Tel budgets sales of $60,000 for April, $100,000 for May, and $80,000 for June. In addition, sales are 40% cash and 60% on credit. All credit sales are collected in the month following the sale. The April 1 balance in accounts receivable is $15,000. Prepare a schedule of budgeted cash receipts for April, May, and June.

QS 20-10 Cash receipts budget P2

X-Tel budgets sales of $60,000 for April, $100,000 for May, and $80,000 for June. In addition, sales com- missions are 10% of sales dollars and the company pays a sales manager a salary of $6,000 per month. Sales commissions and salaries are paid in the month incurred. Prepare a selling expense budget for April, May, and June.

QS 20-11 Selling expense budget

P1

May June

Sales in units . . . . . . . . . . . . . . . . . . . . . . . 180 200

Champ, Inc., predicts the following sales in units for the coming two months. Each month’s ending inven- tory of finished units should be 60% of the next month’s sales. The April 30 finished goods inventory is 108 units. Compute budgeted production (in units) for May.

QS 20-12 Manufacturing: Production budget

P1

800 Chapter 20 Master Budgets and Performance Planning

QS 20-13 Manufacturing: Direct materials budget

P1

Miami Solar manufactures solar panels for industrial use. The company budgets production of 5,000 units (solar panels) in July and 5,300 units in August. Each unit requires 3 pounds of direct materials, which cost $6 per pound. The company’s policy is to maintain direct materials inventory equal to 30% of the next month’s direct materials requirement. As of June 30, the company has 4,500 pounds of direct materials in inventory, which complies with the policy. Prepare a direct materials budget for July.

QS 20-14 Manufacturing: Direct labor budget P1

Miami Solar budgets production of 5,000 solar panels in July. Each unit requires 4 hours of direct labor at a rate of $16 per hour. Prepare a direct labor budget for July.

QS 20-15 Manufacturing: Factory overhead budget P1

Miami Solar budgets production of 5,300 solar panels for August. Each unit requires 4 hours of direct la- bor at a rate of $16 per hour. Variable factory overhead is budgeted to be 70% of direct labor cost, and fixed factory overhead is $180,000 per month. Prepare a factory overhead budget for August.

QS 20-16 Manufacturing: Production budget

P1

Atlantic Surf manufactures surfboards. The company’s sales budget for the next three months is shown below. In addition, company policy is to maintain finished goods inventory equal (in units) to 40% of the next month’s unit sales. As of June 30, the company has 1,600 finished surfboards in inventory, which complies with the policy. Prepare a production budget for the months of July and August.

July August September

Sales in units . . . . . . . . . . . 4,000 6,500 3,500

QS 20-17 Manufacturing: Production budget

P1

Forrest Company manufactures phone chargers and has a JIT policy that ending inventory should equal 10% of the next month’s estimated unit sales. It estimates that October’s actual ending inventory will con- sist of 40,000 units. November and December sales are estimated to be 400,000 and 350,000 units, respec- tively. Compute the number of units to be produced in November.

QS 20-18 Manufacturing: Factory overhead budget P1

Hockey Pro budgets production of 3,900 hockey pucks during May. The company assigns variable over- head at the rate of $1.50 per unit. Fixed overhead equals $46,000 per month. Prepare a factory overhead budget for May.

QS 20-19 Cash receipts P2

Music World reports the following sales forecast: August, $150,000; and September, $170,000. Cash sales are normally 40% of total sales and all credit sales are expected to be collected in the month following the date of sale. Prepare a schedule of cash receipts for September.

QS 20-20 Cash receipts, with uncollectible accounts

P2

The Guitar Shoppe reports the following sales forecast: August, $150,000; and September, $170,000. Cash sales are normally 40% of total sales, 55% of credit sales are collected in the month following sale, and the remaining 5% of credit sales are written off as uncollectible. Prepare a schedule of cash receipts for September.

QS 20-21 Cash receipts, with uncollectible accounts P2

Wells Company reports the following sales forecast: September, $55,000; October, $66,000; and November, $80,000. All sales are on account. Collections of credit sales are received as follows: 25% in the month of sale, 60% in the first month after sale, and 10% in the second month after sale. 5% of all credit sales are written off as uncollectible. Prepare a schedule of cash receipts for November.

QS 20-22 Computing budgeted accounts receivable

P2

Kingston anticipates total sales for June and July of $420,000 and $398,000, respectively. Cash sales are normally 60% of total sales. Of the credit sales, 20% are collected in the same month as the sale, 70% are collected during the first month after the sale, and the remaining 10% are collected in the second month after the sale. Determine the amount of accounts receivable reported on the company’s budgeted balance sheet as of July 31.

Santos Co. is preparing a cash budget for February. The company has $20,000 cash at the beginning of February and anticipates $75,000 in cash receipts and $100,250 in cash payments during February. What amount, if any, must the company borrow during February to maintain a $5,000 cash balance? The com- pany has no loans outstanding on February 1.

QS 20-23 Budgeted loan activity

P2

Chapter 20 Master Budgets and Performance Planning 801

Following are selected accounts for a manufacturing company. For each account, indicate whether it will appear on a budgeted income statement (BIS) or a budgeted balance sheet (BBS). If an item will not ap- pear on either budgeted financial statement, label it NA.

QS 20-25 Budgeted financial statements

P3 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Office salaries expense . . . . . . . . . . . . . . .

Accumulated depreciation . . . . . . . . . . . . .

Amortization expense . . . . . . . . . . . . . . . . .

Interest expense on loan payable . . . . . . .

Cash dividends paid . . . . . . . . . . . . . . . . . .

Bank loan owed . . . . . . . . . . . . . . . . . . . . .

Cost of goods sold . . . . . . . . . . . . . . . . . . .

Torres Co. forecasts merchandise purchases of $15,800 in January, $18,600 in February, and $20,200 in March; 40% of purchases are paid in the month of purchase and 60% are paid in the following month. At December 31 of the prior year, the balance of accounts payable (for December purchases) is $22,000. Prepare a schedule of cash payments for merchandise for each of the months of January, February, and March.

QS 20-27A Merchandising: Cash payments for merchandise P4

Garda purchased $600,000 of merchandise in August and expects to purchase $720,000 in September. Merchandise purchases are paid as follows: 25% in the month of purchase and 75% in the following month. Compute cash payments for merchandise for September.

QS 20-26A Merchandising: Cash payments for merchandise P4

Raider-X Company forecasts sales of 18,000 units for April. Beginning inventory is 3,000 units. The de- sired ending inventory is 30% higher than the beginning inventory. How many units should Raider-X purchase in April?

QS 20-28A Merchandising: Computing purchases P4

Lexi Company forecasts unit sales of 1,040,000 in April, 1,220,000 in May, 980,000 in June, and 1,020,000 in July. Beginning inventory on April 1 is 280,000 units, and the company wants to have 30% of next month’s sales in inventory at the end of each month. Prepare a merchandise purchases budget for the months of April, May, and June.

QS 20-29A Merchandising: Computing purchases P4

Montel Company’s July sales budget calls for sales of $600,000. The store expects to begin July with $50,000 of inventory and to end the month with $40,000 of inventory. Gross margin is typically 40% of sales. Determine the budgeted cost of merchandise purchases for July.

QS 20-30A Merchandising: Purchases budget P4

Royal Philips Electronics of the Netherlands reports sales of €24.5 billion for a recent year. Assume that the company expects sales growth of 3% for the next year. Also assume that selling expenses are typically 20% of sales, while general and administrative expenses are 4% of sales. 1. Compute budgeted sales for the next year. 2. Assume budgeted sales for next year are €25 billion, and then compute budgeted selling expenses and

budgeted general and administrative expenses for the next year.

QS 20-31 Operating budgets

P1

EXERCISES

Exercise 20-1 Sustainability and selling expense budget P1

MM Co. predicts sales of $30,000 for May. MM Co. pays a sales manager a monthly salary of $3,000 plus a commission of 6% of sales dollars. MM’s production manager recently found a way to reduce the amount of packaging MM uses. As a result, MM’s product will receive better placement on store shelves and thus May sales are predicted to increase by 8%. In addition, MM’s shipping costs are predicted to decrease from 4% of sales to 3% of sales. Compute (1) budgeted sales and (2) budgeted selling expenses for May assuming MM switches to this more sustainable packaging.

Use the following information to prepare a cash budget for the month ended on March 31 for Gado Company. The budget should show expected cash receipts and cash payments for the month of March and the balance expected on March 31. a. Beginning cash balance on March 1, $72,000. b. Cash receipts from sales, $300,000. c. Budgeted cash payments for direct materials,

$140,000.

QS 20-24 Manufacturing: Cash budget

P2 d. Budgeted cash payments for direct labor, $80,000.

e. Other budgeted cash expenses, $45,000. f. Cash repayment of bank loan, $20,000.

802 Chapter 20 Master Budgets and Performance Planning

Match the definitions 1 through 8 with the term or phrase a through h. a. Budget e. Master budget b. Top-down budgeting f. Budgetary slack c. Participatory budgeting g. Sales budget d. Cash budget h. Budgeted income statement

1. Shows expected cash inflows and outflows and helps determine financing needs. 2. A plan showing units to be sold; the usual starting point in the master budget process. 3. A report that shows predicted revenues and expenses for a budgeting period. 4. A formal statement of future plans, usually expressed in monetary terms. 5. Approach in which top management passes down a budget without employee input. 6. A budgetary cushion used to meet performance targets. 7. A comprehensive business plan that includes operating, investing, and financing budgets. 8. Employees affected by a budget help in preparing it.

Exercise 20-2 Budget definitions

C1

Exercise 20-3 Manufacturing: Production budget

P1

Ruiz Co. provides the following sales forecast for the next four months.

April May June July

Sales (units) . . . . . . . . . . . 500 580 540 620

The company wants to end each month with ending finished goods inventory equal to 25% of next month’s forecasted sales. Finished goods inventory on April 1 is 190 units. Prepare a production budget for the months of April, May, and June.

The production budget for Manner Company shows units to be produced as follows: July, 620; August, 680; and September, 540. Each unit produced requires two hours of direct labor. The direct labor rate is currently $20 per hour but is predicted to be $21 per hour in September. Prepare a direct labor budget for the months July, August, and September.

Exercise 20-5 Manufacturing: Direct labor budget P1

Rida, Inc., a manufacturer in a seasonal industry, is preparing its direct materials budget for the second quarter. It plans production of 240,000 units in the second quarter and 52,500 units in the third quarter. Raw material inventory is 43,200 pounds at the beginning of the second quarter. Other information fol- lows. Prepare a direct materials budget for the second quarter.

Exercise 20-6 Manufacturing: Direct materials budget

P1

Direct materials . . . . . . . . . . . . . Each unit requires 0 .60 pounds of raw material, priced at $175 per pound . The company plans to end each quarter with an ending inventory of materials equal to 30% of next quarter’s budgeted materials requirements .

April May June July

Production (units) . . . . . . 455 570 560 540

Zira Co. reports the following production budget for the next four months.Exercise 20-4 Manufacturing: Direct materials budget

P1

Each finished unit requires five pounds of raw materials, and the company wants to end each month with raw materials inventory equal to 30% of next month’s production needs. Beginning raw materials inven- tory for April was 663 pounds. Assume direct materials cost $4 per pound. Prepare a direct materials budget for April, May, and June.

Addison Co. budgets production of 2,400 units during the second quarter. In addition, information on its direct labor and its variable and fixed overhead is shown below. For the second quarter, prepare (1) a di- rect labor budget and (2) a factory overhead budget.

Exercise 20-7 Manufacturing: Direct labor and factory overhead budgets

P1 Direct labor . . . Each finished unit requires 4 direct labor hours, at a cost of $20 per hour .

Variable overhead . . . Applied at the rate of $11 per direct labor hour .

Fixed overhead . . . . . Budgeted at $450,000 per quarter .

Chapter 20 Master Budgets and Performance Planning 803

Refer to Exercise 20-8. Prepare (1) a direct labor budget and (2) a factory overhead budget for April, May, and June.

Exercise 20-9 Manufacturing: Direct labor and factory overhead budgets P1

Blue Wave Co. predicts the following unit sales for the coming four months: September, 4,000 units; October, 5,000 units; November, 7,000 units; and December, 7,600 units. The company’s policy is to maintain finished goods inventory equal to 60% of the next month’s sales. At the end of August, the com- pany had 2,400 finished units on hand. Prepare a production budget for each of the months of September, October, and November.

Exercise 20-10 Manufacturing: Production budget P1

Tyler Co. predicts the following unit sales for the next four months: April, 3,000 units; May, 4,000 units; June, 6,000 units; and July, 2,000 units. The company’s policy is to maintain finished goods inventory equal to 30% of the next month’s sales. At the end of March, the company had 900 finished units on hand. Prepare a production budget for each of the months of April, May, and June.

Exercise 20-11 Manufacturing: Production budget

P1

Electro Company budgets production of 450,000 transmissions in the second quarter and 520,000 trans- missions in the third quarter. Each transmission requires 0.80 pounds of a key raw material. The company aims to end each quarter with an ending inventory of direct materials equal to 20% of next quarter’s bud- geted materials requirements. Beginning inventory of this raw material is 72,000 pounds. Direct materials cost $1.70 per pound. Prepare a direct materials budget for the second quarter.

Exercise 20-13 Manufacturing: Direct materials budget P1

Branson Belts makes handcrafted belts. The company budgets production of 4,500 belts during the second quarter. Each belt requires 4 direct labor hours, at a cost of $17 per hour. Prepare a direct labor budget for the second quarter.

Exercise 20-14 Manufacturing: Direct labor budget P1

Ramos Co. provides the following sales forecast and production budget for the next four months. Exercise 20-8 Manufacturing: Direct materials budget

P1 April May June July

Sales (units) . . . . . . . . . . . . . . . . . . . . . . . . . . 500 580 530 600 Budgeted production (units) . . . . . . . . . . . . 442 570 544 540

The company plans for finished goods inventory of 120 units at the end of June. In addition, each finished unit requires 5 pounds of direct materials, and the company wants to end each month with direct materials inventory equal to 30% of next month’s production needs. Beginning direct materials inventory for April was 663 pounds. Direct materials cost $2 per pound. Each finished unit requires 0.50 hours of direct labor at the rate of $16 per hour. The company budgets variable overhead at the rate of $20 per direct labor hour and budgets fixed overhead of $8,000 per month. Prepare a direct materials budget for April, May, and June.

Electro Company manufactures an innovative automobile transmission for electric cars. Management pre- dicts that ending finished goods inventory for the first quarter will be 90,000 units. The following unit sales of the transmissions are expected during the rest of the year: second quarter, 450,000 units; third quarter, 525,000 units; and fourth quarter, 475,000 units. Company policy calls for the ending finished goods inventory of a quarter to equal 20% of the next quarter’s budgeted sales. Prepare a production bud- get for both the second and third quarters that shows the number of transmissions to manufacture.

Exercise 20-12 Manufacturing: Preparing production budgets (for two periods) P1 Check Second-quarter production, 465,000 units

Exercise 20-15 Manufacturing: Direct materials, direct labor, and overhead budgets

P1

MCO Leather manufactures leather purses. Each purse requires 2 pounds of direct materials at a cost of $4 per pound and 0.8 direct labor hours at a rate of $16 per hour. Variable manufacturing overhead is charged at a rate of $2 per direct labor hour. Fixed manufacturing overhead is $10,000 per month. The company’s policy is to end each month with direct materials inventory equal to 40% of the next month’s materials requirement. At the end of August the company had 3,680 pounds of direct materials in inventory. The company’s production budget reports the following. Prepare budgets for September and October for (1) direct materials, (2) direct labor, and (3) factory overhead.

Production Budget September October November

Units to be produced . . . . . . . . . . . . . 4,600 6,200 5,800

804 Chapter 20 Master Budgets and Performance Planning

Exercise 20-16 Manufacturing: Direct materials, direct labor, and overhead budgets

P1

Ornamental Sculptures Mfg. manufactures garden sculptures. Each sculpture requires 8 pounds of direct materials at a cost of $3 per pound and 0.5 direct labor hours at a rate of $18 per hour. Variable manufac- turing overhead is charged at a rate of $3 per direct labor hour. Fixed manufacturing overhead is $4,000 per month. The company’s policy is to maintain direct materials inventory equal to 20% of the next month’s materials requirement. At the end of February the company had 5,280 pounds of direct materials in inventory. The company’s production budget reports the following. Prepare budgets for March and April for (1) direct materials, (2) direct labor, and (3) factory overhead.

Production Budget March April May

Units to be produced . . . . . . . . . . . . . 3,300 4,600 4,800

Exercise 20-18 Budgeted cash receipts

P2

Jasper Company has sales on account and for cash. Specifically, 70% of its sales are on account and 30% are for cash. Credit sales are collected in full in the month following the sale. The company forecasts sales of $525,000 for April, $535,000 for May, and $560,000 for June. The beginning balance of accounts re- ceivable is $400,000 on April 1. Prepare a schedule of budgeted cash receipts for April, May, and June.

Exercise 20-19 Budgeted cash payments

P2

Zisk Co. purchases raw materials on account. Budgeted purchase amounts are April, $80,000; May, $110,000; and June, $120,000. Payments are made as follows: 70% in the month of purchase and 30% in the month after purchase. The March 31 balance of accounts payable is $22,000. Prepare a schedule of budgeted cash payments for April, May, and June.

Exercise 20-17 Preparation of cash budgets (for three periods)

P2

Kayak Co. budgeted the following cash receipts (excluding cash receipts from loans received) and cash payments (excluding cash payments for loan principal and interest payments) for the first three months of next year.

Cash Receipts Cash Payments

January . . . . . . . . . . . $525,000 $475,000

February . . . . . . . . . . 400,000 350,000

March . . . . . . . . . . . . 450,000 525,000

According to a credit agreement with its bank, Kayak requires a minimum cash balance of $30,000 at each month-end. In return, the bank has agreed that the company can borrow up to $150,000 at a monthly inter- est rate of 1%, paid on the last day of each month. The interest is computed based on the beginning bal- ance of the loan for the month. The company repays loan principal with any cash in excess of $30,000 on the last day of each month. The company has a cash balance of $30,000 and a loan balance of $60,000 at January 1. Prepare monthly cash budgets for January, February, and March.

Karim Corp. requires a minimum $8,000 cash balance. Loans taken to meet this requirement cost 1% in- terest per month (paid monthly). Any excess cash is used to repay loans at month-end. The cash balance on July 1 is $8,400, and the company has no outstanding loans. Forecasted cash receipts (other than for loans received) and forecasted cash payments (other than for loan or interest payments) follow. Prepare a cash budget for July, August, and September. (Round interest payments to the nearest whole dollar.)

Exercise 20-20 Cash budget

P2

July August September

Cash receipts . . . . . . . . . . . . . . . . $20,000 $26,000 $40,000

Cash payments . . . . . . . . . . . . . . . 28,000 30,000 22,000

Exercise 20-21 Cash budget

P2

Foyert Corp. requires a minimum $30,000 cash balance. Loans taken to meet this requirement cost 1% interest per month (paid monthly). Any excess cash is used to repay loans at month-end. The cash balance on October 1 is $30,000, and the company has an outstanding loan of $10,000. Forecasted cash receipts (other than for loans received) and forecasted cash payments (other than for loan or interest payments) follow. Prepare a cash bud- get for October, November, and December. (Round interest payments to the nearest whole dollar.)

October November December

Cash receipts . . . . . . . . . . . . . . . . $110,000 $80,000 $100,000

Cash payments . . . . . . . . . . . . . . . 120,000 75,000 80,000

Chapter 20 Master Budgets and Performance Planning 805

Use the following information to prepare the September cash budget for PTO Co. The following informa- tion relates to expected cash receipts and cash payments for the month ended September 30.

Exercise 20-22 Manufacturing: Cash budget

P2

Mike’s Motors Corp. manufactures motors for dirt bikes. The company requires a minimum $30,000 cash balance at each month-end. If necessary, the company borrows to meet this requirement at a cost of 2% interest per month (paid at the end of each month). Any cash balance above $30,000 at month-end is used to repay loans. The cash balance on July 1 is $34,000, and the company has no outstanding loans at that time. Forecasted cash receipts and forecasted cash payments (other than for loan activity) are as follows. Prepare a cash budget for July, August, and September.

Exercise 20-23 Manufacturing: Cash budget

P2

Cash Cash Receipts Payments

July . . . . . . . . . . . . . . . . . . . . . . . . $ 85,000 $113,000

August . . . . . . . . . . . . . . . . . . . . . . 111,000 99,900

September . . . . . . . . . . . . . . . . . . 150,000 127,400

Exercise 20-24A Merchandising: Preparation of purchases budgets (for three periods)

P4

Walker Company prepares monthly budgets. The current budget plans for a September ending merchan- dise inventory of 30,000 units. Company policy is to end each month with merchandise inventory equal to 15% of budgeted sales for the following month. Budgeted sales and merchandise purchases for the next three months follow. The company budgets sales of 200,000 units in October. Prepare the merchandise purchases budgets for the months of July, August, and September.

Sales (Units) Purchases (Units)

July . . . . . . . . . . . . . . . . 180,000 200,250

August . . . . . . . . . . . . . . 315,000 308,250

September . . . . . . . . . . 270,000 259,500

Exercise 20-26A Merchandising: Preparing a budgeted income statement and balance sheet

P4

Use the information in Exercise 20-25 and the following additional information to prepare a budgeted in- come statement for the month of July and a budgeted balance sheet for July 31. a. Cost of goods sold is 55% of sales. b. Inventory at the end of June is $80,000 and at the end of July is $60,000. c. Salaries payable on June 30 are $50,000 and are expected to be $60,000 on July 31.

a. Beginning cash balance, September 1, $40,000. b. Budgeted cash receipts from sales in September,

$255,000. c. Raw materials are purchased on account.

Purchase amounts are August (actual), $80,000; and September (budgeted), $110,000. Payments for direct materials are made as follows: 65% in the month of purchase and 35% in the month following purchase.

d. Budgeted cash payments for direct labor in September, $40,000.

e. Budgeted depreciation expense for September, $4,000.

f. Other cash expenses budgeted for September, $60,000.

g. Accrued income taxes payable in September, $10,000.

h. Bank loan interest payable in September, $1,000.

Exercise 20-25A Merchandising: Preparing a cash budget

P4

Use the following information to prepare the July cash budget for Acco Co. It should show expected cash receipts and cash payments for the month and the cash balance expected on July 31. a. Beginning cash balance on July 1: $50,000. b. Cash receipts from sales: 30% is collected in the month of sale, 50% in the next month, and 20% in the

second month after sale (uncollectible accounts are negligible and can be ignored). Sales amounts are May (actual), $1,720,000; June (actual), $1,200,000; and July (budgeted), $1,400,000.

c. Payments on merchandise purchases: 60% in the month of purchase and 40% in the month following purchase. Purchases amounts are: June (actual), $700,000; and July (budgeted), $750,000.

d. Budgeted cash payments for salaries in July: $275,000. e. Budgeted depreciation expense for July: $36,000. f. Other cash expenses budgeted for July: $200,000. g. Accrued income taxes due in July: $80,000. h. Bank loan interest paid in July: $6,600.

Check Ending cash balance, $122,400

[continued on next page]

806 Chapter 20 Master Budgets and Performance Planning

d. The equipment account balance is $1,600,000 on July 31. On June 30, the accumulated depreciation on equipment is $280,000.

e. The $6,600 cash payment of interest represents the 1% monthly expense on a bank loan of $660,000. f. Income taxes payable on July 31 are $30,720, and the income tax rate is 30%. g. The only other balance sheet accounts are Common Stock, with a balance of $600,000 on June 30; and

Retained Earnings, with a balance of $964,000 on June 30.

Check Net income, $71,680; Total assets, $2,686,400

Exercise 20-27A Merchandising: Computing budgeted cash payments for purchases P4

Hardy Company’s cost of goods sold is consistently 60% of sales. The company plans ending merchandise inventory for each month equal to 20% of the next month’s budgeted cost of goods sold. All merchandise is purchased on credit, and 50% of the purchases made during a month is paid for in that month. Another 35% is paid for during the first month after purchase, and the remaining 15% is paid for during the second month after purchase. Expected sales are August (actual), $325,000; September (actual), $320,000; October (estimated), $250,000; and November (estimated), $310,000. Compute October’s expected cash payments for purchases.

Check Budgeted purchases: August, $194,400; October, $157,200

Exercise 20-28A Merchandising: Computing budgeted purchases and cost of goods sold

P4

Ahmed Company purchases all merchandise on credit. It recently budgeted the month-end accounts pay- able balances and merchandise inventory balances below. Cash payments on accounts payable during each month are expected to be May, $1,600,000; June, $1,490,000; July, $1,425,000; and August, $1,495,000. Use the available information to compute the budgeted amounts of (1) merchandise purchases for June, July, and August and (2) cost of goods sold for June, July, and August.

Accounts Payable Merchandise Inventory

May 31 . . . . . . . . . . . . $150,000 $250,000

June 30 . . . . . . . . . . . . 200,000 400,000

July 31 . . . . . . . . . . . . . 235,000 300,000

August 31 . . . . . . . . . . 195,000 330,000

Check June purchases, $1,540,000; June cost of goods sold, $1,390,000

Exercise 20-29A Merchandising: Computing budgeted accounts payable and purchases— sales forecast in dollars

P4

Big Sound, a merchandising company specializing in home computer speakers, budgets its monthly cost of goods sold to equal 70% of sales. Its inventory policy calls for ending inventory at the end of each month to equal 20% of the next month’s budgeted cost of goods sold. All purchases are on credit, and 25% of the pur- chases in a month is paid for in the same month. Another 60% is paid for during the first month after pur- chase, and the remaining 15% is paid for in the second month after purchase. The following sales budgets are set: July, $350,000; August, $290,000; September, $320,000; October, $275,000; and November, $265,000. Compute the following: (1) budgeted merchandise purchases for July, August, September, and October; (2) budgeted payments on accounts payable for September and October; and (3) budgeted ending balances of accounts payable for September and October. Hint: For part 1, refer to Exhibits 20A.2 and 20A.3 for guidance, but note that budgeted sales are in dollars for this assignment.

Check July purchases, $236,600; Sep. payments on accts. pay., $214,235

Hector Company reports the following sales and purchases data. Payments for purchases are made in the month after purchase. Selling expenses are 10% of sales, administrative expenses are 8% of sales, and both are paid in the month of sale. Rent expense of $7,400 is paid monthly. Depreciation expense is $2,300 per month. Prepare a schedule of budgeted cash payments for August and September.

Exercise 20-30A Merchandising: Budgeted cash payments

P4

July August September

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 $72,000 $66,000

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,400 19,200 21,600

Castor, Inc., is preparing its master budget for the quarter ended June 30. Budgeted sales and cash pay- ments for merchandise for the next three months follow.

Exercise 20-31A Merchandising: Cash budget

P4 Budgeted April May June Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000 $40,000 $24,000

Cash payments for merchandise . . . . . . . . . . . . . 20,200 16,800 17,200

Chapter 20 Master Budgets and Performance Planning 807

Sales are 50% cash and 50% on credit. All credit sales are collected in the month following the sale. The March 31 balance sheet includes balances of $12,000 in cash, $12,000 in accounts receivable, $11,000 in accounts payable, and a $2,000 balance in loans payable. A minimum cash balance of $12,000 is required. Loans are obtained at the end of any month when a cash shortage occurs. Interest is 1% per month based on the beginning- of-the-month loan balance and is paid at each month-end. If an excess balance of cash exists, loans are repaid at the end of the month. Operating expenses are paid in the month incurred and include sales commissions (10% of sales), shipping (2% of sales), office salaries ($5,000 per month), and rent ($3,000 per month). Prepare a cash budget for each of the months of April, May, and June (round all dollar amounts to the nearest whole dollar).

Budgeted July August September

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $64,000 $80,000 $48,000

Cash payments for merchandise . . . . . . . . . . . . . 40,400 33,600 34,400

Kelsey is preparing its master budget for the quarter ended September 30. Budgeted sales and cash pay- ments for merchandise for the next three months follow.

Exercise 20-32A Merchandising: Cash budget

P4

Sales are 20% cash and 80% on credit. All credit sales are collected in the month following the sale. The June 30 balance sheet includes balances of $15,000 in cash; $45,000 in accounts receivable; $4,500 in accounts payable; and a $5,000 balance in loans payable. A minimum cash balance of $15,000 is required. Loans are obtained at the end of any month when a cash shortage occurs. Interest is 1% per month based on the beginning-of-the-month loan balance and is paid at each month-end. If an excess balance of cash exists, loans are repaid at the end of the month. Operating expenses are paid in the month incurred and consist of sales commissions (10% of sales), office salaries ($4,000 per month), and rent ($6,500 per month). (1) Prepare a cash receipts budget for July, August, and September. (2) Prepare a cash budget for each of the months of July, August, and September. (Round all dollar amounts to the nearest whole dollar.)

The following information is available for Zetrov Company. a. The cash budget for March shows an ending bank loan of $10,000 and an ending cash balance of $50,000. b. The sales budget for March indicates sales of $140,000. Accounts receivable are expected to be 70%

of the current-month sales. c. The merchandise purchases budget indicates that $89,000 in merchandise will be purchased on ac-

count in March. Purchases on account are paid 100% in the month following the purchase. Ending in- ventory for March is predicted to be 600 units at a cost of $35 each.

d. The budgeted income statement for March shows net income of $48,000. Depreciation expense of $1,000 and $26,000 in income tax expense were used in computing net income for March. Accrued taxes will be paid in April.

e. The balance sheet for February shows equipment of $84,000 with accumulated depreciation of $46,000, common stock of $25,000, and ending retained earnings of $8,000. There are no changes budgeted in the Equipment or Common Stock accounts.

Prepare a budgeted balance sheet at the end of March.

Exercise 20-33A Merchandising: Budgeted balance sheet

P3

Exercise 20-34 Budgeted income statement

P3

Fortune, Inc., is preparing its master budget for the first quarter. The company sells a single product at a price of $25 per unit. Sales (in units) are forecasted at 45,000 for January, 55,000 for February, and 50,000 for March. Cost of goods sold is $14 per unit. Other expense information for the first quarter follows. Prepare a budgeted income statement for this first quarter. (Round expense amounts to the nearest dollar.)

Commissions . . . . . . . . 8% of sales dollars Advertising . . . . . . . . . . 15% of sales dollars Interest . . . . . . . . . . . . . 5% annually on a $250,000 note payable Tax rate . . . . . . . . . . . . . 30%

Rent . . . . . . . . . . . . . . . . $14,000 per month Office salaries . . . . . . . . $75,000 per month Depreciation . . . . . . . . . . $40,000 per month

Exercise 20-35 Activity-based budgeting

A1

Render Co. CPA is preparing activity-based budgets for 2019. The partners expect the firm to generate billable hours for the year as follows.

Data entry . . . . . . . . . . . 2,200 hours Auditing . . . . . . . . . . . . . 4,800 hours

Tax . . . . . . . . . . . . . . . . . 4,300 hours Consulting . . . . . . . . . . 750 hours

The company pays $15 per hour to data-entry clerks, $30 per hour to audit personnel, $40 per hour to tax personnel, and $50 per hour to consulting personnel. Prepare a schedule of budgeted labor costs for 2019 using activity-based budgeting.

808 Chapter 20 Master Budgets and Performance Planning

PROBLEM SET A

Problem 20-1A Manufacturing: Preparing production and manufacturing budgets

P1

Black Diamond Company produces snow skis. Each ski requires 2 pounds of carbon fiber. The company’s management predicts that 5,000 skis and 6,000 pounds of carbon fiber will be in inventory on June 30 of the current year and that 150,000 skis will be sold during the next (third) quarter. A set of two skis sells for $300. Management wants to end the third quarter with 3,500 skis and 4,000 pounds of carbon fiber in inventory. Carbon fiber can be purchased for $15 per pound. Each ski requires 0.5 hours of direct labor at $20 per hour. Variable overhead is applied at the rate of $8 per direct labor hour. The company budgets fixed overhead of $1,782,000 for the quarter.

Required

1. Prepare the third-quarter production budget for skis. 2. Prepare the third-quarter direct materials (carbon fiber) budget; include the dollar cost of purchases. 3. Prepare the direct labor budget for the third quarter. 4. Prepare the factory overhead budget for the third quarter.

Check (1) Units manuf., 148,500

Problem 20-2A Manufacturing: Cash budget

P2

Built-Tight is preparing its master budget for the quarter ended September 30. Budgeted sales and cash payments for product costs for the quarter follow.

$64,000

16,160 4,040

20,200

$80,000

13,440 3,360

16,800

$48,000

13,760 3,440

17,200

Budgeted sales Budgeted cash payments for Direct materials Direct labor Factory overhead

1 2 3 4 5 6

A B C D SeptemberAugustJuly

Sales are 20% cash and 80% on credit. All credit sales are collected in the month following the sale. The June 30 balance sheet includes balances of $15,000 in cash; $45,000 in accounts receivable; $4,500 in accounts payable; and a $5,000 balance in loans payable. A minimum cash balance of $15,000 is required. Loans are obtained at the end of any month when a cash shortage occurs. Interest is 1% per month based on the beginning-of-the-month loan balance and is paid at each month-end. If an excess balance of cash exists, loans are repaid at the end of the month. Operating expenses are paid in the month incurred and consist of sales commissions (10% of sales), office salaries ($4,000 per month), and rent ($6,500 per month). 1. Prepare a cash receipts budget for July, August, and September. 2. Prepare a cash budget for each of the months of July, August, and September. (Round amounts to the

dollar.)

MERLINE MANUFACTURING Income Statement

For Month Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,250,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125,000

Operating expenses

Sales commissions (10%) . . . . . . . . . . . . . . . . . . . . . 225,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Store rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . 45,000

Depreciation—Office equipment . . . . . . . . . . . . . . . 50,000

Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 515,000

Merline Manufacturing makes its product for $75 per unit and sells it for $150 per unit. The sales staff receives a 10% commission on the sale of each unit. Its December income statement follows.

Problem 20-3A Manufacturing: Preparation and analysis of budgeted income statements

P3

Management expects December’s results to be repeated in January, February, and March of 2020 without any changes in strategy. Management, however, has an alternative plan. It believes that unit sales will increase at a rate of 10% each month for the next three months (beginning with January) if the item’s

Chapter 20 Master Budgets and Performance Planning 809

selling price is reduced to $125 per unit and advertising expenses are increased by 15% and remain at that level for all three months. The cost of its product will remain at $75 per unit, the sales staff will continue to earn a 10% commission, and the remaining expenses will stay the same.

Required

1. Prepare budgeted income statements for each of the months of January, February, and March that show the expected results from implementing the proposed changes. Use a three-column format, with one column for each month.

Analysis Component

2. Is net income for March expected to increase with the proposed strategy changes?

Check (1) Budgeted net income: January, $196,250

Problem 20-4A Manufacturing: Preparation of a complete master budget

P1 P2 P3

The management of Zigby Manufacturing prepared the following estimated balance sheet for March 2019.

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Accounts receivable . . . . . . . . . . . . . . . . . 342,248

Raw materials inventory . . . . . . . . . . . . . . 98,500

Finished goods inventory . . . . . . . . . . . . . 325,540

Total current assets . . . . . . . . . . . . . . . . . . 806,288

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Accumulated depreciation . . . . . . . . . . . . . (150,000)

Equipment, net . . . . . . . . . . . . . . . . . . . . . . 450,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $1,256,288

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . . $ 200,500

Short-term notes payable . . . . . . . . . . . . 12,000

Total current liabilities . . . . . . . . . . . . . . . 212,500

Long-term note payable . . . . . . . . . . . . . . 500,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . 712,500

Common stock . . . . . . . . . . . . . . . . . . . . . 335,000

Retained earnings . . . . . . . . . . . . . . . . . . 208,788

Total stockholders’ equity . . . . . . . . . . . . 543,788

Total liabilities and equity . . . . . . . . . . . . $1,256,288

ZIGBY MANUFACTURING Estimated Balance Sheet

March 31, 2019

To prepare a master budget for April, May, and June of 2019, management gathers the following information. a. Sales for March total 20,500 units. Forecasted sales in units are as follows: April, 20,500; May, 19,500;

June, 20,000; and July, 20,500. Sales of 240,000 units are forecasted for the entire year. The product’s selling price is $23.85 per unit and its total product cost is $19.85 per unit.

b. Company policy calls for a given month’s ending raw materials inventory to equal 50% of the next month’s materials requirements. The March 31 raw materials inventory is 4,925 units, which complies with the policy. The expected June 30 ending raw materials inventory is 4,000 units. Raw materials cost $20 per unit. Each finished unit requires 0.50 units of raw materials.

c. Company policy calls for a given month’s ending finished goods inventory to equal 80% of the next month’s expected unit sales. The March 31 finished goods inventory is 16,400 units, which complies with the policy.

d. Each finished unit requires 0.50 hours of direct labor at a rate of $15 per hour. e. Overhead is allocated based on direct labor hours. The predetermined variable overhead rate is $2.70

per direct labor hour. Depreciation of $20,000 per month is treated as fixed factory overhead. f. Sales representatives’ commissions are 8% of sales and are paid in the month of the sales. The sales

manager’s monthly salary is $3,000. g. Monthly general and administrative expenses include $12,000 administrative salaries and 0.9%

monthly interest on the long-term note payable. h. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are

collected in full in the month following the sale (none are collected in the month of the sale). i. All raw materials purchases are on credit, and no payables arise from any other transactions. One

month’s raw materials purchases are fully paid in the next month. j. The minimum ending cash balance for all months is $40,000. If necessary, the company borrows

enough cash using a short-term note to reach the minimum. Short-term notes require an interest pay- ment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the mini- mum, the excess will be applied to repaying the short-term notes payable balance.

k. Dividends of $10,000 are to be declared and paid in May. l. No cash payments for income taxes are to be made during the second calendar quarter. Income tax will

be assessed at 35% in the quarter and paid in the third calendar quarter. m. Equipment purchases of $130,000 are budgeted for the last day of June. [continued on next page]

810 Chapter 20 Master Budgets and Performance Planning

Required

Prepare the following budgets and other financial information as required. All budgets and other financial information should be prepared for the second calendar quarter, except as otherwise noted below. Round calculations up to the nearest whole dollar, except for the amount of cash sales, which should be rounded down to the nearest whole dollar. 1. Sales budget. 2. Production budget. 3. Raw materials budget. 4. Direct labor budget. 5. Factory overhead budget. 6. Selling expense budget.

7. General and administrative expense budget. 8. Cash budget. 9. Budgeted income statement for the entire second quarter

(not for each month separately). 10. Budgeted balance sheet as of the end of the second calendar

quarter.

Check (2) Units to produce: April, 19,700; May, 19,900 (3) Cost of raw materials purchases: April, $198,000 (5) Total overhead cost: May, $46,865 (8) Ending cash balance: April, $83,346; May, $124,295 (10) Budgeted total assets: June 30, $1,299,440

During the last week of August, Oneida Company’s owner approaches the bank for a $100,000 loan to be made on September 2 and repaid on November 30 with annual interest of 12%, for an interest cost of $3,000. The owner plans to increase the store’s inventory by $80,000 during September and needs the loan to pay for inventory acquisitions. The bank’s loan officer needs more information about Oneida’s ability to repay the loan and asks the owner to forecast the store’s November 30 cash position. On September 1, Oneida is expected to have a $5,000 cash balance, $159,100 of net accounts receivable, and $125,000 of accounts pay- able. Its budgeted sales, merchandise purchases, and various cash payments for the next three months follow.

Problem 20-6AA Merchandising: Preparation of cash budgets (for three periods)

P4

$250,000 240,000

20,000 10,000 35,000

$375,000 225,000

22,000 10,000 30,000

$400,000 200,000

24,000 10,000 20,000

100,000 3,000

Sales Merchandise purchases Cash payments Payroll Rent Other cash expenses Repayment of bank loan Interest on the bank loan

1 2 3 4 5 6 7 8 9

A B C D NovemberOctoberSeptemberBudgeted Figures*

*Operations began in August; August sales were $215,000 and purchases were $125,000.

The budgeted September merchandise purchases include the inventory increase. All sales are on account. The company predicts that 25% of credit sales is collected in the month of the sale, 45% in the month follow- ing the sale, 20% in the second month, 9% in the third, and the remainder is uncollectible. Applying these percents to the August credit sales, for example, shows that $96,750 of the $215,000 will be collected in September, $43,000 in October, and $19,350 in November. All merchandise is purchased on credit; 80% of the balance is paid in the month following a purchase, and the remaining 20% is paid in the second month. For example, of the $125,000 August purchases, $100,000 will be paid in September and $25,000 in October.

Keggler’s Supply is a merchandiser of three different products. The company’s February 28 inventories are footwear, 20,000 units; sports equipment, 80,000 units; and apparel, 50,000 units. Management believes each of these inventories is too high. As a result, a new policy dictates that ending inventory in any month should equal 30% of the expected unit sales for the following month. Expected sales in units for March, April, May, and June follow.

Budgeted Sales in Units

March April May June

Footwear . . . . . . . . . . . . . . . . . . 15,000 25,000 32,000 35,000

Sports equipment . . . . . . . . . . 70,000 90,000 95,000 90,000

Apparel . . . . . . . . . . . . . . . . . . . 40,000 38,000 37,000 25,000

Problem 20-5AA Merchandising: Preparation and analysis of purchases budgets

P4

Required

Prepare a merchandise purchases budget (in units) for each product for each of the months of March, April, and May.

Check March budgeted purchases: Footwear, 2,500; Sports equip., 17,000; Apparel, 1,400

Chapter 20 Master Budgets and Performance Planning 811

Required

Prepare a cash budget for September, October, and November. Show supporting calculations as needed. Check Budgeted cash balance: September, $99,250

Near the end of 2019, the management of Dimsdale Sports Co., a merchandising company, prepared the following estimated balance sheet for December 31, 2019.

Problem 20-8AA Merchandising: Preparation of a complete master budget P4

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,000

Accounts receivable . . . . . . . . . . . . 525,000

Inventory . . . . . . . . . . . . . . . . . . . . . 150,000

Total current assets . . . . . . . . . . . . . $ 711,000

Equipment . . . . . . . . . . . . . . . . . . . . 540,000

Less: Accumulated depreciation . . . 67,500

Equipment, net . . . . . . . . . . . . . . . 472,500

Total assets . . . . . . . . . . . . . . . . . . . $1,183,500

DIMSDALE SPORTS COMPANY Estimated Balance Sheet

December 31, 2019

Liabilities and Equity Accounts payable . . . . . . . . . . . . . $360,000

Bank loan payable . . . . . . . . . . . . . 15,000

Taxes payable (due 3/15/2020) . . . 90,000

Total liabilities . . . . . . . . . . . . . . . . $ 465,000

Common stock . . . . . . . . . . . . . . . . 472,500

Retained earnings . . . . . . . . . . . . . 246,000

Total stockholders’ equity . . . . . . . 718,500

Total liabilities and equity . . . . . . . $1,183,500

Aztec Company sells its product for $180 per unit. Its actual and budgeted sales follow.

Units Dollars

April (actual) . . . . . . . . . . . . . . . . 4,000 $ 720,000

May (actual) . . . . . . . . . . . . . . . . . 2,000 360,000

June (budgeted) . . . . . . . . . . . . . 6,000 1,080,000

July (budgeted) . . . . . . . . . . . . . . 5,000 900,000

August (budgeted) . . . . . . . . . . . 3,800 684,000

Problem 20-7AA Merchandising: Preparation and analysis of cash budgets with supporting inventory and purchases budgets

P4

All sales are on credit. Recent experience shows that 20% of credit sales is collected in the month of the sale, 50% in the month after the sale, 28% in the second month after the sale, and 2% proves to be uncollectible. The product’s purchase price is $110 per unit. 60% of purchases made in a month is paid in that month and the other 40% is paid in the next month. The company has a policy to maintain an ending monthly inventory of 20% of the next month’s unit sales plus a safety stock of 100 units. The April 30 and May 31 actual inventory levels are consistent with this policy. Selling and administrative expenses for the year are $1,320,000 and are paid evenly throughout the year in cash. The company’s minimum cash balance at month-end is $100,000. This minimum is maintained, if necessary, by bor- rowing cash from the bank. If the balance exceeds $100,000, the company repays as much of the loan as it can without going below the minimum. This type of loan carries an annual 12% interest rate. On May 31, the loan balance is $25,000, and the company’s cash balance is $100,000. (Round amounts to the nearest dollar.)

Required

1. Prepare a schedule that shows the computation of cash collections of its credit sales (accounts receiv- able) in each of the months of June and July.

2. Prepare a schedule that shows the computation of budgeted ending inventories (in units) for April, May, June, and July.

3. Prepare the merchandise purchases budget for May, June, and July. Report calculations in units and then show the dollar amount of purchases for each month.

4. Prepare a schedule showing the computation of cash payments for product purchases for June and July. 5. Prepare a cash budget for June and July, including any loan activity and interest expense. Compute the

loan balance at the end of each month.

Check (1) Cash collections: June, $597,600; July, $820,800

(3) Budgeted purchases: May, $308,000; June, $638,000

(5) Budgeted ending loan balance: June, $43,650; July, $0

812 Chapter 20 Master Budgets and Performance Planning

To prepare a master budget for January, February, and March of 2020, management gathers the following information. a. The company’s single product is purchased for $30 per unit and resold for $55 per unit. The expected

inventory level of 5,000 units on December 31, 2019, is more than management’s desired level, which is 20% of the next month’s expected sales (in units). Expected sales are January, 7,000 units; February, 9,000 units; March, 11,000 units; and April, 10,000 units.

b. Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 60% is collected in the first month after the month of sale and 40% in the second month after the month of sale. For the December 31, 2019, accounts receivable balance, $125,000 is collected in January 2020 and the remaining $400,000 is collected in February 2020.

c. Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the December 31, 2019, accounts payable balance, $80,000 is paid in January 2020 and the remaining $280,000 is paid in February 2020.

d. Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $60,000 per year.

e. General and administrative salaries are $144,000 per year. Maintenance expense equals $2,000 per month and is paid in cash.

f. Equipment reported in the December 31, 2019, balance sheet was purchased in January 2019. It is be- ing depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $36,000; February, $96,000; and March, $28,800. This equipment will be depreciated under the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equip- ment is purchased.

g. The company plans to buy land at the end of March at a cost of $150,000, which will be paid with cash on the last day of the month.

h. The company has a working arrangement with its bank to obtain additional loans as needed. The inter- est rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $25,000 at the end of each month.

i. The income tax rate for the company is 40%. Income taxes on the first quarter’s income will not be paid until April 15.

Required

Prepare a master budget for each of the first three months of 2020; include the following component bud- gets (show supporting calculations as needed, and round amounts to the nearest dollar). 1. Monthly sales budgets (showing both budgeted unit sales and dollar sales). 2. Monthly merchandise purchases budgets. 3. Monthly selling expense budgets. 4. Monthly general and administrative expense budgets. 5. Monthly capital expenditures budgets. 6. Monthly cash budgets. 7. Budgeted income statement for the entire first quarter (not for each month). 8. Budgeted balance sheet as of March 31, 2020.

Check (2) Budgeted purchases: January, $114,000; February, $282,000 (3) Budgeted selling expenses: January, $82,000; February, $104,000 (6) Ending cash bal.: January, $30,100; February, $210,300 (8) Budgeted total assets at March 31, $1,568,650

PROBLEM SET B

Problem 20-1B Manufacturing: Preparing production and manufacturing budgets

P1

NSA Company produces baseball bats. Each bat requires 3 pounds of aluminum alloy. Management pre- dicts that 8,000 bats and 15,000 pounds of aluminum alloy will be in inventory on March 31 of the current year and that 250,000 bats will be sold during this year’s second quarter. Bats sell for $80 each. Management wants to end the second quarter with 6,000 finished bats and 12,000 pounds of aluminum alloy in inventory. Aluminum alloy can be purchased for $4 per pound. Each bat requires 0.5 hours of direct labor at $18 per hour. Variable overhead is applied at the rate of $12 per direct labor hour. The com- pany budgets fixed overhead of $1,776,000 for the quarter.

Required

1. Prepare the second-quarter production budget for bats. 2. Prepare the second-quarter direct materials (aluminum alloy) budget; include the dollar cost of purchases.

Check (1) Units manuf., 248,000

[continued on next page]

Chapter 20 Master Budgets and Performance Planning 813

Problem 20-2B Manufacturing: Cash budget

P2

A1 Manufacturing is preparing its master budget for the quarter ended September 30. Budgeted sales and cash payments for product costs for the quarter follow.

Sales are 20% cash and 80% on credit. All credit sales are collected in the month following the sale. The June 30 balance sheet includes balances of $12,900 in cash; $47,000 in accounts receivable; $5,100 in accounts payable; and a $2,600 balance in loans payable. A minimum cash balance of $12,600 is required. Loans are obtained at the end of any month when a cash shortage occurs. Interest is 1% per month based on the beginning-of-the-month loan balance and is paid at each month-end. If an excess balance of cash exists, loans are repaid at the end of the month. Operating expenses are paid in the month incurred and consist of sales commissions (10% of sales), office salaries ($4,600 per month), and rent ($7,100 per month). 1. Prepare a cash receipts budget for July, August, and September. 2. Prepare a cash budget for each of the months of July, August, and September. (Round amounts to the

dollar.)

Budgeted sales Budgeted cash payments for Direct materials Direct labor Factory overhead

1 2 3 4 5 6

A B C D SeptemberAugustJuly

$63,400

12,480 10,400 18,720

$80,600

9,900 8,250

14,850

$48,600

10,140 8,450 15,210

HCS MFG. Income Statement

For Month Ended June 30, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 Operating expenses Sales commissions (10%) . . . . . . . . . . . . . . . . . . . . . 130,000 Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Store rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . 40,000 Depreciation—Office equipment . . . . . . . . . . . . . . . 50,000 Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 244,000

Management expects June’s results to be repeated in July, August, and September without any changes in strategy. Management, however, has another plan. It believes that unit sales will increase at a rate of 10% each month for the next three months (beginning with July) if the item’s selling price is reduced to $115 per unit and advertising expenses are increased by 25% and remain at that level for all three months. The cost of its product will remain at $60 per unit, the sales staff will continue to earn a 10% commission, and the remaining expenses will stay the same.

Required

1. Prepare budgeted income statements for each of the months of July, August, and September that show the expected results from implementing the proposed changes. Use a three-column format, with one column for each month.

Analysis Component

2. Use the budgeted income statements from part 1 to recommend whether management should imple- ment the proposed plan. Explain.

Check Budgeted net income: July, $102,500

HCS MFG. makes its product for $60 per unit and sells it for $130 per unit. The sales staff receives a com- mission of 10% of dollar sales. Its June income statement follows.

Problem 20-3B Manufacturing: Preparation and analysis of budgeted income statements

P3

3. Prepare the direct labor budget for the second quarter. 4. Prepare the factory overhead budget for the second quarter.

814 Chapter 20 Master Budgets and Performance Planning

The management of Nabar Manufacturing prepared the following estimated balance sheet for June 2019.Problem 20-4B Manufacturing: Preparation of a complete master budget

P1 P2 P3

To prepare a master budget for July, August, and September of 2019, management gathers the following information. a. Sales were 20,000 units in June. Forecasted sales in units are as follows: July, 21,000; August, 19,000;

September, 20,000; and October, 24,000. The product’s selling price is $17 per unit and its total prod- uct cost is $14.35 per unit.

b. Company policy calls for a given month’s ending finished goods inventory to equal 70% of the next month’s expected unit sales. The June 30 finished goods inventory is 16,800 units, which does not comply with the policy.

c. Company policy calls for a given month’s ending raw materials inventory to equal 20% of the next month’s materials requirements. The June 30 raw materials inventory is 4,375 units (which also fails to meet the policy). The budgeted September 30 raw materials inventory is 1,980 units. Raw materials cost $8 per unit. Each finished unit requires 0.50 units of raw materials.

d. Each finished unit requires 0.50 hours of direct labor at a rate of $16 per hour. e. Overhead is allocated based on direct labor hours. The predetermined variable overhead rate is $2.70

per direct labor hour. Depreciation of $20,000 per month is treated as fixed factory overhead. f. Monthly general and administrative expenses include $9,000 administrative salaries and 0.9% monthly

interest on the long-term note payable. g. Sales representatives’ commissions are 10% of sales and are paid in the month of the sales. The sales

manager’s monthly salary is $3,500. h. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are

collected in full in the month following the sale (none are collected in the month of the sale). i. All raw materials purchases are on credit, and no payables arise from any other transactions. One

month’s raw materials purchases are fully paid in the next month. j. Dividends of $20,000 are to be declared and paid in August. k. Income taxes payable at June 30 will be paid in July. Income tax expense will be assessed at 35% in the

quarter and paid in October. l. Equipment purchases of $100,000 are budgeted for the last day of September. m. The minimum ending cash balance for all months is $40,000. If necessary, the company borrows

enough cash using a short-term note to reach the minimum. Short-term notes require an interest pay- ment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the mini- mum, the excess will be applied to repaying the short-term notes payable balance.

Required

Prepare the following budgets and other financial information as required. All budgets and other financial information should be prepared for the third calendar quarter, except as otherwise noted below. Round calculations to the nearest whole dollar. 1. Sales budget. 2. Production budget. 3. Raw materials budget. 4. Direct labor budget. 5. Factory overhead budget. 6. Selling expense budget.

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 Accounts receivable . . . . . . . . . . . . . . . . . 249,900 Raw materials inventory . . . . . . . . . . . . . . 35,000 Finished goods inventory . . . . . . . . . . . . . 241,080 Total current assets . . . . . . . . . . . . . . . . . . 565,980 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 720,000 Accumulated depreciation . . . . . . . . . . . . . (240,000) Equipment, net . . . . . . . . . . . . . . . . . . . . . . 480,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $1,045,980

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . . . $ 51,400 Income taxes payable . . . . . . . . . . . . . . . . 10,000 Short-term notes payable . . . . . . . . . . . . 24,000 Total current liabilities . . . . . . . . . . . . . . . 85,400 Long-term note payable . . . . . . . . . . . . . . 300,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . 385,400 Common stock . . . . . . . . . . . . . . . . . . . . . 600,000 Retained earnings . . . . . . . . . . . . . . . . . . 60,580 Total stockholders’ equity . . . . . . . . . . . . 660,580 Total liabilities and equity . . . . . . . . . . . . $1,045,980

NABAR MANUFACTURING Estimated Balance Sheet

June 30, 2019

7. General and administrative expense budget. 8. Cash budget. 9. Budgeted income statement for the entire quarter (not for each

month separately). 10. Budgeted balance sheet as of September 30, 2019.

Check (2) Units to produce: July, 17,500; August, 19,700 (3) Cost of raw materials purchases: July, $50,760 (5) Total overhead cost: August, $46,595 (8) Ending cash balance: July, $96,835; August, $141,180 (10) Budgeted total assets: Sep. 30, $1,054,920

Chapter 20 Master Budgets and Performance Planning 815

Budgeted Sales in Units

April May June July

Water skis . . . . . . . . . . . . 70,000 90,000 130,000 100,000

Tow ropes . . . . . . . . . . . . 100,000 90,000 110,000 100,000

Life jackets . . . . . . . . . . . 160,000 190,000 200,000 120,000

Required

1. Prepare a merchandise purchases budget (in units) for each product for each of the months of April, May, and June.

Analysis Component

2. What business conditions might lead to inventory levels becoming too high?

Check (1) April budgeted purchases: Water skis, 39,000; Tow ropes, 19,000; Life jackets, 29,000

H20 Sports is a merchandiser of three different products. The company’s March 31 inventories are water skis, 40,000 units; tow ropes, 90,000 units; and life jackets, 150,000 units. Management believes inventory levels are too high for all three products. As a result, a new policy dictates that ending inventory in any month should equal 10% of the expected unit sales for the following month. Expected sales in units for April, May, June, and July follow.

Problem 20-5BA Merchandising: Preparation and analysis of purchases budgets

P4

Problem 20-6BA Merchandising: Preparation of cash budgets (for three periods)

P4

During the last week of March, Sony Stereo’s owner approaches the bank for an $80,000 loan to be made on April 1 and repaid on June 30 with annual interest of 12%, for an interest cost of $2,400. The owner plans to increase the store’s inventory by $60,000 in April and needs the loan to pay for inventory acquisi- tions. The bank’s loan officer needs more information about Sony Stereo’s ability to repay the loan and asks the owner to forecast the store’s June 30 cash position. On April 1, Sony Stereo is expected to have a $3,000 cash balance, $135,000 of accounts receivable, and $100,000 of accounts payable. Its budgeted sales, merchandise purchases, and various cash payments for the next three months follow.

$220,000 210,000

16,000 6,000

64,000

$300,000 180,000

17,000 6,000 8,000

$380,000 220,000

18,000 6,000 7,000

80,000 2,400

Sales Merchandise purchases Cash payments Payroll Rent Other cash expenses Repayment of bank loan Interest on bank loan

1 2 3 4 5 6 7 8 9

A B C D

JuneMayAprilBudgeted Figures*

*Operations began in March; March sales were $180,000 and purchases were $100,000.

The budgeted April merchandise purchases include the inventory increase. All sales are on account. The company predicts that 25% of credit sales is collected in the month of the sale, 45% in the month follow- ing the sale, 20% in the second month, 9% in the third, and the remainder is uncollectible. Applying these percents to the March credit sales, for example, shows that $81,000 of the $180,000 will be collected in April, $36,000 in May, and $16,200 in June. All merchandise is purchased on credit; 80% of the balance is paid in the month following a purchase, and the remaining 20% is paid in the second month. For exam- ple, of the $100,000 March purchases, $80,000 will be paid in April and $20,000 in May.

Required

Prepare a cash budget for April, May, and June. Show supporting calculations as needed. Check Budgeted cash balance: April, $53,000

Units Dollars

January (actual) . . . . . . . . . . . . . 18,000 $396,000

February (actual) . . . . . . . . . . . . 22,500 495,000

March (budgeted) . . . . . . . . . . . 19,000 418,000

April (budgeted) . . . . . . . . . . . . . 18,750 412,500

May (budgeted) . . . . . . . . . . . . . 21,000 462,000

Connick Company sells its product for $22 per unit. Its actual and budgeted sales follow. Problem 20-7BA Merchandising: Preparation and analysis of cash budgets with supporting inventory and purchases budgets

P4

816 Chapter 20 Master Budgets and Performance Planning

All sales are on credit. Recent experience shows that 40% of credit sales is collected in the month of the sale, 35% in the month after the sale, 23% in the second month after the sale, and 2% proves to be uncol- lectible. The product’s purchase price is $12 per unit. Of purchases made in a month, 30% is paid in that month and the other 70% is paid in the next month. The company has a policy to maintain an ending monthly inventory of 20% of the next month’s unit sales plus a safety stock of 100 units. The January 31 and February 28 actual inventory levels are consistent with this policy. Selling and administrative expenses for the year are $1,920,000 and are paid evenly throughout the year in cash. The company’s minimum cash balance for month-end is $50,000. This minimum is maintained, if necessary, by borrowing cash from the bank. If the balance exceeds $50,000, the company repays as much of the loan as it can without going below the minimum. This type of loan carries an annual 12% interest rate. At February 28, the loan bal- ance is $12,000, and the company’s cash balance is $50,000.

Required

1. Prepare a schedule that shows the computation of cash collections of its credit sales (accounts receiv- able) in each of the months of March and April.

2. Prepare a schedule showing the computations of budgeted ending inventories (in units) for January, February, March, and April.

3. Prepare the merchandise purchases budget for February, March, and April. Report calculations in units and then show the dollar amount of purchases for each month.

4. Prepare a schedule showing the computation of cash payments on product purchases for March and April.

5. Prepare a cash budget for March and April, including any loan activity and interest expense. Compute the loan balance at the end of each month.

Analysis Component

6. Refer to your answer to part 5. The cash budget indicates whether the company must borrow addi- tional funds at the end of March. Suggest some reasons that knowing the loan needs in advance would be helpful to management.

Check (1) Cash collections: March, $431,530; April, $425,150

(3) Budgeted purchases: February, $261,600; March, $227,400

(5) Ending cash balance: March, $58,070; April, $94,920

Problem 20-8BA Merchandising: Preparation of a complete master budget

P4

Near the end of 2019, the management of Isle Corp., a merchandising company, prepared the following estimated balance sheet for December 31, 2019.

ISLE CORPORATION Estimated Balance Sheet

December 31, 2019

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,000

Accounts receivable . . . . . . . . . . . . . 525,000

Inventory . . . . . . . . . . . . . . . . . . . . . . 150,000

Total current assets . . . . . . . . . . . . . . $ 711,000

Equipment . . . . . . . . . . . . . . . . . . . . . 540,000

Less: Accumulated depreciation . . . . 67,500

Equipment, net . . . . . . . . . . . . . . . . 472,500

Total assets . . . . . . . . . . . . . . . . . . . . $1,183,500

Liabilities and Equity Accounts payable . . . . . . . . . . . . . . . . . $360,000

Bank loan payable . . . . . . . . . . . . . . . . 15,000

Taxes payable (due 3/15/2020) . . . . . . 90,000

Total liabilities . . . . . . . . . . . . . . . . . . . . $ 465,000

Common stock . . . . . . . . . . . . . . . . . . . 472,500

Retained earnings . . . . . . . . . . . . . . . . 246,000

Total stockholders’ equity . . . . . . . . . . 718,500

Total liabilities and equity . . . . . . . . . . $1,183,500

To prepare a master budget for January, February, and March of 2020, management gathers the following information. a. The company’s single product is purchased for $30 per unit and resold for $45 per unit. The expected

inventory level of 5,000 units on December 31, 2019, is more than management’s desired level for 2020, which is 25% of the next month’s expected sales (in units). Expected sales are January, 6,000 units; February, 8,000 units; March, 10,000 units; and April, 9,000 units.

b. Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 60% is collected in the first month after the month of sale and 40% in the second month after the month of sale. For the $525,000 accounts receivable balance at December 31, 2019, $315,000 is collected in January 2020 and the remaining $210,000 is collected in February 2020.

c. Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the $360,000 accounts payable balance at December 31, 2019, $72,000 is paid in January 2020 and the remaining $288,000 is paid in February 2020.

Chapter 20 Master Budgets and Performance Planning 817

d. Sales commissions equal to 20% of sales dollars are paid each month. Sales salaries (excluding com- missions) are $90,000 per year.

e. General and administrative salaries are $144,000 per year. Maintenance expense equals $3,000 per month and is paid in cash.

f. Equipment reported in the December 31, 2019, balance sheet was purchased in January 2019. It is being depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $72,000; February, $96,000; and March, $28,800. This equipment will be depreciated using the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equip- ment is purchased.

g. The company plans to buy land at the end of March at a cost of $150,000, which will be paid with cash on the last day of the month.

h. The company has a contract with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full pay- ments on these loans are made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $36,000 at the end of each month.

i. The income tax rate for the company is 40%. Income taxes on the first quarter’s income will not be paid until April 15.

Required

Prepare a master budget for each of the first three months of 2020; include the following component bud- gets (show supporting calculations as needed, and round amounts to the nearest dollar). 1. Monthly sales budgets (showing both budgeted unit sales and dollar sales). 2. Monthly merchandise purchases budgets. 3. Monthly selling expense budgets. 4. Monthly general and administrative expense budgets. 5. Monthly capital expenditures budgets. 6. Monthly cash budgets. 7. Budgeted income statement for the entire first quarter (not for each month). 8. Budgeted balance sheet as of March 31, 2020.

Check (2) Budgeted purchases: January, $90,000; February, $255,000 (3) Budgeted selling expenses: January, $61,500; February, $79,500 (6) Ending cash bal.: January, $182,850; February, $107,850 (8) Budgeted total assets at March 31, $1,346,875

SERIAL PROBLEM Business Solutions

P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 20 Santana Rey expects second-quarter 2020 sales of Business Solutions’s line of computer furniture to be the same as the first quarter’s sales (reported below) without any changes in strategy. Monthly sales averaged 40 desk units (sales price of $1,250) and 20 chairs (sales price of $500).

BUSINESS SOLUTIONS—Computer Furniture Segment Segment Income Statement*

For Quarter Ended March 31, 2020

Sales† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $180,000

Cost of goods sold‡ . . . . . . . . . . . . . . . . . . . . . 115,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Expenses

Sales commissions (10%) . . . . . . . . . . . . . . . . 18,000

Advertising expenses . . . . . . . . . . . . . . . . . . . 9,000

Other fixed expenses . . . . . . . . . . . . . . . . . . . 18,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

*Reflects revenue and expense activity only related to the computer furniture segment. † Revenue: (120 desks × $1,250) + (60 chairs × $500) = $150,000 + $30,000 = $180,000. ‡ Cost of goods sold: (120 desks × $750) + (60 chairs × $250) + $10,000 = $115,000.

©Alexander Image/Shutterstock

Santana Rey believes that sales will increase each month for the next three months (April, 48 desks, 32 chairs; May, 52 desks, 35 chairs; June, 56 desks, 38 chairs) if selling prices are reduced to $1,150 for

818 Chapter 20 Master Budgets and Performance Planning

desks and $450 for chairs and advertising expenses are increased by 10% and remain at that level for all three months. The products’ variable cost will remain at $750 for desks and $250 for chairs. The sales staff will continue to earn a 10% commission, the fixed manufacturing costs per month will remain at $10,000, and other fixed expenses will remain at $6,000 per month.

Required

1. Prepare budgeted income statements for the computer furniture segment for each of the months of April, May, and June that show the expected results from implementing the proposed changes. Use a three-column format, with one column for each month.

2. Use the budgeted income statements from part 1 to recommend whether Santana Rey should imple- ment the proposed changes.

Check (1) Budgeted income (loss): April, $(660); May, $945

COMPANY ANALYSIS P3

Accounting Analysis

AA 20-1 Financial statements often serve as a starting point in formulating budgets. Review Apple’s finan- cial statements in Appendix A to determine its cash paid for acquisitions of property, plant, and equipment.

Required

1. Which financial statement reports the amount of cash paid for acquisitions of property, plant, and equip- ment? In which section (operating, investing, or financing) of this statement is the information reported?

2. Indicate the amount of cash paid for acquisitions of property and equipment in the year ended September 30, 2017.

APPLE

AA 20-2 Companies often budget selling expenses and general and administrative expenses (SGA) as a percentage of expected sales.

Required

1. For both Apple and Google, list sales (in dollars) and total selling expenses and general and administrative expenses (in dollars) for the 2017 and 2016 fiscal years. Use the financial statements in Appendix A.

2. Compute each company’s ratio of total selling expenses and general and administrative expenses to sales for the 2017 and 2016 fiscal years.

3. Which company (Apple or Google) spends more, as a percent of sales, on selling, general, and administrative expenses?

COMPARATIVE ANALYSIS P1

APPLE GOOGLE

AA 20-3 Access Samsung’s and Apple’s income statements (in Appendix A) for fiscal year 2017. The ratio of investments in property, plant, and equipment to sales can be used to assess how much a company is investing to maintain and expand its productive capacity.

Required

1. Compute Samsung’s ratio of investments in property, plant, and equipment to sales for 2017. 2. Compute Apple’s ratio of investments in property, plant, and equipment to sales for fiscal 2017. 3. Drawing on the answers to parts 1 and 2, which company (Samsung or Apple) invested more (as a

percent of sales) in property, plant, and equipment? 4. Assume Samsung forecasts total sales of 24,000,000 for 2018 and plans to invest 18% of 2018

forecasted sales in property, plant, and equipment. What amount will Samsung budget for investments in property, plant, and equipment for 2018? Forecasts and budgets are all in millions of Korean won.

GLOBAL ANALYSIS P2

Samsung

ETHICS CHALLENGE C1

BTN 20-1 The budget process and budgets themselves can impact management actions, both positively and negatively. For instance, a common practice among not-for-profit organizations and government agen- cies is for management to spend any amounts remaining in a budget at the end of the budget period, a practice often called “use it or lose it.” The view is that if a department manager does not spend the bud- geted amount, top management will reduce next year’s budget by the amount not spent. To avoid losing budget dollars, department managers often spend all budgeted amounts regardless of the value added to products or services. All of us pay for the costs associated with this budget system.

Beyond the Numbers

APPLE

Chapter 20 Master Budgets and Performance Planning 819

Required

Write a half-page report to a local not-for-profit organization or government agency offering a solution to the “use it or lose it” budgeting problem.

BTN 20-3 Certified Management Accountants must understand budgeting. Access the Institute of Management Accountants website (imanet.org), click on the “CMA Certification” tab, and select “Taking the Exam.” Scroll down and select “Review the Most Recent Content Specifications Outline.”

Required

1. List the budgeting methodologies that are covered on the CMA exam. 2. List the types of budgets (“annual profit plans”) covered on the CMA exam.

TAKING IT TO THE NET C1

BTN 20-2 The sales budget is usually the first and most crucial of the component budgets in a master budget because all other budgets usually rely on it for planning purposes.

Required

Assume that your company’s sales staff provides information on expected sales and selling prices for items making up the sales budget. Prepare a one-page memorandum to your supervisor outlining concerns with the sales staff’s input in the sales budget when its compensation is at least partly tied to these bud- gets. More generally, explain the importance of assessing any potential bias in information provided to the budget process.

COMMUNICATING IN PRACTICE C1

BTN 20-4 Your team is to prepare a budget report outlining the costs of attending college (full-time) for the next two semesters (30 hours) or three quarters (45 hours). This budget’s focus is solely on attending college; do not include personal items in the team’s budget. Your budget must include tuition, books, sup- plies, club fees, food, housing, and all costs associated with travel to and from college. This budgeting exercise is similar to the initial phase in activity-based budgeting. Include a list of any assumptions you use in completing the budget. Be prepared to present your budget in class.

TEAMWORK IN ACTION A1

BTN 20-5 Misfit Juicery sells juice made from misshapen and scrap fruit and vegetables. Co-founders Anna Yang and Phil Wong stress the importance of planning and budgeting for business success.

Required

1. How can budgeting help Anna and Phil efficiently develop and operate their business? 2. Anna and Phil hope to expand their business. How can a budget be useful in expanding a business’s

operations?

ENTREPRENEURIAL DECISION C1

BTN 20-6 To help understand the factors impacting a sales budget, you are to visit three businesses with the same ownership or franchise membership. Record the selling prices of two identical products at each location, such as regular and premium gas sold at gas stations. You are likely to find a difference in prices for at least one of the three locations you visit.

Required

1. Identify at least three external factors that must be considered when setting the sales budget. Note: There is a difference between internal and external factors that impact the sales budget.

2. What factors might explain any differences identified in the prices of the businesses you visited?

HITTING THE ROAD P1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

CONCEPTUAL C1 Define standard costs and explain how

standard cost information is useful for management by exception.

ANALYTICAL A1 Analyze changes in sales from expected

amounts.

P5 Appendix 21A—Compute overhead spending and efficiency variances.

P6 Appendix 21A—Prepare journal entries for standard costs and account for price and quantity variances.

PROCEDURAL P1 Prepare a flexible budget and interpret a

flexible budget performance report.

P2 Compute the total cost variance.

P3 Compute materials and labor variances.

P4 Compute overhead controllable and volume variances.

Chapter Preview

21 Flexible Budgets and Standard Costs

OVERHEAD STANDARDS AND VARIANCES

Flexible overhead budget

Standard overhead rate

P4 Overhead variances Analyzing

A1 Sales variances

NTK 21-5

MATERIALS AND LABOR VARIANCES

Price variance

Quantity variance

P3 Materials variances Labor variances

NTK 21-3, 21-4

FIXED AND FLEXIBLE BUDGETS

Fixed budget reports

Evaluation focus

P1 Flexible budget reports

NTK 21-1 NTK 21-2

STANDARD COSTING

C1 Standard costs Setting standard costs

P2 Cost variance analysis

821

“Take the risk!”—Jen Rubio

Up and Away

New York—“The idea for Away came about when I was traveling and my suitcase broke,” recalls Jen Rubio. “I called my most well-traveled friends and none of them could recommend a de- cent option to replace it, so my co-founder Steph Korey and I decided to look into why that was, and whether or not we could fix it.” Their company,  Away  (AwayTravel.com), has seen its sales for luggage soar.

“We interviewed hundreds of travelers to find out more about how they actually traveled,” explains Steph. “We asked them to tell us what bothered them most about the experience and then designed luggage with thoughtful features so that we could solve problems travelers face.”

“We obsessed over every detail,” says Jen. “We set incredi- bly high standards.” Away uses only quality materials—“best in the world” wheels and zippers, and a lightweight but strong shell. Jen and Steph also determined how long it takes to make each bag in developing labor and overhead standards.

“We keep costs for the customer low with our direct-to- consumer model,” explains Steph. Away focuses on variances be- tween actual and expected costs. Manufacturers like Away use standard costs to set budgets and control costs.

Away has already sold more than 300,000 suitcases. When production booms, budgets can become outdated.  Flexible

budgets, which reflect budgeted costs at different production levels, are then used to analyze results and control costs.

Although budgeting, standard costs, and variances are crucial, Jen and Steph tell entrepreneurs to be passionate and “take thoughtful risks.”

Sources: Away website, January 2019; Money.cnn.com, October 24, 2017; Createcultivate.com, January 23, 2017; Travelandleisure.com, March 9, 2017; Fastcodesign.com, September 11, 2017

©Away

Managers use budgets to control operations and see that planned objectives are met. Budget reports compare budgeted results to actual results. Budget reports are progress reports, or report cards, on management’s performance in achieving planned objectives. These reports can be prepared at any time and for any period. Three common periods for a budget report are a month, quarter, and year.

From the previous chapter, a master budget is based on a predicted level of activity, such as sales volume, for the budget period. In preparing a master budget, two alternative approaches can be used: fixed budgeting or flexible budgeting. A fixed budget, also called a static budget, is based on a single predicted amount of sales or

other activity measure. A flexible budget, also called a variable budget, is based on several different amounts of

sales or other activity measure.

Exhibit 21.1 shows fixed and flexible budgets for a guitar manufacturer.

FIXED AND FLEXIBLE BUDGETS

Point: Budget reports are often used to determine bonuses of managers.

EXHIBIT 21.1 Fixed versus Flexible Budgets (condensed)

Fixed Budget (One activity level) Flexible Budget (Several activity levels)

Sales (in units) . . . . . . . . . . . . . 100 Sales (in units) . . . . . . . . . . . . 100 120 140

Sales (in dollars) . . . . . . . . . . . $80,000 Sales (in dollars) . . . . . . . . . . $80,000 $96,000 $112,000

Costs . . . . . . . . . . . . . . . . . . . . 56,000 Costs . . . . . . . . . . . . . . . . . . . 56,000 67,200 78,400

Net income . . . . . . . . . . . . . . . $24,000 Net income . . . . . . . . . . . . . . $24,000 $28,800 $ 33,600

Exhibit 21.1 shows that the guitar maker forecasts $24,000 of net income if it sells 100 guitars. Only if exactly 100 guitars are sold will the fixed budget be useful in evaluating how well the company controlled costs. A flexible budget can be prepared for any sales level (three are shown in Exhibit 21.1). It is more useful when the actual number of units sold differs from the pre- dicted level of unit sales.

We next look at fixed budget reports. Knowing the limitations of such reports helps us see the benefits of flexible budgets.

822 Chapter 21 Flexible Budgets and Standard Costs

Fixed Budget Reports One use of a budget is to compare actual results with planned activities. Information for this analysis is often presented in a performance report that shows budgeted amounts, actual amounts, and variances (differences between budgeted and actual amounts). In a fixed budget, the master budget is based on a single prediction for sales volume, and the budgeted amount for each cost essentially assumes this specific (or fixed) amount of sales will occur.

We illustrate fixed budget performance reports with SolCel, which manufactures portable solar cell phone chargers and related supplies. For January 2019, SolCel based its fixed budget on a prediction of 10,000 (composite) units of sales; costs also were budgeted based on 10,000 composite units of sales.

Fixed Budget Performance Report Exhibit 21.2 shows a fixed budget perfor- mance report, a report that compares actual results with the results expected under a fixed budget. SolCel’s actual sales for the period were 12,000 composite units. In addition, SolCel produced 12,000 composite units during the period (meaning its inventory level did not change). The final column in the performance report shows the differences (variances) between the budgeted and actual dollar amounts for each budget item.

EXHIBIT 21.2 Fixed Budget Performance Report

SOLCEL Fixed Budget Performance Report

Fixed Actual For Month Ended January 31, 2019 Budget Results Variances*

Sales (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 12,000

Sales (in dollars) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $125,000 $25,000 F Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 13,000 3,000 U Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 20,000 5,000 U Overhead

Factory supplies . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,100 100 U Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000 1,000 U Depreciation—Machinery . . . . . . . . . . . . . . . . . 8,000 8,000 0 Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . 11,000 11,000 0 Selling expenses

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 10,800 1,800 U Shipping expenses . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,300 300 U General and administrative expenses

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,200 200 U Insurance expenses . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U Depreciation—Office equipment . . . . . . . . . . . . . . 7,000 7,000 0 Administrative salaries . . . . . . . . . . . . . . . . . . . . . . 13,000 13,000 0 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 99,600 11,600 U Income from operations . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 25,400 $13,400 F

*F = Favorable variance; U = Unfavorable variance.

This type of performance report designates differences between budgeted and actual results as variances. We use the letters F and U to describe variances, with meanings as follows:

F = Favorable variance When compared to budget, the actual cost or revenue contributes to a higher income. That is, actual revenue is higher than budgeted revenue, or actual cost is lower than budgeted cost.

U = Unfavorable variance When compared to budget, the actual cost or revenue contributes to a lower income; actual revenue is lower than budgeted revenue, or actual cost is higher than budgeted cost.

Example: How is it that the favor- able sales variance in Exhibit 21.2 is linked with so many unfavor- able cost and expense variances? Answer: Costs have increased with the increase in sales.

Chapter 21 Flexible Budgets and Standard Costs 823

Budget Reports for Evaluation Managers use budget reports to monitor and control operations. From the report in Exhibit 21.2, SolCel’s management might ask: Why is actual income from operations $13,400 higher

than budgeted? Is manufacturing using too much direct material? Is manufacturing using too much direct labor? Why are sales commissions higher than budgeted? Why are so many of the variances unfavorable?

The performance report in Exhibit 21.2 will not be very use- ful in answering these types of questions because it is not based on an “apples to apples” comparison. That is, the budgeted dollar amounts are based on 10,000 units of sales, but the actual dollar amounts are based on 12,000 units of sales. Clearly, the costs to make 12,000 units will be greater than the costs to make 10,000 units, so it is no surprise that SolCel’s total expense variance is unfavorable. In addition, the costs in Exhibit 21.2 with the highest unfavorable variances (direct materials, direct labor, and sales commis- sions) are typically considered variable costs, which increase directly with sales activity. In general, the fixed budget performance report is not useful in analyzing performance when actual sales differ from predicted sales. In the next section, we show how a flexible budget can be more useful in analyzing performance.

Point: The fixed budget report can be useful in evaluating the sales manager’s performance because it shows both budgeted and actual sales, as seen in this chapter’s Decision Analysis.

Cruise Control Budget reporting and evaluation are used at service providers such as Royal Caribbean Cruises, Carnival Cruise Line, and Norwegian Cruise Line. These service providers regularly prepare performance plans and budget requests for their fleets of cruise ships, which describe performance goals, measure outcomes, and analyze variances. ■

Decision Insight

Flexible Budget Reports To address limitations with the fixed budget performance report due to its lack of adjustment to changes in sales volume, management can use a flexible budget. A flexible budget is useful both before and after the period’s activities are complete.

Purpose of Flexible Budgets A flexible budget prepared before the period is often based on several levels of activity.

Budgets for those different levels can provide a “what-if” look at operations. The different levels often include both a best-case and worst-case scenario. This allows management to make adjustments to avoid or lessen the effects of the worst-case scenario.

A flexible budget prepared after the period helps management evaluate past performance. It is especially useful for such an evaluation because it reflects budgeted revenues and costs based on the actual level of activity. The flexible budget gives an “apples to apples” com- parison because the budgeted activity level is the same as the actual activity level. With a flexible budget, comparisons of actual results with budgeted performance are likely to reveal the real causes of any differences. Such information can help managers focus attention on real problem areas and implement corrective actions.

Preparation of Flexible Budgets To prepare a flexible budget, follow these steps: 1 Identify the activity level, such as units produced or sold. 2 Identify costs and classify them as fixed or variable within the relevant range of activity. 3 Compute budgeted sales (Sales price per unit × Number of units of activity). Then subtract

the sum of budgeted variable costs (Variable cost per unit × Number of units of activity) plus budgeted fixed costs.

©Melanie Stetson Freeman/The Christian Science Monitor/Getty Images

P1 Prepare a flexible budget and interpret a flexible budget performance report.

824 Chapter 21 Flexible Budgets and Standard Costs

In a flexible budget, we express each variable cost in one of two ways: either as (1) a constant dollar amount per unit of sales or as (2) a constant percentage of a sales dollar. In the case of a fixed cost, we express its budgeted amount as the total amount expected to occur at any sales volume within the relevant range.

Exhibit 21.3 shows a set of flexible budgets for SolCel for January 2019. 1 SolCel’s management decides that the number of units sold is the relevant activity level. (For SolCel, the number of units sold equals the number of units produced.) For purposes of preparing the flexible budget, management decides it wants budgets at three different activity levels: 10,000 units, 12,000 units, and 14,000 units. 2 SolCel’s management classifies its costs as variable (seven items listed under the “Variable costs” heading) or fixed (five costs listed under the “Fixed costs” heading). These classifications result from management’s investigation of each expense using techniques such as the high-low or regression methods we showed in a previous chapter. Variable and fixed expense categories are not the same for every company, and we must avoid drawing conclusions from specific cases. 3 SolCel next computes budgeted sales and variable costs. At the three different activity lev- els, sales are budgeted to equal $100,000 (computed as $10 × 10,000), $120,000 (computed as $10 × 12,000), and $140,000 (computed as $10 × 14,000), respectively. Likewise, budgeted direct labor equals $15,000 (computed as $1.50 × 10,000) if 10,000 units are sold and $21,000 (computed as $1.50 × 14,000) if 14,000 units are sold. SolCel then lists each of the fixed costs in total.

The flexible budgets in Exhibit 21.3 follow a contribution margin format—beginning with sales followed by variable costs and then fixed costs. The amounts in the first Flexible Budget column are the same as those in the fixed budget report in Exhibit 21.2, as both budgets are based on 10,000 units. As budgeted activity levels increase to 12,000 and 14,000 units, total variable costs increase but total fixed costs stay unchanged.

Point: The total amount of a variable cost changes in direct proportion to a change in activity level. The total amount of a fixed cost remains unchanged regard- less of changes in the level of activity within a relevant (normal) operating range.

Point: The usefulness of a flexible budget depends on valid classifi- cation of variable and fixed costs. Some costs are mixed and must be analyzed to determine their variable and fixed portions.

Example: Using Exhibit 21.3, what is the budgeted income from operations for unit sales of (a) 11,000 and (b) 13,000? Answers: $17,200 for unit sales of 11,000; $27,600 for unit sales of 13,000.

SOLCEL Flexible Budgets

Flexible Budget Flexible Budget for Unit Variable Total Sales of Amount Fixed For Month Ended January 31, 2019 per Unit Cost 10,000 12,000 14,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10 .00 $100,000 $120,000 $140,000

Variable costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .00 10,000 12,000 14,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .50 15,000 18,000 21,000

Factory supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .20 2,000 2,400 2,800

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .30 3,000 3,600 4,200

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . 0 .90 9,000 10,800 12,600

Shipping expenses . . . . . . . . . . . . . . . . . . . . . . . . . 0 .40 4,000 4,800 5,600

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .50 5,000 6,000 7,000

Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . 4 .80 48,000 57,600 67,200

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5 .20 $ 52,000 $ 62,400 $ 72,800

Fixed costs Depreciation—Machinery . . . . . . . . . . . . . . . . . . . $ 8,000 8,000 8,000 8,000

Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . 11,000 11,000 11,000 11,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 1,000 1,000

Depreciation—Office equipment . . . . . . . . . . . . . . 7,000 7,000 7,000 7,000

Administrative salaries . . . . . . . . . . . . . . . . . . . . . . 13,000 13,000 13,000 13,000

Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000 40,000 40,000 40,000

Income from operations . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 22,400 $ 32,800

EXHIBIT 21.3 Flexible Budgets (prepared before the period)

$ C

os t

Unit Sales

Flexible Budget Costs

Total budgeted costs Budgeted

fixed costs

Budgeted variable

costs

Chapter 21 Flexible Budgets and Standard Costs 825

A flexible budget like that in Exhibit 21.3 can be useful to management in planning opera- tions. In addition, as we will show next, a flexible budget prepared after period-end is particu- larly useful in analyzing performance when the actual activity level differs from that predicted by a fixed budget.

Formula for Total Budgeted Costs For approximate “what-if” analyses, compute total budgeted costs at any activity level with this flexible budget formula.

Point: Flexible budgeting allows a budget to be prepared at any actual output level. Performance reports are then prepared comparing the flexible budget to actual revenues and costs.

Total budgeted costs = Total fixed costs + (Total variable cost per unit × Units of activity level)

$94,000 = $40,000 + ($4.80 × 11,250)

Using this formula, management can compute total budgeted costs for any number of activity levels, and then, at the end of the period, compare actual costs to budgeted costs at any activity level. For example, if 11,250 units are actually produced and sold, total budgeted costs are:

Flexible Budget Performance Report SolCel’s actual sales volume for January was 12,000 units. This sales volume is 2,000 units more than the 10,000 units originally pre- dicted in the fixed budget. So, when management evaluates SolCel’s performance, it needs a flexible budget report showing actual and budgeted dollar amounts at 12,000 units.

A flexible budget performance report compares actual performance and budgeted perfor- mance based on actual sales volume (or other activity level). This report directs management’s attention to those costs or revenues that differ substantially from budgeted amounts. In SolCel’s case, we prepare this report after January’s sales volume is known to be 12,000 units. Exhibit 21.4 shows SolCel’s flexible budget performance report for January.

EXHIBIT 21.4 Flexible Budget Performance Report (prepared after the period)

SOLCEL Flexible Budget Performance Report

Flexible Actual Budget Results

For Month Ended January 31, 2019 (12,000 units) (12,000 units) Variances*

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $125,000 $5,000 F Variable costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 13,000 1,000 U Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 20,000 2,000 U Factory supplies . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400 2,100 300 F Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 4,000 400 U Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . 10,800 10,800 0 Shipping expenses . . . . . . . . . . . . . . . . . . . . . . . . 4,800 4,300 500 F Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 5,200 800 F Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . 57,600 59,400 1,800 U Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . 62,400 65,600 3,200 F

Fixed costs Depreciation—Machinery . . . . . . . . . . . . . . . . . . . 8,000 8,000 0 Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . 11,000 11,000 0 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U Depreciation—Office equipment . . . . . . . . . . . . . 7,000 7,000 0 Administrative salaries . . . . . . . . . . . . . . . . . . . . . 13,000 13,000 0 Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 40,200 200 U Income from operations . . . . . . . . . . . . . . . . . . . . $ 22,400 $ 25,400 $3,000 F

*F = Favorable variance; U = Unfavorable variance.

Point: Total budgeted costs = $97,600, computed as $40,000 + ($4.80 × 12,000).

826 Chapter 21 Flexible Budgets and Standard Costs

Analyzing Variances Management uses this report to investigate variances and evaluate SolCel’s performance. Quite often management will focus on large variances. This report shows a $5,000 favorable variance in total dollar sales. Because actual and budgeted volumes are both 12,000 units, the $5,000 favorable sales vari- ance must have resulted from a higher-than-expected selling price. Management would like to determine if the conditions that resulted in higher selling prices are likely to continue.

The other variances in Exhibit 21.4 also direct management’s attention to areas where corrective actions can help control SolCel’s operations. For example, both the direct materials and direct labor variances are relatively large and unfavorable. On the

other hand, relatively large favorable variances are observed for shipping expenses and office supplies. Management will try to determine the causes for these variances, both favorable and unfavorable, and make changes to SolCel’s operations if needed.

In addition to analyzing variances using a flexible budget performance report, manage- ment can also take a more detailed approach based on a standard cost system. We illustrate this next.

SOLCEL Fixed Budget Performance Report For Month Ended January 31, 2019

Fixed Actual Budget Results Variances*

Sales (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 12,000

Sales (in dollars) . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $125,000 $25,000 F Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 10,000 13,000 3,000 U Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 20,000 5,000 U Overhead Factory supplies . . . . . . . . . . . . . . . . . . . . . . 2,000 2,100 100 U Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000 1,000 U Depreciation— machinery . . . . . . . . . . . . . . 8,000 8,000 0 Supervisory salaries . . . . . . . . . . . . . . . . . . . 11,000 11,000 0 Selling expenses Sales commissions . . . . . . . . . . . . . . . . . . . . . . 9,000 10,800 1,800 U Shipping expenses . . . . . . . . . . . . . . . . . . . . . . 4,000 4,300 300 U General and administrative expenses O�ce supplies . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,200 200 U Insurance expenses . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U Depreciation— o�ce equipment. . . . . . . . . . . 7,000 7,000 0 Administrative salaries . . . . . . . . . . . . . . . . . . . 13,000 13,000 0 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 99,600 11,600 U Income from operations . . . . . . . . . . . . . . . . . . . $ 12,000 $ 25,400 $13,400 F

* F = Favorable variance; U 5 Unfavorable variance.

Entrepreneur The head of the strategic consulting division of your financial services firm complains to you about the unfavorable variances on the division’s performance reports. “We worked on more consulting assignments than planned. It’s not surprising our costs are higher than expected. To top it off, this report characterizes our work as poor!” How do you respond? ■ Answer: From the complaints, this performance report appears to compare actual results with a fixed budget. This comparison is useful in determining whether the amount of work actually performed was more or less than planned, but it is not useful in determining whether the division was more or less efficient than planned. If the division worked on more assignments than expected, some costs will certainly increase. Therefore, you should prepare a flexible budget using the actual number of consulting assignments and then compare actual perfor- mance to the flexible budget.

Decision Maker

A manufacturing company reports the following fixed budget and actual results for the past year. The fixed budget assumes a selling price of $40 per unit. The fixed budget is based on 20,000 units of sales, and the actual results are based on 24,000 units of sales. Prepare a flexible budget performance report for the past year. Label variances as favorable (F) or unfavorable (U).P1

Flexible Budget

NEED-TO-KNOW 21-1

Solution

Fixed Budget Actual Results (20,000 units) (24,000 units)

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $972,000

Variable costs* . . . . . . . . . . . . . . . . . . . . . 160,000 240,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . 500,000 490,000

*Budgeted variable cost per unit = $160,000∕20,000 = $8.00.

Flexible Budget Performance Report

Flexible Budget Actual Results (24,000 units) (24,000 units) Variances

Sales . . . . . . . . . . . . . . . . . . . $960,000* $972,000 $12,000 F Variable costs . . . . . . . . . . . . 192,000† 240,000 48,000 U Contribution margin . . . . . . . 768,000 732,000 36,000 U Fixed costs . . . . . . . . . . . . . . 500,000 490,000 10,000 F Income from operations . . . . $268,000 $242,000 $26,000 U

*24,000 × $40 †24,000 × $8

Do More: QS 21-1, QS 21-2, QS 21-3, QS 21-4, E 21-3,

E 21-4, E 21-5, E 21-6

Chapter 21 Flexible Budgets and Standard Costs 827

We next show how standard costs can be used in a flexible budgeting system to enable manage- ment to better understand the reasons for variances.

Standard Costs Standard costs are preset costs for delivering a product or service under normal conditions. These costs are established by personnel, engineering, and accounting studies using past experi- ences. Manufacturing companies usually use standard costing for direct materials, direct labor, and overhead costs.

When actual costs vary from standard costs, management identifies potential problems and takes corrective actions. Management by exception means that managers focus attention on the most significant differences between actual costs and standard costs. Management by exception is most useful when directed at controllable revenues and costs.

Standard costs are often used in preparing budgets because they are the anticipated costs under normal conditions. For example, if the standard direct materials cost is $2.00 per unit and expected production is 50,000 units, the total budgeted direct materials cost is $100,000. Terms such as standard materials cost, standard labor cost, and standard overhead cost are often used to refer to amounts budgeted for direct materials, direct labor, and overhead.

Standard costs can also help control nonmanufacturing costs. Companies providing services can also use standard costs. For example, while quality medical service is paramount, efficiency in providing that service is also important in controlling medical costs. The use of budgeting and standard costing is touted as an effective means to control and monitor medical costs, espe- cially overhead.

Setting Standard Costs Managerial accountants, engineers, personnel administrators, purchasing managers, and produc- tion managers work together to set standard costs. To identify standards for direct labor costs, we can conduct time and motion studies for each labor operation in the process of providing a product or service. From these studies, management can learn the best way to perform the operation and then set the standard labor time required for the operation under normal conditions. Similarly, standards for direct materials are set by studying the quantity, grade, and cost of each material used. Overhead standards are set by considering the resources needed to support production activ- ities. Standards should be challenging but attainable and should acknowledge machine break- downs, material waste, and idle time. Regardless of the care used in setting standard costs and in revising them as conditions change, actual costs frequently differ from standard costs.

STANDARD COSTING C1 Define standard costs and explain how standard cost information is useful for management by exception.

Example: What factors might be considered when deciding whether to revise standard costs? Answer: Changes in the pro- cesses and/or resources needed to carry out the processes.

Cruis’n Standards The Tesla Model S consists of hundreds of parts for which engineers set standards. Various types of labor are also involved in its production, including machining, assembly, painting, and welding, and standards are set for each. Actual results are periodically compared with standards to assess performance. ■

Decision Insight

To illustrate the setting of standard costs, we consider wooden baseball bats manufactured by ProBat. Its engineers have determined that manufacturing one bat requires 0.90 kilograms (kg) of high-grade wood. They also expect some loss of material as part of the process because of inefficiencies and waste. This results in adding an allowance of 0.10 kg, making the standard requirement 1.0 kg of wood for each bat.

The 0.90-kg portion is called an ideal standard; it is the quantity of material required if the process is 100% efficient without any loss or waste. Reality suggests that some loss of material usually occurs with any process. The standard of 1.0 kg is known as the practical standard, the quantity of material required under normal application of the process. The standard direct labor rate should include allowances for employee breaks, cleanup, and machine downtime. Most companies use practical rather than ideal standards.

Point: Companies promoting continuous improvement strive to achieve ideal standards by elimi- nating inefficiencies and waste.

828 Chapter 21 Flexible Budgets and Standard Costs

ProBat needs to develop standard costs for direct materials, direct labor, and overhead. For direct materials and direct labor, ProBat must develop standard quantities and standard prices. For over- head, ProBat must consider the activities that drive overhead costs. ProBat’s standard costs are:

Direct materials High-grade wood is purchased at a standard price of $25 per kg. The pur- chasing department sets this price as the expected price for the budget period. To determine this price, the purchasing department considers factors such as the quality of materials, eco- nomic conditions, supply factors (shortages and excesses), and available discounts.

Direct labor Two hours of labor time are required to manufacture a bat. The direct labor rate is $20 per hour. This rate includes wages, taxes, and fringe benefits. When wage rates differ across employees due to seniority or skill level, the standard direct labor rate is based on the expected mix of workers.

Overhead ProBat assigns overhead at the rate of $10 per direct labor hour.

The standard costs of direct materials, direct labor, and overhead for one bat are shown in Exhibit 21.5 in a standard cost card. These standard cost amounts are then used to prepare manufacturing budgets for a budgeted level of production.

Direct materials (wood)

Direct labor

Overhead

$25 40

20

Production Factor 1 kg 2 hours

2 labor hours

Standard Quantity per Unit Total Standard Cost

$85

STANDARD COST CARD

Total

Standard Cost per Unit $25 per kg $20 per hour

$10 per hour

EXHIBIT 21.5 Standard Cost Card

Cost Variance Analysis Companies analyze differences between actual costs and standard costs to assess performance. A cost variance, also simply called a variance, is the difference between actual and standard costs. Cost variances can be favorable (F) or unfavorable (U). If actual cost is less than standard cost, the variance is favorable (F). If actual costs are greater than standard costs, the variance is unfavorable (U).1

Exhibit 21.6 shows the flow of events in variance analysis: (1) preparing a standard cost per- formance report, (2) computing and analyzing variances, (3) identifying questions and their answers, and (4) taking corrective and strategic actions (if needed). These variance analysis steps are interrelated and are frequently applied in good organizations.

P2 Compute the total cost variance.

1Short-term favorable variances can sometimes lead to long-term unfavorable variances. For instance, if management spends less than the budgeted amount on maintenance or insurance, the performance report would show a favorable short-term variance. Cutting these expenses can lead to major losses in the long run if machinery wears out prema- turely or insurance coverage proves inadequate.

EXHIBIT 21.6 Variance Analysis

Cumulative Pay (Excludes Current Period)

Current Period Gross Pay FUTA

Pay Hours

Gross Pay

Pay Type SIT

FIT

SUTA

Kathleen

Anthony

Nichole

Zoey

Gracie

Totals

Employee

$108,300.00

6,800.00

15,000.00

6,500.00

5,000.00

141,600.00

Regular Overtime

Regular Overtime

Regular Overtime

Salary

Salary

0

4

74

8

80

80

---

---

388.00

21.00

22.00

2,380.00

90.00

25.00

100.00

110.00

80.00 300.00

$2,000.00

20.00

0.00 740.00

500.00

$7,000.00

FICA-SS_EE FICA-Med_EE

FICA-SS_ER FICA-Med_ER

EE-Ben_Plan Withholding ER-Ben_Plan Withholding

Prepare reports Analyze variances Questions and answers Take action

Cost Variance Computation Exhibit 21.7 shows a general formula for computing any cost variance (CV).

*AQ is actual quantity; AP is actual price; SP is standard price; SQ is standard quantity allowed for actual output.

EXHIBIT 21.7 Cost Variance Formulas*

Actual Cost (AC) Standard Cost (SC) AQ × AP

– SQ × SP

Cost Variance (CV)

Chapter 21 Flexible Budgets and Standard Costs 829

Actual quantity (AQ) is the actual amount of material or labor used to manufacture the actual quantity of output for the period. Standard quantity (SQ) is the standard amount of input for the actual quantity of output for the period. Actual price (AP) is the actual amount paid to acquire the actual direct material or direct labor used for the period. SP is the standard price.

We show how to compute the total cost variance for G-Max, a manufacturer of golf equipment and accessories. G-Max set the following standard costs per unit for one of its specialty clubheads.

Budgeted (standard) cost . . . . . . . . . . . . . . . . . . . . . . $ 98,000

Actual cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,550

Total cost variance . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,550 U

G-Max then computes the total cost variance as follows.

Budgeted and actual costs are based on the actual number of units produced (3,500). To make 3,500 clubheads, G-Max should have used 1,750 pounds (0.5 lb. per unit × 3,500 units) of direct materials and 3,500 direct labor hours (1 hour per unit × 3,500 units). Multiplying these standard quantities by their standard unit costs and summing yields the total budgeted cost ($98,000). As G-Max’s actual cost to produce 3,500 units ($101,500) is more than the budgeted cost to produce 3,500 units ($98,000), the total cost variance is unfavorable ($3,550). Next we show how to use more detailed variances to determine the causes of G-Max’s unfavorable total cost variance.

Standard

Direct materials . . . . . . . . . . . . . . . 0 .5 lb . per unit @ $20 per lb .

Direct labor . . . . . . . . . . . . . . . . . 1 hour per unit @ $16 per hour

Overhead . . . . . . . . . . . . . . . . . . . $2 per direct labor hour

Budgeted Cost

Direct materials . . . . . . . . . . . . 0 .5 × 3,500 × $20 = $35,000 Direct labor . . . . . . . . . . . . . . 1 × 3,500 × $16 = 56,000 Overhead . . . . . . . . . . . . . . . . 1 × 3,500 × $2 = 7,000 Total budgeted cost . . . . . . . . $98,000

During May, G-Max actually produced 3,500 clubheads at a total manufacturing cost of $101,550. Budgeted costs, which equal the standard costs per unit multiplied by the number of units actually produced, are computed below.

A manufacturer reports the following standard cost card. For June, the company made 1,200 units and in- curred actual total manufacturing costs of $135,850. Compute the standard cost per unit and the total cost variance. Label the variance as favorable (F) or unfavorable (U).

P2 Cost Variances

NEED-TO-KNOW 21-2

Production Factor Standard

Direct materials . . . . . . . . . . . . 2 lbs . per unit @ $25 per lb .

Direct labor . . . . . . . . . . . . . . 1 .5 hours per unit @ $18 per hour

Overhead . . . . . . . . . . . . . . . . $24 per direct labor hour

Budgeted Cost

Direct materials . . . . . . . . . . . . 2 × 1,200 × $25 = $ 60,000 Direct labor . . . . . . . . . . . . . . . 1 .5 × 1,200 × $18 = 32,400 Overhead . . . . . . . . . . . . . . . . 1 .5 × 1,200 × $24 = 43,200 Total budgeted cost . . . . . . . . $135,600

Solution

Standard cost per unit = (2 × $25) + (1.5 × $18) + (1.5 × $24) = $113 Total cost variance = $135,850 − $135,600 = $250 U

Do More: QS 21-6, E 21-8

Point: In this example overhead is allocated based on direct labor hours.

830 Chapter 21 Flexible Budgets and Standard Costs

Two main factors cause materials and labor variances:

1. Price variance. A difference between actual price per unit of input and standard price per unit of input results in a price (or rate) variance.

2. Quantity variance. A difference between actual quantity of input used and standard quantity of input that should have been used results in a quantity (or usage or efficiency) variance.

Isolating these price and quantity factors in a cost variance leads to the formulas in Exhibit 21.8.

MATERIALS AND LABOR VARIANCES

EXHIBIT 21.8 Price Variance and Quantity Variance Formulas

Actual Cost Standard Cost AQ × AP SQ × SP AQ × SP

Price Variance (AQ × AP) – (AQ × SP)

Cost Variance

Quantity Variance (AQ × SP) – (SQ × SP)

The model in Exhibit 21.8 separates total cost variances for materials or labor into separate price and quantity variances, which is useful in analyzing performance. Exhibit 21.8 illustrates three important rules in computing these variances:

1. In computing a price variance, the quantity (actual) is held constant. 2. In computing a quantity variance, the price (standard) is held constant. 3. Cost variance, or total variance, is the sum of price and quantity variances.

Managers sometimes find it useful to use an alternative (but equivalent) computation for the price and quantity variances, as shown in Exhibit 21.9.

Point: Detailed overhead variances are computed differently, as we show later in this chapter.

EXHIBIT 21.9 Alternative Price Variance and Quantity Variance Formulas

Price Variance (PV) = [Actual Price (AP) − Standard Price (SP)] × Actual Quantity (AQ)

Quantity Variance (QV) = [Actual Quantity (AQ) − Standard Quantity (SQ)] × Standard Price (SP)

The results from applying the formulas in Exhibits 21.8 and 21.9 are identical.

Materials Variances G-Max produced 3,500 units in May. In producing 3,500 units, it actually used 1,800 pounds of direct materials (titanium) at a cost of $21 per pound. It should have used 1,750 pounds of direct materials (3,500 × 0.5 lb. per unit). This amount of 1,750 pounds is the standard quantity of direct materials that should have been used to produce 3,500 units. This information allows us to compute both actual and standard direct materials costs for G-Max’s 3,500 units and its total direct materials cost variance as follows.

P3 Compute materials and labor variances.

©Kristjan Maack/Getty Images/ Nordic Photos

Direct Materials Quantity Price per Unit Cost

Actual quantity and cost . . . . . . . . . . . . 1,800 lbs . × $21 per lb . = $37,800 Standard quantity and cost . . . . . . . . . . 1,750 lbs .* × $20 per lb . = 35,000 Direct materials cost variance . . . . . . . . = $ 2,800 U

*Standard quantity = 3,500 units × 0.5 lb. per unit.

To better isolate the causes of this $2,800 unfavorable total direct materials cost variance, the materials price and quantity variances are computed and shown in Exhibit 21.10.

Chapter 21 Flexible Budgets and Standard Costs 831

EXHIBIT 21.10 Materials Price and Quantity Variances*

Actual Cost Standard Cost AQ × AP

1,800 lbs. × $21 $37,800

SQ × SP 1,750 lbs. × $20

$35,000

AQ × SP 1,800 lbs. × $20

$36,000

$1,800 U $1,000 U

$2,800 U

Quantity Variance $36,000 – $35,000

Total Direct Materials Variance $1,800 U + $1,000 U

Price Variance $37,800 – $36,000

*AQ is actual quantity; AP is actual price; SP is standard price; SQ is standard quantity allowed for actual output.

Point: The direct materials price variance can also be computed as ($21 − $20) × 18,000 = $1,800. The direct materials quantity vari- ance can also be computed as (1,800 − 1,750) × $20 = $1,000.

We now can see the two components of the $2,800 unfavorable direct materials cost variance: The $1,800 unfavorable price variance results from paying $1 more per pound than the standard price, computed as 1,800 lbs. × $1. G-Max also used 50 pounds more of materials than the standard quantity (1,800 actual pounds − 1,750 standard pounds). The $1,000 unfavorable quantity variance is computed as [(1,800 actual lbs. − 1,750 standard lbs.) × $20 standard price per lb.]. Detailed price and quantity variances allow management to ask the responsible indi- viduals for explanations and take corrective actions.

Evaluating Materials Variances The purchasing department is responsible for the price paid for materials. The purchasing manager must explain why a price higher than standard was paid. The purchasing manager might have negotiated poor prices, or purchased higher- quality materials.

The production department is responsible for the quantity of material used. The produc- tion manager must explain why the process used more than the standard amount of materi- als. Perhaps poorly trained workers used excess amounts of materials.

Variance analysis presents challenges. For instance, the production department could have used more than the standard amount of material because the materials’ quality did not meet specifications and led to excessive waste. In this case, the purchasing manager must explain why inferior materials were acquired. However, if analysis shows that waste was due to inefficiencies, not poor-quality material, the production manager must explain what happened.

$1,800 U DM Price DM Qty.

$1,000 U

DM Var. $2,800 U

A manufacturing company reports the following for one of its products. Compute the direct materials (a) price variance and (b) quantity variance and classify each as favorable or unfavorable.

P3

Direct Materials Price and Quantity Variances

NEED-TO-KNOW 21-3

Direct materials standard . . . . . . . . . . 8 pounds @ $6 per pound

Actual direct materials used . . . . . . . . 83,000 pounds @ $5 .80 per pound

Actual finished units produced . . . . . 10,000

Solution

a. Price variance = (Actual quantity × Actual price) − (Actual quantity × Standard price) = (83,000 × $5.80) − (83,000 × $6) = $16,600 Favorable b. Quantity variance = (Actual quantity × Standard price) − (Standard quantity* × Standard price) = (83,000 × $6) − (80,000 × $6) = $18,000 Unfavorable Do More: QS 21-8, E 21-9,

E 21-13*Standard quantity = 10,000 units × 8 standard pounds per unit = 80,000 pounds.

832 Chapter 21 Flexible Budgets and Standard Costs

Labor Variances Labor cost for a product or service depends on the number of hours worked (quantity) and the wage rate paid to employees (price). To illustrate, G-Max’s direct labor standard for 3,500 units of its handcrafted clubheads is one direct labor hour per unit, or 3,500 hours at $16 per hour. But because only 3,400 hours at $16.50 per hour were actually used to complete the units, the actual and standard direct labor costs are

Direct Labor Quantity Rate per Hour Cost

Actual quantity and cost . . . . . . . . . . . 3,400 hrs . × $16 .50 per hr . = $56,100 Standard quantity and cost . . . . . . . . 3,500 hrs .* × $16 .00 per hr . = 56,000 Direct labor cost variance . . . . . . . . . = $ 100 U

*Standard quantity = 3,500 units × 1 standard direct labor hour per unit.

Actual direct labor cost is merely $100 over the standard; that small difference might suggest no immediate concern. A closer look, however, might suggest problems. The direct labor cost vari- ance can be divided into price and quantity variances, which are usually called rate and effi- ciency variances. Computing both the labor rate and efficiency variances reveals a more precise picture, as shown in Exhibit 21.11.

Evaluating Labor Variances Exhibit 21.11 shows that the $100 total unfavorable la- bor cost variance results from a $1,600 favorable efficiency variance and a $1,700 unfavorable rate variance. To produce 3,500 units, G-Max should use 3,500 direct labor hours (3,500 units × 1 direct labor hour per unit). The favorable efficiency variance results from using 100 fewer direct labor hours (3,400 actual DLH − 3,500 standard DLH) than standard for the units pro- duced. The unfavorable rate variance results from paying a wage rate that is $0.50 per hour higher ($16.50 actual rate − $16.00 standard rate) than standard. The personnel administrator or the production manager needs to explain why the wage rate is higher than expected. The produc- tion manager should explain how the labor hours were reduced. If this experience can be re- peated and transferred to other departments, more savings are possible.

One possible explanation of these labor rate and efficiency variances is the use of workers with different skill levels. If so, management must discuss the implications with the production manager who assigns workers to tasks. This might show that higher-skilled workers were used. As a result, fewer labor hours might be required for the work, but the wage rate paid these work- ers is higher than standard because of their greater skills. This higher-than-standard labor cost might require an adjustment of the standard labor rates, or the use of more lower-skilled workers.

Other explanations for direct labor variances are possible. Lower-quality materials, poor employee training or supervision, equipment breakdowns, and idle workers due to reduced demand for the company’s products could lead to unfavorable direct labor efficiency variances.

Example: Compute the rate vari- ance and the efficiency variance for Exhibit 21.11 if 3,700 actual hours are used at an actual price of $15.50 per hour. Answer: $1,700 favorable labor rate variance and $3,200 unfavorable labor efficiency variance.

EXHIBIT 21.11 Labor Rate and Efficiency Variances*

Actual Cost Standard Cost AH × AR

3,400 hrs. × $16.50 $56,100

SH × SR 3,500 hrs. × $16.00

$56,000

AH × SR 3,400 hrs. × $16.00

$54,400

$1,700 U $1,600 F

$100 U

E�ciency Variance $54,400 – $56,000

Total Direct Labor Variance $1,700 U – $1,600 F

Rate Variance $56,100 – $54,400

*Here, we use hours (H) for quantity (Q) and the wage rate (R) for price (P). Thus: AH is actual direct labor hours: AR is actual wage rate; SH is standard direct labor hours allowed for actual output; SR is standard wage rate.

Point: The direct labor efficiency variance can also be computed as (3,400 − 3,500) × $16 = $1,600. The direct labor rate variance can also be computed as ($16.50 − $16) × 3,400 = $1,700.

DL Var. $100 U

DL Rate $1,700 U

DL E�. $1,600 F

Chapter 21 Flexible Budgets and Standard Costs 833

Production Manager A manufacturing variance report for June shows a large unfavorable labor efficiency (quan- tity) variance. What factors do you investigate to identify its possible causes? ■ Answer: An unfavorable labor efficiency variance occurs because more labor hours than standard were used during the period. Possible reasons for this include (1) materials quality could be poor, resulting in more labor consumption due to rework; (2) unplanned interruptions (strike, breakdowns, accidents) could have occurred during the period; and (3) a dif- ferent labor mix might have occurred for a strategic reason such as to expedite orders. This new labor mix could have consisted of a larger proportion of untrained labor, which resulted in more labor hours.

Decision Maker

©Sollina Images/Blend Images

The following information is available for a manufacturer. Compute the direct labor rate and efficiency variances and label them as favorable (F) or unfavorable (U).

Direct Labor Rate and Efficiency Variances

NEED-TO-KNOW 21-4

P3

Do More: QS 21-11, E 21-10, E 21-16

Rate variance = ($13 .10 − $13 .00) × 6,250 = $625 U Efficiency variance = (6,250 − 5,000) × $13 .00 = $16,250 U Total standard hours = 2,500 × 2 .0 = 5,000

Solution

Actual direct labor cost (6,250 hours @ $13 .10 per hour) . . . $81,875

Standard direct labor hours per unit . . . . . . . . . . . . . . . . . . . . 2 .0 hours

Standard direct labor rate per hour . . . . . . . . . . . . . . . . . . . . . $13 .00

Actual production (units) . . . . . . 2,500 units

Budgeted production (units) . . . 3,000 units

In previous chapters we showed how companies use predetermined overhead rates to allocate overhead costs to products or services. In a standard costing system, this allocation is done using the standard amount of the overhead allocation base, such as standard labor hours or standard machine hours. We now show how to use standard costs to develop flexible overhead budgets.

Flexible Overhead Budgets Standard overhead costs are the overhead amounts expected to occur at a certain activity level. Over- head includes fixed costs and variable costs. This requires management to classify overhead costs as fixed or variable (within a relevant range) and to develop a flexible budget for overhead costs.

To illustrate, the first two number columns of Exhibit 21.12 show the overhead cost structure to develop G-Max’s flexible overhead budgets for May 2019. At the beginning of the year, G-Max predicted variable overhead costs of $1.00 per unit (clubhead), comprised of $0.40 per unit for indirect labor, $0.30 per unit for indirect materials, $0.20 per unit for power and lights, and $0.10 per unit for factory maintenance. In addition, G-Max predicts monthly fixed overhead of $4,000.

With these variable and fixed overhead cost amounts, G-Max can prepare flexible overhead budgets at various capacity levels (four rightmost number columns in Exhibit 21.12). At its maxi- mum capacity (100% column), G-Max could produce 5,000 clubheads. At 70% of maximum capac- ity, G-Max could produce 3,500 (computed as 5,000 × 70%) clubheads. Recall that total variable costs will increase as production activity increases, but total fixed costs will not change as produc- tion activity changes. At 70% capacity, variable overhead costs are budgeted at $3,500 (3,500 × $1.00), while at 100% capacity, variable overhead costs are budgeted at $5,000 (5,000 × $1.00). At all capacity levels within the relevant range, fixed overhead costs are budgeted at $4,000 per month.

Standard Overhead Rate To apply standard overhead costs to products or services, management establishes the standard overhead cost rate, using the three-step process below.

Step 1: Determine an Allocation Base The allocation base is a measure of input that is related to overhead costs. Examples can include direct labor hours or machine hours. We

OVERHEAD STANDARDS AND VARIANCES

Point: With increased automation, machine hours are frequently used in applying overhead instead of labor hours.

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834 Chapter 21 Flexible Budgets and Standard Costs

assume that G-Max uses direct labor hours as an allocation base, and it has a standard of one direct labor hour per finished unit.

Step 2: Choose a Predicted Activity Level The predicted activity level is rarely set at 100% of capacity. Difficulties in scheduling work, equipment breakdowns, and insuffi- cient product demand typically cause the activity level to be less than full capacity. Also, good long-run management practices usually call for some excess plant capacity to allow for special opportunities and demand changes. G-Max managers predicted an 80% activity level for May, or a production volume of 4,000 clubheads.

Step 3: Compute the Standard Overhead Rate At the predicted activity level of 4,000 units, the flexible budget in Exhibit 21.12 predicts total overhead of $8,000. At this activity level of 4,000 units, G-Max’s standard direct labor hours are 4,000 hours (4,000 units × 1 direct labor hour per unit). G-Max’s standard overhead rate is then computed as:

EXHIBIT 21.12 Flexible Overhead Budgets

G-MAX Flexible Overhead Budgets

Flexible Budget

Variable Total Amount Fixed

Flexible Budget at Capacity Level of

For Month Ended May 31, 2019 per Unit Cost 70% 80% 90% 100%

Production (in units) . . . . . . . . . . . . . . . . . . . . 1 unit 3,500 4,000 4,500 5,000 Factory overhead

Variable costs

Indirect labor . . . . . . . . . . . . . . . . . . . . . $0 .40/unit $1,400 $1,600 $1,800 $2,000 Indirect materials . . . . . . . . . . . . . . . . . . 0 .30/unit 1,050 1,200 1,350 1,500 Power and lights . . . . . . . . . . . . . . . . . . 0 .20/unit 700 800 900 1,000 Maintenance . . . . . . . . . . . . . . . . . . . . . 0 .10/unit 350 400 450 500 Total variable overhead costs . . . . . . . . $1 .00/unit 3,500 4,000 4,500 5,000 Fixed costs (per month)

Building rent . . . . . . . . . . . . . . . . . . . . . . $1,000 1,000 1,000 1,000 1,000 Depreciation—Machinery . . . . . . . . . . . 1,200 1,200 1,200 1,200 1,200 Supervisory salaries . . . . . . . . . . . . . . . 1,800 1,800 1,800 1,800 1,800 Total fixed overhead costs . . . . . . . . . . $4,000 4,000 4,000 4,000 4,000 Total factory overhead . . . . . . . . . . . . . . . . $7,500 $8,000 $8,500 $9,000

Standard direct labor hours (1 DL hr ./unit) . . . . 3,500 hrs . 4,000 hrs. 4,500 hrs . 5,000 hrs . Predetermined overhead rate per standard direct labor hour . . . . . . . . . . . . . $ 2.00

Point: According to the U.S. Federal Reserve Board, U.S. busi- nesses operated at an average capacity level of 80% between 1972 and 2016. Average capac- ity usage levels ranged from 79% for manufacturing businesses to 87% for mining companies.

Example: What would G-Max’s standard overhead rate per unit be if management expected to operate at 70% capacity? At 100% capacity? Answer: At 70% capacity, the standard overhead rate is $2.14 per unit (rounded), computed as $7,500∕3,500 direct labor hours. At 100% capac- ity, the standard overhead rate per unit is $1.80 ($9,000∕5,000).

Standard overhead rate = Total overhead cost at predicted activity level

Total direct labor hours at predicted activity level

= $8,000 4,000

= $2 per direct labor hour

This standard overhead rate is used in computing overhead cost variances, as we show next, and in recording journal entries in a standard cost system, which we show in the appendix to this chapter.

Measuring Up In the spirit of continuous improvement, competitors compare their processes and performance standards against benchmarks established by industry leaders. Companies that use benchmarking include Jiffy Lube, All Tune and Lube, and SpeeDee Oil Change and Auto Service. ■

Decision Insight

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Chapter 21 Flexible Budgets and Standard Costs 835

Computing Overhead Cost Variances In a standard costing system, overhead is applied with the formula in Exhibit 21.13.

EXHIBIT 21.13 Applying Standard Overhead Cost

Standard overhead applied =

Actual production ×

Standard amount of allocation base ×

Standard overhead rate (at predicted activity level)

The standard overhead applied is based on the standard amount of the allocation base that should have been used, based on the actual production. This standard activity amount is then multiplied by the predetermined standard overhead rate (at the predicted activity level). For G-Max for May, standard overhead applied is computed as:

To illustrate, G-Max’s actual overhead cost incurred in the month (found in other cost reports) is $7,650. Using the formula in Exhibit 21.14, G-Max’s total overhead variance is $650, computed as:

Total Overhead Variance Actual total overhead (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,650

Standard overhead applied (3,500 units × 1 DLH per unit × $2 .00 per DLH) . . . . . . 7,000 Total overhead variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 650 U

This variance is unfavorable: G-Max’s actual overhead was higher than the standard amount.

Overhead Controllable and Volume Variances To help identify factors caus- ing the total overhead cost variance, managers compute overhead volume and overhead control- lable variances, as illustrated in Exhibit 21.15. The results are useful for taking strategic actions to improve company performance.

EXHIBIT 21.15 Framework for Understanding Total Overhead Variance

Overhead Controllable Variance Actual total overhead incurred – Budgeted total overhead

Overhead Volume Variance Budgeted fixed overhead – Applied fixed overhead

Total Overhead Variance Actual total overhead incurred – Standard total overhead applied

Standard overhead applied = 3,500 units × 1 DLH per unit × $2.00 per DLH = $7,000

Overhead cost = Actual overhead − Standard overhead variance incurred applied

EXHIBIT 21.14 Overhead Cost Variance

G-Max produced 3,500 units during the month, which should have used 3,500 direct labor hours. At G-Max’s predicted capacity level of 80%, the standard overhead rate was $2.00 per direct labor hour. The standard overhead applied is $7,000, as computed above.

Actual overhead incurred might differ from the standard overhead applied for the period, and management again will use variance analysis. The difference between the standard amount of overhead cost applied and the total actual overhead incurred is the overhead cost variance (total overhead variance), shown in Exhibit 21.14.

P4 Compute overhead controllable and volume variances.

836 Chapter 21 Flexible Budgets and Standard Costs

A volume variance occurs when the company operates at a different capacity level than was predicted. G-Max predicted it would manufacture 4,000 units, but it only manufactured 3,500 units. The volume variance is usually considered outside the control of the production manager, as it depends mainly on customer demand for the company’s products.

The volume variance is based solely on fixed overhead. Recall that G-Max’s standard fixed overhead rate at the predicted capacity level of 4,000 units was $1 per direct labor hour. The overhead volume variance is computed as:

Overhead Volume Variance Budgeted fixed overhead (at predicted capacity) . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000

Applied fixed overhead (3,500 units × 1 DLH per unit × $1 .00 per DLH) . . . . . . . 3,500 Volume variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 U

Overhead Controllable Variance Actual total overhead (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,650

Budgeted total overhead (from above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Controllable variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 150 U

The volume variance is unfavorable because G-Max made 500 fewer units than it expected. With a total overhead variance of $650 (unfavorable) and a volume variance of $500 (unfavor- able), the controllable overhead variance is computed as:

Controllable variance = Total overhead variance − Overhead volume variance $150 U = $650 − $500

More formally, the controllable variance is the difference between the actual overhead costs incurred and the budgeted overhead costs for the standard hours that should have been used for actual production. Controllable variance is the portion of total overhead variance that is considered to be under management’s control. Because G-Max only produced 3,500 units during the month, we need to compare actual overhead costs to make 3,500 units to the budgeted cost to make 3,500 units. Budgeted total overhead cost to make 3,500 units is computed as:

Budgeted Total Overhead Cost Budgeted variable overhead cost (3,500 units × 1 DLH per unit × $1 VOH* rate per DLH) . . . . . . . . . . . . . . . $3,500 Budgeted fixed overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Budgeted total overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,500

*VOH is variable overhead.

Controllable variance is then computed as:

Analyzing Overhead Controllable and Volume Variances How should management interpret the unfavorable overhead controllable and volume variances? An unfa- vorable volume variance means that the company did not reach its predicted operating level. In this case, 80% of manufacturing capacity was budgeted, but only 70% was used. Management needs to know why the actual level of production differs from the expected level. The main pur- pose of the volume variance is to identify what portion of total overhead variance is caused by failing to meet the expected production level. Often the reasons for failing to meet this expected

Chapter 21 Flexible Budgets and Standard Costs 837

production level are due to factors, such as customer demand, that are beyond employees’ con- trol. This information permits management to focus on explanations for the controllable vari- ance, as we discuss next.

Overhead Variance Reports To help management isolate the reasons for the $150 unfavorable overhead controllable variance, an overhead variance report can be prepared. An overhead variance report shows specific overhead costs and how they differ from bud- geted amounts. Exhibit 21.16 shows G-Max’s overhead variance report for May. The de- tailed listing of individual overhead costs reveals the following sources of the $150 unfavorable overhead controllable variance: (1) Fixed overhead costs and variable factory maintenance costs were incurred as expected. (2) Costs for indirect labor and power and lights were higher than expected. (3) Indirect materials cost was less than expected. Management can use the variance overhead report to identify individual overhead costs to investigate.

Appendix 21A describes an expanded analysis of overhead variances.

A manufacturing company uses standard costs and reports the information below for January. The com- pany uses machine hours to apply overhead, and the standard is two machine hours per finished unit. Compute the total overhead cost variance, overhead controllable variance, and overhead volume variance for January. Indicate whether each variance is favorable or unfavorable.

Overhead Variances

NEED-TO-KNOW 21-5

P4 Predicted activity level . . . . . . . . . . . . . . . 1,500 units

Variable overhead rate budgeted . . . . . . $2 .50 per machine hour

Fixed overhead budgeted . . . . . . . . . . . . $6,000 per month ($2 .00 per machine hour at predicted activity level)

Actual activity level . . . . . . . . . . . . . . . . . . 1,800 units

Actual overhead costs . . . . . . . . . . . . . . . $15,800

EXHIBIT 21.16 Overhead Variance Report

G-MAX Overhead Variance Report

For Month Ended May 31, 2019

Production Level Expected . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80% of capacity (4,000 units)

Actual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70% of capacity (3,500 units)

Flexible Actual Overhead Controllable Variance Budget Results Variances*

Variable overhead costs

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,400 $1,525 $125 U Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050 1,025 25 F Power and lights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 750 50 U Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 350 0 Total variable overhead costs . . . . . . . . . . . . . . . . . . . . . 3,500 3,650 150 U Fixed overhead costs

Building rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 0 Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . 1,200 1,200 0 Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 1,800 0 Total fixed overhead costs . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000 0 Total overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,500 $7,650 $150 U

Overhead Volume Variance Budgeted fixed overhead (4,000 DLH × $1 .00) . . . . . . . . . $4,000 Fixed overhead applied (3,500 DLH × $1 .00) . . . . . . . . . . $3,500 Volume variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 U

*F = Favorable variance; U = Unfavorable variance.

Total overhead variance = $650 unfavorable

Point: Both the flexible budget and actual results are based on 3,500 units produced.

Ovhd. Var $650 U

$150 U $500 U Controllable Volume

838 Chapter 21 Flexible Budgets and Standard Costs

Standard Costing—Management Considerations Companies must consider many factors, both positive and negative, in deciding whether and how to use standard costing systems. Below we summarize some of these factors.

EXHIBIT 21.17 Variance Summary

Direct Materials Quantity Variance

$1,000 U

Direct Materials Price Variance

$1,800 U

Direct Labor Rate Variance

$1,700 U

Direct Labor E�ciency Variance

$1,600 F

Controllable Variance $150 U

Volume Variance $500 U

Total Product Cost Variance $3,550 U

Total Overhead Variance $650 U

Total Direct Labor Variance $100 U

Total Direct Materials Variance $2,800 U

Standard Costing Considerations

Positives Negatives

Provides benchmarks for management by exception . Standards are costly to develop and keep up-to-date .

Motivates employees to work toward goals . Variances are not timely for adapting to rapidly changing

Useful in the budgeting process . business conditions .

Isolates reasons for good or bad performance . Employees might not try for continuous improvement .

As more companies report on their sustainability efforts, organizations provide structure for these reports. One group, the International Integrated Reporting Council (IIRC), is a global group of regulators, in- vestors, and accountants that develops methods for integrated reporting. Integrated reporting is designed to concisely report how an organization’s strategy, performance, sustainability efforts, and governance lead to value creation.

Intel, a maker of computer chips, follows many of the IIRC’s recommendations. In its integrated report, Intel notes it links executive pay, in part, to corporate responsibility metrics. For example, 50% of top management’s annual cash bonus is based on meeting operating performance targets, including those

SUSTAINABILITY AND ACCOUNTING

Solution

Total overhead cost variance Actual total overhead cost (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,800

Standard overhead applied (1,800 × 2 × $4 .50) . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,200 Total overhead variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400 F

Overhead controllable variance Actual total overhead cost (given) . . . . . . . . . . . . . . . . . . . . . $15,800

Budgeted total overhead (1,800 × 2 × $2 .50) + $6,000 . . 15,000 Overhead controllable variance . . . . . . . . . . . . . . . . . . . . . . . $ 800 U

Overhead volume variance Budgeted fixed overhead . . . . . . . . . . . . . . . . $ 6,000

Applied fixed overhead (1,800 × 2 × $2) . . 7,200 Overhead volume variance . . . . . . . . . . . . . . $1,200 F

Summary of Variances Exhibit 21.17 summarizes the manufacturing variances for G-Max.

Do More: QS 21-13, QS 21-14, QS 21-15, E 21-17, E 21-19,

E 21-20

Chapter 21 Flexible Budgets and Standard Costs 839

for corporate responsibility and environmental sustainability. Recently, Intel’s top five managers were paid nearly $10 million for meeting performance targets. By linking executive pay to sustainability targets, Intel motivates managers to integrate sustainability initiatives with their efforts to make financial profits and increase firm value.

Away, this chapter’s feature company, has teamed with charity: water to increase access to clean water. The company donates $30 to charity: water each time an item from its special line of carry-on bags is sold. Although initiatives like these reduce Away’s financial profits, the founders stress the importance of “planet and people” in defining success.

Sales Variances Decision Analysis

Variance analysis can also be applied to sales. The budgeted amount of unit sales is the predicted activity level, and the budgeted selling price is treated as a “standard” price. To illustrate, consider the following sales data from G-Max for two of its golf products, Excel golf balls and Big Bert drivers.

The sales price variance and the sales volume variance are as shown in Exhibit 21.18. The sales price variance measures the impact of the actual sales price differing from the expected price. The sales volume variance measures the impact of operating at a different capacity level than predicted by the fixed budget. The total sales price variance is $850 unfavorable, and the total sales volume variance is $1,000 unfavor- able. However, further analysis of these total sales variances reveals that both the sales price and sales volume variances for Excel golf balls are favorable, while both variances are unfavorable for the Big Bert driver.

A1 Analyze changes in sales from expected amounts.

Budgeted Actual

Sales of Excel golf balls (units) . . . . . . . . . . . . . . . 1,000 units 1,100 units

Sales price per Excel golf ball . . . . . . . . . . . . . . . $10 $10 .50

Sales of Big Bert drivers (units) . . . . . . . . . . . . . . 150 units 140 units

Sales price per Big Bert driver . . . . . . . . . . . . . . . $200 $190

Actual Results AS × AP

Excel Golf Balls

(1,000 × $10)

(1,100 × $10.50)

(1,100 × $10) $11,550 $11,000 $10,000Sales dollars (balls)

$1,000 F$550 F

Big Bert Drivers

(150 × $200)

(140 × $200)

(140 × $190) $26,600 $28,000 $30,000Sales dollars (drivers)

Total $850 U $1,000 U

$2,000 U$1,400 U

Sales Volume Variance (AS × BP) – (BS × BP)

Sales Volume Variance (AS × BP) – (BS × BP)

Sales Price Variance (AS × AP) – (AS × BP)

Sales Price Variance (AS × AP) – (AS × BP)

*AS = actual sales units; AP = actual sales price; BP = budgeted sales price; BS = budgeted sales units (fixed budget).

Fixed BudgetFlexible Budget BS × BPAS × BP

EXHIBIT 21.18 Computing Sales Variances*

Managers use sales variances for planning and control purposes. G-Max sold 90 combined total units (both balls and drivers) more than budgeted, yet its total sales price and sales volume variances are unfa- vorable. The unfavorable sales price variance is due mainly to a decrease in the selling price of Big Bert drivers by $10 per unit. Management must assess whether this price decrease will continue. Likewise, the unfavorable sales volume variance is due to G-Max selling fewer Big Bert drivers (140) than were bud- geted (150). Management must assess whether this decreased demand for Big Bert drivers will persist.

©Away

Standard costs based on expected output of 25,000 units.

Actual costs incurred to produce 27,000 units.

Standard Total Quantity Cost

Direct materials, 4 oz . per unit @ $0 .31 per oz . . . . . . . . . . . . . . . . . . . 100,000 oz . $31,000

Direct labor, 0 .25 hr . per unit @ $6 .00 per hr . . . . . . . . . . . . . . . . . . . . . 6,250 hrs . 37,500

Overhead, 6,250 standard hours × $4 .00 per DLH . . . . . . . . . . . . . . . 25,000

Actual Total Quantity Cost

Direct materials, 110,000 oz . @ $0 .28 per oz . . . . . . . . . . . . . . . . . . . . 110,000 oz . $30,800

Direct labor, 5,400 hrs . @ $7 .00 per hr . . . . . . . . . . . . . . . . . . . . . . . . . 5,400 hrs . 37,800

Overhead ($9,990 + $16,200 + $3,710 + $2,500) . . . . . . . . . . . . . . 32,400

Budget Actual (25,000 units) (27,000 units)

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 .00 per unit $141,210

Variable costs (per unit)

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .24 per unit $30,800

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .50 per unit 37,800

Factory supplies* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .25 per unit 9,990

Utilities* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .50 per unit 16,200

Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .40 per unit 9,180

Fixed costs (per month)

Depreciation—Machinery* . . . . . . . . . . . . . . . . . . . . . $3,750 $3,710

Depreciation—Factory building* . . . . . . . . . . . . . . . . 2,500 2,500

General liability insurance . . . . . . . . . . . . . . . . . . . . . 1,200 1,250

Property taxes on office equipment . . . . . . . . . . . . . 500 485

Other administrative expense . . . . . . . . . . . . . . . . . . 750 900

* Indicates factory overhead item; $0.75 per unit or $3 per direct labor hour for variable overhead, and $0.25 per unit or $1 per direct labor hour for fixed overhead.

Pacific Company provides the following information about its budgeted and actual results for June 2019. Although the expected June volume was 25,000 units produced and sold, the company actually produced and sold 27,000 units, as detailed here.COMPREHENSIVE

Flexible Budgets and Variance Analysis

NEED-TO-KNOW 21-6

840 Chapter 21 Flexible Budgets and Standard Costs

Overall, management can use the detailed sales variances to examine what caused the company to sell more golf balls and fewer drivers. Managers can also use this information to evaluate and even reward salespeople. Extra compensation is paid to salespeople who contribute to a higher profit margin.

Sales Manager The current performance report reveals a large favorable sales volume variance but an unfavorable sales price variance. You did not expect a large increase in sales volume. What steps do you take to analyze this situ- ation? ■ Answer: The unfavorable sales price variance suggests that actual prices were lower than budgeted prices. As the sales manager, you want to know the reasons for a lower-than-expected price. Perhaps your salespeople lowered the price of certain products by offering quantity discounts. You then might want to know what prompted them to offer the quantity discounts (perhaps competitors were offering discounts). You want to determine if the increased sales volume is due mainly to discounted prices or other factors (such as advertising).

Decision Maker

Chapter 21 Flexible Budgets and Standard Costs 841

Required

1. Prepare June flexible budgets showing expected sales, costs, and net income assuming 20,000, 25,000, and 30,000 units of output produced and sold.

2. Prepare a flexible budget performance report that compares actual results with the amounts budgeted if the actual volume of 27,000 units had been expected.

3. Apply variance analysis for direct materials and direct labor. 4. Compute the total overhead variance and the overhead controllable and overhead volume variances. 5. Compute spending and efficiency variances for overhead. (Refer to Appendix 21A.) 6. Prepare journal entries to record standard costs, and price and quantity variances, for direct materials,

direct labor, and factory overhead. (Refer to Appendix 21A.)

PLANNING THE SOLUTION Prepare a table showing the expected results at the three specified levels of output. Compute the vari-

able costs by multiplying the per unit variable costs by the expected volumes. Include fixed costs at the given amounts. Combine the amounts in the table to show total variable costs, contribution margin, total fixed costs, and income from operations.

Prepare a table showing the actual results and the amounts that should be incurred at 27,000 units. Show any differences in the third column and label them with an F for favorable if they increase income or a U for unfavorable if they decrease income.

Using the chapter’s format, compute these total variances and the individual variances requested: Total materials variance (including the direct materials quantity variance and the direct materials

price variance). Total direct labor variance (including the direct labor efficiency variance and rate variance). Total overhead variance (including both controllable and volume overhead variances and their com-

ponent variances). Variable overhead is applied at the rate of $3.00 per direct labor hour. Fixed overhead is applied at the rate of $1.00 per direct labor hour.

SOLUTION 1.

Flexible Budgets

Flexible Budget

Variable Total Amount Fixed

Flexible Budget for Unit Sales of

For Month Ended June 30, 2019 per Unit Cost 20,000 25,000 30,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 .00 $100,000 $125,000 $150,000

Variable costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . 1 .24 24,800 31,000 37,200

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 .50 30,000 37,500 45,000

Factory supplies . . . . . . . . . . . . . . . . . . . . . . . . . 0 .25 5,000 6,250 7,500

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .50 10,000 12,500 15,000

Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .40 8,000 10,000 12,000

Total variable costs . . . . . . . . . . . . . . . . . . . . . . 3 .89 77,800 97,250 116,700

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . $1 .11 22,200 27,750 33,300

Fixed costs Depreciation—Machinery . . . . . . . . . . . . . . . . . $3,750 3,750 3,750 3,750

Depreciation—Factory building . . . . . . . . . . . . . 2,500 2,500 2,500 2,500

General liability insurance . . . . . . . . . . . . . . . . . 1,200 1,200 1,200 1,200

Property taxes on office equipment . . . . . . . . . 500 500 500 500

Other administrative expense . . . . . . . . . . . . . . 750 750 750 750

Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . $8,700 8,700 8,700 8,700

Income from operations . . . . . . . . . . . . . . . . . . . . . $ 13,500 $ 19,050 $ 24,600

842 Chapter 21 Flexible Budgets and Standard Costs

Direct materials cost variances Actual cost (110,000 oz. @ $0.28) . . . . . . . . . . . . . $30,800 Standard cost (108,000 oz. @ $0.31). . . . . . . . . . . . 33,480 Direct materials cost variance . . . . . . . . . . . . . . $ 2,680 F

Actual cost (5,400 hrs. @ $7.00) . . . . . . . . . . . . . . $37,800 Standard cost (6,750 hrs. @ $6.00) . . . . . . . . . . . . 40,500 Direct labor cost variance . . . . . . . . . . . . . . . . . $ 2,700 F

Price and quantity variances (based on formulas in Exhibit 21.10): Standard Cost

$620 U$3,300 F

$2,680 F

AQ × AP 110,000 oz. × $0.28

$30,800

AQ × SP 110,000 oz. × $0.31

$34,100

SQ* × SP 108,000 oz. × $0.31

$33,480

Actual Cost

Price Variance Quantity Variance

Total Direct Materials Variance

Direct labor cost variances

Rate and e�ciency variances (based on formulas in Exhibit 21.11): Standard Cost

AH × AR 5,400 hrs. × $7

$37,800

AH × SR 5,400 hrs. × $6

$32,400

SH† × SR 6,750 hrs. × $6

$40,500

$8,100 F$5,400 U

$2,700 F

Actual Cost

Total Direct Labor Variance

Rate Variance E�ciency Variance

*SQ = 27,000 actual units of output × 4 oz. standard quantity per unit.

†SH = 27,000 actual units of output × 0.25 standard DLH per unit.

2. Flexible Budget Performance Report

Flexible Actual For Month Ended June 30, 2019 Budget Results Variance†

Sales (27,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $135,000 $141,210 $6,210 F Variable costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,480 30,800 2,680 F Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,500 37,800 2,700 F Factory supplies* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,750 9,990 3,240 U Utilities* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500 16,200 2,700 U Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,800 9,180 1,620 F Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . 105,030 103,970 1,060 F Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,970 37,240 7,270 F Fixed costs Depreciation—Machinery* . . . . . . . . . . . . . . . . . . . . . 3,750 3,710 40 F Depreciation—Factory building* . . . . . . . . . . . . . . . . 2,500 2,500 0 General liability insurance . . . . . . . . . . . . . . . . . . . . . 1,200 1,250 50 U Property taxes on office equipment . . . . . . . . . . . . . 500 485 15 F Other administrative expense . . . . . . . . . . . . . . . . . . 750 900 150 U Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,700 8,845 145 U Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,270 $ 28,395 $7,125 F

*Indicates factory overhead item. †F = Favorable variance; U = Unfavorable variance.

3. Variance analysis of materials and labor costs.

Chapter 21 Flexible Budgets and Standard Costs 843

Total overhead cost variance Total overhead cost incurred (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,400 Total overhead applied (27,000 units × 0.25 DLH per unit × $4 per DLH) . . . . . . . . . . . . 27,000 Overhead cost variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,400 U

$32,400 26,500

$ 5,900 U

Controllable variance Total overhead cost incurred (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Budgeted overhead (from flexible budget for 27,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . Controllable variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 6,250 6,750

$ 500 F

Volume variance Budgeted fixed overhead (at predicted capacity) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Applied fixed overhead (6,750 standard DLH × $1.00 fixed overhead rate per DLH) . . . . Volume variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4. Total, controllable, and volume variances for overhead.

5. Variable overhead spending variance, variable overhead efficiency variance, fixed overhead spending variance, and fixed overhead volume variance. (See Appendix 21A.)

Variable overhead variance (factory supplies and utilities)

Variable overhead cost incurred ($9,990 + $16,200) . . . . . . . . . $26,190 Variable overhead cost applied (6,750 hrs. @ $3/hr.) . . . . . . . . . 20,250 Variable overhead cost variance. . . . . . . . . . . . . . . . . . . . . . . . $ 5,940 U

Spending and e ciency variances (based on formulas in Exhibit 21A.2):

AH × AVR

$26,190

AH × SVR 5,400 × $3

$16,200

SH × SVR 6,750 × $3 $20,250

$4,050 F$9,990 U

$5,940 U

Applied OverheadActual Overhead

Spending Variance E�ciency Variance

Total Variable Overhead Variance

Fixed overhead variance (depreciation on machinery and building)

Fixed overhead cost incurred ($3,710 + $2,500) . . . . . . . . . . . . . $6,210 Fixed overhead cost applied (6,750 hrs. @ $1/hr.) . . . . . . . . . . . . 6,750 Fixed overhead cost variance . . . . . . . . . . . . . . . . . . . . . . . . . $ 540 F

Spending and volume variances (based on formulas in Exhibit 21A.2): Actual Overhead Budgeted Overhead

We can also compute: Controllable variance: $5,900 U (both spending variances plus variable overhead e ciency variance) Volume variance: 500 F (identified as above)

6,750 × $1 $6,750$6,250$6,210

$500 F$40 F

$540 F

Spending Variance Volume Variance

Total Fixed Overhead Variance

Applied Overhead

844 Chapter 21 Flexible Budgets and Standard Costs

6. Journal entries under a standard cost system. (Refer to Appendix 21A.)

Work in Process Inventory . . . . . . . . . . . . 33,480 Direct Materials Quantity Variance . . . . . 620 Direct Materials Price Variance . . . . . . 3,300 Raw Materials Inventory . . . . . . . . . . . 30,800

Work in Process Inventory . . . . . . . . . . . . 40,500 Direct Labor Rate Variance . . . . . . . . . . . 5,400 Direct Labor Efficiency Variance . . . . . 8,100 Factory Wages Payable . . . . . . . . . . . . 37,800

Work in Process Inventory* . . . . . . . . . . . . . . 27,000 Variable Overhead Spending Variance . . . . . 9,990 Variable Overhead Efficiency Variance . . . 4,050 Fixed Overhead Spending Variance . . . . . 40 Fixed Overhead Volume Variance . . . . . . . 500 Factory Overhead† . . . . . . . . . . . . . . . . . . . 32,400

*Overhead applied = 6,750 standard DLH × $4 per DLH. †Overhead incurred = $9,990 + $16,200 + $3,710 + $2,500.

APPENDIX

Expanded Overhead Variances and Standard Cost Accounting System21A

EXPANDED OVERHEAD VARIANCES Similar to analysis of direct materials and direct labor, overhead variances can be analyzed further. Exhibit 21A.1 shows an expanded framework for understanding these overhead variances. This framework uses classifications of overhead costs as either variable or fixed. Within those two classifications are further types of variances—spending, efficiency, and volume variances.

Volume variances were explained in the body of the chapter.

A spending variance occurs when management pays an amount different from the standard price to acquire an item. For instance, the actual wage rate paid to indirect labor might be higher than the stan- dard rate. Similarly, actual supervisory salaries might be different than expected. Spending vari- ances such as these cause management to investigate the reasons why the amount paid differs from the standard. Both variable and fixed overhead costs can yield their own spending variances.

Analyzing variable overhead includes computing an efficiency variance, which occurs when standard direct labor hours (the allocation base) expected for actual production differ from the actual direct labor hours used. This efficiency variance reflects on the cost-effectiveness in using the overhead allocation base (such as direct labor).

Exhibit 21A.1 shows that we can combine the variable overhead spending variance, the fixed overhead spending variance, and the variable overhead efficiency variance to get the controllable variance.

Computing Variable and Fixed Overhead Cost Variances To illustrate the computation of more detailed overhead cost variances, we return to G-Max. G-Max produced 3,500 units when 4,000 units were budgeted. Additional data from cost reports (from Exhibit 21.16) show that the actual overhead cost incurred is $7,650 (the variable portion of $3,650 and the fixed

P5 Compute overhead spending and efficiency variances.

EXHIBIT 21A.1 Expanded Framework for Total Overhead Variance

Controllable Variance

Fixed Overhead Variance

Variable Overhead Variance

Total Overhead Variance

Spending Variance

Volume Variance

Spending Variance

E�ciency Variance

Chapter 21 Flexible Budgets and Standard Costs 845

portion of $4,000). From Exhibit 21.12, each unit requires one hour of direct labor, variable overhead is applied at a rate of $1.00 per direct labor hour, and the predetermined fixed overhead rate is $1.00 per direct labor hour. With this information, we compute overhead variances for both variable and fixed overhead as follows.

Variable Overhead Variance Actual variable overhead (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,650

Applied variable overhead (3,500 units × 1 standard DLH × $1 .00 VOH rate per DLH) . . . 3,500 Variable overhead variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 150 U

Management should seek to determine the causes of these unfavorable variances and take corrective ac- tion. To help better isolate the causes of these variances, more detailed overhead variances can be used, as we show next.

Expanded Overhead Variance Formulas Exhibit 21A.2 shows formulas to use in computing detailed overhead variances.

EXHIBIT 21A.2 Variable and Fixed Overhead Variances

*AH = actual direct labor hours; AVR = actual variable overhead rate; SH = standard direct labor hours; SVR = standard variable overhead rate.

†SH = standard direct labor hours; SFR = standard fixed overhead rate.

Actual Variable Overhead Applied Variable Overhead AH × AVR SH × SVRAH × SVR

Variable Overhead Variance*

Spending Variance (AH × AVR) – (AH × SVR)

E�ciency Variance (AH × SVR) – (SH × SVR)

Variable Overhead Variance

Actual Fixed Overhead (Given)

Budgeted Fixed Overhead (Flexible Budget)

Applied Fixed Overhead (SH × SFR)

Fixed Overhead Variance†

Spending Variance Actual – Budgeted

Volume Variance Budgeted – Applied

Fixed Overhead Variance

Variable Overhead Cost Variances Using these formulas, Exhibit 21A.3 offers insight into the causes of G-Max’s $150 unfavorable variable overhead cost variance. G-Max applies overhead based on direct labor hours. It used 3,400 direct labor hours to produce 3,500 units. This compares favor- ably to the standard requirement of 3,500 direct labor hours at one labor hour per unit. At a standard vari- able overhead rate of $1.00 per direct labor hour, this should have resulted in variable overhead costs of $3,400 (middle column of Exhibit 21A.3).

Fixed Overhead Variance Actual fixed overhead (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000

Applied fixed overhead (3,500 units × 1 standard DLH × $1 .00 FOH rate per DLH) . . . . . . 3,500 Fixed overhead variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 U

846 Chapter 21 Flexible Budgets and Standard Costs

G-Max’s cost records, however, report actual variable overhead of $3,650, or $250 higher than expected. This means G-Max has an unfavorable variable overhead spending variance of $250 ($3,650 − $3,400). On the other hand, G-Max used 100 fewer labor hours than expected to make 3,500 units, and its actual variable overhead is lower than its applied variable overhead. Thus, G-Max has a favorable variable over- head efficiency variance of $100 ($3,400 − $3,500).

Fixed Overhead Cost Variances Exhibit 21A.4 provides insight into the causes of G-Max’s $500 unfavorable fixed overhead variance. G-Max reports that it incurred $4,000 in actual fixed overhead; this amount equals the budgeted fixed overhead for May at the expected production level of 4,000 units (see Exhibit 21.12). Thus, the fixed overhead spending variance is zero, suggesting good con- trol of fixed overhead costs. G-Max’s budgeted fixed overhead application rate is $1 per hour ($4,000∕4,000 direct labor hours), but the actual production level is only 3,500 units. With this information, we compute the fixed overhead volume variance shown in Exhibit 21A.4. The applied fixed overhead is computed by multiplying 3,500 standard hours allowed for the actual production by the $1 fixed overhead allocation rate. The volume variance of $500 occurs because 500 fewer units are produced than budgeted; namely, 80% of the manufacturing capacity is budgeted, but only 70% is used. Management needs to know why the actual level of production differs from the expected level.

EXHIBIT 21A.3 Computing Variable Overhead Cost Variances

Actual Overhead Applied Overhead AH × AVR

Given $3,650

SH × SVR 3,500 hrs. × $1.00

$3,500

AH × SVR 3,400 hrs. × $1.00

$3,400

$250 U $100 F

$150 U

Spending Variance $3,650 – $3,400

E�ciency Variance $3,400 – $3,500

Variable Overhead Variance $250 – $100

EXHIBIT 21A.4 Computing Fixed Overhead Cost Variances

Actual Overhead Applied Overhead Given

$4,000

Budgeted Overhead Given

$4,000 3,500 hrs. × $1.00*

$3,500

$0 $500 U

$500 U

Spending Variance $4,000 – $4,000

Volume Variance $4,000 – $3,500

Fixed Overhead Variance $0 – $500

*3,500 units × 1 DLH per unit × $1.00 FOH rate per DLH.

STANDARD COST ACCOUNTING SYSTEM We have shown how companies use standard costs in management reports. Most standard cost systems also record these costs and variances in accounts. This practice simplifies recordkeeping and helps in preparing reports. Although we do not need knowledge of standard cost accounting practices to under- stand standard costs and their use, we must know how to interpret the accounts in which standard costs and variances are recorded. The entries in this section briefly illustrate the important aspects of this pro- cess for G-Max’s standard costs and variances for May. The first of these entries records standard materials cost incurred in May in the Work in Process Inventory account. This part of the entry is similar to the usual accounting entry, but the amount of the debit equals the standard cost ($35,000) instead of the actual cost ($37,800). This entry credits Raw Materials Inventory for actual cost. The difference between standard and actual direct materials costs is recorded with debits to two separate materials variance accounts (recall Exhibit 21.10). Both the materials price and quantity variances are recorded as debits because they reflect additional costs higher than the

P6 Prepare journal entries for standard costs and account for price and quantity variances.

Chapter 21 Flexible Budgets and Standard Costs 847

standard cost (if actual costs are less than the standard, they are recorded as credits). This treatment (debit) reflects their unfavorable effect because they represent higher costs and lower income.

The second entry debits Work in Process Inventory for the standard labor cost of the goods manufac- tured during May ($56,000). Actual labor cost ($56,100) is recorded with a credit to the Factory Wages Payable account. The difference between standard and actual labor costs is explained by two variances (see Exhibit 21.11). The direct labor rate variance is unfavorable and is debited to that account. The direct labor efficiency variance is favorable and that account is credited. The direct labor efficiency variance is favorable because it represents a lower cost and a higher net income.

The entry to assign standard predetermined overhead to the cost of goods manufactured must debit the $7,000 predetermined amount to the Work in Process Inventory account. Actual overhead costs of $7,650 were debited to Factory Overhead during the period (entries not shown here). Thus, when Factory Overhead is applied to Work in Process Inventory, the actual amount is credited to the Factory Overhead account. To account for the difference between actual and standard overhead costs, the entry includes a $250 debit to the Variable Overhead Spending Variance, a $100 credit to the Variable Overhead Efficiency Variance, and a $500 debit to the Volume Variance (recall Exhibits 21A.3 and 21A.4). (An alternative [simpler] approach is to record the difference with a $150 debit to the Controllable Variance account and a $500 debit to the Volume Variance account.)

The balances of these different variance accounts accumulate until the end of the accounting period. As a result, the unfavorable variances of some months can offset the favorable variances of other months. These ending variance account balances, which reflect results of the period’s various transactions and events, are closed at period-end. If the amounts are immaterial, they are added to or subtracted from the balance of the Cost of Goods Sold account. This process is similar to that shown in the job order costing chapter for eliminating an underapplied or overapplied balance in the Factory Overhead account. (Note: These variance balances, which represent differences between actual and standard costs, must be added to or subtracted from the materials, labor, and overhead costs recorded. In this way, the recorded costs equal the actual costs incurred in the period; a company must use actual costs in external financial statements prepared in accordance with generally accepted accounting principles.)

Standard Costing Income Statement In addition to the reports discussed in this chap- ter, management can use a standard costing income statement to summarize company performance for a period. This income statement reports sales and cost of goods sold at their standard amounts, and then

Point: If variances are material, they can be allocated between Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. This closing process is explained in advanced courses.

May 31 Work in Process Inventory (standard cost) . . . . . . . . . . . . . . . . 35,000

Direct Materials Price Variance* . . . . . . . . . . . . . . . . . . . . . . 1,800 Direct Materials Quantity Variance . . . . . . . . . . . . . . . . . . . . 1,000 Raw Materials Inventory (actual cost) . . . . . . . . . . . . . . . 37,800

Record standard cost of direct materials used and record materials variances.

*Many companies record the materials price variance when materials are purchased. For simplicity, we record both the materials price and quantity variances when materials are issued to production.

May 31 Work in Process Inventory (standard cost) . . . . . . . . . . . . . . . . 56,000

Direct Labor Rate Variance . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Direct Labor Efficiency Variance . . . . . . . . . . . . . . . . . . 1,600 Factory Wages Payable (actual cost) . . . . . . . . . . . . . . . . 56,100

Record standard cost of direct labor used and record labor variances.

May 31 Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Volume Variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Variable Overhead Spending Variance . . . . . . . . . . . . . . . . . 250 Variable Overhead Efficiency Variance . . . . . . . . . . . . 100 Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,650

Apply overhead at standard rate of $2 per standard direct labor hour (3,500 hours) and record overhead variances.

848 Chapter 21 Flexible Budgets and Standard Costs

lists the individual sales and cost variances to compute gross profit at actual cost. Exhibit 21A.5 provides an example. Unfavorable variances are added to cost of goods sold at standard cost; favorable variances are subtracted from cost of goods sold at standard cost.

EXHIBIT 21A.5 Standard Costing Income Statement

Standard Costing Income Statement For Year Ended December 31, 2019

Sales revenue (at standard) . . . . . . . . . . . . . . . . . . . . . •••••

Sales price variance . . . . . . . . . . . . . . . . . . . . . . . . . •••

Sales volume variance . . . . . . . . . . . . . . . . . . . . . . . ••• •••

Sales revenue (actual) . . . . . . . . . . . . . . . . . . . . . . . . . •••••

Cost of goods sold (at standard) . . . . . . . . . . . . . . . . . •••••

Manufacturing cost variances

Direct materials price variance . . . . . . . . . . . . . . . . •••

Direct materials quantity variance . . . . . . . . . . . . . . •••

Direct labor rate variance . . . . . . . . . . . . . . . . . . . . •••

Direct labor efficiency variance . . . . . . . . . . . . . . . . •••

Variable overhead spending variance . . . . . . . . . . •••

Variable overhead efficiency variance . . . . . . . . . . •••

Fixed overhead spending variance . . . . . . . . . . . . . •••

Fixed overhead volume variance . . . . . . . . . . . . . . •••

Total manufacturing cost variances . . . . . . . . . . •••

Cost of goods sold (actual) . . . . . . . . . . . . . . . . . . . . . . •••••

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ••••

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . •••

General and administrative expenses . . . . . . . . . . . . . •••

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . •••••

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

Add unfavorable variances; subtract favorable variances .

Prepare the journal entry to record these direct materials variances.

Solution

Direct materials cost actually incurred . . . . . . . . . . . . . . . . . . . $73,200

Direct materials quantity variance . . . . . . . . . . . . . . . . . . . . . . 3,800 F

Direct materials price variance . . . . . . . . . . . . . . . . . . . . . . . . . 1,300 U P6 Recording Variances

NEED-TO-KNOW 21-7

Do More: QS 21-17, E 21-14

Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,700

Direct Materials Price Variance . . . . . . . . . . . . . . . . . . . . . . . . . 1,300

Direct Materials Quantity Variance . . . . . . . . . . . . . . . . . . 3,800

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 73,200

Summary: Cheat Sheet

FIXED AND FLEXIBLE BUDGETS Fixed budget: Based on a single activity level. Flexible budget: Based on several activity levels. Variance: If difference between budgeted and actual amounts is: Favorable → Leads to higher income. Unfavorable → Leads to lower income.

STANDARD COSTING Standard cost: Preset cost for a product or service. Management by exception: When managers focus on significant differences between actual costs and standard costs. Cost variance: Actual cost − Standard cost Actual cost < Standard cost → Favorable Actual cost > Standard cost → Unfavorable Price variance: (AQ × AP) − (AQ × SP) Quantity variance: (AQ × SP) − (SQ × SP) AQ = actual quantity, AP = actual price, SQ = standard quantity, SP = standard price

Total budgeted costs = Total fixed costs + (Total variable cost per unit × Units of activity level)

$ C

os t

Unit Sales

Flexible Budget Costs

Total budgeted costs Budgeted

fixed costs

Budgeted variable

costs

Chapter 21 Flexible Budgets and Standard Costs 849

STANDARD COST VARIANCES Total Variances

Total materials variance = Materials price variance + Materials quantity variance

Total labor variance = Labor rate variance + Labor efficiency variance

Total overhead variance = Overhead controllable variance + Overhead volume variance

Materials Variances

Materials price variance = [AQ × AP] − [AQ × SP]

Materials quantity variance = [AQ × SP] − [SQ × SP]

Labor Variances

Labor rate variance = [AH × AR] − [AH × SR]

Labor efficiency variance = [AH × SR] − [SH × SR]

Overhead Variances

Overhead controllable variance = Actual total overhead − Budgeted total overhead

Overhead volume variance = Budgeted fixed overhead − Applied fixed overhead

Detailed Overhead Variances (Appendix 21A) Variable overhead variance = Variable overhead + Variable overhead

spending variance efficiency variance Fixed overhead variance = Fixed overhead + Fixed overhead

spending variance volume variance

Variable overhead spending variance = [AH × AVR] − [AH × SVR]

Variable overhead efficiency variance = [AH × SVR] − [SH × SVR]

Fixed overhead spending variance = Actual fixed overhead − Budgeted fixed overhead where AQ is Actual Quantity of materials; AP is Actual Price of materials; AH is Actual Hours of labor; AR is Actual Rate of wages; AVR is Actual Variable Rate of overhead; SQ is Standard Quantity of materials; SP is Standard Price of materials; SH is Standard Hours of labor; SR is Standard Rate of wages; SVR is Standard Variable Rate of overhead.

Sales Variances

Sales price variance = [AS × AP] − [AS × BP]

Sales volume variance = [AS × BP] − [BS × BP]

where AS = Actual Sales units; AP = Actual sales Price; BP = Budgeted sales Price; BS = Budgeted Sales units (fixed budget).

⎫ ⎪ ⎬ ⎪ ⎭

= Total overheadvariance

Benchmarking (834) Budget report (821) Controllable variance (836) Cost variance (828) Efficiency variance (844) Favorable variance (822) Fixed budget (821) Fixed budget performance report (822)

Flexible budget (821) Flexible budget performance report (825) Integrated reporting (838) International Integrated Reporting

Council (838) Management by exception (827) Overhead cost variance (835) Price variance (830)

Quantity variance (830) Spending variance (844) Standard costing income statement (847) Standard costs (827) Unfavorable variance (822) Variance (822) Variance analysis (828) Volume variance (836)

Key Terms

1. A company predicts its production and sales will be 24,000 units. At that level of activity, its fixed costs are budgeted at $300,000, and its variable costs are budgeted at $246,000. If its activity level declines to 20,000 units, what will be its budgeted fixed costs and its variable costs? a. Fixed, $300,000; variable, $246,000 b. Fixed, $250,000; variable, $205,000 c. Fixed, $300,000; variable, $205,000 d. Fixed, $250,000; variable, $246,000 e. Fixed, $300,000; variable, $300,000

2. Using the following information about a single-product company, compute its total actual cost of direct materials used.

• Direct materials standard cost: 5 lbs. × $2 per lb. = $10. • Total direct materials cost variance: $15,000 unfavorable. • Actual direct materials used: 300,000 lbs. • Actual units produced: 60,000 units.

a. $585,000 c. $300,000 e. $615,000 b. $600,000 d. $315,000

3. A company uses four hours of direct labor to produce a product unit. The standard direct labor cost is $20 per hour. This period the company produced 20,000 units and used 84,160 hours of direct labor at a total cost of $1,599,040. What is its labor rate variance for the period? a. $83,200 F c. $84,160 F e. $960 F b. $84,160 U d. $83,200 U

4. A company’s standard for a unit of its single product is $6 per unit in variable overhead (4 hours × $1.50 per hour). Actual data for the period show variable overhead costs of $150,000 and production of 24,000 units. Its total variable overhead cost variance is a. $6,000 F. c. $114,000 U. e. $0. b. $6,000 U. d. $114,000 F.

Multiple Choice Quiz

Direct Materials Quantity Variance

$1,000 U

Direct Materials Price Variance

$1,800 U

Direct Labor Rate Variance

$1,700 U

Direct Labor E�ciency Variance

$1,600 F

Controllable Variance $150 U

Volume Variance $500 U

Total Product Cost Variance $3,550 U

Total Overhead Variance $650 U

Total Direct Labor Variance $100 U

Total Direct Materials Variance $2,800 U

850 Chapter 21 Flexible Budgets and Standard Costs

A Superscript letter A denotes assignments based on Appendix 21A.

Icon denotes assignments that involve decision making.

1. What limits the usefulness to managers of fixed budget performance reports?

2. Identify the main purpose of a flexible budget for managers.

3. Prepare a flexible budget performance report title (in proper form) for Spalding Company for calendar-year 2019. Why is a proper title important for this or any report?

4. What type of analysis does a flexible budget perfor- mance report help management perform?

5. In what sense can a variable cost be considered constant? 6. What department is usually responsible for a direct la-

bor rate variance? What department is usually responsible for a direct labor efficiency variance? Explain.

7. What is a price variance? What is a quantity variance? 8. What is the purpose of using standard costs? 9. Google monitors its fixed overhead. In an

analysis of fixed overhead cost variances, what is the volume variance?

10. What is the predetermined standard overhead rate? How is it computed?

11. In general, variance analysis is said to provide information about and variances.

12. Samsung monitors its overhead. In an analysis of overhead cost variances, what is the controllable variance and what causes it?

13. What are the relations among standard costs, flexible bud- gets, variance analysis, and management by exception?

14. How can the manager of advertising sales at Google use flexible budgets to en- hance performance?

15. Is it possible for a retail store such as Apple to use variances in analyzing its operat- ing performance? Explain.

16. Assume that Samsung is budgeted to operate at 80% of capacity but actually operates at 75% of capacity. What effect will the 5% devia- tion have on its controllable variance? Its volume variance?

17. List at least two positive and two negative features of stan- dard costing systems.

18. Describe the concept of management by exception and ex- plain how standard costs help managers apply this concept to control costs.

Discussion Questions

GOOGLE

Samsung

GOOGLE

APPLE

Samsung

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; Fixed costs remain at $300,000; Variable costs = ($246,000∕24,000 units) × 20,000 units = $205,000

2. e; Budgeted direct materials + Unfavorable variance = Actual cost of direct materials used; or 60,000 units × $10 per unit = $600,000 + $15,000 U = $615,000

3. c; (AH × AR) − (AH × SR) = $1,599,040 − (84,160 hours × $20 per hour) = $84,160 F

5. A company’s standard for a unit of its single product is $4 per unit in fixed overhead ($24,000 total∕6,000 units budgeted). Actual data for the period show total actual fixed overhead of $24,100 and production of 4,800 units. Its volume variance is

4. b; Actual variable overhead − Variable overhead applied to production = Variable overhead cost variance; or $150,000 − (96,000 hours × $1.50 per hour) = $6,000 U

5. a; Budgeted fixed overhead − Fixed overhead applied to production = Volume variance; or $24,000 − (4,800 units × $4 per unit) = $4,800 U

a. $4,800 U. c. $100 U. e. $4,900 U. b. $4,800 F. d. $100 F.

QUICK STUDY

QS 21-1 Flexible budget performance report

P1

Beech Company produced and sold 105,000 units of its product in May. For the level of production achieved in May, the budgeted amounts were: sales, $1,300,000; variable costs, $750,000; and fixed costs, $300,000. The following actual financial results are available for May. Prepare a flexible budget perfor- mance report for May.

Actual Sales (105,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,275,000

Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712,500

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

QS 21-2 Flexible budget P1

Based on predicted production of 24,000 units, a company anticipates $300,000 of fixed costs and $246,000 of variable costs. If the company actually produces 20,000 units, what are the flexible budget amounts of fixed and variable costs?

Chapter 21 Flexible Budgets and Standard Costs 851

QS 21-5 Standard cost card P2

BatCo makes metal baseball bats. Each bat requires 1 kg of aluminum at $18 per kg and 0.25 direct labor hours at $20 per hour. Overhead is assigned at the rate of $40 per direct labor hour. What amounts would appear on a standard cost card for BatCo?

QS 21-6 Cost variances P2

Refer to information in QS 21-5. Assume the actual cost to manufacture one metal bat is $40. Compute the cost variance and classify it as favorable or unfavorable.

QS 21-9 Materials cost variances P3

For the current period, Kayenta Company’s manufacturing operations yield a $4,000 unfavorable direct materials price variance. The actual price per pound of material is $78; the standard price is $77.50 per pound. How many pounds of material were used in the current period?

QS 21-4 Flexible budget performance report P1

Refer to information in QS 21-3. Assume that actual sales for the year are $480,000 (26,000 units), actual variable costs for the year are $112,000, and actual fixed costs for the year are $145,000. Prepare a flexi- ble budget performance report for the year.

QS 21-3 Flexible budget

P1

Brodrick Company expects to produce 20,000 units for the year ending December 31. A flexible budget for 20,000 units of production reflects sales of $400,000; variable costs of $80,000; and fixed costs of $150,000. If the company instead expects to produce and sell 26,000 units for the year, calculate the ex- pected level of income from operations.

Juan Company’s output for the current period was assigned a $150,000 standard direct materials cost. The direct materials variances included a $12,000 favorable price variance and a $2,000 favorable quantity variance. What is the actual total direct materials cost for the current period?

QS 21-10 Materials cost variances P3

QS 21-7 Materials variances

P3 Direct materials standard (4 lbs . @ $2 per lb .) . . . . . . . . . . . . $8 per finished unit

Actual finished units produced . . . . . . . . . . . . . . . . . . . . . . . . 60,000 units

Actual cost of direct materials used . . . . . . . . . . . . . . . . . . . . $540,000

Tercer reports the following for one of its products. Compute the total direct materials cost variance and classify it as favorable or unfavorable.

QS 21-8 Materials variances

P3

Tercer reports the following for one of its products. Compute the direct materials price and quantity vari- ances and classify each as favorable or unfavorable.

Direct materials standard (4 lbs . @ $2 per lb .) . . . $8 per finished unit Actual finished units produced . . . . . . . 60,000 units

Actual direct materials used . . . . . . . . . . . . . . . . . 300,000 lbs . Actual cost of direct materials used . . . $540,000

Frontera Company’s output for the current period results in a $20,000 unfavorable direct labor rate variance and a $10,000 unfavorable direct labor efficiency variance. Production for the current period was assigned a $400,000 standard direct labor cost. What is the actual total direct labor cost for the current period?

QS 21-12 Labor cost variances P3

Fogel Co. expects to produce 116,000 units for the year. The company’s flexible budget for 116,000 units of production shows variable overhead costs of $162,400 and fixed overhead costs of $124,000. For the year, the company incurred actual overhead costs of $262,800 while producing 110,000 units. Compute the controllable overhead variance and classify it as favorable or unfavorable.

QS 21-13 Controllable overhead variance P4

The following information describes a company’s direct labor usage in a recent period. Compute the direct labor rate and efficiency variances for the period and classify each as favorable or unfavorable.

QS 21-11 Direct labor variances

P3 Actual direct labor hours used . . . . . . . . . . . . 65,000 Standard direct labor rate per hour . . . . . . . . . . . . . . . $14

Actual direct labor rate per hour . . . . . . . . . . $15 Standard direct labor hours for units produced . . . . . 67,000

852 Chapter 21 Flexible Budgets and Standard Costs

Refer to the information in QS 21-14. Compute the overhead volume variance for November and classify it as favorable or unfavorable.

QS 21-15 Volume variance P4

Alvarez Company’s output for the current period yields a $20,000 favorable overhead volume variance and a $60,400 unfavorable overhead controllable variance. Standard overhead applied to production for the period is $225,000. What is the actual total overhead cost incurred for the period?

QS 21-16 Overhead cost variances

P4

Refer to the information in QS 21-16. Alvarez records standard costs in its accounts. Prepare the journal entry to charge overhead costs to the Work in Process Inventory account and to record any variances.

QS 21-17A Preparing overhead entries

P6

Refer to the information from QS 21-18. Compute the variable overhead spending variance and the vari- able overhead efficiency variance and classify each as favorable or unfavorable.

QS 21-19A Overhead spending and efficiency variances P5

Farad, Inc., specializes in selling used trucks. During the month, Farad sold 50 trucks at an average price of $9,000 each. The budget for the month was to sell 45 trucks at an average price of $9,500 each. Compute the dealership’s sales price variance and sales volume variance for the month and classify each as favor- able or unfavorable.

QS 21-20 Computing sales price and volume variances A1

AirPro Corp. reports the following for November. Compute the total overhead variance and controllable overhead variance for November and classify each as favorable or unfavorable.

QS 21-14 Controllable overhead variance

P4 Actual total factory overhead incurred . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,175 Standard factory overhead:

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 .10 per unit produced

Fixed overhead ($12,000∕12,000 predicted units to be produced) . . . . $1 per unit Predicted units to produce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 units

Actual units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,800 units

QS 21-18A Total variable overhead cost variance

P5

Mosaic Company applies overhead using machine hours and reports the following information. Compute the total variable overhead cost variance and classify it as favorable or unfavorable.

Actual machine hours used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700 hours

Standard machine hours (for actual production) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 hours

Actual variable overhead rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4 .15

Standard variable overhead rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4 .00

In a recent year, BMW sold 182,158 of its 1 Series cars. Assume the company expected to sell 191,158 of these cars during the year. Also assume the budgeted sales price for each car was $30,000 and the actual sales price for each car was $30,200. Compute the sales price variance and the sales volume variance.

QS 21-21 Sales variances A1

MM Co. uses corrugated cardboard to ship its product to customers. Management believes it has found a more efficient way to package its products and use less cardboard. This new approach will reduce shipping costs from $10.00 per shipment to $9.25 per shipment. (1) If the company forecasts 1,200 shipments this year, what amount of total direct materials costs would appear on the shipping depart- ment’s flexible budget? (2) How much is this sustainability improvement predicted to save in direct materials costs for this coming year?

QS 21-22 Sustainability and standard costs

P1

Chapter 21 Flexible Budgets and Standard Costs 853

HH Co. uses corrugated cardboard to ship its product to customers. Currently, the company’s returns de- partment incurs annual overhead costs of $72,000 and forecasts 2,000 returns per year. Management be- lieves it has found a better way to package its products. As a result, the company expects to reduce the number of shipments that are returned due to damage by 5%. In addition, the initiative is expected to re- duce the department’s annual overhead by $12,000. Compute the returns department’s standard overhead rate per return (a) before the sustainability improvement and (b) after the sustainability improvement. Round to the nearest cent.

QS 21-23 Sustainability and standard overhead rate

P4

JPAK manufactures and sells mountain bikes. It operates eight hours a day, five days a week. Using this in- formation, classify each of the following costs as fixed or variable with respect to the number of bikes made.

a. Bike frames d. Taxes on property g. Office supplies b. Screws for assembly e. Bike tires h. Depreciation on tools c. Direct labor f. Gas used for heating i. Management salaries

Exercise 21-2 Classifying costs as fixed or variable

P1

Match the terms a through d with their correct definition 1 through 4. a. Standard cost card b. Management by

exception c. Standard cost d. Ideal standard

QS 21-24 Standard costs

C1 1. Quantity of input required if a production process is 100% efficient. 2. Managing by focusing on large differences from standard costs. 3. Record that accumulates standard cost information. 4. Preset cost for delivering a product or service under normal conditions.

EXERCISES

Exercise 21-1 Management by exception

C1

Resset Co. provides the following results of April’s operations: F indicates favorable and U indicates un- favorable. In applying management by exception, the company investigates all variances of $400 or more. Which variances will the company investigate?

Direct materials price variance . . . . . . . . . . . . . $ 300 F Direct labor efficiency variance . . . . . . . . . . . . . $2,200 F

Direct materials quantity variance . . . . . . . . . . 3,000 U Controllable overhead variance . . . . . . . . . . . . 400 U

Direct labor rate variance . . . . . . . . . . . . . . . . . 100 U Fixed overhead volume variance . . . . . . . . . . . 500 F

Tempo Company’s fixed budget (based on sales of 7,000 units) for the first quarter reveals the following. Compute (1) the total variable cost per unit, (2) total fixed costs, (3) income from operations for sales volume of 6,000 units, and (4) income from operations for sales volume of 8,000 units.

Exercise 21-3 Preparing flexible budgets

P1

Fixed Budget Sales (7,000 units × $400 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . $2,800,000 Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490,000

Production supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000

Plant manager salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000 1,010,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,790,000

Selling expenses

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000

Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000 419,000

Administrative expenses

Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Depreciation—Office equip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Office rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 176,000

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,195,000 Check Income (at 6,000 units), $972,000

854 Chapter 21 Flexible Budgets and Standard Costs

Xion Co. budgets a selling price of $80 per unit, variable costs of $35 per unit, and total fixed costs of $270,000. During June, the company produced and sold 10,800 units and incurred actual variable costs of $351,000 and actual fixed costs of $285,000. Actual sales for June were $885,000. Prepare a flexible budget report showing variances between budgeted and actual results. List variable and fixed expenses separately.

Exercise 21-4 Preparing a flexible budget performance report P1 Check Sales variance, $21,000 F

Exercise 21-5 Preparing a flexible budget performance report

P1

Bay City Company’s fixed budget performance report for July follows. The $647,500 budgeted total ex- penses include $487,500 variable expenses and $160,000 fixed expenses. Actual expenses include $158,000 fixed expenses. Prepare a flexible budget performance report that shows any variances between budgeted results and actual results. List fixed and variable expenses separately.

Fixed Budget Actual Results Variances

Sales (in units) . . . . . . . . . . . . . . . . . . . 7,500 7,200

Sales (in dollars) . . . . . . . . . . . . . . . . . . $750,000 $737,000 $13,000 U

Total expenses . . . . . . . . . . . . . . . . . . . 647,500 641,000 6,500 F

Income from operations . . . . . . . . . . . $102,500 $ 96,000 $ 6,500 UCheck Income variance, $4,000 F

Exercise 21-6 Preparing a flexible budget report

P1

Lewis Co. reports the following results for May. Prepare a flexible budget report showing variances be- tween budgeted and actual results. List variable and fixed expenses separately, and indicate variances as favorable (F) or unfavorable (U).

Budgeted Actual

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $300 per unit $435,000

Variable expenses . . . . . . . . . . . . . . . $120 per unit $172,000

Fixed expenses (total) . . . . . . . . . . . . $125,000 $122,000

Units produced and sold . . . . . . . . . . 1,200 1,400

Exercise 21-7 Standard unit cost; cost variances

P2

A manufactured product has the following information for August.

Standard Actual

Direct materials . . . . . . . . . . . . . . . . . . 2 lbs . per unit @ $2 .50 per lb .

Direct labor . . . . . . . . . . . . . . . . . . . . . 0 .5 hours per unit @ $16 per hour

Overhead . . . . . . . . . . . . . . . . . . . . . . $12 per direct labor hour

Units manufactured . . . . . . . . . . . . . . 12,000

Total manufacturing costs . . . . . . . . . $225,400

Compute the (1) standard cost per unit, (2) total budgeted cost for production in August, and (3) total cost variance for August. Indicate whether the cost variance is favorable or unfavorable.

Exercise 21-8 Standard unit cost; total cost variance

P2

A manufactured product has the following information for June.

Standard Actual

Direct materials . . . . . . . . . . . . . . . . . 6 lbs . @ $8 per lb . 48,500 lbs . @ $8 .10 per lb .

Direct labor . . . . . . . . . . . . . . . . . . . . 2 hrs . @ $16 per hr . 15,700 hrs . @ $16 .50 per hr .

Overhead . . . . . . . . . . . . . . . . . . . . . 2 hrs . @ $12 per hr . $198,000

Units manufactured . . . . . . . . . . . . . 8,000

Compute the (1) standard cost per unit and (2) total cost variance for June. Indicate whether the cost vari- ance is favorable or unfavorable.

Exercise 21-9 Direct materials variances P3

Refer to the information in Exercise 21-8 and compute the (1) direct materials price and (2) direct materi- als quantity variances. Indicate whether each variance is favorable or unfavorable.

Exercise 21-10 Direct labor variances P3

Refer to the information in Exercise 21-8 and compute the (1) direct labor rate and (2) direct labor effi- ciency variances. Indicate whether each variance is favorable or unfavorable.

Chapter 21 Flexible Budgets and Standard Costs 855

Exercise 21-11 Direct materials and direct labor variances

P3

Hutto Corp. has set the following standard direct materials and direct labor costs per unit for the product it manufactures.

During May the company incurred the following actual costs to produce 9,000 units.

Direct materials (15 lbs . @ $4 per lb .) . . . . . . . . . . . . . $60 Direct labor (3 hrs . @ $15 per hr .) . . . . . . . . . . . . . . . $45

Direct materials (138,000 lbs . @ $3 .75 per lb .) . . . . $517,500 Direct labor (31,000 hrs . @ $15 .10 per hr .) . . . . $468,100

Compute the (1) direct materials price and quantity variances and (2) direct labor rate and efficiency vari- ances. Indicate whether each variance is favorable or unfavorable.

Direct materials (10 lbs . @ $3 per lb .) . . . . . . . . . . . . . $30 Direct labor (2 hrs . @ $12 per hr .) . . . . . . . . . . . . . . . $24

Direct materials (92,000 lbs . @ $2 .95 per lb .) . . . . . $271,400 Direct labor (18,800 hrs . @ $12 .05 per hr .) . . . . $226,540

Exercise 21-12 Direct materials and direct labor variances

P3

Reed Corp. has set the following standard direct materials and direct labor costs per unit for the product it manufactures.

During June the company incurred the following actual costs to produce 9,000 units.

Compute the (1) direct materials price and quantity variances and (2) direct labor rate and efficiency vari- ances. Indicate whether each variance is favorable or unfavorable.

Hart Company made 3,000 bookshelves using 22,000 board feet of wood costing $266,200. The company’s direct materials standards for one bookshelf are 8 board feet of wood at $12 per board foot. 1. Compute the direct materials price and quantity variances and classify each as favorable or

unfavorable. 2. Hart applies management by exception by investigating direct materials variances of more than 5% of

actual direct materials costs. Which direct materials variances will Hart investigate further?

Exercise 21-13 Computing and interpreting materials variances P3

Check Price variance, $2,200 U

The following describes production activities of Mercer Manufacturing for the year. Exercise 21-15 Direct materials and direct labor variances

P3 Actual direct materials used . . . . . . . . . . . . . . . 16,000 lbs . at $4 .05 per lb .

Actual direct labor used . . . . . . . . . . . . . . . . . . . 5,545 hours for a total of $105,355

Actual units produced . . . . . . . . . . . . . . . . . . . . 30,000

Budgeted standards for each unit produced are 0.50 pound of direct material at $4.00 per pound and 10 minutes of direct labor at $20 per hour. 1. Compute the direct materials price and quantity variances and classify each as favorable or unfavorable. 2. Compute the direct labor rate and efficiency variances and classify each as favorable or unfavorable.

Refer to Exercise 21-13. Hart Company uses a standard costing system. 1. Prepare the journal entry to charge direct materials costs to Work in Process Inventory and record the

materials variances. 2. Assume that Hart’s materials variances are the only variances accumulated in the accounting period

and that they are immaterial. Prepare the adjusting journal entry to close the variance accounts at period-end.

Exercise 21-14A Recording and closing materials variances

P6 Check (2) Cr. to Cost of Goods Sold, $21,800

Javonte Co. set standards of 3 hours of direct labor per unit of product and $15 per hour for the labor rate. During October, the company uses 16,250 hours of direct labor at a $247,000 total cost to produce 5,600 units of product. In November, the company uses 22,000 hours of direct labor at a $335,500 total cost to produce 6,000 units of product. 1. Compute the direct labor rate variance, the direct labor efficiency variance, and the total direct labor

cost variance for each of these two months. Classify each variance as favorable or unfavorable. 2. Javonte investigates variances of more than 5% of actual direct labor cost. Which direct labor vari-

ances will the company investigate further?

Exercise 21-16 Computing and interpreting labor variances P3

Check (1) October rate variance, $3,250 U

856 Chapter 21 Flexible Budgets and Standard Costs

Sedona Company set the following standard costs for one unit of its product for this year.

Direct material (20 Ibs . @ $2 .50 per Ib .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50

Direct labor (10 hrs . @ $22 .00 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

Variable overhead (10 hrs . @ $4 .00 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Fixed overhead (10 hrs . @ $1 .60 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $326

The $5.60 ($4.00 + $1.60) total overhead rate per direct labor hour is based on an expected operating level equal to 75% of the factory’s capacity of 50,000 units per month. The following monthly flexible budget information is also available.

Budgeted output (units)

Budgeted labor (standard hours)

Budgeted overhead (dollars)

Variable overhead

Fixed overhead

Total overhead

70%Flexible Budget 80% Operating Levels (% of capacity)

75% 35,000

350,000

$ 1,400,000

600,000

$2,000,000

37,500

$2,100,000

600,000

$1,500,000

375,000

$ 1,600,000

40,000

400,000

$2,200,000

600,000

Exercise 21-17 Computing total variable and fixed overhead variances

P4

During the current month, the company operated at 70% of capacity, employees worked 340,000 hours, and the following actual overhead costs were incurred.

Variable overhead costs . . . . . . . . . . . $1,375,000

Fixed overhead costs . . . . . . . . . . . . . . 628,600

Total overhead costs . . . . . . . . . . . . . . $2,003,600

1. Compute the predetermined overhead application rate per hour for total overhead, variable overhead, and fixed overhead.

2. Compute the total variable and total fixed overhead variances and classify each as favorable or unfavorable.

Exercise 21-18A Detailed overhead variances P5

Refer to the information from Exercise 21-17. Compute the following. 1. Variable overhead spending and efficiency variances. 2. Fixed overhead spending and volume variances. 3. Controllable variance.

Check (1) Variable overhead: Spending, $15,000 U

Exercise 21-19 Computing total overhead rate and total overhead variance

P4

World Company expects to operate at 80% of its productive capacity of 50,000 units per month. At this planned level, the company expects to use 25,000 standard hours of direct labor. Overhead is allocated to products using a predetermined standard rate of 0.625 direct labor hour per unit. At the 80% capacity level, the total budgeted cost includes $50,000 fixed overhead cost and $275,000 variable overhead cost. In the current month, the company incurred $305,000 actual overhead and 22,000 actual labor hours while producing 35,000 units. 1. Compute the predetermined standard overhead rate for total overhead. 2. Compute the total overhead variance.

Refer to the information from Exercise 21-19. Compute the (1) overhead volume variance and (2) over- head controllable variance and classify each as favorable or unfavorable.

Exercise 21-20 Computing volume and controllable overhead variances P4

Chapter 21 Flexible Budgets and Standard Costs 857

Exercise 21-21 Overhead controllable and volume variances; overhead variance report

P4

James Corp. applies overhead on the basis of direct labor hours. For the month of May, the company planned production of 8,000 units (80% of its production capacity of 10,000 units) and prepared the fol- lowing overhead budget.

Overhead Budget 80% Operating Level

Production in units . . . . . . . . . . . . . . . . . . . 8,000 Standard direct labor hours . . . . . . . . . . . 24,000 Budgeted overhead Variable overhead costs Indirect materials . . . . . . . . . . . . . . . . $15,000 Indirect labor . . . . . . . . . . . . . . . . . . . 24,000 Power . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Maintenance . . . . . . . . . . . . . . . . . . . 3,000 Total variable costs . . . . . . . . . . . . . . 48,000 Fixed overhead costs Rent of factory building . . . . . . . . . . 15,000 Depreciation—Machinery . . . . . . . . . 10,000 Supervisory salaries . . . . . . . . . . . . . 19,400 Total fixed costs . . . . . . . . . . . . . . . . 44,400 Total overhead costs . . . . . . . . . . . . . . . $92,400

During May, the company operated at 90% capacity (9,000 units) and incurred the following actual over- head costs.

Overhead costs (actual) Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,500 Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,750 Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Rent of factory building . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Total actual overhead costs . . . . . . . . . . . . . . . . . . . . . . . . $99,250

1. Compute the overhead controllable variance and classify it as favorable or unfavorable. 2. Compute the overhead volume variance and classify it as favorable or unfavorable. 3. Prepare an overhead variance report at the actual activity level of 9,000 units.

Blaze Corp. applies overhead on the basis of direct labor hours. For the month of March, the company planned production of 8,000 units (80% of its production capacity of 10,000 units) and prepared the following budget.

Exercise 21-22 Overhead controllable and volume variances; overhead variance report

P4 Overhead Budget 80% Operating Level

Production in units . . . . . . . . . . . . . . . . . . . 8,000 Standard direct labor hours . . . . . . . . . . . . 32,000 Budgeted overhead Variable overhead costs Indirect materials . . . . . . . . . . . . . . . . $10,000 Indirect labor . . . . . . . . . . . . . . . . . . . 16,000 Power . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Maintenance . . . . . . . . . . . . . . . . . . . 2,000 Total variable costs . . . . . . . . . . . . . . 32,000 Fixed overhead costs Rent of factory building . . . . . . . . . . . 12,000 Depreciation—Machinery . . . . . . . . . 20,000 Taxes and insurance . . . . . . . . . . . . . 2,400 Supervisory salaries . . . . . . . . . . . . . 13,600 Total fixed costs . . . . . . . . . . . . . . . . . 48,000 Total overhead costs . . . . . . . . . . . . . . . $80,000

858 Chapter 21 Flexible Budgets and Standard Costs

During March, the company operated at 90% capacity (9,000 units), and it incurred the following actual overhead costs.

Overhead costs (actual)

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Rent of factory building . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . 19,200

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Total actual overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . $81,700

1. Compute the overhead controllable variance. 2. Compute the overhead volume variance. 3. Prepare an overhead variance report at the actual activity level of 9,000 units.

Comp Wiz sells computers. During May, it sold 350 computers at a $1,200 average price each. The May fixed budget included sales of 365 computers at an average price of $1,100 each. 1. Compute the sales price variance and classify it as favorable or unfavorable. 2. Compute the sales volume variance and classify it as favorable or unfavorable.

Exercise 21-23 Computing sales variances

A1

Fixed Budget Report For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $975,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000

Machinery repairs (variable cost) . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Depreciation—Plant equipment (straight-line) . . . . . . . . . . . . . . 300,000

Utilities ($45,000 is variable) . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,000

Plant management salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 1,955,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,045,000

Selling expenses

Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000

Sales salary (fixed annual amount) . . . . . . . . . . . . . . . . . . . . . . . 250,000 430,000

General and administrative expenses

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000

Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,000

Entertainment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 456,000

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 159,000

Required

1. Classify all items listed in the fixed budget as variable or fixed. Also determine their amounts per unit or their amounts for the year, as appropriate.

PROBLEM SET A

Problem 21-1A Preparing and analyzing a flexible budget

A1 P1

Phoenix Company’s 2019 master budget included the following fixed budget report. It is based on an expected production and sales volume of 15,000 units.

Chapter 21 Flexible Budgets and Standard Costs 859

2. Prepare flexible budgets (see Exhibit 21.3) for the company at sales volumes of 14,000 and 16,000 units.

3. The company’s business conditions are improving. One possible result is a sales volume of 18,000 units. The company president is confident that this volume is within the relevant range of existing capacity. How much would operating income increase over the budgeted amount of $159,000 if this level is reached without increasing capacity?

4. An unfavorable change in business is remotely possible; in this case, production and sales volume for the year could fall to 12,000 units. How much income (or loss) from operations would occur if sales volume falls to this level?

Check (2) Budgeted income at 16,000 units, $260,000

(4) Potential operating loss, $(144,000)

Problem 21-2A Preparing and analyzing a flexible budget performance report

A1 P1 P2

Refer to the information in Problem 21-1A. Phoenix Company’s actual income statement follows.

Statement of Income from Operations For Year Ended December 31, 2019

Sales (18,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,648,000

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,185,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278,000

Machinery repairs (variable cost) . . . . . . . . . . . . . . . . . . . . . . . . 63,000

Depreciation—Plant equipment . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Utilities (fixed cost is $147,500) . . . . . . . . . . . . . . . . . . . . . . . . . 200,500

Plant management salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000 2,236,500

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,411,500

Selling expenses

Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,500

Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,500

Sales salary (annual) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268,000 474,000

General and administrative expenses

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,000

Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,000

Entertainment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,500 466,500

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 471,000

Required

1. Prepare a flexible budget performance report for 2019. 2. Compute both the (a) sales variance and (b) direct materials cost variance.

Check (1) Variances: Fixed costs, $36,000 U; Income, $9,000 F

Antuan Company set the following standard costs for one unit of its product. Problem 21-3A Flexible budget preparation; computation of materials, labor, and overhead variances; and overhead variance report

P1 P2 P3 P4

Direct materials (6 Ibs . @ $5 per Ib .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30

Direct labor (2 hrs . @ $17 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Overhead (2 hrs . @ $18 .50 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $101

The predetermined overhead rate ($18.50 per direct labor hour) is based on an expected volume of 75% of the factory’s capacity of 20,000 units per month. Following are the company’s budgeted overhead costs per month at the 75% capacity level.

860 Chapter 21 Flexible Budgets and Standard Costs

The company incurred the following actual costs when it operated at 75% of capacity in October.

Direct materials (91,000 Ibs . @ $5 .10 per lb .) . . . . . . . . . . . . . . . $ 464,100

Direct labor (30,500 hrs . @ $17 .25 per hr .) . . . . . . . . . . . . . . . . . 526,125

Overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,250

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177,750

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000

Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Depreciation—Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89,000 560,500

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,550,725

Required

1. Examine the monthly overhead budget to (a) determine the costs per unit for each variable overhead item and its total per unit costs and (b) identify the total fixed costs per month.

2. Prepare flexible overhead budgets (as in Exhibit 21.12) for October showing the amounts of each vari- able and fixed cost at the 65%, 75%, and 85% capacity levels.

3. Compute the direct materials cost variance, including its price and quantity variances. 4. Compute the direct labor cost variance, including its rate and efficiency variances. 5. Prepare a detailed overhead variance report (as in Exhibit 21.16) that shows the variances for indi-

vidual items of overhead.

Check (2) Budgeted total overhead at 13,000 units, $507,000 (3) Materials variances: Price, $9,100 U; Quantity, $5,000 U (4) Labor variances: Rate, $7,625 U; Efficiency, $8,500 U

Overhead Budget (75% Capacity)

Variable overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 45,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000

Total variable overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000

Fixed overhead costs

Depreciation—Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000

Total fixed overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,000

Total overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $555,000

Problem 21-4A Computing materials, labor, and overhead variances

P3 P4

Trico Company set the following standard unit costs for its single product.

The predetermined overhead rate is based on a planned operating volume of 80% of the productive capac- ity of 60,000 units per quarter. The following flexible budget information is available.

Direct materials (30 Ibs . @ $4 per Ib .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120

Direct labor (5 hrs . @ $14 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Factory overhead—Variable (5 hrs . @ $8 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Factory overhead—Fixed (5 hrs . @ $10 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280

Chapter 21 Flexible Budgets and Standard Costs 861

Problem 21-5AA Expanded overhead variances

P5

Refer to the information in Problem 21-4A.

Required

Compute these variances: (a) variable overhead spending and efficiency, (b) fixed overhead spending and volume, and (c) total overhead controllable.

During the current quarter, the company operated at 90% of capacity and produced 54,000 units of prod- uct; actual direct labor totaled 265,000 hours. Units produced were assigned the following standard costs.

Direct materials (1,620,000 Ibs . @ $4 per Ib .) . . . . . . . . . . . . . . . . . . . . . . . . $ 6,480,000

Direct labor (270,000 hrs . @ $14 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,780,000

Factory overhead (270,000 hrs . @ $18 per hr .) . . . . . . . . . . . . . . . . . . . . . . . 4,860,000

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,120,000

Direct materials (1,615,000 Ibs . @ $4 .10 per lb .) . . . . . . . . . . . . . . . . . . . . . $ 6,621,500

Direct labor (265,000 hrs . @ $13 .75 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . 3,643,750

Fixed factory overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,350,000

Variable factory overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200,000

Total actual costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,815,250

Actual costs incurred during the current quarter follow.

Required

1. Compute the direct materials cost variance, including its price and quantity variances. 2. Compute the direct labor cost variance, including its rate and efficiency variances. 3. Compute the overhead controllable and volume variances.

Check (1) Materials variances: Price, $161,500 U; Quantity, $20,000 F (2) Labor variances: Rate, $66,250 F; Efficiency, $70,000 F

Operating Levels

70% 80% 90%

Production in units . . . . . . . . . . . . . . . . . . . . 42,000 48,000 54,000

Standard direct labor hours . . . . . . . . . . . . 210,000 240,000 270,000

Budgeted overhead

Fixed factory overhead . . . . . . . . . . . . . . $2,400,000 $2,400,000 $2,400,000

Variable factory overhead . . . . . . . . . . . . $1,680,000 $1,920,000 $2,160,000

Boss Company’s standard cost accounting system recorded this information from its December operations. Problem 21-6AA Recording and analyzing materials, labor, and overhead variances

C1 P6

Standard direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Direct materials quantity variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Direct materials price variance (favorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Actual direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000

Direct labor efficiency variance (favorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Direct labor rate variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Actual overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000

Volume variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Controllable variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Required

1. Prepare December 31 journal entries to record the company’s costs and variances for the month. (Do not prepare the journal entry to close the variances.)

Analysis Component

2. If management investigates all variances above $5,000, which variances will management investigate?

Check (1) Dr. Work in Process Inventory (for overhead), $354,000

862 Chapter 21 Flexible Budgets and Standard Costs

PROBLEM SET B

Problem 21-1B Preparing and analyzing a flexible budget

A1 P1

Tohono Company’s 2019 master budget included the following fixed budget report. It is based on an expected production and sales volume of 20,000 units.

Fixed Budget Report For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000 Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260,000 Machinery repairs (variable cost) . . . . . . . . . . . . . . . . . . . . . . . . 57,000 Depreciation—Machinery (straight-line) . . . . . . . . . . . . . . . . . . . 250,000 Utilities (25% is variable cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Plant manager salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 2,107,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 893,000 Selling expenses Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116,000 Sales salary (fixed annual amount) . . . . . . . . . . . . . . . . . . . . . . . 160,000 356,000 General and administrative expenses Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,000 Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,000 Entertainment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 412,000 Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 125,000

Required

1. Classify all items listed in the fixed budget as variable or fixed. Also determine their amounts per unit or their amounts for the year, as appropriate.

2. Prepare flexible budgets (see Exhibit 21.3) for the company at sales volumes of 18,000 and 24,000 units. 3. The company’s business conditions are improving. One possible result is a sales volume of 28,000

units. The company president is confident that this volume is within the relevant range of existing capacity. How much would operating income increase over the budgeted amount of $125,000 if this level is reached without increasing capacity?

4. An unfavorable change in business is remotely possible; in this case, production and sales volume for the year could fall to 14,000 units. How much income (or loss) from operations would occur if sales volume falls to this level?

Check (2) Budgeted income at 24,000 units, $372,400

(4) Potential operating loss, $(246,100)

Problem 21-2B Preparing and analyzing a flexible budget performance report

A1 P1 P2

Refer to the information in Problem 21-1B. Tohono Company’s actual income statement follows.

Statement of Income from Operations For Year Ended December 31, 2019

Sales (24,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,648,000 Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,400,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000 Machinery repairs (variable cost) . . . . . . . . . . . . . . 60,000 Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . 250,000 Utilities (variable cost, $64,000) . . . . . . . . . . . . . . . 218,000 Plant manager salaries . . . . . . . . . . . . . . . . . . . . . . 155,000 2,443,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,205,000 Selling expenses Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,000 Sales salary (annual) . . . . . . . . . . . . . . . . . . . . . . . . 162,000 376,000 General and administrative expenses Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . 104,000 Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232,000 Entertainment expense . . . . . . . . . . . . . . . . . . . . . . 100,000 436,000 Income from operations . . . . . . . . . . . . . . . . . . . . . . . $ 393,000

Chapter 21 Flexible Budgets and Standard Costs 863

Required

1. Prepare a flexible budget performance report for 2019.

Analysis Component

2. Compute and interpret both the (a) sales variance and (b) direct materials cost variance.

Check (1) Variances: Fixed costs, $45,000 U; Income, $20,600 F

Problem 21-3B Flexible budget preparation; computation of materials, labor, and overhead variances; and overhead variance report

P1 P2 P3 P4

Suncoast Company set the following standard costs for one unit of its product.

Direct materials (4 .5 lbs . @ $6 per lb .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27

Direct labor (1 .5 hrs . @ $12 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Overhead (1 .5 hrs . @ $16 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $69

The predetermined overhead rate ($16.00 per direct labor hour) is based on an expected volume of 75% of the factory’s capacity of 20,000 units per month. Following are the company’s budgeted overhead costs per month at the 75% capacity level.

Overhead Budget (75% Capacity)

Variable overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22,500

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500

Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Total variable overhead costs . . . . . . . . . . . . . . . . . . . . . $180,000

Fixed overhead costs

Depreciation—Building . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . 72,000

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,000

Total fixed overhead costs . . . . . . . . . . . . . . . . . . . . . . . . 180,000

Total overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000

The company incurred the following actual costs when it operated at 75% of capacity in December.

Direct materials (69,000 lbs . @ $6 .10 per lb .) . . . . . . . . . . . . . . $ 420,900

Direct labor (22,800 hrs . @ $12 .30 per hr .) . . . . . . . . . . . . . . . . 280,440

Overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,600

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,260

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,100

Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,800

Depreciation—Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,500

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,000 355,260

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,056,600

Required

1. Examine the monthly overhead budget to (a) determine the costs per unit for each variable overhead item and its total per unit costs and (b) identify the total fixed costs per month.

2. Prepare flexible overhead budgets (as in Exhibit 21.12) for December showing the amounts of each variable and fixed cost at the 65%, 75%, and 85% capacity levels.

3. Compute the direct materials cost variance, including its price and quantity variances.

Check (2) Budgeted total overhead at 17,000 units, $384,000 (3) Materials variances: Price, $6,900 U; Quantity, $9,000 U

[continued on next page]

864 Chapter 21 Flexible Budgets and Standard Costs

4. Compute the direct labor cost variance, including its rate and efficiency variances. 5. Prepare a detailed overhead variance report (as in Exhibit 21.16) that shows the variances for indi-

vidual items of overhead.

(4) Labor variances: Rate, $6,840 U; Efficiency, $3,600 U

Problem 21-4B Computing materials, labor, and overhead variances

P3 P4

Kryll Company set the following standard unit costs for its single product.

The predetermined overhead rate is based on a planned operating volume of 80% of the productive capac- ity of 60,000 units per quarter. The following flexible budget information is available.

Direct materials (25 Ibs . @ $4 per Ib .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100

Direct labor (6 hrs . @ $8 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Factory overhead—Variable (6 hrs . @ $5 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Factory overhead—Fixed (6 hrs . @ $7 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220

During the current quarter, the company operated at 70% of capacity and produced 42,000 units of prod- uct; direct labor hours worked were 250,000. Units produced were assigned the following standard costs.

Direct materials (1,050,000 Ibs . @ $4 per Ib .) . . . . . . . . . . . . . . . . . . . . . . . . . . $4,200,000

Direct labor (252,000 hrs . @ $8 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,016,000

Factory overhead (252,000 hrs . @ $12 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . 3,024,000

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,240,000

Operating Levels

70% 80% 90%

Production in units . . . . . . . . . . . . . . . . . . . . 42,000 48,000 54,000

Standard direct labor hours . . . . . . . . . . . . 252,000 288,000 324,000

Budgeted overhead

Fixed factory overhead . . . . . . . . . . . . . . $2,016,000 $2,016,000 $2,016,000

Variable factory overhead . . . . . . . . . . . . 1,260,000 1,440,000 1,620,000

Direct materials (1,000,000 Ibs . @ $4 .25 per lb .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,250,000

Direct labor (250,000 hrs . @ $7 .75 per hr .) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,937,500

Fixed factory overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,960,000

Variable factory overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000

Total actual costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,347,500

Actual costs incurred during the current quarter follow.

Required

1. Compute the direct materials cost variance, including its price and quantity variances. 2. Compute the direct labor cost variance, including its rate and efficiency variances. 3. Compute the total overhead controllable and volume variances.

Check (1) Materials variances: Price, $250,000 U; Quantity, $200,000 F (2) Labor variances: Rate, $62,500 F; Efficiency, $16,000 F

Problem 21-5BA Expanded overhead variances

P5

Refer to the information in Problem 21-4B.

Required

Compute these variances: (a) variable overhead spending and efficiency, (b) fixed overhead spending and volume, and (c) total overhead controllable.

Chapter 21 Flexible Budgets and Standard Costs 865

Kenya Company’s standard cost accounting system recorded this information from its June operations.

Required

1. Prepare journal entries dated June 30 to record the company’s costs and variances for the month. (Do not prepare the journal entry to close the variances.)

Analysis Component

2. Identify the variances that would attract the attention of a manager who uses management by excep- tion. Describe what action(s) the manager should consider.

Standard direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000

Direct materials quantity variance (favorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Direct materials price variance (favorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Actual direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Direct labor efficiency variance (favorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Direct labor rate variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Actual overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Volume variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Controllable variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Problem 21-6BA Recording and analyzing materials, labor, and overhead variances

C1 P6

Check (1) Dr. Work in Process Inventory (for overhead), $230,000

SERIAL PROBLEM Business Solutions

P1

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 21 Business Solutions’s second-quarter 2020 fixed budget performance report for its computer fur- niture operations follows. The $156,000 budgeted expenses include $108,000 in variable expenses for desks and $18,000 in variable expenses for chairs, as well as $30,000 fixed expenses. The actual expenses include $31,000 fixed expenses. Prepare a flexible budget performance report that shows any variances between budgeted results and actual results. List fixed and variable expenses separately.

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Fixed Budget Actual Results Variances

Desk sales (in units) . . . . . . . . . . . . . . . 144 150

Chair sales (in units) . . . . . . . . . . . . . . . 72 80

Desk sales . . . . . . . . . . . . . . . . . . . . . . . $180,000 $186,000 $6,000 F

Chair sales . . . . . . . . . . . . . . . . . . . . . . . 36,000 41,200 5,200 F

Total expenses . . . . . . . . . . . . . . . . . . . 156,000 163,880 7,880 U

Income from operations . . . . . . . . . . . . $ 60,000 $ 63,320 $3,320 F Check Variances: Fixed expenses, $1,000 U

COMPANY ANALYSIS C1

Accounting Analysis

AA 21-1 Flexible budgets and standard costs emphasize the importance of a similar unit of measure for meaningful analysis. When Apple compiles GAAP financial reports, it applies the same unit of mea- surement, U.S. dollars, for most measures of business operations. One issue is how to adjust account val- ues for its subsidiaries that compile financial reports in currencies other than the U.S. dollar. Apple’s annual report says: “The Company translates the assets and liabilities of its non-U.S. dollar functional cur- rency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in AOCI in shareholders’ equity.”

Required

1. In which financial statement does Apple report the gains and losses from foreign currency translation for subsidiaries that do not use the U.S. dollar as their functional currency?

APPLE

[continued on next page]

866 Chapter 21 Flexible Budgets and Standard Costs

AA 21-2 The usefulness of budgets, variances, and related analyses often depends on the accuracy of management’s estimates of future sales activity.

Required

1. Identify and enter the 2016 and 2017 sales (in $ millions) into a table for Apple and Google using their financial statements in Appendix A.

2. Assume that at the end of 2016 we estimate Apple’s 2017 sales will increase by 5% from its 2016 sales. What is Apple’s 2017 estimated sales?

3. Assume that at the end of 2016 we estimate Google’s 2017 sales will increase by 20% from its 2016 sales. What is Google’s 2017 estimated sales?

4. Using answers to parts 2 and 3, which company’s estimated 2017 sales is closer to its actual 2017 sales?

COMPARATIVE ANALYSIS A1

APPLE GOOGLE

AA 21-3 Access Samsung’s financial statements in Appendix A.

Required

1. Identify and enter the 2016 and 2017 sales (in W millions) into a table for Samsung. 2. Assume that at the end of 2016 we estimate Samsung’s 2017 sales will increase by 20% from its 2016

sales. What is Samsung’s 2017 estimated sales? 3. Are the estimated 2017 sales from part 2 higher or lower than Samsung’s actual 2017 sales?

GLOBAL ANALYSIS A1

Samsung

ETHICS CHALLENGE C1

BTN 21-1 Setting materials, labor, and overhead standards is challenging. If standards are set too low, companies might purchase inferior products and employees might not work to their full potential. If stan- dards are set too high, companies could be unable to offer a quality product at a profitable price and employees could be overworked. The ethical challenge is to set a high but reasonable standard. Assume that as a manager you are asked to set the standard materials price and quantity for the new 1,000 CKB Mega-Max chip, a technically advanced product. To properly set the price and quantity standards, you assemble a team of specialists to provide input.

Required

Identify four types of specialists that you would assemble to provide information to help set the materials price and quantity standards. Briefly explain why you chose each individual.

Beyond the Numbers

BTN 21-2 The reason we use the words favorable and unfavorable when evaluating variances is made clear when we look at the closing of accounts. To see this, consider that (1) all variance accounts are closed at the end of each period (temporary accounts), (2) a favorable variance is always a credit balance, and (3) an unfavorable variance is always a debit balance. Write a half-page memorandum to your instruc- tor with three parts that answer the following three requirements. (Assume that variance accounts are closed to Cost of Goods Sold.)

Required

1. Does Cost of Goods Sold increase or decrease when closing a favorable variance? Does gross margin increase or decrease when a favorable variance is closed to Cost of Goods Sold? Explain.

COMMUNICATING IN PRACTICE P6

2. Translating financial statements requires the use of a currency exchange rate. For each of the following financial statement items, indicate the exchange rate the company would apply to translate into U.S. dollars. Enter “CR” (current rate in effect at the balance sheet date) or “Avg” (the average rate in effect during the period).

a. Cash b. Sales revenue c. Property, plant and equipment

Chapter 21 Flexible Budgets and Standard Costs 867

BTN 21-3 Access iSixSigma’s website (iSixSigma.com) to search for and read information about the purpose and use of benchmarking to complete the following requirements. Hint: Look in the “Methodology” link.

Required

1. Write a one-paragraph explanation (in layperson’s terms) of benchmarking. 2. How does standard costing relate to benchmarking?

TAKING IT TO THE NET C1

BTN 21-6 Training employees to use standard amounts of materials in production is common. Typically, large companies invest in this training but small organizations do not. One can observe these different practices in a trip to two different pizza businesses. Visit both a local pizza business and a national pizza chain business and then complete the following.

Required

1. Observe and record the number of raw material items used to make a typical cheese pizza. Also observe how the person making the pizza applies each item when preparing the pizza.

2. Record any differences in how items are applied between the two businesses. 3. Estimate which business is more profitable from your observations. Explain.

HITTING THE ROAD C1

BTN 21-5 Away, as discussed in the chapter opener, uses a costing system with standard costs for direct materials, direct labor, and overhead costs. Two comments frequently are mentioned in relation to stan- dard costing and variance analysis: “Variances are not explanations” and “Management’s goal is not to minimize variances.”

Required

Write a short memo (no more than one page) to Jen Rubio and Steph Korey, Away’s co-founders, inter- preting these two comments in the context of their luggage business.

ENTREPRENEURIAL DECISION C1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

BTN 21-4 Many service industries link labor rate and time (quantity) standards with their processes. One example is the standard time to board an aircraft. The reason time plays such an important role in the ser- vice industry is that it is viewed as a competitive advantage: best service in the shortest amount of time. Although the labor rate component is difficult to observe, the time component of a service delivery stan- dard is often readily apparent—for example, “Lunch will be served in less than five minutes, or it is free.”

Required

Break into teams and select two service industries for your analysis. Identify and describe all the time ele- ments each industry uses to create a competitive advantage.

TEAMWORK IN ACTION C1

2. Does Cost of Goods Sold increase or decrease when closing an unfavorable variance? Does gross margin increase or decrease when an unfavorable variance is closed to Cost of Goods Sold? Explain.

3. Explain the meaning of a favorable variance and an unfavorable variance.

Learning Objectives

CONCEPTUAL C1 Distinguish between direct and indirect

expenses and identify bases for allocating indirect expenses to departments.

C2 Explain transfer pricing and methods to set transfer prices.

C3 Appendix 22C—Describe allocation of joint costs across products.

PROCEDURAL P1 Prepare a responsibility accounting

report using controllable costs.

P2 Allocate indirect expenses to departments.

P3 Prepare departmental income statements and contribution reports.

ANALYTICAL A1 Analyze investment centers using return

on investment and residual income.

A2 Analyze investment centers using profit margin and investment turnover.

A3 Analyze investment centers using the balanced scorecard.

A4 Compute the number of days in the cash conversion cycle.

Chapter Preview

22 Performance Measurement and Responsibility Accounting

RESPONSIBILITY ACCOUNTING

Performance evaluation

Controllable versus uncontrollable costs

P1 Responsibility accounting for cost centers

NTK 22-1

PROFIT CENTERS

C1 Direct and indirect expenses

P2 Expense allocation P3 Departmental income

statements

Departmental contribution to overhead

NTK 22-2

INVESTMENT CENTERS

A1 Return on investment Residual income

A2 Profit margin Investment turnover

NTK 22-3, 22-4

NONFINANCIAL MEASURES

A3 Balanced scorecard C2 Transfer pricing

A4 Cash conversion cycle

C3 Appendix: Joint costs

NTK 22-5

869

“It takes courage to dream big”—Galen Welsch

Drink Up!

COLORADO SPRINGS, CO—Millions of people do not have access to safe drinking water. Seeking to help remedy this crisis, father-son duo Randy and Galen Welsch started Jibu (Jibuco.com). Jibu gives African entrepreneurs training and resources to start their own water supply businesses. In turn, Jibu’s franchisees provide their communities with safe drink- ing water and jobs.

Instead of drilling, owners draw water from nearby sources and use solar-powered equipment to clean it. “There’s nothing more important than safe drinking water,” explains Randy. “Our model produces water that people can actually afford . . . [and] we harness the spirit of local owners.” Randy asserts that “by making profits, their businesses are more sustainable than rely- ing on donations to provide water.”

Randy and Galen rely on accounting to help run the busi- ness. “To break even,” says Galen, “a franchisee must sell about 1,000 liters of water per day. Pricing is critical. If owners sell at our prescribed price, they should be cash-flow positive in about three months.” Randy and Galen rely on income statements from each franchisee to monitor performance. Entrepreneurs must understand return on investment (ROI) and residual income, along with cost concepts such as direct and indirect expenses, to grow their businesses.

From an idea sparked by Galen’s Peace Corps trip to Africa, Jibu is flourishing. The company has over two hundred fran- chise locations, has provided over five hundred jobs, and has sold over 30 million liters of drinking water. “Build the plane as you fly it,” Galen advises. “Success comes from many failures.”

Sources: Jibu website, January 2019; Colorado Springs Business Journal, December 31, 2015; EY Citizen Today, December 2015; Forbes.com, August 24, 2017

©Jibu

Performance Evaluation Many large companies are easier to manage if they are divided into smaller units, called divi- sions, segments, or departments. For example, LinkedIn organizes its operations around three geographic segments: North America, Europe, and Asia-Pacific. Callaway Golf organizes its operations around two product lines, golf balls and golf clubs, while Kraft Heinz organizes its operations both geographically and around several product lines. In these decentralized orga- nizations, decisions are made by unit managers rather than by top management. Top manage- ment then evaluates the performance of unit managers.

In responsibility accounting, unit managers are evaluated only on things they can control. Methods of performance evaluation vary for cost centers, profit centers, and investment centers. A cost center incurs costs without directly generating revenues. The manufacturing depart-

ments of a manufacturer are cost centers. Also, its service departments, such as accounting, advertising, and purchasing, are cost centers. Kraft Heinz’s Dover, Delaware, manufacturing plant is a cost center. Cost center managers are evaluated on their success in controlling actual costs compared to budgeted costs.

A profit center generates revenues and incurs costs. Product lines are often evaluated as profit centers. Kraft Heinz’s beverage and condiment product lines are profit centers. Profit center managers are evaluated on their success in generating income. A profit center man- ager would not have the authority to make major investing decisions, such as the decision to build a new manufacturing plant.

An investment center generates revenues and incurs costs, and its manager is also respon- sible for the investments made in its operating assets. Kraft Heinz’s chief operating officer for U.S. operations has the authority to make decisions such as building a new manufacturing plant. Investment center managers are evaluated on their use of investment center assets to generate income.

This chapter describes ways to measure performance for these three types of responsibility centers.

RESPONSIBILITY ACCOUNTING

Callaway Golf

Golf Clubs Golf Balls

Point: Responsibility accounting does not place blame. Instead, it is used to identify opportunities to improve performance.

870 Chapter 22 Performance Measurement and Responsibility Accounting

Controllable versus Uncontrollable Costs We often evaluate a manager’s performance using responsibility accounting reports that describe a department’s activities in terms of whether a cost is controllable. Controllable costs are those for which a manager has the power to determine or at least sig-

nificantly affect the amount incurred. Uncontrollable costs are not within the manager’s control or influence.

For example, department managers often have little or no control over depreciation expense because they cannot affect the amount of equipment assigned to their departments. Also, department managers rarely control their own salaries. However, they can control or influence items such as the cost of supplies used in their department. When evaluating managers’ performance, we should use data reflecting their departments’ outputs along with their controllable costs and expenses.

A responsibility accounting system recognizes that control over costs and expenses belongs to several levels of management. We illustrate this in the partial organization chart in Exhibit 22.1. The lines in this chart connecting the managerial positions reflect channels of authority. For exam- ple, the three department managers (beverage, food, and service) in this company are responsible for controllable costs incurred in their departments. These department managers report to the vice president (VP) of the West region, who has overall control of the department costs. Similarly, the costs of the West region are reported to and controlled by the executive vice president (EVP) of U.S. operations, who in turn reports to the president, and, ultimately, the board of directors.

Responsibility Accounting for Cost Centers A responsibility accounting performance report lists actual expenses that a manager is responsible for and their budgeted amounts. Management’s analysis of differences between

P1 Prepare a responsibility accounting report using controllable costs.

Point: Cost refers to a monetary outlay to acquire some resource that has a future benefit. Expense usually refers to an expired cost.

Board of Directors

President

Executive Vice President,

U.S.A.

Executive Vice President,

Asia

Executive Vice President,

Europe

Vice President, East

Region

Vice President, West

Region

Plant Manager, Food

Department

Manager, Service

Department

Plant Manager, Beverage

Department

EXHIBIT 22.1 Responsibility Accounting Chart (partial)

Chapter 22 Performance Measurement and Responsibility Accounting 871

Executive Vice President, U.S. Operations For July

Budgeted Amount

Over (Under) Budget Controllable Costs

Salaries, VPs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quality control costs . . . . . . . . . . . . . . . . . . . . . . . O�ce costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . West region . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . East region . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 80,000 21,000 29,500

276,700 390,000

$ 797,200

Vice President, West Region

Controllable Costs

Salaries, department managers . . . . . . . . . . . . . $ 75,000 $ 1,500 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,600 0 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,800 (500) Beverage department . . . . . . . . . . . . . . . . . . . . . 79,600 300 Food department . . . . . . . . . . . . . . . . . . . . . . . . . . 61,500 2,700

(1,200)Service department . . . . . . . . . . . . . . . . . . . . . . . . 43,200

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $276,700 $ 2,800

For July

Budgeted Amount

Over (Under) Budget

For July

Budgeted Amount

Over (Under) Budget

$ 0 1,400 (700)

2,800 (9,400)

$ (5,900)

Plant Manager, Beverage Department

Controllable Costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,600 $ 900 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 (400) Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 (200) Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,600 $ 300

Actual Amount

$ 80,000 22,400 28,800

279,500 380,600

$ 791,300

$ 76,500 10,600 6,300

79,900 64,200 42,000

$279,500

Actual Amount

Actual Amount

$ 52,500 19,600 7,800

$ 79,900

EXHIBIT 22.2 Responsibility Accounting Performance Reports

Below are Rios Co.’s annual budgeted and actual costs for the Western region’s manufacturing plant. The plant has two operating departments: Motorcycle and ATV. The plant manager is responsible for all of the plant’s costs (other than her own salary). Each operating department has a manager who is responsible for that department’s direct materials, direct labor, and overhead costs. Prepare responsi- bility accounting reports like those in Exhibit 22.2 for (1) the plant manager and (2) each operating department manager. P1

Responsibility Accounting

NEED-TO-KNOW 22-1

budgeted and actual amounts often results in corrective or strategic managerial actions. Upper- level management uses performance reports to evaluate the effectiveness of lower-level manag- ers in keeping costs within budgeted amounts.

Exhibit 22.2 shows summarized performance reports for the three management levels identi- fied in Exhibit 22.1. The Beverage department is a cost center, and its manager is responsible for controlling costs. Costs under the control of the Beverage department plant manager are totaled and included among the controllable costs of the VP of the West region. Costs under the control of this VP are totaled and included among the controllable costs of the EVP of U.S. operations. In this way, responsibility accounting reports provide relevant information for each management level. (If the VP and EVP are responsible for more than just costs, the responsibil- ity accounting system is expanded, as we show later in this chapter.)

The number of controllable costs reported varies across management levels. At lower levels, managers have limited responsibility and fewer controllable costs. Responsibility and control broaden for higher-level managers; their reports span a wider range of costs. However, reports to higher-level managers usually are summarized because (1) lower-level managers are often responsible for detailed costs and (2) detailed reports can obscure the broader issues facing top managers of an organization.

Point: Responsibility accounting divides a company into subunits, or responsibility centers.

Point: Responsibility accounting typically uses flexible budgets.

872 Chapter 22 Performance Measurement and Responsibility Accounting

Budgeted Amount Actual Amount

Motorcycle ATV Motorcycle ATV

Direct materials . . . . . . . . . . . . $ 97,000 $138,000 $ 98,500 $133,800 Direct labor . . . . . . . . . . . . . . . 52,000 105,000 56,100 101,300 Dept . mgr . salary . . . . . . . . . . . 60,000 56,000 60,000 56,000 Rent and utilities . . . . . . . . . . . 9,000 12,000 8,400 10,900 Overhead . . . . . . . . . . . . . . . . 45,000 81,000 47,000 78,000 Totals . . . . . . . . . . . . . . . . . . . . $263,000 $392,000 $270,000 $380,000

Solution 1. Responsibility Accounting Performance Report

Plant Manager, Western Region

Budgeted Actual Over (Under) Budget

Dept . mgr . salaries . . . . . . . . . $116,000 $116,000 $ 0 Rent and utilities . . . . . . . . . . . 21,000 19,300 (1,700) Motorcycle dept .* . . . . . . . . . 194,000 201,600 7,600 ATV dept .† . . . . . . . . . . . . . . . . 324,000 313,100 (10,900) Totals . . . . . . . . . . . . . . . . . . . . $655,000 $650,000 $ (5,000)

*Costs are from Motorcycle responsibility report, solution 2a. †Costs are from ATV responsibility report, solution 2b.

Responsibility Accounting Performance Report Department Manager, Motorcycle Department

Budgeted Actual Over (Under) Budget

Direct materials . . . . . . . . . . . . $ 97,000 $ 98,500 $1,500

Direct labor . . . . . . . . . . . . . . . 52,000 56,100 4,100

Overhead . . . . . . . . . . . . . . . . 45,000 47,000 2,000

Totals . . . . . . . . . . . . . . . . . . . . $194,000 $201,600 $7,600

2a.

Do More: QS 22-3, E 22-1, E 22-2, P 22-1

Responsibility Accounting Performance Report Department Manager, ATV Department

Budgeted Actual Over (Under) Budget

Direct materials . . . . . . . . . . . . $138,000 $133,800 $ (4,200)

Direct labor . . . . . . . . . . . . . . . 105,000 101,300 (3,700)

Overhead . . . . . . . . . . . . . . . . 81,000 78,000 (3,000)

Totals . . . . . . . . . . . . . . . . . . . . $324,000 $313,100 $(10,900)

2b.

When departments are organized as profit centers, responsibility accounting focuses on how well each department controlled costs and generated revenues. This leads to departmental income statements as a common way to report profit center performance. When computing departmental profits, we confront two accounting challenges that involve allocating expenses.

1. How to allocate indirect expenses such as rent and utilities, which benefit several departments. 2. How to allocate service department expenses such as payroll or purchasing, which per-

form services that benefit several departments.

We explain these allocations and profit center income reporting.

Direct and Indirect Expenses Direct expenses are costs readily traced to a department because they are incurred for that department’s sole benefit. They are not allocated across departments. For example, the salary of

PROFIT CENTERS

Chapter 22 Performance Measurement and Responsibility Accounting 873

an employee who works in only one department is a direct expense of that one department. Direct expenses are often, but not always, controllable costs.

Indirect expenses are costs incurred for the joint benefit of more than one department; they cannot be readily traced to only one department. For example, if two or more departments share a single building, all enjoy the benefits of the expenses for rent, heat, and light. Likewise, the operating departments that perform an organization’s main functions, for example, manufactur- ing and selling, benefit from the work of service departments. Service departments, like payroll and human resource management, do not generate revenues, but their support is crucial for the operating departments’ success.

Expense Allocations General Model Indirect and service department expenses are allocated across departments that benefit from them. Ideally, we allocate these expenses by using a cause-effect relation. Often such cause-effect relations are hard to identify. When we cannot identify cause-effect relations, we allocate each indirect or service department expense based on approximating the relative benefit each department receives. Exhibit 22.3 summarizes the general model for cost allocation.

C1 Distinguish between direct and indirect expenses and identify bases for allocating indirect expenses to departments.

Point: Service department expenses can be viewed as a special case of indirect expenses.

EXHIBIT 22.3 General Model for Cost Allocation

Allocated cost = Total cost to allocate × Percentage of allocation base used

Allocating Indirect Expenses Allocation bases vary across departments and organi- zations. No standard rule for the “best” allocation bases exists. Managers must use judgment in developing allocation bases because employee morale can suffer if allocations are perceived as unfair. Exhibit 22.4 shows some commonly used bases for allocating indirect expenses.

P2 Allocate indirect expenses to departments.

Indirect Expense Common Allocation Bases

Wages and salaries . . . . . . . . . . . . . . . . Relative amount of hours worked in each department

Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . Square feet of space occupied

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . Square feet of space occupied

Advertising . . . . . . . . . . . . . . . . . . . . . . . Percentage of total sales

Depreciation . . . . . . . . . . . . . . . . . . . . . Hours of depreciable asset used

EXHIBIT 22.4 Bases for Allocating Indirect Expenses

More complicated allocation schemes are possible. For example, some locations in a retail store (ground floor near the entrance, for example) are more valuable than others. Departments with better locations can be allocated more cost. Advertising campaigns can be analyzed to see the amount of advertising devoted to each department, or utilities costs can be allocated based on machine hours used in each department. Management must determine whether these more accurate cost allocations justify the effort and expense to compute them.

Allocating Service Department Expenses To generate revenues, operating de- partments require services provided by departments such as personnel, payroll, and purchasing. Such service departments are typically evaluated as cost centers because they do not produce revenues. A departmental accounting system can accumulate and report costs incurred by each service department for this purpose. The system then allocates a service department’s expenses to operating departments that benefit from them. Exhibit 22.5 shows some commonly used bases for allocating service department expenses to operating departments.

©Ariel Skelley/Blend Images

Point: Some companies ask supervisors to estimate time spent supervising specific departments for purposes of expense allocation.

Service Department Common Allocation Bases

Office expenses . . . . . . . . . . . . . . . . . . Number of employees or sales in each department

Personnel expenses . . . . . . . . . . . . . . . Number of employees in each department

Payroll expenses . . . . . . . . . . . . . . . . . Number of employees in each department

Purchasing costs . . . . . . . . . . . . . . . . . Dollar amounts of purchases or number of purchase orders processed

Maintenance expenses . . . . . . . . . . . . Square feet of floor space occupied

EXHIBIT 22.5 Bases for Allocating Service Department Expenses

874 Chapter 22 Performance Measurement and Responsibility Accounting

Illustration of Cost Allocation We illustrate the general approach to allocating costs by looking at cleaning services for a retail store (an indirect cost). An outside company cleans the retail store for a total cost of $800 per month. Management allocates this cost across the store’s three departments based on floor space (in square feet) that each department occupies. Exhibit 22.6 shows this allocation.

Department Percent of Total Cost Allocated Department Square Feet Square Feet to Department

Jewelry . . . . . . . . . . . . . . . . . 2,400 60% (2,400 sq ft/4,000 sq ft) $480

Watch Repair . . . . . . . . . . . . . 600 15 (600 sq ft/4,000 sq ft) 120

China and Silver . . . . . . . . . . 1,000 25 (1,000 sq ft/4,000 sq ft) 200

Totals . . . . . . . . . . . . . . . . . . . 4,000 100% $800

EXHIBIT 22.6 Cost Allocation

The total cost to allocate is $800. Since the Jewelry department occupies 60% of the store’s total floor space (2,400 square feet/4,000 square feet), it is allocated 60% of the total cleaning cost. This allocated cost of $480 is computed as $800 × 60%. When the allocation process is com- plete, these and other allocated costs are deducted in computing the net income for each depart- ment. The calculations are similar for other allocation bases and for service department costs.

Allocate a retailer’s purchasing department’s costs of $20,000 to its operating departments using each department’s percentage of total purchase orders.

P2 Cost Allocations

NEED-TO-KNOW 22-2

Department Number of Purchase Orders

Clothing . . . . . . . . . . . . . . . . 250

Health Care . . . . . . . . . . . . . 450

Sporting Goods . . . . . . . . . . 300

Total . . . . . . . . . . . . . . . . . . . 1,000

Do More: QS 22-4, QS 22-5, QS 22-6, E 22-3, E 22-4,

E 22-5

Clothing . . . . . . . . . . . . . . . . $20,000 × 25% = $ 5,000 Health Care . . . . . . . . . . . . . 20,000 × 45% = 9,000 Sporting Goods . . . . . . . . . . 20,000 × 30% = 6,000 Total . . . . . . . . . . . . . . . . . . . $20,000

Solution

Departmental Income Statements Departmental income is computed using the formula in Exhibit 22.7.

P3 Prepare departmental income statements and contribution reports.

Departmental = Department − Department direct − Allocated indirect − Allocated service income sales expenses expenses department expenses

EXHIBIT 22.7 Departmental Income

We prepare departmental income statements using A-1 Hardware and its five departments. Two of them (general office and purchasing) are service departments, and the other three (Hard- ware, Housewares, and Appliances) are operating departments. Since the service departments do not generate sales, we do not prepare departmental income statements for them. Instead, we allocate their expenses to operating departments.

Preparing departmental income statements involves four steps.

Step 1 : Accumulating revenues, direct expenses, and indirect expenses by department. Step 2 : Allocating indirect expenses across both service and operating departments. Step 3 : Allocating service department expenses to operating departments. Step 4 : Preparing departmental income statements.

Chapter 22 Performance Measurement and Responsibility Accounting 875

General of�cee PurchasingGeneral of�ce Purchasing HousewaresHardware AppliancesAppliancesHousewaresHardware

Departmental revenues

2 Departmental direct expenses

2 Allocated company indirect expenses

2 Allocated service department expenses

5 Departmental net income

Departmental direct expenses

1 Allocated company indirect expenses

5 Total service department expenses EXHIBIT 22.8 Departmental Performance Reporting

Exhibit 22.8 summarizes these steps in preparing departmental performance reports for cost centers and profit centers (links to the steps are coded with circled numbers 1 through 4). A-1 Hardware’s service departments (general office and purchasing) are cost centers, so their perfor- mance is based on how well they control their direct department expenses. The company’s operating departments (Hardware, Housewares, and Appliances) are profit centers, and their performance is based on how well they generate departmental net income.

Apply Step 1: We first collect the necessary data from general company and departmen- tal accounts. Exhibit 22.9 shows these data.

Point: Operating departments generate revenues. Service departments do not.

Point: We sometimes allocate service department costs across other service departments before allocating them to operating de- partments. This “step-wise” process is covered in advanced courses.

Direct expenses

Indirect expenses

Total expenses......................

Sales..........................................

Cost of goods sold.................

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

Depreciation—Equip..............

Rent .......................................

Advertising.............................

Insurance...............................

Salaries..................................

2,500

$220,000

$ 147,800

900

12,000

1,000

51,900

1,500

0

200

13,300

500

$ 0

0

100

8,200

300

$ 0

73,800

300

15,600

400

$119,500

43,800

200

7,000

$ 71,700

100

$47,800

30,200

7,800

200

100

Operating DepartmentsService Departments

General O�ce

Expense Account Bal.

A-1 HARDWARE Revenues and Expenses

For Year Ended December 31, 2019 Purchasing Hardware Housewares Appliances

Utilities................................... 2,400

EXHIBIT 22.9 Cost Data

Point: Sales and cost of goods sold data are from operating de- partment records.

Exhibit 22.9 shows the direct and indirect expenses by department. Each department uses pay- roll records, fixed asset and depreciation records, and supplies requisitions to determine the amounts of its expenses for salaries, depreciation, and supplies. The total amount for each of these direct expenses is entered in the Expense Account Balance column. That column also lists the amount of each indirect expense.

Apply Step 2: Using the general model, A-1 Hardware allocates indirect costs. We show this with the departmental expense allocation spreadsheet in Exhibit 22.10. After selecting allocation bases, indirect expenses are recorded in company accounts and allocated to both operating and service departments. Detailed calculations for indirect expense allocations, which follow the general model of cost allocation, are in Appendix 22A (see Exhibits 22A.1 thru 22A.6).

876 Chapter 22 Performance Measurement and Responsibility Accounting

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

Indirect expenses

Service department expenses

Total expenses allocated to operating departments........................................................

Total department expenses.......

Direct expenses

Depreciation—Equipment......

Rent expense......................... Utilities expense.................... Advertising expense.............. Insurance expense.................

General o�ce department..... Purchasing department..........

Amount and value of space... Floor space............................ Sales...................................... Value of insured assets.........

Sales..................................... Purchase orders....................

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

$ 51,900

72,200

$72,200

1,500

12,000 2,400 1,000 2,500

900

$13,300

$ 0

15,300

(15,300)

500

600 300

400

200

$8,200

$ 0

9,700

(9,700)

300

600 300

200

100

$ 15,600

23,370

7,650 3,880

$34,900

400

4,860 810 500 900

300

$ 7,000

11,980

4,590 2,630

$19,200

100

3,240 540 300 600

200

$ 7,800

11,850

3,060 3,190

$18,100

200

2,700 450 200 400

100

Allocation of Expenses to Departments

General O�ce Dept.Allocation Base

Expense Account Bal.

A-1 HARDWARE Departmental Expense Allocations

For Year Ended December 31, 2019

Purchasing Dept.

Hardware Dept.

Housewares Dept.

Appliances Dept.

(see note a) (see note a) (see note a)

aThe allocation base is not relevant as direct expenses are not allocated.

8 9 10 11 12 13

4 5 6

1 2 3

7

21

17 18 19

14 15 16

20

EXHIBIT 22.10 Departmental Expense Allocation Spreadsheet

Apply Step 3: We then allocate service department expenses to operating departments. Service department expenses typically are not allocated to other service departments. After service department costs are allocated, no expenses remain in the service departments, as shown in row 21 of Exhibit 22.10. Detailed calculations for service department expense allocations, which fol- low the general model of cost allocation, are in Appendix 22A (see Exhibits 22A.7 and 22A.8).

Apply Step 4: The departmental expense allocation spreadsheet is now used to prepare departmental performance reports. The general office and purchasing departments are cost cen- ters, and their managers are evaluated on their control of costs.

Exhibit 22.11 shows income statements for the three operating departments. This exhibit uses the spreadsheet (in Exhibit 22.10) for its operating expenses; information on sales and cost of goods sold comes from departmental records.

A-1 HARDWARE Departmental Income Statements

Hardware Housewares Appliances For Year Ended December 31, 2019 Department Department Department Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,500 $71,700 $47,800 $239,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,800 43,800 30,200 147,800

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,700 27,900 17,600 91,200

Operating expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,600 7,000 7,800 30,400

Depreciation expense—Equipment . . . . . . . . . . . . . 400 100 200 700

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 200 100 600

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,860 3,240 2,700 10,800

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 810 540 450 1,800

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . 500 300 200 1,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 900 600 400 1,900

Share of general office expenses . . . . . . . . . . . . . . 7,650 4,590 3,060 15,300

Share of purchasing expenses . . . . . . . . . . . . . . . . 3,880 2,630 3,190 9,700

Total operating expenses . . . . . . . . . . . . . . . . . . . . 34,900 19,200 18,100 72,200

Operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . $ 10,800 $ 8,700 $ (500) $ 19,000

EXHIBIT 22.11 Departmental Income Statements (operating departments)

Direct expenses

Allocated service department expenses

Allocated indirect expenses

Chapter 22 Performance Measurement and Responsibility Accounting 877

Higher-level managers use departmental income statements to determine which of a company’s departments are most profitable. After considering all costs, the Hardware department is most profitable. The company might attempt to expand its Hardware department.

Departmental Contribution to Overhead Exhibit 22.11 shows that the Appliances department reported an operating loss of $(500). Should this department be eliminated? We must be careful when indirect expenses are a large portion of total expenses and when weaknesses in assumptions and decisions in allocating indirect expenses can greatly affect income. Also, operating department managers might have no control over the level of service department services they use. In these and other cases, we might better evaluate profit center performance using the departmental contribution to overhead, a measure of the amount of sales less direct expenses. A department’s contribution is said to be “to overhead” because of the practice of considering all indirect expenses as overhead. Thus, the excess of a department’s sales over direct expenses is a contribution toward at least a portion of total overhead.

The upper half of Exhibit 22.12 shows a departmental contribution to overhead as part of an expanded income statement. Departmental contribution to overhead, because it focuses on the direct expenses that are under the profit center manager’s control, is often a better way to assess that manager’s performance.

EXHIBIT 22.12 Departmental Contribution to Overhead

A-1 HARDWARE Income Statement Showing Departmental Contribution to Overhead

Hardware Housewares Appliances For Year Ended December 31, 2019 Department Department Department Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,500 $ 71,700 $47,800 $239,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,800 43,800 30,200 147,800 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,700 27,900 17,600 91,200 Direct expenses Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,600 7,000 7,800 30,400 Depreciation expense—Equipment . . . . . . . . . . . . . 400 100 200 700 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 200 100 600 Total direct expenses . . . . . . . . . . . . . . . . . . . . . . . . 16,300 7,300 8,100 31,700 Departmental contributions to overhead . . . . . . . . $ 29,400 $20,600 $ 9,500 $ 59,500 Indirect expenses Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,800 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 General office department expense . . . . . . . . . . . . 15,300 Purchasing department expense . . . . . . . . . . . . . . 9,700 Total indirect expenses . . . . . . . . . . . . . . . . . . . . . . 40,500 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,000

Point: Operating income is the same in Exhibits 22.11 and 22.12. The method of reporting indirect expenses in Exhibit 22.12 does not change income but does identify each operating depart- ment’s contribution to overhead.

Exhibit 22.12 shows a $9,500 positive contribution to overhead for the Appliances department. If this department were eliminated, the company would be worse off. Further, the Appliance department’s manager is better evaluated using this $9,500 than on the department’s operating loss of $(500). The company also compares each department’s contribution to overhead to bud- geted amounts to assess each department’s performance.

Behavioral Aspects of Departmental Performance Reports An organiza- tion must consider potential effects on employee behavior from departmental income statements and contribution to overhead reports. These include: Indirect expenses are typically uncontrollable costs for department managers. Thus, depart-

mental contribution to overhead might be a better way to evaluate department manager performance. Including uncontrollable costs in performance evaluation is inconsistent with responsibility accounting and can reduce manager morale.

878 Chapter 22 Performance Measurement and Responsibility Accounting

Alternatively, including indirect expenses in the department manager’s performance evalua- tion can lead the manager to be more careful in using service departments, which can reduce the organization’s costs.

Some companies allocate budgeted service department costs rather than actual service costs. In this way, operating departments are not held responsible for excessive costs from service departments, and service departments are more likely to control their costs.

We describe both financial and nonfinancial measures of investment center performance.

Return-on-Investment and Residual Income Investment center managers are typically evaluated using performance measures that combine income and assets. These measures include: return on investment residual income profit margin investment turnover

To illustrate, let’s consider ZTel Company, which operates two divisions as investment centers: LCD and S-Phone. The LCD division manufactures liquid crystal display (LCD) touch-screen monitors and sells them for use in computers, cellular phones, and other prod- ucts. The S-Phone division sells smartphones. Exhibit 22.13 shows current-year income and assets for the divisions.

INVESTMENT CENTERS

A1 Analyze investment centers using return on investment and residual income.

Return on investment = Investment center income

Investment center average invested assets

The return on investment for the LCD division is 21% (rounded), computed as $526,500/$2,500,000. The S-Phone division’s return on investment is 23% (rounded), computed as $417,600/$1,850,000. ZTel’s management can use ROI as part of its performance evaluation for its investment center managers. For example, actual ROI can be compared to targeted ROI or to the ROI for similar departments at competing businesses.

Investment Center Residual Income Another way to evaluate division perfor- mance is to compute investment center residual income, which is computed as follows.

Residual income = Investment centerincome − Target investment center

income

Assume ZTel’s top management sets target income at 8% of investment center assets. For an investment center, this target percentage is typically the cost of obtaining financing. Applying this formula using data from Exhibit 22.13 yields the residual income for ZTel’s divisions in Exhibit 22.14.

EXHIBIT 22.13 Investment Center Income and Assets

LCD Division S-Phone Division

Investment center income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 526,500 $ 417,600

Investment center average invested assets . . . . . . . . . . . . 2,500,000 1,850,000

Investment Center Return on Investment One measure to evaluate division performance is the investment center return on investment (ROI), also called return on assets (ROA). This measure is computed as follows.

Chapter 22 Performance Measurement and Responsibility Accounting 879

Residual income is usually expressed in dollars. The LCD division produced more dollars of residual income than the S-Phone division. ZTel’s management can use residual income, along with ROI, to evaluate investment center manager performance.

Using residual income to evaluate division performance encourages division managers to accept all opportunities that return more than the target income, thus increasing company value. For example, the S-Phone division might (mistakenly) not want to accept a new customer that will provide a 15% return on investment because that will reduce the S-Phone division’s overall return on investment (23%, as shown above). However, the S-Phone division should accept this opportunity because the new customer would increase residual income by providing income above the target income of 8% of invested assets.

EXHIBIT 22.14 Investment Center Residual Income

LCD Division S-Phone Division

Investment center income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $526,500 $417,600

Less target investment center income: $2,500,000 × 8% . . . . . . . 200,000 $1,850,000 × 8% . . . . . . . 148,000 Investment center residual income . . . . . . . . . . . . . . . . . . . . . . . . . $326,500 $269,600

The Media division of a company reports income of $600,000, average invested assets of $7,500,000, and a target income of 6% of average invested assets. Compute the division’s (a) return on investment and (b) residual income.

Solution

a. $600,000∕$7,500,000 = 8% b. $600,000 − ($7,500,000 × 6%) = $150,000

Return on Investment and Residual Income

NEED-TO-KNOW 22-3

A1

Do More: QS 22-9, QS 22-10, E 22-9, E 22-10

Measurement Issues Evaluations of investment center performance using return on investment and residual income can be affected by how a company answers these questions:

1. How do you compute average invested assets? It is common to compute the average by add- ing the year’s beginning amount of invested assets to the year’s ending amount of invested assets and dividing that sum by 2. Averages based on monthly or quarterly asset amounts are also acceptable. Seasonal variations in invested assets, if any, impact this average.

2. How do you measure invested assets? It is common to measure invested assets using their net book values. For example, depreciable assets would be measured at their cost minus accumulated depreciation. As net book value declines over a depreciable asset’s useful life, the result is that return on investment and residual income would increase over that asset’s life. This might cause managers not to invest in new assets. In addition, in measur- ing invested assets, companies commonly exclude assets that are not used in generating investment center income, such as land held for resale.

3. How do you measure investment center income? It is common to exclude both interest expense and tax expense from investment center income. Interest expense reflects a com- pany’s financing decisions, and tax expense is typically considered outside the control of an investment center manager. Excluding interest and taxes in these calculations enables more meaningful comparisons of return on investment and residual income across invest- ment centers and companies.

Point: Economic Value Added (EVA®), developed and trade- marked by Stern, Stewart, and Co., addresses issues in comput- ing residual income. This method uses a variety of adjustments to compute income, assets, and the target rate.

In the Money Executive pay is often linked to performance measures. Bonus payments are often based on exceed- ing a target return on investment or certain balanced scorecard indicators. Stock awards, such as stock options and restricted stock, reward executives when their company’s stock price rises. The goal of bonus plans and stock awards is to encourage executives to make decisions that increase company performance and value. ■

Decision Insight

880 Chapter 22 Performance Measurement and Responsibility Accounting

Investment Center Profit Margin and Investment Turnover We can further examine investment center (division) performance by splitting return on invest- ment into two measures—profit margin and investment turnover—as follows.

A2 Analyze investment centers using profit margin and investment turnover.

Return on investment = Profit margin × Investment turnover

Return on investment = Investment center income

Investment center sales ×

Investment center sales Investment center average assets

Profit margin measures the income earned per dollar of sales. It equals investment center income divided by investment center sales. In analyzing investment center performance, we typically use a measure of income before tax.

Investment turnover measures how efficiently an investment center generates sales from its invested assets. It equals investment center sales divided by investment center average assets.

Profit margin is expressed as a percent, while investment turnover is interpreted as the number of times assets were converted into sales. Higher profit margin and higher investment turnover indicate better performance.

To illustrate, consider Walt Disney Co., which reports in Exhibit 22.15 results for two of its operating divisions: Media Networks and Parks and Resorts.

Point: This partitioning of return on investment is sometimes called DuPont analysis.

EXHIBIT 22.15 Walt Disney Division Sales, Income, and Assets

$ millions Media Networks Parks and Resorts

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $23,510 $18,415

Income . . . . . . . . . . . . . . . . . . . . . . . . . 6,902 3,774

Average invested assets . . . . . . . . . . . 32,591 28,884

Profit margin and investment turnover for these two divisions are computed and shown in Exhibit 22.16.

EXHIBIT 22.16 Walt Disney Division Profit Margin and Investment Turnover

$ millions Media Networks Parks and Resorts

Profit margin: $6,902∕$23,510 . . . . . . . 29 .36% $3,774∕$18,415 . . . . . . . 20 .49% Investment turnover: $23,510∕$32,591 . . . . . . 0 .72 $18,415∕$28,884 . . . . . . 0 .64 Return on investment: 29 .36% × 0 .72 . . . . . . . . . 21 .14% 20 .49% × 0 .64 . . . . . . . . . 13 .11%

Disney’s Media Networks division makes 29.36 cents of profit for every dollar of sales, while its Parks and Resorts division makes 20.49 cents of profit per dollar of sales. The Media Networks division (0.72 investment turnover) is slightly more efficient than the Parks and Resorts division (0.64 investment turnover) in using assets. Top management can use profit margin and investment turnover to evaluate the performance of division manag- ers. The measures can also aid management when considering further investment in its divisions. Because of both a much higher profit margin and higher investment turnover, the Media Networks division’s return on investment (21.14%) is much greater than that of the Parks and Resorts division (13.11%).

Chapter 22 Performance Measurement and Responsibility Accounting 881

Division Manager You manage a division in a highly competitive industry. You will receive a cash bonus if your divi- sion achieves an ROI above 12%. Your division’s profit margin is 7%, equal to the industry average, and your division’s investment turnover is 1.5. How can you increase your chance of receiving the bonus? ■ Answer: Your division’s ROI is 10.5% (7% × 1.5). In a competitive industry, it is difficult to increase profit margins by raising prices. Your division might be better able to control costs than increase profit margin. You might increase advertising to increase sales without increasing invested assets. Investment turnover and ROI increase if the advertising attracts customers.

Decision Maker

A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment.

Solution

a. $2,000∕$50,000 = 4% b. $50,000∕$10,000 = 5.0 c. $2,000∕$10,000 = 20%

Margin, Turnover, and Return on Investment

NEED-TO-KNOW 22-4

A2

Do More: QS 22-12, E 22-11, E 22-12

Evaluating performance solely on financial measures has limitations. For example, some invest- ment center managers might forgo profitable opportunities to keep their return on investment high. Also, residual income is less useful when comparing investment centers of different size. And, both return on investment and residual income can encourage managers to focus too heav- ily on short-term financial goals.

In response to these limitations, companies consider nonfinancial measures. A delivery com- pany such as FedEx might track the percentage of on-time deliveries. The percentage of defec- tive tennis balls manufactured can be used to assess performance of Penn’s production managers. Walmart’s credit card screens commonly ask customers at checkout whether the cashier was friendly or the store was clean. Coca-Cola measures its water usage as part of an effort to enhance the sustainability of its production process. This kind of information can help division managers run their divisions and help top management evaluate division manager per- formance. A popular measure that includes nonfinancial indicators is the balanced scorecard.

Balanced Scorecard The balanced scorecard is a system of performance measures, including nonfinancial mea- sures, used to assess company and division manager performance. The balanced scorecard requires managers to think of their company from four perspectives.

1. Customer: What do customers think of us? 2. Internal Processes: Which operations are crucial to customer needs? 3. Innovation/Learning: How can we improve? 4. Financial: What do our owners think of us?

The balanced scorecard collects information on several key performance indicators (KPIs) within each of the four perspectives. These key indicators vary across companies. Exhibit 22.17 lists common performance indicators used in the balanced scorecard.

After selecting key performance indicators, companies collect data on each indicator and compare actual amounts to target (goal) amounts to assess performance. For example, a com- pany might have a goal of filling 98% of customer orders within two hours. Balanced scorecard reports are often presented in graphs or tables that can be updated frequently. Such timely infor- mation aids division managers in their decisions and can be used by top management to evaluate division manager performance.

NONFINANCIAL PERFORMANCE EVALUATION MEASURES

A3 Analyze investment centers using the balanced scorecard.

Point: One survey indicates that nearly 60% of global companies use some form of balanced scorecard.

882 Chapter 22 Performance Measurement and Responsibility Accounting

Exhibit 22.18 is an example of balanced scorecard reporting on the customer perspective for an Internet retailer. This scorecard reports that the retailer is getting 62% of its potential custom- ers successfully through the purchasing process and that 2.2% of all orders are returned. The color of the circles in the Trend column reveals whether the company is exceeding its goal (green), roughly meeting the goal (gray), or not meeting the goal (red). The direction of the arrows reveals any trend in performance: An upward arrow indicates improvement, a downward arrow indicates declining performance, and an arrow pointing sideways indicates no change.

A review of this balanced scorecard suggests the retailer is meeting or exceeding its goals on orders returned and customer satisfaction. Further, purchasing success and customer satisfaction are improving. The company has received more customer complaints than was hoped for; how- ever, the number of customer complaints is declining. A manager would combine this information with similar information from the other three performance indicators (internal processes, innova- tion and learning, and financial perspectives) to get an overall view of division performance.

Potential customers purchasing

Orders returned

Customer satisfaction rating

Number of customer complaints

62%

2.2%

9.5 of 10.0

142

80%

2%

9.5

100

ActualKPI: Customer Perspective Goal Trend EXHIBIT 22.18 Balanced Scorecard Reporting: Internet Retailer

Classify each of the performance measures below into the most likely balanced scorecard perspective to which it relates: customer (C), internal processes (P), innovation and growth (I), or financial (F). 1. On-time delivery rate 5. Residual income 2. Accident-free days 6. Patents applied for 3. Sustainability training workshops held 7. Sales returns 4. Defective products made 8. Customer complaints

Solution

1. C 2. P 3. I 4. P 5. F 6. I 7. C 8. C Do More: QS 22-13, QS 22-14,

E 22-16, E 22-17

A3 Balanced Scorecard

NEED-TO-KNOW 22-5

$0 2012 2006 2009 2004

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

400 600 1,200

Sustainability Training Financial Results

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 0706

Va lu

e of

$ 1 I

nv es

te d

08 09

• Defect rates

• Cycle time

• Product costs

• Labor hours per order

• Production days with- out an accident

• Employee satisfaction

• Employee turnover

• $ spent on training

• # of new products

• # of patents

• $ spent on research

Internal ProcessesCustomer Innovation/Learning Financial

• Customer satisfaction rating

• # of new customers acquired

• % of on-time deliveries

• % of sales from new products

• Time to fill orders

% of sales returned

• Net income

• ROI

• Sales growth

• Cash flow

• Residual income

• Stock price•

EXHIBIT 22.17 Balanced Scorecard Performance Indicators

CEO As CEO, your best-performing division, based on ROI, reported a large decrease in employee satisfaction. Should you investigate reasons for employee dissatisfaction or ignore it because financial performance is superb? ■ Answer: You should investigate. Lower employee satisfaction can lead to increased employee turnover and lower customer satisfaction, both of which can have serious finan- cial costs to the company.

Decision Maker

Chapter 22 Performance Measurement and Responsibility Accounting 883

Point: Transfer pricing can impact company profits when divisions are located in countries with different tax rates; this is covered in advanced courses.

This chapter focused on performance measurement and reporting. Companies report on their sustain- ability performance in a variety of ways. One approach integrates sustainability metrics in the four balanced scorecard perspectives (customer, internal process, innovation and learning, and financial). Many key performance indicators address the internal process and innovation and learning perspec- tives. For example, General Mills reports on its environmental targets and progress in its annual cor- porate sustainability report. Exhibit 22.19 captures how this information might appear as part of a balanced scorecard report.

Some companies can report the direct effects on profits from a focus on sustainability. For example, Target recently started a Made to Matter department. To be sold in this department, brands must focus on consumer wellness and be committed to social responsibility. Target’s Made to Matter department reported sales of over $1 billion in a recent year.

Jibu, this chapter’s feature company, prioritizes “impact maximization.” Co-founder Galen Welsch believes that a socially driven business model can “solve the world’s problems, like lack of water, and transform lives. Profits are a means to an end. They enable us to attract great owners who can provide workers with reliable incomes. All while selling a product that is critical to life at a fair price.”

SUSTAINABILITY AND ACCOUNTING

Transfer Pricing Divisions in decentralized companies sometimes do business with one another. For exam- ple, a separate division of Harley-Davidson manufactures the plastic and fiberglass parts used in the company’s motorcycles. Anheuser-Busch InBev’s metal container division makes cans used in its brewing operations and also sells cans to soft-drink companies. A division of Prince produces strings used in tennis rackets made by Prince and other manufacturers.

The price used to record transfers of goods across divisions of the same company is called the transfer price. Transfer prices can be used in cost, profit, and investment centers.

In decentralized organizations, division managers have input on or decide transfer prices. Since these transfers are not with customers outside the company, the transfer price has no direct impact on the company’s overall profits. However, transfer prices can impact division perfor- mance evaluations and, if set incorrectly, lead to bad decisions.

Transfer prices are set using one of three approaches.

1. Cost (such as variable manufacturing cost per unit) 2. Market price 3. Negotiated price

To illustrate the impact of alternative transfer prices on divisional profits, consider ZTel, a Smartphone manufacturer. ZTel’s LCD division makes touch-screen monitors that are used in ZTel’s Smartphone division or sold to outside customers. LCD’s variable manufacturing cost is $40 per monitor, and the market price is $80 per monitor. There are two extreme positions one can take for the transfer price. Low Transfer Price The Smartphone division manager wants to pay a low transfer price.

The transfer price cannot be less than $40 per monitor, as any lower price would cause the LCD manager to lose money on each monitor sold.

High Transfer Price The LCD division manager wants to receive a high transfer price. The transfer price cannot be more than $80 per monitor, as the Smartphone division manager will not pay more than the market price.

This means the transfer price must be between $40 and $80 per monitor, and a negotiated price somewhere between these two extremes is reasonable. Appendix 22B expands on transfer pric- ing and details on the three approaches.

C2 Explain transfer pricing and methods to set transfer prices.

©Jibu

884 Chapter 22 Performance Measurement and Responsibility Accounting

Cash Conversion CycleDecision Analysis

Effectively managing working capital is important for businesses to survive and profit. For example, lean manufacturers try to reduce the time from paying for raw materials from suppliers (cash outflow) to collecting on credit sales from customers (cash inflow). As we show in other chapters, ratios based on accounts receivable, accounts payable, and inventory are used to evaluate performance on each of these separate working capital dimensions. These ratios can be combined to summarize how effec- tively a company manages its working capital. The cash conversion cycle, or cash-to-cash cycle, measures the average time it takes to convert cash outflows into cash inflows from customers. It is defined in Exhibit 22.20.

A4 Compute the number of days in the cash conversion cycle.

EXHIBIT 22.20 Cash Conversion Cycle

Exhibit 22.21 shows these calculations for General Mills, a food processor.

EXHIBIT 22.21 General Mills Cash Conversion Cycle

Emissions

Energy usage

Solid waste

Fuel

20%

20

50

35

Target Reduction

23%

10

38

25

Actual ReductionKPI: Internal Process Perspective Trend EXHIBIT 22.19 Balanced Scorecard— Sustainability

General Mills’s cash conversion cycle is 8 days in 2016 and 10 days in 2017. This is low and indicates General Mills efficiently manages its cash. For comparison, the American Productivity and Quality Center (APQC), a benchmarking company, reports an average cash conversion cycle of 45 days for the companies it studies. The most efficient companies report cash conversion cycles of 30 days or less, while the least efficient take over 80 days to convert cash outflows to suppliers to cash inflows from customers.

$ millions 2017 2016

Accounts receivable, net, end of year . . . . . . . . . . $ 1,430 $ 1,361

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,620 $16,563

Days’ sales in accounts receivable . . . . . . . . . . . 33 days 30 days

Inventory, end of year . . . . . . . . . . . . . . . . . . . . . . . $ 1,484 $ 1,414

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $10,056 $10,734

Days’ sales in inventory . . . . . . . . . . . . . . . . . . . . 54 days 48 days

Accounts payable, end of year . . . . . . . . . . . . . . . . $ 2,120 $ 2,047

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $10,056 $10,734

Days’ payable outstanding . . . . . . . . . . . . . . . . . . 77 days 70 days Cash conversion cycle (1) + (2) − (3) . . . . . . . . . . 10 days 8 days

1

2

3

Formulas for Components of the Cash Conversion Cycle

Days’ sales in accounts receivable = Accounts receivable, net

Net sales × 365

Days’ sales in inventory = Inventory

Cost of goods sold × 365

Days’ payable outstanding = Accounts payable Cost of goods sold

× 365 (or Days’ sales in accounts payable)

Cash conversion cycle = Days’ sales inaccounts receivable + Days’ sales in

inventory − Days’ payable outstanding

Chapter 22 Performance Measurement and Responsibility Accounting 885

If a company’s cash conversion cycle is too long, it risks missing good investment opportunities. Companies can consider the following actions to speed up the cash conversion cycle.

Offering customers fewer days to pay. Offering customers discounts for prompt payment.

Management requests departmental income statements for Gamer’s Haven, a computer store that has five departments. Three are operating departments (Hardware, Software, and Repairs) and two are service departments (general office and purchasing). COMPREHENSIVE

Departmental Cost Allocations and Income Statements

NEED-TO-KNOW 22-6

General Office Purchasing Hardware Software Repairs

Sales . . . . . . . . . . . . . . . . . . . . . . . — — $960,000 $600,000 $840,000 Cost of goods sold . . . . . . . . . . . . — — 500,000 300,000 200,000 Direct expenses Payroll . . . . . . . . . . . . . . . . . . . $60,000 $45,000 80,000 25,000 325,000 Depreciation . . . . . . . . . . . . . . 6,000 7,200 33,000 4,200 9,600 Supplies . . . . . . . . . . . . . . . . . . 15,000 10,000 10,000 2,000 25,000

The departments incur several indirect expenses. To prepare departmental income statements, the indirect expenses must be allocated across the five departments. Then the expenses of the two service departments must be allocated to the three operating departments. Total cost amounts and the allocation bases for each indirect expense follow.

Indirect Expense Total Cost Allocation Basis

Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 Square footage occupied Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Square footage occupied Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000 Dollars of sales Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Value of assets insured Service departments General office . . . . . . . . . . . . . . . . . . . . . . . . . . . ? Number of employees Purchasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? Dollars of cost of goods sold

The following additional information is needed for indirect expense allocations.

Square Insured Cost of Department Feet Sales Assets Employees Goods Sold

General office . . . . . . . . . . . 500 $ 60,000 Purchasing . . . . . . . . . . . . . 500 72,000 Hardware . . . . . . . . . . . . . . 4,000 $ 960,000 330,000 5 $ 500,000 Software . . . . . . . . . . . . . . . 3,000 600,000 42,000 5 300,000 Repairs . . . . . . . . . . . . . . . . 2,000 840,000 96,000 10 200,000 Totals . . . . . . . . . . . . . . . . . . 10,000 $2,400,000 $600,000 20 $1,000,000

Required

1. Prepare a departmental expense allocation spreadsheet for Gamer’s Haven. 2. Prepare a departmental income statement reporting net income for each operating department and for

all operating departments combined.

PLANNING THE SOLUTION Set up and complete four tables to allocate the indirect expenses—one each for rent, utilities, advertis-

ing, and insurance. Allocate the departments’ indirect expenses using a spreadsheet like the one in Exhibit 22.10. Enter the

given amounts of the direct expenses for each department. Then enter the allocated amounts of the indirect expenses that you computed.

Complete two tables for allocating the general office and purchasing department costs to the three operating departments. Enter these amounts on the spreadsheet and determine the total expenses allo- cated to the three operating departments.

Prepare departmental income statements like the one in Exhibit 22.11. Show sales, cost of goods sold, gross profit, individual expenses, and net income for each of the three operating departments and for the combined company.

Adopting lean principles to reduce inventory levels. Negotiating longer times to pay suppliers.

886 Chapter 22 Performance Measurement and Responsibility Accounting

SOLUTION Allocations of the four indirect expenses across the five departments.

Square Percent Allocated Rent Feet of Total Cost

General office . . . . . . . . . . . 500 5 .0% $ 7,500

Purchasing . . . . . . . . . . . . . 500 5 .0 7,500

Hardware . . . . . . . . . . . . . . 4,000 40 .0 60,000

Software . . . . . . . . . . . . . . . 3,000 30 .0 45,000

Repairs . . . . . . . . . . . . . . . . 2,000 20 .0 30,000

Totals . . . . . . . . . . . . . . . . . . 10,000 100 .0% $150,000

Square Percent Allocated Utilities Feet of Total Cost

General office . . . . . . . . . . . 500 5 .0% $ 2,500

Purchasing . . . . . . . . . . . . . 500 5 .0 2,500

Hardware . . . . . . . . . . . . . . 4,000 40 .0 20,000

Software . . . . . . . . . . . . . . . 3,000 30 .0 15,000

Repairs . . . . . . . . . . . . . . . . 2,000 20 .0 10,000

Totals . . . . . . . . . . . . . . . . . . 10,000 100 .0% $50,000

Sales Percent Allocated Advertising Dollars of Total Cost

Hardware . . . . . . . . . . . . . $ 960,000 40 .0% $ 50,000

Software . . . . . . . . . . . . . . 600,000 25 .0 31,250

Repairs . . . . . . . . . . . . . . . 840,000 35 .0 43,750

Totals . . . . . . . . . . . . . . . . . $2,400,000 100 .0% $125,000

Assets Percent Allocated Insurance Insured of Total Cost

General office . . . . . . . . . . . $ 60,000 10 .0% $ 3,000

Purchasing . . . . . . . . . . . . . 72,000 12 .0 3,600

Hardware . . . . . . . . . . . . . . 330,000 55 .0 16,500

Software . . . . . . . . . . . . . . . 42,000 7 .0 2,100

Repairs . . . . . . . . . . . . . . . . 96,000 16 .0 4,800

Totals . . . . . . . . . . . . . . . . . . $600,000 100 .0% $30,000

1. Allocations of service department expenses to the three operating departments.

General Office Percent Allocated Allocations to Employees of Total Cost

Hardware . . . . . . . . . . . . . . 5 25 .0% $23,500

Software . . . . . . . . . . . . . . . 5 25 .0 23,500

Repairs . . . . . . . . . . . . . . . . 10 50 .0 47,000

Totals . . . . . . . . . . . . . . . . . . 20 100 .0% $94,000

Purchasing Cost of Percent Allocated Allocations to Goods Sold of Total Cost

Hardware . . . . . . . . . . . . . . $ 500,000 50 .0% $37,900

Software . . . . . . . . . . . . . . . 300,000 30 .0 22,740

Repairs . . . . . . . . . . . . . . . . 200,000 20 .0 15,160

Totals . . . . . . . . . . . . . . . . . . $1,000,000 100 .0% $75,800

GAMER’S HAVEN Departmental Expense Allocations

Expense General For Year Ended Allocation Account Office Purchasing Hardware Software Repairs December 31, 2019 Base Balance Dept. Dept. Dept. Dept. Dept.

Direct Expenses Payroll . . . . . . . . . . . . . . . . . . . . . $ 535,000 $ 60,000 $ 45,000 $ 80,000 $ 25,000 $ 325,000

Depreciation . . . . . . . . . . . . . . . . 60,000 6,000 7,200 33,000 4,200 9,600

Supplies . . . . . . . . . . . . . . . . . . . 62,000 15,000 10,000 10,000 2,000 25,000

Indirect Expenses Rent . . . . . . . . . . . . . . . . . . . . . . . Square ft . 150,000 7,500 7,500 60,000 45,000 30,000

Utilities . . . . . . . . . . . . . . . . . . . . Square ft . 50,000 2,500 2,500 20,000 15,000 10,000

Advertising . . . . . . . . . . . . . . . . . Sales 125,000 — — 50,000 31,250 43,750

Insurance . . . . . . . . . . . . . . . . . . Assets 30,000 3,000 3,600 16,500 2,100 4,800

Total expenses . . . . . . . . . . . . . . . . 1,012,000 94,000 75,800 269,500 124,550 448,150

Service Department Expenses General office . . . . . . . . . . . . . . . Employees (94,000) 23,500 23,500 47,000

Purchasing . . . . . . . . . . . . . . . . . Goods sold (75,800) 37,900 22,740 15,160 Total expenses allocated to operating departments . . . . . $1,012,000 $ 0 $ 0 $330,900 $170,790 $510,310

Chapter 22 Performance Measurement and Responsibility Accounting 887

GAMER’S HAVEN Departmental Income Statements

For Year Ended December 31, 2019 Hardware Software Repairs Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 960,000 $ 600,000 $ 840,000 $2,400,000 Cost of goods sold . . . . . . . . . . . . . . . . . 500,000 300,000 200,000 1,000,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . 460,000 300,000 640,000 1,400,000 Expenses Payroll . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 25,000 325,000 430,000 Depreciation . . . . . . . . . . . . . . . . . . . . 33,000 4,200 9,600 46,800 Supplies . . . . . . . . . . . . . . . . . . . . . . . 10,000 2,000 25,000 37,000 Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 45,000 30,000 135,000 Utilities . . . . . . . . . . . . . . . . . . . . . . . . 20,000 15,000 10,000 45,000 Advertising . . . . . . . . . . . . . . . . . . . . . 50,000 31,250 43,750 125,000 Insurance . . . . . . . . . . . . . . . . . . . . . . 16,500 2,100 4,800 23,400 Share of general office . . . . . . . . . . . 23,500 23,500 47,000 94,000 Share of purchasing . . . . . . . . . . . . . . 37,900 22,740 15,160 75,800 Total expenses . . . . . . . . . . . . . . . . . . 330,900 170,790 510,310 1,012,000 Operating income . . . . . . . . . . . . . . . . . $129,100 $129,210 $129,690 $ 388,000

2. Departmental income statements.

APPENDIX

Cost Allocations 22A In this appendix we use our general model of cost allocation (see Exhibit 22.3) to show how the cost allocations in Exhibits 22.10 and 22.11 are computed. A-1 Hardware’s departments use the allocation bases in Exhibit 22A.1: square feet of floor space, dollar value of insured assets, sales dollars, and number of purchase orders.

For each cost allocation that follows, we use the general formula here from Exhibit 22.3 to allocate indi- rect and service department costs.

EXHIBIT 22A.1 Departments’ Allocation Bases

Floor Space Value of Insured Number of Department (square feet) Assets ($) Sales ($) Purchase Orders*

General office . . . . . . . . . . 1,500 $ 38,000 __

Purchasing . . . . . . . . . . . . . 1,500 19,000 __

Hardware . . . . . . . . . . . . . . 4,050 85,500 $119,500 394

Housewares . . . . . . . . . . . . 2,700 57,000 71,700 267

Appliances . . . . . . . . . . . . . 2,250 38,000 47,800 324

Total . . . . . . . . . . . . . . . . . . 12,000 $237,500 $239,000 985

*Purchasing department tracks purchase orders by department.

Allocated cost = Total cost to allocate × Percentage of allocation base used

From Exhibit 22.9, the company has these four indirect costs to allocate.

Rent expense . . . . . . . . . . . . . $12,000 Advertising expense . . . . . . . . . $1,000

Utilities expense . . . . . . . . . . 2,400 Insurance expense . . . . . . . . . . 2,500

Allocation of Rent The two service departments (General office and Purchasing) occupy 25% of the total space (3,000 sq. feet/12,000 sq. feet). However, they are located near the back of the building, which is of lower value than space near the front that is occupied by operating departments. Management estimates that space near the back accounts for $1,200 (10%) of the total rent expense of $12,000. Exhibit 22A.2 shows how we allocate the $1,200 rent expense between these two service departments in proportion to their square footage.

888 Chapter 22 Performance Measurement and Responsibility Accounting

EXHIBIT 22A.2 Allocating Indirect (Rent) Expense to Service Departments

Square Percent Allocated Department Feet of Total Cost*

General office . . . . . . . . . . 1,500 50 .0% $ 600 Purchasing . . . . . . . . . . . . . 1,500 50 .0 600 Totals . . . . . . . . . . . . . . . . . . 3,000 100 .0% $1,200

*See row 13 of departmental expense allocation spreadsheet (Exhibit 22.10).

EXHIBIT 22A.3 Allocating Indirect (Rent) Expense to Operating Departments

Square Percent Allocated Department Feet of Total Cost*

Hardware . . . . . . . . . . . . . . 4,050 45 .0% $ 4,860 Housewares . . . . . . . . . . . . 2,700 30 .0 3,240 Appliances . . . . . . . . . . . . . 2,250 25 .0 2,700 Totals . . . . . . . . . . . . . . . . . . 9,000 100 .0% $10,800

*See row 13 of departmental expense allocation spreadsheet (Exhibit 22.10).

We then have the remaining amount of $10,800 ($12,000 − $1,200) of rent expense to allocate to the three operating departments, as shown in Exhibit 22A.3.

Allocation of Utilities We next allocate the $2,400 of utilities expense to all departments based on square footage occupied, as shown in Exhibit 22A.4.

EXHIBIT 22A.4 Allocating Indirect (Utilities) Expense to All Departments

Square Percent Allocated Department Feet of Total Cost*

General office . . . . . . . . . . . . 1,500 12 .50% $ 300 Purchasing . . . . . . . . . . . . . . . 1,500 12 .50 300 Hardware . . . . . . . . . . . . . . . . 4,050 33 .75 810 Housewares . . . . . . . . . . . . . . 2,700 22 .50 540 Appliances . . . . . . . . . . . . . . . 2,250 18 .75 450 Totals . . . . . . . . . . . . . . . . . . . . 12,000 100 .00% $2,400

*See row 14 of departmental expense allocation spreadsheet (Exhibit 22.10).

EXHIBIT 22A.5 Allocating Indirect (Advertising) Expense to Operating Departments

Percent Allocated Department Sales of Total Cost*

Hardware . . . . . . . . . . . . . . . . $119,500 50 .0% $ 500 Housewares . . . . . . . . . . . . . . 71,700 30 .0 300 Appliances . . . . . . . . . . . . . . . 47,800 20 .0 200 Totals . . . . . . . . . . . . . . . . . . . . $239,000 100 .0% $1,000

*See row 15 of departmental expense allocation spreadsheet (Exhibit 22.10).

Allocation of Advertising Exhibit 22A.5 shows the allocation of $1,000 of advertising expense to the three operating departments on the basis of sales dollars. We exclude the service departments from this alloca- tion because they do not generate sales.

Allocation of Insurance We allocate the $2,500 of insurance expense to each service and operating depart- ment, as shown in Exhibit 22A.6.

Value of Percent Allocated Department Insured Assets of Total Cost*

General office . . . . . . . . . . . . . $ 38,000 16 .0% $ 400 Purchasing . . . . . . . . . . . . . . . 19,000 8 .0 200 Hardware . . . . . . . . . . . . . . . . 85,500 36 .0 900 Housewares . . . . . . . . . . . . . . 57,000 24 .0 600 Appliances . . . . . . . . . . . . . . . 38,000 16 .0 400 Total . . . . . . . . . . . . . . . . . . . . . $237,500 100 .0% $2,500

*See row 16 of departmental expense allocation spreadsheet (Exhibit 22.10).

EXHIBIT 22A.6 Allocating Indirect (Insurance) Expense to All Departments

Allocation of Service Department Expenses Next we allocate the total expenses of the two service depart- ments to the three operating departments. Exhibit 22A.7 shows the allocation of total General office expenses ($15,300) to operating departments. This amount of $15,300 includes the $14,000 of direct service depart- ment expenses, plus $1,300 of indirect expenses that were allocated to the General office department.

Chapter 22 Performance Measurement and Responsibility Accounting 889

EXHIBIT 22A.7 Allocating Service Department (General Office) Expenses to Operating Departments

Percent Allocated Department Sales of Total Cost*

Hardware . . . . . . . . . . . . . . . . $119,500 50 .0% $ 7,650 Housewares . . . . . . . . . . . . . . 71,700 30 .0 4,590 Appliances . . . . . . . . . . . . . . . 47,800 20 .0 3,060 Total . . . . . . . . . . . . . . . . . . . . . $239,000 100 .0% $15,300

*See row 19 of departmental expense allocation spreadsheet (Exhibit 22.10).

Exhibit 22A.8 shows the allocation of total Purchasing department expenses ($9,700) to operating depart- ments. This amount of $9,700 includes $8,600 of direct expenses plus $1,100 of indirect expenses that were allocated to the Purchasing department.

APPENDIX

Transfer Pricing 22B In this appendix we show how to determine transfer prices and discuss issues in transfer pricing.

Alternative Transfer Prices The top portion of Exhibit 22B.1 reports data on the LCD division of ZTel. That division manufactures liquid crystal display (LCD) touch-screen monitors for use in ZTel’s S-Phone division’s smartphones. The monitors can also be used in other products. The LCD division can sell its monitors to the S-Phone division as well as to buyers other than S-Phone. Likewise, the S-Phone division can purchase monitors from suppliers other than LCD.

EXHIBIT 22B.1 LCD Division Manufacturing Information—Monitors

Production capacity . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Selling price per unit to outside customers . . . . $80

Variable manufacturing costs per unit . . . . $40

Fixed manufacturing costs . . . . . . . . . . . . . $2,000,000

$40 Variable Manufacturing Cost per Unit

$0

$80 Market Price per Unit

I won’t pay more than the $80 market price to buy this from LCD.

My department loses money if the transfer price is less

than $40 per monitor.

LCD Manager

Negotiation Range

S-Phone Manager

EXHIBIT 22A.8 Allocating Service Department (Purchasing) Expenses to Operating Departments

Number of Percent Allocated Department Purchase Orders of Total Cost*

Hardware . . . . . . . . . . . . . . 394 40 .00% $3,880 Housewares . . . . . . . . . . . . 267 27 .11 2,630 Appliances . . . . . . . . . . . . . 324 32 .89 3,190 Total . . . . . . . . . . . . . . . . . . . 985 100 .00% $9,700

*See row 20 of departmental expense allocation spreadsheet (Exhibit 22.10).

The bottom portion of Exhibit 22B.1 reveals the range of transfer prices for transfers of monitors from LCD to S-Phone. The transfer price can reasonably range from $40 (the variable manufacturing cost per unit) to $80 (the cost of buying the monitor from an outside supplier).

The LCD manager wants to report a divisional profit. Thus, this manager will not accept a transfer price less than $40; a price less than $40 would cause the division to lose money on each monitor transferred. The LCD manager will consider transfer prices of only $40 or more.

890 Chapter 22 Performance Measurement and Responsibility Accounting

The S-Phone division manager also wants to report a divisional profit. Thus, this manager will not pay more than $80 per monitor because similar monitors can be bought from outside suppliers at that price. The S-Phone manager will consider transfer prices of only $80 or less.

As any transfer price between $40 and $80 per monitor is possible, how does ZTel determine the transfer price? The answer depends in part on whether the LCD division has excess capacity to manufacture monitors.

No Excess Capacity If the LCD division can sell every monitor it produces (100,000 units) at a market price of $80 per monitor, LCD managers would not accept any transfer price less than $80 per monitor. This is a market-based transfer price—one based on the market price of the good or service being trans- ferred. Any transfer price less than $80 would cause the LCD division managers to incur an unnecessary opportunity cost that would lower the division’s income and hurt its managers’ performance evaluation. Typically, a division operating at full capacity will sell to external customers rather than sell internally. Still, the market-based transfer price of $80 can be considered the maximum possible transfer price when there is excess capacity, which is the case we consider next.

Excess Capacity Assume the LCD division is producing only 80,000 units. Because LCD has $2,000,000 of fixed manufacturing costs, both the LCD division and the top management of ZTel prefer that the S-Phone division purchases its monitors from LCD. For example, if S-Phone purchases its monitors from an outside supplier at the market price of $80 each, LCD manufactures no units. Then, LCD reports a division loss equal to its fixed costs, and ZTel overall reports a lower net income. With excess capacity, LCD should accept any transfer price of $40 per unit or greater, and S-Phone should purchase monitors from LCD. This will allow LCD to recover some (or all) of its fixed costs and increase ZTel’s overall profits. For example, if a transfer price of $50 per monitor is used, the S-Phone manager is pleased to buy from LCD because that price is below the market price of $80. For each monitor transferred from LCD to S-Phone at $50, the LCD division receives a contribution margin of $10 (computed as $50 transfer price less $40 variable cost) to contribute toward recovering its fixed costs. This form of transfer pricing is called cost-based transfer pricing. Under this approach, the transfer price might be based on variable costs, total costs, or variable costs plus a markup. With excess capacity, division managers will often negotiate a transfer price that lies between the vari- able cost per unit and the market price per unit. In this case, the negotiated transfer price and resulting departmental performance reports reflect, in part, the negotiating skills of the respective division manag- ers. This might not be best for overall company performance. Determining the transfer price under excess capacity is complex and is covered in advanced courses.

Additional Issues in Transfer Pricing Several additional issues arise in determining transfer prices.

No market price exists. Sometimes there is no market price for the product being transferred. The product might be a key component that requires additional conversion costs at the next stage and is not easily replicated by an outside company. For example, there is no market for a console for a Nissan Maxima and there is no substitute console Nissan can use in assembling a Maxima. In this case, a market-based transfer price cannot be used.

Cost control. To provide incentives for cost control, transfer prices might be based on standard, rather than actual, costs. For example, if a transfer price of actual variable costs plus a markup of $20 per unit is used in the case above, LCD has no incentive to control its costs.

Nonfinancial factors. Factors such as quality control, reduced lead times, and impact on employee morale can be important factors in determining transfer prices.

Transfer Pricing Approaches Used by Companies

Negotiated 17%

Market 37%

Cost 46%

APPENDIX

Joint Costs and Their Allocation22C Most manufacturing processes involve joint costs, which refer to costs incurred to produce or purchase two or more products at the same time. For example, a sawmill company incurs joint costs when it buys logs that it cuts into lumber, as shown in Exhibit 22C.1. The joint costs include the logs (raw material) and their being cut (conversion) into boards classified as Clear, Select, No. 1 Common, No. 2 Common, No. 3 Common, and other types of lumber and by-products. After the logs are cut into boards, any further pro- cessing costs on the boards are not joint costs.

C3 Describe allocation of joint costs across products.

Chapter 22 Performance Measurement and Responsibility Accounting 891

When a joint cost is incurred, a question arises as to whether to allocate it to different products resulting from it. The answer is that when management wishes to estimate the costs of individual products, joint costs are included and must be allocated to these joint products. However, when management needs information to help decide whether to sell a product at a certain point in the production process or to process it further, the joint costs are ignored. (We study this sell-or-process-further decision in a later chapter.) Financial statements prepared according to GAAP must assign joint costs to products. To do this, management must decide how to allocate joint costs across products benefiting from these costs. If some products are sold and others remain in inventory, allocating joint costs involves as- signing costs to both cost of goods sold and ending inventory. The two usual methods to allocate joint costs are the (1) physical basis and (2) value basis. The physical basis typically involves allocating a joint cost using physical characteristics such as the ratio of pounds, cubic feet, or gallons of each joint product to the total pounds, cubic feet, or gallons of all joint products flowing from the cost. This method is not preferred because the resulting cost allocations do not reflect the relative market values the joint cost gen- erates. The preferred approach is the value basis, which allocates a joint cost in proportion to the sales value of the output produced by the process at the “split-off point”; see Exhibit 22C.1. The split-off point is the point at which separate products can be identified.

Physical Basis Allocation of Joint Costs To illustrate the physical basis of allocating a joint cost, we con- sider a sawmill that bought logs for $30,000. When cut, these logs produce 100,000 board feet of lumber in the grades and amounts shown in Exhibit 22C.2. The logs produce 20,000 board feet of No. 3 Common lumber, which is 20% of the total. With physical allocation, the No. 3 Common lumber is assigned 20% of the $30,000 cost of the logs, or $6,000 ($30,000 × 20%). Because this low-grade lumber sells for $4,000, this allocation gives a $2,000 loss from its production and sale. The physical basis for allocating joint costs does not reflect the extra value flowing into some products or the inferior value flowing into others. That is, the portion of a log that produces Clear- and Select-grade lumber is worth more than the portion used to produce the three grades of common lumber, but the physical basis fails to reflect this.

Joint Products

Joint Cost

Split-o� Point

Clear

Select

No. 1 Common

No. 3 Common

No. 2 Common

Cutting of Logs

EXHIBIT 22C.1 Joint Products from Logs

Value Basis Allocation of Joint Costs Exhibit 22C.3 illustrates the value basis method of allocation. It deter- mines the percents of the total costs allocated to each grade by the ratio of each grade’s sales value at the split-off point to the total sales value of $50,000 (sales value is the unit selling price multiplied by the num- ber of units produced). The Clear and Select lumber grades receive 24% of the total cost ($12,000/$50,000) instead of the 10% portion using a physical basis. The No. 3 Common lumber receives only 8% of the total cost, or $2,400, which is much less than the $6,000 assigned to it using the physical basis.

Board Feet Percent Allocated Sales Gross Grade of Lumber Produced of Total Cost Value Profit

Clear and Select . . . . . . . . . . . . . . 10,000 10 .0% $ 3,000 $12,000 $ 9,000

No . 1 Common . . . . . . . . . . . . . . . 30,000 30 .0 9,000 18,000 9,000

No . 2 Common . . . . . . . . . . . . . . . 40,000 40 .0 12,000 16,000 4,000

No . 3 Common . . . . . . . . . . . . . . . 20,000 20 .0 6,000 4,000 (2,000)

Totals . . . . . . . . . . . . . . . . . . . . . . . 100,000 100 .0% $30,000 $50,000 $20,000

EXHIBIT 22C.2 Allocating Joint Costs on a Physical Basis

Sales Percent Allocated Gross Grade of Lumber Value of Total Cost Profit

Clear and Select . . . . . . . . . . . . . . . . . . . . . $12,000 24 .0% $ 7,200 $ 4,800

No . 1 Common . . . . . . . . . . . . . . . . . . . . . . 18,000 36 .0 10,800 7,200

No . 2 Common . . . . . . . . . . . . . . . . . . . . . . 16,000 32 .0 9,600 6,400

No . 3 Common . . . . . . . . . . . . . . . . . . . . . . 4,000 8 .0 2,400 1,600

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 100 .0% $30,000 $20,000

EXHIBIT 22C.3 Allocating Joint Costs on a Value Basis

An outcome of value basis allocation is that each grade produces exactly the same 40% gross profit at the split-off point. This 40% rate equals the gross profit rate from selling all the lumber made from the $30,000 logs for a combined price of $50,000. It is this closer matching of cost and revenues that makes the value basis allocation of joint costs the preferred method.

Example: Refer to Exhibit 22C.3. If the sales value of Clear and Select lumber is changed to $10,000, what is the revised ratio of the market value of No. 1 Common to the total? Answer: $18,000∕$48,000 = 37.5%

892 Chapter 22 Performance Measurement and Responsibility Accounting

RESPONSIBILITY ACCOUNTING Cost center: Incurs costs; generates no revenues. Profit center: Generates revenues and incurs costs. Investment center: Manager is responsible for investments, revenues, and costs. Controllable costs: Manager can determine or influence. Uncontrollable costs: Not within the manager’s control or influence.

PROFIT CENTERS Direct expenses: Can be readily traced to departments; not allocated. Indirect expenses: Incurred for joint benefit of more than one department; must be allocated. General model of cost allocation

Allocated cost = Total cost to allocate × Percentage of allocation base used

Departmental contribution to overhead

Summary: Cheat Sheet

Departmental income statement Departmental = Department − Department direct − Allocated indirect − Allocated service income sales expenses expenses department expenses

Department sales − Direct expenses

INVESTMENT CENTERS

Return on investment = Investment center income

Investment center average invested assets

Residual income = Investment centerincome − Target investment center

income

BALANCED SCORECARD System of performance measures. Customers: What do they think of us? Internal processes: Which are crucial to customer needs? Innovation/learning: How can we improve? Financial: What do owners think of us?

TRANSFER PRICING Price set on transfers of goods across divisions.

CASH CONVERSION CYCLE Measures efficiency of cash management.

Days’ sales in Accounts Receivable +

Days’ sales in Inventory −

Days’ payable outstanding

Minimum Maximum Negotiated price Cost Market price

Return on investment = Profit margin × Investment turnover

Return on investment = Investment center income

Investment center sales ×

Investment center sales Investment center average assets

Balanced scorecard (881) Cash conversion cycle (884) Controllable costs (870) Cost-based transfer pricing (890) Cost center (869) Decentralized organization (869) Departmental contribution to

overhead (877) Departmental income statements (872)

Direct expenses (872) Indirect expenses (873) Investment center (869) Investment turnover (880) Joint cost (890) Market-based transfer price (890) Negotiated transfer price (890) Profit center (869)

Profit margin (880) Residual income (878) Responsibility accounting (869) Responsibility accounting

performance report (870) Return on investment (ROI) (878) Transfer price (883) Uncontrollable costs (870)

Key Terms

Multiple Choice Quiz

1. A retailer has three departments—Housewares, Appliances, and Clothing—and buys advertising that benefits all de- partments. Advertising expense is $150,000 for the year, and departmental sales for the year follow: Housewares, $356,250; Appliances, $641,250; and Clothing, $427,500.

How much advertising expense is allocated to Appliances if allocation is based on departmental sales?

a. $37,500 c. $45,000 e. $641,250 b. $67,500 d. $150,000

Days’ sales in accounts receivable = Accounts receivable, net

Net sales × 365

Days’ sales in inventory = Inventory

Cost of goods sold × 365

Days’ payable outstanding = Accounts payable Cost of goods sold

× 365 (or Days’ sales in accounts payable)

Chapter 22 Performance Measurement and Responsibility Accounting 893

A,B,C Superscript letter A, B, or C denotes assignments based on Appendix 22A, 22B, or 22C.

Icon denotes assignments that involve decision making.

1. Why are many companies divided into departments? 2. What is the difference between operating departments and

service departments? 3. What are controllable costs? 4. costs are not within the manager’s control or

influence. 5. In responsibility accounting, why are reports to higher-

level managers usually summarized? 6. How are decisions made in decentralized organizations? 7. Is it possible to evaluate a cost center’s profitability?

Explain. 8. What is the difference between direct and indirect expenses?

9. Suggest a reasonable basis for allocating each of the following indirect expenses to departments: (a) salary of a supervisor who manages several departments, (b) rent, (c) heat, (d) electricity for lighting, (e) janitorial services, ( f ) advertising, (g) expired insurance on equipment, and (h) property taxes on equipment.

10. Samsung has many departments. How is a department’s contribution to overhead measured?

11. Google aims to give its managers timely cost reports. In responsibility ac- counting, who receives timely cost reports and specific cost information? Explain.

Discussion Questions

Samsung

GOOGLE

2. Indirect expenses a. Cannot be readily traced to one department. b. Are allocated to departments based on the relative ben-

efit each department receives. c. Are the same as uncontrollable expenses. d. a, b, and c above are all true. e. a and b above are true.

3. A division reports the information below. What is the divi- sion’s investment turnover?

a. 37.5% c. 2.5 e. 4 b. 15 d. 2.67 4. A company operates three retail departments X, Y, and Z as

profit centers. Which department has the largest dollar

amount of departmental contribution to overhead, and what is the dollar amount contributed?

Sales . . . . . . . . . . . . . . . . . . . $500,000

Income . . . . . . . . . . . . . . . . . . 75,000

Average assets . . . . . . . . . . . 200,000

Allocated Cost of Direct Indirect

Department Sales Goods Sold Expenses Expenses

X . . . . . $500,000 $350,000 $50,000 $40,000

Y . . . . . 200,000 75,000 20,000 50,000

Z . . . . . 350,000 150,000 75,000 10,000

a. Department Y, $55,000 d. Department Z, $200,000 b. Department Z, $125,000 e. Department X, $60,000 c. Department X, $500,000

5. Using the data in question 4, Department X’s contribution to overhead as a percentage of sales is

a. 20%. c. 12%. e. 32%. b. 30%. d. 48%.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; [$641,250∕($356,250 + $641,250 + $427,500)] × $150,000 = $67,500

2. d 3. c; $500,000∕200,000 = 2.5 4. b;

5. a; $100,000/$500,000 = 20%

Dept. X Dept. Y Dept. Z

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000 $200,000 $350,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . 350,000 75,000 150,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 125,000 200,000

Direct expenses . . . . . . . . . . . . . . . . . . . . . . 50,000 20,000 75,000

Departmental contribution to overhead . . . $100,000 $105,000 $125,000

894 Chapter 22 Performance Measurement and Responsibility Accounting

12. What is a transfer price? What are the three main ap- proaches to setting transfer prices?

13.B Under what conditions is a market-based transfer price most likely to be used?

14.C What is a joint cost? How are joint costs usually allo- cated among the products produced from them?

15. Each Apple retail store has several depart- ments. Why is it useful for its management to (a) collect accounting information about each department and (b) treat each department as a profit center?

16. Apple delivers its products to locations around the world. List three controllable and three uncontrollable costs for its delivery department.

17. Define and describe the cash conversion cycle and identify its three components.

18. Can management of a company such as Samsung use the cash conversion cy- cle as a useful measure of performance? Explain.APPLE

APPLE

Samsung

QUICK STUDY

QS 22-1 Allocation and measurement terms

C1

In each blank next to the following terms, place the identifying letter of its best description. 1. Cost center 2. Profit center 3. Responsibility

accounting system 4. Service department 5. Indirect expenses 6. Controllable costs

A. Incurs costs without directly yielding revenues. B. Provides information used to evaluate the performance of a department. C. Does not directly manufacture products but contributes to profit-

ability of the entire company. D. Costs incurred for the joint benefit of more than one department. E. Costs that a manager has the ability to affect. F. Incurs costs and also generates revenues.

QS 22-2 Basis for cost allocation

C1

In each blank next to the following types of indirect expenses and service department expenses, place the identifying letter of the best allocation basis to use to distribute it to the departments indicated.

1. Computer service expenses of production scheduling for operating departments.

2. General office department expenses of the operating departments.

3. Maintenance department expenses of the operating departments.

4. Electric utility expenses of all departments.

A. Relative number of employees. B. Proportion of total time in each department

for maintenance. C. Proportion of floor space occupied by each

department. D. Proportion of total processing time for

each operating department.

QS 22-3 Responsibility accounting report

P1

Jose Ruiz manages a car dealer’s service department. His department is organized as a cost center. Costs for a recent quarter are shown below. List the costs that would appear on a responsibility accounting report for the service department.

Cost of parts . . . . . . . . . . . . . . . . . . . . . . . . . . $22,400

Mechanics’ wages . . . . . . . . . . . . . . . . . . . . . 14,300

Manager’s salary . . . . . . . . . . . . . . . . . . . . . . . 8,000

Building depreciation (allocated) . . . . . . . . . . 4,500

Shop supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200

Utilities (allocated) . . . . . . . . . . . . . . . . . . . . . . . 800

Administrative costs (allocated) . . . . . . . . . . . . . 2,200

QS 22-5 Allocating costs to departments P2

Mervon Company has two operating departments: Mixing and Bottling. Mixing has 300 employees and Bottling has 200 employees. Indirect factory costs include administrative costs of $160,000. Administrative costs are allocated to operating departments based on the number of workers. Determine the administra- tive costs allocated to each operating department.

QS 22-4 Allocating costs to departments

P2

Macee Department Store has three departments, and it conducts advertising campaigns that benefit all departments. Advertising costs are $100,000 this year, and departmental sales for this year follow. How much advertising cost is allocated to each department if the allocation is based on departmental sales?

Department Sales

1 . . . . . . . . . . . . . . . . . . . . . . $220,000

2 . . . . . . . . . . . . . . . . . . . . . . 400,000

3 . . . . . . . . . . . . . . . . . . . . . . 180,000

Chapter 22 Performance Measurement and Responsibility Accounting 895

QS 22-6 Allocating costs to departments P2

Mervon Company has two operating departments: Mixing and Bottling. Mixing occupies 22,000 square feet. Bottling occupies 18,000 square feet. Indirect factory costs include maintenance costs of $200,000. If maintenance costs are allocated to operating departments based on square footage occupied, determine the amount of maintenance costs allocated to each operating department.

A retailer pays $130,000 rent each year for its two-story building. The space in this building is occupied by five departments as specified here.

QS 22-7 Rent expense allocated to departments

P2

The company allocates 65% of total rent expense to the first floor and 35% to the second floor, and then allocates rent expense for each floor to the departments occupying that floor on the basis of space occu- pied. Determine the rent expense to be allocated to each department.

Check Allocated to Jewelry dept., $25,350

Use the information in the following table to compute each department’s contribution to overhead (both in dollars and as a percent). Which department contributes the largest dollar amount to total overhead? Which contributes the highest percent (as a percent of sales)? Round percents to one decimal.

QS 22-8 Departmental contribution to overhead

P3 Dept. A Dept. B Dept. C

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $53,000 $180,000 $84,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 34,185 103,700 49,560

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,815 76,300 34,440

Total direct expenses . . . . . . . . . . . . . . . . . . . . 3,660 37,060 7,386

Contribution to overhead . . . . . . . . . . . . . . . . . $ $ $

Contribution percent (of sales) . . . . . . . . . . . . . % % %

Investment Center Net Income Average Assets Return on Investment

Cameras and camcorders . . . . . . . . . . . . . . $4,500,000 $20,000,000 _________%

Phones and communications . . . . . . . . . . . . 1,500,000 12,500,000 _________

Computers and accessories . . . . . . . . . . . . . 800,000 10,000,000 _________

Compute return on investment for each of the divisions below (each is an investment center). Which divi- sion performed the best, based on return on investment?

QS 22-9 Computing return on investment

A1

Refer to the information in QS 22-9. Assume a target income of 12% of average invested assets. Compute residual income for each division.

QS 22-10 Computing residual income A1

QS 22-11 Performance measures

A1 A2

Fill in the blanks in the schedule below for two separate investment centers A and B. Round answers to the nearest whole percent.

Investment Center A B

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $ $10,400,000

Income . . . . . . . . . . . . . . . . . . . . . . . . . $ 352,000 $

Average invested assets . . . . . . . . . . $1,400,000 $

Profit margin . . . . . . . . . . . . . . . . . . . . 8 .0% %

Investment turnover . . . . . . . . . . . . . . 1 .5

Return on investment . . . . . . . . . . . . . % 12 .0%

Department Square feet occupied

Jewelry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,440 (first-floor)

Cosmetics . . . . . . . . . . . . . . . . . . . . . . . . . . 3,360 (first-floor)

Housewares . . . . . . . . . . . . . . . . . . . . . . . . 2,016 (second-floor)

Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960 (second-floor)

Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,824 (second-floor)

896 Chapter 22 Performance Measurement and Responsibility Accounting

A company’s shipping division (an investment center) has sales of $2,420,000, net income of $516,000, and average invested assets of $2,250,000. Compute the division’s profit margin and investment turnover.

QS 22-12 Computing profit margin and investment turnover A2

The Windshield division of Fast Car Co. makes windshields for use in Fast Car’s Assembly division. The Windshield division incurs variable costs of $200 per windshield and has capacity to make 500,000 wind- shields per year. The market price is $450 per windshield. The Windshield division incurs total fixed costs of $3,000,000 per year. If the Windshield division is operating at full capacity, what transfer price should be used on transfers between the Windshield and Assembly divisions?

QS 22-16B Determining transfer prices without excess capacity

C2

Walt Disney reports the following information for its two Parks and Resorts divisions.

U.S. International

Current Year Prior Year Current Year Prior Year

Hotel occupancy rates . . . . . . . . . . . . 87% 83% 79% 78%

Assume Walt Disney uses a balanced scorecard and sets a target of 85% occupancy in its resorts. (1) Which division(s) exceeded the occupancy target during the current year? (2) Which division(s) improved its occupancy performance during the current year?

QS 22-14 Performance measures— balanced scorecard

A3

Classify each of the performance measures below into the most likely balanced scorecard perspective it relates to. Label your answers using C (customer), P (internal process), I (innovation and growth), or F (financial).

1. Customer wait time 2. Number of days of employee

absences 3. Profit margin 4. Number of new products introduced

5. Employee sustainability training sessions attended

6. Length of time raw materials are in inventory 7. Customer satisfaction index 8. Gallons of water reused

QS 22-13 Performance measures— balanced scorecard

A3

(1) Use the information below to compute the number of days in the cash conversion cycle for each company. (2) Which company is more effective at managing cash?

QS 22-15 Cash conversion cycle and efficiency

A4 Spartan Co. Chen Co.

Days’ sales in accounts receivable . . . . . . . . . 32 45

Days’ sales in inventory . . . . . . . . . . . . . . . . . . 20 24

Days’ payable outstanding . . . . . . . . . . . . . . . 27 32

A company purchases a 10,020-square-foot commercial building for $325,000 and spends an additional $50,000 to divide the space into two separate rental units and prepare it for rent. Unit A, which has the desirable location on the corner and contains 3,340 square feet, will be rented for $1.00 per square foot. Unit B contains 6,680 square feet and will be rented for $0.75 per square foot. How much of the joint cost should be assigned to Unit B using the value basis of allocation?

QS 22-18C Joint cost allocation

C3

The Windshield division of Fast Car Co. makes windshields for use in Fast Car’s Assembly division. The Windshield division incurs variable costs of $200 per windshield and has capacity to make 500,000 wind- shields per year. The market price is $450 per windshield. The Windshield division incurs total fixed costs of $3,000,000 per year. If the Windshield division has excess capacity, what is the range of possible trans- fer prices that could be used on transfers between the Windshield and Assembly divisions?

QS 22-17B Determining transfer prices with excess capacity

C2

Chapter 22 Performance Measurement and Responsibility Accounting 897

For a recent year L’Oréal reported operating profit of €3,385 (in millions) for its cosmetics division. Total assets were €12,888 (in millions) at the beginning of the year and €13,099 (in millions) at the end of the year. Compute return on investment for the year. State your answer as a percent, rounded to two decimals.

QS 22-19 Return on investment

A1

EXERCISES

Exercise 22-1 Responsibility accounting report—cost center

P1

Arctica manufactures snowmobiles and ATVs. These products are made in different departments, and each department has its own manager. Each responsibility performance report only includes those costs that the particular department manager can control: raw materials, wages, supplies used, and equipment depreciation. Using the data below, prepare a responsibility accounting report for the Snowmobile department.

Totals

Raw materials

Rent

Utilities

Employee wages

Depreciation—Equip.

Supplies used

Dept. manager salary

ActualBudget

ATVSnowmobile Combined Snowmobile ATV Combined

5,700

$ 19,500

$49,560

10,400

4,300

3,300

6,000

360

6,300

$73,440

$27,500

20,500

5,200

900

12,500

540

12,000

$123,000

$ 47,000

30,900

9,500

4,200

18,500

900

5,300

$49,280

$ 19,420

10,660

4,400

3,170

6,000

330

6,300

$74,680

$28,820

21,240

4,400

920

12,500

500

$ 48,240

31,900

8,800

4,090

18,500

830

11,600

$123,960

Refer to the information in Exercise 22-1 and prepare a responsibility accounting report for the ATV department.

Exercise 22-2 Responsibility accounting report—cost center P1

Advertising and purchasing department expenses are allocated to operating departments on the basis of dollar sales and purchase orders, respectively. Information about the allocation bases for the three operat- ing departments follows.

The following is a partially completed lower section of a departmental expense allocation spreadsheet for Cozy Bookstore. It reports the total amounts of direct and indirect expenses allocated to its five depart- ments. Complete the spreadsheet by allocating the expenses of the two service departments (advertising and purchasing) to the three operating departments.

Exercise 22-3 Service department expenses allocated to operating departments P2

Service department expenses

Total expenses allocated to

Total department expenses..........

Advertising department.............. Sales

operating departments...............

$698,000

?

$24,000

$ 0

?

$34,000

$ 0

?

$425,000

? ?

?

$90,000

? ?

?

$125,000

? ?

?

Purchasing department...............Purch. orders

Allocation of Expenses to Departments

Advertising Dept.Allocation Base

Expense Account Bal.

Purchasing Dept.

Books Dept.

Magazines Dept.

Newspapers Dept.

Check Total expenses allocated to Books dept., $452,820

Department Sales Purchase Orders

Books . . . . . . . . . . . . . . . . . . . . . . . . . . $495,000 516

Magazines . . . . . . . . . . . . . . . . . . . . . . . 198,000 360

Newspapers . . . . . . . . . . . . . . . . . . . . . 207,000 324

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000 1,200

898 Chapter 22 Performance Measurement and Responsibility Accounting

Exercise 22-4 Indirect payroll expense allocated to departments

P2

Jessica Porter works in both the Jewelry department and the Cosmetics department of a retail store. She assists customers in both departments and arranges and stocks merchandise in both departments. The store allocates her $30,000 annual wages between the two departments based on the time worked in the two departments in each two-week pay period. On average, Jessica reports the following hours and activities spent in the two departments. Allocate Jessica’s annual wages between the two departments.

Activities Hours Selling in Jewelry department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Arranging and stocking merchandise in Jewelry department . . . . . . . . . . . . . . 6

Selling in Cosmetics department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Arranging and stocking merchandise in Cosmetics department . . . . . . . . . . . . 7

Idle time spent waiting for a customer to enter one of the departments . . . . . 4Check Assign $7,500 to Cosmetics

Exercise 22-5 Departmental expense allocations

P2

Woh Che Co. has four departments: Materials, Personnel, Manufacturing, and Packaging. In a recent month, the four departments incurred three shared indirect expenses. The amounts of these indirect ex- penses and the bases used to allocate them follow.

Indirect Expense Cost Allocation Base

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 82,500 Number of employees

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Square feet occupied

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500 Value of assets in use

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $155,000

Departmental data for the company’s recent reporting period follow.

Department Employees Square Feet Asset Values

Materials . . . . . . . . . . . . . . . 27 25,000 $ 6,000

Personnel . . . . . . . . . . . . . . 9 5,000 1,200

Manufacturing . . . . . . . . . . . 63 55,000 37,800

Packaging . . . . . . . . . . . . . . 51 15,000 15,000

Total . . . . . . . . . . . . . . . . . . . 150 100,000 $60,000

1. Use this information to allocate each of the three indirect expenses across the four departments. 2. Prepare a summary table that reports the indirect expenses assigned to each of the four departments.

Check (2) Total of $29,600 assigned to Materials dept.

Department Direct Expenses Square Feet Sales

Advertising . . . . . . . . . . . . . $ 18,000 1,120 —

Administrative . . . . . . . . . . . 25,000 1,400 —

Shoes . . . . . . . . . . . . . . . . . . 103,000 7,140 $273,000

Clothing . . . . . . . . . . . . . . . . 15,000 4,340 77,000

Exercise 22-6 Departmental expense allocation spreadsheet

P2

Marathon Running Shop has two service departments (advertising and administrative) and two operating de- partments (Shoes and Clothing). The table that follows shows the direct expenses incurred and square footage occupied by all four departments, as well as total sales for the two operating departments for the year 2019.

The advertising department developed and distributed 120 advertisements during the year. Of these, 90 promoted shoes and 30 promoted clothing. Utilities expense of $64,000 is an indirect expense to all departments. Prepare a departmental expense allocation spreadsheet for Marathon Running Shop. The spreadsheet should assign (1) direct expenses to each of the four departments, (2) the $64,000 of utilities expense to the four departments on the basis of floor space occupied, (3) the advertising department’s expenses to the two operating departments on the basis of the number of ads placed that promoted a de- partment’s products, and (4) the administrative department’s expenses to the two operating departments based on the amount of sales. Provide supporting computations for the expense allocations.

Check Total expenses allocated to Shoes dept., $177,472

Chapter 22 Performance Measurement and Responsibility Accounting 899

Below are departmental income statements for a guitar manufacturer. The manufacturer is considering eliminating its Electric Guitar department since it has a net loss. The company classifies advertising, rent, and utilities expenses as indirect.

Exercise 22-7 Departmental contribution report

P3 Departmental Income Statements

For Year Ended December 31, 2019 Acoustic Electric

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $112,500 $105,500

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,675 66,750

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,825 38,750

Operating expenses

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . 8,075 6,250

Depreciation expense—Equipment . . . . . . . . . . . . . 10,150 9,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,300 13,500

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,030 1,700

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,105 5,950

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,045 2,550

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . 46,705 38,950

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,120 $ (200)

1. Prepare a departmental contribution report that shows each department’s contribution to overhead. 2. Based on contribution to overhead, should the Electric Guitar department be eliminated?

Jansen Company reports the following for its Ski department for the year 2019. All of its costs are direct, except as noted.

Exercise 22-8 Departmental income statement and contribution to overhead

P3 Sales . . . . . . . . . . . . . . . . . . . $605,000

Cost of goods sold . . . . . . . . 425,000

Salaries . . . . . . . . . . . . . . . . . 112,000 ($15,000 is indirect)

Utilities . . . . . . . . . . . . . . $14,000 ($3,000 is indirect)

Depreciation . . . . . . . . . . 42,000 ($10,000 is indirect)

Office expenses . . . . . . . 20,000 (all indirect)

Prepare a (1) departmental income statement for 2019 and (2) departmental contribution to overhead re- port for 2019. (3) Based on these two performance reports, should Jansen eliminate the Ski department?

You must prepare a return on investment analysis for the regional manager of Fast & Great Burgers. This growing chain is trying to decide which outlet of two alternatives to open. The first location (A) requires a $1,000,000 investment and is expected to yield annual net income of $160,000. The second location (B) re- quires a $600,000 investment and is expected to yield annual net income of $108,000. Compute the return on investment for each Fast & Great Burgers alternative. Using return on investment as your only criterion, which location (A or B) should the company open? (The chain currently generates an 18% return on total assets.)

Exercise 22-9 Investment center analysis

A1

Megamart, a retailer of consumer goods, provides the following information on two of its departments (each considered an investment center).

Exercise 22-10 Computing return on investment and residual income; investing decision

A1 Average Investment Center Sales Income Invested Assets

Electronics . . . . . . . . . . . . . . . . . . . . . $40,000,000 $2,880,000 $16,000,000 Sporting Goods . . . . . . . . . . . . . . . . . 20,000,000 2,040,000 12,000,000

1. Compute return on investment for each department. Using return on investment, which department is most efficient at using assets to generate returns for the company?

2. Assume a target income level of 12% of average invested assets. Compute residual income for each department. Which department generated the most residual income for the company?

3. Assume the Electronics department is presented with a new investment opportunity that will yield a 15% return on investment. Should the new investment opportunity be accepted?

900 Chapter 22 Performance Measurement and Responsibility Accounting

Exercise 22-11 Computing margin and turnover; department efficiency A2

Refer to information in Exercise 22-10. Compute profit margin and investment turnover for each depart- ment. (1) Which department generates the most net income per dollar of sales? (2) Which department is most efficient at generating sales from average invested assets?

Exercise 22-13 Residual income A1

Refer to the information in Exercise 22-12. Assume that each of the company’s divisions has a required rate of return of 7%. Compute residual income for each division.

Exercise 22-12 Return on investment

A1 A2

A food manufacturer reports the following for two of its divisions for a recent year.

$ millions Beverage Division Cheese Division

Invested assets, beginning . . . . . . . . . . . $2,662 $4,455

Invested assets, ending . . . . . . . . . . . . . . 2,593 4,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,681 3,925

Operating income . . . . . . . . . . . . . . . . . . . 349 634

For each division, compute (1) return on investment, (2) profit margin, and (3) investment turnover for the year. Round answers to two decimals.

Exercise 22-15 Return on investment

A1 A2

ZNet Co. is a web-based retail company. The company reports the following for the past year.

The company’s CEO believes that sales for next year will increase by 20% and both profit margin (%) and the level of average invested assets will be the same as for the past year. 1. Compute return on investment for the past year. 2. Compute profit margin for the past year. 3. If the CEO’s forecast is correct, what will return on investment equal for next year? 4. If the CEO’s forecast is correct, what will investment turnover equal for next year?

Sales . . . . . . . $5,000,000 Operating income . . . . . $1,000,000 Average invested assets . . . $12,500,000

Apple Inc. reports the following for three of its geographic segments for a recent year.

$ millions Americas Europe China

Operating income . . . . . . . . . . . . . . . . . . . . $30,684 $16,514 $17,032

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,600 54,938 44,764

Compute profit margin for each division. Express answers as percentages, rounded to one decimal.

Exercise 22-14 Profit margin

A2

USA Airlines uses the following performance measures. Classify each of the performance measures be- low into the most likely balanced scorecard perspective it relates to. Label your answers using C (cus- tomer), P (internal process), I (innovation and growth), or F (financial).

1. Cash flow from operations 2. Number of reports of mishandled

or lost baggage 3. Percentage of on-time departures 4. On-time flight percentage 5. Percentage of ground crew trained 6. Return on investment 7. Market value

Exercise 22-16 Performance measures— balanced scorecard

A3 8. Accidents or safety incidents per mile flown

9. Customer complaints 10. Flight attendant training sessions attended 11. Time airplane is on ground between flights 12. Airplane miles per gallon of fuel 13. Revenue per seat 14. Cost of leasing airplanes

Chapter 22 Performance Measurement and Responsibility Accounting 901

Midwest Mfg. uses a balanced scorecard as part of its performance evaluation. The company wants to include information on its sustainability efforts in its balanced scorecard. For each of the sustainability items below, indicate the most likely balanced scorecard perspective it relates to. Label your answers us- ing C (customer), P (internal process), I (innovation and learning), or F (financial).

1. CO2 emissions 2. Number of solar panels installed 3. Gallons of water used 4. Customer surveys of company’s

sustainability reputation 5. Pounds of recyclable packaging used

6. Pounds of trash diverted from landfill 7. Dollar sales of green products 8. Number of sustainability training

workshops held 9. Cubic feet of natural gas used 10. Patents for green products applied for

Exercise 22-17 Sustainability and the balanced scorecard

A3

(1) Use the information below to compute the number of days in the cash conversion cycle for each year. Round calculations to the nearest whole day. (2) Did the company manage cash more effectively in the current year?

Exercise 22-18 Cash conversion cycle

A4

Current Year Prior Year

Accounts payable, end of year . . . . . . . . . . . . . . . . $ 4,603 $ 8,548

Accounts receivable, net, end of year . . . . . . . . . . 18,685 15,726

Inventory, end of year . . . . . . . . . . . . . . . . . . . . . . . 6,904 6,055

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 205,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 130,000

The Trailer division of Baxter Bicycles makes bike trailers that attach to bicycles and can carry children or cargo. The trailers have a retail price of $200 each. Each trailer incurs $80 of variable manufacturing costs. The Trailer division has capacity for 40,000 trailers per year and incurs fixed costs of $1,000,000 per year. 1. Assume the Assembly division of Baxter Bicycles wants to buy 15,000 trailers per year from the

Trailer division. If the Trailer division can sell all of the trailers it manufactures to outside customers, what price should be used on transfers between Baxter Bicycles’s divisions? Explain.

2. Assume the Trailer division currently only sells 20,000 Trailers to outside customers, and the Assembly division wants to buy 15,000 trailers per year from the Trailer division. What is the range of acceptable prices that could be used on transfers between Baxter Bicycles’s divisions? Explain.

Exercise 22-20B Determining transfer prices

C2

Heart & Home Properties is developing a subdivision that includes 600 home lots. The 450 lots in the Canyon section are below a ridge and do not have views of the neighboring canyons and hills; the 150 lots in the Hilltop section offer unobstructed views. The expected selling price for each Canyon lot is $55,000 and for each Hilltop lot is $110,000. The developer acquired the land for $4,000,000 and spent another $3,500,000 on street and utilities improvements. Assign the joint land and improvement costs to the lots using the value basis of allocation and determine the average cost per lot.

Exercise 22-21C Assigning joint real estate costs C3

Check Total Hilltop cost, $3,000,000

Pirate Seafood Company purchases lobsters and processes them into tails and flakes. It sells the lobster tails for $21 per pound and the flakes for $14 per pound. On average, 100 pounds of lobster are processed into 52 pounds of tails and 22 pounds of flakes, with 26 pounds of waste. Assume that the company purchased 2,400 pounds of lobster for $4.50 per pound and processed the lobsters with an additional labor cost of $1,800. No materials or labor costs are assigned to the waste. If 1,096 pounds of tails and 324 pounds of flakes are sold, what is (1) the allocated cost of the sold items and (2) the allocated cost of the ending inventory? The company allocates joint costs on a value basis.

Exercise 22-22C Assigning joint product costs C3

Check (2) Inventory cost, $2,268

Use the information below to compute the number of days in the cash conversion cycle for Apple ($ millions). Round calculations to the nearest whole day.

Exercise 22-19 Cash conversion cycle

A4 Accounts payable, end of year . . . . . . . . . . . . . . . . . . $49,049 Inventory, end of year . . . . . . . . . . . . . . $ 4,855

Accounts receivable, net, end of year . . . . . . . . . . . . 17,874 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Cost of goods sold . . . . . . . . . . . . . . . . . 141,048

902 Chapter 22 Performance Measurement and Responsibility Accounting

Required

1. Prepare responsibility accounting performance reports like those in Exhibit 22.2 that list costs con- trolled by the following.

a. Manager of the Camper department. c. Manager of the Indiana plant. b. Manager of the Trailer department. In each report, include the budgeted and actual costs and show the amount that each actual cost is over

or under the budgeted amount.

Analysis Component

2. Did the plant manager or the operating department managers better manage costs?

Check (1a) $500 total over budget (1c) Indiana plant controllable costs, $1,900 total under budget

L’Oréal reports the following for a recent year for the major divisions in its cosmetics branch.

Total Assets Total Assets € millions Sales Income End of Year Beginning of Year

Professional products . . . . . . . . . . . . € 2,717 € 552 € 2,624 € 2,516 Consumer products . . . . . . . . . . . . . 9,530 1,765 5,994 5,496 Luxury products . . . . . . . . . . . . . . . . 4,507 791 3,651 4,059 Active cosmetics . . . . . . . . . . . . . . . . 1,386 278 830 817 Total . . . . . . . . . . . . . . . . . . . . . . . . . . €18,140 €3,386 €13,099 €12,888

1. Compute profit margin for each division. State your answers as percents, rounded to two decimal places. Which L’Oréal division has the highest profit margin?

2. Compute investment turnover for each division. Round your answers to two decimal places. Which L’Oréal division has the best investment turnover?

Exercise 22-23 Profit margin and investment turnover

A2

PROBLEM SET A

Problem 22-1A Responsibility accounting performance reports; controllable and budgeted costs

P1

Billie Whitehorse, the plant manager of Travel Free’s Indiana plant, is responsible for all of that plant’s costs other than her own salary. The plant has two operating departments and one service department. The Camper and Trailer operating departments manufacture different products and have their own managers. The office department, which Whitehorse also manages, provides services equally to the two operating departments. A budget is prepared for each operating department and the office department. The company’s responsibility accounting system must assemble information to present budgeted and actual costs in performance reports for each operating department manager and the plant manager. Each performance report includes only those costs that a particular operating department manager can control: raw materials, wages, supplies used, and equipment depreciation. The plant manager is responsible for the department managers’ salaries, utilities, building rent, office salaries other than her own, and other office costs plus all costs controlled by the two operating department managers. The annual departmental bud- gets and actual costs for the two operating departments follow.

The office department’s annual budget and its actual costs follow.

Budget Actual

Campers Trailers Combined Campers Trailers Combined

Raw materials . . . . . . . . . . . . . . . . . $195,000 $275,000 $   470,000 $194,200 $273,200 $   467,400 Employee wages . . . . . . . . . . . . . . 104,000 205,000 309,000 106,600 206,400 313,000 Dept . manager salary . . . . . . . . . . . 43,000 52,000 95,000 44,000 53,500 97,500 Supplies used . . . . . . . . . . . . . . . . . 33,000 90,000 123,000 31,700 91,600 123,300 Depreciation—Equip . . . . . . . . . . . . 60,000 125,000 185,000 60,000 125,000 185,000 Utilities . . . . . . . . . . . . . . . . . . . . . . 3,600 5,400 9,000 3,300 5,000 8,300 Building rent . . . . . . . . . . . . . . . . . . 5,700 9,300 15,000 5,300 8,700 14,000 Office department costs . . . . . . . . . 68,750 68,750 137,500 67,550 67,550 135,100 Totals . . . . . . . . . . . . . . . . . . . . . . . . $513,050 $830,450 $1,343,500 $512,650 $830,950 $1,343,600

Budget Actual

Plant manager salary . . . . . . . . . . . $ 80,000 $ 82,000 Other office salaries . . . . . . . . . . . . 32,500 30,100 Other office costs . . . . . . . . . . . . . . 25,000 23,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . $137,500 $135,100

Chapter 22 Performance Measurement and Responsibility Accounting 903

National Bank has several departments that occupy both floors of a two-story building. The departmental accounting system has a single account, Building Occupancy Cost, in its ledger. The types and amounts of occupancy costs recorded in this account for the current period follow.

Depreciation—Building . . . . . . . . . . . . . . . . . $18,000

Interest—Building mortgage . . . . . . . . . . . . 27,000

Taxes—Building and land . . . . . . . . . . . . . . . 9,000

Gas (heating) expense . . . . . . . . . . . . . . . . . 3,000

Lighting expense . . . . . . . . . . . . . . . . . . . . . 3,000

Maintenance expense . . . . . . . . . . . . . . . . . 6,000

Total occupancy cost . . . . . . . . . . . . . . . . . . $66,000

Problem 22-2A Allocation of building occupancy costs to departments

P2

The building has 4,000 square feet on each floor. In prior periods, the accounting manager merely divided the $66,000 occupancy cost by 8,000 square feet to find an average cost of $8.25 per square foot and then charged each department a building occupancy cost equal to this rate times the number of square feet that it occupied. Diane Linder manages a first-floor department that occupies 1,000 square feet, and Juan Chiro man- ages a second-floor department that occupies 1,800 square feet of floor space. In discussing the depart- mental reports, the second-floor manager questions whether using the same rate per square foot for all departments makes sense because the first-floor space is more valuable. This manager also references a recent real estate study of average local rental costs for similar space that shows first-floor space worth $30 per square foot and second-floor space worth $20 per square foot (excluding costs for heating, light- ing, and maintenance).

Required

1. Allocate occupancy costs to the Linder and Chiro departments using the current allocation method. 2. Allocate the depreciation, interest, and taxes occupancy costs to the Linder and Chiro departments in

proportion to the relative market values of the floor space. Allocate the heating, lighting, and mainte- nance costs to the Linder and Chiro departments in proportion to the square feet occupied (ignoring floor space market values).

3. Which allocation method (1 or 2) produces the lowest allocated occupancy cost for a manager of a second-floor department?

Check (1) Total allocated to Linder and Chiro, $23,100 (2) Total occupancy cost to Linder, $9,600

Problem 22-3A Departmental income statements; forecasts

P3

Williams Company began operations in January 2019 with two operating (selling) departments and one service (office) department. Its departmental income statements follow.

Departmental Income Statements

For Year Ended December 31, 2019 Clock Mirror Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000 $55,000 $185,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,700 34,100 97,800

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,300 20,900 87,200

Direct expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 7,000 27,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200 500 1,700

Store supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 400 1,300

Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . 1,500 300 1,800

Total direct expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 23,600 8,200 31,800

Allocated expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,020 3,780 10,800

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600 1,400 4,000

Share of office department expenses . . . . . . . . . . . . . 10,500 4,500 15,000

Total allocated expenses . . . . . . . . . . . . . . . . . . . . . . . 20,120 9,680 29,800

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,720 17,880 61,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,580 $ 3,020 $ 25,600

904 Chapter 22 Performance Measurement and Responsibility Accounting

Williams plans to open a third department in January 2020 that will sell paintings. Management predicts that the new department will generate $50,000 in sales with a 55% gross profit margin and will require the following direct expenses: sales salaries, $8,000; advertising, $800; store supplies, $500; and equipment depreciation, $200. It will fit the new department into the current rented space by taking some square foot- age from the other two departments. When opened, the new Painting department will fill one-fifth of the space presently used by the Clock department and one-fourth used by the Mirror department. Management does not predict any increase in utilities costs, which are allocated to the departments in proportion to occupied space (or rent expense). The company allocates office department expenses to the operating departments in proportion to their sales. It expects the Painting department to increase total office department expenses by $7,000. Since the Painting department will bring new customers into the store, management expects sales in both the Clock and Mirror departments to increase by 8%. No changes for those departments’ gross profit percents or their direct expenses are expected except for store supplies used, which will increase in proportion to sales.

Required

Prepare departmental income statements that show the company’s predicted results of operations for calendar-year 2020 for the three operating (selling) departments and their combined totals. (Round per- cents to the nearest one-tenth and dollar amounts to the nearest whole dollar.)

Check 2020 forecasted combined net income (sales), $43,472 ($249,800)

Vortex Company operates a retail store with two departments. Information about those departments follows.Problem 22-4A Departmental contribution to income

P3 Department A Department B

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $450,000

Cost of goods sold . . . . . . . . . . . . . . . 497,000 291,000

Direct expenses: Salaries . . . . . . . . . . 125,000 88,000

Insurance . . . . . . . . 20,000 10,000

Utilities . . . . . . . . . . 24,000 14,000

Depreciation . . . . . . 21,000 12,000

Maintenance . . . . . . 7,000 5,000

The company also incurred the following indirect costs.

Indirect costs are allocated as follows: salaries on the basis of sales; insurance and depreciation on the basis of square footage; and office expenses on the basis of number of employees. Additional information about the departments follows.

Salaries . . . . . . . . . . . . . $36,000 Depreciation . . . . . . . . $15,000

Insurance . . . . . . . . . . . 6,000 Office expenses . . . . . 50,000

Department Square Footage Number of Employees

A . . . . . . . . . . . 28,000 75 B . . . . . . . . . . . 12,000 50

Required

1. For each department, determine the departmental contribution to overhead and the departmental net income.

2. Should Department B be eliminated?

Check (1) Dept. A net income, $38,260

Georgia Orchards produced a good crop of peaches this year. After preparing the following income state- ment, the company is concerned about the net loss on its No. 3 peaches.

Problem 22-5AC Allocation of joint costs

C3

Chapter 22 Performance Measurement and Responsibility Accounting 905

Income Statement

For Year Ended December 31, 2019 No. 1 No. 2 No. 3 Combined

Sales (by grade) No . 1: 300,000 Ibs . @ $1 .50/lb . . . . . . . . . . . . . . $450,000 No . 2: 300,000 Ibs . @ $1 .00/lb . . . . . . . . . . . . . . $300,000 No . 3: 750,000 Ibs . @ $0 .25/lb . . . . . . . . . . . . . . $ 187,500 Total sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $937,500 Costs Tree pruning and care @ $0 .30/Ib . . . . . . . . . . . . 90,000 90,000 225,000 405,000 Picking, sorting, and grading @ $0 .15/Ib . . . . . . 45,000 45,000 112,500 202,500 Delivery costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 15,000 37,500 67,500 Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 150,000 375,000 675,000 Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $150,000 $(187,500) $262,500

In preparing this statement, the company allocated joint costs among the grades on a physical basis as an equal amount per pound. The company’s delivery cost records show that $30,000 of the $67,500 relates to crating the No. 1 and No. 2 peaches and hauling them to the buyer. The remaining $37,500 of delivery costs is for crating the No. 3 peaches and hauling them to the cannery.

Required

1. Prepare reports showing cost allocations on a sales value basis to the three grades of peaches. Separate the delivery costs into the amounts directly identifiable with each grade. Then allocate any shared delivery costs on the basis of the relative sales value of each grade. (Round percents to the nearest one- tenth and dollar amounts to the nearest whole dollar.)

2. Using answers to part 1, prepare an income statement using the joint costs allocated on a sales value basis.

Analysis Component

3. Do delivery costs fit the definition of a joint cost?

Check (1) $129,600 tree pruning and care costs allocated to No. 2

(2) Net income from No. 1 & No. 2 peaches, $140,400 & $93,600

PROBLEM SET B

Problem 22-1B Responsibility accounting performance reports; controllable and budgeted costs

P1

Britney Brown, the plant manager of LMN Co.’s Chicago plant, is responsible for all of that plant’s costs other than her own salary. The plant has two operating departments and one service department. The Refrigerator and Dishwasher operating departments manufacture different products and have their own managers. The office department, which Brown also manages, provides services equally to the two operat- ing departments. A monthly budget is prepared for each operating department and the office department. The company’s responsibility accounting system must assemble information to present budgeted and actual costs in performance reports for each operating department manager and the plant manager. Each performance report includes only those costs that a particular operating department manager can control: raw materials, wages, supplies used, and equipment depreciation. The plant manager is responsible for the department managers’ salaries, utilities, building rent, office salaries other than her own, and other office costs plus all costs controlled by the two operating department managers. The April departmental budgets and actual costs for the two operating departments follow.

Budget Actual

Refrigerators Dishwashers Combined Refrigerators Dishwashers Combined

Raw materials . . . . . . . . . . . $400,000 $200,000 $ 600,000 $385,000 $202,000 $ 587,000

Employee wages . . . . . . . . 170,000 80,000 250,000 174,700 81,500 256,200

Dept . manager salary . . . . . 55,000 49,000 104,000 55,000 46,500 101,500

Supplies used . . . . . . . . . . . 15,000 9,000 24,000 14,000 9,700 23,700

Depreciation—Equip . . . . . . 53,000 37,000 90,000 53,000 37,000 90,000

Utilities . . . . . . . . . . . . . . . . 30,000 18,000 48,000 34,500 20,700 55,200

Building rent . . . . . . . . . . . . 63,000 17,000 80,000 65,800 16,500 82,300

Office department costs . . . 70,500 70,500 141,000 75,000 75,000 150,000

Totals . . . . . . . . . . . . . . . . . . $856,500 $480,500 $1,337,000 $857,000 $488,900 $1,345,900

906 Chapter 22 Performance Measurement and Responsibility Accounting

The office department’s budget and its actual costs for April follow.

Budget Actual

Plant manager salary . . . . . . . . . . . $ 80,000 $ 85,000

Other office salaries . . . . . . . . . . . . 40,000 35,200

Other office costs . . . . . . . . . . . . . . 21,000 29,800

Totals . . . . . . . . . . . . . . . . . . . . . . . . $141,000 $150,000

Required

1. Prepare responsibility accounting performance reports like those in Exhibit 22.2 that list costs con- trolled by the following.

a. Manager of the Refrigerator department. b. Manager of the Dishwasher department. c. Manager of the Chicago plant. In each report, include the budgeted and actual costs for the month and show the amount by which

each actual cost is over or under the budgeted amount.

Analysis Component

2. Did the plant manager or the operating department managers better manage costs?

Check (1a) $11,300 total under budget

(1c) Chicago plant controllable costs, $3,900 total over budget

Harmon’s has several departments that occupy all floors of a two-story building that includes a basement floor. Harmon rented this building under a long-term lease negotiated when rental rates were low. The departmental accounting system has a single account, Building Occupancy Cost, in its ledger. The types and amounts of occupancy costs recorded in this account for the current period follow.

Problem 22-2B Allocation of building occupancy costs to departments

P2

Building rent . . . . . . . . . . . . . . . . . . . $400,000

Lighting expense . . . . . . . . . . . . . . . 25,000

Cleaning expense . . . . . . . . . . . . . . . 40,000

Total occupancy cost . . . . . . . . . . . . $465,000

The building has 7,500 square feet on each of the upper two floors but only 5,000 square feet in the base- ment. In prior periods, the accounting manager merely divided the $465,000 occupancy cost by 20,000 square feet to find an average cost of $23.25 per square foot and then charged each department a building occupancy cost equal to this rate times the number of square feet that it occupies. Jordan Style manages a department that occupies 2,000 square feet of basement floor space. In dis- cussing the departmental reports with other managers, she questions whether using the same rate per square foot for all departments makes sense because different floor space has different values. Style checked a recent real estate report of average local rental costs for similar space that shows first-floor space worth $40 per square foot, second-floor space worth $20 per square foot, and basement space worth $10 per square foot (excluding costs for lighting and cleaning).

Required

1. Allocate occupancy costs to Style’s department using the current allocation method. 2. Allocate the building rent cost to Style’s department in proportion to the relative market value of the

floor space. Allocate to Style’s department the lighting and cleaning costs in proportion to the square feet occupied (ignoring floor space market values). Then, compute the total occupancy cost allocated to Style’s department.

3. Which allocation method (1 or 2) produces the lowest allocated occupancy cost for a manager of a basement department?

Check (1) Total costs allocated to Style’s dept., $46,500

(2) Total occupancy cost to Style, $22,500

Chapter 22 Performance Measurement and Responsibility Accounting 907

Bonanza Entertainment began operations in January 2019 with two operating (selling) departments and one service (office) department. Its departmental income statements follow.

Departmental Income Statements

For Year Ended December 31, 2019 Movies Video Games Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 $200,000 $800,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 154,000 574,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 46,000 226,000

Direct expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000 15,000 52,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 6,000 18,500

Store supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 1,000 5,000

Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . 4,500 3,000 7,500

Total direct expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 25,000 83,000

Allocated expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,000 9,000 50,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,380 1,620 9,000

Share of office department expenses . . . . . . . . . . . . . 56,250 18,750 75,000

Total allocated expenses . . . . . . . . . . . . . . . . . . . . . . . 104,630 29,370 134,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162,630 54,370 217,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,370 $ (8,370) $ 9,000

Problem 22-3B Departmental income statements; forecasts

P3

The company plans to open a third department in January 2020 that will sell compact discs. Management predicts that the new department will generate $300,000 in sales with a 35% gross profit margin and will require the following direct expenses: sales salaries, $18,000; advertising, $10,000; store supplies, $2,000; and equipment depreciation, $1,200. The company will fit the new department into the current rented space by taking some square footage from the other two departments. When opened, the new Compact Disc department will fill one-fourth of the space presently used by the Movie department and one-third of the space used by the Video Game department. Management does not predict any increase in utilities costs, which are allocated to the departments in proportion to occupied space (or rent expense). The company allocates office department expenses to the operating departments in proportion to their sales. It expects the Compact Disc department to increase total office department expenses by $10,000. Since the Compact Disc department will bring new custom- ers into the store, management expects sales in both the Movie and Video Game departments to increase by 8%. No changes for those departments’ gross profit percents or for their direct expenses are expected except for store supplies used, which will increase in proportion to sales.

Required

Prepare departmental income statements that show the company’s predicted results of operations for cal- endar-year 2020 for the three operating (selling) departments and their combined totals. (Round percents to the nearest one-tenth and dollar amounts to the nearest whole dollar.)

Check 2020 forecasted Movies net income (sales), $52,450 ($648,000)

Guitar Department Piano Department

Sales . . . . . . . . . . . . . . . . . . . . . . . $370,500 $279,500

Cost of goods sold . . . . . . . . . . . . 320,000 175,000

Direct expenses: Salaries . . . . . . . 35,000 25,000

Maintenance . . . 12,000 10,000

Utilities . . . . . . . 5,000 4,500

Insurance . . . . . 4,200 3,700

Sadar Company operates a store with two departments: Guitar and Piano. Information about those depart- ments follows.

Problem 22-4B Departmental contribution to income

P3

908 Chapter 22 Performance Measurement and Responsibility Accounting

The company also incurred the following indirect costs.

Indirect costs are allocated as follows: advertising on the basis of sales; salaries on the basis of number of employees; and office expenses on the basis of square footage. Additional information about the depart- ments follows.

Department Square Footage Number of Employees

Guitar . . . . . . . . . . . 5,000 3

Piano . . . . . . . . . . . 3,000 2

Advertising . . . . . . . . . . . . . . $15,000 Salaries . . . . . . . . . . $27,000 Office expenses . . . . . . . . . $3,200

Check (1) Piano dept. net income, $42,850

Required

1. For each department, determine the departmental contribution to overhead and the departmental net income.

2. Should the Guitar department be eliminated? Explain.

Rita and Rick Redding own and operate a tomato grove. After preparing the following income statement, Rita and Rick are concerned about the loss on the No. 3 tomatoes.

Problem 22-5BC Allocation of joint costs

C3

Income Statement

For Year Ended December 31, 2019 No. 1 No. 2 No. 3 Combined

Sales (by grade)

No . 1: 500,000 Ibs . @ $1 .80/lb . . . . . . . . . . . . . . . . . . . . . . . . . $900,000

No . 2: 400,000 Ibs . @ $1 .25/lb . . . . . . . . . . . . . . . . . . . . . . . . . $500,000

No . 3: 100,000 Ibs . @ $0 .40/lb . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Total sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,440,000

Costs

Land preparation, seeding, and cultivating @ $0 .70/Ib . . . . . . 350,000 280,000 70,000 700,000

Harvesting, sorting, and grading @ $0 .04/Ib . . . . . . . . . . . . . . 20,000 16,000 4,000 40,000

Delivery costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 7,000 3,000 20,000

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 303,000 77,000 760,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $520,000 $197,000 $(37,000) $ 680,000

In preparing this statement, Rita and Rick allocated joint costs among the grades on a physical basis as an equal amount per pound. Also, their delivery cost records show that $17,000 of the $20,000 relates to crat- ing the No. 1 and No. 2 tomatoes and hauling them to the buyer. The remaining $3,000 of delivery costs is for crating the No. 3 tomatoes and hauling them to the cannery.

Required

1. Prepare reports showing cost allocations on a sales value basis to the three grades of tomatoes. Separate the delivery costs into the amounts directly identifiable with each grade. Then allocate any shared delivery costs on the basis of the relative sales value of each grade. (Round percents to the nearest one-tenth and dollar amounts to the nearest whole dollar.)

2. Using answers to part 1, prepare an income statement using the joint costs allocated on a sales value basis.

Analysis Component

3. Do delivery costs fit the definition of a joint cost?

Check (1) $1,120 harvesting, sorting, and grading costs allocated to No. 3

(2) Net income from No. 1 & No. 2 tomatoes, $426,569 & $237,151

Chapter 22 Performance Measurement and Responsibility Accounting 909

SERIAL PROBLEM Business Solutions

A4

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 22 Santana Rey’s two departments, Computer Consulting Services and Computer Workstation Furniture Manufacturing, have each been profitable for Business Solutions. Santana has heard of the cash conversion cycle and wants to use it as another performance measure for the workstation manufacturing department. Data below are for the most recent two quarters.

©Alexander Image/Shutterstock

COMPANY ANALYSIS A1

Accounting Analysis

AA 22-1 Review Apple’s financial statements in Appendix A and identify its (a) total assets as of September 30, 2017, and September 24, 2016, and (b) operating income for the year ended September 30, 2017.

Required

1. Assume Apple’s target income is 12% of average assets. Compute Apple’s residual income for fiscal 2017 using operating income.

2. Compute Apple’s return on investment (in percent) for fiscal 2017 using operating income. Round to two decimals.

APPLE

Required

1. Compute profit margin for each company. 2. Compute investment turnover for each company. 3. Refer to answers for parts 1 and 2. Which company performed better?

AA 22-2 Apple and Google compete in several product categories. Sales, income, and asset information are provided for fiscal year 2017 for each company below.

COMPARATIVE ANALYSIS A2

$ millions Apple Google

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $110,855

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351 12,662

Invested assets, beginning of year . . . . . . . . . . . 321,686 167,497

Invested assets, end of year . . . . . . . . . . . . . . . . 375,319 197,295

APPLE GOOGLE

AA 22-3 Review Samsung’s financial statements in Appendix A and identify its (a) total assets as of December 31, 2017, and December 31, 2016, and (b) operating profit for the year ended December 31, 2017.

Required

1. Assume Samsung’s target income is 12% of average assets. Compute Samsung’s residual income for 2017 using operating profit (in millions of Korean won).

GLOBAL ANALYSIS A1

Samsung

Required

1. Compute the cash conversion cycle for the first quarter. 2. Compute the cash conversion cycle for the second quarter. 3. Did the cash conversion cycle increase or decrease from the first to the second quarter?

1st Quarter 2nd Quarter

Days’ sales in accounts receivable . . . . . . . . . . . 19 days 21 days

Days’ sales in inventory . . . . . . . . . . . . . . . . . . . . 25 days 24 days

Days’ payable outstanding . . . . . . . . . . . . . . . . . . 31 days 28 days

[continued on next page]

APPLE

910 Chapter 22 Performance Measurement and Responsibility Accounting

2. Compute Samsung’s return on investment (in percent) for 2017 using operating profit. Round to two decimals.

3. Compute Apple’s return on investment (in percent) for fiscal 2017 using operating income (from Appendix A). Round to two decimals.

4. Using the answers for parts 2 and 3, which company (Samsung or Apple) had the higher return on investment?

ETHICS CHALLENGE P3

BTN 22-1 Super Security Co. offers a range of security services for athletes and entertainers. Each type of service is considered within a separate department. Marc Pincus, the overall manager, is compensated partly on the basis of departmental performance by staying within the quarterly cost budget. He often revises operations to make sure departments stay within budget. Says Pincus, “I will not go over budget even if it means slightly compromising the level and quality of service. These are minor compromises that don’t significantly affect my clients, at least in the short term.”

Required

1. Is there an ethical concern in this situation? If so, which parties are affected? Explain. 2. Can Pincus take action to eliminate or reduce any ethical concerns? Explain. 3. What is Super Security’s ethical responsibility in offering professional services?

Beyond the Numbers

BTN 22-2 Improvement Station is a national home improvement chain with more than 100 stores throughout the country. The manager of each store receives a salary plus a bonus equal to a percent of the store’s net income for the reporting period. The following net income calculation is on the Denver store manager’s performance report for the recent monthly period.

COMMUNICATING IN PRACTICE P2

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500,000

Cost of goods sold . . . . . . . . . . . . . . . . 800,000

Wages expense . . . . . . . . . . . . . . . . . . . 500,000

Utilities expense . . . . . . . . . . . . . . . . . . 200,000

Home office expense . . . . . . . . . . . . . . 75,000

Net income . . . . . . . . . . . . . . . . . . . . . . $ 925,000

Manager’s bonus (0 .5%) . . . . . . . . . . . . $ 4,625

In previous periods, the bonus had also been 0.5%, but the performance report had not included any charges for the home office expense, which is now assigned to each store as a percent of its sales.

Required

Assume that you are the national office manager. Write a half-page memorandum to your store managers explaining why home office expense is in the new performance report.

BTN 22-3 This chapter described and used spreadsheets to prepare various managerial reports (see Exhibit 22.10). You can download from websites various tutorials showing how spreadsheets are used in managerial accounting and other business applications.

Required

1. Link to the website Lacher.com. Select “Table of Contents” under “Microsoft Excel Examples.” Identify and list three tutorials for review.

2. Describe in a half-page memorandum to your instructor how the applications described in each tuto- rial are helpful in business and managerial decision making.

TAKING IT TO THE NET P2

Chapter 22 Performance Measurement and Responsibility Accounting 911

BTN 22-4 Apple and Samsung compete across the world in several markets.

Required

1. Design a three-tier responsibility accounting organizational chart assuming that you have available internal information for both companies. Use Exhibit 22.1 as an example. The goal of this assignment is to design a reporting framework for the companies; numbers are not required. Limit your reporting framework to sales activity only.

2. Explain why it is important to have similar performance reports when comparing performance within a company (and across different companies). Be specific in your response.

TEAMWORK IN ACTION P1

BTN 22-5 Randy and Galen Welsch’s company Jibu provides African franchisees with training and resources to sell drinking water.

Required

1. How can Jibu use departmental (franchisee) income statements to assist in understanding and control- ling operations?

2. Are departmental income statements always the best measure of a department’s performance? Explain.

ENTREPRENEURIAL DECISION P3

BTN 22-6 Visit a local movie theater and check out both its concession area and its viewing areas. The manager of a theater must confront questions such as

∙ How much return do we earn on concessions? ∙ What types of movies generate the greatest sales? ∙ What types of movies generate the greatest net income?

Required

Assume that you are the new accounting manager for a 16-screen movie theater. You are to set up a responsibility accounting reporting framework for the theater. 1. Recommend how to segment the different departments of a movie theater for responsibility reporting. 2. Propose an expense allocation system for heat, rent, insurance, and maintenance costs of the theater.

HITTING THE ROAD C1 P1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

APPLE Samsung

Learning Objectives

CONCEPTUAL C1 Describe the importance of relevant

costs for short-term decisions.

ANALYTICAL A1 Determine service selling price using

time and materials pricing.

P4 Evaluate segment elimination decisions.

P5 Evaluate keep or replace decisions.

P6 Determine product selling price using cost data.

P7 Evaluate special offer decisions.

PROCEDURAL P1 Evaluate make or buy decisions.

P2 Evaluate sell or process further decisions.

P3 Determine sales mix with constrained resources.

Chapter Preview

23 Relevant Costing for Managerial Decisions

DECISIONS AND INFORMATION

Managerial decisions

C1 Relevant costs and benefits

NTK 23-1

PRODUCTION DECISIONS

P1 Make or buy P2 Sell or process P3 Sales mix

NTK 23-2, 23-3, 23-4

CAPACITY DECISIONS

P4 Segment elimination P5 Keep or replace

NTK 23-5

PRICING DECISIONS

P6 Normal pricing P7 Special offer

A1 Time and materials

NTK 23-6

913

“We’re green chemists”—Sean Hunt

Green Is Good

PHILADELPHIA—Hydrogen peroxide is used in many common household products, including toothpastes and cleaners, yet the traditional process to produce it is energy-intensive and hazardous. Completing their advanced studies, Gaurab Chakrabarti and Sean Hunt discovered a simple process to con- vert plant starches into hydrogen peroxide. “Not only does our process reduce manufacturing waste,” says Gaurab, “it creates a pure product that is clean and safe.” Sean calls their company, Solugen (Solugentech.com), a “green chemistry” company.

Avoiding the gases, chemicals, and cancer-causing agents used by traditional manufacturers, Solugen uses few inputs: air, water, proprietary enzymes, and plant material. “Not only is our process emissions-free, it actually reduces CO2 levels,” says Sean.

The duo’s main product, Bioperoxide, has many possible ap- plications. As Solugen’s production process is about 10 times cheaper than the traditional process, consumer product manu- facturers might buy hydrogen peroxide from Solugen rather than making their own.

While Gaurab and Sean started by selling Bioperoxide as a cleaner for hot tubs and pools, their company now also pro- cesses Bioperoxide further into its Ode to Clean branded clean- ing products. These make or buy, sell or process further, and

other short-term decisions depend on incremental costs and revenues of the alternative courses of action, as this chapter shows.

Sources: Solugen website, January 2019; Ag Funder News, October 24, 2017; PR Newswire, October 24, 2017; Forbes.com, October 24, 2017

©Solugen

This chapter focuses on the use of accounting information to make several important manage- rial decisions. Most of these involve short-term decisions. This differs from methods used for longer-term managerial decisions described in the next chapter and in several other chapters of this text.

Decision Making Managerial decision making involves five steps: (1) Define the decision task, (2) identify alter- native courses of action, (3) collect relevant information and evaluate each alternative, (4) select the preferred course of action, and (5) analyze and assess decisions made. These five steps are illustrated in Exhibit 23.1.

DECISIONS AND INFORMATION

EXHIBIT 23.1 Managerial Decision Making

Define task and goal

Identify alternative actions

Select course of action

Collect relevant information

Analyze and assess decision

$0 2011 2010 2009 2008 2007

Ratio

15%

0.0%

30%

45%

Task and Goal Millions

$200 $300 $400 $500 $600 $700

$900 $800

Alternative 1

400 600

Alternative 2

Both managerial and financial accounting information play important roles in most management decisions. The accounting system provides primarily financial information such as performance reports and budget analyses for decision making. Nonfinancial infor- mation is also important and includes environmental effects, political sensitivities, and social responsibility.

914 Chapter 23 Relevant Costing for Managerial Decisions

Relevant Costs and Benefits In making short-term decisions, managers focus on the relevant benefits and the relevant costs. Incremental costs, or differential costs, are the relevant costs in making decisions. These are

the additional costs incurred if a company pursues a certain course of action. Incremental revenues, the additional revenue generated by selecting a certain course of

action over another, are the key rewards from that action.

Three types of costs are important in our discussion of relevant costs: sunk costs, out-of- pocket costs, and opportunity costs.

Sunk cost arises from a past decision and cannot be avoided or changed; it is irrele- vant to future decisions. An example is the cost of computer equipment previously purchased by a company. This cost is not relevant to the decision of whether to replace the computer equipment. Likewise, depreciation of the original cost of plant (and in- tangible) assets is a sunk cost. Most of a company’s allocated costs, including fixed overhead items such as depreciation and administrative expenses, are sunk costs.

Out-of-pocket cost requires a future outlay of cash and is relevant for current and future decisions. These costs are usually the direct result of management’s decisions. For instance, future purchases of computer equipment involve out-of-pocket costs. The cost of future computer purchases is relevant to the decision of whether to re- place the computer equipment.

Opportunity cost is the potential benefit lost by taking a specific action when two or more al- ternative choices are available. An example is a student giving up wages from a job to attend summer school. The forgone wages should be considered as part of the total cost of attending summer school. Companies continually choose between alternative courses of action. For in- stance, a company making standardized products might be approached by a customer to supply a special (nonstandard) product. A decision to accept or reject the special order must consider not only the profit to be made from the special order but also the profit given up by devoting time and resources to this order instead of pursuing an alternative project. The profit given up is an opportunity cost. Consideration of opportunity costs is important. Although opportunity costs are not entered in accounting records, they are relevant to many managerial decisions.

We show how to apply relevant costs and benefits to analyze common managerial decisions. We also discuss some qualitative factors, not easily expressed in terms of costs and benefits, that managers must consider.

C1 Describe the importance of relevant costs for short-term decisions.

"Sunk costs are not relevant to my decision."

"I must consider out-of-pocket and opportunity costs."

Match each of the terms below with its definition. 1. Sunk cost a. Additional costs incurred from a course of action 2. Out-of-pocket cost b. Additional revenue from a course of action 3. Opportunity cost c. A future outlay of cash 4. Incremental cost d. Potential benefit lost from taking a course of action 5. Incremental revenue e. A cost that arises from a past decision and cannot be changed

Solution

1. e 2. c 3. d 4. a 5. b

C1 Relevant Costs

NEED-TO-KNOW 23-1

Do More: QS 23-4

Managers experience many different scenarios that require analyzing alternative actions and making decisions. We describe several different decision scenarios next. We set these tasks in the context of FasTrac, an exercise supplies and equipment manufacturer. For each decision, we

PRODUCTION DECISIONS

Chapter 23 Relevant Costing for Managerial Decisions 915

P1 Evaluate make or buy decisions.

$ per unit Make Buy

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0 .45 —

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .50 —

Overhead costs (using incremental rate) . . . . . . . . . . . . . . 0.20 — Purchase price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — $1 .20

Total cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1 .15 $1 .20

EXHIBIT 23.2 Make or Buy Analysis Using Relevant Costs

Exhibit 23.2 shows that the relevant cost to make Part 417 is $1.15. It is cheaper to make the part than to buy it. If incremental overhead costs are less than $0.25 per unit, the total cost to make the part will be less than the purchase price of $1.20 per unit.

Decision rule: If the incremental cost to make is less than the cost to buy, make the product.

Additional Factors While it is cheaper to make Part 417, FasTrac must also consider several nonfinancial factors. These factors might include product quality, timeliness of delivery (especially in a just-in-time setting), reactions of customers and suppliers, and other intangibles like employee morale and workload. It must also consider whether making the part requires in- cremental fixed costs to expand plant capacity. When these additional factors are considered, small unit cost differences might not matter.

Make or Buy IT Companies apply make or buy decisions to their services. Many now outsource their information technology activities. Information tech- nology companies provide infrastructure and services to enable businesses to focus on their key activities. It is argued that outsourcing saves money and streamlines operations, and without the headaches. ■

Decision Insight

assume FasTrac is operating at 80% of its full capacity. We treat each of these decision tasks as separate from each other.

Make or Buy The decision to make or buy a component is common. Apple buys the component parts for its electronic products, but it could consider making these components in its own manufacturing facilities. The process of buying goods or services from an external supplier is called outsourc- ing. This decision depends on incremental costs. We use FasTrac to illustrate.

FasTrac currently buys Part 417, a component of the main product it sells, for $1.20 per unit. With excess productive capacity, management is considering making Part 417 instead of buying it. Making Part 417 would incur variable costs of $0.45 for direct materials and $0.50 for direct labor. FasTrac’s normal predetermined overhead rate is 100% of direct labor cost. If manage- ment incorrectly relies on this historical overhead rate, it would mistakenly believe that the cost to make the component part is $1.45 per unit ($0.45 + $0.50 + $0.50) and conclude the com- pany is better off buying the part at $1.20 per unit. This analysis is flawed, however, because it uses the historical predetermined overhead rate.

Only incremental overhead costs are relevant to this decision. Incremental overhead costs of making the part might include, for example, additional power for operating machines, extra sup- plies, added cleanup costs, materials handling, and quality control. Assume that management computes an incremental overhead rate of $0.20 per unit if it makes the part. We can then pre- pare a per unit analysis, using relevant costs, as shown in Exhibit 23.2.

916 Chapter 23 Relevant Costing for Managerial Decisions

A company currently pays $5 per unit to buy a key part for a product it manufactures. It can make the part for $1.50 per unit for direct materials and $2.50 per unit for direct labor. The company normally allocates overhead costs at the rate of 50% of direct labor. Incremental overhead costs to make this part are $0.75 per unit. Should the company make or buy the part?

Solution

P1 Make or Buy

NEED-TO-KNOW 23-2

Do More: QS 23-6, QS 23-7, E 23-1, E 23-2

$ per unit Make Buy

Direct materials . . . . . . . . . . . . . . . . . $1 .50 —

Direct labor . . . . . . . . . . . . . . . . . . . . 2 .50 —

Overhead (incremental) . . . . . . . . . . 0 .75 —

Cost to buy the part . . . . . . . . . . . . . — $5 .00

Total cost per unit . . . . . . . . . . . . . . . $4 .75 $5 .00

The company should make the part because the cost to make it is less than the cost to buy it.

P2 Evaluate sell or process further decisions.

Sell or Process Further Some companies must decide whether to sell partially completed products as is or to process them further for sale as other products. For example, a peanut grower could sell its peanut har- vest as is, or it could process peanuts into other products such as peanut butter, trail mix, and candy. The decision depends on the incremental costs and benefits of further processing.

To illustrate, suppose FasTrac has 40,000 units of partially finished Product Q. It has already spent $30,000 to manufacture these 40,000 units. FasTrac can sell the 40,000 units to another manufacturer as raw material for $50,000. Alternatively, it can process them further and pro- duce finished Products X, Y, and Z. Processing the units further will cost an additional $80,000 and will yield total revenues of $150,000. FasTrac must decide whether the added revenues from selling finished Products X, Y, and Z exceed the costs of finishing them.

Exhibit 23.3 presents the analysis.

The incremental income from processing further ($70,000) is greater than the incremental income ($50,000) from selling Product Q as is. Therefore, FasTrac should process further and earn an additional $20,000 of income ($70,000 − $50,000). The $30,000 of previously incurred manu- facturing costs are excluded from the analysis. These costs are sunk, and they are not relevant to the decision. The incremental revenue from selling Product Q as is ($50,000) is properly included. It is the opportunity cost associated with processing further. The incremental income from processing further is $20,000. Decision rule: Select the alternative with the higher incremental income.

For each of the two independent scenarios below, determine whether the company should sell the partially completed product as is or process it further into other saleable products. 1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is

for $30,000 or processed further into two separate products. The further processing will cost $15,000, and the resulting products can be sold for total revenues of $60,000.

2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for $150,000 or processed further into two separate products. The further processing will cost $75,000, and the resulting products can be sold for total revenues of $200,000.

P2 Sell or Process Further

NEED-TO-KNOW 23-3

EXHIBIT 23.3 Sell or Process Further Analysis

Process Further into Sell as Product Q Products X, Y, and Z

Incremental revenue . . . . . . . . . . . $50,000 $150,000

Incremental cost . . . . . . . . . . . . — (80,000)

Incremental income . . . . . . . . . . . . $50,000 $ 70,000

Chapter 23 Relevant Costing for Managerial Decisions 917

Solution

1.

Do More: QS 23-8, QS 23-9, E 23-3 Delta should be sold as is; doing so will yield an extra $25,000 ($150,000 − $125,000) of income.

Alpha Sell As Is Process Further

Incremental revenue . . . . . . . . . . . $30,000 $60,000

Incremental cost . . . . . . . . . . . . . . . — (15,000)

Incremental income . . . . . . . . . . . . $30,000 $45,000

Alpha should be processed further; doing so will yield an extra $15,000 ($45,000 − $30,000) of income. 2.

Delta Sell As Is Process Further

Incremental revenue . . . . . . . . . . . $150,000 $200,000

Incremental cost . . . . . . . . . . . . . . — (75,000)

Incremental income . . . . . . . . . . . . $150,000 $125,000

Scrap or Rework A variation of the sell or process decision is the scrap or rework deci- sion. Manufacturing processes sometimes yield defective products. Managers must decide whether to scrap or rework these products in process.

Assume that FasTrac has 10,000 defective units of a product that have already cost $1 per unit to manufacture. These units can be sold as is (as scrap) for $0.40 each, or they can be reworked for $0.80 per unit and then sold for their full price of $1.50 each. Should FasTrac sell the units as scrap or rework them?

The $1 per unit manufacturing cost already incurred is a sunk cost and is irrelevant. The $0.40 selling price as scrap is the opportunity cost of reworking. Our analysis is reflected in Exhibit 23.4. FasTrac should rework the units and obtain the higher incremental income.

$ per unit Scrap Rework

Sale of scrapped/reworked units . . . . . . . . . . . . . . $ 0 .40 $ 1 .50

Less out-of-pocket costs to rework defects . . . . . (0 .80)

Incremental income (per unit) . . . . . . . . . . . . . . . $0.40 $ 0.70

EXHIBIT 23.4 Scrap or Rework Analysis

Sales Mix Selection When Resources Are Constrained When a company sells a mix of products, some are more profitable than others. Management concentrates sales efforts on more profitable products. If production facilities or other factors are limited, producing more of one product usually requires producing less of others. In this case, management must identify the most profitable combination, or sales mix, of products. To identify the best sales mix, management focuses on the contribution margin per unit of scarce resource.

To illustrate, assume FasTrac makes and sells two products, A and B. The same machines are used to produce both products. A and B have the following selling prices and variable costs per unit.

P3 Determine sales mix with constrained resources.

$ per unit Product A Product B

Selling price . . . . . . . . . . . $5 .00 $7 .50

Variable costs . . . . . . . . . . 3 .50 5 .50

FasTrac has an existing capacity of 100,000 machine hours per year. In addition, Product A uses 1 machine hour per unit while Product B uses 2 machine hours per unit. With limited resources, FasTrac should focus its productive capacity on the product that yields the highest contribution margin per machine hour, until market demand for that product is satisfied. Exhibit 23.5 shows the relevant analysis.

918 Chapter 23 Relevant Costing for Managerial Decisions

Product A Product B

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 .00 $7 .50

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3 .50) (5 .50)

Contribution margin per unit (i) . . . . . . . . . . . . . . . . . . . . . . . $1 .50 $2 .00

Machine hours per unit (ii) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 hr . 2 hrs .

Contribution margin per machine hour (i) ÷ (ii) . . . . . . . . $1.50 $1.00

EXHIBIT 23.5 Sales Mix Analysis

Exhibit 23.5 shows that although Product B has a higher contribution margin per unit, Product A has a higher contribution margin per machine hour. In this case, FasTrac should produce as much of Product A as possible, up to the market demand. For example, if the market will buy all of Product A that FasTrac can produce, FasTrac should produce 100,000 units of Product A and none of Product B. This sales mix would yield a contribution margin of $150,000 per year, the maximum the company could make subject to its resource constraint.

If demand for Product A is limited—say, to 80,000 units—FasTrac will begin by producing those 80,000 units. This production level would leave 20,000 machine hours to devote to pro- duction of Product B. FasTrac would use these remaining machine hours to produce 10,000 units (20,000 machine hours∕2 machine hours per unit) of Product B. This sales mix would yield the contribution margin shown in Exhibit 23.6.

Point: With such high demand, management should consider expanding its productive capacity.

Sales Mix Contribution Margin Machine Hours Used

Product A (80,000 × $1 .50 per unit) . . . . . . $120,000 80,000 Product B (10,000 × $2 .00 per unit) . . . . . . 20,000 20,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 100,000

EXHIBIT 23.6 Contribution Margin from Sales Mix with Resource Constraint

With limited demand for Product A, the optimal sales mix yields a contribution margin of $140,000, the best the company can do subject to its resource constraint and market demand. Decision rule: If demand for products is limited, produce the most profitable product (per unit of scarce resource) up to the point of total demand (or the capacity constraint). Use remaining capacity to produce the next most profitable product.

Example: Increasing capacity adds fixed costs. To evaluate such strat- egies, subtract these incremental fixed costs from contribution margin at the optimal sales mix.

Fashion Mix Companies such as Gap, TJX Companies, Urban Outfitters, and American Eagle must continuously monitor and manage the sales mix of their product lists. Selling their products worldwide further complicates their decision process. The contribution margin of each product is crucial to their product mix strategies. ■

Decision Insight

©Purestock/SuperStock

A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells for $12.50 per unit. Variable costs are $7 per unit of Gamma and $8 per unit of Omega. The company has a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit and Omega uses 3 machine hours per unit. 1. Compute the contribution margin per machine hour for each product. 2. Assume demand for Gamma is limited to 3,800 units per month. How many units of Gamma and Omega

should the company produce, and what will be the total contribution margin from this sales mix?

Solution

1.

P3

Sales Mix with Constrained Resources

NEED-TO-KNOW 23-4

Gamma Omega

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10 .00 $12 .50

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7 .00) (8 .00)

Contribution margin per unit (i) . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3 .00 $ 4 .50

Machine hours per unit (ii) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 hr . 3 hrs .

Contribution margin per machine hour [(i) ÷ (ii)] . . . . . . . . . . . $ 3.00 $ 1.50

Point: A strategy designed to reduce the impact of constraints or bottlenecks on production is called the theory of constraints.

Chapter 23 Relevant Costing for Managerial Decisions 919

2. The company will begin by producing Gamma to meet the market demand of 3,800 units. This produc- tion level will consume 3,800 machine hours, leaving 1,200 machine hours to produce Omega. With 1,200 machine hours, the company can produce 400 units (1,200 machine hours∕3 machine hours per unit) of Omega. The total contribution margin from this sales mix is

Do More: QS 23-11, E 23-6, E 23-7

Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 units × $3 .00 per unit = $ 11,400 Omega . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 units × $4 .50 per unit = 1,800 Total contribution margin . . . . . . . . . . . . $13,200

Segment Elimination When a segment, division, or store is performing poorly, management must consider eliminat- ing it. As we showed in a previous chapter, determining a segment’s contribution to overhead is an important first step in this analysis. Segments with revenues less than direct costs are candi- dates for elimination. However, contribution to overhead is not sufficient for this decision. We must further classify the segment’s expenses as avoidable or unavoidable. Avoidable expenses are amounts the company would not incur if it eliminated the segment. Unavoidable expenses are amounts that would continue even if the segment was eliminated.

To illustrate, FasTrac is considering eliminating its Treadmill division, which reported a $500 operating loss for the recent year, as shown in Exhibit 23.7. Exhibit 23.7 shows the Tread- mill division contributes $9,700 to recovery of overhead costs. The next step is to classify the division’s costs as either avoidable or unavoidable. Variable costs, such as cost of goods sold and wages expense, are avoidable. In addition, some of the division’s indirect expenses are avoidable; for example, if the Treadmill division were eliminated, FasTrac could reduce its over- all advertising expense by $400 and its overall insurance expense by $300. In addition, FasTrac could avoid office department expenses of $2,200 and purchasing expenses of $1,000 if the Treadmill division were eliminated. These avoidable expenses would not be allocated to other divisions of the company; rather, these expenses would be eliminated. Unavoidable expenses, however, would be reallocated to other divisions if the Treadmill division were eliminated.

FasTrac can avoid a total of $41,800 of expenses if it eliminates the Treadmill division. How- ever, because this division’s sales are $47,800, eliminating the division would reduce FasTrac’s income by $6,000 ($47,800 − $41,800). Based on this analysis, FasTrac should not eliminate its Treadmill division. Decision rule: A segment is a candidate for elimination if its revenues are less than its avoidable expenses.

CAPACITY DECISIONS P4 Evaluate segment elimination decisions.

Example: How can insurance be classified as either avoidable or unavoidable? Answer: It depends on whether the assets insured can be removed and the premi- ums canceled.

Avoidable Unavoidable Treadmill Division Total Expenses Expenses

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $47,800 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 $30,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,800 Direct expenses Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900 7,900 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . 200 $ 200 Total direct expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100 Departmental contribution to overhead . . . . . . . . . . . . . . . . . . $ 9,700 Indirect expenses Rent and utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . 3,150 3,150 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 400 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 300 100 Share of office department expenses . . . . . . . . . . . . . . . . . 3,060 2,200 860 Share of purchasing department expenses . . . . . . . . . . . . . 3,190 1,000 2,190 Total indirect expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,200 Operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (500) Total avoidable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $41,800 Total unavoidable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,500

EXHIBIT 23.7 Classification of Segment Operating Expenses for Analysis

Point: Analysis is summarized as: Sales $ 47,800 Avoidable expenses (41,800)

Reduction in income $ 6,000

Because sales > avoidable expenses, do not eliminate division .

920 Chapter 23 Relevant Costing for Managerial Decisions

Additional Factors When considering elimination of a segment, we must assess its im- pact on other segments. A segment could be unprofitable on its own, but it might still contribute to other segments’ revenues and profits. It is possible then to continue a segment even when its revenues are less than its avoidable expenses. Similarly, a profitable segment might be discon- tinued if its space, assets, or staff can be more profitably used by expanding existing segments or by creating new ones. Our decision to keep or eliminate a segment requires a more complex analysis than simply looking at a segment’s performance report.

Example: Give an example of a segment that a company might profitably use to attract customers even though it might incur a loss. Answer: Warranty and post-sales services.

A bike maker is considering eliminating its Tandem Bike division because it operates at a loss of $6,000 per year. Division sales for the year total $40,000, and the company reports the costs for this division as shown below. Should the Tandem Bike division be eliminated?

P4 Segment Elimination

NEED-TO-KNOW 23-5

Avoidable Expenses Unavoidable Expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . $30,000 $ —

Direct expenses . . . . . . . . . . . . . . . . . . . . 8,000 —

Indirect expenses . . . . . . . . . . . . . . . . . . . 2,500 3,000

Service department costs . . . . . . . . . . . . . 250 2,250

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,750 $5,250

Do More: QS 23-12, QS 23-13, E 23-8

Solution

Total avoidable costs of $40,750 are greater than the division’s sales of $40,000, suggesting the division should be eliminated. Other factors might be relevant since the shortfall in sales ($750) is low. For ex- ample, are tandem bike sales expected to increase in the future? Does the sale of tandem bikes generate sales of other types of products?

Keep or Replace Equipment Businesses periodically must decide whether to keep using equipment or replace it. Advances in technology typically mean newer equipment can operate more efficiently and at lower cost than older equipment. If the reduction in variable manufacturing costs with the new equipment is greater than its net purchase price, the equipment should be replaced. In this setting, the net purchase price of the equipment is its total cost minus any trade-in allowance or cash receipt for the old equipment.

For example, FasTrac has a piece of manufacturing equipment with a book value (cost minus accumulated depreciation) of $20,000 and a remaining useful life of four years. At the end of four years the equipment will have a salvage value of zero. The market value of the equipment is currently $25,000.

FasTrac can purchase a new machine for $100,000 and receive $25,000 in return for trading in its old machine. The new machine will reduce FasTrac’s variable manufacturing costs by $18,000 per year over the four-year life of the new machine. FasTrac’s incremental analysis is shown in Exhibit 23.8.

P5 Evaluate keep or replace decisions.

Increase or (Decrease) in Income

Cost to buy new machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(100,000)

Cash received to trade in old machine . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Reduction in variable manufacturing costs ($18,000 × 4 years) . . . . . . 72,000 Total increase (decrease) in income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (3,000)

EXHIBIT 23.8 Keep or Replace Analysis

Exhibit 23.8 shows that FasTrac should not replace the old equipment with this newer version as it will decrease income by $3,000. The book value of the old equipment ($20,000) is not rele- vant to this analysis. Book value is a sunk cost, and it cannot be changed regardless of whether FasTrac keeps or replaces this equipment. Decision rule: If the reduction in variable manufac- turing cost is greater than the net cost to buy the new machine, the machine should be replaced. The analysis above ignores the time value of money. We consider this in the next chapter.

Chapter 23 Relevant Costing for Managerial Decisions 921

Normal Pricing Managers consider several factors in setting normal selling prices. Target profit: Owners expect a return on their investment (ROI), for example an ROI of 12%. Customer demand: How much will customers pay, and how will they respond to price increases? Competition: Markets for some products are very competitive, and companies are price-

takers, unable to control prices, and simply sell at the market price. Differentiation: Companies with unique products or well-known brands can be price-setters,

having more control in setting prices. Product life cycles: Many products have relatively short life cycles before they are replaced

with new models. These life cycles and expected upgrades can influence pricing.

Normal product selling prices must be set high enough to cover all costs and provide an accept- able return to owners. We consider several pricing approaches using cost data next.

Cost-Plus Methods Cost-plus methods are common when companies are price-setters. Management adds a markup to cost to reach a target price. We first describe the total cost method, where management sets price equal to the product’s total costs plus a desired profit on the product. This is a three-step process:

1. Determine total cost per unit.

Total costs = Product (direct materials,direct labor, and overhead) costs + Selling and

administrative costs

Total cost per unit = Total costs ÷ Total units expected to be produced and sold

2. Determine the dollar markup per unit.

Markup per unit = Total cost per unit × Markup percentage

3. Determine selling price per unit.

Selling price per unit = Total cost per unit + Markup per unit

To illustrate, consider MpPro, a company that produces MP3 players. The company desires a 20% markup on the total cost of this product. It expects to produce and sell 10,000 players. The following additional information is available:

PRICING DECISIONS P6 Determine product selling price using cost data.

Variable costs (per unit) Product costs . . . . . . . . . . . . . . . . . . . $44 Selling and administrative costs . . . . 6

Fixed costs (total) Overhead . . . . . . . . . . . . . . . . . . . . . . $140,000 Selling and administrative costs . . . . 60,000

We apply the three-step total cost method to determine price. 1. Total costs = Product costs + Selling and administrative costs = [($44 × 10,000 units) + $140,000] + [($6 × 10,000 units) + $60,000] = $700,000 Total cost per unit = Total costs∕Total units expected to be produced and sold = $700,000∕10,000 = $70 2. Markup per unit = Total cost per unit × Markup percentage = $70 × 20% = $14 3. Selling price per unit = Total cost per unit + Markup per unit = $70 + $14 = $84

922 Chapter 23 Relevant Costing for Managerial Decisions

Companies often use cost-plus pricing as a starting point in determining selling prices. Many factors determine price, including consumer preferences and competition.

Target Costing When competition is high, companies might be price-takers and have little control in setting prices. In such cases target costing can be useful. Target cost is defined as

Target cost = Expected selling price − Desired profit

If the target cost is too high, lean techniques can be used to determine whether the cost can be reduced enough that the desired profit can be made. For example, if the market price for MP3 players is $80 each and MpPro still wants to make a profit of $14 per unit, it must find a way to reduce its total cost per unit to $66 (computed as $80 price − $14 desired profit).

Sometimes companies compute the desired markup percentage using a target return on investment. For example, if MpPro targets a 14% return on invested assets of $1,000,000, its target profit is $140,000. This equals $14 per unit if 10,000 units are sold, as in this example. The markup percentage is then $14∕$70 = 20%.

Variable Cost Method In addition to the total cost approach of the cost-plus methods, one alternative is to base price on variable cost. Because variable cost is less than total cost, companies that use this method must increase the markup percentage to ensure that the selling price covers all costs. For the variable cost method, the markup percentage to variable cost is determined as

Markup percentage to variable cost =

Target profit +

Fixed overhead costs +

Fixed selling and administrative costs

Total variable cost

For MpPro, the markup percentage, using the variable cost approach, is computed as

Markup percentage to variable cost

= $140,000 + $140,000 + $60,000

[($44 + $6) × 10,000] = 68%

With this markup percentage and total variable cost per unit of $50 (from $44 + $6), the selling price is computed as

Selling price = $50 + ($50 × 68%) = $84

Other Pricing Methods Increased global competition and technological advances have led to other pricing methods. Value-based pricing By focusing on what customers value, this approach determines the

maximum amount customers will pay without reducing demand. Starbucks uses research and customer analysis in setting value-based prices.

Auction-based pricing Rather than forcing sellers to set prices, this approach uses poten- tial buyers’ bid prices. Priceline uses electronic auctions to sell hotel rooms and airline flights.

Dynamic pricing (surge pricing) This strategy uses prices that vary depending on chang- ing market conditions or customer demand. Uber’s fares are higher during peak travel times and popular events.

Mine It Cryptocurrenices like bitcoin use blockchain technology, which is used to create a secure ledger of trans- actions and other data. Bitcoin prices are extremely volatile. However, bitcoin prices depend, in part, on the cost to mine bitcoin (electricity and computers). Some estimate a cost of about $4,000 per bitcoin, with the cost rising as more bitcoins are mined. ■

Decision Insight

©Spaxiax/Shutterstock

Chapter 23 Relevant Costing for Managerial Decisions 923

Companies sometimes receive special offers at prices lower than their normal selling prices. We show how to evaluate these special offers by focusing on incremental revenues and incre- mental expenses next.

Special Offers FasTrac produces and sells approximately 100,000 units of product annually. Its per unit and annual total sales and costs are shown in the contribution margin income statement in Exhibit 23.9. Its normal selling price is $10.00 per unit, and each unit sold generates $1.00 per unit of operating income.

P7 Evaluate special offer decisions.

FasTrac Contribution Margin Income Statement

For Year Ended December 31, 2019

Per Unit Annual Total

Sales (100,000 units) . . . . . . . . . . . . . . . . . $10 .00 $1,000,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . (3 .50) (350,000)

Direct labor . . . . . . . . . . . . . . . . . . . . . . . (2 .20) (220,000)

Variable overhead . . . . . . . . . . . . . . . . . (0 .50) (50,000)

Selling expenses . . . . . . . . . . . . . . . . . . . (1 .40) (140,000)

Contribution margin . . . . . . . . . . . . . . . . . . 2 .40 240,000

Fixed costs

Fixed overhead . . . . . . . . . . . . . . . . . . . . (0 .60) (60,000)

Administrative expenses . . . . . . . . . . . . (0 .80) (80,000)

Operating income . . . . . . . . . . . . . . . . . . . . $ 1 .00 $ 100,000

EXHIBIT 23.9 Selected Operating Income Data

A current customer wants to buy more units and export them to another country. This buyer offers to buy 10,000 units of the product at $8.50 per unit. The offer price is below the normal price of $10.00 per unit, but this sale would be several times larger than any single previous sale and it would use idle capacity. Because the units will be exported, this new business will not affect current domestic sales.

Management needs to know whether accepting the offer will increase income. If manage- ment relies incorrectly on per unit historical costs, it would mistakenly reject the sale because the selling price ($8.50) per unit is less than the total historical costs per unit ($9.00).

FasTrac must analyze the costs of this potential new business differently. The $9.00 historical cost per unit is not necessarily the incremental cost of this special order. The following informa- tion regarding the order is available: The variable manufacturing costs to produce this order will be the same as for FasTrac’s

normal business—$3.50 per unit for direct materials, $2.20 per unit for direct labor, and $0.50 per unit for variable overhead.

Selling expenses for this order will be $0.20 per unit, which is less than the selling expenses of FasTrac’s normal business.

Fixed overhead expenses will not change regardless of whether this order is accepted. They are not relevant to the decision.

This order will incur incremental administrative expenses of $1,000 for clerical work. These are additional fixed costs due to this order.

We use this incremental cost information to determine whether FasTrac should accept this new business. The analysis of relevant benefits and costs in Exhibit 23.10 suggests that the addi- tional business should be accepted. The incremental revenue ($8.50 per unit) exceeds the incremental cost ($6.50 per unit), and the order would yield $20,000 of additional operat- ing income. More generally, FasTrac would increase its income with any price that exceeds $6.50 per unit ($65,000 incremental cost∕10,000 additional units). The key point is that

924 Chapter 23 Relevant Costing for Managerial Decisions

management must not blindly use historical costs, especially allocated overhead costs. Instead, management must focus on the incremental costs to be incurred if the additional business is accepted.

FasTrac Contribution Margin Income Statement (for special offer)

For Year Ended December 31, 2019

Per Unit* Annual Total

Sales (10,000 units) . . . . . . . . . . . . . . . . . . . . . . $ 8 .50 $ 85,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . (3 .50) (35,000)

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . (2 .20) (22,000)

Variable overhead . . . . . . . . . . . . . . . . . . . . . (0 .50) (5,000)

Selling expenses . . . . . . . . . . . . . . . . . . . . . . (0 .20) (2,000)

Contribution margin . . . . . . . . . . . . . . . . . . . . . . 2 .10 21,000

Fixed costs

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . — —

Administrative expenses . . . . . . . . . . . . . . . . (0 .10) (1,000)

Operating income (incremental) . . . . . . . . . . . . $ 2 .00 $ 20,000

*Total cost per unit = $3.50 + $2.20 + $0.50 + $0.20 + $0.10 = $6.50.

EXHIBIT 23.10 Analysis of Special Offer Using Relevant Costs

Point: Ignore allocated fixed over- head costs. The analysis in Exhibit 23.10 uses only incremental fixed overhead costs.

Additional Factors An analysis of the incremental costs pertaining to the additional volume is always relevant for this type of decision. We must be careful when the additional vol- ume approaches or exceeds the factory’s existing available capacity. If the additional volume requires the company to expand its capacity by obtaining more equipment, more space, or more personnel, the incremental costs could quickly exceed the incremental revenue.

Another cautionary note is the effect on existing sales. All new units of the extra business will be sold outside FasTrac’s normal domestic sales channels. If accepting additional business would cause existing sales to decline, this information must be included in our analysis. The contribution margin lost from a decline in sales is an opportunity cost. The company must also consider whether this customer is really a one-time customer. If not, can the company continue to offer this low price in the long run?

Example: Exhibit 23.10 uses quan- titative information. Suggest some qualitative factors to be consid- ered when deciding whether to accept this project. Answer: (1) Impact on relationships with other customers and (2) improved relationship with customer buying additional units.

Partner You are a partner in a small accounting firm that specializes in keeping the books and preparing taxes for clients. A local restaurant is interested in obtaining these services from your firm. Identify factors that are relevant in deciding whether to accept the engagement. ■ Answer: You should identify the differences between existing clients and this potential client. A key difference is that the restaurant business has additional inventory components (groceries, vegetables, meats) and is likely to have a higher proportion of depreciable assets. These differences imply that the partner must spend more hours auditing the records and understanding the business, regulations, and standards that pertain. Such differences suggest that the partner must use a different “formula” for quoting a price to this potential client vis-à-vis current clients.

Decision Maker

A company receives a special order for 200 units that requires stamping the buyer’s name on each unit, yielding an additional fixed cost of $400. Without the order, the company operates at 75% of capacity and produces 7,500 units of product at the costs below. The company’s normal selling price is $22 per unit.

P7 Special Order

NEED-TO-KNOW 23-6

The requested sales price for the special order is $18 per unit. The special order will not affect normal unit sales and will not increase fixed overhead or fixed selling expenses. Variable selling expenses on the spe- cial order are reduced to one-half the normal amount. Should the company accept the special order?

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $37,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Overhead (30% variable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Selling expenses (60% variable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Chapter 23 Relevant Costing for Managerial Decisions 925

Managers consider sustainability issues in many of the decisions discussed in this chapter. Companies that buy rather than make components must consider the labor and safety practices of their suppliers. Apple requires its suppliers to comply with its Supplier Code of Conduct (https://images.apple.com/supplier- responsibility/pdf/Apple-Supplier-Code-of-Conduct-January.pdf). This code details Apple’s require- ments with respect to anti-discrimination, anti-harassment, prevention of involuntary labor and human trafficking, and other issues.

For example, workers are allowed to work no more than 60 hours per week, with a required day of rest every seven days. A real-time work-hour tracking system and frequent reporting enable Apple to assess compliance with the code. In a recent report, Apple noted 97% compliance with its workweek requirement.

For sustainability of direct materials, “we use what’s local,” says Gaurab Chakrabarti, co-founder of Solugen, in describing the raw materials for his company’s plant-based hydrogen peroxide production process. “Sugar, plant starch, you can feed anything into it,” says co-founder Sean Hunt. Instead of using costly petroleum, the duo’s process uses local plants that are in high supply—cane sugar in India and beet sugar in Chile, for example. This is good for the planet and Solugen’s bottom line.

SUSTAINABILITY AND ACCOUNTING

©Solugen

Time and Materials Pricing Decision Analysis

It is common to price services using time and materials pricing. With this method, companies set a price for labor and a price for materials, and each includes a charge for overhead costs and a desired profit mar- gin. Auto mechanics, construction companies, electricians, and accounting and law firms commonly use time and materials pricing. Time and materials pricing follows these steps.

1 Compute the rate (in $) per hour of direct labor. This rate includes a charge for other (non-materials related) overhead costs plus a desired profit margin.

2 Compute the materials markup (%), which includes the overhead costs related to buying, storing, and handling materials, plus a desired profit margin on the materials’ cost.

3 Estimate the number of direct labor hours (DLH) and the total direct materials cost for the service. 4 Using steps 1, 2, and 3, compute the price for the service.

We illustrate time and materials pricing using the following estimates for Erin Builders.

A1 Determine service selling price using time and materials pricing.

Solution

Incremental variable costs per unit for this order of 200 units are computed as follows.

Do More: QS 23-15, E 23-13, E 23-14

The contribution margin from the special order is $640, computed as [($18.00 − $14.80) × 200]. This will cover the incremental fixed costs of $400 and yield incremental income of $240. The offer should be accepted.

Direct materials ($37,500∕7,500) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5 .00 Direct labor ($60,000∕7,500) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 .00 Variable overhead [(0 .30 × $20,000)∕7,500] . . . . . . . . . . . . . . . . . . . . . . . . . 0 .80 Variable selling expenses [(0 .60 × $25,000 × 0 .5)∕7,500] . . . . . . . . . . . . . . 1 .00 Total incremental variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14 .80

Direct labor rate, including fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40 per DLH

Annual direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 hours

Annual direct materials purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000

Annual overhead costs:

Materials purchasing, handling, and storage . . . . . . . . . . . . . . . . . . . . . . . . . $18,000

Non-materials related overhead (depreciation, insurance, taxes, rent) . . . . $36,000

Target profit margin (on both labor and materials) . . . . . . . . . . . . . . . . . . . . . . . 22%

Determine the appropriate action in each of the following managerial decision situations. 1. Packer Company is operating at 80% of its manufacturing capacity of 100,000 product units per year.

A chain store has offered to buy an additional 10,000 units at $22 each and sell them to customers so as not to compete with Packer Company. The following data are available. In producing 10,000 addi- tional units, fixed overhead costs would remain at their current level, but incremental variable overhead costs of $3 per unit would be incurred. Should the company accept or reject this order?

COMPREHENSIVE

Manager Decisions

NEED-TO-KNOW 23-7

926 Chapter 23 Relevant Costing for Managerial Decisions

1 The rate per hour of direct labor is computed as

Direct labor rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40

Non-materials related overhead per hour ($36,000/3,600) . . . . . +10 Total hourly conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Profit margin (22% × $50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +11 Rate per hour of direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $61

2 The materials markup per dollar of material cost is computed as

Materials purchasing, handling, and storage ($18,000/$600,000) . . . . . . . . . . . 3%

Profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +22% Materials markup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25%

3 The job is estimated to use 300 direct labor hours and $14,000 of direct materials. 4 Erin uses time and materials pricing to set the $35,800 price for the job as we see in Exhibit 23.11.

ERIN BUILDERS Time and Materials Price Quote to Install Deck and Porch

Direct labor (300 hours @ $61 per DLH) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,300

Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Materials markup ($14,000 × 25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Time and materials price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35,800

EXHIBIT 23.11 Time and Materials Pricing

Costs at 80% Capacity Per Unit Total

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $ 8 .00 $ 640,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 .00 560,000

Overhead (fixed and variable) . . . . . . . . . . . . 12 .50 1,000,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27 .50 $2,200,000

2. Green Company uses Part JR3 in manufacturing its products. It has always purchased this part from a supplier for $40 each. It recently upgraded its own manufacturing capabilities and has enough excess capacity (including trained workers) to begin manufacturing Part JR3 instead of buying it. The com- pany prepares the following cost projections of making the part, assuming that overhead is allocated to the part at the normal predetermined rate of 200% of direct labor cost. The required volume of output to produce the part will not require any incremental fixed overhead. Incremental variable overhead cost will be $17 per unit. Should the company make or buy this part?

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Overhead (fixed and variable) (200% of direct labor) . . . . . . . . . . . . . . . . 30

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56

Chapter 23 Relevant Costing for Managerial Decisions 927

3. Gold Company’s manufacturing process causes a relatively large number of defective parts to be pro- duced. The defective parts can be (a) sold for scrap, (b) melted to recover the recycled metal for reuse, or (c) reworked to be good units. Reworking defective parts reduces the output of other good units because no excess capacity exists. Each reworked unit means that one new unit cannot be produced. The following information reflects 500 defective parts currently available. Should the company melt the parts, sell them as scrap, or rework them?

Proceeds of selling as scrap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500

Additional cost of melting down defective parts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Cost of purchases avoided by using recycled metal from defects . . . . . . . . . . . . . . . . 4,800

Cost to rework 500 defective parts

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Incremental overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750

Cost to produce 500 new parts

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Incremental overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Selling price per good unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

PLANNING THE SOLUTION Determine whether Packer Company should accept the additional business by finding the incremental

costs of materials, labor, and overhead that will be incurred if the order is accepted. Omit fixed costs that the order will not increase. If the incremental revenue exceeds the incremental cost, accept the order.

Determine whether Green Company should make or buy the component by finding the incremental cost of making each unit. If the incremental cost exceeds the purchase price, the component should be purchased. If the incremental cost is less than the purchase price, make the component.

Determine whether Gold Company should sell the defective parts, melt them down and recycle the metal, or rework them. To compare the three choices, examine all costs incurred and benefits received from the alternatives in working with the 500 defective units versus the production of 500 new units. For the scrapping alternative, include the costs of producing 500 new units and subtract the $2,500 proceeds from selling the old ones. For the melting alternative, include the costs of melting the defec- tive units, add the net cost of new materials in excess over those obtained from recycling, and add the direct labor and overhead costs. For the reworking alternative, add the costs of direct labor and incre- mental overhead. Select the alternative that has the lowest cost. The cost assigned to the 500 defective units is sunk and not relevant in choosing among the three alternatives.

SOLUTION 1. This decision involves accepting additional business. Since current unit costs are $27.50, it appears

initially as if the offer to sell for $22 should be rejected, but the $27.50 cost includes fixed costs. When the analysis includes only incremental costs, the per unit cost is as shown in the following table. The offer should be accepted because it will produce $4 of additional profit per unit (computed as $22 price less $18 incremental cost), which yields a total profit of $40,000 for the 10,000 additional units.

Direct materials . . . . . . . . . . . . . . . . . . . . $ 8 .00

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 7 .00

Variable overhead (given) . . . . . . . . . . . 3 .00

Total incremental cost . . . . . . . . . . . . . . $18 .00

Direct materials . . . . . . . . . . . . . . . . . . . . $11 .00

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 15 .00

Variable overhead . . . . . . . . . . . . . . . . . 17 .00

Total incremental cost . . . . . . . . . . . . . . $43 .00

2. For this make or buy decision, the analysis must include only incremental overhead per unit ($30 − $17). When only the $17 incremental overhead is included, the relevant unit cost of manufacturing the part is shown in the following table. It would be better to continue buying the part for $40 instead of making it for $43.

928 Chapter 23 Relevant Costing for Managerial Decisions

3. The goal of this scrap or rework decision is to identify the alternative that produces the greatest net benefit to the company. To compare the alternatives, we determine the net cost of obtaining 500 mar- ketable units as follows. Analysis shows that the incremental cost of 500 marketable parts is smallest if the defects are reworked.

Sell Melt and Rework Incremental Cost to Produce 500 Marketable Units As Is Recycle Units

Direct materials

New materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $6,000

Recycled metal materials . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,800)

Net materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Melting costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Total direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 1,600

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 $1,500

Incremental overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200 3,200 1,750

Cost to produce 500 marketable units . . . . . . . . . . . . . . . . . . 14,200 9,800 3,250

Less proceeds of selling defects as scrap . . . . . . . . . . . . . . . . (2,500)

Opportunity costs* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,800

Incremental cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,700 $9,800 $9,050

* The $5,800 opportunity cost is the lost contribution margin from not being able to produce and sell 500 units because of reworking, computed as ($40 − [$14,200/500 units]) × 500 units.

Incremental costs: Additional costs incurred from a course of action. Incremental revenues: Additional revenues from a course of action. Sunk cost: From a past decision and cannot be changed. Out-of-pocket cost: Future outlay of cash. Opportunity cost: Potential benefit lost by taking an action when alternatives exist.

PRODUCTION DECISIONS Make or buy

If, Incremental cost to make > Cost to buy → then, Make Sell or process

If, Revenues from processing − Processing costs > Sale price → then, Process

Sales mix Produce as much of the product with the highest contribution margin per unit of scarce resource, up to customer demand. Then produce the other product until capacity is used up.

CAPACITY DECISIONS Segment

Eliminate if, Revenues < Avoidable expenses Equipment

Replace if, Reduction in variable mfg. costs > Net cost of new machine

Summary: Cheat Sheet

PRICING DECISIONS Normal Price must cover all costs plus provide a profit. Cost-plus Price = Cost + Markup

where Markup per unit = Cost per unit × Markup % Target costing

Target cost = Expected selling price − Desired profit

Special offer If, Incremental revenue > Incremental cost → then, Accept

Service Use time and materials pricing. Both labor and materials prices include charges for overhead and a desired profit margin.

Time and Materials Price Quote Labor: Rate per hour of direct labor × Direct labor hours Materials: Direct materials cost × (1 + Markup %), where Markup % = Materials overhead % + Profit % A charge for overhead and a desired profit margin are included in the Rate per hour of direct labor and in the materials Markup %.

Auction-based pricing (922) Avoidable expense (919) Blockchain (922) Dynamic pricing (922) Incremental cost (914)

Incremental revenue (914) Markup (921) Materials markup (925) Outsourcing (915) Price-setter (921)

Price-taker (921) Time and materials pricing (925) Total cost method (921) Unavoidable expense (919) Value-based pricing (922)

Key Terms

Chapter 23 Relevant Costing for Managerial Decisions 929

Icon denotes assignments that involve decision making.

1. Identify the five steps involved in the managerial deci- sion-making process.

2. Is nonfinancial information ever useful in managerial deci- sion making?

3. What is a relevant cost? Identify the two types of relevant costs.

4. What are incremental revenues? 5. Identify some qualitative factors that should be consid-

ered when making managerial decisions. 6. Google has many types of costs. What is an

out-of-pocket cost? What is an opportunity

cost? Are opportunity costs recorded in the accounting records?

7. Samsung must confront sunk costs. Why are sunk costs irrelevant in decid- ing whether to sell a product in its present condition or to make it into a new product through additional processing?

8. Identify the incremental costs incurred by Apple for shipping one additional iPod from a warehouse to a retail store along with the store’s normal order of 75 iPods.

Discussion Questions

APPLE

Samsung

GOOGLE

Multiple Choice Quiz

1. A company inadvertently produced 3,000 defective MP3 players. The players cost $12 each to produce. A recycler offers to purchase the defective players as they are for $8 each. The production manager reports that the defects can be corrected for $10 each, enabling them to be sold at their regular market price of $19 each. The company should a. Correct the defect and sell them at the regular price. b. Sell the players to the recycler for $8 each. c. Sell 2,000 to the recycler and repair the rest. d. Sell 1,000 to the recycler and repair the rest. e. Throw the players away.

2. A company’s productive capacity is limited to 480,000 ma- chine hours. Product X requires 10 machine hours to pro- duce; Product Y requires 2 machine hours to produce. Product X sells for $32 per unit and has variable costs of $12 per unit; Product Y sells for $24 per unit and has vari- able costs of $10 per unit. Assuming that the company can sell as many of either product as it produces, it should a. Produce X and Y in the ratio of 57% X and 43% Y. b. Produce X and Y in the ratio of 83% X and 17% Y. c. Produce equal amounts of Product X and Product Y. d. Produce only Product X. e. Produce only Product Y.

3. A company receives a special one-time order for 3,000 units of its product at $15 per unit. The company has excess capacity

and it currently produces and sells the units at $20 each to its regular customers. Production costs are $13.50 per unit, which includes $9 of variable costs. To produce the special order, the company must incur additional fixed costs of $5,000. Should the company accept the special order? a. Yes, because incremental revenue exceeds incremental

costs. b. No, because incremental costs exceed incremental

revenue. c. No, because the units are being sold for $5 less than the

regular price. d. Yes, because incremental costs exceed incremental

revenue. e. No, because incremental costs exceed $15 per unit

when total costs are considered. 4. A cost that cannot be changed because it arises from a past

decision and is irrelevant to future decisions is a. An uncontrollable cost. d. An opportunity cost. b. An out-of-pocket cost. e. An incremental cost. c. A sunk cost.

5. The potential benefit of one alternative that is lost by choos- ing another is known as a. An alternative cost. d. An opportunity cost. b. A sunk cost. e. An out-of-pocket cost. c. A differential cost.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a; Reworking provides incremental revenue of $11 per unit ($19 − $8); it costs $10 to rework them. The company is better off by $1 per unit when it reworks these products and sells them at the regular price.

2. e; Product X has a $2 contribution margin per machine hour [($32 − $12)∕10 MH]; Product Y has a $7 contribution margin per machine hour [($24 − $10)∕2 MH]. It should produce as much of Product Y as possible.

3. a; Total revenue from the special order = 3,000 units × $15 per unit = $45,000; and Total costs for the special order = (3,000 units × $9 per unit) + $5,000 = $32,000. Net income from the special order = $45,000 − $32,000 = $13,000. Thus, it should accept the order.

4. c 5. d

930 Chapter 23 Relevant Costing for Managerial Decisions

9. Apple is considering eliminating one of its stores in a large U.S. city. What are some factors that it should consider in making this decision?

10. Assume that Samsung manufactures and sells 60,000 units of a product at $11,000 per unit in domestic markets. It costs $6,000 per

unit to manufacture ($4,000 variable cost per unit, $2,000 fixed cost per unit). Can you describe a situation in which the company is willing to sell an additional 8,000 units of the product in an international market at $5,000 per unit?

11. Explain how a price-setter differs from a price-taker. 12. What is time and materials pricing?

Samsung

QUICK STUDY

QS 23-1 Identifying relevant costs

C1

Helix Company has been approached by a new customer to provide 2,000 units of its regular product at a special price of $6 per unit. The regular selling price of the product is $8 per unit. Helix is operating at 75% of its capacity of 10,000 units. Identify whether the following costs are relevant to Helix’s decision as to whether to accept the order at the special selling price. No additional fixed manufacturing overhead will be incurred because of this order. The only additional selling expense on this order will be a $0.50 per unit shipping cost. There will be no additional administrative expenses because of this order. Place an X in the appropriate column to identify whether the cost is relevant or irrelevant to accepting this order.

Item Relevant Not Relevant

a . Selling price of $6 .00 per unit

b . Direct materials cost of $1 .00 per unit

c . Direct labor of $2 .00 per unit

d . Variable manufacturing overhead of $1 .50 per unit

e . Fixed manufacturing overhead of $0 .75 per unit

f . Regular selling expenses of $1 .25 per unit

g . Additional selling expenses of $0 .50 per unit

h . Administrative expenses of $0 .60 per unit

Item Relevant Not Relevant

a . $15,000 cost already incurred to produce

b . $20,000 selling price

c . $22,000 additional processing costs

d . $35,000 revenues from processing

QS 23-3 Identifying relevant costs

C1

Zycon has produced 10,000 units of partially finished Product A. These units cost $15,000 to produce, and they can be sold to another manufacturer for $20,000. Instead, Zycon can process the units further and produce finished Products X, Y, and Z. Processing further will cost an additional $22,000 and will yield total revenues of $35,000. Place an X in the appropriate column to identify whether the item is relevant or irrelevant to the sell or process further decision.

QS 23-2 Special offer P7

Refer to the data in QS 23-1. Based on financial considerations alone, should Helix accept this order at the special price?

QS 23-5 Sell or process

P2

Garcia Company has 10,000 units of its product that were produced last year at a total cost of $150,000. The units were damaged in a rainstorm because the warehouse where they were stored developed a leak in the roof. Garcia can sell the units as is for $2 each or it can repair the units at a total cost of $18,000 and then sell them for $5 each. Should Garcia sell the units as is or repair them and then sell them?

QS 23-4 Relevant costs

C1

Label each of the following statements as either true (“T”) or false (“F”). 1. Relevant costs are also known as unavoidable costs. 2. Incremental costs are also known as differential costs. 3. An out-of-pocket cost requires a current and/or future outlay of cash. 4. An opportunity cost is the potential benefit that is lost by taking a specific action when two

or more alternative choices are available. 5. A sunk cost will change with a future course of action.

APPLE

Chapter 23 Relevant Costing for Managerial Decisions 931

Kando Company incurs a $9 per unit cost for Product A, which it currently manufactures and sells for $13.50 per unit. Instead of manufacturing and selling this product, the company can purchase it for $5 per unit and sell it for $12 per unit. If it does so, unit sales would remain unchanged and $5 of the $9 per unit costs of Product A would be eliminated. Should the company continue to manufacture Product A or pur- chase it for resale?

QS 23-6 Make or buy

P1

Signal mistakenly produced 1,000 defective cell phones. The phones cost $60 each to produce. A salvage company will buy the defective phones as they are for $30 each. It would cost Signal $80 per phone to rework the phones. If the phones are reworked, Signal could sell them for $120 each. Signal has excess capacity. Should Signal scrap or rework the phones?

QS 23-10 Scrap or rework

P2

Xia Co. currently buys a component part for $5 per unit. Xia believes that making the part would require $2.25 per unit of direct materials and $1.00 per unit of direct labor. Xia allocates overhead using a prede- termined overhead rate of 200% of direct labor cost. Xia estimates an incremental overhead rate of $0.75 per unit to make the part. Should Xia make or buy the part?

QS 23-7 Make or buy

P1

Excel Memory Company can sell all units of computer memory X and Y that it can produce, but it has limited production capacity. It can produce two units of X per hour or three units of Y per hour, and it has 4,000 production hours available. Contribution margin is $5 for Product X and $4 for Product Y. What is the most profitable sales mix for this company?

QS 23-11 Selection of sales mix

P3

Rory Company has a machine with a book value of $75,000 and a remaining five-year useful life. A new machine is available at a cost of $112,500, and Rory can also receive $60,000 for trading in its old ma- chine. The new machine will reduce variable manufacturing costs by $13,000 per year over its five-year useful life. Should the machine be replaced?

QS 23-14 Keep or replace

P5

Holmes Company produces a product that can be either sold as is or processed further. Holmes has already spent $50,000 to produce 1,250 units that can be sold now for $67,500 to another manufacturer. Alternatively, Holmes can process the units further at an incremental cost of $250 per unit. If Holmes processes further, the units can be sold for $375 each. Should Holmes sell the product now or process it further?

QS 23-8 Sell or process further

P2

A company has already incurred $5,000 of costs in producing 6,000 units of Product XY. Product XY can be sold as is for $15 per unit. Instead, the company could incur further processing costs of $8 per unit and sell the resulting product for $21 per unit. Should the company sell Product XY as is or process it further?

QS 23-9 Sell or process further P2

A guitar manufacturer is considering eliminating its Electric Guitar division because its $76,000 expenses are higher than its $72,000 sales. The company reports the following expenses for this division. Should the division be eliminated?

QS 23-12 Segment elimination

P4

Avoidable Expenses Unavoidable Expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . $56,000

Direct expenses . . . . . . . . . . . . . . . . . . . . 9,250 $1,250

Indirect expenses . . . . . . . . . . . . . . . . . . 470 1,600

Service department costs . . . . . . . . . . . . . 6,000 1,430

QS 23-13 Segment elimination

P4

A division of a large company reports the information shown below for a recent year. Variable costs and direct fixed costs are avoidable, and 40% of the indirect fixed costs are avoidable. Based on this informa- tion, should the division be eliminated?

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000

Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,000

Fixed costs

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (25,000)

932 Chapter 23 Relevant Costing for Managerial Decisions

QS 23-16 Product pricing using total cost P6

Garcia Co. sells snowboards. Each snowboard requires direct materials of $100, direct labor of $30, and variable overhead of $45. The company expects fixed overhead costs of $635,000 and fixed selling and administrative costs of $115,000 for the next year. It expects to produce and sell 10,000 snowboards in the next year. What will be the selling price per unit if Garcia uses a markup of 15% of total cost?

QS 23-18 Product pricing using variable costs

P6

GoSnow sells snowboards. Each snowboard requires direct materials of $110, direct labor of $35, and variable overhead of $45. The company expects fixed overhead costs of $265,000 and fixed selling and administrative costs of $211,000 for the next year. The company has a target profit of $200,000. It expects to produce and sell 10,000 snowboards in the next year. Compute the selling price using the variable cost method.

QS 23-20 Time and materials pricing A1

Meng uses time and materials pricing. Its rate per hour of direct labor is $55. Its materials markup is 30%. What price should Meng quote for a job that will take 80 direct labor hours and use $3,800 of direct materials?

Exercise 23-2 Make or buy

P1

Gelb Company currently manufactures 40,000 units per year of a key component for its manufacturing process. Variable costs are $1.95 per unit, fixed costs related to making this component are $65,000 per year, and allocated fixed costs are $58,500 per year. The allocated fixed costs are unavoidable whether the company makes or buys this component. The company is considering buying this component from a sup- plier for $3.50 per unit. Should it continue to manufacture the component, or should it buy this component from the outside supplier?

QS 23-15 Special offer

P7

Radar Company sells bikes for $300 each. The company currently sells 3,750 bikes per year and could make as many as 5,000 bikes per year. The bikes cost $225 each to make: $150 in variable costs per bike and $75 of fixed costs per bike. Radar received an offer from a potential customer who wants to buy 750 bikes for $250 each. Incremental fixed costs to make this order are $50,000. No other costs will change if this order is accepted. Compute Radar’s additional income (ignore taxes) if it accepts this order.

QS 23-17 Product pricing using total cost P6

José Ruiz wants to start a company that makes snowboards. Competitors sell a similar snowboard for $240 each. José believes he can produce a snowboard for a total cost of $200 per unit, and he plans a 25% markup on his total cost. Compute José’s planned selling price. Can José compete with his planned selling price?

QS 23-19 Target costing P6

Raju is a price-taker in a competitive product market. The current market price is $80 per unit, and Raju’s desired profit is 20% of market price. Using target costing, what is the highest Raju’s costs can be?

QS 23-21 Time and materials pricing

A1

Cheng Co. reports the following information for the coming year. Determine its (a) rate per hour of direct labor (in $) and (b) materials markup (in %).

Direct labor rate, including fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50 per DLH

Annual direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 hours

Annual direct materials purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $560,000

Annual overhead costs:

Materials purchasing, handling, and storage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $39,200

Non-materials related overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $114,000

Target profit margin (on both labor and materials) . . . . . . . . . . . . . . . . . . . . . . . . . . . 30%

EXERCISES

Exercise 23-1 Make or buy

P1

Gilberto Company currently manufactures 65,000 units per year of one of its crucial parts. Variable costs are $1.95 per unit, fixed costs related to making this part are $75,000 per year, and allocated fixed costs are $62,000 per year. Allocated fixed costs are unavoidable whether the company makes or buys the part. Gilberto is considering buying the part from a supplier for a quoted price of $3.25 per unit guaranteed for a three-year period. Should the company continue to manufacture the part, or should it buy the part from the outside supplier?

Cobe Company has already manufactured 28,000 units of Product A at a cost of $28 per unit. The 28,000 units can be sold at this stage for $700,000. Alternatively, the units can be processed further at a $420,000 total additional cost and be converted into 5,600 units of Product B and 11,200 units of Product C. Per unit selling price for Product B is $105 and for Product C is $70. Should the 28,000 units of Product A be processed further or not?

Exercise 23-3 Sell or process further

P2

Chapter 23 Relevant Costing for Managerial Decisions 933

A company must decide between scrapping or reworking units that do not pass inspection. The company has 22,000 defective units that cost $6 per unit to manufacture. The units can be sold as is for $2.00 each, or they can be reworked for $4.50 each and then sold for the full price of $8.50 each. If the units are sold as is, the company will be able to build 22,000 replacement units at a cost of $6 each and sell them at the full price of $8.50 each. (1) What is the incremental income from selling the units as scrap? (2) What is the incremental income from reworking and selling the units? (3) Should the company sell the units as scrap or rework them?

Exercise 23-4 Scrap or rework

P2

Varto Company has 7,000 units of its sole product in inventory that it produced last year at a cost of $22 each. This year’s model is superior to last year’s, and the 7,000 units cannot be sold at last year’s regular selling price of $35 each. Varto has two alternatives for these items: (1) They can be sold to a wholesaler for $8 each or (2) they can be processed further at a cost of $125,000 and then sold for $25 each. Should Varto sell the products as is or process further and then sell them?

Exercise 23-5 Sell or process further

P2

Colt Company owns a machine that can produce two specialized products. Production time for Product TLX is two units per hour and for Product MTV is five units per hour. The machine’s capacity is 2,750 hours per year. Both products are sold to a single customer who has agreed to buy all of the company’s output up to a maximum of 4,700 units of Product TLX and 2,500 units of Product MTV. Selling prices and variable costs per unit to produce the products follow. Determine (1) the company’s most profitable sales mix and (2) the contribution margin that results from that sales mix.

Exercise 23-6 Sales mix determination and analysis

P3

$ per unit Product TLX Product MTV

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . $15 .00 $9 .50

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . 4 .80 5 .50 Check (2) $55,940

Childress Company produces three products, K1, S5, and G9. Each product uses the same type of direct material. K1 uses 4 pounds of the material, S5 uses 3 pounds of the material, and G9 uses 6 pounds of the material. Demand for all products is strong, but only 50,000 pounds of material are available. Information about the selling price per unit and variable cost per unit of each product follows. Orders for which prod- uct should be produced and filled first, then second, and then third?

Exercise 23-7 Sales mix

P3

Check K1 contribution margin per pound, $16

$ per unit K1 S5 G9

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160 $112 $210

Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 85 144

Marinette Company makes several products, including canoes. The company has been experiencing losses from its canoe segment and is considering dropping that product line. The following information is avail- able regarding its canoe segment. Should management discontinue the manufacturing of canoes?

Exercise 23-8 Income analysis of eliminating departments

P4

Check Income impact if canoe segment dropped, $(175,000)

Income Statement—Canoe Segment

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Variable selling and administrative . . . . . . . . . . . . . . . . . . . 200,000

Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,450,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000

Fixed costs

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (125,000)

934 Chapter 23 Relevant Costing for Managerial Decisions

Exercise 23-10 Keep or replace

P5

Xinhong Company is considering replacing one of its manufacturing machines. The machine has a book value of $45,000 and a remaining useful life of five years, at which time its salvage value will be zero. It has a current market value of $52,000. Variable manufacturing costs are $36,000 per year for this ma- chine. Information on two alternative replacement machines follows. Should Xinhong keep or replace its manufacturing machine? If the machine should be replaced, which alternative new machine should Xinhong purchase?

Alternative A Alternative B

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000 $125,000

Variable manufacturing costs per year . . . . . . . . . . . . 19,000 15,000

Exercise 23-11 Product pricing using total costs

P6

Steeze Co. makes snowboards and uses the total cost approach in setting product prices. Its costs for pro- ducing 10,000 units follow. The company targets a profit of $300,000 on this product.

1. Compute the total cost per unit. 2. Compute the markup percentage on total cost. 3. Compute the product’s selling price using the total cost method.

Variable Costs per Unit

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Fixed Costs (in total)

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $470,000

Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000

Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . 325,000

Exercise 23-12 Product pricing using variable costs

P6

Rios Co. makes drones and uses the variable cost approach in setting product prices. Its costs for produc- ing 20,000 units follow. The company targets a profit of $300,000 on this product.

1. Compute the variable cost per unit. 2. Compute the markup percentage on variable cost. 3. Compute the product’s selling price using the variable cost method.

Variable Costs per Unit

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Fixed Costs (in total)

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $670,000

Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305,000

Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . 285,000

Exercise 23-9 Analyzing income effects from eliminating departments

P4

Suresh Co. expects its five departments to yield the following income for next year.

Sales

Expenses

Avoidable

Unavoidable

Total expenses Net income (loss)

Dept. N Dept. O Dept. P Dept. T Total

$63,000 $ 35,000

9,800

51,800

61,600

36,400

12,600

49,000

$(14,000)

$56,000

22,400

4,200

26,600

$29,400

$42,000

14,000

29,400

43,400

37,800

9,800

47,600

$(19,600)

Dept. M

$28,000 $224,000

120,400

107,800

228,200

$ (4,200)1,400$ (1,400)$

Recompute and prepare the departmental income statements (including a combined total column) for the company under each of the following separate scenarios: Management (1) eliminates departments with expected net losses and (2) eliminates departments with sales dollars that are less than avoidable expenses.

Chapter 23 Relevant Costing for Managerial Decisions 935

Goshford Company produces a single product and has capacity to produce 100,000 units per month. Costs to produce its current sales of 80,000 units follow. The regular selling price of the product is $100 per unit. Management is approached by a new customer who wants to purchase 20,000 units of the product for $75 per unit. If the order is accepted, there will be no additional fixed manufacturing overhead and no additional fixed selling and administrative expenses. The customer is not in the com- pany’s regular selling territory, so there will be a $5 per unit shipping expense in addition to the regu- lar variable selling and administrative expenses. Determine whether management should accept or reject the new business.

Costs at Per Unit 80,000 Units

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12 .50 $1,000,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 .00 1,200,000

Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . 10 .00 800,000

Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . 17 .50 1,400,000

Variable selling and administrative expenses . . . . . . . . . . . . 14 .00 1,120,000

Fixed selling and administrative expenses . . . . . . . . . . . . . . . 13 .00 1,040,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $82 .00 $6,560,000

Exercise 23-14 Special offer

P7

Farrow Co. expects to sell 150,000 units of its product in the next period with the following results.

Sales (150,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,250,000

Costs and expenses

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385,500

Total costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,660,500

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 589,500

The company has an opportunity to sell 15,000 additional units at $12 per unit. The additional sales would not affect its current expected sales. Direct materials and labor costs per unit would be the same for the additional units as they are for the regular units. However, the additional volume would create the follow- ing incremental costs: (1) total overhead would increase by 15% and (2) administrative expenses would increase by $64,500. Prepare an analysis to determine whether the company should accept or reject the offer to sell additional units at the reduced price of $12 per unit.

Exercise 23-13 Special offer

P7

Check Income increase, $3,000

HH Auto Repair reports the following information for the coming year.

Direct labor rate, including fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $36 per DLH

Annual direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 hours

Annual direct materials (parts) purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

Annual overhead costs:

Materials purchasing, handling, and storage . . . . . . . . . . . . . . . . . . . . . . . . . $360,000

Non-materials related overhead (depreciation, insurance, taxes, rent) . . . . $170,000

Target profit margin (on both labor and materials) . . . . . . . . . . . . . . . . . . . . . . . 32%

Exercise 23-15 Time and materials pricing

A1

1. Compute the rate per hour of direct labor (in $). 2. Compute the materials markup (in %). 3. What price should the company quote for a job requiring four direct labor hours and $580 in parts?

936 Chapter 23 Relevant Costing for Managerial Decisions

PROBLEM SET A

Problem 23-1A Analyzing income effects of additional business

P7

Jones Products manufactures and sells to wholesalers approximately 400,000 packages per year of underwater markers at $6 per package. Annual costs for the production and sale of this quantity are shown in the table.

Direct materials . . . . . . . . . . . . . . . . . . . . $ 576,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 144,000

Overhead . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Selling expenses . . . . . . . . . . . . . . . . . . . 150,000

Administrative expenses . . . . . . . . . . . . 100,000

Total costs and expenses . . . . . . . . . . . . $1,290,000

Check Operating income:

(1) $1,110,000

(2) $126,000

A new wholesaler has offered to buy 50,000 packages for $5.20 each. These markers would be marketed under the wholesaler’s name and would not affect Jones Products’s sales through its normal channels. A study of the costs of this additional business reveals the following:

∙ Direct materials costs are 100% variable. ∙ Per unit direct labor costs for the additional units would be 50% higher than normal because their pro-

duction would require overtime pay at 1½ times the usual labor rate. ∙ Twenty-five percent of normal annual overhead costs are fixed at any production level from 350,000 to

500,000 units. The remaining 75% of annual overhead costs are variable with volume. ∙ Accepting the new business would involve no additional selling expenses. ∙ Accepting the new business would increase administrative expenses by a $5,000 fixed amount.

Required

Prepare a three-column comparative income statement that shows the following: 1. Annual operating income without the special order (column 1). 2. Annual operating income received from the new business only (column 2). 3. Combined annual operating income from normal business and the new business (column 3).

Problem 23-2A Analyzing income effects of additional business

P7

Calla Company produces skateboards that sell for $50 per unit. The company currently has the capacity to produce 90,000 skateboards per year but is selling 80,000 skateboards per year. Annual costs for 80,000 skateboards follow.

Direct materials . . . . . . . . . . . . . . . . . . . . $ 800,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 640,000

Overhead . . . . . . . . . . . . . . . . . . . . . . . . 960,000

Selling expenses . . . . . . . . . . . . . . . . . . . 560,000

Administrative expenses . . . . . . . . . . . . 480,000

Total costs and expenses . . . . . . . . . . . . $3,440,000

A new retail store has offered to buy 10,000 of its skateboards for $45 per unit. The store is in a different market from Calla’s regular customers and would not affect regular sales. A study of its costs in anticipa- tion of this additional business reveals the following:

∙ Direct materials and direct labor are 100% variable. ∙ Thirty percent of overhead is fixed at any production level from 80,000 units to 90,000 units; the

remaining 70% of annual overhead costs are variable with respect to volume. ∙ Selling expenses are 60% variable with respect to number of units sold, and the other 40% of selling

expenses are fixed. ∙ There will be an additional $2 per unit selling expense for this order. ∙ Administrative expenses would increase by a $1,000 fixed amount.

Chapter 23 Relevant Costing for Managerial Decisions 937

Required

1. Prepare a three-column comparative income statement that reports the following: a. Annual income without the special order. b. Annual income from the special order. c. Combined annual income from normal business and the new business. 2. Should Calla accept this order?

Check (1b) Added income from order, $123,000

Problem 23-3A Make or buy

P1

Haver Company currently produces component RX5 for one of its products. The current cost per unit to manufacture the required 50,000 units of RX5 follows.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5 .00

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 .00

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 .00

Total cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22 .00

Check (1) Incremental cost to make RX5, $740,000

Direct materials and direct labor are 100% variable. Overhead is 80% fixed. An outside supplier has offered to supply the 50,000 units of RX5 for $18.00 per unit.

Required

1. Determine the total incremental cost of making 50,000 units of RX5. 2. Determine the total incremental cost of buying 50,000 units of RX5. 3. Should the company make or buy RX5?

Problem 23-4A Sell or process

P2

Harold Manufacturing produces denim clothing. This year, it produced 5,000 denim jackets at a manufac- turing cost of $45 each. These jackets were damaged in the warehouse during storage. Management inves- tigated the matter and identified three alternatives for these jackets. 1. Jackets can be sold as is to a secondhand clothing shop for $6 each. 2. Jackets can be disassembled at a cost of $32,000 and sold to a recycler for $12 each. 3. Jackets can be reworked and turned into good jackets. However, with the damage, management esti-

mates it will be able to assemble the good parts of the 5,000 jackets into only 3,000 jackets. The remaining pieces of fabric will be discarded. The cost of reworking the jackets will be $102,000, but the jackets can then be sold for their regular price of $45 each.

Required

Which alternative should Harold choose? Show analysis for each alternative. Check Incremental income for alternative 2, $28,000

Edgerron Company is able to produce two products, G and B, with the same machine in its factory. The following information is available.

Product G Product B

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . $120 $160

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . 40 90

Contribution margin per unit . . . . . . . . . . . . . . . . . $ 80 $ 70

Machine hours to produce 1 unit . . . . . . . . . . . . . . 0 .4 hour 1 .0 hours

Maximum unit sales per month . . . . . . . . . . . . . . . 600 units 200 units

The company presently operates the machine for a single eight-hour shift for 22 working days each month. Management is thinking about operating the machine for two shifts, which will increase its productivity by another eight hours per day for 22 days per month. This change would require $15,000 additional fixed costs per month.

Problem 23-5A Analyzing sales mix strategies

P3

938 Chapter 23 Relevant Costing for Managerial Decisions

Required

1. Determine the contribution margin per machine hour that each product generates. 2. How many units of Product G and Product B should the company produce if it continues to operate

with only one shift? How much total contribution margin does this mix produce each month? 3. If the company adds another shift, how many units of Product G and Product B should it produce?

How much total incremental income would this mix produce each month? Should the company add the new shift?

4. Suppose the company determines that it can increase Product G’s maximum sales to 700 units per month by spending $12,000 per month in marketing efforts. Should the company pursue this strategy and the double shift? Compute total incremental income.

Check Units of Product G: (2) 440

(3) 600

Departmental Income Statements

For Year Ended December 31, 2019 Dept. 100 Dept. 200 Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $436,000 $290,000 $726,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262,000 207,000 469,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174,000 83,000 257,000

Operating expenses

Direct expenses

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 12,000 29,000

Store supplies used . . . . . . . . . . . . . . . . . . . . . . . 4,000 3,800 7,800

Depreciation—Store equipment . . . . . . . . . . . . . 5,000 3,300 8,300

Total direct expenses . . . . . . . . . . . . . . . . . . . . . . 26,000 19,100 45,100

Allocated expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000 39,000 104,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,440 4,720 14,160

Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . 9,900 8,100 18,000

Office salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,720 12,480 31,200

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . 2,000 1,100 3,100

Miscellaneous office expenses . . . . . . . . . . . . . 2,400 1,600 4,000

Total allocated expenses . . . . . . . . . . . . . . . . . . . 107,460 67,000 174,460

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133,460 86,100 219,560

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,540 $ (3,100) $ 37,440

Elegant Decor Company’s management is trying to decide whether to eliminate Department 200, which has produced losses or low profits for several years. The company’s departmental income statements show the following.

In analyzing whether to eliminate Department 200, management considers the following: a. The company has one office worker who earns $600 per week, or $31,200 per year, and four sales-

clerks who each earns $500 per week, or $26,000 per year for each salesclerk. b. The full salaries of two salesclerks are charged to Department 100. The full salary of one salesclerk is

charged to Department 200. The salary of the fourth clerk, who works half-time in both departments, is divided evenly between the two departments.

c. Eliminating Department 200 would avoid the sales salaries and the office salary currently allocated to it. However, management prefers another plan. Two salesclerks have indicated that they will be quit- ting soon. Management believes that their work can be done by the other two clerks if the one office worker works in sales half-time. Eliminating Department 200 will allow this shift of duties. If this change is implemented, half the office worker’s salary would be reported as sales salaries and half would be reported as office salary.

d. The store building is rented under a long-term lease that cannot be changed. Therefore, Department 100 will use the space and equipment currently used by Department 200.

Problem 23-6A Analyzing possible elimination of a department

P4

Chapter 23 Relevant Costing for Managerial Decisions 939

e. Closing Department 200 will eliminate its expenses for advertising, bad debts, and store supplies; 70% of the insurance expense allocated to it to cover its merchandise inventory; and 25% of the miscella- neous office expenses presently allocated to it.

Required

1. Prepare a three-column report that lists items and amounts for (a) the company’s total expenses (including cost of goods sold)—in column 1, (b) the expenses that would be eliminated by closing Department 200—in column 2, and (c) the expenses that will continue—in column 3.

2. Prepare a forecasted annual income statement for the company reflecting the elimination of Department 200 assuming that it will not affect Department 100’s sales and gross profit. The state- ment should reflect the reassignment of the office worker to one-half time as a salesclerk.

3. Should Department 200 be eliminated?

Check (1) Total expenses: (a) $688,560, (b) $284,070

(2) Forecasted net income without Department 200, $31,510

PROBLEM SET B

Problem 23-1B Analyzing income effects of additional business

P7

Windmire Company manufactures and sells to local wholesalers approximately 300,000 units per month at a sales price of $4 per unit. Monthly costs for the production and sale of this quantity follow.

Direct materials . . . . . . . . . . . . . . . . . . . . $384,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 96,000

Overhead . . . . . . . . . . . . . . . . . . . . . . . . 288,000

Selling expenses . . . . . . . . . . . . . . . . . . . 120,000

Administrative expenses . . . . . . . . . . . . 80,000

Total costs and expenses . . . . . . . . . . . . $968,000

A new out-of-state distributor has offered to buy 50,000 units next month for $3.44 each. These units would be marketed in other states and would not affect Windmire’s sales through its normal channels. A study of the costs of this new business reveals the following:

∙ Direct materials costs are 100% variable. ∙ Per unit direct labor costs for the additional units would be 50% higher than normal because their pro-

duction would require overtime pay at 1½ times their normal rate to meet the distributor’s deadline. ∙ Twenty-five percent of normal annual overhead costs are fixed at any production level from 250,000 to

400,000 units. The remaining 75% of annual overhead costs are variable with volume. ∙ Accepting the new business would involve no additional selling expenses. ∙ Accepting the new business would increase administrative expenses by a $4,000 fixed amount.

Required

Prepare a three-column comparative income statement that shows the following: 1. Monthly operating income without the special order (column 1). 2. Monthly operating income received from the new business only (column 2). 3. Combined monthly operating income from normal business and the new business (column 3).

Check Operating income: (1) $232,000, (2) $44,000

Problem 23-2B Analyzing income effects of additional business

P7

Mervin Company produces circuit boards that sell for $8 per unit. It currently has capacity to produce 600,000 circuit boards per year but is selling 550,000 boards per year. Annual costs for the 550,000 circuit boards follow.

Direct materials . . . . . . . . . . . . . . . . . . . . $ 825,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 1,100,000

Overhead . . . . . . . . . . . . . . . . . . . . . . . . 1,375,000

Selling expenses . . . . . . . . . . . . . . . . . . . 275,000

Administrative expenses . . . . . . . . . . . . 550,000

Total costs and expenses . . . . . . . . . . . . $4,125,000

940 Chapter 23 Relevant Costing for Managerial Decisions

An overseas customer has offered to buy 50,000 circuit boards for $6 per unit. The customer is in a differ- ent market from Mervin’s regular customers and would not affect regular sales. A study of its costs in anticipation of this additional business reveals the following:

∙ Direct materials and direct labor are 100% variable. ∙ Twenty percent of overhead is fixed at any production level from 550,000 units to 600,000 units; the

remaining 80% of annual overhead costs are variable with respect to volume. ∙ Selling expenses are 40% variable with respect to number of units sold, and the other 60% of selling

expenses are fixed. ∙ There will be an additional $0.20 per unit selling expense for this order. ∙ Administrative expenses would increase by a $700 fixed amount.

Required

1. Prepare a three-column comparative income statement that reports the following: a. Annual income without the special order. b. Annual income from the special order. c. Combined annual income from normal business and the new business. 2. Should management accept the order?

Analysis Component

3. What nonfinancial factors should Mervin consider? Explain. 4. Assume that the new customer wants to buy 100,000 units instead of 50,000 units—it will only buy

100,000 units or none and will not take a partial order. Without any computations, how does this change your answer in part 2?

Check (1b) Additional income from order, $4,300

Problem 23-3B Make or buy

P1

Alto Company currently produces component TH1 for one of its products. The current cost per unit to manufacture its required 400,000 units of TH1 follows.

Direct materials and direct labor are 100% variable. Overhead is 75% fixed. An outside supplier has offered to supply the 400,000 units of TH1 for $4 per unit.

Required

1. Determine whether management should make or buy the TH1.

Analysis Component

2. What factors besides cost must management consider when deciding whether to make or buy TH1?

Direct materials . . . . . . . . . . . . . . $1 .20

Direct labor . . . . . . . . . . . . . . . . . 1 .50

Overhead . . . . . . . . . . . . . . . . . . . 6 .00

Total cost per unit . . . . . . . . . . . . $8 .70

Check (1) Incremental cost to make TH1, $1,680,000

Problem 23-4B Sell or process

P2

Micron Manufacturing produces electronic equipment. This year, it produced 7,500 oscilloscopes at a manufacturing cost of $300 each. These oscilloscopes were damaged in the warehouse during storage and, while usable, cannot be sold at their regular selling price of $500 each. Management has investigated the matter and has identified three alternatives for these oscilloscopes. 1. They can be sold as is to a wholesaler for $75 each. 2. They can be disassembled at a cost of $400,000 and the parts sold to a recycler for $130 each. 3. They can be reworked and turned into good units. The cost of reworking the units will be $3,200,000,

after which the units can be sold at their regular price of $500 each.

Required

Which alternative should management pursue? Show analysis for each alternative. Check Incremental income for alternative 2, $575,000

Chapter 23 Relevant Costing for Managerial Decisions 941

Sung Company is able to produce two products, R and T, with the same machine in its factory. The follow- ing information is available.

Product R Product T

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60 $80

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 45

Contribution margin per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40 $35

Machine hours to produce 1 unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .4 hour 1 .0 hours

Maximum unit sales per month . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 units 175 units

The company presently operates the machine for a single eight-hour shift for 22 working days each month. Management is thinking about operating the machine for two shifts, which will increase its productivity by another eight hours per day for 22 days per month. This change would require $3,250 additional fixed costs per month.

Required

1. Determine the contribution margin per machine hour that each product generates. 2. How many units of Product R and Product T should the company produce if it continues to operate

with only one shift? How much total contribution margin does this mix produce each month? 3. If the company adds another shift, how many units of Product R and Product T should it produce?

How much total incremental income would this mix produce each month? Should the company add the new shift?

4. Suppose the company determines that it can increase Product R’s maximum sales to 675 units per month by spending $4,500 per month in marketing efforts. Should the company pursue this strategy and the double shift? Compute incremental income.

Check Units of Product R: (2) 440

(3) 550

Problem 23-5B Analyzing sales mix strategies

P3

Esme Company’s management is trying to decide whether to eliminate Department Z, which has pro- duced low profits or losses for several years. The company’s departmental income statements show the following.

Departmental Income Statements

For Year Ended December 31, 2019 Dept. A Dept. Z Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $700,000 $175,000 $875,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461,300 125,100 586,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238,700 49,900 288,600

Operating expenses

Direct expenses

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000 3,000 30,000

Store supplies used . . . . . . . . . . . . . . . . . . . . . . . 5,600 1,400 7,000

Depreciation—Store equipment . . . . . . . . . . . . 14,000 7,000 21,000

Total direct expenses . . . . . . . . . . . . . . . . . . . . . 46,600 11,400 58,000

Allocated expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,200 23,400 93,600

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,080 5,520 27,600

Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . 21,000 4,000 25,000

Office salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,800 5,200 26,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . 4,200 1,400 5,600

Miscellaneous office expenses . . . . . . . . . . . . . 1,700 2,500 4,200

Total allocated expenses . . . . . . . . . . . . . . . . . . . 139,980 42,020 182,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186,580 53,420 240,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 52,120 $ (3,520) $ 48,600

Problem 23-6B Analyzing possible elimination of a department

P4

942 Chapter 23 Relevant Costing for Managerial Decisions

In analyzing whether to eliminate Department Z, management considers the following items: a. The company has one office worker who earns $500 per week, or $26,000 per year, and four sales-

clerks who each earns $450 per week, or $23,400 per year for each salesclerk. b. The full salaries of three salesclerks are charged to Department A. The full salary of one salesclerk is

charged to Department Z. c. Eliminating Department Z would avoid the sales salaries and the office salary currently allocated to it.

However, management prefers another plan. Two salesclerks have indicated that they will be quitting soon. Management believes that their work can be done by the two remaining clerks if the one office worker works in sales half-time. Eliminating Department Z will allow this shift of duties. If this change is implemented, half the office worker’s salary would be reported as sales salaries and half would be reported as office salary.

d. The store building is rented under a long-term lease that cannot be changed. Therefore, Department A will use the space and equipment currently used by Department Z.

e. Closing Department Z will eliminate its expenses for advertising, bad debts, and store supplies; 65% of the insurance expense allocated to it to cover its merchandise inventory; and 30% of the miscella- neous office expenses presently allocated to it.

Required

1. Prepare a three-column report that lists items and amounts for (a) the company’s total expenses (including cost of goods sold)—in column 1, (b) the expenses that would be eliminated by closing Department Z—in column 2, and (c) the expenses that will continue—in column 3.

2. Prepare a forecasted annual income statement for the company reflecting the elimination of Department Z assuming that it will not affect Department A’s sales and gross profit. The statement should reflect the reassignment of the office worker to one-half time as a salesclerk.

Analysis Component

3. Reconcile the company’s combined net income with the forecasted net income assuming that Department Z is eliminated (list both items and amounts). Analyze the reconciliation and explain why you think the department should or should not be eliminated.

Check (1) Total expenses: (a) $826,400, (b) $181,960

(2) Forecasted net income without Department Z, $55,560

SERIAL PROBLEM Business Solutions

P3

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 23 Santana Rey has found that Business Solutions’s line of computer desks and chairs has become popular, and she is finding it hard to keep up with demand. She knows that she cannot fill all of her orders for both items, so she decides she must determine the optimal sales mix given the resources she has avail- able. Information about the desks and chairs follows.

©Alexander Image/Shutterstock Santana has determined that she only has 1,015 direct labor hours available for the next quarter and wants to optimize her contribution margin given the limited number of direct labor hours available.

Required

Determine the optimal sales mix and the contribution margin the business will earn at that sales mix.

Desks Chairs

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . $1,125 $375

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . 500 200

Contribution margin per unit . . . . . . . . . . . . . . . . . . $ 625 $175

Direct labor hours per unit . . . . . . . . . . . . . . . . . . . 5 hours 4 hours

Expected demand for next quarter . . . . . . . . . . . . . 175 desks 50 chairs

Chapter 23 Relevant Costing for Managerial Decisions 943

ETHICS CHALLENGE P7

BTN 23-1 Bert Asiago, a salesperson for Convertco, received an order from a potential new customer for 50,000 units of Convertco’s single product at a price $25 below its regular selling price of $65. Asiago knows that Convertco has the capacity to produce this order without affecting regular sales. He has spoken to Convertco’s controller, Bia Morgan, who has informed Asiago that at the $40 selling price, Convertco will not be covering its variable costs of $42 for the product, and she recommends the order not be accepted. Asiago knows that variable costs include his sales commission of $4 per unit. If he accepts a $2 per unit commission, the sale will produce a contribution margin of zero. Asiago is eager to get the new customer because he believes that this could lead to the new customer becoming a regular customer.

Required

1. Determine the contribution margin per unit on the order as determined by the controller. 2. Determine the contribution margin per unit on the order as determined by Asiago if he takes the lower

commission. 3. Do you recommend Convertco accept the special order? What factors must management consider?

Beyond the Numbers

COMPANY ANALYSIS P6

Accounting Analysis

AA 23-1 Assume Apple is designing a new smartphone. Each unit of this new phone is expected to require $230 of direct materials, $10 of direct labor, $20 of variable overhead, and $20 of variable selling and administrative costs.

Required

1. If Apple uses the variable cost method to set selling prices and plans a markup of 200% of variable costs, what is the expected selling price per unit of this new phone?

2. Assume that Apple is a “price-taker” and the market sales price for this type of phone is $800 per unit. Compute Apple’s target cost if the company desires a profit of 60% of sales price.

APPLE

AA 23-2 Apple and Google sell a variety of products. Some products are more profitable than others. Teams of employees in each company make advertising, investment, and product mix decisions. Assume a typical ad costs $800,000 and that the average product for both Apple and Google sells for $400 per unit and generates a contribution margin of 20%.

Required

1. Estimate how many additional products this ad must sell to justify its cost. 2. If instead Google targets its advertising toward products with contribution margins of 25% or higher,

and all other information is unchanged, estimate how many additional products this ad must sell to justify its cost.

COMPARATIVE ANALYSIS P6

APPLE GOOGLE

AA 23-3 Assume Samsung is designing a new smartphone. Each unit of this new phone is expected to require $285 of direct materials, $10 of direct labor, $30 of variable overhead, $5 of variable selling and administrative costs, and $20 of fixed selling and administrative costs.

Required

1. If Samsung uses the variable cost method to set selling prices and plans a markup of 250% of variable costs, what is the expected selling price per unit of this new phone?

2. If instead Samsung uses the total cost method to set selling prices and plans a markup of 220% of total costs, what is the expected selling price per unit of this new phone?

GLOBAL ANALYSIS P6

Samsung

944 Chapter 23 Relevant Costing for Managerial Decisions

BTN 23-4 Break into teams and identify costs that an airline such as Delta Air Lines would incur on a flight from Green Bay to Minneapolis. (1) Identify the individual costs as variable or fixed. (2) Assume that Delta is trying to decide whether to drop this flight because it seems to be unprofit- able. Determine which costs are likely to be saved if the flight is dropped. Set up your answer in the following format.

TEAMWORK IN ACTION C1

BTN 23-2 Assume that you work for Greeble’s Sporting Goods, and your manager requests that you out- line the pros and cons of discontinuing its Golf department. That department appears to be generating losses, and your manager believes that discontinuing it will increase overall store profits.

Required

Prepare a memorandum to your manager outlining what management should consider when trying to de- cide whether to discontinue its Golf department.

COMMUNICATING IN PRACTICE C1

BTN 23-3 Many companies must determine whether to internally produce their component parts or to outsource them. Further, some companies now outsource key components or business processes to inter- national providers. Access the website SourcingMag.com and review the available information on busi- ness process outsourcing (search for “What is Business Process Outsourcing?”).

Required

1. According to this website, what is business process outsourcing? 2. What types of processes are commonly outsourced, according to this website?

TAKING IT TO THE NET P1

BTN 23-5 Suppose Gaurab Chakrabarti and Sean Hunt’s company, Solugen, makes peroxide-based cleaners in different strengths. The founders must decide on the best sales mix. Assume the company has a capacity of 400 hours of processing time available each month and it makes two types of cleaners, Deluxe and Premium. Information on these products follows.

ENTREPRENEURIAL DECISION P3

Deluxe Premium

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . $70 $90

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . $40 $50

Processing time per unit . . . . . . . . . . . . . . . . . . . . 1 hour 2 hours

Variable or Fixed Cost Saved If Flight Is Dropped RationaleCost

Chapter 23 Relevant Costing for Managerial Decisions 945

Required

1. Assume the markets for both types of cleaners are unlimited. How many Deluxe cleaners and how many Premium cleaners should the company make each month? Explain. How much total contribution margin does this mix produce each month?

2. Assume the market for the Deluxe model is limited to 60 per month, with no market limit for the Premium model. How many Deluxe cleaners and how many Premium cleaners should the company make each month? Explain. How much total contribution margin does this mix produce each month?

BTN 23-6 Restaurants often add and remove menu items. Visit a restaurant and identify a new food item. Make a list of costs that the restaurant must consider when deciding whether to add that new item. Also, make a list of nonfinancial factors that the restaurant must consider when adding that item.

HITTING THE ROAD C1

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Learning Objectives

ANALYTICAL A1 Analyze a capital investment project

using break-even time.

PROCEDURAL P1 Compute payback period and describe

its use.

P4 Compute internal rate of return and explain its use.

P2 Compute accounting rate of return and explain its use.

P3 Compute net present value and describe its use.

Chapter Preview

24 Capital Budgeting and Investment Analysis

NON–PRESENT VALUE METHODS

P1 Payback period Even cash flows

Uneven cash flows

P2 Accounting rate of return

NTK 24-1, 24-2

PRESENT VALUE METHODS

P3 Net present value NPV complications

P4 Internal rate of return Comparison of methods

Postaudit

A1 Break-even time

NTK 24-3, 24-4

CAPITAL BUDGETING

Capital budgeting process

Capital investment cash flows

947

“How may I help you?”—Robot

Hi, Robot!

BURLINGAME, CA—Many companies use robots in their opera- tions. Manufacturers have robots perform repetitive tasks that can cause injuries if done by human workers. This allows humans to focus on more value-added work. Fellow Robots (fellowrobots.com) extends this concept to retailers. The com- pany manufactures robots that perform inventory tasks for retailers—locating inventory, notifying management of out of stocks, checking prices, and ensuring products are in the proper locations on the shelves.

As CEO Marco Mascorro notes, these “social” robots can also guide customers to products in the store and recommend items based on what the customer is shopping for. “These robots don’t just do things for us,” says Marco, “they do things with us.” The company’s robots use artificial intelligence (AI) to “continually learn from [their] interactions with humans,” says Marco, and retail employees use data analytics techniques to better manage the customer experience.

Businesses considering robots must consider whether the future benefits—increased revenues, lower costs, and increased

customer satisfaction—outweigh the costs of purchasing robots and training workers. The methods shown in this chapter, such as payback period, net present value analysis, and internal rates of return, can be used to make good investment decisions.

Sources: Fellow Robots website, January 2019; CNBC.com, March 26, 2015; CNBC. com, August 30, 2016; Robophil.com, April 25, 2016

©Fellow Robots

EXHIBIT 24.1 Capital Budgeting Process

NPV & IRR

2007 2005 2003 2001

12%

10%

8%

6%

4%

2%

0%

–2%

Return on Assets: Circ uit City Best Buy

NPV & IRR

200700 20052005 202003 2001

12%

10%

8%

6%

4%

2%

0%

–2%

ReReturn on Assetets: Circ uit CitytyCirc Best Buyuy

2009

�������� ��������� ������� �� ������ ������������� � ���������

The process begins when department or plant managers submit proposals for new investments in property, plant, and equipment. A capital budget committee, usually consisting of members with accounting and finance expertise, evaluates the proposals and forms recommendations for approval or rejection. Finally, the board of directors approves the capital expenditures for the year.

Capital budgeting decisions require careful analysis because they are usually the most difficult and risky decisions that managers make. These decisions are difficult because they require predict- ing events that will not occur until well into the future. A capital budgeting decision is risky because The outcome is uncertain. Large amounts of money are usually involved. The investment involves a long-term commitment. The decision could be difficult or impossible to reverse, no matter how poor it turns out to be.

Risk is especially high for investments in technology due to innovations and uncertainty.

Capital budgeting is the process of analyzing alternative long-term investments and deciding which assets to acquire or sell. Common examples of capital budgeting decisions include buy- ing a machine or a building or acquiring an entire company. An objective for these decisions is to earn a satisfactory return on investment.

Capital Budgeting Process Exhibit 24.1 summarizes the capital budgeting process.

CAPITAL BUDGETING

948 Chapter 24 Capital Budgeting and Investment Analysis

Capital Investment Cash Flows Managers use several methods to evaluate capital budgeting decisions. Nearly all of these meth- ods involve predicting future cash inflows and cash outflows of proposed investments, assessing the risk of and returns on those cash flows, and then choosing which investments to make. Exhibit 24.2 summarizes cash outflows (−) and cash inflows (+) over the life of a typical capital expenditure for a depreciable asset.

Acquisition Use Disposal

(−) Initial investment (+) Revenues (−) Operating costs (−) Repairs and maintenance

(+) Disposal proceeds

FOR SAL

E

EXHIBIT 24.2 Capital Investment Cash Flows

The investment begins with an initial cash outflow to acquire the asset. Over the asset’s life it generates cash inflows from revenues. The asset also creates cash outflows for operating costs, repairs, and maintenance. Finally, the asset is disposed of, and its salvage value can provide another cash inflow.

Management often restates future cash flows in terms of their present value. This approach applies the time value of money: A dollar today is worth more than a dollar tomorrow. Simi- larly, a dollar tomorrow is worth less than a dollar today. Restating future cash flows in terms of their present value is called discounting. The time value of money is important when evaluating capital investments, but managers sometimes use methods that ignore it.

All investments, whether they involve the purchase of a machine or another long-term asset, are expected to produce net cash flows. Net cash flow is cash inflows minus cash outflows. Some- times managers perform simple analyses of the financial feasibility of an investment’s net cash flow without using the time value of money. This section explains two common methods in this category: (1) payback period and (2) accounting rate of return.

Payback Period An investment’s payback period (PBP) is the expected amount of time to recover the initial investment amount. Managers prefer investing in assets with shorter payback periods to reduce the risk of an unprofitable investment over the long run. Acquiring assets with short payback periods reduces a company’s risk from potentially inaccurate long-term predictions of future cash flows.

Payback Period with Even Cash Flows To illustrate payback period for an in- vestment with even cash flows, we look at data from FasTrac, a manufacturer of exercise equip- ment and supplies. (Even cash flows are cash flows that are the same amount each year; uneven cash flows are cash flows that are not all equal in amount.) FasTrac is considering several differ- ent capital investments, one of which is to purchase a machine to use in manufacturing a new product. The machine has the following features.

METHODS NOT USING TIME VALUE OF MONEY

M et

ho ds

N OT

Usi ng Time Value of Money

$

P1 Compute payback period and describe its use.

Cost of machine . . . . . . . . . . . . . . . . . . . . . . . . $16,000

Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 years

Salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . $0

Expected sales per year . . . . . . . . . . . . . 1,000 units

Product selling price per unit . . . . . . . . . $30

Chapter 24 Capital Budgeting and Investment Analysis 949

EXHIBIT 24.3 Cash Flow Analysis

Expected Expected Cash Flow Analysis—Machinery Investment Net Income Net Cash Flow

Annual sales of new product (1,000 × $30) . . . . . . . . . . . . . . . . $30,000 $30,000 Less annual expenses

Materials, labor, and overhead (except depreciation) . . . . . . 15,500 15,500

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Additional selling and administrative expenses . . . . . . . . . . . 9,500 9,500

Annual pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Less income taxes (30% of pretax income) . . . . . . . . . . . . . . . . . 900 900

Annual net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,100 Annual net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,100

Exhibit 24.3 shows the expected annual net income and expected annual net cash flow for this asset over its expected useful life.

The amount of net cash flow from the machinery is computed by subtracting expected cash outflows from expected cash inflows. The Expected Net Cash Flow column of Exhibit 24.3 excludes all noncash revenues and expenses. Because depreciation does not impact cash flows, it is excluded. Alternatively, managers can adjust the projected net income for revenue and expense items that do not affect cash flows. For FasTrac, this means taking the $2,100 net income and adding back the $2,000 depreciation, to yield $4,100 of net cash flow.

The formula for computing the payback period of an investment that produces even net cash flows is in Exhibit 24.4.

Point: The payback method uses cash flows, not net income.

EXHIBIT 24.4 Payback Period Formula with Even Cash Flows

Payback period = Cost of investment

Annual net cash flow

The payback period reflects the amount of time for the investment to generate enough net cash flow to return (or pay back) the cash initially invested to purchase it. FasTrac’s payback period for this machine is just under four years.

Payback period = $16,000 $4,100

= 3.9 years (rounded)

The initial investment is fully recovered in 3.9 years, or just before reaching the halfway point of this machine’s useful life of eight years.

Companies prefer short payback periods to increase return and reduce risk. The more quickly a company receives cash, the sooner it is available for other uses and the less time it is at risk of loss. A shorter payback period also improves the company’s ability to respond to unanticipated changes and lowers its risk of having to keep an unprofitable investment.

Point: Excel for payback.

A B

1 Investment $16,000

2 Cash flow $4,100

3 Payback period

=B1∕B2 = 3.9

e-Payback Health care providers use electronic systems to improve their operations. With e-charting, doctors’ orders and notes are saved electronically. Such systems allow for more personalized care plans, more efficient staffing, and re- duced costs. Investments in such systems are evaluated on the basis of payback periods and other financial measures. ■

Decision Insight

Payback Period with Uneven Cash Flows What happens if the net cash flows are uneven? In this case, the payback period is computed using the cumulative total of net cash flows. The word cumulative refers to the addition of each period’s net cash flows as we progress through time. To illustrate, consider data for another investment that FasTrac is considering. This machine is predicted to generate uneven net cash flows over the next eight years. The rel- evant data and payback period computation are shown in Exhibit 24.5.

©JGI/Tom Grill/Blend Images LLC

950 Chapter 24 Capital Budgeting and Investment Analysis

Year 0 refers to the date of initial investment at which the $16,000 cash outflow occurs to acquire the machinery. By the end of Year 1, the cumulative net cash flow is $(13,000), com- puted as the $(16,000) initial cash outflow plus Year 1’s $3,000 cash inflow. This process con- tinues throughout the asset’s life. The cumulative net cash flow amount changes from negative to positive in Year 5. Specifically, at the end of Year 4, the cumulative net cash flow is $(1,000). As soon as FasTrac receives net cash inflow of $1,000 during the fifth year, it has fully recov- ered the $16,000 initial investment. If we assume that cash flows are received uniformly within each year, receipt of the $1,000 occurs about one-fifth (0.20) of the way through the fifth year. This is computed as $1,000 divided by Year 5’s total net cash flow of $5,000, or 0.20. This yields a payback period of 4.2 years, computed as 4 years plus 0.20 of Year 5.

Evaluating Payback Period Payback period has two strengths. It uses cash flows, not income. It is easy to use.

Payback period has three main weaknesses. It does not reflect differences in the timing of net cash flows within the payback period. It ignores all cash flows after the point where an investment’s costs are fully recovered. It ignores the time value of money.

To illustrate, if FasTrac had another investment with predicted cash inflows of $9,000, $3,000, $2,000, $1,800, and $1,000 in its first 5 years, its payback period would also be 4.2 years. However, this alternative is more desirable because it returns cash more quickly. In addition, an investment with a 3-year payback period that stops producing cash after 4 years is likely not as good as an alter- native with a 5-year payback period that generates net cash flows for 15 years. Because of these limitations, payback period should never be the only consideration in capital budgeting decisions.

Point: 4.2 years is 4 years + (0.20 × 12 months) = 4 years + 2.4 months.

EXHIBIT 24.5 Payback Period Calculation with Uneven Cash Flows

Period* Expected Net Cash Flows Cumulative Net Cash Flows

Year 0 . . . . . . . . . . . . . . . . . . . . . . $(16,000) $(16,000) Year 1 . . . . . . . . . . . . . . . . . . . . . . 3,000 (13,000) Year 2 . . . . . . . . . . . . . . . . . . . . . . 4,000 (9,000) Year 3 . . . . . . . . . . . . . . . . . . . . . . 4,000 (5,000) Year 4 . . . . . . . . . . . . . . . . . . . . . . 4,000 (1,000) Year 5 . . . . . . . . . . . . . . . . . . . . . . 5,000 4,000 Year 6 . . . . . . . . . . . . . . . . . . . . . . 3,000 7,000 Year 7 . . . . . . . . . . . . . . . . . . . . . . 2,000 9,000 Year 8 . . . . . . . . . . . . . . . . . . . . . . 2,000 11,000 Payback period = 4 years + $1,000∕$5,000 of Year 5 = 4.2 years

*All cash inflows and outflows occur uniformly within each year 1 through 8.

Payback occurs between Years 4 and 5 .

Example: Find the payback period in Exhibit 24.5 if net cash flows for the first 4 years are: Year 1 = $6,000; Year 2 = $5,000; Year 3 = $4,000; Year 4 = $3,000. Answer: 3.33 years

A company is considering purchasing equipment costing $75,000. Future annual net cash flows from this equipment are $30,000, $25,000, $15,000, $10,000, and $5,000. Cash flows occur uniformly within each year. What is this investment’s payback period?

Solution

Payback Period

NEED-TO-KNOW 24-1

P1

Period Expected Net Cash Flows Cumulative Net Cash Flows

Year 0 . . . . . . . . . . . $(75,000) $(75,000) Year 1 . . . . . . . . . . . 30,000 (45,000) Year 2 . . . . . . . . . . . 25,000 (20,000) Year 3 . . . . . . . . . . . 15,000 (5,000) Year 4 . . . . . . . . . . . 10,000 5,000 Year 5 . . . . . . . . . . . 5,000 10,000 Payback period = 3.5 years, computed as 3 + $5,000∕$10,000

Payback occurs between Years 3 and 4 .

Do More: QS 24-1, QS 24-5, E 24-1, E 24-3, E 24-5

Chapter 24 Capital Budgeting and Investment Analysis 951

Accounting Rate of Return The accounting rate of return (ARR) is the percentage accounting return on annual average investment. It is called an “accounting” return because it is based on net income, rather than on cash flows. It is computed by dividing a project’s after-tax net income by the average amount invested in it. To illustrate, we return to FasTrac’s $16,000 machinery investment described in Exhibit 24.3. We first compute (1) the after-tax net income and (2) the average amount invested. The $2,100 after-tax net income is from Exhibit 24.3.

If a company uses straight-line depreciation, we find the average amount invested by using the formula in Exhibit 24.6. Because FasTrac uses straight-line depreciation, its average amount invested for the eight years equals the sum of the book value at the beginning of the asset’s investment period ($16,000) and the book value at the end of its investment period ($0), divided by 2, as shown in Exhibit 24.6.

P2 Compute accounting rate of return and explain its use.

Point: Amount invested includes all costs that must be incurred to get the asset in its location and ready for use.

If an investment has a salvage value, the average amount invested when using straight-line depreciation is computed as (Beginning book value + Salvage value)∕2.

If a company uses a depreciation method other than straight-line, for example, MACRS for tax purposes, the calculation of average book value is more complicated. In this case, the book value of the asset is computed for each year of its life. The general formula for the annual aver- age investment is shown in Exhibit 24.7.

Once we determine the annual after-tax net income and the annual average amount invested, FasTrac’s accounting rate of return is computed as shown in Exhibit 24.8.

Accounting rate of return = Annual after-tax net income Annual average investment

= $2,100 $8,000

= 26.25%

EXHIBIT 24.8 Accounting Rate of Return Formula

FasTrac management must decide whether a 26.25% accounting rate of return is satisfactory. To make this decision, we must consider the investment’s risk. We cannot say an investment with a 26.25% return is preferred over one with a lower return unless we consider any differ- ences in risk. When comparing investments with similar lives and risk, a company will prefer the investment with the higher accounting rate of return.

Evaluating Accounting Rate of Return The accounting rate of return has three weaknesses. It ignores the time value of money. It focuses on income, not cash flows. If income (and thus the accounting rate of return) varies from year to year, the project might

appear desirable in some years and not in others.

Because of these limitations, the accounting rate of return should never be the only consider- ation in capital budgeting decisions.

Point: Excel for ARR.

A B

1 Beg. book value $16,000

2 End. book value $0

3 Net income $2,100

4 Acctg rate of return

=B3∕((B1+B2)∕2) = 26.25%

Annual average investment = Sum of individual years’ average book values Number of years of the planned investment

EXHIBIT 24.7 General Formula for Average Amount Invested(general case)

Annual average investment = Beginning book value + Ending book value

2

= $16,000 + $0

2 = $8,000

EXHIBIT 24.6 Computing Average Amount Invested under Straight-Line Depreciation

(straight-line case only)

952 Chapter 24 Capital Budgeting and Investment Analysis

The following data relate to a company’s decision on whether to purchase a machine. The company uses straight-line depreciation. What is the machine’s accounting rate of return?

Do More: QS 24-6, QS 24-7, E 24-7, E 24-8

P2

Accounting Rate of Return

NEED-TO-KNOW 24-2

Solution

Annual average investment = ($180,000 + $15,000)∕2 = $97,500 Accounting rate of return = $40,000∕$97,500 = 41% (rounded)

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $180,000 Salvage value . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Annual after-tax net income . . . . . . . . . . . . . 40,000

This section describes two capital budgeting methods that use the time value of money: (1) net present value and (2) internal rate of return. These methods require an understand- ing of the concept of present value—see Appendix B. This chapter’s assignments that use time value of money can be solved using tables in Appendix B, Excel, or a financial calculator.

Net Present Value Net present value analysis applies the time value of money to future cash inflows and cash outflows so management can evaluate a project’s benefits and costs at one point in time. Specifically, net present value (NPV) is computed by discounting the future net cash flows from the investment at the project’s required rate of return and then subtract-

ing the initial amount invested. A company’s required rate of return, often called its hurdle rate, is typically its cost of capital, which is an average of the rate the company must pay to its lenders and investors.

To illustrate, let’s return to FasTrac’s proposed machinery purchase described in Exhibit 24.3. Does this machine provide a satisfactory return while recovering the amount invested? Recall that the machine requires a $16,000 investment and is expected to provide $4,100 annual net cash inflows for the next eight years. If we assume that net cash inflows from this machine are received at each year-end and that FasTrac requires a 12% annual return, net present value can be computed as in Exhibit 24.9. (The initial investment occurs at the beginning of Year 0.)

METHODS USING TIME VALUE OF MONEY

Point: The assumption of end-of- year cash flows simplifies compu- tations and is common in practice.

Methods Using Time Value of Money

$

P3 Compute net present value and describe its use.

Present Value Present Value of Net Cash Flows* of 1 at 12%† Net Cash Flows

Year 1 . . . . . . . . . . . . . . . . . . . . . . $ 4,100 0 .8929 $ 3,661

Year 2 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .7972 3,269

Year 3 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .7118 2,918

Year 4 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .6355 2,606

Year 5 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .5674 2,326

Year 6 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .5066 2,077

Year 7 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .4523 1,854

Year 8 . . . . . . . . . . . . . . . . . . . . . . 4,100 0 .4039 1,656

Totals . . . . . . . . . . . . . . . . . . . . . . . $32,800 20,367 Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16,000) Net present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,367

*Net cash flows occur at the end of each year. †Present value of 1 factors are taken from Table B.1 in Appendix B.

EXHIBIT 24.9 Net Present Value Calculation with Equal Cash Flows

Example: What is the net present value in Exhibit 24.9 if a 10% re- turn is applied? Answer: $5,873

Discounted future net cash flows − Initial investment = Net present value

Chapter 24 Capital Budgeting and Investment Analysis 953

The first number column of Exhibit 24.9 shows annual net cash flows. Present value of 1 fac- tors, also called discount factors, are shown in the second column. Taken from Table B.1 in Appendix B, they assume that net cash flows are received at each year-end. (To simplify present value computations and for assignment material at the end of this chapter, we assume that net cash flows are received at year-end.) Annual net cash flows from Exhibit 24.9 are multiplied by the discount factors to give present values of annual net cash flows in the far-right column. These annual amounts are summed to yield total present value of net cash flows of $20,367.

The last three lines of Exhibit 24.9 show the NPV computations. The asset’s $16,000 initial cost is deducted from the $20,367 total present value of all future net cash flows to give this asset’s NPV of $4,367. This means the present value of this machine’s future net cash flows exceeds the initial $16,000 investment by $4,367. FasTrac should invest in this machine. Rule: If NPV > 0, invest.

Net Present Value Decision Rule The decision rule in applying NPV is as follows: When an asset’s expected future cash flows yield a positive net present value when discounted at the required rate of return, the asset should be acquired. This decision rule is reflected in the graphic below. When comparing several investment opportunities of similar cost and risk, we prefer the one with the highest positive net present value.

Invest

Do not invest

Present value of net cash flows

($)

Amount invested

($)

If NPV > $0

If NPV < $0

Net present value

($)

Simplifying Computations—Calculator or Excel Another way to simplify present value calculations, whether net cash flows are equal in amount or not, is to use a calcula- tor with compound interest functions or a spreadsheet program. Whatever procedure you use, it is important to understand the concepts behind these computations.

Cash Savings from Automation NPV analysis also can be used to decide whether to automate a production process. Increased automation from the use of robotics and computer numerical control (CNC) machines can yield cash savings from reduced direct labor costs. For example, an eyewear manufacturer is considering investing in an $8 million automated

Cost of Capital by Industry

% Cost of Capital

Electronics

2%0% 4% 6% 8% 10%

Food (retail)

Beverages

Cable TV

Source: Damodaran, Aswath, “Damodaran Online,” http://pages. stern.nyu.edu/~adamodar/

Point: Cost of capital computation is covered in advanced courses.

Simplifying Computations—Annuity The computations in Exhibit 24.9 use sepa- rate present value of 1 factors for each of the eight years. Each year’s net cash flow is multiplied by its present value of 1 factor to determine its present value; these are then added to give the asset’s total present value. This computation can be simplified if annual net cash flows are equal in amount. A series of cash flows of equal dollar amount is called an annuity. In this case we use Table B.3, which gives the present value of 1 to be received for a number of periods. To deter- mine the present value of these eight annual receipts discounted at 12%, go down the 12% col- umn of Table B.3 to the factor on the eighth line. This cumulative discount factor, also known as an annuity factor, is 4.9676. We then compute the $20,367 present value for these eight annual $4,100 receipts, computed as 4.9676 × $4,100. These calculations are summarized below.

Example: Why does the net present value of an investment increase when a lower discount rate is used? Answer: The present value of net cash flows increases.

With a financial calculator: N 8 I/Y 12 PMT 4100 CPT PV Multiply answer ($−20,367) by −1 since the company is receiving cash, and subtract initial investment ($16,000) to yield NPV of $4,367.

Initial investment

$(16,000)

$ 20,367 $4,100 x 4.9676

$(1 6,0

00 )

$4, 100 $4,

100 $4,

100 $4,

100 $4,

100 $4,

100 $4,

100 $4,

100

$ 4,367 NPV

$0

Net cash inflow, Years 1–8

Disposal

Point: Excel for NPV.

A B

1 Investment $16,000

2 Cash flow $4,100

3 Periods 8

4 Interest rate 12%

5 Net present value

=PV(B4,B3,−B2)−B1 = $4,367

954 Chapter 24 Capital Budgeting and Investment Analysis

manufacturing system. If the investment is made, the company can reduce its direct labor costs by $1.5 million in each year of the 10-year useful life of the system. All other costs and revenues are expected to be unchanged. The NPV analysis, using a 10% discount rate and assuming the system has no salvage value, follows. The NPV is positive. The present value of the cash savings from reduced direct labor costs exceeds the cost of the automated manufacturing system. The company should automate its production process.

Present Value of Present Value of Net Cash Savings an Annuity at 10% Net Cash Flows

Years 1–10 . . . . . . . . . . . . . . . . . . . . . $1,500,000 6 .1446 $ 9,216,900

Initial investment . . . . . . . . . . . . . . . (8,000,000) Net present value . . . . . . . . . . . . . . . $ 1,216,900

Systems Manager Management adopts a policy requiring purchases above $5,000 to be submitted with cash flow projections for capital budget approval. As systems manager, you want to upgrade your computers at a $25,000 cost. You consider submitting several orders each under $5,000 to avoid the approval process. You believe the computers will increase profits and wish to avoid a delay. What do you do? ■ Answer: Your dilemma is whether to abide by rules designed to prevent abuse or to bend them to acquire an investment that you believe will benefit the firm. You should not pursue the latter action because breaking up the order into small components is dishonest and there are consequences. Develop a proposal for the entire package and then do all you can to expedite its processing, particularly by pointing out its benefits.

Decision Ethics

Net Present Value Complications The following factors can complicate NPV analysis. We discuss each of them. Unequal cash flows Inflation Salvage value Comparing positive NPV projects Accelerated depreciation Capital rationing

Uneven Cash Flows Net present value analysis can also be used when net cash flows are uneven (unequal). To illustrate, assume that FasTrac can choose only one capital investment from among Projects A, B, and C. Each project requires the same $12,000 initial investment. Future net cash flows for each project are shown in the first three number columns of Exhibit 24.10.

EXHIBIT 24.10 Net Present Value Calculation with Uneven Cash Flows

Present

Present Value of Net Cash Flows

Value of Net Cash Flows

A B C 1 at 10% A B C

Year 1 . . . . . . . . . . . . . . . . . . $ 5,000 $ 8,000 $ 1,000 0 .9091 $ 4,546 $ 7,273 $ 909

Year 2 . . . . . . . . . . . . . . . . . . 5,000 5,000 5,000 0 .8264 4,132 4,132 4,132

Year 3 . . . . . . . . . . . . . . . . . . 5,000 2,000 9,000 0 .7513 3,757 1,503 6,762

Totals . . . . . . . . . . . . . . . . . . . $15,000 $15,000 $15,000 12,435 12,908 11,803

Initial investment . . . . . . . . (12,000) (12,000) (12,000) Net present value . . . . . . . . $ 435 $ 908 $ (197)

The three projects in Exhibit 24.10 have the same expected total net cash flows of $15,000. Project A is expected to produce equal amounts of $5,000 each year. Project B is expected to produce a larger amount in the first year. Project C is expected to produce a larger amount in the third year. The fourth column of Exhibit 24.10 shows the present value of 1 factors from Table B.1 assuming a 10% required return.

Computations in the three rightmost columns show that Project A has a $435 positive NPV. Project B has the largest NPV of $908 because it brings in cash more quickly. Project C has a $(197) negative NPV because its larger cash inflows are delayed. Projects with higher cash flows in earlier years generally yield higher net present values. If FasTrac requires a 10% return,

Example: If 12% is the required return in Exhibit 24.10, which project is preferred? Answer: Project B. Net present values are: A = $10; B = $553; C = $(715).

Example: Will the rankings of Projects A, B, and C change with the use of different discount rates, assuming the same rate is used for all projects? Answer: No; only the NPV amounts will change.

Chapter 24 Capital Budgeting and Investment Analysis 955

it should reject Project C because its NPV implies a return under 10%. If only one project can be accepted, Project B appears best because it yields the highest NPV.

Salvage Value FasTrac predicted the $16,000 machine to have zero salvage value at the end of its useful life. In many cases, assets are expected to have nonzero salvage values. If so, this amount is an additional net cash inflow expected to be received at the end of the final year of the asset’s life. All other computations remain the same. For example, the net present value of the $16,000 investment that yields $4,100 of net cash flows for eight years is $4,367, as shown in Exhibit 24.9. If that machine is expected to have a $1,500 salvage value at the end of its eight- year life, the present value of this salvage amount is $606 (computed as $1,500 × 0.4039). The net present value of the machine, including the present value of its expected salvage amount, is $4,973 (computed as $4,367 + $606).

Accelerated Depreciation Depreciation methods can affect net present value analysis. Accelerated depreciation is commonly used for income tax purposes. Accelerated depreciation produces larger depreciation deductions in the early years of an asset’s life and smaller deduc- tions in later years. This pattern results in smaller income tax payments in early years and larger tax payments in later years. Using accelerated depreciation for tax reporting increases the NPV of an asset’s cash flows because it produces larger net cash inflows in the early years of the as- set’s life. Using accelerated depreciation for tax reporting always makes an investment more desirable because early cash flows are more valuable than later ones.

Inflation Large price-level increases should be considered in NPV analyses. Discount rates should already include inflation forecasts. Net cash flows can be adjusted for inflation by using future value computations. For example, if the expected net cash inflow in Year 1 is $4,100 and 5% inflation is expected, then the expected net cash inflow in Year 2 is $4,305, computed as $4,100 × 1.05 (1.05 is the future value of $1 [Table B.2] for 1 period with a 5% rate).

Comparing Positive NPV Projects When considering several projects of similar invest- ment amounts and risk levels, we can compare the different projects’ NPVs and rank them on the dollar amounts of their NPVs. However, if the amount invested differs substantially across projects, this is of limited value for comparison purposes. One way to compare projects, espe- cially when a company cannot fund all positive net present value projects, is to use the profit- ability index, which is computed as

Point: Excel for PV of salvage value.

A B

1 Salvage value $1,500

2 Useful life 8

3 Interest rate 12%

4 Present value

=PV(B3,B2,0,−B1) = $606

Point: Salvage values and the use of accelerated depreciation increase the NPV.

Point: Tax savings from deprecia- tion is called depreciation tax shield.

Example: When is it appropriate to use different discount rates for different projects? Answer: When risk levels are different.

Profitability index = Present value of net cash flows

Initial investment

Exhibit 24.11 illustrates computation of the profitability index for three potential research and development (R&D) investments. A profitability index less than 1 indicates an investment with a negative net present value. Investment 3 shows an index of 0.9, meaning a negative NPV. This means we can drop Investment 3 from consideration. Both Investments 1 and 2 have profit- ability indexes greater than 1; thus, they have positive net present values. Investment 1’s NPV equals $150,000 (computed as $900,000 − $750,000); Investment 2’s NPV equals $125,000 (computed as $375,000 − $250,000). Ideally, the company would accept all positive NPV proj- ects, but if forced to choose, it should select the project with the higher profitability index. Thus, Investment 2 is ranked ahead of Investment 1 based on its higher profitability index. Investment 2 returns $1.50 NPV per dollar invested, whereas Investment 1 returns only $1.20 NPV per dollar invested. Rule: Invest in the project with the highest profitability index.

R&D Investment

1 2 3

Present value of net cash flows (a) . . . . . . . . . . . . $900,000 $375,000 $270,000

Amount invested (b) . . . . . . . . . . . . . . . . . . . . . . . . 750,000 250,000 300,000

Profitability index (a)∕(b) . . . . . . . . . . . . . . . . . . . 1.2 1.5 0.9

EXHIBIT 24.11 Profitability Index

956 Chapter 24 Capital Budgeting and Investment Analysis

Capital Rationing Some firms face capital rationing, or financing constraints that limit them from accepting all positive NPV projects. This can be in two forms, hard rationing and soft rationing. Hard rationing is imposed by external forces, such as debt covenants that restrict the firm’s

ability to borrow more money. Soft rationing is internally imposed by management and the board of directors. For example,

management might place spending limits on certain employees or departments until they show they can make good decisions.

Whether due to hard or soft capital rationing, the profitability index can be used to select the best of several competing projects.

Internal Rate of Return Another way to evaluate capital investments is to use the internal rate of return (IRR), which equals the discount rate that yields an NPV of zero for an investment. If we compute the total present value of a project’s net cash flows using the IRR as the discount rate, and then subtract the initial investment from this total present value, we will get a zero NPV.

We use the data for FasTrac’s Project A from Exhibit 24.10 to compute its IRR. Below is the two-step process for computing IRR with even cash flows.

Step 1: Compute the present value factor for the investment project.

Present value factor = Amount invested

Annual net cash flows =

$12,000 $5,000

= 2.4000

Step 2: Identify the discount rate (IRR) yielding the present value factor. Search Table B.3 for a present value factor of 2.4000 in the 3-year row (equaling the 3-year project duration). The 12% discount rate yields a present value factor of 2.4018. This implies that the IRR is approximately 12%.

P4 Compute internal rate of return and explain its use.

Project A Net Cash Flows

Investment . . . . . . . $(12,000) Annuity, Yrs 1-3 . . . 5,000 Hurdle rate = 10%

A company is considering two potential projects. Each project requires a $20,000 initial investment and is expected to generate end-of-year annual cash flows as shown below. Assuming a discount rate of 10%, compute the net present value of each project.

P3 Net Present Value

NEED-TO-KNOW 24-3

Net Cash Inflows

Year 1 Year 2 Year 3 Total

Project A . . . . . . . . . . . . . . $12,000 $8,500 $ 4,000 $24,500

Project B . . . . . . . . . . . . . 4,500 8,500 13,000 26,000

Solution

Net present values are computed as follows.

Project A Project B

Present Present Present Value of 1 Net Value of Net Net Value of Net

Year at 10% Cash Flows Cash Flows Cash Flows Cash Flows

1 0 .9091 $12,000 $ 10,909 $ 4,500 $ 4,091

2 0 .8264 8,500 7,024 8,500 7,024

3 0 .7513 4,000 3,005 13,000 9,767

Totals $24,500 $ 20,938 $26,000 $ 20,882

Initial investment (20,000) (20,000) Net present value $ 938 $ 882

Do More: QS 24-2, QS 24-8, QS 24-9, QS 24-11, E 24-2,

E 24-6, E 24-9

Point: Excel for IRR.

A B

1 Investment −$12,000

2 Cash flow Year 1 5,000

3 Cash flow Year 2 5,000

4 Cash flow Year 3 5,000

5 Internal rate of return

=IRR(B1:B4) = 12.04%

Chapter 24 Capital Budgeting and Investment Analysis 957

When cash flows are equal, as with Project A, we compute the present value factor by divid- ing the initial investment by its annual net cash flows. We then use an annuity table to determine the discount rate equal to this present value factor. For FasTrac’s Project A, we look across the 3-period row of Table B.3 and find that the discount rate corresponding to the present value fac- tor of 2.4000 roughly equals the 2.4018 value for the 12% rate. This row of Table B.3 is repro- duced here.

The 12% rate is the project’s IRR. Because this project’s IRR is greater than the hurdle rate of 10%, it should be accepted. Rule: If IRR > hurdle rate, invest.

Uneven Cash Flows If net cash flows are uneven, it is best to use either a calculator or spreadsheet software to compute IRR. We show the use of Excel in this chapter’s appendix.

Use of Internal Rate of Return To use the IRR to evaluate a project, compare it to a predetermined hurdle rate, which is a minimum acceptable rate of return. The decision rule us- ing IRR is applied as follows.

Invest

Do not invest

Internal rate of return

(%)

Hurdle rate (%)

If > 0%

If < 0%

If the IRR is higher than the hurdle rate, the investment should be made. If the IRR is less than the hurdle rate, do not invest.

Comparing Projects Using IRR Multiple projects are often ranked by the extent to which their IRR exceeds the hurdle rate. IRR can be used to compare projects with different amounts invested because the IRR is expressed as a percent rather than as a dollar value in NPV.

Example: How can management evaluate the risk of an invest- ment? Answer: It must assess the uncertainty of future cash flows.

Discount Rate

Periods 1% 5% 10% 12% 15%

3 . . . . . . . . . . . . . 2 .9410 2 .7232 2 .4869 2.4018 2 .2832

Present Value of an Annuity of 1 for Three Periods

With a financial calculator: CF CFO 12000 +/−

CO1 5000

F01 3

IRR CPT This yields IRR of 12.04%.

Manager Pay and IRR A survey reported that 41% of top managers would reject a project with an internal rate of return above the cost of capital if the project would cause the firm to miss its earnings forecast. The roles of benchmarks and manager compensation plans must be considered in capital budgeting decisions. ■

Decision Insight

Entrepreneur You are developing a new product and you use a 12% discount rate to compute its NPV. Your banker, from whom you hope to obtain a loan, expresses concern that your discount rate is too low. How do you respond? ■ Answer: The banker is probably concerned because new products are risky and therefore should be evaluated using a higher rate of return. You should conduct a thorough technical analysis and obtain detailed market data and information about any similar products. These factors might support the use of a lower return. You must convince yourself that the risk level is consistent with the discount rate used. You should also be confident that your company has the capacity and the resources to handle the new product.

Decision Maker

Point: Advanced courses consider factors other than investment size that can be important in comparing projects.

958 Chapter 24 Capital Budgeting and Investment Analysis

A machine costing $58,880 is expected to generate net cash flows of $8,000 for each of the next 10 years. 1. Compute the machine’s internal rate of return (IRR). 2. If a company’s hurdle rate is 6.5%, use IRR to determine whether the company should purchase this machine.

Solution

1. PV factor = Amount invested/Net cash flows = $58,880∕$8,000 = 7.36. Scanning the “Periods equal 10” row in Table B.3 for a present value factor near 7.36 indicates the IRR is 6%.

2. The machine should not be purchased because its IRR (6%) is less than the company’s hurdle rate (6.5%). Do More: QS 24-3, QS 24-13,

E 24-14

P4 Internal Rate of Return

NEED-TO-KNOW 24-4

Comparison of Capital Budgeting Methods We explained four methods that managers use to evaluate capital investment projects. How do these methods compare with each other? Exhibit 24.12 addresses that question. Neither the payback period nor the accounting rate of return considers the time value of money. Both the net present value and the internal rate of return do.

Accounting Rate Net Present Internal Rate Payback Period of Return Value of Return

Measurement basis • Cash flows • Accrual income • Cash flows • Cash flows Measurement unit • Years • Percent • Dollars • Percent Strengths • Easy to understand • Easy to understand • Reflects time value • Reflects time value • Allows comparison • Allows comparison of money of money

of projects of projects • Reflects varying risks • Allows comparisons over project’s life of dissimilar projects

Limitations • Ignores time • Ignores time value • Difficult to compare • Ignores varying risks value of money of money dissimilar projects over life of project

• Ignores cash flows • Ignores annual rates after payback period over life of project

EXHIBIT 24.12 Comparing Capital Budgeting Methods

Payback period is probably the simplest method. It gives managers an estimate of how soon they will recover their initial investment. Managers sometimes use this method when they have limited cash to invest and a number of projects to choose from.

Accounting rate of return yields a percent measure computed using accrual income in- stead of cash flows. The accounting rate of return is an average rate for the entire invest- ment period.

Net present value considers all estimated net cash flows for the project’s expected life. It can be applied to even and uneven cash flows and can reflect changes in the level of risk over a project’s life. Because NPV yields a dollar measure, comparing projects of unequal sizes is more difficult. The profitability index, based on each project’s net present value, can be used in this case.

Internal rate of return considers all cash flows from a project. It is readily computed when the cash flows are even but requires some trial and error or use of a financial calculator or com- puter when cash flows are uneven. Because the IRR is a percent measure, it is readily used to compare projects with different investment amounts. However, IRR does not reflect changes in risk over a project’s life.

Postaudit Companies should evaluate the outcomes of capital budgeting decisions. A postaudit is an evaluation of a project’s actual results versus its projected results. The same method used to sup- port the capital budgeting decision should be used in the postaudit. For example, if an NPV analysis was used to make an investment decision, NPV analysis should be used to evaluate that

Chapter 24 Capital Budgeting and Investment Analysis 959

investment decision. Instead of forecasted cash flows, the postaudit uses actual cash flows (for periods that have passed) and revised future cash flows. Benefits of a postaudit include Managers will likely be more careful in the investment proposals they submit. Poor investments can be identified earlier and management can change its investments.

For example, FasTrac’s machinery purchase in Exhibit 24.9 was expected to generate future cash flows of $4,100 per year for eight years and an NPV of $4,367. Assume the machinery only generates $3,000 of actual net cash flows in both Years 1 and 2, and FasTrac expects net cash flows of $3,000 per year for the next six years. The present value of this investment is now only $14,902.80 (computed as $3,000 × 4.9676), and the machinery’s NPV is now −$1,097.20 (computed as $14,902.80 − $16,000). Based on this postaudit, FasTrac might sell the machin- ery and invest in a different project.

And the Winner Is . . . How do we choose among the methods for evaluating capital investments? Management surveys consistently show internal rate of return (IRR) as the most popular method, followed by payback period and net present value (NPV). Few companies use accounting rate of return (ARR), but nearly all use more than one method. ■

Decision Insight

Company Usage of Capital Budgeting Methods 40%20% 30%10%0%

ARR

NPV

Payback

IRR

Other

Predicting the future benefits of solar panel installations in terms of reduced energy costs, however, is challenging for several reasons. First, the amount of solar energy that can be produced depends on geo- graphic location, with locations nearer the equator typically better. Second, south-facing roofs are better able to capture solar energy than other orientations. Third, cost savings from solar energy require predic- tions of the future costs of other sources of power, which can be volatile. These factors must be considered when performing a net present value calculation on a potential investment in solar power.

Fellow Robots, this chapter’s feature company, makes “social” robots that handle simple inventory- related tasks, allowing retail employees to focus on the activities that add value to customers. This not only increases profits, but also increases employee satisfaction, which can increase morale and decrease turnover.

Net present value calculations extend to investments in sustainable energy sources like solar power. To illustrate, consider a potential investment of $11,000 in a solar panel system in Phoenix. The system is expected to last for 30 years and require $100 of maintenance costs per year. The typical home uses 14,000 kilowatt hours (kWh) of electricity per year, at a cost of $0.12 per kilowatt hour. According to the National Renewable Energy Laboratory (pvwatts.nrel.gov), a typical solar panel system in Phoenix could supply 8,642 kilowatt hours (kWh) of electricity per year. The net present value of a potential investment in a solar panel system, using a 6% discount rate, is computed in Exhibit 24.13. The NPV is $1,898, indicating the investment should be accepted.

SUSTAINABILITY AND ACCOUNTING

EXHIBIT 24.13 NPV of Solar Investment

Electricity cost savings (8,642 kWh × $0 .12) . . . . . . . . . . . . . . . $ 1,037 Annual maintenance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100)

Net annual cash inflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 937

Present value of net cash inflows ($937 × 13 .7648*) . . . . . . . . $12,898 Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,000)

Net present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,898

*From Table B.3: 30 periods, 6%

©Fellow Robots

Point: 4.9676 is the present value of ordinary annuity factor for 8 periods at 12%.

960 Chapter 24 Capital Budgeting and Investment Analysis

White Company can invest in one of two projects, TD1 or TD2. Each project requires an initial investment of $101,250 and produces the year-end cash inflows shown in the following table.

COMPREHENSIVE

Evaluating Investments

NEED-TO-KNOW 24-5

Net Cash Flows

TD1 TD2

Year 1 . . . . . . . . . . $ 20,000 $ 40,000 Year 2 . . . . . . . . . . 30,000 40,000 Year 3 . . . . . . . . . . 70,000 40,000 Totals . . . . . . . . . . . $120,000 $120,000

Break-Even TimeDecision Analysis

The first section of this chapter explained several methods to evaluate capital investments. Break-even time of an investment project is a variation of the payback period method that overcomes the limitation of not using the time value of money. Break-even time (BET) is a time-based measure used to evaluate a capital investment’s acceptability. Its computation yields a measure of expected time, reflecting the time period until the present value of the net cash flows from an investment equals the initial cost of the invest- ment. In basic terms, break-even time is computed by restating future cash flows in terms of present val- ues and then determining the payback period using these present values. To illustrate, we return to the FasTrac case involving a $16,000 investment in machinery. The annual net cash flows from this investment are projected at $4,100 for eight years. Exhibit 24.14 shows the com- putation of break-even time for this investment decision.

A1 Analyze a capital investment project using break-even time.

Present Value Present Value Cumulative Present Year Cash Flows of 1 at 10% of Cash Flows Value of Cash Flows

0 . . . . . . . . . . . . $(16,000) 1 .0000 $(16,000) $(16,000)

1 . . . . . . . . . . . . 4,100 0 .9091 3,727 (12,273)

2 . . . . . . . . . . . . 4,100 0 .8264 3,388 (8,885)

3 . . . . . . . . . . . . 4,100 0 .7513 3,080 (5,805)

4 . . . . . . . . . . . . 4,100 0 .6830 2,800 (3,005)

5 . . . . . . . . . . . . 4,100 0 .6209 2,546 (459) 6 . . . . . . . . . . . . 4,100 0 .5645 2,314 1,855 7 . . . . . . . . . . . . 4,100 0 .5132 2,104 3,959

8 . . . . . . . . . . . . 4,100 0 .4665 1,913 5,872

*The time of analysis is the start of Year 1 (same as end of Year 0). All cash flows occur at the end of each year.

EXHIBIT 24.14 Break-Even Time Analysis*

Break-even time

The rightmost column of this exhibit shows that break-even time is between 5 and 6 years, or about 5.2 years—also see margin graph (where the line crosses the zero point). This is the time the project takes to break even after considering the time value of money (recall that the payback period computed without

considering the time value of money was 3.9 years). We interpret this as cash flows earned after 5.2 years contribute to a positive net present value that, in this case, eventually amounts to $5,872.

Break-even time is a useful measure for managers because it identifies the point in time when they can expect the cash flows to begin to yield net positive returns. Managers expect a positive net present value from an investment if break-even time is less than the investment’s estimated life. The method allows managers to compare and rank alternative investments, giv- ing the project with the shortest break-even time the highest rank.

0 1 2 3 4 5 76 8 –$16,000

–$12,000

–$8,000

–$4,000

$0

$4,000

$8,000

Cumulative Present Value of Cash Flows

Investment Manager Management asks you, the investment manager, to evaluate three alternative investments. Investment recovery time is crucial because cash is scarce. The time value of money is also important. Which capital budgeting method(s) do you use to assess the investments? ■ Answer: You should use break-even time because both the time value of money and recovery time are important. The break-even time method is superior because it accounts for the time value of money, which is an important consideration in this decision.

Decision Maker

Chapter 24 Capital Budgeting and Investment Analysis 961

Required

1. Compute the payback period for both projects. Which project has the shortest payback period? 2. Assume that the company requires a 10% return from its investments. Compute the net present value of

each project. 3. Drawing on your answers to parts 1 and 2, determine which project, if any, should be chosen. 4. Compute the internal rate of return for Project TD2. Based on its internal rate of return, should Project

TD2 be chosen?

PLANNING THE SOLUTION Compute the payback period for the series of unequal cash flows (Project TD1) and for the series of

equal cash flows (Project TD2). Compute White Company’s net present value of each investment using a 10% discount rate. Use the payback and net present value rules to determine which project, if any, should be selected. Compute the internal rate of return for the series of equal cash flows (Project TD2) and determine

whether that internal rate of return is greater than the company’s 10% discount rate.

SOLUTION 1. The payback period for a project with a series of equal cash flows is computed as follows.

Payback period = Cost of investment

Annual net cash flow

For Project TD2, the payback period equals 2.53 (rounded), computed as $101,250/$40,000. This means that the company expects to recover its investment in Project TD2 after approximately two and one-half years of its three-year life.

Next, determining the payback period for a series of unequal cash flows (as in Project TD1) requires us to compute the cumulative net cash flows from the project at the end of each year. Assuming the cash outflow for Project TD1 occurs at the end of Year 0 and cash inflows occur continuously over Years 1, 2, and 3, the payback period calculation follows.

The cumulative net cash flow for Project TD1 changes from negative to positive in Year 3. As cash flows are received continuously, the point at which the company has recovered its investment into Year 3 is 0.73 (rounded), computed as $51,250/$70,000. This means that the payback period for TD1 is 2.73 years, computed as 2 years plus 0.73 of Year 3.

Present Value Present Value of Net Cash Flows of 1 at 10% Net Cash Flows

Year 1 . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 0 .9091 $ 18,182 Year 2 . . . . . . . . . . . . . . . . . . . . . . . 30,000 0 .8264 24,792 Year 3 . . . . . . . . . . . . . . . . . . . . . . . 70,000 0 .7513 52,591 Totals . . . . . . . . . . . . . . . . . . . . . . . . $120,000 95,565 Amount invested . . . . . . . . . . . . . . . (101,250) Net present value . . . . . . . . . . . . . $ (5,685)

2. TD1:

Expected Net Cumulative Net Period Cash Flows Cash Flows

0 . . . . . . . . . $(101,250) $(101,250) 1 . . . . . . . . . 20,000 (81,250) 2 . . . . . . . . . 30,000 (51,250) 3 . . . . . . . . . 70,000 18,750

TD1:

TD2: Present Value Present Value of Net Cash Flows of 1 at 10% Net Cash Flows

Year 1 . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 0 .9091 $ 36,364 Year 2 . . . . . . . . . . . . . . . . . . . . . . . 40,000 0 .8264 33,056 Year 3 . . . . . . . . . . . . . . . . . . . . . . . 40,000 0 .7513 30,052 Totals . . . . . . . . . . . . . . . . . . . . . . . . $120,000 99,472 Amount invested . . . . . . . . . . . . . . . (101,250) Net present value . . . . . . . . . . . . . $ (1,778)

962 Chapter 24 Capital Budgeting and Investment Analysis

3. White Company should not invest in either project. Both are expected to yield a negative net present value, and it should invest only in positive net present value projects. Although the company expects to recover its investment from both projects before the end of these projects’ useful lives, the projects are not acceptable after considering the time value of money.

4. To compute Project TD2’s internal rate of return, we first compute a present value factor as follows.

Present value factor = Amount invested

Net cash flow = $101,250∕$40,000 = 2.5313 (rounded)

Then, we search Table B.3 for the discount rate that corresponds to the present value factor of 2.5313 for three periods. From Table B.3, this discount rate is 9%. Project TD2’s internal rate of return of 9% is below this company’s hurdle rate of 10%. Thus, Project TD2 should not be chosen.

APPENDIX

Using Excel to Compute Net Present Value and Internal Rate of Return24A

Computing present values and internal rates of return for projects with uneven cash flows is tedious and error prone. These calculations can be performed simply and accurately by using functions built into Excel. Many calculators and other types of spreadsheet software can perform them too. To illustrate, con- sider FasTrac, a company that is considering investing in a new machine with the expected cash flows shown in the following spreadsheet. Cash outflows are entered as negative numbers, and cash inflows are entered as positive numbers. Assume FasTrac requires a 12% annual return, entered as 0.12 in cell C1.

A B C 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Annual discount rate Initial investment, made at beginning of period 1 Annual cash flows received at end of period:

1 2 3 4 5 6 7 8

0.12 –16000

3000 4000 4000 4000 5000 3000 2000 2000

=NPV(C1,C4:C11)+C2

=IRR(C2:C11)

To compute the net present value of this project, the following is entered into cell C13:

=NPV(C1,C4:C11)+C2

This instructs Excel to use its NPV function to compute the present value of the cash flows in cells C4 through C11, using the discount rate in cell C1, and then add the amount of the (negative) initial invest- ment. For this stream of cash flows and a discount rate of 12%, the net present value is $1,326.03. To compute the internal rate of return for this project, the following is entered into cell C15:

=IRR(C2:C11)

This instructs Excel to use its IRR function to compute the internal rate of return of the cash flows in cells C2 through C11. By default, Excel starts with a guess of 10%, and then uses trial and error to find the IRR. The IRR equals 14.47% for this project.

Chapter 24 Capital Budgeting and Investment Analysis 963

NON–PRESENT VALUE METHODS Payback period: Expected time to recover initial investment. With even cash flows:

With uneven cash flows: Determine when cumulative cash flows change from negative to positive.

Summary: Cheat Sheet

Payback period = Cost of investment

Annual net cash flow

Excel for payback.

A B

1 Investment $16,000

2 Cash flow $4,100

3 Payback period

=B1∕B2 = 3.9

Accounting rate of return: Percentage accounting return on annual aver- age investment.

PRESENT VALUE METHODS Annuity: Series of cash flows of equal dollar amounts. Net present value (NPV): Discounted future cash flows − Initial amount invested. Cost of capital (hurdle rate): Required rate of return on a potential investment. Net present value decision rule:

Annual average investment = Beginning book value + Ending book value

2(straight-line case only)

Accounting rate of return = Annual after-tax net income Annual average investment

Excel for ARR.

A B

1 Beg. book value $16,000

2 End. book value $0

3 Net income $2,100

4 Acctg rate of return

=B3∕((B1+B2)∕2) = 26.25%

Invest

Do not invest

Present value of net cash flows

($)

Amount invested

($)

If NPV > $0

If NPV < $0

Net present value

($)

Internal rate of return (IRR): Discount rate that yields NPV of zero for an investment.

Break-even time: Payback period using discounted cash flows.

Excel for NPV.

A B

1 Investment $16,000

2 Cash flow $4,100

3 Periods 8

4 Interest rate 12%

5 Net present value

=PV(B4,B3,−B2)−B1 = $4,367

Profitability index = Present value of net cash flows

Initial investment

Internal rate of return decision rule:

Invest

Do not invest

Internal rate of return

(%)

Hurdle rate (%)

If > 0%

If < 0%

Excel for IRR.

A B

1 Investment −$12,000

2 Cash flow Year 1 5,000

3 Cash flow Year 2 5,000

4 Cash flow Year 3 5,000

5 Internal rate of return

=IRR(B1:B4) = 12.04%

Accounting rate of return (ARR) (951) Annuity (953) Break-even time (BET) (960) Capital budgeting (947)

Capital rationing (956) Cost of capital (952) Hurdle rate (952) Internal rate of return (IRR) (956)

Net present value (NPV) (952) Payback period (PBP) (948) Postaudit (958) Profitability index (955)

Key Terms

964 Chapter 24 Capital Budgeting and Investment Analysis

A Superscript letter A denotes assignments based on Appendix 24A.

Icon denotes assignments that involve decision making.

1. Capital budgeting decisions require careful analysis be- cause they are generally the most and decisions that management faces.

2. What is capital budgeting? 3. Identify four reasons that capital budgeting decisions

are risky. 4. Identify two disadvantages of using the payback period for

comparing investments. 5. Why is an investment more attractive to management if

it has a shorter payback period? 6. What is the average amount invested in a machine during its

predicted five-year life if it costs $200,000 and has a $20,000 salvage value? Assume that net income is received evenly throughout each year and straight-line depreciation is used.

7. If the present value of the expected net cash flows from a machine, discounted at 10%, exceeds the amount to be in- vested, what can you say about the investment’s expected rate of return? What can you say about the expected rate of return if the present value of the net cash flows, discounted at 10%, is less than the investment amount?

8. Why is the present value of $100 that you expect to receive one year from today worth less than $100 received today? What is the present value of $100 that you expect to receive one year from today, discounted at 12%?

9. If a potential investment’s internal rate of return is above the company’s hurdle rate, should the investment be made?

Discussion Questions

Multiple Choice Quiz

1. The minimum acceptable rate of return for an investment decision is called the a. Hurdle rate of return. d. Average rate of return. b. Payback rate of return. e. Break-even rate of return. c. Internal rate of return.

2. A company is considering the purchase of new equipment costing $90,000. The projected after-tax annual net income from the equipment is $3,600, after deducting $30,000 depre- ciation. Assume that revenue is to be received at each year- end, and the machine has a useful life of three years with zero salvage value. Management requires a 12% return on its in- vestments. What is the net present value of this machine? a. $60,444 c. $(88,560) e. $(9,300) b. $80,700 d. $90,000

3. A disadvantage of using the payback period to compare in- vestment alternatives is that it a. Ignores cash flows beyond the payback period. b. Cannot be used to compare alternatives with different

initial investments.

c. Cannot be used when cash flows are not uniform. d. Involves the time value of money. e. Cannot be used if a company records depreciation.

4. A company is considering the purchase of equipment for $270,000. Projected annual cash inflow from this equip- ment is $61,200 per year. The payback period is a. 0.2 years. c. 4.4 years. e. 3.9 years. b. 5.0 years. d. 2.3 years.

5. A company buys a machine for $180,000 that has an ex- pected life of nine years and no salvage value. The company expects an annual net income (after taxes of 30%) of $8,550. What is the accounting rate of return? a. 4.75% c. 2.85% e. 6.65% b. 42.75% d. 9.50%

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a 2. e;

3. a 4. c; Payback = $270,000∕$61,200 per year = 4.4 years 5. d; Accounting rate of return = $8,550∕[($180,000 + $0)∕2] = 9.5% Present Value Present

of an Annuity Value of Net Cash Flow of 1 at 12% Cash Flows

Years 1–3 . . . . . . . . . . $3,600 + $30,000 2 .4018 $ 80,700 Amount invested . . . . . (90,000)

Net present value . . . . . $ (9,300)

Chapter 24 Capital Budgeting and Investment Analysis 965

10. Google managers must select deprecia- tion methods. Why does the use of the ac- celerated depreciation method (instead of straight-line) for income tax reporting increase an investment’s value?

11. Samsung management is planning to in- vest in a new companywide computerized inventory tracking system. What makes this potential in- vestment risky?

12. Google management is planning to acquire new equipment to manufacture tablet

computers. What are some of the costs and benefits that would be included in Google’s analysis?

13. Apple is considering expanding a store. Identify three methods management can use to evaluate whether to expand.

14. What is a postaudit? What are its potential benefits? 15. Discuss the advantages of break-even time over the payback

period. List two conditions under which payback period and break-even time are similar.

GOOGLE

GOOGLE

Samsung

APPLE

QUICK STUDY QS 24-1 Payback period P1

Park Co. is considering an investment that requires immediate payment of $27,000 and provides expected cash inflows of $9,000 annually for four years. What is the investment’s payback period?

QS 24-2 Net present value P3

Park Co. is considering an investment that requires immediate payment of $27,000 and provides expected cash inflows of $9,000 annually for four years. If Park Co. requires a 10% return on its investments, what is the net present value of this investment? (Round your calculations to the nearest dollar.)

Park Co. is considering an investment that requires immediate payment of $27,000 and provides expected cash inflows of $9,000 annually for four years. Assume Park Co. requires a 10% return on its investments. Based on its internal rate of return, should Park Co. make the investment?

QS 24-3 Internal rate of return P4

Howard Co. is considering two alternative investments. The payback period is 3.5 years for Investment A and 4 years for Investment B. 1. If management relies on the payback period, which investment is preferred? 2. Will an investment with a shorter payback period always be chosen over an investment with a longer

payback period?

QS 24-4 Analyzing payback periods

P1

Project A requires a $280,000 initial investment for new machinery with a five-year life and a salvage value of $30,000. The company uses straight-line depreciation. Project A is expected to yield annual net income of $20,000 per year for the next five years. Compute Project A’s payback period.

QS 24-5 Payback period P1

Peng Company is considering an investment expected to generate an average net income after taxes of $1,950 for three years. The investment costs $45,000 and has an estimated $6,000 salvage value. Compute the accounting rate of return for this investment; assume the company uses straight-line depreciation. Express your answer as a percentage, rounded to two decimal places.

QS 24-7 Compute accounting rate of return P2

Project A requires a $280,000 initial investment for new machinery with a five-year life and a salvage value of $30,000. The company uses straight-line depreciation. Project A is expected to yield annual net income of $20,000 per year for the next five years. Compute Project A’s accounting rate of return. Express your answer as a percentage, rounded to two decimal places.

QS 24-6 Accounting rate of return

P2

Peng Company is considering an investment expected to generate an average net income after taxes of $1,950 for three years. The investment costs $45,000 and has an estimated $6,000 salvage value. Assume Peng requires a 15% return on its investments. Compute the net present value of this investment. (Round each present value calculation to the nearest dollar.)

QS 24-8 Net present value

P3

If Quail Company invests $50,000 today, it can expect to receive $10,000 at the end of each year for the next seven years, plus an extra $6,000 at the end of the seventh year. What is the net present value of this investment assuming a required 10% return on investments? (Round present value calculations to the near- est dollar.)

QS 24-9 Compute net present value

P3

966 Chapter 24 Capital Budgeting and Investment Analysis

Yokam Company is considering two alternative projects. Project 1 requires an initial investment of $400,000 and has a present value of cash flows of $1,100,000. Project 2 requires an initial investment of $4 million and has a present value of cash flows of $6 million. Compute the profitability index for each project. Based on the profitability index, which project should the company prefer? Explain.

QS 24-10 Profitability index

P3

QS 24-11 Net present value

P3

Following is information on an investment considered by Hudson Co. The investment has zero salvage value. The company requires a 12% return from its investments. Compute this investment’s net present value.

Investment A1

Initial investment . . . . . . . . . . . . . . . . . . . . . . . . $(200,000)

Expected net cash flows: Year 1 . . . . . . . . . . . . 100,000

Year 2 . . . . . . . . . . . . 90,000

Year 3 . . . . . . . . . . . . 75,000

QS 24-12 Net present value, with salvage value P3

Refer to the information in QS 24-11 and instead assume the investment has a salvage value of $20,000. Compute the investment’s net present value.

QS 24-13 Internal rate of return P4

A company is considering investing in a new machine that requires a cash payment of $47,947 today. The machine will generate annual cash flows of $21,000 for the next three years. What is the internal rate of return if the company buys this machine?

QS 24-14 Net present value

P3

A company is considering investing in a new machine that requires a cash payment of $47,947 today. The machine will generate annual cash flows of $21,000 for the next three years. Assume the company uses an 8% discount rate. Compute the net present value of this investment. (Round your answer to the nearest dollar.)

A company is investing in a solar panel system to reduce its electricity costs. The system requires a cash payment of $125,374.60 today. The system is expected to generate net cash flows of $13,000 per year for the next 35 years. The investment has zero salvage value. The company requires an 8% return on its invest- ments. Compute the net present value of this investment.

QS 24-15 Net present value

P3

A company is investing in a solar panel system to reduce its electricity costs. The system requires a cash pay- ment of $125,374.60 today. The system is expected to generate net cash flows of $13,000 per year for the next 35 years. The investment has zero salvage value. Compute the internal rate of return on this investment.

QS 24-16 Internal rate of return

P4

Heels, a shoe manufacturer, is evaluating the costs and benefits of new equipment that would custom fit each pair of athletic shoes. The customer would have his or her foot scanned by digital computer equip- ment; this information would be used to cut the raw materials to provide the customer a perfect fit. The new equipment costs $90,000 and is expected to generate an additional $35,000 in cash flows for five years. A bank will make a $90,000 loan to the company at a 10% interest rate for this equipment’s pur- chase. Use the following table to determine the break-even time for this equipment. (Round the present value of cash flows to the nearest dollar.)

QS 24-17 Compute break-even time

A1

Present Value Present Value Cumulative Present Value Year Cash Flows* of 1 at 10% of Cash Flows of Cash Flows

0 $(90,000) 1 .0000

1 35,000 0 .9091

2 35,000 0 .8264

3 35,000 0 .7513

4 35,000 0 .6830

5 35,000 0 .6209

*All cash flows occur at year-end.

Chapter 24 Capital Budgeting and Investment Analysis 967

Siemens AG invests €80 million to build a manufacturing plant to build wind turbines. The company predicts net cash flows of €16 million per year for the next eight years. Assume the company requires an 8% rate of return from its investments. 1. What is the payback period of this investment? 2. What is the net present value of this investment?

QS 24-18 Capital budgeting methods

P1 P3

EXERCISES

Exercise 24-1 Payback period computation; uneven cash flows P1

Beyer Company is considering the purchase of an asset for $180,000. It is expected to produce the follow- ing net cash flows. The cash flows occur evenly within each year. Compute the payback period for this investment (round years to two decimals).

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Net cash flows . . . . . . . . . . . $60,000 $40,000 $70,000 $125,000 $35,000 $330,000

Refer to the information in Exercise 24-1 and assume that Beyer requires a 10% return on its investments. Compute the net present value of this investment. (Round to the nearest dollar.) Should Beyer accept the investment?

Exercise 24-2 Net present value P3

A machine can be purchased for $150,000 and used for five years, yielding the following net incomes. In projecting net incomes, straight-line depreciation is applied using a five-year life and zero salvage value. Compute the machine’s payback period (ignore taxes). (Round the payback period to three decimals.)

Year 1 Year 2 Year 3 Year 4 Year 5

Net income . . . . . . . . . . . . $10,000 $25,000 $50,000 $37,500 $100,000

Exercise 24-3 Payback period computation; straight-line depreciation

P1

Refer to the information in Exercise 24-3 and assume instead that double-declining depreciation is applied. Compute the machine’s payback period (ignore taxes). (Round the payback period to three decimals.)

Exercise 24-4 Payback period; accelerated depreciation P1

Exercise 24-5 Payback period computation; even cash flows

P1

Compute the payback period for each of these two separate investments (round the payback period to two decimals). a. A new operating system for an existing machine is expected to cost $520,000 and have a useful life of

six years. The system yields an incremental after-tax income of $150,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000.

b. A machine costs $380,000, has a $20,000 salvage value, is expected to last eight years, and will gener- ate an after-tax income of $60,000 per year after straight-line depreciation.

Exercise 24-6 Net present value P3

Refer to the information in Exercise 24-5. Assume the company requires a 10% rate of return on its invest- ments. Compute the net present value of each potential investment. (Round to the nearest dollar.)

Exercise 24-7 Accounting rate of return

P2

A machine costs $700,000 and is expected to yield an after-tax net income of $52,000 each year. Management predicts this machine has a 10-year service life and a $100,000 salvage value, and it uses straight-line depreciation. Compute this machine’s accounting rate of return.

968 Chapter 24 Capital Budgeting and Investment Analysis

Exercise 24-9 Computing net present value P3

After evaluating the risk of the investment described in Exercise 24-8, B2B Co. concludes that it must earn at least an 8% return on this investment. Compute the net present value of this investment. (Round the net present value to the nearest dollar.)

Exercise 24-8 Payback period and accounting rate of return on investment

P1 P2

B2B Co. is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $360,000 with a 12-year life and no salvage value. It will be depreciated on a straight-line basis. The company expects to sell 144,000 units of the equipment’s product each year. The expected annual income related to this equipment follows. Compute the (1) payback period and (2) accounting rate of return for this equipment.

Check (1) 5.39 years, (2) 20.42%

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $225,000

Costs

Materials, labor, and overhead (except depreciation on new equipment) . . . . . . . . . . . . . . . 120,000

Depreciation on new equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500

Total costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,500

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,500

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,750

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,750

Exercise 24-10 NPV and profitability index

P3

Following is information on two alternative investments being considered by Jolee Company. The com- pany requires a 10% return from its investments.

Project A Project B

Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . $(160,000) $(105,000)

Expected net cash flows: Year 1 . . . . . . . . . . . . . 40,000 32,000

Year 2 . . . . . . . . . . . . . 56,000 50,000

Year 3 . . . . . . . . . . . . . 80,295 66,000

Year 4 . . . . . . . . . . . . . 90,400 72,000

Year 5 . . . . . . . . . . . . . 65,000 24,000

For each alternative project, compute the (a) net present value and (b) profitability index. (Round your an- swers in part b to two decimal places.) If the company can only select one project, which should it choose?

Refer to the information in Exercise 24-11 and instead assume the company requires a 12% return on its investments. Compute each project’s (a) net present value and (b) profitability index. (Round present value calculations to the nearest dollar.) Express the profitability index as a percentage (rounded to two decimal places). If the company can choose only one project, which should it choose?

Exercise 24-12 Net present value, profitability index P3

Following is information on two alternative investments being considered by Tiger Co. The company re- quires a 4% return from its investments.

Exercise 24-11 Net present value, profitability index

P3 Project X1 Project X2

Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . $(80,000) $(120,000)

Expected net cash flows: Year 1 . . . . . . . . . . . . . 25,000 60,000

Year 2 . . . . . . . . . . . . . 35,500 50,000

Year 3 . . . . . . . . . . . . . 60,500 40,000

Compute each project’s (a) net present value and (b) profitability index. (Round present value calculations to the nearest dollar and round the profitability index to two decimal places.) If the company can choose only one project, which should it choose?

Chapter 24 Capital Budgeting and Investment Analysis 969

Refer to the information in Exercise 24-11. Create an Excel spreadsheet to compute the internal rate of return for each of the projects. Based on internal rate of return, determine whether the company should accept either of the two projects.

Exercise 24-13A Internal rate of return P4

C1 C2 C3

Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 96,000 $180,000

Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . 108,000 96,000 60,000

Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . 168,000 96,000 48,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . $288,000 $288,000 $288,000

Phoenix Company can invest in each of three cheese-making projects: C1, C2, and C3. Each project re- quires an initial investment of $228,000 and would yield the following annual cash flows.

1. Assuming that the company requires a 12% return from its investments, use net present value to deter- mine which projects, if any, should be acquired.

2. Using the answer from part 1, is the internal rate of return higher or lower than 12% for Project C2?

Exercise 24-14 Computing and interpreting net present value and internal rate of return

P3 P4

Refer to the information in Exercise 24-10. Create an Excel spreadsheet to compute the internal rate of return for each of the projects. Round the percentage return to two decimals.

Exercise 24-17A Using Excel to compute IRR P4

OptiLux is considering investing in an automated manufacturing system. The system requires an initial investment of $4 million, has a 20-year life, and will have zero salvage value. If the system is imple- mented, the company will save $500,000 per year in direct labor costs. The company requires a 10% return from its investments. 1. Compute the proposed investment’s net present value. 2. Using your answer from part 1, is the investment’s internal rate of return higher or lower than 10%?

Exercise 24-15 NPV and IRR for automation investment

P3 P4

Refer to the information in Exercise 24-15. Create an Excel spreadsheet to compute the internal rate of return for the proposed investment. Round the percentage return to two decimals.

Exercise 24-16A IRR for automation investment P4

This chapter explained two methods to evaluate investments using recovery time, the payback period and break-even time (BET). Refer to QS 24-17 and compute the recovery time for both the payback period and break-even time.

Exercise 24-18 Comparing payback and BET A1 P1

PROBLEM SET A

Problem 24-1A Computing payback period, accounting rate of return, and net present value

P1 P2 P3

Factor Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $480,000 cost with an expected four-year life and a $20,000 salvage value. All sales are for cash, and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following.

Expected annual sales of new product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,840,000

Expected annual costs of new product

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672,000

Overhead (excluding straight-line depreciation on new machine) . . . . . . . . . . . . . . 336,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30%

970 Chapter 24 Capital Budgeting and Investment Analysis

Required

1. Compute straight-line depreciation for each year of this new machine’s life. (Round depreciation amounts to the nearest dollar.)

2. Determine expected net income and net cash flow for each year of this machine’s life. (Round answers to the nearest dollar.)

3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year. (Round the payback period to two decimals.)

4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year. (Round the percentage return to two decimals.)

5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. Hint: Salvage value is a cash inflow at the end of the asset’s life. Round the net present value to the nearest dollar.

Check (4) 21.56%

(5) $107,356

Most Company has an opportunity to invest in one of two new projects. Project Y requires a $350,000 invest- ment for new machinery with a four-year life and no salvage value. Project Z requires a $350,000 investment for new machinery with a three-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

Project Y Project Z

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000 $280,000

Expenses

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000 35,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 42,000

Overhead including depreciation . . . . . . . . . . . . . . . 126,000 126,000

Selling and administrative expenses . . . . . . . . . . . . . 25,000 25,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 228,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 52,000

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 15,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000 $ 36,400

Required

1. Compute each project’s annual expected net cash flows. (Round the net cash flows to the nearest dollar.) 2. Determine each project’s payback period. (Round the payback period to two decimals.) 3. Compute each project’s accounting rate of return. (Round the percentage return to one decimal.) 4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that

cash flows occur at each year-end. (Round the net present value to the nearest dollar.)

Check For Project Y: (2) 2.44 years, (3) 32%

(4) $125,286

Problem 24-2A Analyzing and computing payback period, accounting rate of return, and net present value

P1 P2 P3

Manning Corporation is considering a new project requiring a $90,000 investment in test equipment with no salvage value. The project would produce $66,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between the two alternative depreciation schedules shown in the table.

Problem 24-3A Computing cash flows and net present values with alternative depreciation methods

P3 Straight-Line MACRS Depreciation Depreciation*

Year 1 . . . . . . . . . . $ 9,000 $18,000

Year 2 . . . . . . . . . . 18,000 28,800

Year 3 . . . . . . . . . . 18,000 17,280

Year 4 . . . . . . . . . . 18,000 10,368

Year 5 . . . . . . . . . . 18,000 10,368

Year 6 . . . . . . . . . . 9,000 5,184

Totals . . . . . . . . . . . $90,000 $90,000

* The modified accelerated cost recovery system (MACRS) for depreciation is discussed in Chapter 8.

Chapter 24 Capital Budgeting and Investment Analysis 971

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) straight-line depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) MACRS deprecia- tion expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the income amount before depreciation minus the income taxes. (Round answers to the nearest dollar.)

3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the dis- count rate. (Round the net present value to the nearest dollar.)

Analysis Component

5. Which depreciation method (straight-line or MACRS) results in a higher net present value?

Check Net present value: (3) $108,518

(4) $110,303

Interstate Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.

Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value.

Problem 24-4A Computing net present value of alternate investments

P3

Cost of old machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $112,000

Cost of overhaul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Annual expected revenues generated . . . . . . . . . . . . . . . . . . 95,000

Annual cash operating costs after overhaul . . . . . . . . . . . . . . 42,000

Salvage value of old machine in 5 years . . . . . . . . . . . . . . . . 15,000

Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more product being produced and sold.

Required

1. Determine the net present value of alternative 1. 2. Determine the net present value of alternative 2. 3. Which alternative do you recommend that management select?

Cost of new machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Salvage value of old machine now . . . . . . . . . . . . . . . . . . . 29,000

Annual expected revenues generated . . . . . . . . . . . . . . . . 100,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Salvage value of new machine in 5 years . . . . . . . . . . . . . 20,000

Problem 24-5A Payback period, break-even time, and net present value

P1 A1

Sentinel Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $250,000 and will yield the following expected cash flows. Management requires a 10% return on investments.

Period 1 Period 2 Period 3 Period 4 Period 5

Cash flow . . . . . . . . . . . . . $47,000 $52,000 $75,000 $94,000 $125,000

972 Chapter 24 Capital Budgeting and Investment Analysis

Required

1. Determine the payback period for this investment. (Round the answer to one decimal.) 2. Determine the break-even time for this investment. (Round the answer to one decimal.) 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project?

Check (1) Payback period, 3.8 years

Cortino Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $300,000 cost with an expected four-year life and a $20,000 salvage value. All sales are for cash and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following.

Expected annual sales of new product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,150,000

Expected annual costs of new product

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000

Overhead (excluding straight-line depreciation on new machine) . . . . . . . . . . . . . . 210,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30%

PROBLEM SET B

Problem 24-1B Computing payback period, accounting rate of return, and net present value

P1 P2 P3

Required

1. Compute straight-line depreciation for each year of this new machine’s life. (Round depreciation amounts to the nearest dollar.)

2. Determine expected net income and net cash flow for each year of this machine’s life. (Round answers to the nearest dollar.)

3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year. (Round the payback period to two decimals.)

4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year. (Round the percentage return to two decimals.)

5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. Hint: Salvage value is a cash inflow at the end of the asset’s life.

Check (4) 21.88%

(5) $70,915

Lenitnes Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $250,000 and will yield the following expected cash flows. Management requires a 10% return on its investments.

Check (1) Payback period, 2.4 years

Required

1. Determine the payback period for this investment. (Round the answer to one decimal.) 2. Determine the break-even time for this investment. (Round the answer to one decimal.) 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project?

Problem 24-6A Payback period, break-even time, and net present value

A1 P1 Period 1 Period 2 Period 3 Period 4 Period 5

Cash flow . . . . . . . . . . . . . . $125,000 $94,000 $75,000 $52,000 $47,000

Chapter 24 Capital Budgeting and Investment Analysis 973

Aikman Company has an opportunity to invest in one of two projects. Project A requires a $240,000 investment for new machinery with a four-year life and no salvage value. Project B also requires a $240,000 investment for new machinery with a three-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

Problem 24-2B Analyzing and computing payback period, accounting rate of return, and net present value

P1 P2 P3

Check For Project A: (2) 2.4 years

(3) 33.3%

(4) $90,879

Required

1. Compute each project’s annual expected net cash flows. (Round net cash flows to the nearest dollar.) 2. Determine each project’s payback period. (Round the payback period to two decimals.) 3. Compute each project’s accounting rate of return. (Round the percentage return to one decimal.) 4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that

cash flows occur at each year-end. (Round net present values to the nearest dollar.)

Analysis Component

5. Identify the project you would recommend to management and explain your choice.

Project A Project B

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000 $200,000

Expenses

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 25,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 30,000

Overhead including depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 90,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 18,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,000 163,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,000 37,000

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,100 11,100

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,900 $ 25,900

Problem 24-3B Computating cash flows and net present values with alternative depreciation methods

P3

Grossman Corporation is considering a new project requiring a $30,000 investment in an asset having no sal- vage value. The project would produce $12,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between two alternative depreciation schedules as shown in the table.

Straight-Line MACRS Depreciation Depreciation*

Year 1 . . . . . . $ 3,000 $ 6,000

Year 2 . . . . . . 6,000 9,600

Year 3 . . . . . . 6,000 5,760

Year 4 . . . . . . 6,000 3,456

Year 5 . . . . . . 6,000 3,456

Year 6 . . . . . . 3,000 1,728

Totals . . . . . . . $30,000 $30,000

* The modified accelerated cost recovery system (MACRS) for depreciation is discussed in Chapter 8.

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following items for each of the six years: (a) pretax income before depreciation, (b) straight-line depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following items for each of the six years: (a) pretax income before depreciation, (b) MACRS deprecia- tion expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

974 Chapter 24 Capital Budgeting and Investment Analysis

3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the dis- count rate. (Round the net present value to the nearest dollar.)

Analysis Component

5. Explain why the MACRS depreciation method increases the net present value of this project.

Check Net present value: (3) $10,041

(4) $10,635

Problem 24-4B Computing net present value of alternate investments

P3

Archer Foods has a freezer that is in need of repair and is considering whether to replace the old freezer with a new freezer or have the old freezer extensively repaired. Information about the two alternatives fol- lows. Management requires a 10% rate of return on its investments.

Alternative 1: Keep the old freezer and have it repaired. If the old freezer is repaired, it will be kept for another eight years and then sold for its salvage value.

Alternative 2: Sell the old freezer and buy a new one. The new freezer is larger than the old one and will allow the company to expand its product offerings, thereby generating more revenues. Also, it is more energy efficient and will yield substantial operating cost savings.

Check (1) Net present value of alternative 1, $(5,921)

Required

1. Determine the net present value of alternative 1. 2. Determine the net present value of alternative 2. 3. Which alternative do you recommend that management select? Explain.

Cost of old freezer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $75,000

Cost of repair . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Annual expected revenues generated . . . . . . . . . . . . . . . . 63,000

Annual cash operating costs after repair . . . . . . . . . . . . . . 55,000

Salvage value of old freezer in 8 years . . . . . . . . . . . . . . . . 3,000

Cost of new freezer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000

Salvage value of old freezer now . . . . . . . . . . . . . . . . . . 5,000

Annual expected revenues generated . . . . . . . . . . . . . . 68,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . . . . . 30,000

Salvage value of new freezer in 8 years . . . . . . . . . . . . . 8,000

Problem 24-5B Payback period, break- even time, and net present value

P1 A1

Aster Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $800,000 and yield the following expected cash flows. Management requires investments to have a payback period of two years, and it requires a 10% return on its investments.

Required

1. Determine the payback period for this investment. 2. Determine the break-even time for this investment. 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project? Explain.

Check (1) Payback period, 2.4 years

Period 1 Period 2 Period 3 Period 4

Cash flow . . . . . . $300,000 $350,000 $400,000 $450,000

Chapter 24 Capital Budgeting and Investment Analysis 975

Retsa Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $800,000 and will yield the following expected cash flows. Management requires investments to have a payback period of two years, and it requires a 10% return on its investments.

Problem 24-6B Payback period, break- even time, and net present value

P1 A1

Required

1. Determine the payback period for this investment. (Round the answer to one decimal.) 2. Determine the break-even time for this investment. (Round the answer to one decimal.) 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project? Explain. 5. Compare your answers for parts 1 through 4 with those for Problem 24-5B. What are the causes of the

differences in results and your conclusions?

Check (1) Payback period, 1.9 years

Required

Compute the (1) payback period and (2) accounting rate of return for this equipment. Report ARR in percent, rounded to one decimal.

SERIAL PROBLEM Business Solutions

P1 P2

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 24 Santana Rey is considering the purchase of equipment for Business Solutions that would allow the company to add a new product to its computer furniture line. The equipment is expected to cost $300,000 and to have a six-year life and no salvage value. It will be depreciated on a straight-line basis. Business Solutions expects to sell 100 units of the equipment’s product each year. The expected annual income related to this equipment follows.

©Alexander Image/Shutterstock

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,000

Costs

Materials, labor, and overhead (except depreciation) . . . . . . . . . . . . . . 200,000

Depreciation on new equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Total costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287,500

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,500

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,250

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61,250

COMPANY ANALYSIS P3

Accounting Analysis

AA 24-1 Assume Apple invested $2.12 billion to expand its manufacturing capacity. Assume that these assets have a 10-year life and that Apple requires a 10% internal rate of return on these assets.

Required

1. What is the amount of annual cash flows that Apple must earn from these projects to have a 10% inter- nal rate of return? Hint: Identify the 10-period, 10% factor from the present value of an annuity table, and then divide $2.12 billion by this factor to get the annual cash flows necessary.

APPLE

Period 1 Period 2 Period 3 Period 4

Cash flow . . . . . . . . . . . . . . . . . . . . . $450,000 $400,000 $350,000 $300,000

[continued on next page]

976 Chapter 24 Capital Budgeting and Investment Analysis

BTN 24-2 Payback period, accounting rate of return, net present value, and internal rate of return are common methods to evaluate capital investment opportunities. Assume that your manager asks you to identify the measurement basis and unit that each method offers and to list the advantages and disadvan- tages of each method. Present your response in memorandum format of less than one page.

COMMUNICATING IN PRACTICE P1 P2 P3 P4

BTN 24-3 Capital budgeting is an important topic, and there are websites designed to help people understand the methods available. Access TeachMeFinance.com’s capital budgeting web page (teachmefinance.com/capitalbudgeting.html). This web page contains an example of a capital budgeting case involving a $15,000 initial cash outflow.

TAKING IT TO THE NET P1 P3

2. Access Apple’s financial statements for the fiscal year ended September 30, 2017, from Appendix A. a. Determine the amount that Apple invested in capital assets for 2017. Hint: Refer to the statement

of cash flows. b. Did Apple invest more in capital assets or in marketable securities for 2017?

AA 24-2 Assume that Google invests $2.42 billion in capital assets. Assume that these assets have a seven-year life and that management requires a 15% internal rate of return on those projects.

Required

1. What is the amount of annual cash flows that Google must earn from those expenditures to achieve a 15% internal rate of return? Hint: Identify the seven-period, 15% factor from the present value of an annuity table and then divide $2.42 billion by the factor to get the annual cash flows required.

2. Refer to the financial statements in Appendix A. Identify the amount that Google invested in capital assets for the year ended December 31, 2017.

3. Refer to AA 24-1, part 2a. Did Google or Apple invest more in capital assets for 2017?

COMPARATIVE ANALYSIS P3

APPLE GOOGLE

ETHICS CHALLENGE P3

BTN 24-1 A consultant commented that “too often the numbers look good but feel bad.” This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, personal biases and expectations can influence present value computations.

Required

1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate. 2. Why is understanding the three reasons mentioned for estimation error important when evaluating

investment projects? Link this response to your answer for part 1.

Beyond the Numbers

AA 24-3 Refer to Samsung’s statement of cash flows in Appendix A for the year ended December 31, 2017.

Required

1. What amount (in millions of Korean won) did Samsung spend to acquire property, plant, and equip- ment during 2017?

2. Assume the investment in part 1 is expected to generate annual net cash flows of 7,000,000 (in millions of Korean won) per year for the next 10 years. Compute the net present value of the investment using a discount rate of 9%.

GLOBAL ANALYSIS P3

Samsung

[continued from previous page]

Chapter 24 Capital Budgeting and Investment Analysis 977

Required

Compute the payback period and the net present value (assuming a 10% required rate of return) of the fol- lowing investment—assume that its cash flows occur at year-end. Compared to the example case at the website, the larger cash inflows in the example below occur in the later years of the project’s life. Is this investment acceptable based on the application of these two capital budgeting methods? Explain.

BTN 24-6 Visit or call a local auto dealership and inquire about leasing a car. Ask about the down pay- ment and the required monthly payments. You will likely find the salesperson does not discuss the cost to purchase this car but focuses on the affordability of the monthly payments. This chapter gives you the tools to compute the cost of this car using the lease payment schedule in present dollars and to estimate the profit from leasing for an auto dealership.

Required

1. Compare the cost of leasing the car to buying it in present dollars using the information from the dealer- ship you contact. (Assume you will make a final payment at the end of the lease and then own the car.)

2. Is it more costly to lease or buy the car? Support your answer with computations.

HITTING THE ROAD P3

BTN 24-4 Break into teams and identify four reasons that an international airline such as Southwest or Delta would invest in a project when an analysis using both payback period and net present value indicates it to be a poor investment. (Hint: Think about qualitative factors.) Provide an example of an investment project that supports your answer.

TEAMWORK IN ACTION P1 P3

BTN 24-5 Read the chapter opener about Marco Mascorro and his company, Fellow Robots. Suppose Marco’s business continues to grow, and he builds a massive new manufacturing facility and warehousing center to make the business more efficient and reduce costs.

Required

1. What are some of the management tools that Marco can use to evaluate whether the new manufactur- ing facility and warehousing center will be a good investment?

2. What information does Marco need to use the tools that you identified in your answer to part 1? 3. What are some of the advantages and disadvantages of each tool identified in your answer to part 1?

ENTREPRENEURIAL DECISION P1 P2 P3 P4

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

Period 0 Period 1 Period 2 Period 3 Period 4 Period 5

Cash flow . . . . . . . . . . . . . . $(15,000) $1,000 $2,000 $3,000 $6,000 $7,000

A-1A-1

This appendix includes financial information for (1) Apple, (2) Google, and (3) Samsung. Apple states that it designs, manufactures, and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, network- ing solutions, and third-party digital content and applications; it competes with both Google and Samsung in the United States and globally. The information in this appendix is taken from annual 10-K reports (or annual report for Samsung) filed with the SEC or other regulatory agency. An annual report is a sum- mary of a company’s financial results for the year along with its current financial condition and future plans. This report is directed to external users of financial information, but it also affects the actions and decisions of internal users.

A company often uses an annual report to showcase itself and its products. Many annual reports include photos, diagrams, and illustrations related to the company. The primary objective of annual reports, however, is the financial section, which communicates much information about a company, with most data drawn from the accounting information system. The content of a typical annual report’s finan- cial section follows.

Letter to Shareholders Financial History and Highlights Quantitative and Qualitative Disclosures about Risk Factors Management Discussion and Analysis Management’s Report on Financial Statements and on Internal Controls Report of Independent Accountants (Auditor’s Report) and on Internal Controls Financial Statements Notes to Financial Statements Directors, Officers, and Corporate Governance Executive Compensation Accounting Fees and Services

This appendix provides the financial statements for Apple (plus selected notes), Google, and Samsung. The appendix is organized as follows:

Apple A-2 through A-9 Google A-10 through A-13 Samsung A-14 through A-17

Many assignments at the end of each chapter refer to information in this appendix. We encourage readers to spend time with these assignments; they are especially useful in showing the relevance and diversity of accounting and reporting.

appendix

Financial Statement Information A

APPLE

Samsung GOOGLE

Special note: The SEC maintains the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database at SEC.gov for U.S. filers. The Form 10-K is the annual report form for most companies. It provides electronically accessible information. The Form 10-KSB is the annual report form filed by small businesses. It requires slightly less information than the Form 10-K. One of these forms must be filed within 90 days after the company’s fiscal year-end. (Forms 10-K405, 10-KT, 10-KT405, and 10-KSB405 are slight variations of the usual form due to certain regulations or rules.)

A PP

LE A-2 Appendix A Financial Statement Information

Apple Inc. CONSOLIDATED BALANCE SHEETS

(In millions, except number of shares which are reflected in thousands and par value)

September 30, 2017 September 24, 2016 ASSETS

Current assets Cash and cash equivalents $ 20,289 $ 20,484 Short-term marketable securities 53,892 46,671 Accounts receivable, less allowances of $58 and $53, respectively 17,874 15,754 Inventories 4,855 2,132 Vendor non-trade receivables 17,799 13,545 Other current assets 13,936 8,283 Total current assets 128,645 106,869 Long-term marketable securities 194,714 170,430 Property, plant and equipment, net 33,783 27,010 Goodwill 5,717 5,414 Acquired intangible assets, net 2,298 3,206 Other non-current assets 10,162 8,757 Total assets $ 375,319 $ 321,686

LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities Accounts payable $ 49,049 $ 37,294 Accrued expenses 25,744 22,027 Deferred revenue 7,548 8,080 Commercial paper 11,977 8,105 Current portion of long-term debt 6,496 3,500 Total current liabilities 100,814 79,006 Deferred revenue, non-current 2,836 2,930 Long-term debt 97,207 75,427 Other non-current liabilities 40,415 36,074 Total liabilities 241,272 193,437 Commitments and contingencies

Shareholders’ equity Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 5,126,201 and 5,336,166 shares issued and outstanding, respectively 35,867 31,251 Retained earnings 98,330 96,364 Accumulated other comprehensive income (loss) (150) 634 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity $ 375,319 $ 321,686

See accompanying Notes to Consolidated Financial Statements.

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Appendix A Financial Statement Information A-3

Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS

(In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 30, 2017 September 24, 2016 September 26, 2015 Net sales $ 229,234 $ 215,639 $ 233,715 Cost of sales 141,048 131,376 140,089 Gross margin 88,186 84,263 93,626 Operating expenses Research and development 11,581 10,045 8,067 Selling, general and administrative 15,261 14,194 14,329 Total operating expenses 26,842 24,239 22,396 Operating income 61,344 60,024 71,230 Other income (expense), net 2,745 1,348 1,285 Income before provision for income taxes 64,089 61,372 72,515 Provision for income taxes 15,738 15,685 19,121 Net income $ 48,351 $ 45,687 $ 53,394

Earnings per share: Basic $ 9.27 $ 8.35 $ 9.28 Diluted $ 9.21 $ 8.31 $ 9.22 Shares used in computing earnings per share: Basic 5,217,242 5,470,820 5,753,421 Diluted 5,251,692 5,500,281 5,793,069 Cash dividends declared per share $ 2.40 $ 2.18 $ 1.98

See accompanying Notes to Consolidated Financial Statements.

Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In millions) Years ended September 30, 2017 September 24, 2016 September 26, 2015 Net income $ 48,351 $ 45,687 $ 53,394 Other comprehensive income (loss): Change in foreign currency translation, net of tax effects of $(77), $8 and $201, respectively 224 75 (411) Change in unrealized gains/losses on derivative instruments: Change in fair value of derivatives, net of tax benefit (expense) of $(478), $(7) and $(441), respectively 1,315 7 2,905 Adjustment for net (gains) losses realized and included in net income, net of tax expense (benefit) of $475, $131 and $630, respectively (1,477) (741) (3,497) Total change in unrealized gains/losses on derivative instruments, net of tax (162) (734) (592) Change in unrealized gains/losses on marketable securities: Change in fair value of marketable securities, net of tax benefit (expense) of $425, $(863) and $264, respectively (782) 1,582 (483) Adjustment for net (gains) losses realized and included in net income, net of tax expense (benefit) of $35, $(31), and $(32), respectively (64) 56 59 Total change in unrealized gains/losses on marketable securities, net of tax (846) 1,638 (424) Total other comprehensive income (loss) (784) 979 (1,427) Total comprehensive income $ 47,567 $ 46,666 $ 51,967

See accompanying Notes to Consolidated Financial Statements.

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LE A-4 Appendix A Financial Statement Information

Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In millions, except number of shares which are reflected in thousands) Accumulated Other Common Stock and Comprehensive Total Additional Paid-In Capital Retained Income Shareholders’ Shares Amount Earnings (Loss) Equity

Balances as of September 27, 2014 5,866,161 $ 23,313 $ 87,152 $ 1,082 $ 111,547 Net income — — 53,394 — 53,394 Other comprehensive income (loss) — — — (1,427) (1,427) Dividends and dividend equivalents declared — — (11,627) — (11,627) Repurchase of common stock (325,032) — (36,026) — (36,026) Share-based compensation — 3,586 — — 3,586 Common stock issued, net of shares withheld for employee taxes 37,624 (231) (609) — (840) Tax benefit from equity awards, including transfer pricing adjustments — 748 — — 748 Balances as of September 26, 2015 5,578,753 $ 27,416 $ 92,284 $ (345) $ 119,355 Net income — — 45,687 — 45,687 Other comprehensive income (loss) — — — 979 979 Dividends and dividend equivalents declared — — (12,188) — (12,188) Repurchase of common stock (279,609) — (29,000) — (29,000) Share-based compensation — 4,262 — — 4,262 Common stock issued, net of shares withheld for employee taxes 37,022 (806) (419) — (1,225) Tax benefit from equity awards, including transfer pricing adjustments — 379 — — 379 Balances as of September 24, 2016 5,336,166 $ 31,251 $ 96,364 $ 634 $ 128,249 Net income — — 48,351 — 48,351 Other comprehensive income (loss) — — — (784) (784) Dividends and dividend equivalents declared — — (12,803) — (12,803) Repurchase of common stock (246,496) — (33,001) — (33,001) Share-based compensation — 4,909 — — 4,909 Common stock issued, net of shares withheld for employee taxes 36,531 (913) (581) — (1,494) Tax benefit from equity awards, including transfer pricing adjustments — 620 — — 620 Balances as of September 30, 2017 5,126,201 $ 35,867 $ 98,330 $ (150) $ 134,047

See accompanying Notes to Consolidated Financial Statements.

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Appendix A Financial Statement Information A-5

Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions) Years ended September 30, 2017 September 24, 2016 September 26, 2015 Cash and cash equivalents, beginning of the year $ 20,484 $ 21,120 $ 13,844 Operating activities: Net income 48,351 45,687 53,394 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 10,157 10,505 11,257 Share-based compensation expense 4,840 4,210 3,586 Deferred income tax expense 5,966 4,938 1,382 Other (166) 486 385 Changes in operating assets and liabilities: Accounts receivable, net (2,093) 527 417 Inventories (2,723) 217 (238) Vendor non-trade receivables (4,254) (51) (3,735) Other current and non-current assets (5,318) 1,055 (283) Accounts payable 9,618 1,837 5,001 Deferred revenue (626) (1,554) 1,042 Other current and non-current liabilities (154) (2,033) 9,058 Cash generated by operating activities 63,598 65,824 81,266 Investing activities: Purchases of marketable securities (159,486) (142,428) (166,402) Proceeds from maturities of marketable securities 31,775 21,258 14,538 Proceeds from sales of marketable securities 94,564 90,536 107,447 Payments made in connection with business acquisitions, net (329) (297) (343) Payments for acquisition of property, plant and equipment (12,451) (12,734) (11,247) Payments for acquisition of intangible assets (344) (814) (241) Payments for strategic investments, net (395) (1,388) — Other 220 (110) (26) Cash used in investing activities (46,446) (45,977) (56,274) Financing activities: Proceeds from issuance of common stock 555 495 543 Excess tax benefits from equity awards 627 407 749 Payments for taxes related to net share settlement of equity awards (1,874) (1,570) (1,499) Payments for dividends and dividend equivalents (12,769) (12,150) (11,561) Repurchases of common stock (32,900) (29,722) (35,253) Proceeds from issuance of term debt, net 28,662 24,954 27,114 Repayments of term debt (3,500) (2,500) — Change in commercial paper, net 3,852 (397) 2,191 Cash used in financing activities (17,347) (20,483) (17,716) Increase (decrease) in cash and cash equivalents (195) (636) 7,276 Cash and cash equivalents, end of the year $ 20,289 $ 20,484 $ 21,120

Supplemental cash flow disclosure: Cash paid for income taxes, net $ 11,591 $ 10,444 $ 13,252 Cash paid for interest $ 2,092 $ 1,316 $ 514

See accompanying Notes to Consolidated Financial Statements.

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LE A-6 Appendix A Financial Statement Information

Basis of Presentation and Preparation In the opinion of the Company’s management, the consoli- dated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s fiscal year 2017 included 53 weeks and ended on September 30, 2017. A 14th week was included in the first fiscal quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. The Company’s fiscal years 2016 and 2015 ended on September 24, 2016 and September 26, 2015, respectively, and spanned 52 weeks each. Unless otherwise stated, references to particu- lar years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years.

Revenue Recognition Net sales consist primarily of revenue from the sale of hard- ware, software, digital content and applications, accesso- ries, and service and support contracts. The Company recognizes revenue when persuasive evidence of an ar- rangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or deter- minable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software ac- counting guidance for the following types of sales transac- tions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For the sale of most third-party products, the Company recognizes revenue based on the gross amount billed to cus- tomers because the Company establishes its own pricing for

such products, retains related inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its customers. For third- party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net ba- sis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. The Company records deferred revenue when it receives payments in advance of the delivery of products or the perfor- mance of services. This includes amounts that have been de- ferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeem- able on iTunes Store, App Store, Mac App Store, TV App Store and iBooks Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and sup- port contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered un- der the Company’s standard limited warranty. The Company records reductions to revenue for esti- mated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For the Company’s other customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are re- mitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. For multi-element arrangements that include hardware products containing software essential to the hardware prod- uct’s functionality, undelivered software elements that relate to the hardware product’s essential software, and undeliv- ered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. For sales of qualifying versions of iPhone, iPad, iPod touch, Mac, Apple Watch and Apple TV, the Company has

APPLE INC. SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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Appendix A Financial Statement Information A-7

indicated it may from time to time provide future unspeci- fied software upgrades to the device’s essential software and/or non-software services free of charge. The Company has identified up to three deliverables regularly included in arrangements involving the sale of these devices. The Company allocates revenue between these deliverables us- ing the relative selling price method. Revenue allocated to the delivered hardware and the related essential software is recognized at the time of sale, provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be pro- vided. Cost of sales related to delivered hardware and re- lated essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as in- curred, and engineering and sales and marketing costs are recognized as operating expenses as incurred.

Shipping Costs Amounts billed to customers related to shipping and han- dling are classified as revenue, and the Company’s shipping and handling costs are classified as cost of sales.

Warranty Costs The Company generally provides for the estimated cost of hardware and software warranties in the period the related revenue is recognized. The Company assesses the adequacy of its accrued warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in fu- ture estimates.

Software Development Costs Research and development (“R&D”) costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capital- ization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established and as a result software de- velopment costs were expensed as incurred.

Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses.

Other Income and Expense

Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted- average number of shares of common stock outstanding during the period increased to include the number of addi- tional shares of common stock that would have been out- standing if the potentially dilutive securities had been issued.

Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equiva- lents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the clas- sifications at each balance sheet date. The Company classi- fies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contrac- tual maturity date. Marketable debt securities with maturi- ties of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. Marketable equity securities, including mutual funds, are classified as either short-term or long-term based on the nature of each secu- rity and its availability for use in current operations. The Company’s marketable debt and equity securities are car- ried at fair value, with unrealized gains and losses, net of taxes, reported as a component of accumulated other com- prehensive income/(loss) (“AOCI”) in shareholders’ equity, with the exception of unrealized losses believed to be other-than-temporary which are reported in earnings in the current period. The cost of securities sold is based upon the specific identification method.

Accounts Receivable (Trade Receivables) The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, re- tailers, value-added resellers, small and mid-sized businesses and education, enterprise and government customers. As of September 30, 2017, the Company had two cus- tomers that individually represented 10% or more of total trade receivables, each of which accounted for 10%. As of September 24, 2016, the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10%. The Company’s cellular network carri- ers accounted for 59% and 63% of trade receivables as of September 30, 2017 and September 24, 2016, respectively.

Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors, including

Apple Inc. Notes—continued

$ millions 2017 2016 2015 Interest and dividend income $ 5,201 $ 3,999 $2,921 Interest expense (2,323) (1,456) (733) Other expense, net (133) (1,195) (903) Total other income (expense), net $ 2,745 $ 1,348 $1,285

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The Company does not amortize goodwill and intangi- ble assets with indefinite useful lives; rather, such assets are required to be tested for impairment at least annually or sooner if events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible asset impairment tests in the fourth quarter of each year. The Company did not recognize any impairment charges related to goodwill or indefinite lived intangible assets during 2017, 2016 and 2015. For purposes of testing goodwill for impairment, the Company estab- lished reporting units based on its current reporting struc- ture. Goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. In 2017 and 2016, the Company’s goodwill was primarily allocated to the Americas and Europe reporting units. The Company amortizes its intangible assets with defi- nite useful lives over their estimated useful lives and re- views these assets for impairment. The Company typically amortizes its acquired intangible assets with definite useful lives over periods from three to seven years.

Acquired Intangible Assets The Company’s acquired intangible assets with definite useful lives primarily consist of patents and licenses. The following table summarizes the components of acquired intangible asset balances as of September 30, 2017. Amortization expense related to acquired intangible assets was $1.2 billion in 2017.

Apple Inc. Notes—continued

historical experience, age of the accounts receivable bal- ances, credit quality of the Company’s customers, current economic conditions and other factors that may affect the customers’ abilities to pay.

Inventories Inventories are stated at the lower of cost, computed using the first-in, first-out method, and net realizable value. Any adjustments to reduce the cost of inventories to their net real- izable value are recognized in earnings in the current period.

Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between one and five years for ma- chinery and equipment, including product tooling and man- ufacturing process equipment; and the shorter of lease term or useful life for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use soft- ware are amortized using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Depreciation and amortization expense on property and equipment was $8.2 billion, $8.3 billion and $9.2 billion during 2017, 2016 and 2015, respectively.

Property, Plant and Equipment, Net ($ millions) 2017 2016 Land and buildings $ 13,587 $ 10,185 Machinery, equipment and internal-use software 54,210 44,543 Leasehold improvements 7,279 6,517 Gross property, plant and equipment 75,076 61,245 Accumulated depreciation and amortization (41,293) (34,235) Total property, plant and equipment, net $ 33,783 $ 27,010

Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment, in- ventory component prepayments and identifiable intangi- bles, excluding goodwill and intangible assets with indefinite useful lives, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is mea- sured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to gener- ate. If property, plant and equipment, inventory component prepayments and certain identifiable intangibles are consid- ered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the asset exceeds its fair value.

Gross Net Carrying Accumulated Carrying $ millions Amount Amortization Amount

Definite-lived and amortizable acquired intangible assets $ 7,507 $ (5,309) $ 2,198 Indefinite-lived and non-amortizable acquired intangible assets 100 — 100 Total acquired intangible assets $ 7,607 $ (5,309) $ 2,298

Fair Value Measurements The Company applies fair value accounting for all finan- cial assets and liabilities and non-financial assets and li- abilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be re- ceived from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities that are required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk mea- surements or assumptions that market participants would use to price the asset or liability, such as risks inherent in valuation techniques, transfer restrictions and credit risk. Fair value is estimated by applying the following hierarchy,

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Appendix A Financial Statement Information A-9

which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement:

Level 1—Quoted prices in active markets for identical assets or liabilities. Level 2—Observable inputs other than quoted prices in ac- tive markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive mar- kets, or other inputs that are observable or can be corrobo- rated by observable market data for substantially the full term of the assets or liabilities. Level 3—Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.

The Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model-driven val- uations using significant inputs derived from or corrobo- rated by observable market data. In accordance with the fair value accounting require- ments, companies may choose to measure eligible financial instruments and certain other items at fair value. The Company has not elected the fair value option for any eli- gible financial instruments.

Accrued Warranty and Indemnification The following table shows changes in the Company’s ac- crued warranties and related costs for 2017 and 2016:

Apple Inc. Notes—continued

Dividends The Company declared and paid cash dividends per share during the periods presented as follows:

Segment Information and Geographic Data

$ millions 2017 2016 Beginning accrued warranty and related costs $ 3,702 $ 4,780 Cost of warranty claims (4,322) (4,663) Accruals for product warranty 4,454 3,585 Ending accrued warranty and related costs $ 3,834 $ 3,702

Term Debt As of September 30, 2017, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $104.0 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and interest is payable in arrears. The Company recognized $2.2 billion, $1.4 billion and $722 million of interest expense on its term debt for 2017, 2016 and 2015, respectively. As of September 30, 2017 and September 24, 2016, the fair value of the Company’s Notes, based on Level 2 inputs, was $106.1 billion and $81.7 billion, respectively.

2017 2016 Dividends Amount Dividends Amount Per Share (in millions) Per Share (in millions) Fourth quarter $ 0.63 $ 3,252 $ 0.57 $ 3,071 Third quarter 0.63 3,281 0.57 3,117 Second quarter 0.57 2,988 0.52 2,879 First quarter 0.57 3,042 0.52 2,898 Total cash dividends declared and paid $ 2.40 $ 12,563 $ 2.18 $ 11,965

Net sales by product (mil.) 2017 2016 2015 iPhone $141,319 $136,700 $155,041 iPad 19,222 20,628 23,227 Mac 25,850 22,831 25,471 Services 29,980 24,348 19,909 Other Products 12,863 11,132 10,067 Total net sales $229,234 $215,639 $233,715

Reportable segment (mil.) 2017 2016 2015 Americas: Net sales $96,600 $ 86,613 $ 93,864 Operating income $30,684 $ 28,172 $ 31,186 Europe: Net sales $54,938 $ 49,952 $ 50,337 Operating income $16,514 $ 15,348 $ 16,527 Greater China: Net sales $44,764 $ 48,492 $ 58,715 Operating income $17,032 $ 18,835 $ 23,002 Japan: Net sales $17,733 $ 16,928 $ 15,706 Operating income $ 8,097 $ 7,165 $ 7,617 Rest of Asia Pacific: Net sales $15,199 $ 13,654 $ 15,093 Operating income $ 5,304 $ 4,781 $ 5,518

A reconciliation of the Company’s segment operating in- come to the Consolidated Statements of Operations for 2017, 2016 and 2015 is as follows:

$ millions 2017 2016 2015 Segment operating income $ 77,631 $ 74,301 $83,850 Research and development expense (11,581) (10,045) (8,067) Other corporate expenses, net (4,706) (4,232) (4,553) Total operating income $ 61,344 $ 60,024 $71,230

A-10 Appendix A Financial Statement Information G

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Google Inc. (Alphabet Inc.)a CONSOLIDATED BALANCE SHEETS

(In millions, except share and par value amounts which are reflected in thousands, and par value per share amounts)

As of As of December 31, 2016 December 31, 2017

Assets Current assets Cash and cash equivalents $ 12,918 $ 10,715 Marketable securities 73,415 91,156 Total cash, cash equivalents, and marketable securities 86,333 101,871 Accounts receivable, net of allowance of $467 and $674 14,137 18,336 Income taxes receivable, net 95 369 Inventory 268 749 Other current assets 4,575 2,983 Total current assets 105,408 124,308 Non-marketable investments 5,878 7,813 Deferred income taxes 383 680 Property and equipment, net 34,234 42,383 Intangible assets, net 3,307 2,692 Goodwill 16,468 16,747 Other non-current assets 1,819 2,672 Total assets $ 167,497 $ 197,295 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $ 2,041 $ 3,137 Accrued compensation and benefits 3,976 4,581 Accrued expenses and other current liabilities 6,144 10,177 Accrued revenue share 2,942 3,975 Deferred revenue 1,099 1,432 Income taxes payable, net 554 881 Total current liabilities 16,756 24,183 Long-term debt 3,935 3,969 Deferred revenue, non-current 202 340 Income taxes payable, non-current 4,677 12,812 Deferred income taxes 226 430 Other long-term liabilities 2,665 3,059 Total liabilities 28,461 44,793 Commitments and contingencies Stockholders’ equity: Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 691,293 (Class A 296,992, Class B 47,437, Class C 346,864) and 694,783 (Class A 298,470, Class B 46,972, Class C 349,341) shares issued and outstanding 36,307 40,247 Accumulated other comprehensive loss (2,402) (992) Retained earnings 105,131 113,247 Total stockholders’ equity 139,036 152,502 Total liabilities and stockholders’ equity $ 167,497 $ 197,295

aGoogle is part of Alphabet, but we loosely refer to Alphabet as “Google” because of its global familiarity and that Google provides 99% of Alphabet’s $110,855 billion in revenues.

See accompanying notes.

Appendix A Financial Statement Information A-11

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Google Inc. (Alphabet Inc.)a CONSOLIDATED STATEMENTS OF INCOME

(In millions)

Year Ended December 31 2015 2016 2017 Revenues $ 74,989 $ 90,272 $ 110,855 Costs and expenses Cost of revenues 28,164 35,138 45,583 Research and development 12,282 13,948 16,625 Sales and marketing 9,047 10,485 12,893 General and administrative 6,136 6,985 6,872 European Commission fine 0 0 2,736 Total costs and expenses 55,629 66,556 84,709 Income from operations 19,360 23,716 26,146 Other income (expense), net 291 434 1,047 Income before income taxes 19,651 24,150 27,193 Provision for income taxes 3,303 4,672 14,531 Net income $ 16,348 $ 19,478 $ 12,662 Less: Adjustment Payment to Class C capital stockholders 522 0 0 Net income available to all stockholders $ 15,826 $ 19,478 $ 12,662

aGoogle is part of Alphabet, but we loosely refer to Alphabet as “Google” because of its global familiarity and that Google provides 99% of Alphabet’s $110,855 billion in revenues.

See accompanying notes.

Google Inc. (Alphabet Inc.)a CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In millions)

Year Ended December 31 2015 2016 2017 Net income $ 16,348 $ 19,478 $ 12,662 Other comprehensive income (loss): Change in foreign currency translation adjustment (1,067) (599) 1,543 Available-for-sale investments: Change in net unrealized gains (losses) (715) (314) 307 Less: reclassification adjustment for net (gains) losses included in net income 208 221 105 Net change (net of tax effect of $29, $0, and $0) (507) (93) 412 Cash flow hedges: Change in net unrealized gains (losses) 676 515 (638) Less: reclassification adjustment for net (gains) losses included in net income (1,003) (351) 93 Net change (net of tax effect of $115, $64, and $247) (327) 164 (545) Other comprehensive income (loss) (1,901) (528) 1,410 Comprehensive income $ 14,447 $ 18,950 $ 14,072

aGoogle is part of Alphabet, but we loosely refer to Alphabet as “Google” because of its global familiarity and that Google provides 99% of Alphabet’s $110,855 billion in revenues.

See accompanying notes.

A-12 Appendix A Financial Statement Information G

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Google Inc. (Alphabet Inc.)a CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands)

Class A and Class B Common Stock, Class C Accumulated Capital Stock and Other Total Additional Paid-In Capital Comprehensive Retained Stockholders’ Shares Amount Income (Loss) Earnings Equity

Balance as of December 31, 2014 680,172 $ 28,767 $ 27 $ 75,066 $ 103,860 Common and capital stock issued 8,714 664 0 0 664 Stock-based compensation expense 0 5,151 0 0 5,151 Stock-based compensation tax benefits 0 815 0 0 815 Tax withholding related to vesting of restricted stock units 0 (2,779) 0 0 (2,779) Repurchases of capital stock (2,391) (111) 0 (1,669) (1,780) Adjustment Payment to Class C capital stockholders 853 475 0 (522) (47) Net income 0 0 0 16,348 16,348 Other comprehensive loss 0 0 (1,901) 0 (1,901) Balance as of December 31, 2015 687,348 32,982 (1,874) 89,223 120,331

Cumulative effect of accounting change 0 180 0 (133) 47 Common and capital stock issued 9,106 298 0 0 298 Stock-based compensation expense 0 6,700 0 0 6,700 Tax withholding related to vesting of restricted stock units 0 (3,597) 0 0 (3,597) Repurchases of capital stock (5,161) (256) 0 (3,437) (3,693) Net income 0 0 0 19,478 19,478 Other comprehensive loss 0 0 (528) 0 (528) Balance as of December 31, 2016 691,293 36,307 (2,402) 105,131 139,036

Cumulative effect of accounting change 0 0 0 (15) (15) Common and capital stock issued 8,652 212 0 0 212 Stock-based compensation expense 0 7,694 0 0 7,694 Tax withholding related to vesting of restricted stock units 0 (4,373) 0 0 (4,373) Repurchases of capital stock (5,162) (315) 0 (4,531) (4,846) Sale of subsidiary shares 0 722 0 0 722 Net income 0 0 0 12,662 12,662 Other comprehensive loss 0 0 1,410 0 1,410 Balance as of December 31, 2017 694,783 $ 40,247 $ (992) $ 113,247 $ 152,502

aGoogle is part of Alphabet, but we loosely refer to Alphabet as “Google” because of its global familiarity and that Google provides 99% of Alphabet’s $110,855 billion in revenues.

See accompanying notes.

Appendix A Financial Statement Information A-13

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Google Inc. (Alphabet Inc.)a CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions)

Year Ended December 31 2015 2016 2017 Operating activities Net income $ 16,348 $ 19,478 $ 12,662 Adjustments: Depreciation and impairment of property and equipment 4,132 5,267 6,103 Amortization and impairment of intangible assets 931 877 812 Stock-based compensation expense 5,203 6,703 7,679 Deferred income taxes (179) (38) 258 Loss on marketable and non-marketable investments, net 334 275 194 Other 212 174 137 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable (2,094) (2,578) (3,768) Income taxes, net (179) 3,125 8,211 Other assets (318) 312 (2,164) Accounts payable 203 110 731 Accrued expenses and other liabilities 1,597 1,515 4,891 Accrued revenue share 339 593 955 Deferred revenue 43 223 390 Net cash provided by operating activities 26,572 36,036 37,091 Investing activities Purchases of property and equipment (9,950) (10,212) (13,184) Proceeds from disposals of property and equipment 35 240 99 Purchases of marketable securities (74,368) (84,509) (92,195) Maturities and sales of marketable securities 62,905 66,895 73,959 Purchases of non-marketable investments (2,326) (1,109) (1,745) Maturities and sales of non-marketable investments 154 494 533 Cash collateral related to securities lending (350) (2,428) 0 Investments in reverse repurchase agreements 425 450 0 Acquisitions, net of cash acquired, and purchases of intangible assets (236) (986) (287) Proceeds from collection of notes receivable 0 0 1,419 Net cash used in investing activities (23,711) (31,165) (31,401) Financing activities Net payments related to stock-based award activities (2,375) (3,304) (4,166) Adjustment Payment to Class C capital stockholders (47) 0 0 Repurchases of capital stock (1,780) (3,693) (4,846) Proceeds from issuance of debt, net of costs 13,705 8,729 4,291 Repayments of debt (13,728) (10,064) (4,377) Proceeds from sale of subsidiary shares 0 0 800 Net cash used in financing activities (4,225) (8,332) (8,298) Effect of exchange rate changes on cash and cash equivalents (434) (170) 405 Net decrease in cash and cash equivalents (1,798) (3,631) (2,203) Cash and cash equivalents at beginning of period 18,347 16,549 12,918 Cash and cash equivalents at end of period $ 16,549 $ 12,918 $ 10,715

Supplemental disclosures of cash flow information Cash paid for taxes, net of refunds $ 3,651 $ 1,643 $ 6,191 Cash paid for interest, net of amounts capitalized $ 96 $ 84 $ 84

aGoogle is part of Alphabet, but we loosely refer to Alphabet as “Google” because of its global familiarity and that Google provides 99% of Alphabet’s $110,855 billion in revenues.

See accompanying notes.

A-14 Appendix A Financial Statement Information SA

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Samsung Electronics Co., Ltd. and Subsidiaries CONSOLIDATED STATEMENTS OF FINANCIAL POSITION

(In millions of Korean won) December 31, 2017 December 31, 2016

Assets KRW KRW Current assets Cash and cash equivalents 30,545,130 32,111,442 Short-term financial instruments 49,447,696 52,432,411 Short-term available-for-sale financial assets 3,191,375 3,638,460 Trade receivables 27,695,995 24,279,211 Non-trade receivables 4,108,961 3,521,197 Advance payments 1,753,673 1,439,938 Prepaid expenses 3,835,219 3,502,083 Inventories 24,983,355 18,353,503 Other current assets 1,421,060 1,315,653 Assets held-for-sale — 835,806 Total current assets 146,982,464 141,429,704 Non-current assets Long-term available-for-sale financial assets 7,752,180 6,804,276 Held-to-maturity financial assets 106,751 — Investment in associates and joint ventures 6,802,351 5,837,884 Property, plant and equipment 111,665,648 91,473,041 Intangible assets 14,760,483 5,344,020 Long-term prepaid expenses 3,434,375 3,834,831 Net defined benefit assets 825,892 557,091 Deferred income tax assets 5,061,687 5,321,450 Other non-current assets 4,360,259 1,572,027 Total assets 301,752,090 262,174,324 Liabilities and Equity Current liabilities Trade payables 9,083,907 6,485,039 Short-term borrowings 15,767,619 12,746,789 Other payables 13,899,633 11,525,910 Advances received 1,249,174 1,358,878 Withholdings 793,582 685,028 Accrued expenses 13,996,273 12,527,300 Income tax payable 7,408,348 2,837,353 Current portion of long-term liabilities 278,619 1,232,817 Provisions 4,294,820 4,597,417 Other current liabilities 403,139 351,176 Liabilities held-for-sale — 356,388 Total current liabilities 67,175,114 54,704,095 Non-current liabilities Debentures 953,361 58,542 Long-term borrowings 1,814,446 1,244,238 Long-term other payables 2,043,729 3,317,054 Net defined benefit liabilities 389,922 173,656 Deferred income tax liabilities 11,710,781 7,293,514 Provisions 464,324 358,126 Other non-current liabilities 2,708,985 2,062,066 Total liabilities 87,260,662 69,211,291 Equity attributable to owners of the parent Preference shares 119,467 119,467 Ordinary shares 778,047 778,047 Share premium 4,403,893 4,403,893 Retained earnings 215,811,200 193,086,317 Other components of equity (13,899,191) (11,934,586) Accumulated other comprehensive income attributable to assets held for-sale — (28,810) 207,213,416 186,424,328 Non-controlling interests 7,278,012 6,538,705 Total equity 214,491,428 192,963,033 Total liabilities and equity 301,752,090 262,174,324

The above consolidated statement of financial position should be read in conjunction with the accompanying notes.

Appendix A Financial Statement Information A-15

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Samsung Electronics Co., Ltd. and Subsidiaries CONSOLIDATED STATEMENTS OF PROFIT OR LOSS

For the year ended December 31 2017 2016

(In millions of Korean won) KRW KRW Revenue 239,575,376 201,866,745 Cost of sales 129,290,661 120,277,715 Gross profit 110,284,715 81,589,030 Selling and administrative expenses 56,639,677 52,348,358 Operating profit 53,645,038 29,240,672 Other non-operating income 3,010,657 3,238,261 Other non-operating expense 1,419,648 2,463,814 Share of profit of associates and joint ventures 201,442 19,501 Financial income 9,737,391 11,385,645 Financial expense 8,978,913 10,706,613 Profit before income tax 56,195,967 30,713,652 Income tax expense 14,009,220 7,987,560 Profit for the period 42,186,747 22,726,092

Profit attributable to owners of the parent 41,344,569 22,415,655 Profit attributable to non-controlling interests 842,178 310,437

Earnings per share —Basic 299,868 157,967 —Diluted 299,868 157,967

The above consolidated statement of financial position should be read in conjunction with the accompanying notes.

Samsung Electronics Co., Ltd. and Subsidiaries CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the year ended December 31 2017 2016

(In millions of Korean won) KRW KRW Profit for the period 42,186,747 22,726,092 Other comprehensive income (loss) Items not to be reclassified to profit or loss subsequently: Remeasurement of net defined benefit liabilities, net of tax 414,247 963,602 Shares of other comprehensive income (loss) of associates and joint ventures, net of tax (6,347) 50,438 Items to be reclassified to profit or loss subsequently: Changes in value of available-for-sale financial assets, net of tax 511,207 (23,839) Share of other comprehensive income (loss) of associates and joint ventures, net of tax (49,256) (130,337) Foreign currency translation, net of tax (6,334,987) 1,131,536 Gain (loss) on valuation of derivatives (37,121) — Other comprehensive income (loss) for the period, net of tax (5,502,257) 1,991,400 Total comprehensive income for the period 36,684,490 24,717,492

Comprehensive income attributable to: Owners of the parent 35,887,505 24,310,814 Non-controlling interests 796,985 406,678

The above consolidated statement of financial position should be read in conjunction with the accompanying notes.

A-16 Appendix A Financial Statement Information SA

M SU

N G

Samsung Electronics Co., Ltd. and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

Accumulated other comprehensive income Equity Other attributable to attributable Non Preference Ordinary Share Retained Components assets held- to owners controlling In millions of Korean won shares shares premium earnings of equity for-sale of the parent interests Total

Balance as at January 1, 2016 119,467 778,047 4,403,893 185,132,014 (17,580,451) 23,797 172,876,767 6,183,038 179,059,805 Profit for the period — — — 22,415,655 — — 22,415,655 310,437 22,726,092 Changes in value of available-for-sale financial assets, net of tax — — — — (87,706) (23,797) (111,503) 87,664 (23,839) Share of other comprehensive income (loss) of associates and joint ventures, net of tax — — — — (80,146) 212 (79,934) 35 (79,899) Foreign currency translation, net of tax — — — — 1,160,316 — 1,160,316 (28,780) 1,131,536 Remeasurement of net defined benefit liabilities, net of tax — — — — 926,280 — 926,280 37,322 963,602

Classified as held-for-sale — — — — 29,022 (29,022) — — —

Total comprehensive income (loss) — — — 22,415,655 1,947,766 (52,607) 24,310,814 406,678 24,717,492 Dividends — — — (3,061,361) — — (3,061,361) (65,161) (3,126,522) Capital transaction under common control — — — — (37) — (37) 12,272 12,235 Changes in consolidated entities — — — — — — — 1,790 1,790 Acquisition of treasury stock — — — — (7,707,938) — (7,707,938) — (7,707,938) Retirement of treasury stock — — — (11,399,991) 11,399,991 — — — —

Others — — — — 6,083 — 6,083 88 6,171

Total transactions with owners — — — (14,461,352) 3,698,099 — (10,763,253) (51,011) (10,814,264)

Balance as at December 31, 2016 119,467 778,047 4,403,893 193,086,317 (11,934,586) (28,810) 186,424,328 6,538,705 192,963,033 Profit for the period — — — 41,344,569 — — 41,344,569 842,178 42,186,747 Changes in value of available-for-sale financial assets, net of tax — — — — 489,150 — 489,150 22,057 511,207 Share of other comprehensive income (loss) of associates and joint ventures, net of tax — — — — (54,300) — (54,300) (1,303) (55,603) Foreign currency translation, net of tax — — — — (6,289,926) 28,810 (6,261,116) (73,871) (6,334,987) Remeasurement of net defined benefit liabilities, net of tax — — — — 406,323 — 406,323 7,924 414,247

Gain (loss) on valuation of derivatives — — — — (37,121) — (37,121) — (37,121)

Total comprehensive income (loss) — — — 41,344,569 (5,485,874) 28,810 35,887,505 796,985 36,684,490 Dividends — — — (6,747,123) — — (6,747,123) (64,277) (6,811,400) Capital transaction under common control — — — — (2,992) — (2,992) 15,114 12,122 Changes in consolidated entities — — — — (2,699) — (2,699) (9,352) (12,051) Acquisition of treasury stock — — — — (8,350,424) — (8,350,424) — (8,350,424) Retirement of treasury stock — — — (11,872,563) 11,872,563 — — — —

Others — — — — 4,821 — 4,821 837 5,658

Total transactions with owners — — — (18,619,686) 3,521,269 — (15,098,417) (57,678) (15,156,095)

Balance as at December 31, 2017 119,467 778,047 4,403,893 215,811,200 (13,899,191) — 207,213,416 7,278,012 214,491,428

The above consolidated statement of financial position should be read in conjunction with the accompanying notes.

Appendix A Financial Statement Information A-17

SA M

SU N

G

Samsung Electronics Co., Ltd. and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS

For the year ended December 31 2017 2016

(In millions of Korean won) KRW KRW Cash flows from operating activities Profit for the period 42,186,747 22,726,092 Adjustments 36,211,232 30,754,471 Changes in assets and liabilities arising from operating activities (10,620,547) (1,180,953) Cash generated from operations 67,777,432 52,299,610 Interest received 1,581,117 1,405,085 Interest paid (542,715) (443,838) Dividends received 173,305 256,851 Income tax paid (6,827,098) (6,132,064) Net cash inflow from operating activities 62,162,041 47,385,644 Cash flows from investing activities Net decrease (increase) in short-term financial instruments 387,627 (6,780,610) Disposal of short-term available-for-sale financial assets 499,856 3,010,003 Acquisition of short-term available-for-sale financial assets — (2,129,551) Disposal of long-term financial instruments 1,750,221 789,862 Acquisition of long-term financial instruments (1,079,355) (1,741,547) Disposal of long-term available-for-sale financial assets 191,826 2,010,356 Acquisition of long-term available-for-sale financial assets (358,497) (1,498,148) Acquisition of held-to-maturity financial assets (106,751) — Disposal of investment in associates and joint ventures 355,926 2,280,203 Acquisition of investment in associates and joint ventures (25,293) (84,306) Disposal of property, plant and equipment 308,354 270,874 Acquisition of property, plant and equipment (42,792,234) (24,142,973) Disposal of intangible assets 733 6,944 Acquisition of intangible assets (983,740) (1,047,668) Cash outflow from business combinations (8,754,268) (622,050) Cash inflow from business transfers 1,248,834 — Others (28,455) 19,936 Net cash outflow from investing activities (49,385,216) (29,658,675) Cash flows from financing activities Net increase in short-term borrowings 2,730,676 1,351,037 Acquisition of treasury stock (8,350,424) (7,707,938) Proceeds from long-term borrowings and debentures 998,311 1,041,743 Repayment of long-term borrowings and debentures (1,140,803) (252,846) Dividends paid (6,804,297) (3,114,742) Net increase in non-controlling interests 5,670 13,232 Net cash outflow from financing activities (12,560,867) (8,669,514) Effect of exchange rate changes on cash and cash equivalents (1,782,270) 417,243 Net (decrease) increase in cash and cash equivalents (1,566,312) 9,474,698 Cash and cash equivalents Beginning of the period 32,111,442 22,636,744 End of the period 30,545,130 32,111,442

The above consolidated statements of cash flows should be read in conjunction with the accompanying notes.

Learning Objectives

CONCEPTUAL C1 Describe the earning of interest and the

concepts of present and future values.

P3 Apply present value concepts to an annuity by using interest tables.

P4 Apply future value concepts to an annuity by using interest tables.

PROCEDURAL P1 Apply present value concepts to a single

amount by using interest tables.

P2 Apply future value concepts to a single amount by using interest tables.

Appendix Preview

B Time Value of Money

PRESENT AND FUTURE VALUE CONCEPTS

C1 Time is money Concept of interest

VALUE OF A SINGLE AMOUNT

P1 Present value of a single amount

P2 Future value of a single amount

NTK B-1, B-2

VALUE OF AN ANNUITY

P3 Present value of an annuity P4 Future value of an annuity

NTK B-3, B-4

Appendix B Time Value of Money B-1

The old saying “Time is money” means that as time passes, the values of assets and liabilities change. This change is due to interest, which is a borrower’s payment to the owner of an asset for its use. The most common example of interest is a savings account. Cash in the account earns interest paid by the financial institution. An example of a liability is a car loan. As we carry the balance of the loan, we accumulate interest costs on it. We must ultimately repay this loan with interest.

Present and future value computations enable us to measure or estimate the interest compo- nent of holding assets or liabilities over time. The present value computation is used to compute the value of future-day assets today. The future value computation is used to compute the value of present-day assets at a future date. The first section focuses on the present value of a single amount. The second section focuses on the future value of a single amount. Then both the pres- ent and future values of a series of amounts (called an annuity) are defined and explained.

PRESENT AND FUTURE VALUE CONCEPTS C1 Describe the earning of interest and the concepts of present and future values.

What’s Five Million Worth? Robert Miles, a maintenance worker, purchased a scratch-off ticket that won him a $5 million jackpot. The $5 million payout was offered to Miles as a $250,000 annuity for 20 years or as a lump-sum payment of $3,210,000, which is about $2,124,378 after taxes. ■

Decision Insight

Graph of PV of a Single Amount We graphically express the present value, called p, of a single future amount, called f, that is received or paid at a future date in Exhibit B.1.

PRESENT VALUE OF A SINGLE AMOUNT

$

Formula of PV of a Single Amount The formula to compute the present value of a single amount is shown in Exhibit B.2, where p = present value (PV); f = future value (FV); i = rate of interest per period; and n = number of periods. (Interest is also called the discount, and interest rate is also called the discount rate.)

f Time

p

Today Future

EXHIBIT B.1 Present Value of a Single Amount Diagram

EXHIBIT B.2 Present Value of a Single Amount Formula

p = f

(1 + i)n

Illustration of PV of a Single Amount for One Period To illustrate present value concepts, assume that we need $220 one period from today. We want to know how much we must invest now, for one period, at an interest rate of 10% to provide for this $220. For this illustration, the p, or present value, is the unknown amount—the specifics are shown graphically as follows.

f = $220(i = 0.10) p = ?

Conceptually, we know p must be less than $220. This is clear from the answer to: Would we rather have $220 today or $220 at some future date? If we had $220 today, we could invest it and see it grow to something more than $220 in the future. Therefore, we would prefer the $220 today. This means that if we were promised $220 in the future, we would take less than $220

P1 Apply present value concepts to a single amount by using interest tables.

B-2 Appendix B Time Value of Money

today. But how much less? To answer that question, we compute an estimate of the present value of the $220 to be received one period from now using the formula in Exhibit B.2 as follows.

p = f

(1 + i)n =

$220 (1 + 0.10)1

= $200

Together, these results tell us we are indifferent between $200 today, or $220 one period from today, or $242 two periods from today given a 10% interest rate per period.

The number of periods (n) in the present value formula does not have to be expressed in years. Any period of time such as a day, a month, a quarter, or a year can be used. Whatever period is used, the interest rate (i) must be compounded for the same period. This means that if a situation expresses n in months and i equals 12% per year, then i is transformed into interest earned per month (or 1%). In this case, interest is said to be compounded monthly. For example, the present value of $1 when n is 12 months and i is 12% compounded monthly follows.

I will pay your allowance at the end

of the month. Do you want to wait or receive its present value today?

This formula is identical to that in Exhibit B.2 except that f equals 1. Table B.1 at the end of this appendix is such a present value table. It is often called a present value of 1 table. A pres- ent value table has three factors: p, i, and n. Knowing two of these three factors allows us to compute the third. (A fourth is f, but, as already explained, we need only multiply the 1 used in the formula by f.) To illustrate the use of a present value table, consider three cases.

Case 1 Solve for p when knowing i and n. To show how we use a present value table, let’s look again at how we estimate the present value of $220 (the f value) at the end of one period (n = 1) where the interest rate (i) is 10%. To solve this case, we go to the present value table (Table B.1) and look in the row for one period and in the column for 10% interest. Here we find a present value (p) of 0.9091 based on a future value of 1. This means, for instance, that $1 to be received one period from today at 10% interest is worth $0.9091 today. Because the future value in this case is not $1 but $220, we multiply the 0.9091 by $220 to get an answer of $200.

Case 2 Solve for n when knowing p and i. To illustrate, assume a $100,000 future value ( f ) that is worth $13,000 today (p) using an interest rate of 12% (i) but where n is unknown. In par- ticular, we want to know how many periods (n) there are between the present value and the fu- ture value. To put this in context, it would fit a situation in which we want to retire with $100,000 but currently have only $13,000 that is earning a 12% return and we are unable to save addi- tional money. How long will it be before we can retire? To answer this, we go to Table B.1 and

We interpret this result to say that given an interest rate of 10%, we are indifferent between $200 today or $220 at the end of one period.

Illustration of PV of a Single Amount for Multiple Periods We can use this formula to compute the present value for any number of periods. To illustrate, consider a pay- ment of $242 at the end of two periods at 10% interest. The present value of this $242 to be received two periods from now is computed as follows.

p = 1

(1 + 0.01)12 = $0.8874

Using Present Value Table to Compute PV of a Single Amount A present value table helps us with present value computations. It gives us present values (factors) for a va- riety of both interest rates (i) and periods (n). Each present value in a present value table assumes that the future value ( f ) equals 1. When the future value ( f ) is different from 1, we simply multi- ply the present value (p) from the table by that future value to give us the estimate. The formula used to construct a table of present values for a single future amount of 1 is shown in Exhibit B.3.

p = 1

(1 + i)n

EXHIBIT B.3 Present Value of 1 Formula

p = f

(1 + i)n =

$242 (1 + 0.10)2

= $200

Point: Excel for PV.

A B

1 Future value $242

2 Periods 2

3 Period int. rate 10%

4 Present value

=−PV(B3,B2,0,B1) = $200

Appendix B Time Value of Money B-3

look in the 12% interest column. Here we find a column of present values (p) based on a future value of 1. To use the present value table for this solution, we must divide $13,000 (p) by $100,000 ( f ), which equals 0.1300. This is necessary because a present value table defines f equal to 1, and p as a fraction of 1. We look for a value nearest to 0.1300 (p), which we find in the row for 18 periods (n). This means that the present value of $100,000 at the end of 18 peri- ods at 12% interest is $13,000; alternatively stated, we must work 18 more years.

Case 3 Solve for i when knowing p and n. In this case, we have, say, a $120,000 future value ( f ) worth $60,000 today (p) when there are nine periods (n) between the present and fu- ture values, but the interest rate is unknown. As an example, suppose we want to retire with $120,000 in nine years, but we have only $60,000 and we are unable to save additional money. What interest rate must we earn to retire with $120,000 in nine years? To answer this, we go to the present value table (Table B.1) and look in the row for nine periods. To use the present value table, we must divide $60,000 (p) by $120,000 ( f ), which equals 0.5000. Recall that this step is necessary because a present value table defines f equal to 1 and p as a fraction of 1. We look for a value in the row for nine periods that is nearest to 0.5000 (p), which we find in the column for 8% interest (i). This means that the present value of $120,000 at the end of nine periods at 8% interest is $60,000 or, in our example, we must earn 8% annual interest to retire in nine years.

A company is considering an investment expected to yield $70,000 after six years. If this company demands an 8% return, how much is it willing to pay for this investment today?

Solution

Today’s value = $70,000 × 0.6302 = $44,114 (using PV factor from Table B.1, i = 8%, n = 6) P1

Present Value of a Single Amount

NEED-TO-KNOW B-1

Formula of FV of a Single Amount We must modify the formula for the present value of a single amount to obtain the formula for the future value of a single amount. In particular, we multiply both sides of the equation in Exhibit B.2 by (1 + i)n to get the result shown in Exhibit B.4.

FUTURE VALUE OF A SINGLE AMOUNT

EXHIBIT B.4 Future Value of a Single Amount Formula

Point: The FV factor in Table B.2 when n = 3 and i = 10% is 1.3310.

f = p × (1 + i)n

Illustration of FV of a Single Amount for One Period The future value ( f ) is defined in terms of p, i, and n. We can use this formula to determine that $200 (p) invested for one period (n) at an interest rate of 10% (i) yields a future value of $220 as follows.

f = p × (1 + i)n

= $200 × (1 + 0.10)1

= $220

Illustration of FV of a Single Amount for Multiple Periods This formula can be used to compute the future value of an amount for any number of periods into the future. To illustrate, assume that $200 is invested for three periods at 10%. The future value of this $200 is $266.20, computed as follows.

f = p × (1 + i)n

= $200 × (1 + 0.10)3

= $200 × 1.3310 = $266.20

Point: Excel for FV.

A B

1 Present value $200

2 Periods 3

3 Period int. rate 10%

4 Future value

=−FV(B3,B2,0,B1) = $266.20

Using Future Value Table to Compute FV of a Single Amount A future value table makes it easier for us to compute future values ( f ) for many different combinations of interest rates (i) and time periods (n). Each future value in a future value table assumes the present value (p)

P2 Apply future value concepts to a single amount by using interest tables.

B-4 Appendix B Time Value of Money

is 1. If the future amount is something other than 1, we multiply our answer by that amount. The formula used to construct a table of future values (factors) for a single amount of 1 is in Exhibit B.5.

Assume that you win a $150,000 cash sweepstakes today. You decide to deposit this cash in an account earning 8% annual interest, and you plan to quit your job when the account equals $555,000. How many years will it be before you can quit working?

Solution

Future value factor = $555,000∕$150,000 = 3.7000 Searching for 3.7 in the 8% column of Table B.2 shows you cannot quit working for 17 years if your deposit earns 8% interest.

Future Value of a Single Amount

NEED-TO-KNOW B-2

EXHIBIT B.5 Future Value of 1 Formula

f = (1 + i)n

P2

Table B.2 at the end of this appendix shows a table of future values for a current amount of 1. This type of table is called a future value of 1 table.

There are some important relations between Tables B.1 and B.2. In Table B.2, for the row where n = 0, the future value is 1 for each interest rate. This is because no interest is earned when time does not pass. We also see that Tables B.1 and B.2 report the same information but in a different manner. In particular, one table is simply the reciprocal of the other. To illustrate this inverse relation, let’s say we invest $100 for a period of five years at 12% per year. How much do we expect to have after five years? We can answer this question using Table B.2 by finding the future value ( f ) of 1, for five periods from now, compounded at 12%. From that table we find f = 1.7623. If we start with $100, the amount it accumulates to after five years is $176.23 ($100 × 1.7623). We can alternatively use Table B.1. Here we find that the present value (p) of 1, discounted five periods at 12%, is 0.5674. Recall the inverse relation between present value and future value. This means that p = 1∕f (or equivalently, f = 1∕p). We can compute the future value of $100 invested for five periods at 12% as follows: f = $100 × (1∕0.5674) = $176.24 (which equals the $176.23 just computed, except for a 1 cent rounding difference).

A future value table has three factors: f, i, and n. Knowing two of these three factors allows us to compute the third. To illustrate, consider three possible cases.

Case 1 Solve for f when knowing i and n. Our preceding example fits this case. We found that $100 invested for five periods at 12% interest accumulates to $176.24.

Case 2 Solve for n when knowing f and i. In this case, we have, say, $2,000 (p) and we want to know how many periods (n) it will take to accumulate to $3,000 ( f ) at 7% interest (i). To answer this, we go to the future value table (Table B.2) and look in the 7% interest column. Here we find a column of future values ( f ) based on a present value of 1. To use a future value table, we must divide $3,000 ( f ) by $2,000 (p), which equals 1.500. This is necessary because a fu- ture value table defines p equal to 1, and f as a multiple of 1. We look for a value nearest to 1.50 ( f ), which we find in the row for six periods (n). This means that $2,000 invested for six periods at 7% interest accumulates to $3,000.

Case 3 Solve for i when knowing f and n. In this case, we have, say, $2,001 (p), and in nine years (n) we want to have $4,000 ( f ). What rate of interest must we earn to accomplish this? To answer that, we go to Table B.2 and search in the row for nine periods. To use a future value table, we must divide $4,000 ( f ) by $2,001 (p), which equals 1.9990. Recall that this is neces- sary because a future value table defines p equal to 1 and f as a multiple of 1. We look for a value nearest to 1.9990 ( f ), which we find in the column for 8% interest (i). This means that $2,001 invested for nine periods at 8% interest accumulates to $4,000.

Point: 1/PV factor = FV factor. 1/FV factor = PV factor.

Point: The FV factor when n = 2 and i = 10%, is 1.2100. Its reciprocal, 0.8264, is the PV factor when n = 2 and i = 10%.

Entrepreneur You are a retailer planning a sale on a security system that requires no payments for two years. At the end of two years, buyers must pay the full amount. The system’s suggested retail price is $4,100, but you are willing to sell it today for $3,000 cash. What is your sale price if payment will not occur for two years and the market interest rate is 10%? ■ Answer: This is a present value question. The interest rate (10%) and present value ($3,000) are known, but the payment required two years later is unknown. The two-year-later price of $3,630 is computed as $3,000 × 1.10 × 1.10. The $3,630 two years from today is equivalent to $3,000 today.

Decision Maker

Appendix B Time Value of Money B-5

Graph of PV of an Annuity An annuity is a series of equal payments occurring at equal intervals. One example is a series of three annual payments of $100 each. An ordinary annuity is defined as equal end-of-period payments at equal intervals. An ordinary annuity of $100 for three periods and its present value (p) are illustrated in Exhibit B.6.

PRESENT VALUE OF AN ANNUITY P3 Apply present value concepts to an annuity by using interest tables.

Formula and Illustration of PV of an Annuity One way to compute the present value of an ordinary annuity is to find the present value of each payment using our present value formula from Exhibit B.3. We then add each of the three present values. To illustrate, let’s look at three $100 payments at the end of each of the next three periods with an interest rate of 15%. Our present value computations are

$100 $100 $100 • • • • Time p

Today Future (n = 1) Future (n = 2) Future (n = 3)

p = $100

(1 + 0.15)1 +

$100 (1 + 0.15)2

+ $100

(1 + 0.15)3 = $228.32

Using Present Value Table to Compute PV of an Annuity This computa- tion is identical to computing the present value of each payment (from Table B.1) and taking their sum or, alternatively, adding the values from Table B.1 for each of the three payments and multiplying their sum by the $100 annuity payment.

A more direct way is to use a present value of annuity table. Table B.3 at the end of this appendix is one such table. This table is called a present value of an annuity of 1 table. If we look at Table B.3 where n = 3 and i = 15%, we see the present value is 2.2832. This means that the present value of an annuity of 1 for three periods, with a 15% interest rate, equals 2.2832.

A present value of an annuity formula is used to construct Table B.3. It also can be con- structed by adding the amounts in a present value of 1 table. To illustrate, we use Tables B.1 and B.3 to confirm this relation for the prior example.

From Table B.1 From Table B.3

i = 15%, n = 1 . . . . . . . . . . 0 .8696 i = 15%, n = 2 . . . . . . . . . . 0 .7561 i = 15%, n = 3 . . . . . . . . . . 0 .6575 Total . . . . . . . . . . . . . . . . . . . 2 .2832 i = 15%, n = 3 . . . . . . . . . . . 2 .2832

We also can use business calculators or spreadsheet programs to find the present value of an annuity.

A company is considering an investment that would produce payments of $10,000 every six months for three years. The first payment would be received in six months. If this company requires an 8% annual return, what is the maximum amount it is willing to pay for this investment today?

Solution

Maximum paid = $10,000 × 5.2421 = $52,421 (using PV of annuity factor from Table B.3, i = 4%, n = 6) P3

Present Value of an Annuity

NEED-TO-KNOW B-3

Point: Excel for PV annuity.

A B

1 Payment $100

2 Periods 3

3 Period int. rate 15%

4 Present value

=−PV(B3,B2,B1) = $228.32

Count Your Blessings “I don’t have good luck—I’m blessed,” proclaimed Andrew “Jack” Whittaker, a sewage treat- ment contractor, after winning the largest ever undivided jackpot in a U.S. lottery. Whittaker had to choose between $315 million in 30 annual installments or $170 million in one lump sum ($112 million after-tax). ■

Decision Insight

EXHIBIT B.6 Present Value of an Ordinary Annuity Diagram

B-6 Appendix B Time Value of Money

Graph of FV of an Annuity The future value of an ordinary annuity is the accumu- lated value of each annuity payment with interest as of the date of the final payment. To illus- trate, let’s consider the earlier annuity of three annual payments of $100. Exhibit B.7 shows the point in time for the future value ( f ). The first payment is made two periods prior to the point when future value is determined, and the final payment occurs on the future value date.

FUTURE VALUE OF AN ANNUITY P4 Apply future value concepts to an annuity by using interest tables.

EXHIBIT B.7 Future Value of an Ordinary Annuity Diagram

$100 $100 $100 • • • • Time

f

Today Future (n = 1) Future (n = 2) Future (n = 3)

Formula and Illustration of FV of an Annuity One way to compute the future value of an annuity is to use the formula to find the future value of each payment and add them. If we assume an interest rate of 15%, our calculation is

f = $100 × (1 + 0.15)2 + $100 × (1 + 0.15)1 + $100 × (1 + 0.15)0 = $347.25

This is identical to using Table B.2 and summing the future values of each payment, or adding the future values of the three payments of 1 and multiplying the sum by $100.

Using Future Value Table to Compute FV of an Annuity A more direct way is to use a table showing future values of annuities. Such a table is called a future value of an annuity of 1 table. Table B.4 at the end of this appendix is one such table. Note that in Table B.4 when n = 1, the future values equal 1 ( f = 1) for all rates of interest. This is because such an annu- ity consists of only one payment, and the future value is determined on the date of that payment— no time passes between the payment and its future value. The future value of an annuity formula is used to construct Table B.4. We also can construct it by adding the amounts from a future value of 1 table. To illustrate, we use Tables B.2 and B.4 to confirm this relation for the prior example.

Note that the future value in Table B.2 is 1.0000 when n = 0, but the future value in Table B.4 is 1.0000 when n = 1. Is this a contradiction? No. When n = 0 in Table B.2, the future value is determined on the date when a single payment occurs. This means that no interest is earned because no time has passed, and the future value equals the payment. Table B.4 describes annu- ities with equal payments occurring at the end of each period. When n = 1, the annuity has one payment, and its future value equals 1 on the date of its final and only payment. Again, no time passes between the payment and its future value date.

From Table B.2 From Table B.4

i = 15%, n = 0 . . . . . . . . . . 1 .0000 i = 15%, n = 1 . . . . . . . . . . 1 .1500 i = 15%, n = 2 . . . . . . . . . . 1 .3225 Total . . . . . . . . . . . . . . . . . . . 3 .4725 i = 15%, n = 3 . . . . . . . . . . . 3 .4725

Point: An ordinary annuity is a series of equal cash flows, with the payment at the end of each period.

A company invests $45,000 per year for five years at 12% annual interest. Compute the value of this annu- ity investment at the end of five years.

Solution

Future value = $45,000 × 6.3528 = $285,876 (using FV of annuity factor from Table B.4, i = 12%, n = 5)

Future Value of an Annuity

NEED-TO-KNOW B-4

P4

Point: Excel for FV annuity.

A B

1 Payment $100

2 Periods 3

3 Period int. rate 15%

4 Future value

=−FV(B3,B2,B1) = $347.25

Appendix B Time Value of Money B-7

Ken Francis is offered the possibility of investing $2,745 today; in return, he would receive $10,000 after 15 years. What is the annual rate of interest for this investment? (Use Table B.1.)

QS B-2 Interest rate on an investment P1

Megan Brink is offered the possibility of investing $6,651 today at 6% interest per year in a desire to accumulate $10,000. How many years must Brink wait to accumulate $10,000? (Use Table B.1.)

QS B-3 Number of periods of an investment P1

Flaherty is considering an investment that, if paid for immediately, is expected to return $140,000 five years from now. If Flaherty demands a 9% return, how much is she willing to pay for this investment?

QS B-4 Present value of an amount P1

CII, Inc., invests $630,000 in a project expected to earn a 12% annual rate of return. The earnings will be reinvested in the project each year until the entire investment is liquidated 10 years later. What will the cash proceeds be when the project is liquidated?

QS B-5 Future value of an amount P2

Beene Distributing is considering a project that will return $150,000 annually at the end of each year for the next six years. If Beene demands an annual return of 7% and pays for the project immediately, how much is it willing to pay for the project?

QS B-6 Present value of an annuity P3

Claire Fitch is planning to begin an individual retirement program in which she will invest $1,500 at the end of each year. Fitch plans to retire after making 30 annual investments in the program earning a return of 10%. What is the value of the program on the date of the last payment (30 years from the present)?

QS B-7 Future value of an annuity P4

QUICK STUDY

QS B-1 Identifying interest rates in tables

C1

Assume that you must estimate what the future value will be two years from today using the future value of 1 table (Table B.2). Which interest rate column and number-of-periods row do you use when working with the following rates? 1. 12% annual rate, compounded annually 2. 6% annual rate, compounded semiannually 3. 8% annual rate, compounded quarterly 4. 12% annual rate, compounded monthly (the answer for number-of-periods in part 4 is not shown in

Table B.2)

PV OF A SINGLE AMOUNT where p = present value (PV); f = future value (FV); i = rate of interest

per period; and n = number of periods. Excel follows:

PV OF AN ANNUITY where p = pres- ent value (PV); f = future value

(FV); i = rate of interest per period; and n = number of periods. Excel follows:

Summary: Cheat Sheet

p = f

(1 + i)n Point: Excel for PV.

A B

1 Future value $242

2 Periods 2

3 Period int. rate 10%

4 Present value

=−PV(B3,B2,0,B1) = $200

FV OF A SINGLE AMOUNT where p = present value (PV); f = future

value (FV); i = rate of interest per period; and n = number of periods. Excel follows:

f = p × (1 + i)n Point: Excel for FV.

A B

1 Present value $200

2 Periods 3

3 Period int. rate 10%

4 Future value

=−FV(B3,B2,0,B1) = $266.20

p = f × [1 − 1

(1 + i)n] ∕i

FV OF AN ANNUITY where p = pres- ent value (PV);

f = future value (FV); i = rate of interest per period; and n = number of periods. Excel follows:

f = p × [(1 + i)n − 1]∕i Point: Excel for FV annuity.

A B

1 Payment $100

2 Periods 3

3 Period int. rate 15%

4 Future value

=−FV(B3,B2,B1) = $347.25

Point: Excel for PV annuity.

A B

1 Payment $100

2 Periods 3

3 Period int. rate 15%

4 Present value

=−PV(B3,B2,B1) = $228.32

B-8 Appendix B Time Value of Money

EXERCISES

Exercise B-1 Present value of an amount P1

Mike Derr Company expects to earn 10% per year on an investment that will pay $606,773 six years from now. Use Table B.1 to compute the present value of this investment. (Round the amount to the nearest dollar.)

Exercise B-2 Present value of an amount P1

On January 1, a company agrees to pay $20,000 in three years. If the annual interest rate is 10%, determine how much cash the company can borrow with this agreement.

Exercise B-3 Number of periods of an investment P2

Tom Thompson expects to invest $10,000 at 12% and, at the end of a certain period, receive $96,463. How many years will it be before Thompson receives the payment? (Use Table B.2.)

Exercise B-4 Interest rate on an investment P2

Bill Padley expects to invest $10,000 for 25 years, after which he wants to receive $108,347. What rate of interest must Padley earn? (Use Table B.2.)

Exercise B-5 Future value of an amount P2

Mark Welsch deposits $7,200 in an account that earns interest at an annual rate of 8%, compounded quar- terly. The $7,200 plus earned interest must remain in the account 10 years before it can be withdrawn. How much money will be in the account at the end of 10 years?

Exercise B-6 Future value of an amount P2

Catten, Inc., invests $163,170 today earning 7% per year for nine years. Use Table B.2 to compute the future value of the investment nine years from now. (Round the amount to the nearest dollar.)

Exercise B-9 Present value of an annuity P3

Dave Krug finances a new automobile by paying $6,500 cash and agreeing to make 40 monthly payments of $500 each, the first payment to be made one month after the purchase. The loan bears interest at an an- nual rate of 12%. What is the cost of the automobile?

Exercise B-11 Present value with semiannual compounding

C1 P3

Otto Co. borrows money on April 30, 2019, by promising to make four payments of $13,000 each on November 1, 2019; May 1, 2020; November 1, 2020; and May 1, 2021. 1. How much money is Otto able to borrow if the interest rate is 8%, compounded semiannually? 2. How much money is Otto able to borrow if the interest rate is 12%, compounded semiannually? 3. How much money is Otto able to borrow if the interest rate is 16%, compounded semiannually?

Exercise B-7 Interest rate on an investment P3

Jones expects an immediate investment of $57,466 to return $10,000 annually for eight years, with the first payment to be received one year from now. What rate of interest must Jones earn? (Use Table B.3.)

Exercise B-10 Present values of annuities

P3

C&H Ski Club recently borrowed money and agreed to pay it back with a series of six annual payments of $5,000 each. C&H subsequently borrows more money and agrees to pay it back with a series of four annual payments of $7,500 each. The annual interest rate for both loans is 6%. 1. Use Table B.1 to find the present value of these two separate annuities. (Round amounts to the nearest

dollar.) 2. Use Table B.3 to find the present value of these two separate annuities. (Round amounts to the nearest

dollar.)

Exercise B-8 Number of periods of an investment P3

Keith Riggins expects an investment of $82,014 to return $10,000 annually for several years. If Riggins earns a return of 10%, how many annual payments will he receive? (Use Table B.3.)

Spiller Corp. plans to issue 10%, 15-year, $500,000 par value bonds payable that pay interest semiannu- ally on June 30 and December 31. The bonds are dated December 31, 2019, and are issued on that date. If the market rate of interest for the bonds is 8% on the date of issue, what will be the total cash proceeds from the bond issue?

Exercise B-12 Present value of bonds

P1 P3

Appendix B Time Value of Money B-9

Compute the amount that can be borrowed under each of the following circumstances: 1. A promise to repay $90,000 seven years from now at an interest rate of 6%. 2. An agreement made on February 1, 2019, to make three separate payments of $20,000 on February 1

of 2020, 2021, and 2022. The annual interest rate is 10%.

Exercise B-13 Present value of an amount and of an annuity

P1 P3

Algoe expects to invest $1,000 annually for 40 years to yield an accumulated value of $154,762 on the date of the last investment. For this to occur, what rate of interest must Algoe earn? (Use Table B.4.)

Exercise B-14 Interest rate on an investment P4

Steffi Derr expects to invest $10,000 annually that will earn 8%. How many annual investments must Derr make to accumulate $303,243 on the date of the last investment? (Use Table B.4.)

Exercise B-15 Number of periods of an investment P4

Kelly Malone plans to have $50 withheld from her monthly paycheck and deposited in a savings account that earns 12% annually, compounded monthly. If Malone continues with her plan for two and one-half years, how much will be accumulated in the account on the date of the last deposit?

Exercise B-16 Future value of an annuity P4

Starr Company decides to establish a fund that it will use 10 years from now to replace an aging produc- tion facility. The company will make a $100,000 initial contribution to the fund and plans to make quar- terly contributions of $50,000 beginning in three months. The fund earns 12%, compounded quarterly. What will be the value of the fund 10 years from now?

Exercise B-17 Future value of an amount plus an annuity

P2 P4

For each of the following situations, identify (1) the case as either (a) a present or a future value and (b) a single amount or an annuity, (2) the table you would use in your computations (but do not solve the prob- lem), and (3) the interest rate and time periods you would use. a. You need to accumulate $10,000 for a trip you wish to take in four years. You are able to earn 8%

compounded semiannually on your savings. You plan to make only one deposit and let the money ac- cumulate for four years. How would you determine the amount of the one-time deposit?

b. Assume the same facts as in part (a) except that you will make semiannual deposits to your savings account. c. You want to retire after working 40 years with savings in excess of $1,000,000. You expect to save

$4,000 a year for 40 years and earn an annual rate of interest of 8%. Will you be able to retire with more than $1,000,000 in 40 years? Explain.

d. A sweepstakes agency names you a grand prize winner. You can take $225,000 immediately or elect to receive annual installments of $30,000 for 20 years. You can earn 10% annually on any investments you make. Which prize do you choose to receive?

Exercise B-19 Using present and future value tables

C1 P1 P2 P3 P4

a. How much would you have to deposit today if you wanted to have $60,000 in four years? Annual inter- est rate is 9%.

b. Assume that you are saving up for a trip around the world when you graduate in two years. If you can earn 8% on your investments, how much would you have to deposit today to have $15,000 when you graduate?

c. Would you rather have $463 now or $1,000 ten years from now? Assume that you can earn 9% on your investments.

d. Assume that a college parking sticker today costs $90. If the cost of parking is increasing at the rate of 5% per year, how much will the college parking sticker cost in eight years?

e. Assume that the average price of a new home is $158,500. If the cost of a new home is increasing at a rate of 10% per year, how much will a new home cost in eight years?

f. An investment will pay you $10,000 in 10 years and it also will pay you $400 at the end of each of the next 10 years (Years 1 through 10). If the annual interest rate is 6%, how much would you be willing to pay today for this type of investment?

g. A college student is reported in the newspaper as having won $10,000,000 in the Kansas State Lottery. However, as is often the custom with lotteries, she does not actually receive the entire $10 million now. Instead she will receive $500,000 at the end of the year for each of the next 20 years. If the an- nual interest rate is 6%, what is the present value (today’s amount) that she won? (Ignore taxes.)

Exercise B-18 Practical applications of the time value of money

P1 P2 P3 P4

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B-10 Appendix B Time Value of Money

TABLE B.1* Present Value of 1

p = 1∕(1 + i)n

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15% Periods

1 0 .9901 0 .9804 0 .9709 0 .9615 0 .9524 0 .9434 0 .9346 0 .9259 0 .9174 0 .9091 0 .8929 0 .8696 1 2 0 .9803 0 .9612 0 .9426 0 .9246 0 .9070 0 .8900 0 .8734 0 .8573 0 .8417 0 .8264 0 .7972 0 .7561 2 3 0 .9706 0 .9423 0 .9151 0 .8890 0 .8638 0 .8396 0 .8163 0 .7938 0 .7722 0 .7513 0 .7118 0 .6575 3 4 0 .9610 0 .9238 0 .8885 0 .8548 0 .8227 0 .7921 0 .7629 0 .7350 0 .7084 0 .6830 0 .6355 0 .5718 4 5 0 .9515 0 .9057 0 .8626 0 .8219 0 .7835 0 .7473 0 .7130 0 .6806 0 .6499 0 .6209 0 .5674 0 .4972 5 6 0 .9420 0 .8880 0 .8375 0 .7903 0 .7462 0 .7050 0 .6663 0 .6302 0 .5963 0 .5645 0 .5066 0 .4323 6 7 0 .9327 0 .8706 0 .8131 0 .7599 0 .7107 0 .6651 0 .6227 0 .5835 0 .5470 0 .5132 0 .4523 0 .3759 7 8 0 .9235 0 .8535 0 .7894 0 .7307 0 .6768 0 .6274 0 .5820 0 .5403 0 .5019 0 .4665 0 .4039 0 .3269 8 9 0 .9143 0 .8368 0 .7664 0 .7026 0 .6446 0 .5919 0 .5439 0 .5002 0 .4604 0 .4241 0 .3606 0 .2843 9 10 0 .9053 0 .8203 0 .7441 0 .6756 0 .6139 0 .5584 0 .5083 0 .4632 0 .4224 0 .3855 0 .3220 0 .2472 10 11   0 .8963 0 .8043 0 .7224 0 .6496 0 .5847 0 .5268 0 .4751 0 .4289 0 .3875 0 .3505 0 .2875 0 .2149 11 12   0 .8874 0 .7885 0 .7014 0 .6246 0 .5568 0 .4970 0 .4440 0 .3971 0 .3555 0 .3186 0 .2567 0 .1869 12 13   0 .8787 0 .7730 0 .6810 0 .6006 0 .5303 0 .4688 0 .4150 0 .3677 0 .3262 0 .2897 0 .2292 0 .1625 13 14   0 .8700 0 .7579 0 .6611 0 .5775 0 .5051 0 .4423 0 .3878 0 .3405 0 .2992 0 .2633 0 .2046 0 .1413 14 15   0 .8613 0 .7430 0 .6419 0 .5553 0 .4810 0 .4173 0 .3624 0 .3152 0 .2745 0 .2394 0 .1827 0 .1229 15 16   0 .8528 0 .7284 0 .6232 0 .5339 0 .4581 0 .3936 0 .3387 0 .2919 0 .2519 0 .2176 0 .1631 0 .1069 16 17   0 .8444 0 .7142 0 .6050 0 .5134 0 .4363 0 .3714 0 .3166 0 .2703 0 .2311 0 .1978 0 .1456 0 .0929 17 18   0 .8360 0 .7002 0 .5874 0 .4936 0 .4155 0 .3503 0 .2959 0 .2502 0 .2120 0 .1799 0 .1300 0 .0808 18 19   0 .8277 0 .6864 0 .5703 0 .4746 0 .3957 0 .3305 0 .2765 0 .2317 0 .1945 0 .1635 0 .1161 0 .0703 19 20   0 .8195 0 .6730 0 .5537 0 .4564 0 .3769 0 .3118 0 .2584 0 .2145 0 .1784 0 .1486 0 .1037 0 .0611 20 25   0 .7798 0 .6095 0 .4776 0 .3751 0 .2953 0 .2330 0 .1842 0 .1460 0 .1160 0 .0923 0 .0588 0 .0304 25 30   0 .7419 0 .5521 0 .4120 0 .3083 0 .2314 0 .1741 0 .1314 0 .0994 0 .0754 0 .0573 0 .0334 0 .0151 30 35   0 .7059 0 .5000 0 .3554 0 .2534 0 .1813 0 .1301 0 .0937 0 .0676 0 .0490 0 .0356 0 .0189 0 .0075 35 40   0 .6717 0 .4529 0 .3066 0 .2083 0 .1420 0 .0972 0 .0668 0 .0460 0 .0318 0 .0221 0 .0107 0 .0037 40

* Used to compute the present value of a known future amount. For example: How much would you need to invest today at 10% compounded semiannually to accumulate $5,000 in 6 years from today? Using the factors of n = 12 and i = 5% (12 semiannual periods and a semiannual rate of 5%), the factor is 0.5568. You would need to invest $2,784 today ($5,000 × 0.5568).

TABLE B.2† Future Value of 1

f = (1 + i)n

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15% Periods

0 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 0 1 1 .0100 1 .0200 1 .0300 1 .0400 1 .0500 1 .0600 1 .0700 1 .0800 1 .0900 1 .1000 1 .1200 1 .1500 1 2 1 .0201 1 .0404 1 .0609 1 .0816 1 .1025 1 .1236 1 .1449 1 .1664 1 .1881 1 .2100 1 .2544 1 .3225 2 3 1 .0303 1 .0612 1 .0927 1 .1249 1 .1576 1 .1910 1 .2250 1 .2597 1 .2950 1 .3310 1 .4049 1 .5209 3 4 1 .0406 1 .0824 1 .1255 1 .1699 1 .2155 1 .2625 1 .3108 1 .3605 1 .4116 1 .4641 1 .5735 1 .7490 4 5 1 .0510 1 .1041 1 .1593 1 .2167 1 .2763 1 .3382 1 .4026 1 .4693 1 .5386 1 .6105 1 .7623 2 .0114 5 6 1 .0615 1 .1262 1 .1941 1 .2653 1 .3401 1 .4185 1 .5007 1 .5869 1 .6771 1 .7716 1 .9738 2 .3131 6 7 1 .0721 1 .1487 1 .2299 1 .3159 1 .4071 1 .5036 1 .6058 1 .7138 1 .8280 1 .9487 2 .2107 2 .6600 7 8 1 .0829 1 .1717 1 .2668 1 .3686 1 .4775 1 .5938 1 .7182 1 .8509 1 .9926 2 .1436 2 .4760 3 .0590 8 9 1 .0937 1 .1951 1 .3048 1 .4233 1 .5513 1 .6895 1 .8385 1 .9990 2 .1719 2 .3579 2 .7731 3 .5179 9 10 1 .1046 1 .2190 1 .3439 1 .4802 1 .6289 1 .7908 1 .9672 2 .1589 2 .3674 2 .5937 3 .1058 4 .0456 10 11   1 .1157 1 .2434 1 .3842 1 .5395 1 .7103 1 .8983 2 .1049 2 .3316 2 .5804 2 .8531 3 .4785 4 .6524 11 12   1 .1268 1 .2682 1 .4258 1 .6010 1 .7959 2 .0122 2 .2522 2 .5182 2 .8127 3 .1384 3 .8960 5 .3503 12 13   1 .1381 1 .2936 1 .4685 1 .6651 1 .8856 2 .1329 2 .4098 2 .7196 3 .0658 3 .4523 4 .3635 6 .1528 13 14   1 .1495 1 .3195 1 .5126 1 .7317 1 .9799 2 .2609 2 .5785 2 .9372 3 .3417 3 .7975 4 .8871 7 .0757 14 15   1 .1610 1 .3459 1 .5580 1 .8009 2 .0789 2 .3966 2 .7590 3 .1722 3 .6425 4 .1772 5 .4736 8 .1371 15 16   1 .1726 1 .3728 1 .6047 1 .8730 2 .1829 2 .5404 2 .9522 3 .4259 3 .9703 4 .5950 6 .1304 9 .3576 16 17   1 .1843 1 .4002 1 .6528 1 .9479 2 .2920 2 .6928 3 .1588 3 .7000 4 .3276 5 .0545 6 .8660 10 .7613 17 18   1 .1961 1 .4282 1 .7024 2 .0258 2 .4066 2 .8543 3 .3799 3 .9960 4 .7171 5 .5599 7 .6900 12 .3755 18 19   1 .2081 1 .4568 1 .7535 2 .1068 2 .5270 3 .0256 3 .6165 4 .3157 5 .1417 6 .1159 8 .6128 14 .2318 19 20   1 .2202 1 .4859 1 .8061 2 .1911 2 .6533 3 .2071 3 .8697 4 .6610 5 .6044 6 .7275 9 .6463 16 .3665 20 25   1 .2824 1 .6406 2 .0938 2 .6658 3 .3864 4 .2919 5 .4274 6 .8485 8 .6231 10 .8347 17 .0001 32 .9190 25 30   1 .3478 1 .8114 2 .4273 3 .2434 4 .3219 5 .7435 7 .6123 10 .0627 13 .2677 17 .4494 29 .9599 66 .2118 30 35   1 .4166 1 .9999 2 .8139 3 .9461 5 .5160 7 .6861 10 .6766 14 .7853 20 .4140 28 .1024 52 .7996 133 .1755 35 40   1 .4889 2 .2080 3 .2620 4 .8010 7 .0400 10 .2857 14 .9745 21 .7245 31 .4094 45 .2593 93 .0510 267 .8635 40

† Used to compute the future value of a known present amount. For example: What is the accumulated value of $3,000 invested today at 8% compounded quarterly for 5 years? Using the factors of n = 20 and i = 2% (20 quarterly periods and a quarterly interest rate of 2%), the factor is 1.4859. The accumulated value is $4,457.70 ($3,000 × 1.4859).

Appendix B Time Value of Money B-11

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15% Periods

1 0 .9901 0 .9804 0 .9709 0 .9615 0 .9524 0 .9434 0 .9346 0 .9259 0 .9174 0 .9091 0 .8929 0 .8696 1 2 1 .9704 1 .9416 1 .9135 1 .8861 1 .8594 1 .8334 1 .8080 1 .7833 1 .7591 1 .7355 1 .6901 1 .6257 2 3 2 .9410 2 .8839 2 .8286 2 .7751 2 .7232 2 .6730 2 .6243 2 .5771 2 .5313 2 .4869 2 .4018 2 .2832 3 4 3 .9020 3 .8077 3 .7171 3 .6299 3 .5460 3 .4651 3 .3872 3 .3121 3 .2397 3 .1699 3 .0373 2 .8550 4 5 4 .8534 4 .7135 4 .5797 4 .4518 4 .3295 4 .2124 4 .1002 3 .9927 3 .8897 3 .7908 3 .6048 3 .3522 5 6 5 .7955 5 .6014 5 .4172 5 .2421 5 .0757 4 .9173 4 .7665 4 .6229 4 .4859 4 .3553 4 .1114 3 .7845 6 7 6 .7282 6 .4720 6 .2303 6 .0021 5 .7864 5 .5824 5 .3893 5 .2064 5 .0330 4 .8684 4 .5638 4 .1604 7 8 7 .6517 7 .3255 7 .0197 6 .7327 6 .4632 6 .2098 5 .9713 5 .7466 5 .5348 5 .3349 4 .9676 4 .4873 8 9 8 .5660 8 .1622 7 .7861 7 .4353 7 .1078 6 .8017 6 .5152 6 .2469 5 .9952 5 .7590 5 .3282 4 .7716 9 10 9 .4713 8 .9826 8 .5302 8 .1109 7 .7217 7 .3601 7 .0236 6 .7101 6 .4177 6 .1446 5 .6502 5 .0188 10 11 10 .3676 9 .7868 9 .2526 8 .7605 8 .3064 7 .8869 7 .4987 7 .1390 6 .8052 6 .4951 5 .9377 5 .2337 11 12 11 .2551 10 .5753 9 .9540 9 .3851 8 .8633 8 .3838 7 .9427 7 .5361 7 .1607 6 .8137 6 .1944 5 .4206 12 13 12 .1337 11 .3484 10 .6350 9 .9856 9 .3936 8 .8527 8 .3577 7 .9038 7 .4869 7 .1034 6 .4235 5 .5831 13 14 13 .0037 12 .1062 11 .2961 10 .5631 9 .8986 9 .2950 8 .7455 8 .2442 7 .7862 7 .3667 6 .6282 5 .7245 14 15 13 .8651 12 .8493 11 .9379 11 .1184 10 .3797 9 .7122 9 .1079 8 .5595 8 .0607 7 .6061 6 .8109 5 .8474 15 16   14 .7179 13 .5777 12 .5611 11 .6523 10 .8378 10 .1059 9 .4466 8 .8514 8 .3126 7 .8237 6 .9740 5 .9542 16 17   15 .5623 14 .2919 13 .1661 12 .1657 11 .2741 10 .4773 9 .7632 9 .1216 8 .5436 8 .0216 7 .1196 6 .0472 17 18   16 .3983 14 .9920 13 .7535 12 .6593 11 .6896 10 .8276 10 .0591 9 .3719 8 .7556 8 .2014 7 .2497 6 .1280 18 19   17 .2260 15 .6785 14 .3238 13 .1339 12 .0853 11 .1581 10 .3356 9 .6036 8 .9501 8 .3649 7 .3658 6 .1982 19 20   18 .0456 16 .3514 14 .8775 13 .5903 12 .4622 11 .4699 10 .5940 9 .8181 9 .1285 8 .5136 7 .4694 6 .2593 20 25   22 .0232 19 .5235 17 .4131 15 .6221 14 .0939 12 .7834 11 .6536 10 .6748 9 .8226 9 .0770 7 .8431 6 .4641 25 30   25 .8077 22 .3965 19 .6004 17 .2920 15 .3725 13 .7648 12 .4090 11 .2578 10 .2737 9 .4269 8 .0552 6 .5660 30 35   29 .4086 24 .9986 21 .4872 18 .6646 16 .3742 14 .4982 12 .9477 11 .6546 10 .5668 9 .6442 8 .1755 6 .6166 35 40   32 .8347 27 .3555 23 .1148 19 .7928 17 .1591 15 .0463 13 .3317 11 .9246 10 .7574 9 .7791 8 .2438 6 .6418 40

TABLE B.3‡ Present Value of an Annuity of 1

‡ Used to calculate the present value of a series of equal payments made at the end of each period. For example: What is the present value of $2,000 per year for 10 years assuming an annual interest rate of 9%? For (n = 10, i = 9%), the PV factor is 6.4177. $2,000 per year for 10 years is the equivalent of $12,835 today ($2,000 × 6.4177).

TABLE B.4§

Future Value of an Annuity of 1 f = [(1 + i)n − 1]/i

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15% Periods

1 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 .0000 1 2 2 .0100 2 .0200 2 .0300 2 .0400 2 .0500 2 .0600 2 .0700 2 .0800 2 .0900 2 .1000 2 .1200 2 .1500 2 3 3 .0301 3 .0604 3 .0909 3 .1216 3 .1525 3 .1836 3 .2149 3 .2464 3 .2781 3 .3100 3 .3744 3 .4725 3 4 4 .0604 4 .1216 4 .1836 4 .2465 4 .3101 4 .3746 4 .4399 4 .5061 4 .5731 4 .6410 4 .7793 4 .9934 4 5 5 .1010 5 .2040 5 .3091 5 .4163 5 .5256 5 .6371 5 .7507 5 .8666 5 .9847 6 .1051 6 .3528 6 .7424 5 6 6 .1520 6 .3081 6 .4684 6 .6330 6 .8019 6 .9753 7 .1533 7 .3359 7 .5233 7 .7156 8 .1152 8 .7537 6 7 7 .2135 7 .4343 7 .6625 7 .8983 8 .1420 8 .3938 8 .6540 8 .9228 9 .2004 9 .4872 10 .0890 11 .0668 7 8 8 .2857 8 .5830 8 .8923 9 .2142 9 .5491 9 .8975 10 .2598 10 .6366 11 .0285 11 .4359 12 .2997 13 .7268 8 9 9 .3685 9 .7546 10 .1591 10 .5828 11 .0266 11 .4913 11 .9780 12 .4876 13 .0210 13 .5795 14 .7757 16 .7858 9 10 10 .4622 10 .9497 11 .4639 12 .0061 12 .5779 13 .1808 13 .8164 14 .4866 15 .1929 15 .9374 17 .5487 20 .3037 10 11 11 .5668 12 .1687 12 .8078 13 .4864 14 .2068 14 .9716 15 .7836 16 .6455 17 .5603 18 .5312 20 .6546 24 .3493 11 12   12 .6825 13 .4121 14 .1920 15 .0258 15 .9171 16 .8699 17 .8885 18 .9771 20 .1407 21 .3843 24 .1331 29 .0017 12 13   13 .8093 14 .6803 15 .6178 16 .6268 17 .7130 18 .8821 20 .1406 21 .4953 22 .9534 24 .5227 28 .0291 34 .3519 13 14   14 .9474 15 .9739 17 .0863 18 .2919 19 .5986 21 .0151 22 .5505 24 .2149 26 .0192 27 .9750 32 .3926 40 .5047 14 15   16 .0969 17 .2934 18 .5989 20 .0236 21 .5786 23 .2760 25 .1290 27 .1521 29 .3609 31 .7725 37 .2797 47 .5804 15 16 17 .2579 18 .6393 20 .1569 21 .8245 23 .6575 25 .6725 27 .8881 30 .3243 33 .0034 35 .9497 42 .7533 55 .7175 16 17 18 .4304 20 .0121 21 .7616 23 .6975 25 .8404 28 .2129 30 .8402 33 .7502 36 .9737 40 .5447 48 .8837 65 .0751 17 18 19 .6147 21 .4123 23 .4144 25 .6454 28 .1324 30 .9057 33 .9990 37 .4502 41 .3013 45 .5992 55 .7497 75 .8364 18 19 20 .8109 22 .8406 25 .1169 27 .6712 30 .5390 33 .7600 37 .3790 41 .4463 46 .0185 51 .1591 63 .4397 88 .2118 19 20 22 .0190 24 .2974 26 .8704 29 .7781 33 .0660 36 .7856 40 .9955 45 .7620 51 .1601 57 .2750 72 .0524 102 .4436 20 25 28 .2432 32 .0303 36 .4593 41 .6459 47 .7271 54 .8645 63 .2490 73 .1059 84 .7009 98 .3471 133 .3339 212 .7930 25 30 34 .7849 40 .5681 47 .5754 56 .0849 66 .4388 79 .0582 94 .4608 113 .2832 136 .3075 164 .4940 241 .3327 434 .7451 30 35 41 .6603 49 .9945 60 .4621 73 .6522 90 .3203 111 .4348 138 .2369 172 .3168 215 .7108 271 .0244 431 .6635 881 .1702 35 40 48 .8864 60 .4020 75 .4013 95 .0255 120 .7998 154 .7620 199 .6351 259 .0565 337 .8824 442 .5926 767 .0914 1,779 .0903 40

§ Used to calculate the future value of a series of equal payments made at the end of each period. For example: What is the future value of $4,000 per year for 6 years assuming an annual interest rate of 8%? For (n = 6, i = 8%), the FV factor is 7.3359. $4,000 per year for 6 years accumulates to $29,343.60 ($4,000 × 7.3359).

p = 1 − 1

(1 + i)n ∕i [ ]

Learning Objectives

CONCEPTUAL C1 Distinguish between debt and equity

securities and between short-term and long-term investments.

C2 Describe how to report equity securities with controlling influence.

ANALYTICAL A1 Compute and analyze the components

of return on total assets.

P4 Account for equity securities with insignificant influence.

P5 Account for equity securities with significant influence.

PROCEDURAL P1 Account for debt securities as trading.

P2 Account for debt securities as held-to- maturity.

P3 Account for debt securities as available- for-sale.

Appendix Preview

C Investments

REPORTING AND ANALYSIS

Summary of debt and equity investments

Comprehensive income

A1 Return on assets components

EQUITY INVESTMENTS

Recording equity investments

P4 Insignificant influence P5 Significant influence C2 Controlling influence

NTK C-4, C-5 NTK C-6

BASICS OF INVESTMENTS

C1 Short- vs. long-term Debt vs. equity

Classification and reporting summary

DEBT INVESTMENTS

Recording debt investments

P1 Trading securities P2 Held-to-maturity

securities

P3 Available-for-sale securities

NTK C-1, C-2, C-3

C-1

In prior chapters we covered the reporting of both equity (common and preferred stock) and debt (bonds and notes) from the seller’s (also called issuer or investee) standpoint. This appendix covers the reporting of both equity and debt from the buyer’s (or investor) standpoint.

Purposes and Types of Investments Companies make investments for at least three reasons. (1) Companies invest their extra cash to earn more income. (2) Some entities, such as mutual funds and pension funds, are set up to earn income from investments. (3) Companies make investments for strategic reasons such as invest- ments in competitors, suppliers, and customers. Exhibit C.1 shows short-term (ST) and long-term (LT) investments as a percent of total assets for several companies.

Short-Term Investments Short-term investments, or mar- ketable securities, are investments that (1) management intends to convert to cash within one year or the operating cycle, whichever is longer, and (2) are readily convertible to cash. These investments usu- ally mature between 3 and 12 months. Cash equivalents are not short- term investments because they usually mature within 3 months. Short-term investments are current assets.

Long-Term Investments Long-term investments are investments that are not readily convertible to cash or are not intended to be converted into cash in the short term. Long-term investments also include funds designated for a special purpose, such as investments in land or other assets not used in operations. Long-term investments are noncurrent assets.

Debt Securities versus Equity Securities Investments in securities in- clude both debt and equity securities. Debt securities reflect a creditor relation such as investments in notes, bonds, and certificates of deposit; they are issued by governments, companies, and individuals. Equity securities reflect an owner relation such as invest- ments in shares of stock issued by companies.

Classification and Reporting Accounting for investments in securities depends on three factors: (1) security type, either debt or equity; (2) the company’s intent to hold the security either short term or long term; and (3) the investor’s percentage of ownership in the other company’s (investee’s) equity securities. Exhibit C.2 identifies six classes of securities using these three factors.

BASICS OF INVESTMENTS C1 Distinguish between debt and equity securities and between short-term and long-term investments.

Percent of total assets

Pfizer

Coca-Cola

Starbucks

Microsoft ST 52%

ST 12%

ST 1%

ST 9%

LT 7%

LT 10%

LT 5%

LT 18%

EXHIBIT C.1 Investments of Selected Companies

Investee’s Balance Sheet

Liabilities Notes Payable Bonds Payable Equity Common Stock Preferred Stock

Investor’s Balance Sheet

Assets

Debt Investments

Equity Investments

Available-for-Sale Debt securities that are

not HTM or Trading

Significant Influence Equity securities with significant influence

Controlling Influence Equity securities with controlling influence

Trading Debt securities that are actively traded

Held-to-Maturity Debt securities intended to be held until maturity

Insignificant Influence Equity securities with insignificant influence

Debt Investments Equity Investments

EXHIBIT C.2 Investments in Securities

Debt Investments—Basics This section covers the purchase, sale, and any interest received for debt investments (also called debt securities).

Recording Acquisition Debt investments are recorded at cost when purchased. Assume that Ling Co. paid $30,000 on July 1, 2019, to buy Dell’s 7%, two-year bonds payable with a $30,000 par value. The bonds pay interest semiannually on December 31 and June 30. The entry to record this purchase follows.

Debt Investments

©Scott Olson/Getty Images

C-2 Appendix C Investments

EXHIBIT C.3 Financial Statement Presentation of Debt Investments

Recording Interest Interest revenue for debt investments is recorded when earned. On December 31, 2019, Ling records cash receipt of interest as follows. The $1,050 interest earned from July 1 to December 31 is computed as Principal × Annual rate × Fraction of year.

Reporting Debt Investments Ling’s financial statements at December 31, 2019, report the interest revenue and the investment as shown in Exhibit C.3.

Maturity When bonds mature, we record the proceeds (assuming interest was already recorded).

July 1, 2019 Debt Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Purchased bonds as debt investments .

Assets = Liabilities + Equity +30,000 −30,000

Dec . 31, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Record interest earned ($30,000 × 7% × 6/12).

Assets = Liabilities + Equity +1,050 +1,050

July 1, 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Debt Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Received cash from matured bonds.

Assets = Liabilities + Equity +30,000 −30,000

The cost of a debt security can be either higher or lower than its maturity value. When the investment is long term, the difference between cost and maturity value is amortized as an adjustment to interest revenue over the remaining life of the security. We assume for simplicity that the cost of a long-term debt security equals its maturity value for all assignments.

Point: It is common to add the se- curity name to the account title to track as a subsidiary ledger. For example, the Debt Investments account can be titled Debt Investments (Dell).

Trading securities are debt investments that the company actively buys and sells for profit. Trading securities are always current assets.

The portfolio of trading securities is reported at fair value; this requires a “fair value adjust- ment” from the cost of the portfolio. A portfolio is a group of securities. Any unrealized gain (or loss) from a change in the fair value of the portfolio of trading securities is reported on the income statement.

Recording Fair Value TechCom’s portfolio of trading securities had a total cost of $11,500 and a fair value of $13,000 on December 31, 2019, the first year it held trading securi- ties. The difference between the $11,500 cost and the $13,000 fair value is a $1,500 gain. It is an unrealized gain because it is not yet confirmed by actual sales of securities. The fair value ad- justment for trading securities is recorded with an adjusting entry at the end of each period to equal the difference between the portfolio’s cost and its fair value. TechCom records this gain as follows.

DEBT INVESTMENTS—TRADING P1 Account for debt securities as trading.

Point: Fair Value Adj. is a balance sheet account with either a debit balance (Fair value > Cost) or credit balance (Fair value < Cost).

Assets = Liabilities + Equity +1,500 +1,500

Dec . 31, 2019 Fair Value Adjustment—Trading . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Record unrealized gain in trading securities.

On the income statement for year 2019:

Interest revenue . . . . . . . . . . . . . . . . . . $ 1,050 On the December 31, 2019, balance sheet:

Debt investments . . . . . . . . . . . . . . . . . . . $30,000

Appendix C Investments C-3

This adjustment is computed using our three-step adjusting process.

Step 1: Determine what unadjusted balance equals: Fair Value Adj.–Trading = $0. Step 2: Determine what adjusted balance should equal: Fair Value Adj.–Trading = $1,500 Dr. Explanation: $13,000 fair value > $11,500 cost; thus Fair Value Adj.–Trading requires a $1,500 debit to be at fair value. Step 3: Record the $1,500 adjusting entry to get from step 1 to step 2. Explanation: This means a $1,500 debit to Fair Value Adj.–Trading and a $1,500 credit to Unrealized Gain–Income.

Unadj . bal . is rarely $0; it is $0 here because it’s the first year .

Reporting Fair Value The unrealized gain (or loss) is reported in the Other Revenues and Gains (or Expenses and Losses) section on the income statement. Unrealized Gain—Income (or Unrealized Loss—Income) is a temporary account that is closed to Income Summary at the end of each period. Fair Value Adjustment—Trading is a permanent asset account that adjusts the reported value of the trading securities portfolio from its prior-period fair value to the cur- rent period fair value. The total cost of the trading securities portfolio is maintained in one ac- count, and the fair value adjustment is recorded in a separate account. For example, TechCom’s investment in trading securities is reported in current assets as follows.

Example: If TechCom’s trading securities have a cost of $14,800 and a fair value of $16,100 at Dec. 31, 2020, its adjusting entry is

Unreal. Loss—Income. . . 200 Fair Value Adj.—Trading 200

This is computed as:

$1,500 Beg. Dr. bal. + $200 Cr. = $1,300 End. Dr. bal .

Current Assets Debt investments—Trading (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,500

Fair value adjustment—Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Debt investments—Trading (at fair value) . . . . . . . . . . . . . . . . . . . . . . . . . $13,000

or simply

Debt investments—Trading (at fair value; cost is $11,500) . . . . . . . . . . . $13,000

Debt Investments–Trading

1/1/2019 0 Purch. 11,500

12/31/2019 11,500

Fair Value Adj.–Trading

1/1/2019 0 Adj. 1,500

12/31/2019 1,500

Selling Trading Securities When individual trading securities are sold, the differ- ence between the net proceeds (sale price minus fees) and the cost of the individual trading securities sold is recorded as a gain or a loss. Any prior-period fair value adjustment to the portfolio is not used to compute the gain or loss from the sale of individual trading securi- ties. This is because the balance in the Fair Value Adjustment account is for the entire portfolio, not individual securities. If TechCom sold some of its trading securities that had cost $100 for $120 cash on January 9, 2020, it records the following.

A gain is reported in the Other Revenues and Gains section on the income statement, and a loss is reported in Other Expenses and Losses. When the period-end fair value adjustment for the portfolio of trading securities is computed, it excludes the cost and fair value of any securities sold.

Point: This is a realized $20 gain—realized by actual sale.

Jan . 9, 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Debt Investments—Trading . . . . . . . . . . . . . . . . . . . . . . . 100

Gain on Sale of Debt Investments . . . . . . . . . . . . . . . . . . 20

Sold trading securities costing $100 for $120 cash.

Assets = Liabilities + Equity +120 +20 −100

Berkshire Co. purchases debt investments in trading securities at a cost of $130 on July 1. (This is its first and only purchase of trading securities.) On December 30, Berkshire received $1 of interest from its trad- ing securities. At year-end December 31, the trading securities had a fair value of $140. a. Prepare the July 1 purchase entry of trading securities. b. Prepare the December 30 entry for receipt of cash interest. c. Prepare the December 31 year-end adjusting entry for the trading securities’ portfolio.

Trading Securities

NEED-TO-KNOW C-1

P1

C-4 Appendix C Investments

d. (i) The $10 debit in the Fair Value Adjustment—Trading account is an adjunct asset account in the balance sheet. It increases the $130 balance of the Debt Investments—Trading account to its $140 fair value.

(ii) The $10 credit for Unrealized Gain is reported in the Other Revenues and Gains section of the income statement.

July 1 Debt Investments—Trading . . . . . . . . . . . . . . . . . . . . . . . . . 130

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

Record purchase of trading securities.

b. Dec . 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Record interest received on trading securities.

c. Dec . 31 Fair Value Adjustment—Trading . . . . . . . . . . . . . . . . . . . . . 10 Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . . . 10

Record unrealized gain in fair value of trading securities.

Fair Value Adj.–Trading

Unadj. bal. 0 Adj. 10

Dec. 31 10

e. Jan . 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

Gain on Sale of Debt Investments . . . . . . . . . . . . . . . 3

Debt Investments—Trading . . . . . . . . . . . . . . . . . . . . 33

Record sale of trading securities. Do More: QS C-3, QS C-4,

QS C-5, E C-2, P C-1

Held-to-maturity (HTM) securities are debt securities a company intends and is able to hold until maturity. They are reported in current assets if their maturity dates are within one year or the operating cycle, whichever is longer. Otherwise, they are classified as long-term investments.

The cost of a debt security can be either higher or lower than its maturity value. When the investment is long term, the difference between cost and maturity value is amortized over the remaining life of the security. We assume for simplicity that the cost of a long-term HTM debt security equals its maturity value for all assignments.

Recording Acquisition and Interest All HTM securities are recorded at cost when purchased, and interest revenue is recorded when earned—see earlier “basic” entries.

Reporting HTM Securities at Cost The portfolio of HTM securities is usually reported at (amortized) cost, which is explained in advanced courses. There is no fair value adjustment to the portfolio of HTM securities—neither to short-term nor long-term portfolios.

DEBT INVESTMENTS—HELD-TO-MATURITY

P2 Account for debt securities as held-to-maturity.

d. Explain how each account in entry c is reported in financial statements. e. Prepare the January 3 entry when a portion of its trading securities (that had cost $33) is sold for

$36.

Solution

a.

Appendix C Investments C-5

DEBT INVESTMENTS—AVAILABLE-FOR-SALE Available-for-sale (AFS) securities are debt investments not classified as trading or held-to- maturity securities. If the intent is to sell AFS securities within the longer of one year or the operating cycle, they are classified as short-term investments. Otherwise, they are classified as long-term investments.

Companies adjust the cost of the portfolio of AFS securities for changes in fair value. This is done with a fair value adjustment to its portfolio cost. Any unrealized gain or loss for the portfolio of AFS securities is not reported on the income statement. It is reported in the equity section of the balance sheet (as part of comprehensive income, covered later).

Recording Fair Value Assume that Mitsu Co. had no prior investments in available- for-sale securities other than those purchased in the current period. Exhibit C.4 shows the cost and fair value of the portfolio of investments on December 31, 2019, the end of its reporting period.

P3 Account for debt securities as available-for-sale.

The year-end adjusting entry to record the fair value of the portfolio of investments follows.

Cost Fair Value Unrealized Gain (Loss)

Apple bonds . . . . . . . . . $30,000 $29,050 $ (950)

Intex notes . . . . . . . . . . 43,000 45,500 2,500

Total . . . . . . . . . . . . . . . . $73,000 $74,550 $1,550

EXHIBIT C.4 Cost and Fair Value of Available-for-Sale Securities

Example: If fair value in Exhibit C.4 is $70,000 (instead of $74,550), what entry is made? Answer: Unreal. Loss—Equity . . . 3,000 Fair Value Adj.—AFS . . 3,000

Dec . 31, 2019 Fair Value Adjustment—Available-for-Sale . . . . . . . . . . . . . . . 1,550

Unrealized Gain—Equity . . . . . . . . . . . . . . . . . . . . . . . . . 1,550

Record adjustment to fair value of AFS securities.

Assets = Liabilities + Equity +1,550 +1,550

P2

Held-to-Maturity Securities

NEED-TO-KNOW C-2Prepare journal entries to record the following transactions involving short-term debt investments. a. On May 15, paid $100 cash to purchase Muni’s 120-day short-term debt securities ($100 principal),

dated May 15, that pay 6% interest (categorized as held-to-maturity securities). b. On September 13, received a check from Muni in payment of the principal and 120 days’ interest on

the debt securities purchased in transaction a.

Solution

a. May 15 Debt Investments—HTM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Purchased 120-day, 6% debt securities.

Do More: QS C-6, E C-3

b. Sep . 13 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Debt Investments—HTM . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Collect $100 principal plus interest of $100 × 6% × 120∕360.

C-6 Appendix C Investments

Reporting Fair Value Exhibit C.5 shows the December 31, 2019, balance sheet—it as- sumes these investments are long term, but they also can be short term. It is also common to combine the cost of investments with the balance in the Fair Value Adjustment account and re- port the net as a single amount.

Selling AFS Securities Accounting for the sale of individual AFS securities is identi- cal to accounting for the sale of trading securities. When individual AFS securities are sold, the difference between the cost of the individual securities sold and the net proceeds (sale price less fees) is recorded as a gain or loss on sale of debt investments.

Point: Unrealized Loss—Equity and Unrealized Gain—Equity are permanent (balance sheet) equity accounts.

Reporting for Next Year Let’s extend this example and assume that at the end of its next year, December 31, 2020, Mitsu’s portfolio of long-term AFS securities has an $81,000 cost and an $82,000 fair value. The year-end adjustment is computed using our three-step adjust- ing process.

Point: Income is increased by sell- ing AFS securities with unrealized gains; income is reduced by sell- ing those with unrealized losses.

Step 1: Determine what unadjusted balance equals: Fair Value Adj.–AFS = $1,550 Dr. (from Exhibit C.5). Step 2: Determine what adjusted balance should equal: Fair Value Adj.–AFS = $1,000 Dr. Explanation: $82,000 fair value > $81,000 cost; thus Fair Value Adj.–AFS must have a $1,000 Dr. bal. so securities are at fair value. Step 3: Record the $550 adjusting entry to get from step 1 to step 2. Explanation: This implies a $550 credit to Fair Value Adj.–AFS (and a $550 debit to Unrealized Gain).

Point: Fair Value Adj.—AFS is a permanent account, shown as a deduction or addition to the investment account.

Gard Company completes the following transactions related to its short-term debt investments.

May 8 Purchased FedEx notes as a short-term investment in available-for-sale securities for $12,975. Sep. 2 Sold part of its investment in FedEx notes for $4,475, which had cost $4,325. Oct. 2 Purchased Ajay bonds for $25,600 as a short-term investment in available-for-sale securities.

Available-for-Sale Securities

NEED-TO-KNOW C-3

P3

EXHIBIT C.5 Balance Sheet Presentation of Available-for-Sale Securities

Debt Investments–AFS

1/1/2019 0 Purch. 73,000

12/31/2019 73,000

Fair Value Adj.–AFS

1/1/2019 0 Adj. 1,550

12/31/2019 1,550

Assets Debt investments—Available-for-sale (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . $73,000

Fair value adjustment—Available-for-sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550

Debt investments—Available-for-sale (at fair value) . . . . . . . . . . . . . . . . . . . . . . $74,550

or simply

Debt investments—Available-for-sale (at fair value; cost is $73,000) . . . . . . . . $74,550

Equity

Add unrealized gain on available-for-sale securities* . . . . . . . . . . . . . . . . . . $ 1,550

Re co

nc ile

d

*Included under Accumulated Other Comprehensive Income.

It records the year-end adjustment to fair value as follows.

Example: If cost is $83,000 and fair value is $82,000 at Dec. 31, 2020, it records the following adjustment: Unreal. Gain—Equity 1,550 Unreal. Loss—Equity 1,000 Fair Value Adj.—AFS 2,550

Bal . 12/31/19 1,550

Bal. 12/31/20 1,000

Adj . 12/31/20 550

Fair Value Adjustment—Available-for-Sale

Adj . 12/31/20 550 Bal . 12/31/19 1,550

Bal. 12/31/20 1,000

Unrealized Gain—Equity

The effects of the 2019 and 2020 securities transactions are shown in the following T-accounts.

Assets = Liabilities + Equity −550 −550

Dec . 31, 2020 Unrealized Gain—Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 Fair Value Adjustment—Available-for-Sale . . . . . . . . . . 550 Record adjustment to fair value of AFS securities.

Appendix C Investments C-7

Required

1. Prepare journal entries for the transactions. 2. Prepare a year-end adjusting journal entry as of December 31 if the fair values of the debt securities

held by Gard are $9,600 for FedEx and $22,000 for Ajay. (This year is the first year Gard Company acquired short-term debt investments.)

Solution

1. May 8 Debt Investments—AFS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,975

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,975

Purchased FedEx notes. Sep . 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,475

Gain on Sale of Debt Investment . . . . . . . . . . . . . . . . . . 150

Debt Investments—AFS . . . . . . . . . . . . . . . . . . . . . . . . . 4,325

Sold a portion of its FedEx notes. Oct . 2 Debt Investments—AFS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600

Purchased Ajay bonds.

2. Computation of unrealized gain or loss, along with the adjusting entry, follows.

Debt Investments in Total Fair Unrealized Available-for-Sale Securities Total Cost Value Gain (Loss)

FedEx . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,650* $ 9,600

Ajay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600 22,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . $34,250 $31,600 $(2,650)

*$12,975 − $4,325

Dec . 31 Unrealized Loss—Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,650

Fair Value Adjustment—Available-for-Sale . . . . . . . . 2,650

Record unrealized loss in fair value of ST AFS portfolio.

Do More: QS C-7, QS C-8, QS C-9, QS C-10, E C-4,

E C-5, E C-6

Debt Investments–AFS

Jan. 1 0 May 8 12,975 Sep. 2 4,325 Oct. 2 25,600

Dec. 31 bal. 34,250

Fair Value Adj.–AFS

Jan. 1 0 Dec. 31 adj. 2,650

Dec. 31 bal. 2,650

This section covers equity investments (also called equity securities). Exhibit C.6 summarizes the accounting for equity investments based on an investor’s ownership in the stock. We cover each of these three cases.

Equity Investments

Fair value method (under 20%)

0% 20% 50% 100%

Equity method (20% to 50%)

Investor’s percent ownership of a company’s stock

Consolidation method (more than 50%)

Insignificant Influence

Significant Influence Controlling

EXHIBIT C.6 Accounting for Equity Investments by Percent of Ownership

When an investor has insignificant influence over another company, presumably when it owns less than 20% of voting stock, the stock investment is reported at fair value. Stock investments are classified as short or long term based on managers’ intent and the stock’s marketability. Any cash dividends are recorded as dividend revenue.

EQUITY INVESTMENTS—INSIGNIFICANT INFLUENCE, UNDER 20% P4 Account for equity securities with insignificant influence.

C-8 Appendix C Investments

Recording Acquisition Equity investments are recorded at cost when acquired, includ- ing any commissions and brokerage fees paid. Assume ITI purchases 100 shares of Lynx com- mon stock for $7,000 on October 10, 2019. After the purchase, ITI has insignificant influence over Lynx. It records this purchase as follows.

Assets = Liabilities + Equity +7,000 −7,000

Oct . 10 Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Purchased 100 shares of Lynx.

Recording Dividends If ITI receives $10 in dividends on November 1 from its stock investment, it records the following.

Assets = Liabilities + Equity +10 +10

Nov . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Record dividend received on stock investments.

Recording Fair Value The stock investments portfolio is reported at fair value; this re- quires a “fair value adjustment” from cost of the portfolio. Any unrealized gain (or loss) from a change in the fair value of this portfolio of stock investments is reported on the income statement.

Assume ITI’s portfolio of stock investments with insignificant influence has a total cost of $7,000 and a fair value of $9,000 on December 31, 2019, the first year it held these securities. The difference between the $7,000 cost and the $9,000 fair value is a $2,000 unrealized gain. The fair value adjustment is recorded at the end of each period to equal the difference between the portfolio’s cost and its fair value. ITI records this gain as follows.

Reporting Fair Value The unrealized gain (or loss) is reported in the Other Revenues and Gains (or Expenses and Losses) section on the income statement. Unrealized Gain (or Loss)—Income is a temporary account that is closed to Income Summary at the end of each period. Fair Value Adjustment—Stock is a permanent asset account that adjusts the reported value of the stock investments portfolio from its prior-period fair value to the current-period fair value. The total cost of the portfolio is kept in one account, and the fair value adjustment is kept in a separate account. ITI’s stock investment is reported in its assets.

This adjustment is computed using our three-step adjusting process.

Step 1: Determine what unadjusted balance equals: Fair Value Adj.–Stock = $0. Step 2: Determine what adjusted balance should equal: Fair Value Adj.–Stock = $2,000 Dr. Explanation: $9,000 fair value > $7,000 cost; thus Fair Value Adj.–Stock requires a $2,000 debit to be at fair value. Step 3: Record the $2,000 adjusting entry to get from step 1 to step 2. Explanation: This means a $2,000 debit to Fair Value Adj.–Stock and a $2,000 credit to Unrealized Gain–Income.

Unadj . bal . is rarely $0; it is $0 here because it’s the first year .

Assets Stock investments (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,000

Fair value adjustment—Stock . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Stock investments (at fair value) . . . . . . . . . . . . . . . . . . . . . . . $9,000

or simply

Stock investments (at fair value; cost is $7,000) . . . . . . . . . . $9,000

Stock Investments

1/1/2019 0 Purch. 7,000

12/31/2019 7,000

Fair Value Adj.–Stock

1/1/2019 0 Adj. 2,000

12/31/2019 2,000

Example: If cost is $10,000 and fair value is $8,500 at Dec. 31, 2020, it records the following adjustment: Unreal. Loss—Income 3,500 Fair Value Adj.—Stock 3,500

The FVA—Stock Cr. is computed as: $2,000 Beg. Dr. bal. + $3,500 Cr. = $1,500 End. Cr. bal.

Assets = Liabilities + Equity +2,000 +2,000

Dec . 31 Fair Value Adjustment—Stock . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Record unrealized gain in stock investments.

Appendix C Investments C-9

Selling Stock Investments When individual stock investments are sold, the differ- ence between the net proceeds (sale price minus fees) and the cost of the individual stocks that are sold is recorded as a gain or a loss. Any prior-period fair value adjustment to the portfo- lio is not used to compute the gain or loss from the sale of individual stocks. This is because the balance in the Fair Value Adjustment account is for the entire portfolio, not individual stocks. If ITI sold some of its stock investments that had cost $500 for $800 cash on March 9, 2020, it records the following. A gain is reported in the Other Revenues and Gains section on the income statement and a loss is reported in Other Expenses and Losses.

Assets = Liabilities + Equity +800 +300 −500

Mar . 9 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Gain on Sale of Stock Investments . . . . . . . . . . . . . . . . . 300

Sold stock investments costing $500 for $800 cash.

Derr Co. purchases stock investments (with insignificant influence) at a cost of $250 on December 15. This is its first and only purchase of such securities. On December 28, Derr received a $15 cash dividend from the stock investments. At year-end December 31, the stock investments had a fair value of $200. a. Prepare the December 15 purchase entry for stock investments. b. Prepare the December 28 receipt of cash dividends entry. c. Prepare the December 31 year-end adjusting entry for the stock investments’ portfolio. d. Explain how each account in entry c is reported in financial statements. e. Prepare the January 3 entry when a portion of its stock investments (that had cost $37) is sold for $40.

Solution

a.

d. (i) The $50 credit in the Fair Value Adjustment—Stock account is a contra asset account in the bal- ance sheet. It decreases the $250 balance of the Stock Investments account to its $200 fair value.

(ii) The $50 debit for Unrealized Loss is reported in the Other Expenses and Losses section of the income statement.

Dec . 15 Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Record purchase of stock investments.

b. Dec . 28 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Record dividend received on stock investments.

Stock Investments with Insignificant Influence (<20%)

NEED-TO-KNOW C-4

P4

c. Dec . 31 Unrealized Loss—Income . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Fair Value Adjustment—Stock . . . . . . . . . . . . . . . . . . 50

Record unrealized loss in stock investments.

Fair Value Adj.–Stock

Unadj. bal. 0 Adj. 50

Dec. 31 50

e. Jan . 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Gain on Sale of Stock Investments . . . . . . . . . . . . . . 3

Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Record sale of stock investments.

Do More: QS C-11, QS C-12, QS C-13, E C-7, E C-8,

E C-9, E C-10

A long-term investment classified as equity securities with significant influence means that the investor has significant influence over the investee. An investor that owns between 20% and 50% of a company’s voting stock usually has significant influence. The equity method is used for long- term investments in equity securities with significant influence, which is explained in this section.

EQUITY INVESTMENTS—SIGNIFICANT INFLUENCE, 20% TO 50%

P5 Account for equity securities with significant influence.

C-10 Appendix C Investments

Recording Share of Earnings When the investee reports its earnings, the investor records its share of those earnings in its investment account. Assume that Star reports net in- come of $20,000 for 2019. Micron records its 30% share of those earnings—see entry below. The debit increases Micron’s equity in Star. The credit is 30% of Star’s net income. Earnings from Equity Method Investments is a temporary account (closed to Income Summary at each period-end) and is reported on the investor’s (Micron’s) income statement. If the investee incurs a net loss instead of net income, the investor records its share of the loss and reduces (credits) its investments account.

Reporting Investments with Significant Influence The book value of invest- ments under the equity method equals the cost of investments plus the investor’s share of net income or loss and minus its share of dividends. The Equity Method Investments account is not adjusted to fair value. After Micron records these transactions, its Equity Method Investments account appears as in Exhibit C.7. Micron’s account balance on January 9, 2020, for its investment in Star is $73,000. This is the investment’s cost plus Micron’s share of Star’s earnings minus Micron’s share of Star’s cash dividends.

Recording Share of Dividends Cash dividends received by an investor from an in- vestee under the equity method are accounted for as a conversion of one asset to another. Dividends reduce the Equity Method Investments account. Assume Star pays a total of $10,000 in cash dividends on its common stock. Micron records its 30% share of these dividends re- ceived on January 9, 2020, as follows.

1/1/2019 Investment acquisition 70,000

12/31/2019 Share of earnings 6,000

12/31/2019 Balance 76,000

1/9/2020 Share of dividend 3,000

1/9/2020 Balance 73,000

Equity Method InvestmentsEXHIBIT C.7 Investment in Star Common Stock (ledger T-account)

Recording Acquisition Long-term investments in equity securities with significant in- fluence are recorded at cost when acquired. Micron Co. records the purchase of 3,000 shares (30%) of Star Co. common stock at a total cost of $70,000 on January 1, 2019, as follows.

Jan . 1 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Record purchase of 3,000 Star shares.

Assets = Liabilities + Equity +70,000 −70,000

Dec . 31 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Earnings from Equity Method Investments . . . . . . . . . . . 6,000

Record 30% equity in investee’s $20,000 earnings.

Assets = Liabilities + Equity +6,000 +6,000

Jan . 9 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . 3,000

Record 30% share of $10,000 dividend paid by Star.

Assets = Liabilities + Equity +3,000 −3,000

Selling Investments with Significant Influence When equity method invest- ments are sold, the gain or loss is computed by comparing proceeds from the sale with the book value of the investments on the sale date. If Micron sells all of its Star stock for $80,000 on January 10, 2020, it records the sale as follows.

Jan . 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . 73,000

Gain on Sale of Stock Investments . . . . . . . . . . . . . . . . . 7,000

Sold 3,000 shares of stock for $80,000.

Assets = Liabilities + Equity +80,000 +7,000 −73,000

Appendix C Investments C-11

Prepare entries to record the following transactions of Garcia Company.

2019 Jan. 1 Purchased 400 shares of Lopez Co. common stock for $3,000 cash. Lopez has 1,000 shares of

common stock outstanding, and its policies will be significantly influenced by Garcia. Aug. 1 Lopez declared and paid a cash dividend of $2 per share. Dec. 31 Lopez reported net income for the year of $2,500.

2020 Aug. 1 Lopez declared and paid a cash dividend of $2.25 per share. Dec. 31 Lopez reported net income for the year of $2,750.

2021 Jan. 1 Garcia sold 100 shares of Lopez for $1,300 cash.

Solution

Equity Method Investments

NEED-TO-KNOW C-5

P5

Aug . 1, 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Equity Method Investments . . . . . . . . . . . . . . . . . . . . 800

Record receipt of cash dividend (400 × $2). Dec . 31, 2019 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Earnings from Equity Method Investments . . . . . . . . 1,000

Record equity in investee earnings ($2,500 × 40%).

Jan . 1, 2019 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Record purchase of investment.*

*Garcia’s investment is 40% of Lopez’s stock (400/1,000). Garcia uses the equity method.

Aug . 1, 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Equity Method Investments . . . . . . . . . . . . . . . . . . . . 900

Record receipt of cash dividend (400 × $2.25). Dec . 31, 2020 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . 1,100

Earnings from Equity Method Investments . . . . . . . . 1,100

Record equity in investee earnings ($2,750 × 40%).

Jan . 1, 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300

Gain on Sale of Stock Investments . . . . . . . . . . . . . . 450

Equity Method Investments* . . . . . . . . . . . . . . . . . . . 850

Record sale of investment.

*Book value (Lopez stock) at 1/1/2021. Original cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000 Less 2019 dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (800) Plus share of 2019 earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Less 2020 dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (900) Plus share of 2020 earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100 Book value at date of sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,400

Book value of shares sold ($3,400 × [100/400]) . . . . . . . . . . . . . . $ 850

Do More: QS C-15, E C-12, E C-13, E C-14

A long-term investment classified as equity securities with controlling influence means that the investor has a controlling influence over the investee. An investor who owns more than 50% of a company’s voting stock has control over the investee. This investor can dominate all other shareholders in electing the corporation’s board of directors and has control over the investee’s management.

EQUITY INVESTMENTS—CONTROLLING INFLUENCE, MORE THAN 50% C2 Describe how to report equity securities with controlling influence.

C-12 Appendix C Investments

The consolidation method is used for long-term investments in equity securities with control- ling influence. The investor reports consolidated financial statements when owning such securi- ties. The controlling investor is called the parent and the investee is called the subsidiary. Many companies are parents with subsidiaries. Amazon is the parent of Whole Foods Market, Zappos, and other subsidiaries. When a company operates as a parent with subsidiaries, each entity maintains separate accounting records.

Consolidated financial statements show the financial statements of all entities under the parent’s control, including all subsidiaries. These statements are prepared as if the business were organized as one entity. The individual assets and liabilities of the parent and its subsidiaries are combined on one balance sheet. Their revenues and expenses also are combined on one income statement, and their cash flows are combined on one statement of cash flows. Preparing consolidated financial statements is covered in advanced courses.

©Tim Greenway/Portland Press Herald/Getty Images

Exhibit C.8 summarizes accounting for debt and equity investments.

Accounting Summary for Debt and Equity Investments

Classification Investments Account Reported at

Short-Term Investment in Securities Debt Investments—Held-to-Maturity . . . . . . . . . . . . . . . . . . . . Cost (without any discount or premium amortization) Debt Investments—Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value (with fair value adjustment to income) Debt Investments—Available-for-Sale . . . . . . . . . . . . . . . . . . . Fair value (with fair value adjustment to equity) Stock Investments—insignificant influence . . . . . . . . . . . . . . Fair value (with fair value adjustment to income) Long-Term Investment in Securities Debt Investments—Held-to-Maturity . . . . . . . . . . . . . . . . . . . Cost (with any discount or premium amortized) Debt Investments—Available-for-Sale . . . . . . . . . . . . . . . . . . Fair value (with fair value adjustment to equity) Stock Investments—insignificant influence . . . . . . . . . . . . . . Fair value (with fair value adjustment to income) Equity Method Investments—significant influence . . . . . . . . Equity method (no fair value adjustment)

Consolidated Investments—controlling influence . . . . . . . . . Consolidation method (no fair value adjustment)

EXHIBIT C.8 Accounting for Investments in Securities

Computing and Reporting Comprehensive Income Comprehensive in- come is all changes in equity during a period except those from owners’ investments and divi- dends. Specifically, comprehensive income is computed by adding other comprehensive income to or subtracting it from net income.

Other comprehensive income includes unrealized gains and losses on available-for-sale securities, foreign currency translation adjustments, and other adjustments. (Accumulated other comprehensive income is the cumulative impact for all periods of other comprehensive income.) Comprehensive income is reported in financial statements in one of two ways.

1. On a separate statement of comprehensive income that follows the income statement. 2. On the lower section of the income statement (as a single continuous statement of income

and comprehensive income).

Option 1 is most common. Google, for example, reports a statement of comprehensive income following its income statement (see Appendix A).GOOGLE

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . # Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Frequently consists of: Change in value of available-for-sale investment, net of tax Change in foreign currency translation adjustment Change in cash flow hedges, net of tax

    

Statement of Comprehensive Income

The following transactions relate to Brown Company’s long-term investments. Brown did not own any long- term investments prior to these transactions. Show (1) the necessary journal entries and (2) the relevant por- tions of each year’s balance sheet and income statement that reflect these transactions for both years.

2019 Sep. 9 Purchased 1,000 shares of Packard common stock for $80,000 cash. These shares represent 30%

of Packard’s outstanding shares. Oct. 2 Purchased 2,000 shares of AT&T common stock for $60,000 cash as a long-term investment.

These shares represent less than a 1% ownership in AT&T. 17 Purchased as a long-term investment 1,000 shares of Apple common stock for $40,000 cash.

These shares are less than 1% of Apple’s outstanding shares. Nov. 1 Received $5,000 cash dividend from Packard. 30 Received $3,000 cash dividend from AT&T. Dec. 15 Received $1,400 cash dividend from Apple. 31 Packard’s net income for this year is $70,000.

COMPREHENSIVE

Accounting for Equity Securities with Insignificant Influence and for Equity Securities with Significant Influence

NEED-TO-KNOW C-6

Appendix C Investments C-13

Components of Return on Total Assets Decision Analysis

A company’s return on total assets (or return on assets) is used to assess financial performance. The return on total assets can be separated into two components, profit margin and total asset turnover, for additional analyses. Exhibit C.9 shows how these two components determine return on total assets.

A1 Compute and analyze the components of return on total assets.

Return on total assets = Profit margin × Total asset turnover

Net income Average total assets

= Net income

Net sales ×

Net sales Average total assets

EXHIBIT C.9 Components of Return on Total Assets

Profit margin reflects the percent of net income in each dollar of net sales. Total asset turnover reflects a company’s ability to produce net sales from total assets. All companies want a high return on total assets. By considering these two components, we can often discover strengths and weaknesses not revealed by return on total assets alone. This improves our ability to assess future performance and company strategy. Costco’s return on total assets and its components are in Exhibit C.10.

Costco Walmart

Year Return on Total Assets = Profit Margin × Total Asset Turnover Return on Total Assets

Current Year 7.8% = 2 .1% × 3 .7 7.2% 1 Year Ago 7.2% = 2 .0% × 3 .6 7.5% 2 Years Ago 7.0% = 2 .0% × 3 .5 8.4%

EXHIBIT C.10 Components of Return on Total Assets for Two Competitors

Costco’s return on total assets improved over the three-year period. This increase is driven by both an increase in profit margin and in total asset turnover. Costco increased its return on total assets during a time when other retailers like Walmart have struggled. To continue this trend, Costco’s management must increase net income while keeping total asset turnover steady or at least at a level where it does not decrease return on total assets.

Retailer You are an owner of a retail store. The store’s recent annual performance reveals (industry norms in paren- theses) return on total assets = 11% (11.2%); profit margin = 4.4% (3.5%); and total asset turnover = 2.5 (3.2). What does your analysis reveal? ■ Answer: The store’s 11% return on assets is similar to the 11.2% industry norm. However, the store’s 4.4% profit margin is much higher than the 3.5% norm, but the 2.5 asset turnover is much lower than the 3.2 norm. The poor turnover suggests that this store is less efficient in using assets. It must focus on increasing sales or reducing assets.

Decision Maker

[continued on next page]

C-14 Appendix C Investments

31 Fair values for the investments in equity securities are Packard, $84,000; AT&T, $48,000; and Apple, $45,000.

31 For preparing financial statements, note the following post-closing account balances: Common Stock, $500,000, and Retained Earnings, $350,000.

2020 Jan. 1 Sold all of the Packard shares for $108,000 cash. May 30 Received $3,100 cash dividend from AT&T. June 15 Received $1,600 cash dividend from Apple. Aug. 17 Sold all of the AT&T stock for $52,000 cash. 19 Purchased 2,000 shares of Coca-Cola common stock for $50,000 cash as a long-term invest-

ment. The stock represents less than a 5% ownership in Coca-Cola. Dec. 15 Received $1,800 cash dividend from Apple. 31 Fair values of the investments in equity securities are Apple, $39,000, and Coca-Cola, $48,000. 31 For preparing financial statements, note the following post-closing account balances: Common

Stock, $500,000, and Retained Earnings, $410,000.

PLANNING THE SOLUTION Account for the investment in Packard under the equity method. Account for the investments in AT&T, Apple, and Coca-Cola as stock investments with insignificant

influence. Prepare the information for the two years’ balance sheets by including the relevant asset and equity accounts,

and the two years’ income statements by identifying the relevant revenues, earnings, gains, and losses.

SOLUTION 1. Journal entries for 2019.

Stock Investments

12/31/2018 0 10/2/2019 60,000 10/17/2019 40,000

12/31/2019 100,000

Fair Value Adj.–Stock

12/31/2018 0 Adj. 7,000

12/31/2019 7,000

Fair Unrealized Cost Value Gain (Loss)

AT&T $ 60,000 $48,000 $(12,000) Apple 40,000 45,000 5,000 Total $100,000 $93,000 $ (7,000)

Required balance of the Fair Value Adjustment—Stock account (credit) . . . . . . . . . . . . . . . . $(7,000) Existing balance . . . . . . . . . . . . . . . . . . 0 Necessary adjustment (credit) . . . . . . . $(7,000)

Sep . 9 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Acquired 1,000 shares, a 30% equity in Packard. Oct . 2 Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Acquired 2,000 shares of AT&T. Oct . 17 Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Acquired 1,000 shares of Apple. Nov . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . 5,000 Received dividend from Packard. Nov . 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Received dividend from AT&T. Dec . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 Received dividend from Apple. Dec . 31 Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Earnings from Equity Method Investments . . . . . . . . . . . 21,000 Record 30% share of Packard’s earnings of $70,000 . Dec . 31 Unrealized Loss—Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Fair Value Adjustment—Stock* . . . . . . . . . . . . . . . . . . . . . 7,000 Record change in fair value of stock investments.

*Fair value adjustment computations.

Appendix C Investments C-15

Assets—Long-term investments Stock investments (at fair value; cost is $100,000) . . . $ 93,000

Equity method investments . . . . . . . . . . . . . . . . . . . . . . 96,000

Total long-term investments . . . . . . . . . . . . . . . . . . . . . $189,000

2. The December 31, 2019, selected balance sheet items follow.

The relevant income statement items for the year ended December 31, 2019, follow.

Dividend revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,400

Unrealized loss—Income . . . . . . . . . . . . . . . . . . . . . . . . . . (7,000)

Earnings from equity method investments . . . . . . . . . . . . 21,000

Fair Unrealized Cost Value Gain (Loss)

Apple $40,000 $39,000 $(1,000) Coca-Cola 50,000 48,000 (2,000) Total $90,000 $87,000 $(3,000)

Required balance of the Fair Value Adjustment—Stock account (credit) . . . . . . . . . . . . . . . . $(3,000) Existing balance (credit) . . . . . . . . . . . (7,000) Necessary adjustment (debit). . . . . . . . $ 4,000

2. The December 31, 2020, balance sheet items follow.

The relevant income statement items for the year ended December 31, 2020, follow.

Assets—Long-term investments Stock investments (at fair value; cost is $90,000) . . . . . . . $87,000

Dividend revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,500

Unrealized gain—Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Gain on sale of stock investments . . . . . . . . . . . . . . . . . . . . . . 12,000

Loss on sale of stock investments . . . . . . . . . . . . . . . . . . . . . . (8,000)

1. Journal entries for 2020.

Stock Investments

12/31/2019 100,000 8/17/2020 60,000 8/19/2020 50,000

12/31/2020 90,000

Fair Value Adj.–Stock

12/31/2019 7,000 Adj. 4,000

12/31/2020 3,000

*Fair value adjustment computations.

Jan . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000

Equity Method Investments . . . . . . . . . . . . . . . . . . . . 96,000

Gain on Sale of Stock Investments . . . . . . . . . . . . . . 12,000

Sold 1,000 shares of Packard for cash.

May 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,100

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,100

Received dividend from AT&T.

June 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

Received dividend from Apple.

Aug . 17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000

Loss on Sale of Stock Investments . . . . . . . . . . . . . . . . . . . 8,000

Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Sold 2,000 shares of AT&T for cash.

Aug . 19 Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Acquired 2,000 shares of Coca-Cola.

Dec . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Received dividend from Apple.

Dec . 31 Fair Value Adjustment—Stock* . . . . . . . . . . . . . . . . . . . . . . 4,000

Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . . . 4,000

Record change in fair value of stock investments.

Packard cost at Jan. 1 is $80,000 − $5,000 + $21,000 = $96,000.

C-16 Appendix C Investments

BASICS OF INVESTMENTS Short-term investments: Investments that (1) management intends to convert to cash within one year and (2) are readily convertible to cash. Short-term investments are current assets. Long-term investments: Investments that are not going to be converted into cash in the short term. Long-term investments are noncurrent assets. Debt securities: Reflect a creditor relation and include notes and bonds. Equity securities: Reflect an owner relation and include stock.

DEBT INVESTMENTS

Unrealized gain (or loss): A gain (or loss) not yet confirmed by actual sales of securities. TRADING SECURITIES: Debt investments that are actively bought and sold for profit. Trading secu- rities are always current assets.

Reporting fair value—Trading securities: An unrealized gain (or loss) from a change in the fair value of the portfolio of trading securities is reported on the income statement under Other Revenues and Gains (or Expenses and Losses). Fair Value Adjustment—Trading is an asset account that adjusts the trading securities portfolio to fair value.

Selling trading securities: When sale price > cost, record a gain (shown here). When sale price < cost, record a loss. A gain (or loss) is reported in Other Revenues and Gains (or Expenses and Losses) section on the income statement.

HELD-TO-MATURITY (HTM) SECURITIES: Debt investments that are held until maturity. They are current assets if their maturity is within one year and are long-term investments if their maturity is over one year. They are not reported at fair value.

Summary: Cheat Sheet

Acquiring debt investments:

Debt Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Interest earned and received:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Fair value adjustment—Trading securities: Reflects gain (shown here) or loss.

Fair Value Adjustment—Trading. . . . . . . . . . . . . . . . . . . . 1,500

Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . . 1,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Debt Investments—Trading . . . . . . . . . . . . . . . . . . . 100

Gain on Sale of Debt Investments . . . . . . . . . . . . . 20

Receipt of principal and interest—HTM:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Debt Investments—HTM . . . . . . . . . . . . . . . . . . . . . 100

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Current Assets Debt investments—Trading (at cost) . . . . . . . . . . . . . . $11,500

Fair value adjustment—Trading . . . . . . . . . . . . . . . . . . 1,500

Debt investments—Trading (at fair value) . . . . . . . . . . $13,000

Fair value adjustment—AFS securities: Reflects gain (shown here) or loss.

Fair Value Adjustment—Available-for-Sale . . . . . . . . . . . 1,550

Unrealized Gain—Equity . . . . . . . . . . . . . . . . . . . . . 1,550

Acquiring stock investments (insignificant influence):

Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Dividends received from stock investment (insignificant influence):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Fair value adjustment—Stock (insignificant influence): Reflects gain (shown here) or loss.

Fair Value Adjustment—Stock . . . . . . . . . . . . . . . . . . . . . 2,000

Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . 2,000

AVAILABLE-FOR-SALE (AFS) SECURITIES: Debt investments not classified as trading or held-to-maturity. They are current assets if they are to be sold within one year and long-term invest- ments if they are to be sold beyond one year.

Reporting fair value—AFS securities: An unrealized gain (or loss) from a change in the fair value of the portfolio of AFS securities is reported in the equity section of the balance sheet (as part of comprehensive income). Fair Value Adjustment—AFS is an asset account that adjusts the AFS securities portfolio to fair value.

Selling AFS securities: Identical to selling trading securities.

EQUITY INVESTMENTS Stock investments (insignificant influence): When a company owns less than 20% of voting stock of another company, it has insignificant influ- ence. Can be classified as short or long term.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Stock Investments . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Gain on Sale of Stock Investments . . . . . . . . . . . . . 300

Selling stock investments: When sale price > cost, record a gain (shown here). When sale price < cost, record a loss. A gain (or loss) is reported in Other Revenues and Gains (or Expenses and Losses) section on the income statement.

Assets Debt investments—Available-for-sale (at cost) . . . . . . . . $73,000

Fair value adjustment—Available-for-sale . . . . . . . . . . . . 1,550

Debt investments—Available-for-sale (at fair value) . . . . $74,550

Reporting fair value adjustment from stock (insignificant influence): An unrealized gain (or loss) from a change in the fair value of the portfolio of stock investments is reported on the income statement under Other Revenues and Gains (or Expenses and Losses). Fair Value Adjustment—Stock is an asset account that adjusts the stock investments portfolio to fair value.

Assets Stock investments (at cost) . . . . . . . . . . . . . . . . . . . . . $7,000

Fair value adjustment—Stock . . . . . . . . . . . . . . . . . . . 2,000

Stock investments (at fair value) . . . . . . . . . . . . . . . . . $9,000

Equity method investments: When a company owns between 20% and 50% of voting stock of another company, it has significant influence. Classified as long term.

Appendix C Investments C-17

Selling equity method investments: When sale price > book value, record a gain (shown here). When sale price < book value, record a loss.

Equity securities with controlling influence: When an investor owns more than 50% of a company’s voting stock, it has control over the investee and the consolidation method is used. The controlling investor is called the parent, and the investee is called the subsidiary.

REPORTING AND ANALYSIS

Acquiring equity method investments:

Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . 70,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Recording share of earnings (equity method): Calculated as percentage of ownership times net income of investee.

Equity Method Investments . . . . . . . . . . . . . . . . . . . . . . . 6,000

Earnings from Equity Method Investments . . . . . . 6,000

Recording share of dividends (equity method): Calculated as percentage of ownership times total dividends paid by investee.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Equity Method Investments . . . . . . . . . . . . . . . . . . 3,000

Reporting equity method investments: Equity method investments are not adjusted to fair value. Instead, the account is increased by investee net income and decreased by investee dividends.

Equity Method Investments

1/1/2019 Investment acquisition 70,000

12/31/2019 Share of earnings 6,000

12/31/2019 Balance 76,000

1/9/2020 Share of dividend 3,000

1/9/2020 Balance 73,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Equity Method Investments . . . . . . . . . . . . . . . . . . 73,000

Gain on Sale of Stock Investments . . . . . . . . . . . . . 7,000

Classification Investments Account Reported at

Short-Term Investment in Securities Debt Investments—Held-to-Maturity . . . . . . . . . . . . . . Cost (without any discount or premium amortization) Debt Investments—Trading . . . . . . . . . . . . . . . . . . . . . Fair value (with fair value adjustment to income) Debt Investments—Available-for-Sale . . . . . . . . . . . . . Fair value (with fair value adjustment to equity) Stock Investments—insignificant influence . . . . . . . . . Fair value (with fair value adjustment to income) Long-Term Investment in Securities Debt Investments—Held-to-Maturity . . . . . . . . . . . . . Cost (with any discount or premium amortized) Debt Investments—Available-for-Sale . . . . . . . . . . . . Fair value (with fair value adjustment to equity) Stock Investments—insignificant influence . . . . . . . . . Fair value (with fair value adjustment to income) Equity Method Investments—significant influence . . . Equity method (no fair value adjustment) Consolidated Investments—controlling influence . . . Consolidation method (no fair value adjustment)

Available-for-sale (AFS) securities (C-5) Comprehensive income (C-12) Consolidated financial statements (C-12) Equity method (C-9) Equity securities with controlling

influence (C-11) Equity securities with significant

influence (C-9)

Fair Value Adjustment (C-2) Held-to-maturity (HTM) securities (C-4) Long-term investments (C-1) Other comprehensive income (C-12) Parent (C-12) Profit margin (C-13) Return on total assets (C-13)

Short-term investments (C-1) Subsidiary (C-12) Total asset turnover (C-13) Trading securities (C-2) Unrealized gain (loss) (C-3, C-8)

Key Terms

Multiple Choice Quiz

1. A company purchased $30,000 of 5% bonds for investment purposes on May 1. The bonds pay interest on February 1 and August 1. The amount of interest revenue accrued at December 31 (the company’s year-end) is a. $1,500. c. $1,000. e. $300. b. $1,375. d. $625.

2. This period, Amadeus Co. purchased its only available-for- sale investment in the notes of Bach Co. for $83,000. The period-end fair value of these notes is $84,500. Amadeus records a a. Credit to Unrealized Gain—Equity for $1,500. b. Debit to Unrealized Loss—Equity for $1,500. c. Debit to Investment Revenue for $1,500.

d. Credit to Fair Value Adjustment—Available-for-Sale for $3,500.

e. Credit to Cash for $1,500. 3. Mozart Co. owns 35% of Melody Inc. Melody pays $50,000

in cash dividends to its shareholders for the period. Mozart’s entry to record the Melody dividend includes a a. Credit to Investment Revenue for $50,000. b. Credit to Equity Method Investments for $17,500. c. Credit to Cash for $17,500. d. Debit to Equity Method Investments for $17,500. e. Debit to Cash for $50,000.

C-18 Appendix C Investments

4. A company has net income of $300,000, net sales of $2,500,000, and total assets of $2,000,000. Its return on to- tal assets equals a. 6.7%. c. 8.3%. e. 15.0%. b. 12.0%. d. 80.0%.

5. A company had net income of $80,000, net sales of $600,000, and total assets of $400,000. Its profit margin and total asset turnover are

Profit Margin Total Asset Turnover

a. 1 .5% 13 .3 b. 13 .3% 1 .5 c. 13 .3% 0 .7 d. 7 .0% 13 .3 e. 10 .0% 26 .7

ANSWERS TO MULTIPLE CHOICE QUIZ

1. d; $30,000 × 5% × 5/12 = $625 2. a; Unrealized gain = $84,500 − $83,000 = $1,500 3. b; $50,000 × 35% = $17,500

4. e; $300,000/$2,000,000 = 15% 5. b; Profit margin = $80,000/$600,000 = 13.3%

Total asset turnover = $600,000/$400,000 = 1.5

Icon denotes assignments that involve decision making.

1. Under what two conditions should investments be classified as current assets?

2. On a balance sheet, what valuation must be reported for short-term debt investments in trading securities?

3. If a stock investment with insignificant influence costs $10,000 and is sold for $12,000, how should the difference between these two amounts be recorded?

4. Identify the three classes of debt investments and the three classes of equity investments.

5. Under what conditions should investments be classified as current assets? As long-term assets?

6. For investments in available-for-sale debt securities, how are unrealized (holding) gains and losses reported?

7. If a company purchases its only long-term investments in available-for-sale debt securities this period and their fair value is below cost at the balance sheet date, what entry is required to recognize this unrealized loss?

8. On a balance sheet, what valuation must be reported for debt securities classified as available-for-sale?

9. Under what circumstances are long-term investments in debt securities reported at cost and adjusted for amortiza- tion of any difference between cost and maturity value?

10. In accounting for investments in equity securities, when should the equity method be used?

11. Under what circumstances does a company prepare con- solidated financial statements?

12. Refer to Apple’s statement of comprehen- sive income in Appendix A. What is the amount of change in foreign currency translation, net of tax effects, for the year ended September 30, 2017? Is this change an unrealized gain or an unrealized loss?

13. Refer to Google’s statement of comprehen- sive income in Appendix A. What was the amount of its 2017 change in net unrealized gains (losses) for its AFS investments?

14. Refer to the income statement of Samsung in Appendix A. How can you tell that it uses the consolidated method of accounting?

Discussion Questions

APPLE

Samsung

GOOGLE

QUICK STUDY

QS C-1 Distinguishing between short- and long-term investments

C1

Which of the following statements are true of long-term investments? a. They can be considered cash equivalents. b. They can include assets not used in operations, such as investments in land. c. They generally include investments that will mature in 3 to 12 months. d. They are reported with noncurrent assets on the balance sheet. e. They are always easily sold and therefore qualify as being marketable. f. They can include bonds and stocks not intended to be sold in the near future.

QS C-2 Distinguishing between debt and equity securities

C1

Identify investments as an investment in either debt (D) securities or equity (E) securities. a. U.S. Treasury bonds e. IBM corporate notes i. Chicago municipal bonds b. Google stock f. German government bonds j. Apple stock c. Certificate of deposit g. Amazon stock k. David Bowie bonds d. Apple bonds h. Costco corporate notes l. Facebook stock

Appendix C Investments C-19

QS C-3 Accounting for debt investments classified as trading P1

Prepare Hertog Company’s journal entries to record the following transactions for the current year.

May 7 Purchases Kraft bonds as a short-term investment in trading securities at a cost of $10,300. June 6 Sells its entire investment in Kraft bonds for $11,050 cash.

QS C-5 Reporting trading securities on financial statements P1

Refer to the information in QS C-4. (1) After the fair value adjustment is made, prepare the assets section of Kitty Company’s December 31 classified balance sheet. (2) In which income statement section is the unrealized gain (or loss) on the portfolio of trading securities reported?

QS C-4 Fair value adjustment to a portfolio of trading securities

P1

Kitty Company began operations in the current year and acquired short-term debt investments in trading securities. The year-end cost and fair values for its portfolio of these debt investments follow. Prepare the journal entry to record the December 31 year-end fair value adjustment for these debt securities.

Trading Securities Cost Fair Value

Tesla bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 $ 9,000

Nike bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 21,000

Ford bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 4,000

QS C-6 Accounting for debt investments classified as held-to-maturity

P2

Prepare Garzon Company’s journal entries to record the following transactions for the current year.

Jan. 1 Purchases 6% bonds (as a held-to-maturity investment) issued by PBS at a cost of $40,000, which is the par value.

July 1 Receives first semiannual payment of interest from PBS bonds. Dec. 31 Receives a check from PBS in payment of principal ($40,000) and the second semiannual pay-

ment of interest.

QS C-10 Reporting available-for-sale securities on financial statements P3

Refer to the information in QS C-9. (1) After the fair value adjustment is made, prepare the assets section of Reggit Company’s December 31 classified balance sheet. (2) Is the unrealized gain (or loss) on the portfolio of available-for-sale securities reported on the income statement?

Journ Co. purchased short-term investments in available-for-sale debt securities at a cost of $50,000 cash on November 25. At December 31, these securities had a fair value of $47,000. This is the first and only time the company has purchased such securities. 1. Prepare the November 25 entry to record the purchase of debt securities. 2. Prepare the December 31 year-end adjusting entry for the securities’ portfolio. 3. Prepare the April 6 entry when Journ sells 10% of these securities ($5,000 cost) for $6,000 cash.

QS C-7 Accounting for available- for-sale debt securities

P3

QS C-8 Recording fair value adjustment for available- for-sale debt securities

P3

During the current year, Reed Consulting acquired long-term available-for-sale debt securities on July 1 at a $70,000 cost. At its December 31 year-end, these securities had a fair value of $58,000. This is the first and only time the company purchased such securities. 1. Prepare the July 1 entry to record the purchase of these debt securities. 2. Prepare the year-end adjusting entry related to these securities.

On December 31, Reggit Company held the following short-term investments in its portfolio of available- for-sale debt securities. Reggit had no short-term investments in its prior accounting periods. Prepare the December 31 adjusting entry to report these investments at fair value.

Available-for-Sale Securities Cost Fair Value

Verrizano Corporation bonds . . . . . . . . . . . . . . . . . . . . . . $89,600 $91,600

Preble Corporation notes . . . . . . . . . . . . . . . . . . . . . . . . . 70,600 62,900

Lucerne Company bonds . . . . . . . . . . . . . . . . . . . . . . . . . 86,500 83,100

QS C-9 Adjusting available-for-sale debt securities to fair value

P3

Check Unrealized loss, $9,100

Prepare Riley Company’s journal entries to record the following transactions for the current year.

Apr. 18 Purchases 300 common shares of XLT Co. as a short-term investment at a cost of $42 per share. With this stock investment, Riley has an insignificant influence over XLT.

May 30 Receives $1 per share from XLT in dividends.

QS C-11 Accounting for stock investments P4

C-20 Appendix C Investments

Prepare Tiker Company’s journal entries to record the following transactions and the adjusting entry to record the fair value of the stock investments portfolio. This is the first and only time the company pur- chased such securities.

May 9 Purchases 200 shares of Higo stock as a short-term investment at a cost of $30 per share. Tiker has insignificant influence over Higo.

June 2 Sells 20 shares of its investment in Higo stock ($600 cost) at $33 per share. Dec. 31 The closing market price (fair value) of the Higo stock is $23 per share.

QS C-12 Adjusting stock investments to fair value

P4

On May 20, Montero Co. paid $150,000 to acquire 30 shares (4%) of ORD Corp. as a long-term invest- ment. On August 5, Montero sold one-tenth of the ORD shares for $18,000. 1. Prepare entries to record both (a) the acquisition and (b) the sale of these shares. 2. Should this stock investment be reported at fair value or at cost on the balance sheet?

QS C-13 Reporting stock investments with insignificant influence P4

Rowan Co. purchases 100 common shares (40%) of JBI Corp. as a long-term investment for $500,000 cash on July 1. JBI paid $5,000 in total cash dividends on November 1 and reported net income of $100,000 for the year. Prepare Rowan’s entries to record (1) the purchase of JBI shares, (2) the receipt of its share of JBI dividends, and (3) the December 31 year-end adjustment for its share of JBI net income.

QS C-15 Equity method transactions

P5

Accenture purchases 55% of the voting common stock of JBL. After the purchase, Accenture has a con- trolling influence over JBL. (1) Which method does Accenture use to account for its investment in JBL? (2) What type of financial statements does Accenture prepare after the acquisition?

QS C-16 Equity securities with controlling influence C2

Indicate where each of the following items is reported on financial statements. Choose from the following categories: (a) current assets, (b) long-term investments, (c) current liabilities, (d) long-term liabilities, (e) other revenues and gains, ( f ) other expenses and losses, and (g) equity.

1. Trading securities 2. Unrealized gain on available-for-sale securities 3. Held-to-maturity securities (due in 15 years) 4. Unrealized gain on trading securities 5. Fair value adjustment—Trading

QS C-14 Financial statement presentation of investments

C1 P1 P2 P3 P4

Fivio Co. reports the following information. (1) Compute return on total assets for the current year and for 1 year ago. (2) Is Fivio more efficient or less efficient in using total assets to produce income in the cur- rent year versus 1 year ago?

Total assets, December 31 $210,000 30,200

$340,000 38,400

$770,000 55,500

A B C D

1 2 3

1 Year AgoCurrent Year 2 Years Ago

Net income

QS C-17 Return on total assets

A1

The return on total assets is the focus of analysts, creditors, and other users of financial statements. 1. How is the return on total assets computed? 2. What does this important ratio reflect? 3. Return on total assets can be separated into two important components. Write the formula to separate

the return on total assets into its two basic components. 4. Explain how these components of the return on total assets are helpful to financial statement users for

business decisions.

QS C-18 Component return on total assets A1

EXERCISES

Exercise C-1 Debt and equity securities and short- and long-term investments

C1

Complete the following descriptions by filling in the blanks using the terms or phrases a through g. a. not intended b. not readily c. cash d. operating cycle e. one year f. owner g. creditor 1. Debt securities reflect a(n) relation such as with investments in notes and bonds. 2. Equity securities reflect a(n) relation such as with investments in shares of stock. 3. Short-term investments are securities that (1) management intends to convert to cash within

or the , whichever is longer, and (2) are readily convertible to . 4. Long-term investments in securities are defined as those securities that are convert-

ible to cash or are to be converted into cash in the short term.

Appendix C Investments C-21

Prepare Krum Co.’s journal entries to record the following transactions involving its short-term invest- ments in available-for-sale debt securities, all of which occurred during the current year. a. On August 1, paid $50,000 cash to purchase Houtte’s 9%, six-month debt securities ($50,000 princi-

pal), dated August 1. b. On October 30, received a check from Houtte for 90 days’ interest on the debt securities in part a.

Exercise C-4 Accounting for available- for-sale debt securities

P3

Prepare Natura Co.’s journal entries to record the following transactions involving its short-term invest- ments in held-to-maturity debt securities, all of which occurred during the current year. a. On June 15, paid $1,000 cash to purchase Remed’s 90-day short-term debt securities ($1,000 princi-

pal), dated June 15, that pay 10% interest. b. On September 16, received a check from Remed in payment of the principal and 90 days’ interest on

the debt securities purchased in part a.

Exercise C-3 Accounting for held-to- maturity debt securities

P2

Brooks Co. purchases debt investments as trading securities at a cost of $66,000 on December 27. This is its first and only purchase of such securities. At December 31, these securities had a fair value of $72,000. 1. Prepare the December 27 entry for the purchase of debt investments. 2. Prepare the December 31 year-end fair value adjusting entry for the trading securities’ portfolio. 3. Prepare the January 3 entry when Brooks sells a portion of its trading securities (costing $3,000) for

$4,000 cash.

Exercise C-2 Accounting for debt investments classified as trading P1

Check (3) Gain, $1,000

On December 31, Lujack Co. held the following short-term available-for-sale securities. Lujack had no short-term investments prior to the current period. Prepare the December 31 year-end adjusting entry to record the fair value adjustment for these debt securities.

Available-for-Sale Securities Cost Fair Value

Nintendo Co . notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,450 $48,900

Atlantic bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000 47,000

Kellogg Co . notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 23,200

McDonald’s Corp . bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,300 44,800

Exercise C-5 Fair value adjustment to available-for-sale debt securities

P3

Ticker Services began operations in Year 1 and holds long-term investments in available-for-sale debt securities. The year-end cost and fair values for its portfolio of these investments follow. Prepare journal entries to record each year-end fair value adjustment for these securities.

Portfolio of Available-for-Sale Securities Cost Fair Value

December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 $15,000

December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 25,000

December 31, Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 29,000

December 31, Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,500 19,000

Exercise C-6 Multiyear fair value adjustments to available- for-sale debt securities

P3

Prepare journal entries to record the following transactions involving the short-term stock investments of Duke Co., all of which occurred during the current year. a. On March 22, purchased 1,000 shares of RPI Company stock at $10 per share. Duke’s stock invest-

ment results in it having an insignificant influence over RPI. b. On July 1, received a $1 per share cash dividend on the RPI stock purchased in part a. c. On October 8, sold 50 shares of RPI stock for $15 per share.

Exercise C-7 Accounting for stock investments with insignificant influence

P4 Check (c) Dr. Cash $750

On December 31, Mars Co. had the following portfolio of stock investments with insignificant influence. Mars had no stock investments in prior periods. Prepare the December 31 adjusting entry to report these investments at fair value.

Exercise C-8 Fair value adjustment to stock investments with insignificant influence P4

Stock Investments Cost Fair Value

Apple stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $ 8,000 Chipotle stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 1,500 Under Armour stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 14,000

C-22 Appendix C Investments

Refer to the information in Exercise C-8. (1) After the fair value adjustment is made, prepare the assets section of Mars Co.’s December 31 classified balance sheet. Assume Mars plans to sell its trading securi- ties within the next six months. (2) In which income statement section is the unrealized gain (or loss) on the portfolio of stock investments reported?

Exercise C-9 Reporting stock investments on financial statements P4

Carlsville Company began operations in the current year and had no prior stock investments. The follow- ing transactions are from its short-term stock investments with insignificant influence. Prepare journal entries to record these transactions. On December 31, prepare the adjusting entry to record the fair value adjustment for the portfolio of stock investments.

July 22 Purchased 1,600 shares of Hunt Corp. at $30 per share. Sep. 5 Received a $2 cash dividend for each share of Hunt Corp. Sep. 27 Purchased 3,400 shares of HCA at $34 per share. Oct. 3 Sold 1,600 shares of Hunt at $25 per share. Oct. 30 Purchased 1,200 shares of Black & Decker at $50 per share. Dec. 17 Received a $3 cash dividend for each share of Black & Decker. Dec. 31 Fair value of the short-term stock investments is $180,000.

Exercise C-10 Transactions and fair value adjustments for stock investments with insignificant influence

P4

Check Dec. 31: Dr. Fair Value Adjustment—Stock, $4,400

Prepare journal entries to record the following transactions involving both the short-term and long-term investments of Cancun Corp., all of which occurred during the current year. a. On February 15, paid $160,000 cash to purchase GMI’s 90-day short-term notes at par, which are

dated February 15 and pay 10% interest (classified as held-to-maturity). b. On March 22, bought 700 shares of Fran Inc. common stock at $51 cash per share. Cancun’s stock

investment results in it having an insignificant influence over Fran. c. On May 15, received a check from GMI in payment of the principal and 90 days’ interest on the notes

purchased in part a. d. On July 30, paid $100,000 cash to purchase MP Inc.’s 8%, six-month notes at par, dated July 30 (clas-

sified as trading securities). e. On September 1, received a $1 per share cash dividend on the Fran Inc. common stock purchased in

part b. f. On October 8, sold 30 shares of Fran Inc. common stock for $54 cash per share. g. On October 30, received a check from MP Inc. for three months’ interest on the notes purchased in part d.

Exercise C-11 Transactions in held-to- maturity, trading, and stock investments

P1 P2 P4

Prepare journal entries to record the following transactions and events of Kodax Company.

Year 1

Jan. 2 Purchased 30,000 shares of Grecco Co. common stock for $411,000 cash. Grecco has 90,000 shares of common stock outstanding, and its activities will be significantly influenced by Kodax.

Sep. 1 Grecco declared and paid a cash dividend of $1.50 per share. Dec. 31 Grecco announced that net income for the year is $486,900.

Year 2

June 1 Grecco declared and paid a cash dividend of $2.10 per share. Dec. 31 Grecco announced that net income for the year is $702,750. Dec. 31 Kodax sold 3,000 shares of Grecco for $71,000 cash.

Exercise C-12 Accounting for equity method investments

P5

The following information shows Carperk Company’s individual investments in securities during its cur- rent year, along with the December 31 fair values. a. Investment in Brava Company bonds: $420,500 cost; $457,000 fair value. Carperk intends to hold

these bonds until they mature in 5 years. b. Investment in Baybridge common stock: 29,500 shares; $362,450 cost; $391,375 fair value. Carperk

owns 32% of Baybridge’s voting stock and has a significant influence over Baybridge. c. Investment in Duffa bonds: $165,500 cost; $178,000 fair value. This investment is not readily market-

able and is not classified as held-to-maturity or trading.

Exercise C-13 Classifying investments in securities; recording fair values

C1 P2 P3 P4 P5

Appendix C Investments C-23

d. Investment in Newton notes: $90,300 cost; $88,625 fair value. Newton notes are not readily market- able and are not classified as held-to-maturity or trading.

e. Investment in Farmers common stock: 16,300 shares; $100,860 cost; $111,210 fair value. This stock is marketable, and Carperk intends to sell it within the year. This stock investment results in Carperk having an insignificant influence over Farmers.

Required

1. Identify whether each investment a through e should be classified as a short-term or long-term invest- ment. For each investment, indicate in which of the six investment classifications listed in Exhibit C.2 it should be placed.

2. Prepare a journal entry dated December 31 to record the fair value adjustment for the portfolio of available-for-sale debt securities. Carperk had no available-for-sale debt securities prior to this year.

Check (2) Unrealized gain, $10,825

Selected accounts from GermX Co.’s adjusted trial balance for the year ended December 31 follow. Prepare the assets section of a classified balance sheet. Hint: Fair Value Adjustment—Trading increases trading securities; Fair Value Adjustment—Stock decreases stock investments.

Exercise C-14 Prepare assets section of balance sheet

C1 P1 P2 P3 P4 P5 Trading securities (at cost) . . . . . . . . . . . . . . . . . . $ 5,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Short-term stock investments (at cost) . . . . . . . . 23,000 Fair value adjustment—Stock . . . . . . . . . . . . . . . (1,000)

Equity method investments . . . . . . . . . . . . . . . . . 70,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . 2,000

Held-to-maturity securities (long-term) . . . . . . . . 13,000 Fair value adjustment—Trading . . . . . . . . . . . . . . 500

Wixi Co. has the following equity investments in FSN, DELL, and ATI. (1) Which of these companies are subsidiaries of Wixi? (2) How are individual assets and liabilities of a parent and its subsidiary(ies) re- ported on a balance sheet? FSN stock: Wixi owns 70% of the voting common stock and has controlling influence. DELL stock: Wixi owns 5% of the voting common stock and has insignificant influence. ATI stock: Wixi owns 30% of the voting common stock and has significant influence.

Exercise C-15 Equity securities with controlling influence

C2

Use the following information of Prescrip Co. to prepare a calendar year-end statement of comprehensive income.

Exercise C-16 Preparing a statement of comprehensive income

C2Total comprehensive income (final total) . . . . . . . . . . . . $ 9,400 Other comprehensive income (subtotal) . . . . . $ (600) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Change in foreign currency translation . . . . . . 1,400

Change in value of available-for-sale securities . . . . . . (2,000)

Following are financial data for Nike and Under Armour. (1) Compute return on total assets for the current year for (a) Nike and (b) Under Armour. (2) Compute both profit margin and total asset turnover for the current year for (a) Nike and (b) Under Armour. (3) Which company more efficiently used its assets in the current year?

Exercise C-17 Return on total assets

A1

Nike Under Armour

$ millions Current Year 1 Year Prior Current Year 1 Year Prior

Net income . . . . . . . . . . . . . . . . $ 3,760 $ 3,273 $ 257 $ 233

Net sales . . . . . . . . . . . . . . . . . . 32,376 30,601 4,825 3,963

Total assets . . . . . . . . . . . . . . . . 21,396 21,597 3,644 2,866

PROBLEM SET A

Problem C-1A Recording and adjusting trading debt securities

P1

Kirkland Company had no trading debt securities prior to this year. It had the following transactions this year involving trading debt securities. Aug. 2 Purchased Verizon bonds for $10,000. Sep. 7 Purchased Apple bonds for $35,000. 12 Purchased Mastercard bonds for $20,000. Oct. 21 Sold some of its Verizon bonds that had cost $2,000 for $2,100 cash. 23 Sold some of its Apple bonds that had cost $15,000 for $15,400 cash. Nov. 1 Purchased Walmart bonds for $40,000. Dec. 10 Sold all of its Mastercard bonds for $18,000 cash.

C-24 Appendix C Investments

Mead Inc. began operations in Year 1. Following is a series of transactions and events involving its long- term debt investments in available-for-sale securities.

Year 1

Jan. 20 Purchased Johnson & Johnson bonds for $20,500. Feb. 9 Purchased Sony notes for $55,440. June 12 Purchased Mattel bonds for $40,500. Dec. 31 Fair values for debt in the portfolio are Johnson & Johnson, $21,500; Sony, $52,500; and Mat-

tel, $46,350.

Year 2

Apr. 15 Sold all of the Johnson & Johnson bonds for $23,500. July 5 Sold all of the Mattel bonds for $35,850. July 22 Purchased Sara Lee notes for $13,500. Aug. 19 Purchased Kodak bonds for $15,300. Dec. 31 Fair values for debt in the portfolio are Kodak, $17,325; Sara Lee, $12,000; and Sony, $60,000.

Year 3

Feb. 27 Purchased Microsoft bonds for $160,800. June 21 Sold all of the Sony notes for $57,600. June 30 Purchased Black & Decker bonds for $50,400. Aug. 3 Sold all of the Sara Lee notes for $9,750. Nov. 1 Sold all of the Kodak bonds for $20,475. Dec. 31 Fair values for debt in the portfolio are Black & Decker, $54,600, and Microsoft, $158,600.

Required

1. Prepare journal entries to record these transactions and the year-end fair value adjustments to the port- folio of long-term available-for-sale debt securities.

2. Prepare a table that summarizes the (a) total cost, (b) total fair value adjustment, and (c) total fair value of the portfolio of long-term available-for-sale debt securities at each year-end.

3. Prepare a table that summarizes (a) the realized gains and losses and (b) the unrealized gains or losses for the portfolio of long-term available-for-sale debt securities at each year-end.

Problem C-2A Recording, adjusting, and reporting available-for-sale debt securities

P3

Check (2b) Fair Value Adj. bal.: 12/31/Year 1, $3,910 Dr.; 12/31/Year 2, $5,085 Dr. (3b) Unrealized Gain at 12/31/Year 3, $2,000

Problem C-3A Debt investments in available-for-sale securities; unrealized and realized gains and losses

P3

Stoll Co.’s long-term available-for-sale portfolio at the start of this year consists of the following.

Available-for-Sale Securities Cost Fair Value

Company A bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $535,300 $490,000

Company B notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,380 154,000

Company C bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662,750 640,940

Stoll enters into the following transactions involving its available-for-sale debt securities this year.

Jan. 29 Sold one-half of the Company B notes for $79,200. July 6 Purchased Company X bonds for $126,600. Nov. 13 Purchased Company Z notes for $267,900. Dec. 9 Sold all of the Company A bonds for $515,000.

The fair values at December 31 are B, $81,000; C, $610,000; X, $118,000; and Z, $278,000.

Required

1. Prepare journal entries to record these transactions. 2. Prepare a table to compare the year-end cost and fair values of its trading debt securities. Year-end fair

values: Verizon, $8,500; Apple, $22,000; and Walmart, $39,000. 3. Prepare the adjusting entry to record the year-end fair value adjustment for the portfolio of trading debt

securities.

Appendix C Investments C-25

Selk Steel Co., which began operations in Year 1, had the following transactions and events in its long- term investments.

Year 1

Jan. 5 Selk purchased 60,000 shares (20% of total) of Kildaire’s common stock for $1,560,000. Oct. 23 Kildaire declared and paid a cash dividend of $3.20 per share. Dec. 31 Kildaire’s net income for the year is $1,164,000, and the fair value of its stock at December 31

is $30.00 per share.

Year 2

Oct. 15 Kildaire declared and paid a cash dividend of $2.60 per share. Dec. 31 Kildaire’s net income for the year is $1,476,000, and the fair value of its stock at December 31

is $32.00 per share.

Year 3

Jan. 2 Selk sold 3% (equal to 1,800 shares) of its investment in Kildaire for $54,200 cash.

Required

Prepare journal entries to record these transactions and events for Selk. Assume that Selk has a significant influence over Kildaire with its 20% share of stock.

Problem C-5A Accounting for long-term investments in stock with significant influence

P5

Rose Company had no short-term investments prior to this year. It had the following transactions this year involving short-term stock investments with insignificant influence.

Apr. 16 Purchased 3,500 shares of Gem Co. stock at $24 per share. July 7 Purchased 2,000 shares of PepsiCo stock at $49 per share. 20 Purchased 1,000 shares of Xerox stock at $16 per share. Aug. 15 Received a $1.00 per share cash dividend on the Gem Co. stock. 28 Sold 2,000 shares of Gem Co. stock at $30 per share. Oct. 1 Received a $2.50 per share cash dividend on the PepsiCo shares. Dec. 15 Received a $1.00 per share cash dividend on the remaining Gem Co. shares. 31 Received a $1.50 per share cash dividend on the PepsiCo shares.

Required

1. Prepare journal entries to record the preceding transactions and events. 2. Prepare a table to compare the year-end cost and fair values of Rose’s short-term stock investments.

The year-end fair values per share are Gem Co., $26; PepsiCo, $46; and Xerox, $13. 3. Prepare an adjusting entry to record the year-end fair value adjustment for the portfolio of short-term

stock investments.

Analysis Component

4. Explain the balance sheet presentation of the fair value adjustment for Rose’s short-term investments. 5. How do these short-term stock investments affect Rose’s (a) income statement for this year and (b) the

equity section of its balance sheet at this year-end?

Check (2) Cost = $150,000

(3) Dr. Unrealized Loss— Income, $6,000

Problem C-4A Recording, adjusting, and reporting stock investments with insignificant influence

P4

Required

1. Prepare journal entries to record these transactions, including the December 31 adjusting entry to record the fair value adjustment for the long-term investments in available-for-sale securities.

2. Determine the amount Stoll reports on its December 31 balance sheet for its long-term investments in available-for-sale securities.

3. What amount of gains or losses on transactions relating to long-term investments in available-for-sale debt securities does Stoll report on its income statement for this year?

Check (1) Dec 31: Cr. Unrealized Loss— Equity, $22,550

Refer to the transactions in Problem C-5A. Assume that although Selk owns 20% of Kildaire’s outstanding stock, circumstances indicate that it does not have a significant influence over the investee.

Required

Prepare journal entries to record the preceding transactions and events for Selk.

Problem C-6A Accounting for long-term investments in stock without significant influence

P4

C-26 Appendix C Investments

Problem C-2B Recording, adjusting, and reporting available-for-sale debt securities

P3

Paris Inc. began operations in Year 1. Following is a series of transactions and events involving its long- term debt investments in available-for-sale securities.

Year 1

Mar. 10 Purchased Apple bonds for $30,600. Apr. 7 Purchased Ford notes for $56,250. Sep. 1 Purchased Polaroid bonds for $28,200. Dec. 31 Fair values for debt in the portfolio are Apple, $33,000; Ford, $54,600; and Polaroid, $29,400.

Year 2

Apr. 26 Sold all of the Ford notes for $51,250. June 2 Purchased Duracell bonds for $34,650. June 14 Purchased Sears notes for $25,200. Nov. 27 Sold all of the Polaroid bonds for $30,600. Dec. 31 Fair values for debt in the portfolio are Apple, $31,000; Duracell, $32,400; and Sears, $27,600.

Year 3

Jan. 28 Purchased Coca-Cola bonds for $40,000. Aug. 22 Sold all of the Apple bonds for $25,800. Sep. 3 Purchased Motorola notes for $84,000. Oct. 9 Sold all of the Sears notes for $28,800. Oct. 31 Sold all of the Duracell bonds for $27,000. Dec. 31 Fair values for debt in the portfolio are Coca-Cola, $48,000, and Motorola, $82,000.

Required

1. Prepare journal entries to record these transactions and events and any year-end fair value adjustments to the portfolio of long-term available-for-sale debt securities.

2. Prepare a table that summarizes the (a) total cost, (b) total fair value adjustment, and (c) total fair value for the portfolio of long-term available-for-sale debt securities at each year-end.

3. Prepare a table that summarizes (a) the realized gains and losses and (b) the unrealized gains or losses for the portfolio of long-term available-for-sale debt securities at each year-end.

Check (2b) Fair Value Adj. bal.: 12/31/Year 1, $1,950 Dr.; 12/31/Year 2, $550 Dr. (3b) Unrealized Gain at 12/31/Year 3, $6,000

Problem C-3B Debt investments in available-for-sale securities; unrealized and realized gains and losses

P3

Troy’s long-term available-for-sale portfolio at the start of this year consists of the following.

Available-for-Sale Securities Cost Fair Value

Company R bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $559,125 $580,440

Company S notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,380 293,250

Company T bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,295 151,800

PROBLEM SET B

Problem C-1B Recording and adjusting trading debt securities

P1

Ancore Company had no trading debt securities prior to this year. It had the following transactions this year involving trading debt securities.

July 28 Purchased Target bonds for $30,000. Aug. 17 Purchased Kroger bonds for $105,000. 26 Purchased Ford bonds for $60,000. Sep. 5 Sold some of its Target bonds that had cost $6,000 for $6,300 cash. 8 Sold some of its Kroger bonds that had cost $45,000 for $46,200 cash. Oct. 12 Purchased Marshall bonds for $120,000. Nov. 28 Sold all of its Ford bonds for $54,000 cash.

Required

1. Prepare journal entries to record these transactions. 2. Prepare a table to compare the year-end cost and fair values of Ancore’s trading debt securities. Year-

end fair values: Target, $25,500; Kroger, $66,000; and Marshall, $117,000. 3. Prepare the adjusting entry to record the year-end fair value adjustment for the portfolio of trading debt

securities.

Appendix C Investments C-27

Slip Systems had no short-term investments prior to this year. It had the following transactions this year involving short-term stock investments with insignificant influence.

Feb. 6 Purchased 3,400 shares of Nokia stock at $41 per share. Apr. 7 Purchased 1,200 shares of Dell stock at $39 per share. June 2 Purchased 2,500 shares of Merck stock at $72 per share. 30 Received a $1.00 per share cash dividend on the Nokia shares. Aug. 11 Sold 850 shares of Nokia stock at $46 per share. 24 Received a $0.10 per share cash dividend on the Dell shares. Nov. 9 Received a $1.50 per share cash dividend on the remaining Nokia shares. Dec. 18 Received a $0.15 per share cash dividend on the Dell shares.

Required

1. Prepare journal entries to record the preceding transactions and events. 2. Prepare a table to compare the year-end cost and fair values of the short-term stock investments. The

year-end fair values per share are Nokia, $40; Dell, $41; and Merck, $59. 3. Prepare an adjusting entry, if necessary, to record the year-end fair value adjustment for the portfolio

of short-term stock investments.

Analysis Component

4. Explain the balance sheet presentation of the fair value adjustment to Slip’s short-term investments. 5. How do these short-term stock investments affect (a) its income statement this year and (b) the equity

section of its balance sheet at this year-end?

Check (2) Cost = $331,350

(3) Dr. Unrealized Loss— Income, $32,650

Problem C-4B Recording, adjusting, and reporting stock investments with insignificant influence

P4

Brinkley Company, which began operations in Year 1, had the following transactions and events in its long-term investments.

Year 1

Jan. 5 Brinkley purchased 20,000 shares (25% of total) of Bloch’s common stock for $200,500. Aug. 1 Bloch declared and paid a cash dividend of $1.05 per share. Dec. 31 Bloch’s net income for the year is $82,000, and the fair value of its stock is $11.90 per share.

Year 2

Aug. 1 Bloch declared and paid a cash dividend of $1.35 per share. Dec. 31 Bloch’s net income for the year is $78,000, and the fair value of its stock is $13.65 per share.

Year 3

Jan. 8 Brinkley sold 5% (equal to 1,000 shares) of its investment in Bloch for $12,025 cash.

Problem C-5B Accounting for long-term investments in stock with significant influence

P5

Troy enters into the following transactions involving its available-for-sale debt securities this year.

Jan. 13 Sold one-fourth of the Company S notes for $72,250. Apr. 5 Purchased Company V bonds for $133,875. Sep. 2 Sold all of the Company T bonds for $156,750. Oct. 30 Purchased Company X notes for $48,750.

The fair values at December 31 are R, $568,125; S, $234,345; V, $134,940; and X, $45,625.

Required

1. Prepare journal entries to record these transactions, including any necessary December 31 adjust- ing entry to record the fair value adjustment of the long-term investments in available-for-sale securities.

2. Determine the amount Troy reports on its December 31 balance sheet for its long-term investments in available-for-sale securities.

3. What amount of gains or losses on transactions relating to long-term investments in available-for-sale securities does Troy report on its income statement for this year?

Check (1) Dec. 31: Cr. Fair Value Adj—AFS, $690

C-28 Appendix C Investments

SERIAL PROBLEM Business Solutions

P1

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP C While reviewing the March 31, 2020, balance sheet of Business Solutions, Santana Rey notes that the business has built a large cash balance of $68,057. Its most recent bank money market statement shows that the funds are earning an annualized return of 0.75%. S. Rey decides to make several investments with the desire to earn a higher return on the idle cash balance. Accordingly, in April 2020, Business Solutions makes the following investments in trading securities.

Apr. 16 Purchases Johnson & Johnson bonds for $10,000. Apr. 30 Purchases Starbucks notes for $4,400.

On June 30, 2020, the fair value of the Johnson & Johnson bonds is $12,000 and the Starbucks notes is $3,800.

Required

1. Prepare journal entries to record the April purchases of trading securities by Business Solutions. 2. On June 30, 2020, prepare the adjusting entry to record any necessary fair value adjustment to its

portfolio of trading securities. ©Alexander Image/Shutterstock

The following General Ledger assignments focus on the account for investments in available-for-sale securities and equity method investments.

GL C-1 General Ledger assignment C-1 is adapted from Problem C-4A. Prepare journal entries related to short-term investments in available-for-sale securities, including the adjustment to fair value, if neces- sary.

GL C-2 General Ledger assignment C-2 is adapted from Problem C-3A. Prepare journal entries related to long-term investments transactions and the related realized and unrealized gains.

GENERAL LEDGER PROBLEM

GL

COMPANY ANALYSIS A1

Accounting Analysis

AA C-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Compute Apple’s return on total assets for the years ended September 30, 2017, and September 24, 2016. 2. Is the change in Apple’s return on total assets from part 1 favorable or unfavorable? 3. Recently, Apple acquired 100% of Beats Electronics (Beats by Dre) for $3 billion. Will Apple account

for Beats using the equity method or consolidation?

APPLE

Refer to the transactions in Problem C-5B. Assume that although Brinkley owns 25% of Bloch’s outstand- ing stock, circumstances indicate that it does not have a significant influence over the investee.

Required

Prepare journal entries to record these transactions and events for Brinkley.

Problem C-6B Accounting for long-term investments in stock without significant influence

P4

Required

Prepare journal entries to record these transactions and events for Brinkley. Assume that Brinkley has a significant influence over Bloch with its 25% share.

Appendix C Investments C-29

ETHICS CHALLENGE P2 P3

BTN C-1 Kasey Hartman is the controller for Wholemart Company, which has numerous long-term investments in debt securities. Wholemart’s investments are mainly in five-year bonds. Hartman is prepar- ing its year-end financial statements. In accounting for long-term debt securities, she knows that each long-term investment must be designated as a held-to-maturity or an available-for-sale security. Interest rates rose sharply this past year, causing the portfolio’s fair value to substantially decline. The company does not intend to hold the bonds for the entire five years. Hartman also earns a bonus each year, which is computed as a percent of net income.

Required

1. Will Hartman’s bonus depend in any way on the classification of the debt securities? Explain. 2. What criteria must Hartman use to classify the securities as held-to-maturity or available-for-sale? 3. Is there likely any company oversight of Hartman’s classification of the securities? Explain.

Beyond the Numbers

BTN C-2 Assume that you are Jolee Company’s accountant. Company owner Mary Jolee has reviewed the 2019 financial statements you prepared and questions the $6,000 loss reported on the sale of its investment in Kemper Co. common stock. Jolee acquired 50,000 shares of Kemper’s common stock on December 31, 2017, at a cost of $500,000. This stock purchase represented a 40% interest in Kemper. The 2018 income statement reported that earnings from all investments were $126,000. On January 3, 2019, Jolee Company sold the Kemper stock for $575,000. Kemper did not pay any dividends during 2018 but reported a net income of $202,500 for that year. Mary Jolee believes that because the Kemper stock purchase price was $500,000 and was sold for $575,000, the 2019 income statement should report a $75,000 gain on the sale.

Required

Draft a half-page memorandum to Mary Jolee explaining why the $6,000 loss on sale of Kemper stock is correctly reported.

COMMUNICATING IN PRACTICE P4

Required

1. Compute Samsung’s return on total assets for the two most recent years. 2. For the current year, is Samsung’s return on total assets better or worse than (a) Apple’s and (b) Google’s? 3. For the current year, compute Samsung’s profit margin. 4. For the current year, compute Samsung’s total asset turnover.

GLOBAL ANALYSIS A1

AA C-3 Following are selected data from Samsung, Apple, and Google.

Samsung Apple Google

In millions Current Year One Year Prior Two Years Prior Current Year Prior Year Current Year Prior Year

Net income . . . . . W 42,186,747 W 22,726,092 W 19,060,144 $ 48,351 $ 45,687 $ 12,662 $ 19,478

Net sales . . . . . . . 239,575,376 201,866,745 200,653,482 229,234 215,639 110,855 90,272

Total assets . . . . . 301,752,090 262,174,324 242,179,521 375,319 321,686 197,295 167,497

Samsung APPLE GOOGLE

Required

1. Compute return on total assets for Apple and Google for the two most recent years. 2. Which of these two companies has the better return on total assets for the current year? 3. Compute both profit margin and total asset turnover for Apple and Google for the most recent year.

AA C-2 Key figures for Apple and Google follow.

Apple Google

Current 1 Year 2 Years Current 1 Year 2 Years $ millions Year Prior Prior Year Prior Prior

Net income . . . . . . . . . . . $ 48,351 $ 45,687 $ 53,394 $ 12,662 $ 19,478 $ 16,348

Net sales . . . . . . . . . . . . . 229,234 215,639 233,715 110,855 90,272 74,989

Total assets . . . . . . . . . . . 375,319 321,686 290,345 197,295 167,497 147,461

COMPARATIVE ANALYSIS A1

APPLE GOOGLE

C-30 Appendix C Investments

TEAMWORK IN ACTION C2 P1 P2 P3 P4

BTN C-4 Each team member is to become an expert on a specific classification of long-term investments. This expertise will be used to facilitate other teammates’ understanding of the concepts and procedures relevant to the classification chosen. 1. Each team member must select an area for expertise by choosing one of the following classifications

of long-term investments. a. Held-to-maturity debt securities b. Available-for-sale debt securities c. Equity securities with significant influence d. Equity securities with controlling influence 2. Learning teams are to disperse and expert teams are to be formed. Expert teams are made up of those who

select the same area of expertise. The instructor will identify the location where each expert team will meet. 3. Expert teams will collaborate to develop a presentation based on the following requirements. Students

must write the presentation in a format they can show to their learning teams in part 4.

Requirements for Expert Presentation

a. Write a transaction for the acquisition of this type of investment security. The transaction descrip- tion is to include all necessary data to reflect the chosen classification.

b. Prepare the journal entry to record the acquisition. [Note: The expert team on equity securities with controlling influence will substitute requirements

(d) and (e) with a discussion of the reporting of these investments.] c. Identify information necessary to complete the end-of-period adjustment for this investment. d. Assuming that this is the only investment owned, prepare any necessary year-end entries. e. Present the relevant balance sheet section(s). 4. Re-form learning teams. In rotation, experts are to present to their teams the presentations they devel-

oped in part 3. Experts are to encourage and respond to questions.

HITTING THE ROAD C2

BTN C-6 Review financial news sources such as Yahoo! Finance (finance.yahoo.com) and Google Finance (google.com/finance). Identify a company that has recently purchased 50% or more of another company’s outstanding shares and will report consolidated financial statements.

Required

1. Identify whether the acquired company is a supplier, customer, competitor, or unrelated company rela- tive to the purchasing company.

2. What does the purchasing company hope to accomplish with the investment? What is its strategy? Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw-Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

BTN C-3 Access the July 28, 2016, 10-K filing (for year-end June 30, 2016) of Microsoft (ticker: MSFT) at SEC.gov. Review its note 4, “Investments.”

Required

1. How does the “cost-basis” total amount for its investments as of June 30, 2016, compare to the prior year-end amount?

2. Identify at least eight types of investments held by Microsoft as of June 30, 2016. 3. What were Microsoft’s unrealized gains and its unrealized losses from its investments for 2016? 4. Was the cost or fair value (“recorded basis”) of the investments higher as of June 30, 2016?

TAKING IT TO THE NET P1 P2 P3 P4

ENTREPRENEURIAL DECISION P4

BTN C-5 Assume that Echoing Green makes an investment in Sustain Inc., a sustainability consulting firm. The company purchases 200 shares of Sustain stock for $15,000 cash plus a broker’s fee of $500 cash. Sustain has 500 shares of common stock outstanding, and Echoing Green will be able to sig- nificantly influence its policies.

Required

1. Prepare the journal entry to record the investment in Sustain on January 1. 2. Sustain declares and pays a dividend of $1,000. Prepare the journal entry to record Echoing Green’s

receipt of its share of the dividend on July 1. 3. Sustain reports net income of $5,000. Prepare the journal entry to record Echoing Green’s share of

those earnings on December 31.

D-1

Learning Objectives

CONCEPTUAL C1 Describe lean principles.

ANALYTICAL A1 Compute cycle time and cycle efficiency,

and explain their importance to production management.

PROCEDURAL P1 Record product costs using lean

accounting.

A2 Compute days’ sales in work in process inventory.

A3 Compute days’ payable outstanding.

Appendix Preview

D Lean Principles and Accounting

LEAN ACCOUNTING

P1 Key accounts Conversion costs

Accounting entries

A3 Days in payables

NTK D-3

PRODUCTION PERFORMANCE

A1 Cycle time Cycle efficiency

A2 Days in work in process inventory

NTK D-2

LEAN BUSINESS MODEL

C1 Lean principles Lean example

Lean for services

Supply chain

NTK D-1

D-2 Appendix D Lean Principles and Accounting

Competition forces businesses to improve. One approach is to adopt the lean business model, whose goal is to use fewer resources while still satisfying customers. Exhibit D.1 shows key aspects of the lean business model. At the top are overall strategies aimed to eliminate waste in processes and meet customer needs. In the middle are lean business practices such as continu- ous improvement, just-in-time inventory systems, supply chain management, and total quality management. These practices aim to cut waste in spending and increase quality and productiv- ity. Businesses that produce better quality products and services with lower costs are more suc- cessful. At the base of this model are key principles. While all types of businesses can apply lean principles, we focus on manufacturers.

LEAN BUSINESS MODEL

C1 Describe lean principles.

EXHIBIT D.1 Lean Business Model Triple Bottom Line

Lean

Customer Satisfaction JIT

(Just-in-Time)

Supply Chain

Management

Value Streams Pull Production Zero Waste and Zero Defects

Employee Involvement

Continuous Improvement

Quality

ServiceSalesRoasting and blendingAcquire raw materials

EXHIBIT D.2 Trail Mix Value Stream

Lean Principles Following are the three key principles of the lean business model.

Value streams Pull production Zero waste and zero defects

Value Streams Lean businesses aim to provide customers what they want, and when they want it. Customers increasingly want customized products, so manufacturers must be able to produce quickly and without waste. Rather than build standard products in a long assembly line, lean manufacturers use smaller value streams. Value streams consist of all the activities needed to create customer value. For example, a food processor might have separate value streams for its trail mix, energy bars, and energy drinks. All of the processes for each product type occur in one value stream. A trail mix value stream is shown in Exhibit D.2.

Appendix D Lean Principles and Accounting D-3

Push production has several challenges that include the following. Inaccurate sales forecasts can cause too many goods to be produced. This increases storage

costs and risk of obsolescence (decrease in value). Inaccurate sales forecasts can cause not enough goods to be produced. This creates stock-outs

and lost sales. Batch sizes (lot sizes), which are the number of units produced after a machine setup, are

high. This makes it hard to produce customized products. Large batch sizes can also produce more defects before the issue is identified and production is stopped.

To address these issues, many turn to pull production. Pull production follows a lean strategy which includes a focus on reducing (1) cycle time, (2) setup time, and (3) inventory levels.

Cycle Time Cycle time (CT) is the total time a production process takes, starting from put- ting raw materials into production to completing a finished good. This can be in minutes, such as with fast-food restaurants, or weeks, such as with jet engines. Lean businesses reduce cycle time by producing in smaller batch sizes and making goods to customer order. Smaller batch sizes reduce time because goods spend less time waiting for other goods to finish in the produc- tion cycle. Customers get the goods they want more quickly.

Lean businesses focus on improving the following components to reduce cycle time. Process time—Time spent working on and producing the product. Lean companies reduce pro-

cess time by simplifying the production process and by excluding unwanted product features. Inspection time—Time spent inspecting raw materials received, work in process in produc-

tion, and finished goods before shipment. Lean companies emphasize quality materials and processes to reduce inspection time.

Move time—Time spent moving materials and inventory, and employee time spent moving around the production area. Lean businesses reduce move time by strategically placing tools and machinery in the production area.

Wait time—Time an order sits before or between production processes. Lean businesses reduce wait time by avoiding raw material order delays, production bottlenecks, and poor production scheduling.

Value-added

Non-value-added

⎫ ⎬ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

Pull Production Lean manufacturing differs from traditional manufacturing. Lean busi- nesses use pull production, where production begins with a customer order. Goods are “pulled” through the manufacturing process “just-in-time” and delivered to the customer after completion. Traditional manufacturing uses push production, where goods are produced before a cus- tomer order and based on sales forecasts. Goods are “pushed” into inventory and wait for a customer order. Exhibit D.3 shows push production compared with pull production.

EXHIBIT D.3 Push Production Compared with Pull Production

Sales forecast RM inventory FG inventoryProcess 1 Process 2

Sales

Sales

Roasting department

Blending department

Customer order Process 1 Process 2

Roasting department

Blending department

Push (Traditional) Production

Pull (Lean) Production

D-4 Appendix D Lean Principles and Accounting

Of the four parts of cycle time, only process time is a value-added time activity that adds value to the customer. Inspection, move, and wait time are non-value-added time activities because they do not add value to customers.

Setup Time Setup time is the amount of time to prepare a process for production; for ex- ample, preparing the roasting process to make trail mix. Setup time includes time spent starting and calibrating machines. Lean companies want quick setups so they can reduce cycle time when producing goods to customer order in smaller batch sizes.

Inventory Levels Lean businesses believe holding inventory is wasteful and instead use just- in-time inventory. The following table compares how traditional and lean manufacturers manage inventory.

Inventory Traditional Approach Lean (Just-in-Time) Approach

Raw materials . . . . . . . . . . Bought to hold in inventory; enters production based on sales forecast .

Bought after a customer order; enters production immediately after receipt .

Work in process . . . . . . . . . Larger; not a priority to reduce . Reduced as cycle times get faster . Finished goods . . . . . . . . . Held in inventory until sold . Delivered to customers after goods are finished .

Zero Waste and Zero Defects Lean businesses aim for zero waste and zero defects. Employees of lean businesses are empowered to stop production if they see something wrong. Defective goods are not passed on to the next process. Instead, the source of the problem is identified and corrected before production resumes. Fewer defects lead to lower scrap and rework costs, fewer warranty claims, and increased customer satisfaction.

Lean Production Example Nike implemented a lean approach to its clothes manufacturing in several countries. Clothes manufacturing requires sewing, ironing, and packing processes. Exhibit D.4 compares Nike’s traditional approach to its new lean approach. Several benefits and cost savings are identified.

EXHIBIT D.4 Lean Production at Nike

Traditional Approach Lean Approach Benefits from Lean Approach

Production layout . . . . . . . . . Sewing, ironing, and packing processes are physically separated .

All processes in the apparel value stream are located together .

Reduced move time of both employees and inventory .

Production starts with . . . . . . . Sales forecast . Customer order . Less inventory . Quality control . . . . . . . . . . . . End-of-line quality

inspection . Each employee inspects her own output before passing it to the next step .

Fewer defects .

Supervision . . . . . . . . . . . . . . One supervisor for each process .

One supervisor for the entire value stream .

Reduced overhead costs .

Source: Distelhorst, Greg; Hainmueller, Jens; and Locke, Richard M. Does Lean Improve Labor Standards? Management and Social Performance in the Nike Supply Chain, August 29, 2015.

Lean Processes for Service Businesses Lean principles also apply to retailers and service businesses. Amazon applied lean principles when it changed its fulfillment process to use machines for repetitive, low-value-added steps and human employees for high-value, complex work. As a result, the number of defects (incor- rect order fulfillments) was reduced. Amazon also applies lean principles to customer service. Employees are empowered to make quick decisions to satisfy customers. If customers call about a defective product, employees can “stop the line” by removing the product from Amazon’s website until the source of the defect is resolved. This lean approach reduced the number of defective products sold and increased customer satisfaction.

©Mihajlo Maricic/Alamy Stock Photo

Appendix D Lean Principles and Accounting D-5

Taco Bell applies lean principles to food service. By focusing on customer value, manage- ment determined “We are in the business of feeding people, not making food.” As a result, the company changed from food processing to food assembly. Ingredients are preprocessed in off- site facilities and shipped just-in-time to restaurants. Employees then assemble ingredients to suit customer orders. With a lean approach, inventory levels fell, quality and customer satisfac- tion increased, and costs decreased.

Supply Chain Management Supply chain management or logistics is the control of materials, information, and finances as they move between suppliers, manufacturers, and customers. Lean businesses use supply chain management to ensure raw materials arrive just-in-time for production and customers receive their orders on schedule.

All types of businesses must manage their supply chains. Nike outsources all of its produc- tion, and it uses review programs to make sure its suppliers follow ethical practices while sup- plying quality goods. Taco Bell’s just-in-time preprocessed food deliveries require close coordination and information sharing with its suppliers.

One measure of success in supply chain management is in the demand for its services. A materials handling industry report forecasts over 1.4 million openings for logistics jobs in sup- ply chain management. These include jobs for data analysts, marketers, human resource manag- ers, and fulfillment center employees. Average annual salaries of around $100,000 are common for supply chain managers.

Point: The Council of Supply Chain Professionals (cscmp.org) offers more information.

Part A For each item, identify whether it best applies to lean businesses (L) or traditional businesses (T). 1. Production begins with a sales forecast. 4. Processes are located together. 2. Only finished goods are inspected for quality. 5. Uses push production. 3. Uses pull production. 6. Produces in small lot sizes.

Solution

1. T 2. T 3. L 4. L 5. T 6. L

Part B Identify which of the statements below are true (T) or false (F). Lean businesses aim to: 1. Reduce inventory levels. 4. Produce many defective products. 2. Increase profits. 5. Reduce wait time. 3. Produce in large lot sizes. 6. Reduce inspection time.

Solution

1. T 2. T 3. F 4. F 5. T 6. T

C1 Lean Production

NEED-TO-KNOW D-1

Do More: QS D-1, QS D-2, E D-1

Cycle Time and Cycle Efficiency Lean businesses use many nonfinancial measures to evaluate the performance of their produc- tion processes. It is important for lean businesses to reduce the time it takes to produce products and to improve efficiency. Cycle time (CT), as covered earlier, is the time it takes to produce a good or provide a service. It is more specifically defined in Exhibit D.5.

PRODUCTION PERFORMANCE A1 Compute cycle time and cycle efficiency, and explain their importance to production management.

EXHIBIT D.5 Cycle Time

Cycle time = Process time + Inspection time + Move time + Wait time

D-6 Appendix D Lean Principles and Accounting

To illustrate, assume that Rocky Mountain Bikes receives and produces an order for 500 mountain bikes. Assume that it took the following times to produce this order.

EXHIBIT D.7 Days’ Sales in Work in Process Inventory

Days’ sales in work in process inventory = Work in process inventory

Cost of goods sold × 365

Axis Co., a computer maker, reports work in process inventory of $503 and cost of goods sold of $45,829. Axis computes its days’ sales in work in process inventory as follows.

$503 $45,829

× 365 = 4 days

As explained, process time is the only activity that adds value to the customer (value-added activity). Inspection, move, and wait times do not add value to customers (non-value-added activities). Lean businesses try to reduce non-value-added time to improve cycle efficiency (CE). Cycle efficiency, defined in Exhibit D.6, measures the amount of cycle time spent on value-added activities. A CE of 1 means a value stream’s time is spent entirely on value-added activities. If the CE is low, too much time is being spent on non-value-added activities and the production process should be reviewed with an aim to eliminate waste.

EXHIBIT D.6 Cycle Efficiency Cycle efficiency =

Value-added time Cycle time

Process time... 1.8 days Inspection time... 0.5 days Move time... 0.7 days Wait time... 3.0 days

Time Type Days %

Value-added 1.8 30% Non-value-added 4.2 70 Total 6.0 100%

A2 Compute days’ sales in work in process inventory.

In this case, cycle time is 6.0 days (1.8 + 0.5 + 0.7 + 3.0 days). Cycle efficiency is computed as

Cycle efficiency = 1.8 days 6.0 days

= 0.30, or 30%

This means that Rocky Mountain Bikes’s value-added time (its process time, or time spent working on the product) is 30%. The other 70% of time is spent on non-value-added activities. The 30% CE for Rocky Mountain Bikes is low. Employees and managers try to reduce time spent on non-value-added activities.

Days’ Sales in Work in Process Inventory Lean businesses aim to reduce inventory. They typically do not have a separate Raw Materials Inventory account and hold few finished goods. This means the Work in Process Inventory account can be used to measure production efficiency. Work in process inventory reflects delay in getting products to customers, which lean businesses consider wasteful. Getting products to customers sooner by reducing work in process inventory can increase customer satisfaction. To measure production efficiency, we can use days’ sales in work in process inventory, defined in Exhibit D.7 and usually rounded to the nearest whole day.

Appendix D Lean Principles and Accounting D-7

Days’ Sales in Work in Process Inventory

A2 Work in process inventory . . . . . . . $2,053 Cost of goods sold . . . . . . $46,828

Solution

Days’ sales in work in process inventory = ($2,053/$46,828) × 365 = 16 days Do More: QS D-11, E D-10,

E D-11

Part 1

The following information is for an order of Aero Guitars produced by Tyler Co. Compute cycle time and cycle efficiency. Cycle Time and Cycle

Efficiency

NEED-TO-KNOW D-2

A1Process time . . . 8 days Inspection time . . . 0 .2 days Move time . . . 0 .4 days Wait time . . . . 1 .4 days

Solution

Cycle time = Process time + Inspection time + Move time + Wait time = 8 + 0.2 + 0.4 + 1.4 = 10 days Cycle efficiency = Value-added time / Cycle time

= 8/10 = 80% → 80% of the company’s time is spent on value-added activities. Only process time is considered value-added time.

Part 2

Use the following information to compute days’ sales in work in process inventory.

Do More: QS D-9, QS D-10, E D-6, E D-7, E D-8, E D-9

Key Accounts Lean businesses usually have fewer transactions to record and use fewer accounts. The key accounts in lean accounting follow. Work in Process Inventory Lean businesses put raw materials immediately into produc-

tion, so a separate Raw Materials Inventory account is not used. Raw materials purchases are recorded in Work in Process Inventory.

Conversion Costs Direct labor, indirect labor, and overhead costs are recorded in this account. In lean businesses, employees work within individual value streams and they do both direct and indirect labor tasks. For example, employees in a trail mix value stream might do roasting, blending, packaging, and cleaning duties. Therefore, all of these costs are accumulated in the Conversion Costs account.

Conversion Costs In lean accounting, estimated conversion costs are applied to work in process. For example, if a business budgets for $10,000,000 of conversion costs and 4,000 production hours in a value stream, the conversion cost rate is computed as follows.

Conversion cost rate = Budgeted conversion costs Budgeted production hours

= $10,000,000 4,000 hours*

= $2,500 per production hour

*Two 8-hour shifts per day × 250 factory days per year.

This rate can be expressed in terms of units of product. For example, if 5 products can be made each hour, the conversion cost rate is $500 per unit ($2,500/5 units).

Point: Work in Process Inventory is also called Raw and In Process Inventory.

LEAN ACCOUNTING P1 Record product costs using lean accounting.

Work in Process Inventory

Raw mtls. # Conversion # To COGS #

Lower days’ sales in work in process inventory means the company is completing its production cycle more quickly. Adopting a lean model should result in a smaller number of days’ sales in work in process inventory.

D-8 Appendix D Lean Principles and Accounting

Actual and applied (budgeted) conversion costs often differ in an accounting period. Applied conversion costs are based on estimates made at the beginning of the period. Actual conversion costs can differ from estimates because of events such as wage rate changes or utility cost changes. Accounting for such differences is covered in advanced courses.

Accounting Entries Solshine manufactures solar panels. Each solar panel requires $40 of raw materials and $160 of conversion costs. The company produced and sold 200 solar panels for $480 each this period. Actual conversion costs equaled applied conversion costs. The relevant journal entries follow.

Point: Variations of lean account- ing exist. Some use “backflush” accounting, where entries are delayed until goods are finished or sold. Other methods are in advanced courses.

➄ Finished Goods Inventory . . . . . . . . . . . . . . . . 3,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . 37,000

Work in Process Inventory . . . . . . . . . . . 40,000

Record inventory and cost of goods sold.

➃ Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,800 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,800

Record sales on credit (185 units × $480 selling price).

Entry ① records materials purchased ($40 per panel × 200 panels to produce = $8,000) as Work in Process Inventory. Separate raw materials inventory accounts are not used.

Entry ② applies conversion costs ($160 per panel × 200 panels to produce = $32,000) to Work in Process Inventory. This applied conversion cost is based on a predetermined budgeted amount of conversion costs.

Entry ③ records actual conversion costs to produce 200 solar panels. This amount includes the actual costs of direct labor, indirect labor, and other overhead costs. The various credit accounts in this journal entry would include Salaries Payable, Wages Payable, Utilities Payable, Accumulated Depreciation—Manufacturing Equipment, and others.

Entry ④ records the sale of goods on account (200 panels sold × $480 sales price per panel = $96,000).

Entry ⑤ records the related cost of 200 panels sold (200 × $200 = $40,000). Because lean businesses make goods to order, finished product costs are immediately recorded in Cost of Goods Sold.

When Finished Goods Inventory Remains Lean businesses sometimes end an accounting period with finished but unsold goods. If instead of selling 200 panels, assume Solshine sold 185 panels and had 15 panels left in inventory. It records journal entries ①, ②, and ③ as above; but it records entries ④ and ⑤ as follows. Finished Goods Inventory is in- creased for the cost of goods not sold (15 units × $200). Cost of goods sold is computed as 185 units sold × $200 = $37,000.

Conversion Costs

32,000 32,000

0

Work in Process Inventory

8,000 32,000 40,000

0

Point: A traditional manufacturer would first transfer finished product costs to Finished Goods Inventory.

➀ Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Acquired raw materials on credit (200 units × $40). ➁ Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Conversion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Apply conversion costs to production (200 units × $160). ➂ Conversion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Various Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Record actual conversion costs (given).

➃ Accounts Receivable . . . . . . . . . . . . . . . . . . . . 96,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Record sales on credit (200 units × $480). ➄ Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . 40,000 Work in Process Inventory . . . . . . . . . . . 40,000

Record cost of goods sold (200 × $200).

Conversion Costs

Actual # Applied #

Point: Conversion Costs is a temporary account.

Appendix D Lean Principles and Accounting D-9

A lean business incurs $45 in raw materials costs and $75 in conversion costs to produce an office chair. Each chair is sold for $170. In the current period, the business produced 500 units and sold 470 units. Prepare the necessary journal entries following lean accounting. Assume actual conversion costs equal applied conversion costs.

Solution

Lean Accounting Entries

NEED-TO-KNOW D-3

P1

Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . 22,500

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . 22,500

Acquired raw materials on credit ($45 × 500). Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . 37,500

Conversion Costs . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Apply conversion costs to production ($75 × 500). Conversion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Various Accounts . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Record actual conversion costs.

Do More: QS D-3, QS D-4, QS D-5, QS D-6, E D-2, E D-3, E D-4

Nike implemented lean processes and achieved increased productivity, lower inventory levels, lower defect rates, and faster production. These improvements benefited the “profit” aspect of the triple bottom line, but lean processes can have other triple bottom line benefits. Nike saw major improvements in com- pliance with labor rules. This means that, with lean principles, Nike both increased profits and working conditions for employees (“people”) in its supply chain.

Lean businesses also try to reduce waste. Apple’s Environmental Responsibility Report shows a focus on the “planet” aspect of the triple bottom line. Apple strives for a closed-loop supply chain, where products are built using only renewable resources or recycled material, as shown in Exhibit D.8.

To achieve its goal, Apple works with its suppliers to use 100% recycled tin in the main part of its iPhone. It also has programs to encourage customers to recycle old devices. Robots disassemble more than 2.5 million iPhones per year to reclaim materials.

SUSTAINABILITY AND ACCOUNTING

Raw materials Manufacturing

Reuse & Recycling

Customer use EXHIBIT D.8 Closed-Loop Supply Chain

©Petovarga/Shutterstock

Days’ Payable Outstanding Decision Analysis

Companies that buy on credit monitor how long they take to pay creditors. This is particularly important for lean businesses because they usually have long-term contracts with important suppliers. Taking too long to pay could harm important partnerships. Paying too soon, however, means the company has less cash

A3 Compute days’ payable outstanding.

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,900

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,900

Sold on credit ($170 × 470). Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,400

Work in Process Inventory . . . . . . . . . . . . . . . . . . . . 60,000

Record ending inventory ($120 × 30) and cost of goods sold ($120 × 470).

D-10 Appendix D Lean Principles and Accounting

available for other needs. Days’ payable outstanding, defined in Exhibit D.9, is a measure of how long, on average, a company takes to pay its creditors and is usually rounded to the nearest whole day.

Under Armour 2016

Accounts payable $ 410 Cost of goods sold $2,585 Days’ payable 58 days

EXHIBIT D.9 Days’ Payable Outstanding Days’ payable outstanding =

Accounts payable Cost of goods sold

× 365

Nike’s days’ payable outstanding is shown in Exhibit D.10. Its days’ payable outstanding is roughly 39 days [($2,048/$19,038) × 365] in 2017. This decreased from the two prior years. A company’s days’ payable outstanding can be compared to its typical credit terms and to its industry competitors. Under Armour’s days’ payable outstanding was 75 at the end of 2017. A company with 30 days to pay and a days’ payable outstanding of 12 days should consider paying its creditors later. On the other hand, a company with 30 days to pay and a days’ payable outstanding of 55 days risks hurting its partnerships with key suppliers.

0 Match Group Facebook Twitter

Days’ Payable Outstanding Social Media companies

D ay

s

20

40

60

EXHIBIT D.10 Days’ Payable Outstanding for Two Competitors

Days’ payable outstanding varies across industries and across companies within an industry. Yum Brands’s (a restaurant operator) days’ payable outstanding has been over 100 days in recent years. Pandora Media Group (a music streaming company) has about 6 days’ payable outstanding.

LEAN BUSINESS MODEL Goal: Use fewer resources while satisfying customers. Key Principles: Value streams :: Pull production :: Zero waste & Zero defects Value streams: Activities that create customer value. Pull production: Production starts with customer order. Push production: Production begins with sales forecast.

PRODUCTION PERFORMANCE Time Components

Process time } Value-added Inspection time Move time Wait time

Setup time: Time to prepare a process for production.

Non-value-added ⎫ ⎪ ⎬ ⎪ ⎭

Summary: Cheat Sheet

LEAN ACCOUNTING

Cycle time = Process time + Inspection time + Move time + Wait time

Cycle efficiency = Value-added time

Cycle time

Days’ sales in WIP = Work in process inventory

Cost of goods sold × 365

Conversion cost rate = Budgeted conversion costs

Budgeted production hours

Days’ Payable Outstanding = Accounts payable Cost of goods sold

× 365

Acquire raw materials on credit:

Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Apply conversion costs to production:

Work in Process Inventory (Conversion cost rate × Units of activity) . . . 32,000

Conversion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Record actual conversion costs:

Conversion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Various Costs (Wages Payable, Acc . Dep .-Mfg . Eq ., etc) . . . . . . . . 32,000

Entries for Materials and Conversion Costs No separate Raw Materials Inventory account.

Key Terms

Batch size (lot size) (D-3) Closed-loop supply chain (D-9)

Conversion cost rate (D-7) Cycle efficiency (CE) (D-6)

Cycle time (CT) (D-3) Days’ payable outstanding (D-10)

Company $ millions 2017 2016 2015

Nike Accounts payable, end of year . . . . . . . . . . . $ 2,048 $ 2,191 $ 2,131 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . $19,038 $17,405 $16,534 Days’ payable outstanding . . . . . . . . . . . . . 39 days 46 days 47 days Under Armour Days’ payable outstanding . . . . . . . . . . . . . 75 days 58 days 36 days

Appendix D Lean Principles and Accounting D-11

Days’ sales in work in process inventory (D-6)

Lean business model (D-2) Non-valued-added time (D-4)

Pull production (D-3) Push production (D-3) Setup time (D-4)

Supply chain management (D-5) Value-added time (D-4) Value stream (D-2)

1. What are the three key principles of the lean business model?

2. How does push production differ from pull production? 3. What are three common problems with push production? 4. Define supply chain management. 5. Apple wants a closed-loop supply chain.

Define a closed-loop supply chain and discuss methods the company uses to meet its goal.

6. Can management of a retail company like Amazon use lean techniques? Explain.

7. Define setup time and provide some examples of tasks that are included in setup time.

8. Why do lean accounting systems not use separate Raw Materials Inventory accounts?

9. Do lean accounting systems use Finished Goods Inventory accounts? Explain.

10. Define and describe cycle time and identify the components of cycle time.

11. Explain the difference between value-added time and non- value-added time.

12. Define and describe cycle efficiency. 13. Can management of a company like

Samsung use cycle time and cycle effi- ciency as useful measures of performance? Explain.

Discussion Questions

QUICK STUDY

QS D-1 Lean business model C1

Identify each of the following as applying more to lean (L) or to traditional (T) businesses. 1. Production begins with sales forecasts. 4. Uses large batch sizes. 2. Uses “pull” production. 5. Quality is controlled at each process. 3. Aims for zero defects. 6. Uses just-in-time inventory systems.

QS D-2 Lean business model

C1

Identify each of the following as applying more to lean (L) or to traditional (T) businesses. 1. Production begins with a customer order. 5. Uses small batch sizes. 2. Reducing defects is not a priority. 6. Quality control is only at product completion. 3. Inventory levels are lower. 7. Cycle times are shorter. 4. Wait times are high. 8. Move times are high.

QS D-3 Lean accounting for materials P1

Use lean accounting to prepare the journal entry to record the purchase of $28,000 of raw materials on credit.

QS D-4 Lean accounting for conversion costs P1

Use lean accounting to prepare journal entries for the following transactions. 1. Applied $43,600 of conversion costs to production. 2. Incurred actual conversion costs of $43,600. Hint: Credit “Various Accounts.”

QS D-5 Lean accounting for cost of goods sold P1

Use lean accounting to prepare journal entries for the following transactions. 1. Sold $16,800 of goods on credit. 2. Recorded cost of goods sold of $11,760.

QS D-6 Lean accounting for COGS and inventory P1

Use lean accounting to prepare journal entries for the following transactions. 1. Sold $33,250 of goods for cash. 2. Recorded cost of goods sold of $23,250, and finished goods inventory of $1,860.

QS D-7 Conversion cost rate P1

A manufacturer estimates annual conversion costs of $1,207,500 and plans production of 2,100 hours. Compute the conversion cost rate per hour.

APPLE

Samsung

D-12 Appendix D Lean Principles and Accounting

A manufacturer estimates annual conversion costs of $1,000,000 and plans production of 1,600 hours to make 12,800 units. The company can produce 8 units per hour. 1. Compute the conversion cost rate per hour. 2. Prepare the journal entry to apply conversion costs to an order of 520 units.

QS D-8 Conversion cost rate

P1

A company reports ending work in process inventory of $770 and cost of goods sold of $23,404. Compute days’ sales in work in process inventory. Round the answer to the nearest whole day.

QS D-11 Days’ sales in work in process inventory A2

Compute (a) manufacturing cycle time and (b) manufacturing cycle efficiency using the following infor- mation from a manufacturing company.

QS D-9 Cycle time and cycle efficiency

A1 Process time . . . . . . . . . . . . . . . . . . . . . . . . . . 15 .0 minutes Move time . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 .4 minutes Inspection time . . . . . . . . . . . . . . . . . . . . . . . . 2 .0 minutes Wait time . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 .6 minutes

Compute (a) cycle time, (b) value-added time, (c) non-value-added time, and (d) cycle efficiency using the following information for a manufacturer.

QS D-10 Cycle time and cycle efficiency

A1 Process time . . . . . . . . . . . . . . . . . . . . . . . . . . 2 .10 days Move time . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .75 days Inspection time . . . . . . . . . . . . . . . . . . . . . . . . 0 .50 days Wait time . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .15 days

A company reports ending accounts payable of $2,055 and cost of goods sold of $18,300. Compute days’ payable outstanding. Round the answer to the nearest whole day.

QS D-12 Days’ payable outstanding

A3

Use lean accounting to prepare journal entries for the following transactions. 1. Purchased $22,500 of raw materials on credit. 2. Applied conversion costs of $67,500. 3. Incurred actual conversion costs of $67,500. Hint: Credit “Various Accounts.” 4. Sold $120,000 of goods on credit. 5. Recorded cost of goods sold of $90,000.

Exercise D-2 Lean accounting

P1

Robo-Pool manufactures robotic pool vacuums. Each unit requires $225 of raw materials and $375 of conversion costs and is sold for $700. During a recent month, the company produced and sold 120 units. Prepare journal entries to record each of the following. 1. Purchase of raw materials on credit. 3. Sold 120 units on credit. 2. Applied conversion costs to production. 4. Record cost of goods sold.

Exercise D-3 Lean accounting

P1

EXERCISES

Exercise D-1 Lean business model

C1

Identify each of the following production processes as lean (L) or traditional (T). 1. The process produces standard goods, with no option for customization. Production begins with

the quarterly sales forecast, and finished goods are stored until sold. 2. The process uses push production. Large batch sizes are used, and inspection occurs only when

goods are completed. 3. The process uses value streams to meet the demand for customized products. The value streams

depend on quality materials, and employees are empowered to “stop the line” if defects are detected.

4. The production process begins when a customer makes an order. Raw materials are delivered just-in-time for the process to begin. Little inventory and raw materials are held.

Samsung reports accounts payable of ₩9,569,549 (in millions) and cost of goods sold of ₩28,155,597 (in millions) for a recent year. Compute days’ payable outstanding. Round the answer to the nearest whole day.

QS D-13 Days’ payable outstanding

A3

Samsung

Appendix D Lean Principles and Accounting D-13

Exercise D-4 Lean accounting

P1

Robo-Pool manufactures robotic pool vacuums. Each unit requires $225 of raw materials and $375 of conversion costs and is sold for $700. During a recent month the company produced 120 units and sold 100 units. Prepare journal entries to record each of the following. 1. Purchase of raw materials on credit. 3. Sold 100 units on credit. 2. Applied conversion costs to production. 4. Record ending inventory and cost of goods sold.

Exercise D-5 Lean accounting

P1

Dyzor is a lean manufacturer of wireless sound systems. Its wireless speaker value stream budgets $270,000 of conversion costs and 500 production hours for the next quarter. The company can produce three speaker systems per production hour. Each unit requires materials costs of $44. Assume the com- pany produces and sells 400 units in the next month at a price of $320 each. Prepare journal entries to record each of the following. 1. Purchase of raw materials on credit. 3. Sold 400 units on credit. 2. Applied conversion costs to production. 4. Record cost of goods sold.

Exercise D-6 Cycle time and cycle efficiency

A1

Oakwood Company produces maple bookcases. The following information is available for the production of a recent order of 500 bookcases.

Process time . . . . . . . . . . . . . . . 6 .0 days

Inspection time . . . . . . . . . . . . . 0 .8 days

Move time . . . . . . . . . . . . . . . . . 3 .2 days

Wait time . . . . . . . . . . . . . . . . . . 5 .0 days

1. Compute the company’s manufacturing cycle time. 2. Compute the company’s manufacturing cycle efficiency. 3. Management believes it can reduce move time by 1.2 days and wait time by 2.8 days by adopting lean

manufacturing techniques. Compute the company’s cycle efficiency assuming the company’s predic- tions are correct.

Exercise D-7 Cycle time and cycle efficiency

A1

Best Ink produces printers for personal computers. The following information is available for production of a recent order of 500 printers.

Process time . . . . . . . . . . . . . . . 16 .0 hours

Inspection time . . . . . . . . . . . . . 3 .5 hours

Move time . . . . . . . . . . . . . . . . . 9 .0 hours

Wait time . . . . . . . . . . . . . . . . . . 21 .5 hours

1. Compute the company’s manufacturing cycle time. 2. Compute the company’s manufacturing cycle efficiency. 3. Assume the company wishes to increase its manufacturing cycle efficiency to 0.80. If process time is

unchanged, what is the maximum number of hours of non-value-added time the company can have and meet this goal?

Exercise D-8 Cycle time

A1

A manufacturer makes T-shirts in several processes. Information on the components of cycle time follow. Compute (a) value-added time, (b) inspection time, (c) move time, (d) wait time, and (e) cycle time.

Cutting and sewing processing . . . . . . . . . . . . . . 18 min . Wait time before moving . . . . . . . . . . . . . . . . . . . 4 min .

Wait time before moving . . . . . . . . . . . . . . . . . . . 6 min . Moving shirts to packaging . . . . . . . . . . . . . . . . . 2 min .

Moving shirts to ironing . . . . . . . . . . . . . . . . . . . . 8 min . Packaging T-shirts . . . . . . . . . . . . . . . . . . . . . . . . . 10 min .

Ironing T-shirts . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 min . Quality inspection . . . . . . . . . . . . . . . . . . . . . . . . . 12 min .

Exercise D-9 Cycle efficiency

A1

Management of a T-shirt manufacturer believes if the company applies lean principles, then cycle effi- ciency can be improved. The following are estimated completion times for different activities in the man- ufacturing process. Compute cycle efficiency for the (a) traditional approach and (b) lean approach.

Activity Traditional Lean Activity Traditional Lean

Cutting and sewing processing . . . . 18 min . 18 min . Wait time before moving . . . . . . 8 min . 2 min .

Wait time before moving . . . . . . . . . 6 min . 3 min . Moving shirts to packaging . . . . 6 min . 1 min .

Moving shirts to ironing . . . . . . . . . . 8 min . 4 min . Packaging T-shirts . . . . . . . . . . . 10 min . 10 min .

Ironing T-shirts . . . . . . . . . . . . . . . . . 8 min . 8 min . Quality inspection . . . . . . . . . . . 16 min . 4 min .

D-14 Appendix D Lean Principles and Accounting

Use the information below for a soda maker to answer the requirements.Exercise D-10 Days’ sales in work in process inventory

A2 Current Year Prior Year

Work in process at year-end . . . . . . . . . . . . . $ 81,000 $ 94,000

Cost of goods sold for the year . . . . . . . . . . . 1,967,000 1,800,000

1. Compute days’ sales in work in process inventory for the current year. Round to the nearest day. 2. Compute days’ sales in work in process inventory for the prior year. Round to the nearest day. 3. Did days’ sales in work in process inventory increase or decrease from the prior year?

Use the information below for Netflix to answer the requirements.Exercise D-12 Days’ payable outstanding

A3 $ thousands Current Year Prior Year

Accounts payable at year-end . . . . . . . . . . . $ 312,842 $ 253,491

Cost of goods sold for the year . . . . . . . . . . . 6,029,901 4,591,476

1. Compute days’ payable outstanding for the current year. Round to the nearest day. 2. Compute days’ payable outstanding for the prior year. Round to the nearest day. 3. Did days’ payable outstanding increase or decrease from the prior year?

Apple uses lean principles to reduce waste and use fewer resources. The data below are from its recent Environmental Responsibility Report.

Exercise D-14 Lean business model and sustainability

C1 Key Performance Indicator Current Year Prior Year

% of energy from renewable sources . . . . . . 96 93

Recycled waste (millions of pounds) . . . . . . . 28 .2 19 .6

1. Did Apple’s percent (%) of energy used from renewable sources increase or decrease in the current year? 2. How much more waste (in millions of pounds) did Apple recycle in the current year relative to the

prior year?

Use the information below for Tesla to answer the requirements.Exercise D-11 Days’ sales in work in process inventory

A2 $ thousands Current Year

Work in process at year-end . . . . . . . . . . . . . $ 233,476

Cost of goods sold for the year . . . . . . . . . . 4,453,776

1. Compute days’ sales in work in process inventory for the current year. Round to the nearest day. 2. If the company’s work in process inventory were 5% lower, by how many days would days’ sales in

work in process inventory be reduced? Round to the nearest day. 3. If the company’s cost of goods sold were 12% higher, by how many days would days’ sales in work in

process inventory be reduced? Round to the nearest day.

Use the information below to answer the requirements.Exercise D-13 Days’ payable outstanding

A3 $ millions Current Year

Accounts payable at year-end . . . . . . . . . . . $ 1,931

Cost of goods sold for the year . . . . . . . . . . . 28,164

1. Compute days’ payable outstanding for the current year. Round to the nearest day. 2. If the company’s accounts payable were 8% lower, by how many days would days’ payable outstanding

be reduced? Round to the nearest day. 3. If the company’s accounts payable were 8% higher, by how many days would days’ payable outstanding

be increased? Round to the nearest day.

APPLE

Appendix D Lean Principles and Accounting D-15

PROBLEMS

Problem D-1 Lean accounting

P1

Robo-Lawn is a lean manufacturer of robotic lawn mowers. Each mower requires $250 of raw materials. Estimated conversion costs to produce 2,000 units in the next year are $800,000. During a recent quarter, the company produced 600 mowers and sold 580 mowers. Each mower is sold for $1,000.

Required

1. Compute the conversion cost rate per mower. 2. Prepare journal entries to record (a) purchase of raw materials on credit, (b) applied conversion costs

to production, (c) sale of mowers on credit, and (d) cost of goods sold and finished goods inventory.

Problem D-2 Lean accounting

P1

Auto-Motion is a lean manufacturer of self-driving wheelchairs. The company budgets $680,000 of con- version costs and 2,000 production hours for the next year. Each wheelchair requires 25 production hours and materials costs of $4,300. The company started and completed 75 wheelchairs during the year and sold 68. Each wheelchair is sold for $15,000. Actual conversion costs equal applied conversion costs.

Required

1. Prepare journal entries to record (a) the purchase of raw materials on credit to produce 80 units, (b) applied conversion costs to the production of 75 units, (c) actual conversion costs of $637,500 (credit “Various Accounts”), (d) sale of 68 units on credit, and (e) ending inventory and cost of goods sold.

2. Compute the ending balances of Work in Process Inventory, Finished Goods Inventory, and Conversion Costs. Assume each of these inventory accounts began the year with a balance of zero.

Problem D-3 Cycle time and cycle efficiency

A1

Ruiz Foods makes energy bars using a traditional manufacturing process. Raw materials are stored in inventory and then moved into production. Work in process inventory is moved across the company’s three separate departments. The information below (in the Traditional column) is available for a recent order. If the company adopts lean manufacturing, management believes both move time and wait time can be reduced, as shown in the Lean column.

Activity Traditional Lean

Process time . . . . . . . . . . . . . . . . . . . . . . . . . 24 hours 24 hours

Inspection time . . . . . . . . . . . . . . . . . . . . . . . 4 hours 4 hours

Move time . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 hours 3 hours

Wait time . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 hours 1 hour

Required

1. Compute the total amount of non-value-added time under the traditional manufacturing process. 2. Compute cycle efficiency under the traditional manufacturing process. Round to two decimals. 3. Compute the total amount of non-value-added time under the proposed lean manufacturing process. 4. Compute cycle efficiency under the proposed lean manufacturing process. Round to two decimals. 5. Would the proposed lean approach improve cycle efficiency?

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IND-1

Abercrombie & Fitch, 431 Absorption costing, 717, 739

computing unit product cost, 740 controlling costs, 748–749 converting income under variable costing

to, 746 CVP analysis, 749 income from variable costing vs., 720 income reporting implication, 741–746

summary of, 745 units produced are less than units

sold, 744 units produced equal units sold, 741–742 units produced exceed units sold, 743

price setting, 748 production planning, 746–747 variable costing vs., 746–750

Accelerated depreciation, NPV and, 955 Accelerated depreciation method, 308 Accenture, 672 Account, 45 Account balance, 49 Account form of balance sheet, 17, 61 Accounting, 3, 85

business transactions and, 9–14 communicating with users, 15–17 debt investments, C-2–C-6 ethics as key concept in, 6 factory overhead, 623 functions of, 3 fundamentals of, 6–9 importance of, 3–5 labor costs, 622–623 as language of business, 4 lean accounting, D-7–D-8 materials costs, 621–622 merchandise purchases, 145–149

cash discounts, 145–147 ownership transfer, 148–149 without cash discounts, 145

merchandise sales, 150–152 cash discounts, 151 returns and allowances, 151–152 without cash discounts, 150–151

merchandisers adjusting entries for, 153–154 closing entries for, 154–155 financial statements preparation, 154 summary of entries, 155

opportunities in, 4–5 prepayments, 111–112 principles and assumptions of, 7–8 process costing, 620–625 purchase allowances, 148 purchase returns, 147–148 responsibility accounting, 869–871 with reversing entries, 115–116 technology and, 4 for transfers, 624–625

across departments, 624–625 to cost of goods sold, 625 to finished goods, 625

transportation costs, 148–149 without reversing entries, 115

Accounting assumptions, 8; see also Accounting principles

business entity assumption, 8 going-concern assumption, 8 monetary unit assumption, 8 time period assumption, 8

Accounting constraints, 8 cost-benefit constraint, 8 materiality constraint, 8

Accounting cycle, 104–105 adjusting for merchandisers, 153–154

inventory shrinkage, 153 merchandising cost flow in, 153 sales discounts, returns, and

allowances, 154 steps in, 105

Accounting equation, 10 business activities and, 22 debits and credits in, 50 expanded accounting equation, 10 transaction analysis (example), 11–14

Accounting errors, 59 Accounting fraud, 87 Accounting fundamentals, 6–9

assumptions, 8 ethics as key concept, 6 generally accepted accounting

principles, 7 international standards, 7 principles and assumptions, 7–8

Accounting information external users, 4 internal users of, 4 users of, 4

Accounting period, 85–86 timing and reporting, 85–86

Accounting principles, 7–8 change in, 515–516 expense recognition, 8 full disclosure, 8 measurement, 7 revenue recognition principle, 7–8, 87,

91, 96 Accounting quality, 59 Accounting rate of return (ARR), 951 Accounting salaries, 5 Accounting scandals, 6 Accounting year, 59 Account(s), 45

analyzing and processing transactions, 51–56

asset accounts, 45 chart of accounts, 48–49 equity accounts, 47–48 liability accounts, 47 system of, 45–48

Accounts payable, 13, 47, 343, 460 Accounts receivable, 13, 46, 271–273, 459

aging of receivables method, 279–280 estimating bad debts, 278–280 valuation of, 271–273

allowance method, 275–277 direct write-off method, 274 percent of receivables method, 278 percent of sales method, 278 sales on bank credit cards, 273 sales on credit, 271–272 sales on installment, 273

Accounts receivable ledger, 271 Accounts receivable subsidiary ledger, 271 Accounts receivable turnover, 507 Accounts receivable turnover ratio, 285 Accrual basis accounting, 86

cash basis vs., 86–87 Accrued expenses, 93–95, 98

future cash payment of, 94–95 future payment of, 94–95 interest expenses, 94 reversing entries for (example), 115–116 salaries expense, 93–94

Accrued interest expense, 94 Accrued interest revenue, 96 Accrued liabilities, 47, 93

Index Note: page numbers followed by n indicate information found in footnotes. Bold entries indicate defined terms.

IND-2 Index

Accrued Warranty and Indemnification, A-9

Acquired Intangible Assets, A-8 Advertising Costs, A-7 Allowance for Doubtful Accounts, A-7 Basis of Presentation and

Preparation, A-6 Cash Equivalents and Marketable

Securities, A-7 Dividends, A-9 Earnings Per Share, A-7 Fair Value Measurements, A-8 Inventories, A-8 Long-Lived Assets Including

Goodwill, A-8 Other Income and Expense, A-7 Property, Plant, and Equipment, A-8 Revenue Recognition, A-6–A-7 Shipping Costs, A-7 Software Development Costs, A-7 Term Debt, A-9 Warranty Costs, A-7

Appraisal activities, 671 Appropriated retained earnings, 431 Asset(s), 9; see also Intangible assets;

Plant asset(s) custody of, 236 insurance against casualty, 236 intangible assets, 317–319 natural resources, 315–316 plant assets, 303–315 prepaid accounts, 46

Asset accounts, 45 accounts receivable, 45 building accounts, 46 cash, 45 equipment accounts, 46 land, 46 note receivable, 46 prepaid accounts, 46 supplies accounts, 46

Asset book value, 307 Asset theft control, 236 Asset turnover, 506 Association of Certified Fraud Examiners

(ACFE), 241, 249, 537 AT&T, 420 Atlanta Falcons, 8, 47 Auction-based pricing, 922 Audit, 6, 237, 536 Auditors, 4–5, 6

independent reviews, 237 Authorized stock, 419 Automation, 626 Available-for-sale (AFS) securities,

C-5–C-6 recording fair value, C-5 reporting fair value, C-5 selling, C-5

Average cost, 196, 211–212

prepaid insurance, 87–88 supplies as prepaid expense, 88–89 unearned (deferred) revenues, 91–92

Adjusting entry method, 166n Adjustments, work sheet example for,

113–114 Administrative expenses, 543 Aging of accounts receivable, 279–280 Agranoff, Brennan, 571 Allocation base, 579, 621 Allowance for Doubtful Accounts, 276 Allowance method, 275–277

recording bad debts expense, 275 recovering bad debt, 277 writing off bad debt, 276–277

Allowance for Sales Discounts, 154 Alternative collection timing, 782 Altria Group, 433 Amazon, 148, 151, 237, 433, 542, 611, 712,

C-12, D-4 American Express, 273, 453 American Greetings, 419 Amortization, 317

bond discount, 384–385 intangible assets, 317–319 lease amortization, 400 lease asset amortization, 399 premium bond, 387 straight-line bond amortization, 385, 387

Analysis period, 599 Angel investors, 418 Anheuser-Busch InBev, 883 Annual Federal Unemployment Tax Return

(Form 940), 356 Annual financial statements, 85 Annual report, A-1

contents of, A-1 Annuity, 953

future value of, B-6 present value of, B-5

Anytime Fitness, 318 Apple, 3, 11, 17, 47, 61, 310, 418, 425,

432, 457–458, 498–510, 784, 915, 925

financial statement information, A-2–A-9 Assets, A-2 Consolidated Statements of Cash

Flows, A-5 Consolidated Statements of

Comprehensive Income, A-3 Consolidated Statements of

Operations, A-3 Consolidated Statements of

Shareholders’ Equity, A-4 Liabilities and Shareholders’ Equity,

A-2 Notes to Consolidated Financial

Statements, A-5–A-9 Accounts Receivable (Trade

Receivables), A-7

Accrued revenues, 95–97, 98 future cash receipt of, 96–97 interest revenue, 96 services revenue, 96

Accrued salaries expense, 93–94 Accrued services revenue, 96 Accumulated depletion, 315 Accumulated depreciation account, 90 Acid-test (quick) ratio, 159, 507 Activity, 663 Activity-based budgeting (ABB), 787–788 Activity-based costing (ABC), 657,

663–669 advantages of, 668 application of, 664–667 assigning overhead costs to cost

objects, 665 computing overhead allocation rates,

664–554 disadvantages of, 668–669 identifying activities and costs, 664 multiple departmental rates vs., 667 service providers, 671–672 steps in, 663 tracing cost to activity cost pools, 664

Activity-based management (ABM), 669–672

activity levels and examples, 669–670 costs of good/poor quality, 671 costs of quality, 670–671 lean manufacturing, 671

Activity cost driver, 664 Activity cost pool, 663 Activity overhead (cost pool) rate, 664 Actual overhead, 581–582 Additional Medicare tax, 346 Adidas, 11, 306, 386, 395, 397, 542 Adjusted trial balance, 98–99

in financial statement preparation, 98–99 work sheet example for, 113–114

Adjusting accounts, 87 framework for, 87 links to financial statements, 97 three-step process of, 87 unearned (deferred) revenues, 91–92

Adjusting entries, 87 accrued expenses, 93–95 accrued revenues, 95–97 bank reconciliation, 247–249 depreciation, 89–90 end-of-period interest adjustment, 284 expected returns and allowances,

167–168 for merchandisers, 153–154, 165–166

inventory shrinkage, 153 sales discounts, returns, and

allowances, 154 new revenue recognition rules, 167–168 periodic inventory system, 165–166 prepaid (deferred) expenses, 87–90

Index IND-3

Budgetary slack, 772 Budgeted balance sheet, 786 Budgeted financial statements, 785–787

budgeted balance sheet, 786 budgeted income statement, 785

Budgeted income statement, 785 Budgeting, 771

activity-based budgeting (ABB), 787–788

benefits of, 772 human behavior and, 772 merchandise purchases budget, 795–796 potential negative outcomes of, 772 service companies and, 786–787

Budgeting process, 771–774 reporting and timing, 773 steps in, 771

Build-A-Bear Workshop, 143 Buildings, 46, 304 Buildings accounts, 46 Bull market, 510 Business activities

accounting equation and, 22 financing activities, 22 investing activities, 22 operating activities, 17, 22

Business entities corporation, 8 partnership, 8 sole proprietorship, 8

Business entity assumption, 8 Business segment, 515 Business transactions

accounting and, 9–14 capital, 10

Calendar-year companies, 59 Call premium, 389 Callable bonds, 389, 392 Callaway Golf, 869 Canceled checks, 246 Capacity decisions, 919–920

keep or replace equipment, 920 segment elimination, 919–920

Capital minimum legal capital, 419 paid-in capital, 420 stockholders’ equity, 419–420

Capital budgeting, 947–949 capital investment cash flows, 948 comparison of methods, 958–959 methods not using time value of money,

948–951 accounting rate of return (ARR), 951 payback period, 948–950

postaudit, 958–959 summary of process, 947 time value of money methods, 952–957

internal rate of return, 956–957 net present value, 952–955

Board of directors, 4, 418 Boeing, 543 Bond(s), 21, 381

advantages of, 381–382 amortizing a bond discount, 384–385 basics of, 381–382 disadvantages of, 382 features of, 392–393 financing, 382–382 issuing, 382

at discount, 384–385 at par, 382–383 at premium, 386–388

junk bonds, 389 retirement

at maturity, 388–389 before maturity, 389 by conversion, 389

secured or unsecured, 392 trading of, 382

Bond certificate, 382 Bond discount, 383–385 Bond indenture, 382 Bond premium, 383, 386–387 Bond pricing, 395–396

PV of discount bond, 395–396 PV of premium bond, 396

Bond rating services, 385 Bond retirement, 388–389 Bonded employees, 236 Bonus plans, 350 Book value of assets, 90, 307 Book value per common share, 433 Bookkeeping, 3 Borba, Scott, 381 Boston Beer, 346 Boston Celtics, 48, 92, 353 Boston Red Sox, 784 Bot-Networking, 238 Bottom-up approach, 772 Bradley, Barbara, 453 Break-even chart, 706 Break-even (in units), 749 Break-even point, 704

changes in estimates, 706–707 contribution margin income statement, 705 cost-volume-profit chart, 706 formula method, 704–705

Break-even point in composite units, 712 Break-even point in dollars, 705 Break-even point in units, 704 Break-even time (BET), 960 Brigham, Justin, 657, 672 Brigham, Sarah Taylor, 657, 672 Brunswick, 312 BucketFeet, 550 Budget, 537, 709, 771 Budget reports, 821

for evaluation, 832 Budgetary control, 771

Avoidable expense, 919 AwayTravel, 821, 839 Azucar Ice Cream Company, 611

Backflush costing, 671 Bad debts, 274

allowance method, 275–277 direct write-off method, 274 estimation of, 278–280

aging of receivables method, 279–280 percent of receivables method, 278 percent of sales method, 278

recording and writing off, 274–276 recovery of, 274, 277 summary of methods, 280 writing off, 276–277

Balance column accounts, 51 Balance sheet, 15, 17, 99–100

budgeted balance sheet, 786 cash flow classifications and, 455 classified balance sheet, 158 common-size balance sheet, 502–503 comparative balance sheet, 499–500 costs and, 543 inventory error, 201 manufacturers, 543 merchandisers, 543 prepared from trial balance, 60–61 servicers, 543 work sheet example for, 113–114

Balance sheet expenditures, 311 Balance sheet methods, 278 Balanced Scorecard, 551, 881–882 Bank account, 245 Bank credit cards, 273 Bank reconciliation, 247–249

adjusting entries, 247–249 illustration of, 248–249

Bank statement, 246 Banker’s rule, 282, 344 Banking activities

bank account, deposit, and check, 245 bank statement, 246 basic services, 245–246 as controls, 245–249 electronic funds transfer (EFT), 245

Base amount, 503 Base period, 499 Basic earnings per share, 432 Batch-level activities, 669 Batch size (lot size), D-2 Batlle, Suzy, 611, 627 Bear market, 510 Bearer bonds, 392 Benchmarking, 834 Benchmarks, 498 Best Buy, 148, 351, 542 Betterments (improvements), 312 Blockchain, 922 Blue chips, 498

IND-4 Index

Classification categories, 106–107 current assets, 106 current liabilities, 107 equity, 107 intangible assets, 107 long-term investments, 106 long-term liabilities, 107 plant assets, 107

Classification structure, 105–107 Classified balance sheet, 47, 105–107

classification categories, 106–107 example of, 106 for merchandiser, 158

Clawbacks, 6, 87 Cleveland Cavaliers, 48 Closed-loop supply chain, D-9 Closing entries, 100–101

for merchandisers, 166 Closing entry method, 166n Closing process, 100–104

four-step process, 101–103 general ledger (example), 103 post-closing trial balance, 104 recording closing entries, 101–103 temporary and permanent accounts, 101

Coca-Cola, 498, 881 Collateral, 392 Collections in advance, 412 Columbia Sportswear, 10 Commercial substance of exchange, 323 Committee of Sponsoring Organizations

(COSO), 235 Common-size analysis, 502 Common-size balance sheets, 503 Common-size financial statements,

502–503 Common-size graphics, 504–505 Common-size income statements, 608 Common-size percent, 502 Common stock, 8, 48, 50, 418

analysis of, 464 cash dividends, 422–423 issuance

discount on stock, 421 no-par value stock, 421 noncash assets, 421 par value stock, 420 premium on stock, 420 stated value stock, 421

stock dividends, 423–424 stock splits, 425

Communication, 772 Comparative financial statements,

498–500 comparative balance sheets, 499–500 comparative income statements, 499–500 dollar change, 499 percent change, 499

Competitors, 498 Composite unit, 711

Cash flow on total assets, 467 Cash flows from financing, 463–464

common stock transactions, 464 noncurrent liabilities, 463 notes payable transactions, 463 proving cash balances, 464 retained earnings transactions, 464 three-stage process of analysis, 463–464

Cash flows from investing, 461–462 noncurrent assets, 461–462 plant asset transactions, 461–462 three-stage process of analysis, 461–462

Cash flows from operating, 457–460 direct method of reporting, 472–475 indirect method application, 457–460 indirect/direct methods of reporting, 457

Cash management, 239 goals of, 239

Cash Over and Short, 240, 244 Cash paid for interest, 784 Cash paid for interest and income

taxes, 474 Cash paid for inventory, 473 Cash paid for wages and operating

expenses, 474 Cash payment in a future period(s), 94 Cash payment for materials, 782 Cash receipts, 472–473

cash over and short, 240, 244 control of, 239–241 by mail, 240–241 over-the-counter receipts, 239–240

Cash receipts from sales, 781 Cash receipts in a future period(s), 96–97 Cash received from customers, 472 Cash sources and uses, 467 Cash-to-cash cycle, 884 Cellular manufacturing, 671 Certificate in management accounting

(CMA), 5 Certified bookkeeper (CB), 5 Certified Financial Manager (CFM), 538 Certified forensic accountant (CrFA), 5 Certified fraud examiner (CFE), 5 Certified internal auditor (CIA), 5 Certified Management Accountant

(CMA), 538 Certified payroll professional (CPP), 5 Certified public accountants (CPAs), 5 Change in accounting estimate,

310, 432 Change in income (percent), 714 Chart of accounts, 48 Check, 245 Check register, 254 Chevron, 353 Chief executive officer (CEO), 418,

535, 537 Chief financial officer (CFO), 535 Clark, Maxine, 143

Capital expenditures, 311 Capital expenditures budget, 781 Capital investment cash flows, 948 Capital rationing, 956 Capital stock, 419

authorized stock, 419 basics of, 419 classes of stock, 419 market value, 419 no-par value stock, 419 par value stock, 419 selling (issuing) stock, 419 stated value stock, 419 stockholders’ equity, 419–420

Care.com, 235 Carey, Deb, 303 CarMax, 305 Carrying (book) value of bond, 384 Cash, 45, 239, 453 Cash account, analyzing, 456 Cash balances, 464 Cash basis accounting, 86 Cash budget, 241, 781–784

alternative collection timing, 782 cash payments for materials, 782 cash receipts from sales, 781 loan activity, 784 preparation of, 783 uncollectible accounts, 782

Cash controls, 238–244 cash, cash equivalents, and liquidity,

238–239 cash management, 239 cash receipts, 239–241

Cash conversion cycle, 884 Cash disbursements

cash budget, 241 cash over and short, 144 petty cash system, 242

Cash discount, 146 Cash dividends, 422–423

accounting for, 422–423 deficits and, 423 payment of, 55

Cash equivalents, 239, 453 Cash flow; see also Indirect method of

reporting cash flows; Statement of cash flows

analyzing cash sources and uses, 467 balance sheet linkage, 455 capital investment cash flow, 948 cash sources and uses, 467 classification of, 454–455 from financing activities, 454 from investing activities, 454 from operating activities, 454 importance of, 453 measurement of, 453 reporting basics, 453–457 uneven cash flows, 954

Index IND-5

Cost classifications, 539–540 direct vs. indirect, 539 fixed vs. variable, 539 identification of, 541 product vs. period cost, 540 types of, 539–540

Cost concepts, service companies, 541 Cost constraint, 8 Cost controls, variable vs. absorption

costing, 748–749 Cost determination, 304–305

buildings, 304 land, 304 land improvements, 304 lump-sum purchase, 305 machinery and equipment, 304

Cost equation, 701 Cost flow(s)

cost of goods manufactured and, 546–549 inventory assumptions, 193 job order costing, 572–573 service firms, 586 summary of, 582–583

Cost of goods manufactured, 547 cost flow and, 546–549 schedule of, 547–548

Cost of goods sold, 143, 154, 183, 544 accounting for transfer to, 625 manufacturer, 544 merchandiser, 544

Cost of goods sold budget, 779 Cost object, 539, 613, 658 Cost per equivalent unit (FIFO), 632 Cost per equivalent unit (weighted-

average method), 616–617 Cost per unit, 548, 613 Cost-plus methods, 921–924 Cost-plus pricing, 584 Cost pool activity rate, 665 Cost pools, 660 Cost principle, 7, 304 Cost reconciliation, 617–618 Cost of sales, 143 Cost variance, 828 Cost variance analysis, 828–829

computation, 828–829 labor cost variances, 832–833 labor variances, 830, 832–833 materials variances, 830–831

Cost variance formulas, 828–829 Cost-volume-profit (CVP) analysis, 697, 749

application of, 707–713 assumptions in, 713 buying a productive asset, 711 changes in estimates, 706–707 evaluating strategies, 710–711 income from sales and costs, 708–709 increase operating expense, 711 sales mix and break-even, 711–713 sales for target income, 709–710

Copyright Term Extension Act (CTEA), 319 Corporate income taxes, 361–362

deferred income tax liabilities, 361–362 income tax liabilities, 361

Corporate social responsibility (CRS), 551 Corporate taxation, 417 Corporation, 8, 417

advantages of, 417 capital stock basics, 419 characteristics of, 417 disadvantages of, 417 form of organization, 417–420 organization and management, 418 stockholders of, 418–419

Cost(s), 304 balance sheet and, 543 classification of, 539–540 controllable vs. uncontrollable, 870 hybrid system, 627 income statement and, 543–554 incremental costs, 914 managerial costs, 539–540 manufacturing costs, 542 nonmanufacturing costs, 542–543 opportunity cost, 914 out-of-pocket cost, 914 prime and conversion costs, 543 reporting of, 542–545 service companies, 541, 544–545 sunk cost, 914 transferring across departments, 613

Cost accounting system, 571 Cost allocations, 887–889

example computations of, 887–889 advertising, 888 insurance, 888 rent, 887–888 service department expenses, 888–889 utilities, 888

illustration of, 874 joint costs, 890–891

Cost-based transfer pricing, 890 Cost behavior

curvilinear costs, 700 fixed costs, 698 graph of costs to volume, 698 identification of, 697–700 measuring of, 701–703

comparison of methods, 702–703 high-low method, 701–702 regression, 702 scatter diagram, 701

mixed costs, 698–699 step-wise costs, 700 variable costs, 698–699

Cost-benefit constraint, 8 Cost-benefit principle, 238 Cost of capital, 952 Cost center, 869, 871

responsibility accounting for, 870

Composition of current assets, 506 Compound journal entry, 54 Comprehensive income, C-12

computing and reporting, C-12 Computer numerical control (CNC), 953 Computer viruses, 237 Conceptual framework, 7 Conservatism, 8 Conservatism constraint, 239 Consignee, 191 Consignor, 191 Consolidated financial statements, C-12 Consolidation method, C-12 Contingent liabilities, 352–353

accounting for, 352–353 debt guarantees, 353 other contingencies, 353 potential legal claims, 353 reasonably possible, 352 uncertainties vs., 353

Continuing operations, 515 Continuous budgeting, 773 Continuous improvement, 550 Continuous life, 417 Continuous processing, 626 Contra account, 90 Contra asset account, 167 Contra revenue account, 151–152 Contract rate on bonds, 383 Contractual restriction, 431 Contribution format, 749 Contribution margin, 703–705, 717 Contribution margin income statement, 741 Contribution margin income statement

method, 705 Contribution margin per composite unit, 712 Contribution margin per machine hour,

917–918 Contribution margin per unit, 703 Contribution margin per unit of scarce

resource, 917 Contribution margin ratio, 703 Contributors, 4 Control, 536, 772; see also Internal

control(s); Technological controls Control account, 271 Control activities, 235

cash control, 238–244 Control environment, 235 Controllable costs, 748, 870 Controllable variance, 836 Controlling operations, 583, 786 Converse, 62, 389 Conversion cost, 543, 614

lean accounting, D-7 Conversion cost per equivalent unit, 614 Conversion cost rate, D-7 Convertible bonds, 389, 392 Coordination, 772 Copyright, 318

IND-6 Index

partial-year depreciation, 309–310 reporting of, 310 salvage value, 305 tax reporting and, 309 useful life, 305–306

Depreciation expense, direct method, 474 DICK’S Sporting Goods, 86 Diluted earnings per share, 432 Direct costing, 739 Direct costs, 539

indirect costs vs., 539–540 Direct expenses, 872 Direct labor, 542, 828 Direct labor budget, 777 Direct labor costs, 542 Direct materials, 542, 828 Direct materials budget, 776–777 Direct materials costs, 542 Direct method, 457

operating activities section, 475 operating cash flows, 457, 472–475

operating cash payments, 473–474 operating cash receipts, 472

summary of adjustment for, 475 Direct write-off method, 274–275

assessment of, 274–275 recording and writing off, 274 recovering a bad debt, 274

Directors, 4, 418 Discarding plant assets, 312–314 Discontinued segments, 515 Discount amortization, straight-line

method, 385 Discount bond

amortizing of, 384–385 cash payments with, 384 issuing of, 384 present value (PV) of, 395–396 recording issuance of, 384 straight-line bond amortization, 385

Discount on bond payable, 384 Discount factors, 953 Discount period, 146–148 Discount on stock, 421 Discounts lost, 168 Dishonored note, 283 Disposal of assets

plant assets, 313–314 by discarding, 313 by exchanging, 323–324 selling, 313–314

Distribution managers, 4 Dividend in arrears, 427 Dividend yield, 433, 510 Dividends, 48

cash dividends, 422–423 cumulative or noncumulative, 427 financial statement effects, 425 participating or nonparticipating, 427 payment of cash dividend, 55

available-for-sale (AFS) securities recording, C-5 reporting fair value, C-6 selling, C-6

basics of, C-2 held-to-maturity securities, C-4–C-5 interest earned, C-2 maturity, C-2 reporting, C-2 trading, C-3–C-4

recording fair value, C-3 reporting fair value, C-3 selling, C-3–C-4

Debt ratio, 62 Debt securities, C-1; see also Bond(s) Debt-to-equity ratio, 392–393, 508–509 Debtors, 46 Decentralization organizations, 869 Decision making, 913; see also Managerial

decision making capital budgeting, 957–958

Declining-balance method, 308 Defective goods, 152 Deferred expenses, 87–90 Deferred income tax asset, 362 Deferred income tax liability, 361–362 Deferred revenues, 91–92, 343 Defined benefit plans, 400 Degree of operating leverage (DOL), 714 Dell, 542–543, 553 Demand-pull system, 550 Departmental contribution to overhead, 877 Departmental income, 874 Departmental income statements, 872,

874–877 Departmental overhead rate, 657, 660–662

ABC vs., 667 application of, 660–661 cost flows under, 660 overhead rate methods vs., 661–662

Departmental performance reports, behavioral aspects of, 877–878

Departmental transfers, accounting for, 624–625

Depletion, 315–316 Deposit ticket, 245 Deposits in transit, 247 Depreciation, 89–90, 305–310

accelerated, 308, 955 accumulated depreciation, 90 adjusting entries for, 89–90 changes in estimates, 310 cost and, 305 factors in computing, 305–306 as income statement adjustment, 459 methods, 306–309

comparison of, 309 declining-balance, 308 straight-line, 306–307 units-of-production, 307–308

Cost-volume-profit (CVP) chart, 706–707, 720

Costco, 62, 108, 203 Costs of quality, 670 Costs of quality report, 670 Coupon bonds, 392 Coupon rate, 383 Credit, 49 Credit balance, 49 Credit card, 272 Credit card number theft, 237 Credit memorandum, 152, 247 Credit period, 146 Credit sales, 46 Credit terms, 145–146 Creditors, 47 Cumulative preferred stock, 427 Current assets, 106

composition of, 506 Current liabilities, 107, 341–342 Current portion of long-term

debt, 349 Current ratio, 108, 506 Curvilinear costs, 700 Customer, 4 Customer lists, 319 Customer orientation, 550

processes, 626 Customized production, 571 CVP analysis. see Cost-volume-profit

(CVP) analysis Cybercrime, 237 Cycle efficiency (CE), D-6 Cycle time, D-2, D-5

Dallas Cowboys, 47 Damaged goods, 191–192 Date of declaration, 422 Date of payment, 422 Date of record, 422 Days’ payable outstanding, D-10 Days’ sales in inventory,

203, 508 Days’ sales in raw materials

inventory, 552 Days’ sales in receivables, 250 Days’ sales uncollected, 250, 507 Days’ sales in work in process

inventory, D-5 DDB (double-declining-balance)

depreciation method, 308 Debit, 49 Debit balance, 49 Debit card, 273 Debit memorandum,

147, 247 Debt guarantees, 353 Debt investments

accounting summary for, C-12 acquisition, C-2

Index IND-7

Estimated line of cost behavior, 701 Estimated overhead, 579–580 Ethical decision making, 6 Ethics, 6, 537

managerial accounting and, 537–538 Even cash flows, 948 Events, 11 Excel

cost estimation, 716–717 CVP chart, 72 IRR computation, 962 least-squares regression, 716–717 NPV computation, 962

Executive summary, 512 Expanded accounting equation, 10 Expected returns and allowances,

167–168 Expected sales discounts, 167

adjusting entry, 167 Expense accounts, 48, 111

close debit balances, 102 Expense allocations, 873–874

general model, 873 illustration of, 874 indirect expenses, 873 service department expenses, 873

Expense recognition, 275 inventory costs, 192

Expense recognition principle, 8, 87, 275

inventory costs, 192 Expenses, 10

accrued, 93–95 fixed, 353 general and administrative, 156 organization expenses, 418 recognition of, 86–87 selling expenses, 156

External failure costs, 671 External (independent auditors), 4 External transactions, 11 External users, 4 Extraordinary repairs, 312

Face amount, 381 Face value, 344, 381 Facebook, 86, 271 Facility-level activities, 669 Factor, 285 Factoring fee, 285 Factory overhead, 542

accounting for, 623–624 Factory overhead budget, 778–779 Factory overhead costs, 542 Factory Overhead T-account, 585

adjusting underapplied/overapplied overhead, 585

Fair value, 7 Favorable variance, 822 Federal depository bank, 356

Enterprise risk management (ERM), 535 Environmental profit and loss (EP&L)

account, 750–751 EOM (end of month), 145 EPS (earnings per share), 432, 515 Equipment, 46 Equipment accounts, 46 Equity, 9–10, 22, 47, 107

reporting of, 431–432 statement of retained earnings, 431–432

Equity accounts, 46–48 expense accounts, 48 Owner Distributions, 48 Owner Investments, 48 revenue accounts, 48

Equity investments accounting summary for, C-7–C-12 controlling influence, C-11–C-12 insignificant influence, C-7–C-9

recording acquisition, C-8 recording dividends, C-8 recording fair value, C-8 reporting fair value, C-8 selling stock investments, C-9

significant influence, C-9–C-11 recording acquisition, C-10 reporting investments, C-10 selling investments, C-10 share of dividends, C-10 share of earnings, C-10

Equity method, C-9 Equity method investments

acquisition, C-10 share of dividends, C-10 share of earnings, C-10

Equity ratio, 508 Equity securities, C-1 Equity securities with controlling

influence, C-11–C-12 Equity securities with significant

influence, C-9 Equivalent payments concept, 396 Equivalent units of production (EUP),

613–614, 616 example of, 616–617 FIFO method of process costing,

631–634 for materials and conversion costs, 614 weighted average vs. FIFO, 614

Errors inventory and financial statement effects,

201–202 searching for, 59

Estimated liabilities, 349–350 bonus plans, 350 health and pension benefits,

349–350 multi-period, 351 vacation benefits, 350 warranty liabilities, 350–351

preferred stock, 427 stock dividends, 423–424 stock splits, 425

Dividends accounts, close to Retained Earnings, 102

Documentation, source documents, 45 Dodd-Frank Wall Street Reform and

Consumer Protection Act, 6 clawback, 6 whistleblower, 6

Dollar change, 499 Dollar sales at target income, 709 Domino’s Pizza, 342 Double-declining-balance (DDB)

depreciation method, 308 Double-declining-balance (DDB)

depreciation schedule, 308 Double-entry accounting, 49–50

debits and credits, 49–50 double-entry system, 49–50

Double taxation, 9, 417 Dow Jones, 418 Doyon, David, 739 Doyon, Shay, 739 Dynamic pricing, 922

E-commerce, 237, 550 Earnings, 15 Earnings per share (EPS), 432, 515 eBay, 21, 237 EDGAR (Electronic Data Gathering,

Analysis, and Retrieval) database, 10, A-1

Effective interest amortization discount bond, 397–398 premium bond, 397–398

Effective interest method, 397 Efficiency, 497, 506

cycle time and, D-5–D-6 Efficiency variance, 844 Electronic funds transfer (EFT),

245–246, 359 Elements, 7 e.l.f. Cosmetics, 381 Ellis-Brown, Nailah, 697, 714 Ellis Island Tropical Tea, 697, 714 Employee benefits, 349 Employee earnings report, 359 Employee FICA taxes, 346 Employee income tax, 346–347 Employee payroll deductions, 346 Employee voluntary deductions, 347 Employer FICA tax, 347 Employer payroll taxes, 347–348

recording taxes, 348 Employer’s Quarterly Federal Tax Return

(Form 941), 356 End of month (EOM), 145 End-of-period interest adjustment, 284, 344 Enron, 6

IND-8 Index

Fixed overhead cost recognized from inventory, 746

Fixed overhead cost variances, 844–846 Fixed overhead variance, 844–846 Fixed vs. variable cost, 539 Flexible budget, 821

formula for total budgeted costs, 952 preparation of, 832–825 purpose of, 832 reports, 823–826

Flexible budget performance report, 825 analyzing variances, 826

Flexible overhead budgets, 833 FOB destination, 148 FOB (free on board) point, 148 FOB (free on board) shipping point, 191 Ford Motor Company, 350, 353, 460, 627 Form 10-K, A-1 Form 10-KSB, A-1 Form 940, Annual Federal Unemployment

Tax Return, 356 Form 941, Employer’s Quarterly Federal

Tax Return, 356 Form W-2, Wage and Tax Statement, 357 Form W-4, Withholding allowance

certificate, 360 Formula method, 704–705 Franchise(s), 318 Franchise fee, 345 Fraud, 237, 249

managerial accounting and, 537–538 triple-threat of, 237

Fraud triangle, 6, 537 Fraudulent activities, 244 Free on board (FOB), 148 Free on board (FOB) destination, 191 Free cash flows, 467 Freight-in, 149 Freight-out, 149 Friedman, Eric, 45 Full costing, 739 Full disclosure principle, 8 FUTA and SUTA taxes, 358 Future value

annuity, B-1, B-6 single amount, B-3–B-4

Future value table, B-10–B-11

GAAP. see Generally accepted accounting principles (GAAP)

Gain on retirement of debt, 475 Gap, 85, C-13 Gateway Distributors, 275 General accounting principles, 7–9 General and administrative expense, 156 General and administrative expense

budget, 780 General journal, 51 General ledger, 45, 48

after closing process (example), 103

Financial statements, 15–17 “account” underlying financial

statements, 45–48 adjusted trial balance, 98–99 adjusting accounts links, 97–98 adjusting entries, 98 balance sheet, 17 basis of, 45–49 classified balance sheet, 158 communicating with users, 15–17 external information users of, 4 formats of, 156–158 income statement, 15 internal information users, 4 ledger and chart of accounts, 48–49 links among, 16 for merchandisers, 154 multiple-step income statement, 156–157 period and product costs in, 540 periodic inventory system, 163–166 presentation issues, 61 single-step income statement, 157 source documents, 45 statement of cash flows, 17 statement of owner’s equity, 17 steps to prepare, 99–100 work sheet example for, 100,

113–115 Financial statements preparation

across time, 59 from adjusted trial balance, 98–100 from trial balance, 60 presentation issues, 61

Financing activities, 17, 22, 454; see also Cash flows from financing

noncurrent liabilities, 463–464 proving cash balances, 464 three-stage analysis, 463–464

Financing budgets, 781 cash budget, 781–784

Finished goods inventory, 543, 573, 625 lean accounting, D-8

Firehouse Subs, 318 First-in, first-out (FIFO), 193, 195,

210–211; see also FIFO method of process costing

financial statement effects, 197–198 First Industrial Realty, 275 First Tennessee National Corporation, 671 Fiscal year, 59, 85 Fitbit, 45 Fitch, 385 Fixed budget, 821 Fixed budget performance report, 822 Fixed budget reports, 822

for evaluation, 832 Fixed cost, 539, 698, 749 Fixed expenses, 353 Fixed overhead cost deferred

in inventory, 746

Federal income taxes withheld, 360 Federal Insurance Contributions Act

(FICA) taxes, 346 income taxes and, 356

Federal and state unemployment taxes, 347 Federal Unemployment Tax Act

(FUTA), 347 FedEx, 671, 881 Fellow Robots, 947, 959 FIFO method of process costing, 614,

631–636 conversion, 633–634 cost per EUP, 632 costs per equivalent unit, 633 direct materials, 633 equivalent units of production (EUP),

632–634 physical flow of units, 642 process cost summary, 635–636

Fila, 384, 395, 398 Finance lease, 398–399 Finance.Yahoo.com, 10 Financial accounting, 4

managerial accounting vs., 536 Financial Accounting Standards Board

(FASB), 7 conceptual framework, 7–9

Financial leverage, 62, 381, 428 Financial performance evaluation measures

investment turnover, 880 profit margin, 878 residual income, 878 return on investment, 878

Financial reporting, 498 Financial statement analysis, 498

basics of, 497–498 building blocks of, 497 effects of dividends and splits, 425 horizontal analysis, 498–502 information for, 498 purpose of, 497 ratio analysis, 506–511 standards for comparison, 498 tools of analysis, 498 vertical analysis, 502–505

Financial statement analysis report, 512 analysis overview, 512 assumptions, 512 evidential matter, 512 executive summary, 512 inferences, 512 key factors, 512

Financial statement effects of costing methods, 197–198 inventory errors, 201–202 periodic costing system, 212–213

Financial statement information, A-1 Apple, A-2–A-9 Google, A-10–A-13 Samsung, A-14–A-17

Index IND-9

Income Summary account, 101–102 close to Retained Earnings, 102

Income tax liabilities, corporate income taxes, 361–362

Income taxes payable, 460 Income under absorption costing, 719 Incorporation, 418 Incorporators, 418 Incremental cost, 914 Incremental revenue, 913 Indefinite life, 317 Independent reviews, 237 Indirect costs, 539 Indirect expenses, 873

allocation of, 873 Indirect labor, 542, 581 Indirect labor costs, 542 Indirect materials, 542, 581 Indirect method of reporting cash

flows, 457 adjustments

accounts payable, 460 accounts receivable, 459 changes in current assets and

liabilities, 459–460 depreciation, 459 gain on retirement of debt, 459 income statement items not affecting

cash, 459 income taxes payable, 460 interest payable, 460 inventory, 460 loss on sale of plant assets, 459 prepaid expenses, 460 summary of, 460

application of, 457–460 spreadsheet preparation, 470–471

Industry comparisons, 498 Industry practices, 8 Inflation, NPV analysis and, 955 Information & communication, 235 Initial public offering (IPO), 419 Inspection time, D-3 Installment accounts receivable, 273 Installment note, 390–391 Installment sales, 273 Institute of Management Accountants

(IMA), 537 Statement of Ethical Professional

Practice, 538 Intangible assets, 107, 317–319

cost determination and amortization, 317 types of, 317–320

copyrights, 318 franchises and licenses, 318 goodwill, 318 leaseholds, 318 other intangibles, 318 patents, 317 trademarks and trade names, 318

Horizontal analysis, 498–502 comparative financial statements, 498–500

Horizontal axis, 698 Human error, 237 Human fraud, 237 Human resource managers, 4 Hunt, Sean, 913, 925 Hurdle rate, 952, 957 Hybrid costing system, 627 Hybrid inventory system, 144

IASB (International Accounting Standards Board), 7

IBM, 382 Ideal standard, 827 IFRS (International Financial Reporting

Standards), 7 Impairment of asset value, 310, 317 Impersonation/identity theft online,

237–238 Inadequacy, 306 Income

merchandiser reporting, 143–144 net income, 156

Income from operations, 156 Income reporting

absorption costing, 741–747 summary of, 745 units produced are less than units

sold, 744 units produced equal units sold,

741–742 units produced exceed units sold, 743

variable costing converting to absorption costing, 746 summary of, 746 units produced are less than units

sold, 744 units produced equal units sold,

741–742 units produced exceed units sold, 743

Income statement, 15, 99–100 budgeted income statement, 785 common-size income statements,

503–504 comparative income statements, 499–500 cost of goods sold, 545 costs and, 543–545 departmental income statements,

874–877 inventory errors, 201–202 manufacturers, 545 merchandisers, 545 multiple-step, 156–157 prepared from trial balance, 60 servicers, 545 single-step, 157 work sheet example for, 100, 113–114

Income statement expenditures, 311 Income statement method, 278

General ledger accounts, job cost sheet links and, 574

General Mills, 627, 883–884 General Motors, 460, 550 General-purpose financial

statements, 498 Generally accepted accounting principles

(GAAP), 7 international standards, 7

Global economy, 550 Globalink, 275 Going-concern assumption, 8 Golden State Warriors, 48 Goods, 143 Goods on consignment, 191 Goods in process inventory, 543 Goods in transit, 191 Goodwill, 318 Google, 47, 318, 417–418, 457–458, 501,

505–506, 535, C-12 financial statement information

Consolidated Balance Sheets, A-10 Consolidated Statements of Cash

Flows, A-13 Consolidated Statements of

Comprehensive Income, A-11 Consolidated Statements of

Income, A-11 Consolidated Statements of

Stockholders’ Equity, A-12 Government regulation, 417 Graph of costs to volume, 698 Green Bay Packers, 8, 419 Gross margin, 144 Gross margin ratio, 159 Gross method, 146–147, 151, 168 Gross pay, 346, 359 Gross profit, 144, 154, 156 Gross profit method, 215 Gross profit ratio, 159 Group, bulk, or basket purchase, 305 Guidelines (rules of thumb), 498

Hackers, 238 Hard rationing, 956 Harley-Davidson, 273, 342, 883 Harris, Carla, 497 Health and pension benefits, 349–350 Held-to-maturity (HTM)

securities, C-4 recording acquisition and interest, C-5 reporting securities at cost, C-5

Hershey Company, 306, 572 Heterogeneity, 571 High-low method, 702 Home Depot, 272, 343 Homex, 192 Honda, 550 Honored note, 283 HoopSwagg, 571, 587

IND-10 Index

Investment centers, 869, 878–881 financial performance evaluation

measures, 878–879 investment turnover, 878 nonfinancial performance evaluation

measures, 881–883 profit margin, 880 residual income, 878 return on investment, 878 transfer pricing, 883

Investment grade bonds, 385 Investment turnover, 880 Investors, 4 Invoice, 146, 252 Invoice approval, 253 Invoice fraud, 197 ISO 9000 standards, 550

Jack in the Box, 250, 320 Jarden, 106 Jibu, 869, 883 Job, 571 Job cost sheet, 573, 613

general ledger accounts and, 574 managerial decisions and, 583–584

Job lot, 571 Job order costing, 571–574

cost accounting system, 571 cost flows, 573 job cost sheet, 573 job order vs. process operations, 572 job order production, 571 production activities in, 572 service companies, 586

Job order costing system, 573, 613 cost flows, 612 process operations vs., 612–613

Job order manufacturing, 571 Job order production, 571 Johnson & Johnson, 787 Joint costs, 890

physical basis allocation, 891 value basis allocation, 891

Journal, 51 Journal entries, lean accounting, D-8 Journalizing, 51 Journalizing transactions, 51–52

presentation issues, 61 steps in, 51

Junk bonds, 389 Just-in-time (JIT) inventory, 671, 776, D-4 Just-in-time (JIT) manufacturing, 550 Just-in-time production, 626

Keep or replace equipment decision, 920 Key performance indicators (KPIs), 881–882 Kickbacks, 197 Known liabilities, 341–345

accounts payable, 343 examples of, 342–345 multi-period known liabilities, 348–349

determining item costs, 191 fraud in, 192 goods in transit, 191 internal controls, 192 manufacturers, 543–544 periodic inventory system, 163–166 perpetual inventory system, 144 physical counts of, 192 reporting for a merchandiser, 144 valuation of, 200–202

effects of inventory errors, 201–202 lower of cost or market, 200–201

Inventory costing cost flow assumptions, 193 effects of costing methods, 197–198 financial statement effects of, 197–198,

212–213 illustration of, 194 LIFO conformity rule, 198 periodic system, 209–213

financial statement effects, 212–213 first-in, first-out, 210–211 last-in, first-out, 211 specific identification, 210 weighted average, 211–212

perpetual system, 193–198 financial statement effects, 197–198 first-in, first-out, 195 last-in, first-out, 195–196 specific identification, 194 weighted average, 196–197

tax effects of, 198 Inventory errors, financial statements

effects of, 201–202 Inventory estimation methods, 214–215

gross profit method, 215 retail inventory method, 214

Inventory levels, D-4 Inventory management, analysis of, 203 Inventory relation, 201 Inventory returns estimated, 166, 168 Inventory turnover, 203, 507, 552 Investing activities, 17, 22, 454

cash flows from, 461–462 additional long-term assets, 462 noncurrent assets, 461–462 three-stage analysis, 461–462

Investing budgets, 781 capital expenditures budget, 781

Investment(s) accounting summary for, C-12 available-for-sale (AFS) securities,

C-5–C-6 basics of, C-1–C-2 classification and reporting, C-2 debt vs. equity securities, C-1 equity method investments, C-9–C-11 long-term investments, C-1 purposes and types of, C-1 short-term investments, C-1

Integrated reporting, 838 Intel, 498, 542, 838 Interest, 282, 344

end-of-period adjustment, 344 on notes receivable, 281–282

Interest earned, 282 Interest expense, 94 Interest payable, 460 Interest revenue, 96 Interim financial statements, 85, 214 Internal control(s), 6, 192; see also Cash

controls; Principles of internal control

asset insurance and bonded employees, 236 custody of assets, 236 documentation and verification, 252–254 established responsibilities, 236 independent reviews, 237 invoice, 252–253 invoice approval, 253 limitations of, 237–238 principles of, 236–237 purchase order, 252 purchase requisition, 252 receiving report, 253 recordkeeping, 236 regular and independent reviews, 237 related transactions checks, 236 technology and, 236 voucher, 253–254

Internal control system, 235, 537 fraud and, 235–238 principles of, 236–237 purposes of, 235 Sarbanes-Oxley Act (SOX), 235

Internal failure costs, 671 Internal rate of return (IRR), 956–957

comparing projects using, 957 Excel and, 962 two-step process for, 956–957 uneven cash flows, 957 use of, 957

Internal Revenue Service (IRS), 346 Internal transactions, 11 Internal users, 4 International Accounting Standards

Board (IASB), 7 International Financial Reporting

Standards (IFRS), 7 GAAP vs., 7

International Integrated Reporting Council (IIRC), 838

International standards, 7 Intracompany comparisons, 498 Inventory, 106, 144, 460

basics of, 191–192 cash paid for, 473 consignment, 191 costs determination, 192 damaged or obsolete goods, 191–192

Index IND-11

Maker of the note, 282 Malcolm Baldrige National Quality Award

(MBNQA), 550 Management accounting, 535 Management by exception, 827 Management of a corporation, 418 Management’s Discussion and Analysis

(MD&A), 498 Managerial accounting, 4, 535–538

basics of, 535–538 career paths, 538 financial accounting vs., 536 flexibility of reporting, 536 focus of information, 537 fraud and ethics in, 537–538 implications of fraud for, 537–538 lean practices, 550 nature of, 536–537 nature of information, 537 purpose of, 535–536 purpose of information, 536 time dimension, 537 timeliness of information, 536–537 trends in, 550–551

corporate social responsibility (CSR), 551

customer orientation, 550 e-commerce, 550 global economy, 550 just-in-time manufacturing, 550 service economy, 550 total quality management, 550 triple bottom line, 551 value chain, 551

users and decision makers, 536 Managerial costs

concepts of, 539–541 identification of cost

classifications, 541 service companies, 541 types of cost classifications, 539–540

Managerial decision making, 536, 913, 957–958

behavioral aspects of performance reports, 877–878

capacity decisions, 919–920 information and, 913–914 job cost sheets and, 583–584 keep or replace equipment, 920 make or buy, 915 pricing decisions, 921–924 process cost summary, 619 production decisions, 914–918 relevant costs and benefits, 914 sales mix with constrained resources,

917–918 scrap or rework, 917 segment elimination, 919 sell or process further, 916 standard costing, 838

Liability accounts, 46–47 accounts payable, 47 accrued liabilities, 47 note payable, 47 unearned revenue accounts, 47

Licenses, 318 Life expectancy of plant assets, 305–306 LIFO conformity rule, 198 Lightning Wear, 627 Limited liability company (LLC), 8 Limited liability of stockholders, 417 Limited life, 317 Line graph, 501 LinkedIn, 869 Liquid assets, 238 Liquidating cash dividend, 423 Liquidating dividend, 423 Liquidity, 159, 238 Liquidity and efficiency, 497, 506–509

accounts receivable turnover, 507 acid-test ratio, 507 current ratio, 506 days’ sales in inventory, 508 days’ sales uncollected, 507 inventory turnover, 507 total asset turnover, 508 turnover rate of assets, 506 type of business, 506 working capital, 506

Liquidity of receivables, 285 List price, 145 L.L. Bean, 572 Logistics, D-5 Long-term investments, 106 Long-term liabilities, 107, 342

bond financing, 381–382 bond retirement, 388–389 discount bonds, 384–385 installment notes, 390–391 leases and pensions, 398–400 long-term notes payable, 390–391 mortgage notes and bonds, 391 par bonds, 382–383 premium bonds, 386–388

Long-term notes payable, 390–391 installment notes, 390–391 issuing of, 390 mortgage notes and bonds, 391 payment of principal and interest, 390

Long-term use, 17 Loss on sale of assets, 474 Lower of cost or market (LCM), 200–201

computation of, 200 recording of, 200–201 valuing inventory at, 200–201

Lump-sum purchase, plant assets, 305

Machinery and equipment, cost of, 304 Major League Baseball, 318, 350 Make or buy decision, 915

payroll liabilities, 346–349 sales taxes payable, 343 short-term notes payable, 343–344 unearned revenues, 343

KPMG, 572 Kraft Heinz, 869

Labor cost flows, 577–578 accounting for, 622–623 documents and, 577–578

Labor cost variances, 832–833 evaluation of, 832–833

Labor unions, 4 Lack of mutual agency, 417 Land, 46, 304–305 Land improvements, 304 Lantern Inn B&B, 739, 751 Large stock dividend, 423 Last-in, first-out (LIFO), 193, 195–196, 211

financial statement effects, 197–198 Last-in, last-out, 193, 211 Lean accounting, 671, D-7–D-8

conversion costs, D-7 finished goods inventory, D-8 journal entries, D-8 key accounts, D-7

Lean business model, 550, D-2–D-5 Lean manufacturing, 671 Lean practices, value chain and, 551 Lean principles, D-2–D-4

cycle time, D-2–D-3 pull production, D-2–D-3 service providers, D-4 value streams, D-2

Lean production, example of, D-4 Lease, 318, 398

finance lease, 398–399 operating leases, 399–400 short-term lease, 400

Lease liabilities, 398 Leasehold, 318 Leasehold improvements, 318 Leases, 318 Least-squares regression, 702

Excel and, 716–717 Ledger, 45, 48

presentation issues in, 61 Lenders (creditors), 4 Lessee, 318, 398 Lessor, 318, 398 Liabilities, 9, 22; see also Contingent

liabilities; Estimated liabilities characteristics of, 341–342 classifying, 341 contingent liabilities, 352–353 current liabilities, 341–342 defined, 341 known liabilities, 341–345 long-term liabilities, 342 uncertainty in, 342

IND-12 Index

Microsoft, 548 Mineral deposits, 315 Minimum legal capital, 419 Miscellaneous expenses, 240 Misfit Juicery, 771, 787 Mixed costs, 698–699 Modified Accelerated Cost Recovery

System (MACRS), 309 Monetary unit assumption, 8 Monitoring, 235 Monster Worldwide, 419 Moody’s, 385 Morgan Stanley, 497 MoringaConnect, 535, 552 Mortgage, 391 Mortgage bonds, 391 Mortgage contract, 391 Mortgage notes, 391 Motivation, 772 Move time, D-3 Multi-period estimated liabilities, 351 Multi-period known liabilities, 348–349 Multiple cost classifications, 541 Multiple-step income statement, 156–157 Murphy, Bobby, 85

National Renewable Energy Laboratory, 959

Natural business year, 86 Natural resources, 315

cost determination and depletion, 315–316

plant assets tied into extracting, 316 Negotiated transfer price, 890 Net assets, 9 Net cash flow, 948 Net income, 15, 156 Net income (or loss), 460 Net income per share, 432 Net loss, 15 Net method, 151, 168

recording transactions under, 168–170 Net pay, 346 Net present value (NPV), 952–956

accelerated depreciation, 955 annuity, 953 calculator or Excel, 953 capital rationing, 956 comparing positive NPV projects, 955 complications of, 954–956 Excel and, 962 inflation, 955 salvage value, 955 uneven cash flows, 954

Net realizable value, 192 Net sales, 47n Net working capital, 506 New England Patriots, 47 New Frontier Energy, 275 New Glarus Brewing, 303

Materials markup, 925 Materials purchases, 575 Materials requisition, 575, 620 Materials use (requisitions), 575–576 Maturity date, 381 Maturity date of a note, 282 McDonald’s, 345 Measurement principle, 7 Medicare benefits, 346 Medicare taxes, 346 Members, 8 Merchandise, 106, 143 Merchandise inventory, 144, 154

income reporting for, 143–144 inventory reporting for, 144

Merchandise inventory turnover, 203 Merchandise purchases

accounting for, 145–149 discount period, 147 itemized costs of, 149 ownership transfer, 148–149 periodic system, 163–166 purchase with cash discounts, 145–147 purchases on credit, 147 purchases without cash discounts, 145 returns and allowances, 147–148 transportation costs, 148–149

Merchandise purchases budget, 795–796 Merchandise sales, 150–152

accounting for, 150–152 buyer granted allowances, 152 with cash discounts, 151 contra revenue account, 151 periodic system, 163–165 returns and allowances, 151–152 without cash discounts, 150

Merchandiser, 143 accounting cycle and, 153 adjusting entries for, 153–154 balance sheet, 543 classified balance sheet, 158 closing entries for, 154–155 cost flow for single time period, 144 cost of goods sold, 544 financial statement, 154 financial statement formats, 156–158 income statement, 545 inventory systems, 144 merchandise purchases budget, 796 multiple-step income statement, 156–157 net method for, 168–170 operating cycle for, 144 periodic inventory system, 173–166 perpetual inventory system, 169 reporting income for, 143–144 single-step income statement, 157

Merit rating, 348 Meyer, Danny, 191 MGM Resorts, 342 Mickey Mouse Protection Act, 319

Manufacturers accounting reports and, 549 balance sheet, 543 cost flows summary, 582–583 cost of goods sold, 544 income statement, 545 inventory, 543–544

Manufacturing activities flow of, 546–547

materials activity, 546 production activity, 546 sales activity, 546

Manufacturing budgets, 776 Manufacturing costs, 542

accounting reports and, 549 direct labor, 542 direct materials, 542 factory overhead, 542 indirect labor, 542 indirect materials, 542 schedule of cost of goods

manufactured, 584 Manufacturing margin, 742 Manufacturing overhead, 542 Marcelo, Sheila, 235 Margin of safety, 707–708 Marginal costing, 739 Market-based transfer price, 890 Market prospects, 497, 510

dividend yield, 510 price-earnings ratio, 510

Market rate, 383 Market value per share, 419 Marketing managers, 4 Markup, 921 Markup per unit, 921 Markup percentage to variable cost, 922 Master budget, 773–774, 821

components of, 773 financing budgets, 781 investing budgets, 781 merchandiser vs. manufacturer, 796 operating budgets, 774–780 use of, 786

Mastercard, 108, 273, 286, 432 Matching principle, 8, 87 Materiality, 8 Materiality constraint, 275 Materiality principle, 542 Materials activity, 546–547 Materials consumption report, 626 Materials cost flows, 574–576

accounting for, 621–622 documents and, 574–576 materials purchases, 575 materials use (requisitions), 575–576

Materials cost variances, 830–831 evaluation of, 831

Materials and labor variances, 830–833 Materials ledger card, 574

Index IND-13

predetermined overhead rate, 579 record actual overhead, 581–582

Overhead process, 578 Overhead standards and variances, 833–837

computation of, 835–836 flexible overhead budgets, 833 standard overhead rate, 833–834

Overhead variance report, 837 Owner, Capital, 10 Owner distributions, 48 Owner financing, 22 Owner investments, 10, 48 Owner, Withdrawals, 10 Ownership transfer, 148–149

Paid-in capital, 420 Paid-in capital in excess of par value, 420 Pandora Media Group, 341, D-10 Papa John’s, 345 Par bonds, 382–383 Par value, 419 Par value of a bond, 381 Par value stock, 419 Park, James, 45 Partial-year depreciation, 309–310 Participating preferred stock, 427 Participatory budgeting, 772 Partners, 8 Partnership, 3, 8 Patent, 317 Payable, 9 Payback period (PBP), 948–950

evaluation of, 950 even cash flow, 948–949 uneven cash flows, 949–950

Payee of check, 245 Payee of the note, 282 Payroll bank account, 360 Payroll check, 359 Payroll deductions, 346 Payroll fraud, 348 Payroll journal, 358 Payroll liabilities, 346–349

employee FICA taxes, 346 employee income tax, 346–347 employee payroll deductions, 346–347 employer taxes, 347–348 recording deductions, 347 voluntary deductions, 347

Payroll procedures, 360–361 computing federal income taxes, 360 internal control of, 348 payroll bank account, 360 who pays taxes and benefits, 361

Payroll records, 358–359 Payroll register, 358 Payroll reports, 356–358 Penn, 572, 611–612, 881 Pension plans, 349–350, 400 PepsiCo, 498, 542, 626

production budget, 775–776 sales budget, 775

Operating cash flows direct and indirect methods, 457 direct method of reporting, 472–475 major classes of, 472 operating cash payments, 473–474 operating cash receipts, 472

Operating cash payments, 473–474 Operating cash receipts, 472 Operating cycle, 106

for merchandiser, 144 Operating lease, 399–400 Operating leverage, 714 Operation costing systems, 627 Opportunity, 6 Opportunity cost, 914 Opportunity for fraud, 237 Ordinary repairs, 312 O’Reilly Auto, 310 Organization expenses (costs), 418 Organization form. see Corporation Other intangibles, 319 Other postretirement benefits, 400 Out-of-pocket cost, 914 Outsourcing, 915 Outstanding checks, 247 Outstanding stock, 419 Over-the-counter cash receipts, 239–240 Overapplied overhead, 585 Overfunded pension plan, 400 Overhead, 828 Overhead activity base, 579 Overhead allocated to each product

unit, 659 Overhead allocation; see also Activity-

based costing (ABC) alternative methods of, 657–662 assignment of, 657–662 departmental overhead rate method,

660–661 methods compared, 658–659 plantwide vs. departmental methods, 662 plantwide overhead rate method,

658–659 Overhead controllable variances, 835 Overhead cost flows, applying to work in

process, 623–624 Overhead cost variances (OCV), 835–837

analysis of, 836–837 efficiency variance, 844 overhead controllable variances, 853 overhead volume, 835 spending variance, 844

Overhead costs, 578–582, 657; see also Overhead allocation

adjusting overhead, 585 assignment of, 657 estimated overhead, 579–580 overhead process, 578

Next period adjustment, 167 Nike, 11, 18, 159, 317, 393, 467, 512, 571,

713, D-4, D-9–D-10 Nissan, 550 No-par value stock, 419, 421 Nominal rate, 383 Non-value-added activities, 670 Non-value-added time, D-4 Noncash accounts, analyzing, 456 Noncash investing and financing, 455 Noncompete covenants, 319 Noncumulative preferred stock, 427 Noncurrent assets

notes payable transactions, 463–464 plant asset transactions, 461–462

Noncurrent investments, 106 Noncurrent liabilities, cash flow from

financing, 463–464 Nonexecutive employees, 4 Nonfinancial performance evaluation

measures, 881–883 balanced scorecard, 881–882 transfer pricing, 890

Nonmanagerial employees, 4 Nonmanufacturing costs, 542–543, 827 Nonmonetary information, 537 Nonoperating activities, 156 Nonowner (or creditor) financing, 22 Nonparticipating preferred stock, 427 Nonsufficient funds (NSF) check, 247–249 Notes payable, 47 Notes payable transactions, 463–464 Notes receivable, 46, 281–285

computing maturity and interest, 282 end-of-period interest adjustment, 284 honored/dishonored note, 283 interest computation, 282–283 maturity date and period, 282 pledging of, 285 recording, 283 valuing and settling, 283–284

Objectives of accounting, 7 Objectivity, 7 Obsolescence, 306 Obsolete goods, 191–192 Office equipment, 46 Office supplies, 46 Oil reserves, 315 Open market purchase, 389 Operating activities, 17, 22, 454

direct method, 475 indirect method, summary of

adjustment, 460 Operating budgets, 774–780

direct labor budget, 777–778 direct materials budget, 776–777 factory overhead budget, 778–779 general and administrative expense

budget, 780

IND-14 Index

Prepaid insurance, 87–88 Prepayments, 343 Present value

annuity, B-1, B-5 discount bond, 486–487 premium bond, 396 single amount, B-1–B-3

Present value factor, 956 Present value tables, 396, B-10–B-11 Pressure, 6 Pressure for fraud, 237 Prevention activities, 671 Price-earnings (PE) ratio, 432, 510 Price (or rate) variance, 830–831 Price-setter, 921 Price setting, absorption vs. variable

costing, 748 Price-taker, 921 Priceline, 922 Pricing decisions, 921–924

cost-plus methods, 921 normal pricing, 921 other methods, 922 special offers, 923–924 target costing, 922 variable cost method, 922

Prime costs, 543 Prince, 883 Principal, 344 Principal of a note, 282 Principles of internal control,

236–237 adequate records, 236 bond key employees, 236 divide responsibilities for related

transactions, 236 establish responsibilities, 236 insure assets, 236 regular and independent reviews, 237 separation of recordkeeping and asset

custody, 236 technological controls, 236

Prior period adjustments, 431 Private accounting, 5 Pro forma financial statements, 115 Process cost summary, 619–620,

635–636 managers’ use of, 619

Process costing, 571 Process costing systems, 613

accounting and reporting for, 620–625 applying overhead to work in process,

623–624 factory overhead, 623 labor costs, 622–623 materials costs, 621–622 transfer to cost of goods sold, 625 transfer to finished goods, 625 transfers across departments,

624–625

cash flows from investing, 461–462 cost determination, 304–305

buildings, 304 land, 304–305 land improvements, 304 lump-sum purchase, 305 machinery and equipment, 304

discarding of, 313 disposal of, 312–314 exchanging of, 323–324 extraordinary repairs, 312 features of, 303 issues in accounting for, 303 loss on sale of, 459 ordinary repairs, 312 selling of, 313–314 tied into extracting, 316

Planters Company, 628 Plantwide overhead rate, 657–660

application of, 658 cost flows under, 658 departmental rate methods vs., 661–662 example of, 658–659

Pledging receivables, 285 Post-closing trial balance, 104 Postaudit, 958–959 Posting, 51 Posting reference (PR) column, 51 Posting transactions, 51

journal entries, 51–52 Potential legal claims, 353 Practical standard, 827 Predetermined overhead rate, 579,

623, 833 Preemptive right, 418 Preferred stock, 426–428

cumulative or noncumulative, 427 dividend preference of, 427

participating or nonparticipating, 427 issuance of, 427–428 reasons for issuing, 427–428

Premium amortization, straight-line method, 387

Premium bond, 386–388 amortizing premium, 387 cash payments with, 386 issuing of, 386–388 present value (PV) of, 396 recording issuance, 387

Premium on bonds, 386 Premium on stock, 420 Prepaid accounts, 46 Prepaid expenses, 46, 87, 460

alternative accounting for, 111–112 depreciation, 89–90 expense accounts, 111 other prepaid expenses, 89 prepaid insurance, 87–88 revenue accounts, 112 supplies, 88–89

Percent of accounts receivable method, 278 Percent change, 499 Percent of receivables method, 278 Percent of sales method, 278 Performance evaluation, 869 Performance report, 822 Performance reporting, variable costing

and, 717–720 Period(s), 85

accounting period, 85–86 accrual vs. cash basis, 86

Period costs, 540, 542 Period in time, 59 Periodic inventory system, 144,

163–166 adjusting and closing entries,

165–166 credit purchases with cash

discounts, 163 financial statement effects of, 212–213 financial statement preparation, 166 first-in, first-out, 210–211 inventory costing under, 198–213 last-in, first-out, 211 merchandise purchases, 163–164 merchandise sales, 164–165 net method, 169–170 recording transactions, 163–165 specific identification, 210 weighted average, 211–212

Permanent accounts, 101 Perpetual inventory system, 144, 153,

169, 193–198 financial statement effects, 197–198 first-in, first-out, 195 inventory cost flow assumptions, 193 last-in, first-out, 195–196 specific identification, 194 weighted average, 196–197

Petty cash, 242 cash over and short, 244 illustration of, 243 increasing/decreasing of, 243 operating a petty cash fund, 242

Petty cash cashier/custodian, 242 Petty cash payments, 242 Petty cash ticket, 242 Petty cashbox, 242 Pharma-Bio Serv, 275 Pharming, 238 Phishing, 238 Physical basis allocation of joint costs, 891 Physical count of inventory, 192 Physical flow reconciliation, 616, 632 Pizza Hut, 345 Plan, 772 Planning, 22, 535–536, 584 Plant asset(s), 89, 107, 303–314

additional expenditures, 311–312 betterments (improvements), 312

Index IND-15

Rand Medical Billing, 275 Ratio analysis, 498, 506–511

liquidity and efficiency, 506–509 market prospects, 510 profitability, 509–510 solvency, 508–509 summary of, 511

Rationalization, 6 Rationalization for fraud, 237 Raw materials inventory, 543 Raw materials inventory turnover, 552 Realizable value, 276 Reasonably possible contingent

liabilities, 352 Receivables, 9, 271; see also Notes

receivable disposal of, 285 pledging, 285 selling, 285

Receiving report, 253, 574 Recognition and measurement, 7

notes receivable, 281–285 revenue recognition, 7–8, 87–88, 92, 96

Recording, lower of cost or market, 200–201

Recordkeeping, 3, 236 Reebok, 306 Registered bonds, 392 Registrar, 419 Regression, 702 Regulators, 4 REI, 148 Reissuing treasury stock, 430–430 Related transactions, internal controls

for, 236 Relative market (appraised) values, 305 Relevant range, 539, 697, 699 Relevant range of operations, 698 Remittance advice, 245 Rent revenue, 47n Report cards, 821 Report form, 17, 61 Reporting

depreciation, 310 merchandising activities, 143–144 timing and, 85–86

Reporting periods, 85 Research and development costs, 319 Research and development managers, 4 Residual equity, 9 Residual income, 878

measurement issues, 879 Residual interest, 47 Residual value, 305 Responsibility accounting, 869–871

controllable vs. uncontrollable costs, 870 for cost centers, 870 performance evaluation, 869

Responsibility accounting performance report, 870–871

Production decisions, 914–918 make or buy, 915 sales mix, 917–918 scrap or rework, 917–918 sell or process further, 916

Production department, 611 Production managers, 4 Production margin, 742 Production performance, D-5–D-6

cycle time and efficiency, D-5–D-6 days’ sales in work in process

inventory, D-6 push vs. pull production, D-3

Production planning, variable vs. absorption costing, 746–747

Production report, 619 Profit, 15 Profit centers, 869

departmental contribution to overhead, 877

departmental income statements, 874–877

direct and indirect expenses, 872–873

expense allocations, 873 Profit margin, 108, 509, 880 Profitability, 497, 509–510

profit margin, 509 return on common stockholders’

equity, 510 return on total assets, 509

Profitability index, 955 Promissory note, 46, 281 Promoters, 418 Property, plant, and equipment (PP&E), 303 Proprietorship, 8 Proxy, 418 Public accounting, 5 Public companies, 235 Public Company Accounting Oversight

Board (PCAOB), 235 Public sale, 417 Publicly held corporation, 417 Pull production, D-2 Puma, 389, 750–751 Pump ’n dump, 432 Purchase allowances, 147 Purchase order, 252 Purchase requisition, 241, 252 Purchases, 163 Purchases discount, 146 Purchases returns, 147–148 Purchasing managers, 4 Push production, D-2

Qualitative characteristics, 7 Quality of receivables, 285 Quantity (or usage or efficiency)

variance, 830 Quick ratio, 159, 507

FIFO method, 631–636 illustration of, 614–619

cost per equivalent unit, 617 costs assignments and reconciliation,

617–618 equivalent units of production (EUP)

computation, 616–617 overview of, 614–616 physical flow of units, 616 summary, 619–620 use of information, 620–621

overview of process operation, 614–616 Process design, 626 Process manufacturing, 572 Process operations, 572, 611

automation, 626 companies using, 611 continuous processing, 626 customer orientation, 626 equivalent units of production (EUP),

613–614 job order costing systems vs., 612–613 just-in-time production, 626 organization of, 611 process design, 626 service-based businesses, 626 transferring costs across departments,

613–614 trends in, 626

Process production, 572 Process system, cost flows, 612 Process time, D-3 Processing errors, 237 Processing transactions

example of, 52–56 partial payment of accounts payable, 55 pay cash for future insurance

coverage, 55 payment of expense in cash, 54, 56 provide consulting and rental services on

credit, 54 provide services for cash, 53 purchase equipment for cash, 53 purchase supplies for cash, 53, 56 purchase supplies on credit, 53 receipt of cash on account, 54 receipt of cash for future services, 55 receive investment by owner, 53 summarizing transactions in ledger, 57

Product cost, 540, 657 period cost v., 540

Product cost per unit, 779 Product-level activities, 669 Product pricing, 921–924

cost-plus methods, 921 special offers, 923 target costing, 922

Production activity, 546–547 job order costing, 572

Production budget, 775–776

IND-16 Index

Service companies, 143 balance sheet, 543 budgeting for, 786–787 cost concepts, 541 cost concepts for, 541 income statement, 544–545 job order costing, 586 pricing services, 587 process operations and, 626 variable costing for, 749–750

Service department expenses, 873 allocation of, 873

Service economy, 550 Service life, 305 Service managers, 4 Service providers

ABC for, 671–672 lean processes for, D-4–D-5

Services Overhead, 586 Services in Process Inventory, 586 Services revenue, 96 Setup time, D-4 Shake Shack, 191 Shareholders, 4, 8, 417 Shareholders’ equity, 47 Shares, 8 Short selling, 512 Short-term lease, 400 Short-term liabilities, 341 Short-term note payable, 343–344

end-of-period interest adjustment, 344

note extends over two periods, 244 to borrow from bank, 384 to extend credit period, 343

Shrinkage, 153 SI (specific identification), 194, 210 Signature card, 245 Single-step income statement, 157 Sinking fund bonds, 392 Small stock dividend, 423 Snapchat, 85 Social Security Administration

(SSA), 346 Social Security benefits, 346 Social Security taxes, 346 Soft rationing, 956 Software, 319 Solar3D, 275 Sole proprietorship, 8 Solugen, 913, 925 Solvency, 497, 508

debt and equity ratio, 508 debt-to-equity ratio, 508–509 times interest earned, 509

Source documents, 45, 574 Southwest Airlines, 541–542, 671 SpaceX, 312 SPANX, 46 Special offers, 923–924

Sales on credit, 151, 271–272 Sales discount, 146, 151, 167 Sales on installment, 273 Sales manager, 587 Sales mix, 711

constrained resources, 917–918 Sales price variance, 839 Sales Refund Payable, 166, 167 Sales Returns and Allowances,

151–152 Sales taxes payable, 343 Sales variances, 839 Sales volume variances, 839 Salvage value, 305 Salvage value, NPV and, 955 Sam’s Club, 697 Samsung Electronics, 47, 457–458, 501,

505–506 financial statement information

Consolidated Statements of Cash Flows, A-17

Consolidated Statements of Changes in Equity, A-16

Consolidated Statements of Comprehensive Income, A-15

Consolidated Statements of Financial Position, A-14

Consolidated Statements of Profit or Loss, A-15

Sandberg, Sheryl, 271 Sarbanes-Oxley Act (SOX), 6,

235, 538 Scatter diagram, 701 Schedule of accounts receivable, 271 Schedule of cost of goods manufactured,

547–548, 584 estimating cost per unit, 548 preparation of, 547–548 use of, 548

Scrap or rework, 917 Scrap value, 305 Seattle Seahawks, 8 Secured bonds, 392 Securities and Exchange Commission

(SEC), 7, 10 Segment, 504 Segment elimination, 919 Sell or process further, 916 Selling expense, 156, 543 Selling expense budget, 779 Selling (issuing) stock, 419–421 Selling plant assets, 313–314

sale above book value, 314 sale at book value, 314 sale below book value, 314

Selling price per unit, 921 Sensitivity analysis, 710, 786 Separate legal entity, 417 Separation of duties, 236 Serial bonds, 392

Restricted retained earnings, 431 Restrictions and appropriations, 431 Retail inventory method, 214 Retailer, 170 Retained earnings, 420, 422n, 431, 464

appropriated, 431 dividends account closes to, 102 income summary closes to, 102 restricted, 431 statement of retained earnings, 431–432 work sheet example for, 114–115

Retained earnings deficit, 423 Retrospective application, 515 Return, 21 Return on assets (ROA), 18, 21 Return on common stockholders’

equity, 510 Return on investment (ROI), 18, 878

issues in computing, 880 Return and risk analysis, 21 Return on sales, 108 Return on total assets, 509 Revenue(s), 7, 10

accured revenues, 95–97 deferred revenues, 91–92 recognition of, 87–88 revenue accounts, 112

Revenue accounts, 48, 50, 112 close credit balances, 102

Revenue expenditures, 312 Revenue recognition principle, 7–9,

88, 92, 96 Revenue recognition rules, 154 Reverse stock split, 425 Reversing entries, 104, 115–116

accrued expense (example), 115–116 with reversing entries, 115–116 without reversing entries, 115

Revised break-even points in dollars, 711 Revised break-even points in units, 707,

711, 714 Revised forecasted income, 714 Revised margin of safety, 711, 714 Right-of-use asset (lease), 318 Risk, 21 Risk assessment, 235 Ritz Carlton Hotel, 550 Robotics, 626 Rolling budgets, 773 Rubio, Jen, 821

Saba Software, 87 Safety stock, 775 Salaries, 346 Salaries expense, 93–94 Sales, 143 Sales on account (on credit), 46 Sales activity, 546–547 Sales allowance, 151 Sales budget, 775

Index IND-17

T-accounts, 49 change in cash (summary), 466

Taco Bell, D-5 Take-home pay, 346 Taking an inventory, 192 Target, 11, 86, 883 Target cost, 573, 822 Target costing, 922 Target income, 709 Tax reporting, depreciation for, 309 Taxation, corporate taxation, 417 Technological controls, 236

internal control, 237–237 new evidence of processing, 237 processing errors, 237 separation of duties, 237 testing of records, 237

Temporary accounts, 101 Temporary differences, deferred income tax

liabilities, 362 Term bonds, 392 Tesla, 460, 827 Three Twins Ice Cream, 551 TIBCO Software, 391 Timberlands, 315 Time and materials pricing, 925 Time period assumption, 8,

85–86 Time ticket, 577, 620 Time value of money methods, capital

budgeting, 952–957 internal rate of return,

956–957 net present value, 952–955

Times interest earned, 354, 509 Timing and reporting, 85–87

accounting period, 85 accrual vs. cash basis, 86 in bank reconciliation, 247 framework for adjustments, 87 recognizing revenues and expenses,

87–88 Tootsie Roll, 306 Top-down approach, 772 Total asset turnover,

320, 508 Total budgeted costs, 825 Total cost method, 921 Total cost per unit, 921 Total costs, 921 Total quality management, 550 Toyota, 550 Trade (brand) name, 318 Trade discount, 145 Trade-in allowance, 323 Trademark or trade (brand)

name, 318 Trading on the equity, 381 Trading securities, debt investments,

selling, C-3–C-4

Stock, 8; see also Common stock authorized stock, 419 capital stock, 419 classes of, 419 common stock, 420–421 market value of, 419 no-par value stock, 419 par value stock, 419 preferred stock, 426–428 reporting of equity, 431–432 selling (issuing), 419–421 stated value stock, 419 treasury stock, 429–430

Stock certificates and transfer, 419 Stock dividends, 423–424

accounting for, 423–424 large stock dividend, 424 reasons for, 423 recording of, 423–424 small stock dividend, 423–424

Stock quote, 420 Stock splits, 425

financial statement effects, 425 Stockholders, 8, 417–418

certificates and transfer, 419 rights of, 418

Stockholders Equity, 47, 419 Stoppleman, Jeremy, 417 Store credit cards, 273 Store equipment, 46 Store supplies, 46 Straight-line bond amortization,

385, 387 Straight-line depreciation, 89, 306–307 Straight-line depreciation rate, 307 Straight-line depreciation schedule, 307 Strategic plans, 771 Sub Surface Waste Management, 275 Subscription fees revenue, 47n Sunk costs, 914 Supplementary records, 149 Supplier Code of Conduct, 925 Suppliers, 4 Supplies, 46

as prepaid expense, 88–89 Supplies account, 46 Supply chain management, 672, D-5 Surge pricing, 922 Sustainability Accounting Standards

Board (SASB), 551, 627 Sustainability Consortium, 672 Sustainable income, 515–516

changes in accounting principles, 515–516

continuing operations, 515 discontinued segments, 515 earnings per share, 515

Sycamore Brewing, 657, 672 System of accounts, ledger and chart of

accounts, 48–49

Special-order pricing, 749, 751 Specific accounting principles, 7 Specific identification (SI), 194, 210 Spending variance, 844 Spiegel, Evan, 85 Sports Illustrated, 348 Spreadsheet. see Work sheet Stair-step cost, 699 Standard & Poor’s, 385 Standard cost accounting system,

846–847 Standard cost card, 828 Standard costing income statement,

847–848 Standard costs, 827–829

cost variance analysis, 828–829 management considerations, 838 setting of, 827–828 setting standard costs, 827–828

Standard labor cost, 827 Standard materials cost, 827 Standard overhead applied, 835 Standard overhead cost, 827, 833 Standard overhead rate, 833–834

allocation base, 833–834 computation of, 834 predicted activity level, 834

Starbucks, 250, 304, 320, 922 State Unemployment Tax Act

(SUTA), 347 Stated rate, 383 Stated value stock, 419, 421 Statement of cash flows, 15, 17, 453

direct method, 475 financing cash flows, 463–464 format of, 455 indirect and direct reporting

methods, 457 operating cash flows, 457–460 preparation of, 456

analyzing cash/noncash accounts, 456

information for, 456 purpose of, 453 spreadsheet preparation, 470–471

indirect method, 470 summary using T-accounts, 466

Statement of owner’s equity, 15, 17 Statement of retained earnings, 99–100,

431–432 from trial balance, 60 prior period adjustments, 431 restrictions and appropriations, 431 work sheet example for, 100,

114–115 Statement of stockholders’

equity, 432 Static budget, 821 Statutory (legal) restriction, 431 Step-wise cost, 699

IND-18 Index

units produced equal units sold, 741–742 units produced exceed units sold, 743

income under absorption costing, 719 performance reporting and, 717–720 price setting, 748 production planning, 746–747 service firms, 749–750 special-order pricing, 749, 751 unit cost, 717–718 units produced exceed units

sold, 719 Variable costing income statement, 717 Variable overhead variance, 845 Variable production costs, 749 Variance, 786, 822

analysis of, 826, 828 Variance analysis, 826, 828 Vendee, 252 Vendor, 252 Vera Bradley, 453 Verizon, 400 Vertical analysis, 498

common-size balance sheets, 503 common-size income statements,

503–504 common-size statements, 502–505

Vertical axis, 698 Visa, 273, 286, 432 Volume variance, 836 Voters, legislators, and government

officials, 4 Voucher, 241, 253–254 Voucher register, 254 Voucher system, 241–242

invoice, 252–253 invoice approval, 253 purchase order, 252 purchase requisition, 252 receiving report, 253 voucher, 253

W. T. Grant Co., 453 Wage bracket withholding table, 360 Wait time, D-3 Walmart, 108, 203, 241, 672, 881 Walt Disney Co., 319, 572, 880 Warranty, 350–351 Warranty liabilities, 350–351 Weighted average (WA), 193,

196–197, 211 Weighted-average method, 614 Welsch, Galen, 869 Westergren, Tim, 341 Whistleblower, 6 Whole Foods Market, Inc., C-12 Wholesaler, 170 Wi-phishing, 238 Williams, Kwami, 535 Withholding allowances, 346

Uber, 550, 922 Unadjusted statements, 59 Unadjusted trial balance, 58, 98 Unavoidable expenses, 919 Uncertainties not contingencies, 353 Uncertainty in liabilities, 342 Unclassified balance sheet, 45, 105 Uncollectible accounts, 274, 782 Uncontrollable costs, 749, 870 Under Armour, 19, 159, 393, 467, D-10 Underapplied overhead, 585 Underfunded pension plan, 400 Unearned consulting revenue, 92 Unearned (deferred) revenues, 47,

91–92, 343 unearned consulting revenue, 92

Uneven cash flows, 949–950, 954 IRR and, 957

Unfavorable variance, 822 Unit contribution margin, 703 Unit cost computation, 718 Unit costs, 740 Unit-level activities, 669 Unit sales at target income, 709 United By Blue, 551 United States Postal Service (USPS), 587 UnitedHealth Group, 235 Units-of-production depreciation, 307 Unrealized gain (or loss), C-3,

C-8, C-12 equity investments, C-8

Unregistered bonds, 392 Unsecured bonds, 392 Upper Deck, 191 UPS, 149, 671 Useful life, 305

Vacation benefits, 350 Value-added activities, 670 Value-added time, D-4 Value-based pricing, 922 Value basis allocation of joint costs, 891 Value chain, 551

lean practices, 551 Value stream, D-2 Variable budget, 821 Variable cost, 539, 698–699 Variable cost method, 922 Variable costing, 717, 739

absorption costing income vs., 720 absorption costing vs., 748–750 computing unit product costs, 740 controlling costs, 748–749 CVP analysis, 749 income reporting, 718–720 income reporting implication, 741–746

summary of, 745 units produced are less than units

sold, 744

Transaction analysis, 11–14 accounting equation and, 10 analyzing and reporting process,

51–56 investment by owner, 11 payment of accounts payable, 13 payment of expenses in cash, 12 provide services for cash, 12 provide services and facilities for

credit, 13 purchase equipment for cash, 11 purchase supplies for cash, 11 purchase supplies on credit, 12 receipt of cash from accounts

receivable, 13 summary of, 14 withdrawal of cash by owner, 14

Transaction processing illustration of, 52–56 journalizing and posting, 51–56 ledger and chart of accounts, 48–49

Transfer agent, 419 Transfer price, 883 Transfer pricing, 883, 889–890

additional issues in, 890 alternative transfer prices,

889–890 cost control, 890 excess capacity, 890 no excess capacity, 890 no market price, 890 nonfinancial factors, 890

Transferable ownership rights, 417 Transportation costs, 148–149 Transportation-in, 149 Transportation-out, 149 Treasurer, 239 Treasury stock, 429–430

purchasing of, 429 reissuing of, 429–430

selling above cost, 430 selling at cost, 429 selling below cost, 430

Trend analysis, 501–502 Trend percent, 501 Trial balance, 58–61

adjusted trial balance, 98–99 financial statements and, 98–100 preparation of, 58–59 in preparing financial statements, 59–61

balance sheet, 60 income statement, 60 statement of retained earnings, 60

searching for errors, 59 Triple bottom line, 551, D-9 Turnover rate of assets, 506 Twitter, 535 Type of business, 506 Typo-squatting, 238

Index IND-19

Yield, 626 process operations, 626

Yum Brands, D-10

Zero balance, 49 Zero-based budgeting, 773 Zero defects, D-4 Zero waste, D-4

statement of cash flows, 470–471 as tool, 113–114 use of, 113–115

Working capital, 506 Workstation, 611 WorldCom, 6 Wozniak, Steve, 3

Yang, Anna, 771 Yelp, 417

Withholdings, 346 Work center, 611 Work in Process Inventory, 543, 573, 613,

618, 624 lean accounting, D-7

Work sheet, 113, see also Excel applications and analysis, 115 benefits of, 113 five-step process for completion, 113–115 perpetual system, 170–171

CA

Following is a typical chart of accounts, which is used in several assignments. Each company has its own unique set of accounts and numbering system. *An asterisk denotes a contra account.

Assets Current Assets 101 Cash 102 Petty cash 103 Cash equivalents 104 Short-term investments 105 Fair value adjustment–_______ (ST) 106 Accounts receivable 107 Allowance for doubtful accounts* 108 Allowance for sales discounts* 109 Interest receivable 110 Rent receivable 111 Notes receivable 112 Legal fees receivable 119 Merchandise inventory (or Inventory) 120 __________ inventory 121 Inventory returns estimated 124 Office supplies 125 Store supplies 126 _______ supplies 128 Prepaid insurance 129 Prepaid interest 131 Prepaid rent 132 Raw materials inventory 133 Work in process inventory, _______ 134 Work in process inventory, _______ 135 Finished goods inventory 136 Debt investments–Trading (ST) 137 Debt investments–Held-to-maturity (ST) 138 Debt investments–Available-for-sale (ST) 139 Stock investments (ST)

Long-Term Investments 141 Long-term investments 142 Fair value adjustment–_______ (LT) 144 Investment in _______ 145 Bond sinking fund 146 Debt investments–Held-to-maturity (LT) 147 Debt investments–Available-for-sale (LT) 148 Stock investments (LT) 149 Equity method investments

Plant Assets 151 Automobiles 152 Accumulated depreciation–Automobiles* 153 Trucks 154 Accumulated depreciation–Trucks* 155 Boats 156 Accumulated depreciation–Boats* 157 Professional library 158 Accumulated depreciation–Professional

library* 159 Law library 160 Accumulated depreciation–Law library*

161 Furniture 162 Accumulated depreciation–Furniture* 163 Office equipment 164 Accumulated depreciation–Office

equipment* 165 Store equipment 166 Accumulated depreciation–Store

equipment* 167 _______ equipment 168 Accumulated depreciation–_______

equipment* 169 Machinery 170 Accumulated depreciation–Machinery* 173 Building _______ 174 Accumulated depreciation–Building

_______* 175 Building _______ 176 Accumulated depreciation–Building

_______* 179 Land improvements _______ 180 Accumulated depreciation–Land

improvements _______* 181 Land improvements _______ 182 Accumulated depreciation–Land

improvements _______* 183 Land

Natural Resources 185 Mineral deposit 186 Accumulated depletion–Mineral deposit*

Intangible Assets 191 Patents 192 Leasehold 193 Franchise 194 Copyrights 195 Leasehold improvements 196 Licenses 197 Right-of-use asset 198 Accumulated amortization–_______* 199 Goodwill

Liabilities Current Liabilities 201 Accounts payable 202 Insurance payable 203 Interest payable 204 Legal fees payable 207 Office salaries payable 208 Rent payable 209 Salaries payable 210 Wages payable 211 Accrued payroll payable 212 Factory wages payable

214 Estimated warranty liability 215 Income taxes payable 216 Common dividend payable 217 Preferred dividend payable 218 State unemployment taxes payable 219 Employee federal income taxes payable 221 Employee medical insurance payable 222 Employee retirement program payable 223 Employee union dues payable 224 Federal unemployment taxes payable 225 FICA taxes payable 226 Estimated vacation pay liability 227 Sales refund payable 229 Current portion of long-term debt

Unearned Revenues 230 Unearned consulting fees 231 Unearned legal fees 232 Unearned property management fees 233 Unearned _______ fees 234 Unearned _______ fees 235 Unearned janitorial revenue 236 Unearned _______ revenue 238 Unearned rent

Notes Payable 240 Short-term notes payable 241 Discount on short-term notes payable* 244 Current portion of long-term notes payable 245 Notes payable 251 Long-term notes payable 252 Discount on long-term notes payable*

Long-Term Liabilities 253 Lease liability 255 Bonds payable 256 Discount on bonds payable* 257 Premium on bonds payable 258 Deferred income tax liability

Equity Owner’s Equity 301 ______________, Capital 302 ______________, Withdrawals 303 ______________, Capital 304 ______________, Withdrawals 305 ______________, Capital 306 ______________, Withdrawals

Paid-In Capital 307 Common stock, $ _______ par value 308 Common stock, no-par value 309 Common stock, $ _______ stated value 310 Common stock dividend distributable

Chart of Accounts

Chart of Accounts CA-1

311 Paid-in capital in excess of par value, Common stock

312 Paid-in capital in excess of stated value, No-par common stock

313 Paid-in capital from retirement of common stock

314 Paid-in capital, Treasury stock 315 Preferred stock 316 Paid-in capital in excess of par value,

Preferred stock

Retained Earnings 318 Retained earnings 319 Cash dividends (or Dividends) 320 Stock dividends

Other Equity Accounts 321 Treasury stock, Common* 322 Unrealized gain–Equity 323 Unrealized loss–Equity

Revenues 401 ______________ fees earned 402 ______________ fees earned 403 ______________ revenues 404 Revenues 405 Commissions earned 406 Rent revenue (or Rent earned) 407 Dividends revenue (or Dividends earned) 408 Earnings from investment in _______ 409 Interest revenue (or Interest earned) 410 Sinking fund earnings 413 Sales 414 Sales returns and allowances* 415 Sales discounts* 420 Earnings from equity method investments

Cost of Sales Cost of Goods Sold 502 Cost of goods sold 505 Purchases 506 Purchases returns and allowances* 507 Purchases discounts* 508 Transportation-in

Manufacturing 520 Raw materials purchases 521 Freight-in on raw materials 530 Direct labor 540 Factory overhead 541 Indirect materials 542 Indirect labor 543 Factory insurance expired 544 Factory supervision 545 Factory supplies used 546 Factory utilities 547 Miscellaneous production costs 548 Property taxes on factory building 549 Property taxes on factory equipment 550 Rent on factory building 551 Repairs, factory equipment 552 Small tools written off 560 Depreciation of factory equipment

561 Depreciation of factory building 570 Conversion costs

Standard Cost Variances 580 Direct material quantity variance 581 Direct material price variance 582 Direct labor quantity variance 583 Direct labor price variance 584 Factory overhead volume variance 585 Factory overhead controllable variance

Expenses Amortization, Depletion, and Depreciation 601 Amortization expense–_______ 602 Amortization expense–_______ 603 Depletion expense–_______ 604 Depreciation expense–Boats 605 Depreciation expense–Automobiles 606 Depreciation expense–Building _______ 607 Depreciation expense–Building _______ 608 Depreciation expense–Land

improvements _______ 609 Depreciation expense–Land

improvements _______ 610 Depreciation expense–Law library 611 Depreciation expense–Trucks 612 Depreciation expense–_______ equipment 613 Depreciation expense–_______

equipment 614 Depreciation expense–_______ 615 Depreciation expense–_______

Employee-Related Expenses 620 Office salaries expense 621 Sales salaries expense 622 Salaries expense 623 _______ wages expense 624 Employee benefits expense 625 Payroll taxes expense

Financial Expenses 630 Cash over and short 631 Discounts lost 632 Factoring fee expense 633 Interest expense

Insurance Expenses 635 Insurance expense–Delivery equipment 636 Insurance expense–Office equipment 637 Insurance expense–_______

Rental Expenses 640 Rent (or Rental) expense 641 Rent expense–Office space 642 Rent expense–Selling space 643 Press rental expense 644 Truck rental expense 645 _______ rental expense

Supplies Expenses 650 Office supplies expense 651 Store supplies expense

652 _______ supplies expense 653 _______ supplies expense

Miscellaneous Expenses 655 Advertising expense 656 Bad debts expense 657 Blueprinting expense 658 Boat expense 659 Collection expense 661 Concessions expense 662 Credit card expense 663 Delivery expense 664 Dumping expense 667 Equipment expense 668 Food and drinks expense 671 Gas and oil expense 672 General and administrative expense 673 Janitorial expense 674 Legal fees expense 676 Mileage expense 677 Miscellaneous expenses 678 Mower and tools expense 679 Operating expense 680 Organization expense 681 Permits expense 682 Postage expense 683 Property taxes expense 684 Repairs expense–_______ 685 Repairs expense–_______ 687 Selling expense 688 Telephone expense 689 Travel and entertainment expense 690 Utilities expense 691 Warranty expense 692 _______ expense 695 Income tax expense

Gains and Losses 701 Gain on retirement of bonds 702 Gain on sale of machinery 703 Gain on sale of investments 704 Gain on sale of trucks 705 Gain on _______ 706 Foreign exchange gain or loss 801 Loss on disposal of machinery 802 Loss on exchange of equipment 803 Loss on exchange of _______ 804 Loss on sale of notes 805 Loss on retirement of bonds 806 Loss on sale of investments 807 Loss on sale of machinery 808 Loss on _______ 809 Unrealized gain–Income 810 Unrealized loss–Income 811 Impairment gain 812 Impairment loss 815 Gain on sale of debt investments 816 Loss on sale of debt investments 817 Gain on sale of stock investments 818 Loss on sale of stock investments

Clearing Accounts 901 Income summary 902 Manufacturing summary

BR-1

⑧ Standard Cost Variances

Total materials variance

=

Materials price

variance +

Materials quantity variance

Total labor variance

=

Labor rate

variance +

Labor efficiency (quantity) variance

Total overhead variance

=

Overhead controllable

variance +

Overhead volume variance

Overhead controllable = Actual total − Budgeted total variance overhead overhead Overhead volume = Budgeted fixed − Applied fixed variance overhead overhead Variable overhead variance = Variable overhead + Variable overhead

spending variance efficiency variance Fixed overhead variance = Fixed overhead + Fixed overhead

spending variance volume variance

Materials price variance = [AQ × AP] − [AQ × SP]

Materials quantity variance = [AQ × SP] − [SQ × SP]

Labor rate variance = [AH × AR] − [AH × SR]

Labor efficiency (quantity) variance = [AH × SR] − [SH × SR]

Variable overhead spending variance = [AH × AVR] − [AH × SVR] Variable overhead efficiency variance = [AH × SVR] − [SH × SVR] Fixed overhead spending variance = Actual fixed overhead − Budgeted fixed overhead where AQ is Actual Quantity of materials; AP is Actual Price of materials; AH is Actual Hours of labor; AR is Actual Rate of wages; AVR is Actual Variable Rate of overhead; SQ is Standard Quantity of materials; SP is Standard Price of materials; SH is Standard Hours of labor; SR is Standard Rate of wages; SVR is Standard Variable Rate of overhead. ⑨ Sales Variances

Sales price variance = [AS × AP] − [AS × BP]

Sales volume variance = [AS × BP] − [BS × BP]

where AS = Actual Sales units; AP = Actual sales Price; BP = Budgeted sales Price; BS = Budgeted Sales units (fixed budget).

⎫ ⎪ ⎬ ⎪ ⎭

= Total overheadvariance

Contribution Margin Income Statement For period Ended date

Net sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net income (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Schedule of Cost of Goods Manufactured For period Ended date

Direct materials Raw materials inventory, Beginning . . . . . . . . . . . . . . . . . . . . . . $ # Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Raw materials available for use . . . . . . . . . . . . . . . . . . . . . . . . . # Less raw materials inventory, Ending . . . . . . . . . . . . . . . . . . . . . (#) Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Overhead costs (applied) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Add work in process inventory, Beginning . . . . . . . . . . . . . . . . . . . # Total cost of work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Less work in process inventory, Ending . . . . . . . . . . . . . . . . . . . . . (#) Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Flexible Budget For period Ended date

Flexible Budget Flexible Budget

Variable for Unit Amount Fixed Sales of per Unit Cost #

Sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # $ # Variable costs Examples: Direct materials, Direct labor, Other variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # # Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # # Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # # Fixed costs Examples: Depreciation, Property taxes, Manager . . . . . . . $ # # salaries, Administrative salaries . . . . . . . . . . . . . . . . . . . # # Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # # Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Prepare sales

budget

Develop production

or purchases budget

Consolidate operating and capital expenditures budgets into financial budgets: • Cash budget • Budgeted income

statement • Budgeted balance

sheet

Prepare manufacturing,

selling, and general and administrative expense budgets

Prepare capital

expenditures budget

Operating Budgets Capital Expenditures Budget

Financial Budgets

Master Budget Sequence

① Cost Types Variable costs: Total cost changes in proportion to volume of activity. Fixed costs: Total cost does not change in proportion to volume of activity. Mixed costs: Cost consists of both a variable and a fixed element. ② Product Costs Direct materials: Raw materials costs directly linked to finished product. Direct labor: Employee costs directly linked to finished product. Overhead: Production costs indirectly linked to finished product. ③ Costing Systems Job order costing: Costs assigned to each unique unit or batch of units. Process costing: Costs assigned to similar products that are mass-produced in a continuous manner. ④ Costing Ratios Contribution margin ratio = (Net sales − Variable costs)∕Net sales Predetermined overhead rate = Estimated overhead costs∕Estimated activity base Break-even point in units = Total fixed costs∕Contribution margin per unit ⑤ Planning and Control Metrics Cost variance = Actual cost − Standard (budgeted) cost Sales (revenue) variance = Actual sales − Standard (budgeted) sales ⑥ Capital Budgeting Payback period = Time expected to recover investment cost Accounting rate of return = Expected annual net income∕Average annual investment Net present value (NPV) = Present value of future cash flows − Investment cost NPV rule: 1. Compute net present value (NPV in $). 2. If NPV > 0, then accept project; If NPV < 0, then reject project. Internal rate 1. Compute internal rate of return (IRR in %). of return rule: 2. If IRR > hurdle rate, accept project; If IRR < hurdle rate, reject project. ⑦ Costing Terminology Relevant range: Organization’s normal range of operating activity. Direct cost: Cost incurred for the benefit of one cost object. Indirect cost: Cost incurred for the benefit of more than one cost object. Product cost: Cost that is necessary and integral to finished products. Period cost: Cost identified more with a time period than with finished products. Overhead cost: Cost not separately or directly traceable to a cost object. Relevant cost: Cost that is pertinent to a decision. Opportunity cost: Benefit lost by choosing an action from two or more alternatives. Sunk cost: Cost already incurred that cannot be avoided or changed. Standard cost: Cost computed using standard price and standard quantity. Budget: Formal statement of an organization’s future plans. Break-even point: Sales level at which an organization earns zero profit. Incremental cost: Cost incurred only if the organization undertakes a certain action. Transfer price: Price on transaction between divisions within a company.

BRIEF REVIEW: MANAGERIAL ANALYSES AND REPORTS

Total flexible budget costs = Total fixed costs + (Total variable costs per unit × Units of activity level)

Budget variance* = Budget amount − Actual amount *Applies to both flexible and fixed budgets. F = Favorable variance; U = Unfavorable variance.

Activity-Based Costing Steps ① Identify activities and the overhead costs they cause. ② Trace overhead costs to activity cost pools. ③ Compute overhead allocation rates for each activity. ④ Use rates to assign overhead costs to cost objects.

Cost pool activity rate = Overhead costs assigned to pool ÷ Expected activity level

Product Costs

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead Period Expenses

Variable Costing

Product Costs

Variable and Absorption Costing

Absorption costing includes fixed overhead in product costs. Variable costing includes fixed overhead in period expenses.

BRIEF REVIEW: FINANCIAL REPORTS AND TABLES

Balance Sheet Date

ASSETS Current assets Examples: cash, cash equivalents, short-term investments, . . . . . . . . . . . . . . . . . . . $      # accounts receivable, current portion of notes receivable, . . . . . . . . . . . . . . . . . . # inventory, inventory returns estimated, prepaid expenses . . . . . . . . . . . . . . . . . . # Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      #  Long-term investments Examples: investment in stock, investment in bonds, . . . . . . . . . . . . . . . . . . . . .      # land for expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       # Total long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Plant assets Examples: equipment, machinery, buildings, land . . . . . . . . . . . . . . . . . . . . . . . . # Total plant assets, net of depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Intangible assets Examples: patent, trademark, copyright, license, right-of-use, goodwill . . . . . . # Total intangible assets, net of amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      # LIABILITIES AND EQUITY Current liabilities Examples: accounts payable, wages payable, salaries payable, . . . . . . . . . . . . $      # current notes payable, taxes payable, interest payable, . . . . . . . . . . . . . . . . # unearned revenues, current portion of debt, sales refund payable . . . . . . . . # Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      # Long-term liabilities Examples: notes payable, bonds payable, lease liability . . . . . . . . . . . . . . . . . . # Total long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Paid-in capital in excess of par (or stated value) . . . . . . . . . . . . . . . . . . . . . . . . . # Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Less treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (#) Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      #

Income Statement* For period Ended date

Net sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $       # Cost of goods sold (cost of sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Gross margin (gross profit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Operating expenses Examples: depreciation, salaries, wages, rent, utilities, . . . . . . . . . . . . . . . . . . . $      # interest, amortization, advertising, insurance, . . . . . . . . . . . . . . . . . . . . . . . . # taxes, selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Nonoperating gains and losses (unusual and/or infrequent) . . . . . . . . . . . . . . . . . . # Net income (net profit or earnings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $       #

*A typical chart of accounts is at the end of the book and classifies all accounts by financial statement categories.

†Indirect Method: Cash Flows from Operating Activities

Cash flows from operating activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      # Adjustments for operating items not providing or using cash +Noncash expenses and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      # Examples: Expenses for depreciation, depletion, and amortization;

losses from disposal of long-term assets and from retirement of debt −Noncash revenues and gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        # Examples: Gains from disposal of long-term assets and from

retirement of debt Adjustments for changes in current assets and current liabilities +Decrease in noncash current operating asset . . . . . . . . . . . . . . . . . . . . . . . . . .        # −Increase in noncash current operating asset . . . . . . . . . . . . . . . . . . . . . . . . . . .        # +Increase in current operating liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        # −Decrease in current operating liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       # Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . $      #

Statement of Cash Flows For period Ended date

Cash flows from operating activities [Prepared using the indirect (see below)† or direct method] Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      # Cash flows from investing activities [List of individual investing inflows and outflows] Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Cash flows from financing activities [List of individual financing inflows and outflows] Net cash provided (used) by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      # Cash (and equivalents) balance at beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        # Cash (and equivalents) balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      #

Attach separate schedule or note disclosure of “Noncash investing and financing transactions.”

Installment Notes Payment Table Payments

Period Debit   Debit Credit Ending Beginning Interest Notes Ending

Date Balance Expense + Payable = Cash Balance

# # # # # # . . . . . . . . . . . . . . . . . .

Discount Bond Amortization (Straight-Line) Table* Semiannual Period-End Unamortized Bond Discount† Bond Carrying Value‡

Bond life-start . . . . . . . . . . . . . . . . . $ # $ # . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond life-end . . . . . . . . . . . . . . . . . 0 par

* Bond carrying value is adjusted upward to par and its amortized discount downward to zero over the bond life (note: unamortized bond discount plus carrying value equals par).

†Equals total bond discount less its accumulated amortization. ‡Equals bond par value less its unamortized bond discount.

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Premium Bond Amortization (Straight-Line) Table* Semiannual Period-End Unamortized Bond Premium† Bond Carrying Value‡

Bond life-start . . . . . . . . . . . . . . . . . $ # $ # . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond life-end . . . . . . . . . . . . . . . . . . 0 par

* Bond carrying value is adjusted downward to par and its amortized premium downward to zero over the bond life (note: carrying value less unamortized bond premium equals par).

†Equals total bond premium less its accumulated amortization. ‡Equals bond par value plus its unamortized bond premium.

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Effective Interest Amortization Table for Bonds with Semiannual Interest Payment

Semiannual Cash Bond Discount Unamortized Interest Interest Interest or Premium Discount or Carrying Period-End PaidA ExpenseB AmortizationC PremiumD ValueE

# # # # # # . . . . . . . . . . . . . . . . . .

APar value multiplied by the semiannual contract rate. BPrior period’s carrying value multiplied by the semiannual market rate. CThe difference between interest paid and bond interest expense. DPrior period’s unamortized discount or premium less the current period’s discount or premium amortization. EPar value less unamortized discount or plus unamortized premium.

Statement of Retained Earnings For period Ended date

Retained earnings, beginning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     # Add: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       #   # Less: Dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        # Net loss (if exists) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       # Retained earnings, ending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     #

Book balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $# Add: Interest earned & unrecorded cash receipts . . . . $#

Book errors understating the balance . . . . . . . . . . . . . . . . . . . . . . . . . . . $# $# Less: Bank fees & NSF checks . . . . . . . . . . . . . . . . . . . $#

Book errors overstating the balance . . . . . . . . . . . . . . . . . . . . . . . . . . . $# Adjusted book balance . . . . . . . . . . . . . . . . . . . . . . . . $#

Bank statement balance . . . . . . . . . . . . . $# Add: Deposits in transit . . . . . . . . . . . . . #

Bank errors understating the balance . . . . . . . . . . . . . . . . # # Less: Outstanding checks . . . . . . . . . . . . #

Bank errors overstating the balance . . . . . . . . . . . . . . . . # Adjusted bank balance . . . . . . . . . . . . . $#

Bank Reconciliation Date

Balances are equal (reconciled)

Statement of Stockholders’ Equity† For period Ended date

Common Capital in Retained Treasury Stock Excess of Par Earnings Stock Total

Balances, beginning . . . . . . . . . . . . $ # $ # $ # $ # $ # Net income . . . . . . . . . . . . . . . . . . . Cash dividends . . . . . . . . . . . . . . . . Stock issuance . . . . . . . . . . . . . . . . Treasury stock purchase . . . . . . . . Treasury stock reissuance . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . Balances, ending . . . . . . . . . . . . . . $ # $ # $ # $ # $ #

† Additional columns and account titles commonly include number of shares, preferred stock, unrealized gains and losses on available-for-sale securities, foreign currency translation, and comprehensive income.

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BRIEF REVIEW: SELECTED TRANSACTIONS AND RELATIONS ① Merchandising Transactions Summary—Perpetual Inventory System ② Merchandising Cash Flows

Beginning inventory

From supplier

Net purchases

Ending inventory

Pe ri

od 2

Pe ri

od 1

To Balance Sheet

To Income Statement

To Balance Sheet

Beginning inventory

Net purchases

Ending inventory

Cost of goods sold

To Income Statement Cost of

goods sold

Merchandise available for sale

Merchandise available for sale

From supplier

③ Credit Terms and Amounts

Amount Due

Due: Invoice priceDue: Invoice price minus discount*

*Discount refers to a purchase discount for a buyer and a sales discount for a seller.

Discount* period

Credit period

Date of invoice

Credit Terms

Time

④ Bad Debts Estimation

Income Statement Focus [Emphasis on Matching]

Percent of Sales

Sales × Rate = Bad Debts Estimation

Percent of Receivables Aging of Receivables

Balance Sheet Focus [Emphasis on Realizable Value]

Bad Debts Estimation

Allowance for Doubtful

Accounts

× Rate = Accounts Receivable

Allowance for Doubtful

Accounts

Accounts Receivable

(by Age)

Rates (by Age)

Adj. Entry Amt. = Percent of Sales Adj. Entry Amt. = Percent (or Aging) of Receivables − Unadj. Bal. Cr. or + Unadj. Bal. Dr.

or

or

⑤ Bond Valuation

Bond Sets Market Sets Bond Price Determined

Contract rate > Market rate Bond sells at premium

Contract rate = Market rate Bond sells at par

Contract rate < Market rate Bond sells at discount

Contract rate Market rate

A A A A A A A A A A A A A

521 789 506 505 567 152 726 ----- 359 657 254 658 236

521 789 506 505 567 152 726 ----- 359 657 254 658 236

521 789 506 505 567 152 726 ----- 359 657 254 658 236

521 789 506 505 567 152 726 0 359 657 254 658 236

521 789 506 505 567 152 726 ----- 359 657 254 658 236

–012 003

–006 –009 –013

003 –001 ------ –003

008 –003 –003 –003

000027 000028 000029 000030 000031 000032 000033 000034 000035 000036 000037 000038 000039

⑥ Stock Transactions Summary

Stock Transactions Stock Entries Dr. Cr.

Issue par value common stock at par Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par) . Common Stock . . . . . . . . . . . . . . . . . . # Issue par value common stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par) . Common Stock . . . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Par Value, Common Stock . . . . . . # Issue no-par value common stock Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (no-par stock recorded at amount received) . Common Stock . . . . . . . . . . . . . . . . . . # Issue stated value common stock at stated value Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (stated stock recorded at stated value) . Common Stock . . . . . . . . . . . . . . . . . # Issue stated value common stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (stated stock recorded at stated value) . Common Stock . . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Stated Value, Common Stock . . . . . # Issue par value preferred stock at par Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par) . Preferred Stock . . . . . . . . . . . . . . . . . # Issue par value preferred stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par) . Preferred Stock . . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Par Value, Preferred Stock . . . . . . # Reacquire its own common stock Treasury Stock, Common . . . . . . . . . . . . . . . . # (treasury stock recorded at cost) . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . # Reissue its treasury stock at cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost) . Treasury Stock, Common . . . . . . . . . # Reissue its treasury stock above cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost) . Treasury Stock, Common . . . . . . . . . # Paid-In Capital, Treasury . . . . . . . . . . # Reissue its treasury stock below cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost; if paid-in capital Paid-In Capital, Treasury . . . . . . . . . . . . . . . . . # is insufficient to cover amount below cost, Retained Earnings (if necessary) . . . . . . . . . . # retained earnings is debited for remainder) . Treasury Stock, Common . . . . . . . . . #

Issue Common Stock

Issue Preferred Stock

Reacquire Common Stock

Reissue Common Stock

⎫⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭ ⎫ ⎬ ⎭

⑧ A Rose by Any Other Name

* Period-end adjustments depend on unadjusted balances, which can reverse the debit and credit in the adjusting entries shown; the entries in gray are covered in Appendix 4B.

Merchandising Transactions Merchandising Entries Dr. Cr.

Purchasing merchandise for Merchandise Inventory . . . . . . . . . . . . . . . . . . . . # resale . Cash or Accounts Payable . . . . . . . . . . . . . #

Paying freight costs on Merchandise Inventory . . . . . . . . . . . . . . . . . . . . # purchases; FOB shipping point . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Paying within discount period . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Merchandise Inventory . . . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Paying outside discount period . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Recording purchases returns or Cash or Accounts Payable . . . . . . . . . . . . . . . . . . # allowances . Merchandise Inventory . . . . . . . . . . . . . . . . #

Selling merchandise . Cash or Accounts Receivable . . . . . . . . . . . . . . . # Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . . . #

Receiving payment within Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period . Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . # Accounts Receivable . . . . . . . . . . . . . . . . . #

Sales Receiving payment outside Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period . Accounts Receivable . . . . . . . . . . . . . . . . . #

Receiving sales returns Sales Returns and Allowances . . . . . . . . . . . . . . # of nondefective inventory . Cash or Accounts Receivable . . . . . . . . . . #

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . #

Recognizing sales allowances . Sales Returns and Allowances . . . . . . . . . . . . . . # Cash or Accounts Receivable . . . . . . . . . . #

Paying freight costs on sales; Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . # FOB destination . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjustment for shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . # (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . . . . . # larger than physical inventory) .

Period-end adjustment for Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . # Adjusting expected sales discounts .* Allowance for Sales Discounts . . . . . . . . . . #

Period-end adjustment for expected Sales Returns and Allowances . . . . . . . . . . . . . . # returns—both revenue side and Sales Refund Payable . . . . . . . . . . . . . . . . . # cost side .* Inventory Returns Estimated . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . #

Closing temporary accounts Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # with credit balances . Income Summary . . . . . . . . . . . . . . . . . . . . #

Closing temporary accounts Income Summary . . . . . . . . . . . . . . . . . . . . . . . . # Closing with debit balances . Sales Returns and Allowances . . . . . . . . . . # Sales Discounts . . . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . # Delivery Expense . . . . . . . . . . . . . . . . . . . . # “Other Expenses” . . . . . . . . . . . . . . . . . . . . #

⎫⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪

⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭

⑦ Financial Statement Effects of Dividends and Splits Cash

Dividend Small Stock

Dividend Large Stock

Dividend Stock Split

Total assets Decrease No change No change No change

Total liabilities No change No change No change No change

Total stockholders’ equity Decrease No change No change No change

Common stock No change Increase Increase No change

Paid-in capital in excess of par No change Increase No change No change

Retained earnings Decrease Decrease Decrease No change

BR-4

⑦ Inventory Costing Methods ∙ Specific identification (SI) ∙ Weighted-average (WA) ∙ First-in, first-out (FIFO) ∙ Last-in, first-out (LIFO)

⑧ Depreciation and Depletion

Straight-line: Cost − Salvage value Useful life in periods

Units-of-production:

Cost − Salvage value Useful life in units

× Units produced in current period

Declining-balance: Rate* × Beginning-of-period book value *Rate is often double the straight-line rate, or 2 × (1∕Useful life)

Depletion: Cost − Salvage value Total capacity in units

× Units extracted in current period

⑨ Interest Computation Interest = Principal (face) × Rate × Time 10 Accounting for Investment Securities

④ Four-Step Closing Process 1. Transfer revenue and gain account balances to Income Summary. 2. Transfer expense and loss account balances to Income Summary. 3. Transfer Income Summary balance to Retained Earnings. 4. Transfer Dividends balance to Retained Earnings. ⑤ Accounting Concepts Characteristics Assumptions Principles Constraints Relevance Business entity Measurement Cost-benefit Faithful representation Going concern Revenue recognition Materiality Monetary unit Expense recognition Industry practice Time period Full disclosure Conservatism

⑥ Ownership of Inventory

Type Adjusting Entry

Prepaid Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr . Expense Cr . Asset* Unearned Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr . Liability Cr . Revenue Accrued Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr . Expense Cr . Liability Accrued Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr . Asset Cr . Revenue

*For depreciation, credit Accumulated Depreciation (contra asset).

③ Adjustments and Entries

Classification Investments Account Reported at

Short-Term Investment in Securities Debt Investments—Held-to-Maturity . . . . . . . . . . . . . . Cost (without any discount or premium amortization) Debt Investments—Trading . . . . . . . . . . . . . . . . . . . . . Fair value (with fair value adjustment to income) Debt Investments—Available-for-Sale . . . . . . . . . . . . . Fair value (with fair value adjustment to equity) Stock Investments—insignificant influence . . . . . . . . . Fair value (with fair value adjustment to income) Long-Term Investment in Securities Debt Investments—Held-to-Maturity . . . . . . . . . . . . . Cost (with any discount or premium amortization) Debt Investments—Available-for-Sale . . . . . . . . . . . . Fair value (with fair value adjustment to equity) Stock Investments—insignificant influence . . . . . . . . . Fair value (with fair value adjustment to income) Equity Method Investments—significant influence . . . Equity method (no fair value adjustment) Consolidated Investments—controlling influence . . . . Consolidation method (no fair value adjustment)

② Accounting Cycle

2. Journalize

10. Reverse (Optional)

1. Analyze transactions

Accounting Cycle

3. Post

4. Prepare unadjusted

trial balance

5. Adjust

6. Prepare adjusted

trial balance

9. Prepare post-

closing trial balance

7. Prepare statements

8. Close

ANALYSES ① Liquidity and Efficiency

Current ratio = Current assets

Current liabilities pp. 108 & 506

Working capital = Current assets − Current liabilities p. 506

Acid-test ratio = Cash + Short-term investments + Current receivables

Current liabilities pp. 159 & 507

Accounts receivable turnover = Net sales

Average accounts receivable, net pp. 285 & 507

Inventory turnover = Cost of goods sold Average inventory

pp. 203 & 507

Days’ sales uncollected = Accounts receivable, net

Net sales × 365*

pp. 250 & 508

Days’ sales in inventory = Ending inventory

Cost of goods sold × 365*

pp. 203 & 508

Days’ payable outstanding (or Days’ sales in payables) =

Accounts payable Cost of goods sold

× 365* p. 884

Cash conversion cycle =

Days’ sales uncollected +

Days’ sales in inventory−

Days’ payable outstanding p. 884

Total asset turnover = Net sales

Average total assets pp. 320 & 508

Plant asset useful life = Plant asset cost

Depreciation expense

Plant asset age = Accumulated depreciation

Depreciation expense

*360 days is also commonly used.

② Solvency

Debt ratio = Total liabilities

Total assets

Equity ratio = Total equity Total assets

p. 62

Debt-to-equity = Total liabilities

Total equity pp. 392 & 509

Times interest earned = Income before interest expense and income taxes

Interest expense pp. 354 & 509

③ Profitability

Profit margin ratio = Net income Net sales

pp. 108 & 509

Gross margin ratio = Net sales − Cost of goods sold

Net sales p. 159

Return on total assets = Net income

Average total assets pp. 18 & 509

= Profit margin ratio × Total asset turnover p. C-13

Return on common stockholders’ equity = Net income − Preferred dividends

Average common stockholders’ equity p. 510

Book value per common share = Stockholders’ equity applicable to common shares

Number of common shares outstanding p. 433

Basic earnings per share = Net income − Preferred dividends

Weighted-average common shares outstanding p. 432

Cash flow on total assets = Cash flow from operations

Average total assets p. 467

Payout ratio = Cash dividends declared on common stock

Net income p. 433

④ Market

Price-earnings ratio = Market price per share

Earnings per share pp. 432 & 510

Dividend yield = Annual cash dividends per share

Market price per share

pp. 433 & 510

Residual income = Net income − Target net income p. 878

BRIEF REVIEW: FUNDAMENTALS AND ANALYSES

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . #

FUNDAMENTALS ① Accounting Equation

Assets = Liabilities + Equity

↑ ↓ ↓ ↑ ↓ ↑ Debit for Credit for Debit for Credit for Debit for Credit for increases decreases decreases increases decreases increases

Indicates normal balance. *Includes common stock and any preferred stock.

Contributed Capital* Retained Earnings

Common Stock Dividends Revenues Expenses

Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for decreases increases increases decreases decreases increases increases decreases

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

4D-1

APPENDIX

Work Sheet—Perpetual System 4D

No. Account Dr.

Unadjusted Trial

Balance

Adjusted Trial

Balance Income

Statement Balance SheetAdjustments Dr. Dr. Dr. Dr.Cr. Cr. Cr. Cr. Cr.

101 106 108 119 121 126 128 167 168 201 209 227 307 318 319 413 414 415 502 612 622 637 640 652 655

8,200 11,250

21,250 200

3,800 900

34,200

4,000

1,100 4,250

230,450

43,000

9,000

11,300 382,900

0

3,700

16,000

300 10,000 31,900

321,000

382,900

(g) 50 (5) 250

(2) 3,000 (1) 600

(3) 3,700

(4) 800 (h1) 900

(h2) 300

9,600

50

16,000 800

1,200 10,000 31,900

321,000

388,350

8,200 11,250

21,000 500 800 300

34,200

4,000

2,000 4,300

230,400 3,700

43,800 600

9,000 3,000 11,300

388,350

2,000 4,300

230,400 3,700

43,800 600

9,000 3,000 11,300

308,100 12,900

321,000

321,000

321,000

321,000

8,200 11,250

21,000 500 800 300

34,200

4,000

80,250

80,250

50

16,000 800

1,200 10,000 31,900

67,350 12,900 80,250

Cash Accounts receivable Allowance for sales discounts Merchandise inventory Inventory returns estimated Supplies Prepaid insurance Equipment Accumulated depr.—Equip. Accounts payable Salaries payable Sales refund payable Common stock Retained earnings Dividends Sales Sales returns and allowances Sales discounts Cost of goods sold Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Advertising expense Totals Net income Totals

7,400 7,400

(h1) 900 (g) 50

(5) 250 (3) 3,700 (4) 800 (1) 600

(2) 3,000

9,600

(h2) 300

Exhibit 4D.1 shows the work sheet for preparing financial statements of a merchandiser. It differs slightly from the work sheet layout in the prior chapter—the differences are in orange boldface. The adjustments in the work sheet reflect the following: (1) expiration of $600 of prepaid insurance, (2) use of $3,000 of supplies, (3) depreciation of $3,700 for equipment, (4) accrual of $800 of unpaid salaries, and (5) inven- tory shrinkage of $250. Once the adjusted amounts are extended into the financial statement columns, the information is used to develop financial statements.

EXHIBIT 4D.1 Work Sheet for Merchandiser (using a perpetual system)

PROBLEM SET A

Problem 4-6AD ONLINE APPENDIX: Preparing a work sheet for a merchandiser P3

Refer to the data and information in Problem 4-5A.

Required

Prepare and complete the entire 10-column work sheet for Nelson Company. Follow the structure of Exhibit 4D.1.

PROBLEM SET B

Problem 4-6BD ONLINE APPENDIX: Preparing a work sheet for a merchandiser P3

Refer to the data and information in Problem 4-5B.

Required

Prepare and complete the entire 10-column work sheet for Foster Products Company. Follow the structure of Exhibit 4D.1.

G-1

Absorption costing Costing method that assigns both variable and fixed manufacturing costs to products; this method is required under U.S. GAAP; also called full costing. (707, 739)

Accelerated depreciation method Method that produces larger depreciation charges in the early years of an asset’s life and smaller charges in its later years. (308)

Account Record within an accounting system in which increases and decreases are entered and stored in a specific asset, liability, equity, revenue, or expense. (45)

Account balance Difference between total debits and total credits (including the beginning balance) for an account. (49)

Account form balance sheet Balance sheet that lists assets on the left side and liabilities and equity on the right.

Account payable Liability created by buying goods or services on credit; backed by the buyer’s general credit standing.

Accounting Information and measurement system that identifies, records, and communicates relevant information about a company’s business activities. (3)

Accounting cycle Recurring steps performed each accounting period, starting with analyzing transactions and continuing through the post-closing trial balance (or optional reversing entries). (104)

Accounting equation Equality involving a company’s assets, liabil- ities, and equity; Assets = Liabilities + Equity; also called balance sheet equation. (10)

Accounting information system People, records, and methods that collect and process data from transactions and events, organize them in useful reports, and communicate results to decision makers.

Accounting period Length of time covered by financial statements; also called reporting period. (85)

Accounting rate of return (ARR) Rate used to evaluate the accept- ability of an investment; equals the after-tax periodic income from a project divided by the average investment in the asset; also called rate of return on average investment. (951)

Accounts payable ledger Subsidiary ledger listing individual creditor (supplier) accounts.

Accounts receivable Amounts due from customers for credit sales; backed by the customer’s general credit standing. (271)

Accounts receivable ledger Subsidiary ledger listing individual customer accounts.

Accounts receivable turnover Measure of both the quality and liquidity of accounts receivable; indicates how often receivables are received and collected during the period; computed by dividing net sales by average accounts receivable. (285)

Accrual basis accounting Accounting system that recognizes revenues when goods or services are provided and expenses when incurred; the basis for GAAP. (86)

Accrued expenses Costs incurred in a period that are both unpaid and unrecorded; adjusting entries for recording accrued expenses involve increasing expenses and increasing liabilities. (93)

Accrued revenues Revenues earned in a period that are both unrecorded and not yet received in cash (or other assets); adjusting entries for recording accrued revenues involve increasing assets and increasing revenues. (95)

Accumulated depreciation Cumulative sum of all depreciation expense recorded for an asset. (90)

Acid-test ratio Ratio used to assess a company’s ability to settle its current debts with its most liquid assets; defined as quick assets (cash, short-term investments, and current receivables) divided by current liabilities. (159)

Activity An event that causes the consumption of overhead resources in an entity. (663)

Activity-based budgeting (ABB) Budget system based on expected activities. (781)

Activity-based costing (ABC) Cost allocation method that focuses on activities performed; traces costs to activities and then assigns them to cost objects. (663)

Activity-based management (ABM) Approach that uses the link between activities and costs for better management decisions. (669)

Activity cost driver Variable that causes an activity’s cost to go up or down; a causal factor. (664)

Activity cost pool Temporary account that accumulates costs a company incurs to support an activity. (663)

Activity overhead (cost pool) rate Overhead rate for a pool of costs driven by the same activity. (664)

Activity rate The overhead rate in activity-based costing; computed as the total budgeted activity cost divided by the budgeted activity- base usage.

Adjusted trial balance List of accounts and balances prepared after period-end adjustments are recorded and posted. (98)

Adjusting entry Journal entry at the end of an accounting period to bring an asset or liability account to its proper amount and update the related expense or revenue account. (87)

Aging of accounts receivable Process of classifying accounts receivable by how long they are past due for purposes of estimating uncollectible accounts. (279)

Allowance for Doubtful Accounts Contra asset account with a balance approximating uncollectible accounts receivable; also called Allowance for Uncollectible Accounts. (276)

Allowance for Sales Discounts Contra asset account that is re- ported on the balance sheet as a reduction to Accounts Receivable; this allowance account has a normal credit balance. (167)

Glossary

G-2 Glossary

Allowance method Procedure that (a) estimates and matches bad debts expense with its sales for the period and/or (b) reports accounts receivable at estimated realizable value. (275)

Amortization Process of allocating the cost of an intangible asset to expense over its estimated useful life. (317)

Annual financial statements Financial statements covering a one- year period; often based on a calendar year, but any consecutive 12-month (or 52-week) period is acceptable. (85)

Annual report Summary of a company’s financial results for the year along with its current financial condition and future plans; directed to external users of financial information. (A-1)

Annuity Series of equal payments at equal intervals. (953)

Appropriated retained earnings Retained earnings separately reported to inform stockholders of funding needs. (431)

Asset book value Asset’s acquisition costs less its accumulated depreciation (or depletion, or amortization); also sometimes used synonymously as the carrying value of an account; also called book value. (307)

Assets Resources a business owns or controls that are expected to provide current and future benefits to the business. (9)

Auction-based pricing Prices are set by potential buyers’ bids. (922)

Audit Analysis and report of an organization’s accounting system, its records, and its reports using various tests. (6)

Auditors Individuals hired to review financial reports and informa- tion systems. Internal auditors of a company are employed to assess and evaluate its system of internal controls, including the resulting reports. External auditors are independent of a company and are hired to assess and evaluate the “fairness” of financial statements (or to perform other contracted financial services). (6)

Authorized stock Total amount of stock that a corporation’s charter authorizes it to issue. (419)

Available-for-sale (AFS) securities Investments in debt securities that are not classified as trading securities or held-to-maturity securities. (C-5)

Average cost Method for assigning inventory cost to sales; the cost of available-for-sale units is divided by the number of units available to determine per unit cost prior to each sale, which is then multiplied by the units sold to yield the cost of that sale; also called weighted average. (196, 211)

Avoidable expense Expense (or cost) that is relevant for decision making; expense that is not incurred if a department, product, or service is eliminated. (919)

Backflush costing Product costing system that flushes costs of unfinished products from Cost of Goods Sold to Work in Process Inventory at the end of the period. (671)

Bad debts Accounts of customers who do not pay what they have promised to pay; an expense of selling on credit; also called uncollectible accounts. (274)

Balance column account Account with debit and credit columns for recording entries and another column for showing the balance of the account after each entry. (51)

Balance sheet Financial statement that lists types and dollar amounts of assets, liabilities, and equity at a specific date. (15)

Balance sheet equation Equality involving a company’s assets, liabilities, and equity; Assets = Liabilities + Equity; also called accounting equation.

Balanced scorecard A system of performance measurement that collects information on several key performance indicators within each of four perspectives: customer, internal processes, innovation and learning, and financial. (881)

Bank reconciliation Report that explains the difference between the book (company) balance of cash and the cash balance reported on the bank statement, for purposes of computing the adjusted cash balance. (247)

Bank statement Bank report on the depositor’s beginning and ending cash balances, and a listing of its changes, for a period. (246)

Basic earnings per share Net income less any preferred dividends and then divided by weighted-average common shares outstanding. (432)

Batch-level activities Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch; the amount of resources used depends on the number of batches run rather than on the number of units in the batch. (669)

Batch processing Accumulating source documents for a period of time and then processing them all at once such as once a day, week, or month.

Batch size (lot size) The number of units produced after a machine setup. (D-3)

Bearer bonds Bonds made payable to whoever holds them (the bearer); also called unregistered bonds. (392)

Benchmarking Practice of comparing and analyzing company finan- cial performance or position with other companies or standards. (834)

Betterments Expenditures to make a plant asset more efficient or productive; also called improvements. (312)

Blockchain Technology used to create a secure ledger of transac- tions. (922)

Bond Written promise to pay the bond’s par (or face) value and interest at a stated contract rate; often issued in denominations of $1,000. (381)

Bond certificate Document containing bond specifics such as issuer’s name, bond par value, contract interest rate, and maturity date. (382)

Bond indenture Contract between the bond issuer and the bond- holders; identifies the parties’ rights and obligations. (382)

Book value Asset’s acquisition costs less its accumulated deprecia- tion (or depletion, or amortization); also sometimes used synony- mously as the carrying value of an account; also called asset book value. (90)

Book value per common share Recorded amount of equity appli- cable to common shares divided by the number of common shares outstanding. (433)

Book value per preferred share Equity applicable to preferred shares (equals its call price [or par value if it is not callable] plus any cumulative dividends in arrears) divided by the number of preferred shares outstanding.

Bookkeeping Part of accounting that involves recording transactions and events, either manually or electronically; also called recordkeeping. (3)

Break-even point Output level at which sales equal fixed plus variable costs; where income equals zero. (704)

Glossary G-3

Break-even time (BET) Time-based measurement used to evaluate the acceptability of an investment; equals the time expected to pass before the present value of the net cash flows from an investment equals its initial cost. (960)

Budget Formal statement of future plans, usually expressed in monetary terms. (771)

Budget report Report comparing actual results to planned objectives; sometimes used as a progress report. (821)

Budgetary control Management use of budgets to monitor and control company operations. (771)

Budgeted balance sheet Accounting report that presents predicted amounts of the company’s assets, liabilities, and equity balances as of the end of the budget period. (786)

Budgeted income statement Accounting report that presents predicted amounts of the company’s revenues and expenses for the budget period. (785)

Budgeting Process of planning future business actions and express- ing them as formal plans. (771)

Business An organization of one or more individuals selling products and/or services for profit.

Business entity assumption Principle that requires a business to be accounted for separately from its owner(s) and from any other entity. (8)

Business segment Part of a company that can be separately identi- fied by the products or services that it provides or by the geographic markets that it serves; also called segment. (515)

C corporation Corporation that does not qualify for nor elect to be treated as a proprietorship or partnership for income tax purposes and therefore is subject to income taxes; also called C corp.

Call price Amount that must be paid to call and retire a callable preferred stock or a callable bond.

Callable bonds Bonds that give the issuer the option to retire them at a stated amount prior to maturity. (392)

Callable preferred stock Preferred stock that the issuing corporation, at its option, may retire by paying the call price plus any dividends in arrears.

Canceled checks Checks that the bank has paid and deducted from the depositor’s account. (246)

Capital budgeting Process of analyzing alternative investments and deciding which assets to acquire or sell. (947)

Capital expenditures Additional costs of plant assets that provide material benefits extending beyond the current period; also called balance sheet expenditures. (311)

Capital expenditures budget Plan that lists dollar amounts to be both received from disposal of plant assets and spent to purchase plant assets. (781)

Capital lease Long-term lease in which the lessor transfers substan- tially all risks and rewards of ownership to the lessee; not acceptable under GAAP after 2019.

Capital rationing Financing constraints that limit firms from accepting all positive net present value projects. (956)

Capital stock General term referring to a corporation’s stock used in obtaining capital (owner financing). (419)

Capitalize Record the cost as part of a permanent account and allocate it over later periods.

Carrying (book) value of bonds Net amount at which bonds are reported on the balance sheet; equals the par value of the bonds less any unamortized discount or plus any unamortized premium; also called carrying amount or book value. (384)

Cash Includes currency, coins, and amounts on deposit in bank checking or savings accounts. (239)

Cash basis accounting Accounting system that recognizes revenues when cash is received and records expenses when cash is paid. (86)

Cash budget Plan that shows expected cash inflows and outflows during the budget period, including receipts from loans needed to maintain a minimum cash balance and repayments of such loans. (781)

Cash conversion cycle The average time it takes to convert cash outflows into cash inflows from customers. (884)

Cash discount Reduction in the price of merchandise granted by a seller to a buyer when payment is made within the discount period. (146)

Cash equivalents Short-term investment assets that are readily con- vertible to a known cash amount or sufficiently close to their matu- rity date (usually within 90 days) so that market value is not sensitive to interest rate changes. (239)

Cash flow on total assets Ratio of operating cash flows to average total assets; not sensitive to income recognition and measurement; partly reflects on earnings quality. (467)

Cash Over and Short Income statement account used to record cash overages and cash shortages arising from errors in cash receipts or payments. (240)

Cash payments journal Special journal normally used to record all payments of cash; also called cash disbursements journal.

Cash receipts journal Special journal normally used to record all receipts of cash.

Change in an accounting estimate Change in an accounting esti- mate that results from new information, subsequent developments, or improved judgment that impacts current and future periods. (310, 432)

Chart of accounts List of accounts used by a company; includes an identification number for each account. (48)

Check Document signed by a depositor instructing the bank to pay a specified amount to a designated recipient. (245)

Check register Another name for a cash payments journal when the journal has a column for check numbers. (254)

Classified balance sheet Balance sheet that presents assets and liabilities in relevant subgroups, including current and noncurrent classifications. (105)

Closed-loop supply chain Products are built using only renewable resources or recycled material. (D-9)

Closing entries Entries recorded at the end of each accounting period to transfer end-of-period balances in revenue, gain, expense, loss, and withdrawals (dividends for a corporation) accounts to the capital account (or retained earnings for a corporation). (101)

Closing process Necessary end-of-period steps to prepare the accounts for recording the transactions of the next period. (100)

G-4 Glossary

Columnar journal Journal with more than one column.

Committee of Sponsoring Organizations (COSO) Committee of Sponsoring Organizations of the Treadway Commission (or COSO) is a joint initiative of five private sector organizations and is dedi- cated to providing thought leadership through the development of frameworks and guidance on enterprise risk management, internal control, and fraud deterrence. (235)

Common stock Corporation’s basic ownership share; also generi- cally called capital stock. (8, 10, 418)

Common-size financial statement Statement that expresses each amount as a percent of a base amount. In the balance sheet, total assets is usually the base and is expressed as 100%. In the income statement, net sales is usually the base. (502)

Comparative financial statement Statement with data for two or more successive periods placed in side-by-side columns, often with changes shown in dollar amounts and percents. (498)

Compatibility principle Information system principle that pre- scribes an accounting system to conform with a company’s activities, personnel, and structure.

Complex capital structure Any company that issues preferred stock or more than one class of common stock.

Components of accounting systems Five basic components of ac- counting systems are source documents, input devices, information processors, information storage, and output devices.

Composite unit Generic unit that summarizes the sales mix and contribution margins of each product; used in multiproduct break- even analysis. (711)

Compound journal entry Journal entry that affects at least three accounts. (54)

Comprehensive income Net change in equity for a period, exclud- ing owner investments and distributions. (C-12)

Computer hardware Physical equipment in a computerized accounting information system.

Computer network Linkage giving different users and different computers access to common databases and programs.

Computer software Programs that direct operations of computer hardware.

Conceptual framework The basic concepts that underlie the prepa- ration and presentation of financial statements for external users; can serve as a guide in developing future standards and resolving accounting issues that are not addressed directly in current standards using the definitions, recognition criteria, and measurement concepts for assets, liabilities, revenues, and expenses. (7)

Conservatism constraint Principle that prescribes the less optimis- tic estimate when two estimates are about equally likely.

Consignee Receiver of goods owned by another who holds them for purposes of selling them for the owner. (191)

Consignor Owner of goods held by another party who will sell them for the owner. (191)

Consistency concept Principle that prescribes use of the same accounting method(s) over time so that financial statements are comparable across periods.

Consolidated financial statements Financial statements that show all (combined) activities under the parent’s control, including those of any subsidiaries. (C-12)

Contingent liability Obligation to make a future payment if, and only if, an uncertain future event occurs. (352)

Continuous budgeting Practice of preparing budgets for a selected number of future periods and revising those budgets as each period is completed. (773)

Continuous improvement Concept requiring every manager and employee continually to look to improve operations. (550)

Contra account Account linked with another account and having an opposite normal balance; reported as a subtraction from the other account’s balance. (90)

Contract rate Interest rate specified in a bond indenture (or note); multiplied by the par value to determine the interest paid each period; also called coupon rate, stated rate, or nominal rate. (383)

Contributed capital Total amount of cash and other assets received from stockholders in exchange for stock; also called paid- in capital. (10)

Contributed capital in excess of par value Difference between the par value of stock and its issue price when issued at a price above par.

Contribution format Income statement that separately reports variable costs and fixed costs. (749)

Contribution margin Selling price minus variable cost; measures how revenues cover variable costs; the remainder (or contribution) is for fixed costs and any resulting income. (703)

Contribution margin income statement Income statement that separates variable and fixed costs; highlights the contribution margin, which is sales less variable expenses. (741)

Contribution margin per unit Amount that the sale of one unit contributes toward recovering fixed costs and earning profit; defined as sales price per unit minus variable costs per unit. (703)

Contribution margin ratio Product’s contribution margin divided by its sale price. (703)

Control Process of monitoring planning decisions and evaluating the organization’s activities and employees. (536)

Control principle Information system principle that prescribes an accounting system to aid managers in controlling and monitoring business activities.

Controllable costs Costs that a manager has the power to control or at least strongly influence. (748, 870)

Controllable variance Actual total overhead incurred minus budgeted total overhead. Equals the sum of both overhead spending variances (variable and fixed) and the variable overhead efficiency variance. (836)

Controlling account General ledger account, the balance of which (after posting) equals the sum of the balances in its related subsidiary ledger.

Conversion cost per equivalent unit The combined costs of direct labor and factory overhead per equivalent unit. (614)

Conversion cost rate Rate used in applying estimated conversion costs to production in lean accounting. (D-7)

Conversion costs Expenditures incurred in converting raw materials to finished goods; includes direct labor costs and overhead costs. (543)

Convertible bonds Bonds that bondholders can exchange for a set number of the issuer’s shares. (392)

Convertible preferred stock Preferred stock with an option to exchange it for common stock at a specified rate.

Glossary G-5

Copyright Right giving the owner the exclusive privilege to publish and sell a musical, literary, or artistic work during the creator’s life plus 70 years. (318)

Corporate social responsibility (CSR) Explicit consideration of the demands of stakeholders other than just shareholders and creditors in company decisions. (551)

Corporation Business that is a separate legal entity under state or federal laws; its owners are referred to as shareholders or stockholders. (8, 417)

Cost All normal and reasonable expenditures necessary to get an asset in place and ready for its intended use. (304)

Cost accounting system Accounting system for manufacturing activities based on the perpetual inventory system. (571)

Cost-based transfer pricing A transfer pricing system based on the cost of goods or services being transferred across divisions within the same company. (890)

Cost-benefit constraint The notion that the benefit of a disclosure exceeds the cost of that disclosure. (8)

Cost-benefit principle Information system principle that prescribes the benefits from an activity in an accounting system must outweigh the costs of that activity. (238)

Cost center Department that incurs costs but generates no revenues; common example is the accounting or legal department. (869)

Cost constraint The notion that the benefit of a disclosure exceeds the cost of that disclosure. (8)

Cost object Product, process, department, or customer to which costs are assigned. (539, 658)

Cost of capital Rate the company must pay to its long-term credi- tors and shareholders. (952)

Cost of goods available for sale Consists of beginning inventory plus net purchases (or cost of goods manufactured) of a period.

Cost of goods manufactured Total manufacturing costs (direct materials, direct labor, and factory overhead) for the period plus beginning work in process less ending work in process; also called net cost of goods manufactured or cost of goods completed. (547)

Cost of goods sold Cost of inventory sold to customers during a period; also called cost of sales.

Cost of goods sold budget A budget of total manufacturing costs for goods expected to be sold in the period. (779)

Cost-plus pricing Pricing method where target price equals cost plus a markup. (584)

Cost principle Accounting principle that prescribes financial statement information be based on actual costs incurred in business transactions. (7)

Cost of quality report Report that summarizes the costs of quality, classified by prevention, appraisal, internal failure, and external failure costs. (670)

Cost variance Difference between the actual incurred cost and the standard cost. (828)

Cost-volume-profit (CVP) analysis Planning method that includes predicting the volume of activity, the costs incurred, sales earned, and profits received. (697)

Cost-volume-profit (CVP) chart Graphic representation of cost-volume-profit relations. (706)

Costs of quality Costs resulting from manufacturing defective products or providing services that do not meet customer expectations. (670)

Coupon bonds Bonds with interest coupons attached to their cer- tificates; bondholders detach coupons when they mature and present them to a bank or broker for collection. (392)

Credit Recorded on the right side; an entry that decreases an asset or expense account, or increases a liability, revenue, or equity account; abbreviated Cr. (49)

Credit memorandum Notification that the issuer (sender) has credited the recipient’s account in the sender’s records. (247)

Credit period Time period that can pass before a customer’s payment is due. (146)

Credit risk ratio Ratio of the Allowance for Doubtful Accounts divided by Accounts Receivable; the higher this ratio, the higher is credit risk.

Credit terms Description of the amounts and timing of payments that a buyer (debtor) agrees to make in the future. (145)

Creditors Individuals or organizations entitled to receive payments. (47)

Cumulative preferred stock Preferred stock on which undeclared dividends accumulate until paid; common stockholders cannot receive dividends until cumulative dividends are paid. (427)

Current assets Cash and other assets expected to be sold, collected, or used within one year or the company’s operating cycle, whichever is longer. (106)

Current liabilities Obligations due to be paid or settled within one year or the company’s operating cycle, whichever is longer. (107, 341)

Current portion of long-term debt Portion of long-term debt due within one year or the operating cycle, whichever is longer; reported under current liabilities. (349)

Current ratio Ratio used to evaluate a company’s ability to pay its short-term obligations, calculated by dividing current assets by current liabilities. (108)

Curvilinear cost Cost that changes with volume but not at a constant rate. (700)

Customer orientation Company position that its managers and employees be in tune with the changing wants and needs of consumers. (550)

Cycle efficiency (CE) A measure of production efficiency, which is defined as value-added (process) time divided by total cycle time. (D-6)

Cycle time (CT) A measure of the time to produce a product or service, which is the sum of process time, inspection time, move time, and wait time; also called throughput time. (D-3)

Date of declaration Date the directors vote to pay a dividend. (422)

Date of payment Date the corporation makes the dividend payment. (422)

Date of record Date the directors specify for identifying stockhold- ers to receive dividends. (422)

Days’ payable outstanding Average number of days that payables are deferred until payment is made; delaying payment allows the buyer to increase the available cash; computed by dividing accounts

G-6 Glossary

payable by cost of goods sold, and then multiplying this quotient by 365; also called days’ sales in accounts payable. (D-10)

Days’ sales in inventory Estimate of number of days needed to con- vert inventory into receivables or cash; equals ending inventory divided by cost of goods sold and then multiplied by 365; also called days’ stock on hand. (203)

Days’ sales in raw materials inventory Measure of how much raw materials inventory is available in terms of the number of days’ sales; defined as ending raw materials inventory divided by raw materials used and that quotient multiplied by 365 days. (552)

Days’ sales in work in process inventory A measure of production efficiency. Computed as Work in process inventory/Cost of goods sold, multiplied by 365. (D-6)

Days’ sales uncollected Measure of the liquidity of receivables, computed by dividing the current balance of receivables by the annual credit (or net) sales and then multiplying by 365; also called days’ sales in receivables. (250)

Debit Recorded on the left side; an entry that increases an asset or expense account, or decreases a liability, revenue, or equity account; abbreviated Dr. (49)

Debit memorandum Notification that the issuer (sender) has debited the recipient’s account in the sender’s records. (147, 247)

Debt ratio Ratio of total liabilities to total assets; used to reflect risk associated with a company’s debts. (62)

Debt-to-equity ratio Defined as total liabilities divided by total equity; shows the proportion of a company financed by nonowners (creditors) in comparison with that financed by owners. (392)

Debtors Individuals or organizations that owe money. (46)

Decentralized organization Organization divided into smaller units for managerial decision-making purposes. (869)

Declining-balance method Method that determines depreciation charge for the period by multiplying a depreciation rate (often twice the straight-line rate) by the asset’s beginning-period book value. (308)

Deferred income tax liability Corporate income taxes that are deferred until future years because of temporary differences between GAAP and tax rules. (362)

Degree of operating leverage (DOL) Ratio of contribution margin divided by pretax income; used to assess the effect on income of changes in sales. (714)

Departmental accounting system Accounting system that provides information useful in evaluating the profitability or cost-effectiveness of a department.

Departmental contribution to overhead Amount by which a department’s revenues exceed its direct expenses. (877)

Departmental income statements Income statements prepared for each operating department within a decentralized organization. (872)

Depletion Process of allocating the cost of natural resources to periods when they are consumed and sold. (315)

Deposit ticket Lists items such as currency, coins, and checks deposited and their corresponding dollar amounts. (245)

Deposits in transit Deposits recorded by the company but not yet recorded by its bank. (247)

Depreciable cost Cost of a plant asset less its salvage value.

Depreciation Expense created by allocating the cost of plant and equipment to periods in which they are used; represents the expense of using the asset. (89, 305)

Diluted earnings per share Earnings per share calculation that requires dilutive securities be added to the denominator of the basic EPS calculation. (432)

Dilutive securities Securities having the potential to increase com- mon shares outstanding; examples are options, rights, convertible bonds, and convertible preferred stock.

Direct costing Costing method that includes only variable manufac- turing costs (direct materials, direct labor, and variable manufactur- ing overhead) in unit product costs; also called variable or marginal costing.

Direct costs Costs incurred for the benefit of one specific cost object. (539)

Direct expenses Expenses traced to a specific department (object) that are incurred for the sole benefit of that department. (872)

Direct labor Work of employees who physically convert materials to finished product. (542)

Direct labor budget Report showing budgeted costs for direct labor necessary to satisfy estimated production for the period. (777)

Direct labor costs Wages and salaries for direct labor that are separately traced through the production process to finished goods. (542)

Direct materials Raw material that physically becomes part of the product and is clearly identified with specific products or batches of product. (542)

Direct materials budget Report showing budgeted costs for direct materials necessary to satisfy estimated production for the period. (776)

Direct materials costs Expenditures for direct materials that are separately and readily traced through the production process to finished goods. (542)

Direct method Presentation of net cash from operating activities for the statement of cash flows that lists major operating cash receipts less major operating cash payments. (457)

Direct write-off method Method that records the loss from an uncollectible account receivable at the time it is determined to be uncollectible; no attempt is made to estimate bad debts. (274)

Discount on bonds payable Difference between a bond’s par value and its lower issue price or carrying value; occurs when the contract rate is less than the market rate. (384)

Discount on note payable Difference between the face value of a note payable and the (lesser) amount borrowed; reflects the added interest to be paid on the note over its life.

Discount on stock Difference between the par value of stock and its issue price when issued at a price below par value. (421)

Discount period Time period in which a cash discount is available and the buyer can make a reduced payment. (146)

Discount rate Expected rate of return on investments; also called cost of capital, hurdle rate, or required rate of return. (B-1)

Discounts lost Expenses resulting from not taking advantage of cash discounts on purchases. (168)

Glossary G-7

Dividend in arrears Unpaid dividend on cumulative preferred stock; must be paid before any regular dividends on preferred stock and before any dividends on common stock. (427)

Dividend yield Ratio of the annual amount of cash dividends distributed to common shareholders relative to the common stock’s market value (price). (433)

Dividends Corporation’s distributions of assets to its owners. (10, 48)

Dodd-Frank Wall Street Reform and Consumer Protection Act Congressional act to promote accountability and transparency in the financial system, to end the notion of too big to fail, to protect the taxpayer by ending bailouts, and to protect consumers from abusive financial services. (6)

Double-declining-balance (DDB) depreciation Depreciation equals beginning book value multiplied by 2 times the straight-line rate.

Double-entry accounting Accounting system in which each transaction affects at least two accounts and has at least one debit and one credit. (49)

Double taxation Corporate income is taxed, and then its later distribution through dividends is normally taxed again for share- holders. (9)

Dynamic pricing System where prices vary depending on chang- ing market conditions or demand. (922)

Earnings Amount earned after subtracting all expenses necessary for and matched with sales for a period; also called net income, income, or profit.

Earnings per share (EPS) Amount of income earned by each share of a company’s outstanding common stock; also called net income per share. (432)

Effective interest method Allocates interest expense over the bond life to yield a constant rate of interest; interest expense for a period is found by multiplying the balance of the liability at the beginning of the period by the bond market rate at issuance; also called interest method. (397)

Efficiency Company’s productivity in using its assets; usually measured relative to how much revenue a certain level of assets generates. (497)

Efficiency variance Difference between the actual quantity of an input and the standard quantity of that input. (844)

Electronic funds transfer (EFT) Use of electronic communication to transfer cash from one party to another. (245)

Employee benefits Additional compensation paid to or on behalf of employees, such as premiums for medical, dental, life, and disability insurance and contributions to pension plans. (349)

Employee earnings report Record of an employee’s net pay, gross pay, deductions, and year-to-date payroll information. (359)

Enterprise resource planning (ERP) software Programs that manage a company’s vital operations, which range from order taking to production to accounting.

Enterprise risk management (ERM) Systems and processes used to reduce risk to an organization. (535)

Entity Organization that, for accounting purposes, is separate from other organizations and individuals.

Environmental profit and loss (EP&L) account A report in monetary terms of the impact on human welfare from an entity’s activities. (750)

EOM Abbreviation for end of month; used to describe credit terms for credit transactions. (145)

Equity Owner’s claim on the assets of a business; equals the resid- ual interest in an entity’s assets after deducting liabilities; also called net assets or owner’s equity. (9)

Equity method Accounting method used for long-term investments when the investor has “significant influence” over the investee. (C-9)

Equity ratio Portion of total assets provided by equity, computed as total equity divided by total assets. (508)

Equity securities with controlling influence Long-term invest- ment when the investor is able to exert controlling influence over the investee; investors owning 50% or more of voting stock are presumed to exert controlling influence. (C-11)

Equity securities with significant influence Long-term investment when the investor is able to exert significant influence over the in- vestee; investors owning 20% or more (but less than 50%) of voting stock are presumed to exert significant influence. (C-9)

Equivalent units of production (EUP) Number of units that would be completed if all effort during a period had been applied to units that were started and finished. (614)

Estimated liability Obligation of an uncertain amount that can be reasonably estimated. (349)

Estimated line of cost behavior Line drawn on a graph to visually fit the relation between cost and sales. (701)

Ethics Codes of conduct by which actions are judged as right or wrong, fair or unfair, honest or dishonest. (6, 537)

Events Happenings that both affect an organization’s financial posi- tion and can be reliably measured. (11)

Expanded accounting equation Expanded version of: Assets = Liabilities + Equity. For a noncorporation: Equity = Owner’s capital − Owner’s withdrawals + Revenues − Expenses. [For a corporation: Equity = Contributed capital + Retained earnings + Revenues − Expenses − Dividends.] (10)

Expense recognition (or matching) principle Prescribes expenses to be reported in the same period as the revenues that were earned as a result of the expenses. (8, 87)

Expenses Outflows or using up of assets as part of operations of a business to generate sales. (10)

External transactions Exchanges of economic value between one entity and another entity. (11)

External users Persons using accounting information who are not directly involved in running the organization. (4)

Extraordinary repairs Major repairs that extend the useful life of a plant asset beyond prior expectations; treated as a capital expen- diture. (312)

Facility-level activities Activities that relate to overall production and cannot be traced to specific products; costs associated with these activities pertain to a plant’s general manufacturing process. (669)

Factory overhead Factory activities supporting the production pro- cess that are not direct materials or direct labor; also called overhead and manufacturing overhead. (542)

Factory overhead budget Report showing budgeted costs for factory overhead necessary to satisfy the estimated production for the period. (778)

G-8 Glossary

Factory overhead costs Expenditures for factory overhead that cannot be separately or readily traced to finished goods; also called overhead costs. (542)

Fair Value Adjustment An asset account used to adjust an asset’s cost to its fair (market) value; the account has a debit balance when fair value exceeds cost, or it has a credit balance (contra-asset) when fair value is less than cost. Fair value is the estimated price that an asset can be sold in an orderly transaction to a third party. (C-2)

Fair value option (FVO) Option to measure eligible items at fair value; eligible items include financial assets, such as HTM, AFS, and equity method investments, and financial liabilities. FVO is applied “instrument by instrument” and is elected when the eligible item is “first recognized”; once FVO is elected, the decision is “irrevocable.” When FVO is elected, it is measured at “fair value” and unrealized gains and losses are recognized in earnings.

Favorable variance Difference in actual revenues or expenses from the budgeted amount that contributes to a higher income. (822)

Federal depository bank Bank authorized to accept deposits of amounts payable to the federal government. (356)

Federal income taxes withheld Amount of tax that an employer is required to withhold from an employee’s paycheck; amount is deter- mined by the number of exemptions that an employee claims and the income that is paid. (360)

Federal Insurance Contributions Act (FICA) taxes Taxes assessed on both employers and employees; for Social Security and Medicare programs. (346)

Federal Unemployment Tax Act (FUTA) Payroll taxes on employ- ers assessed by the federal government to support its unemployment insurance program. (347)

FIFO (first-in, first-out) method Method to assign cost to inven- tory that assumes items are sold in the order acquired; earliest items purchased are the first sold. (614)

Finance lease Long-term lease where the lessee receives substan- tially all remaining benefits of the asset (one or more of five criteria must be met); a finance lease is similar to the financing of an asset purchase. (398)

Financial accounting Area of accounting aimed mainly at serving external users. (4)

Financial Accounting Standards Board (FASB) Independent group of full-time members responsible for setting accounting rules. (7)

Financial leverage Amount of debt that an entity uses to fund its assets; goal is to earn a higher return on equity by paying dividends on preferred stock or interest on debt at a rate lower than the return earned with the assets from issuing preferred stock or debt; also called trading on the equity. (428)

Financial reporting Process of communicating information relevant for making investment, credit, and business decisions. (498)

Financial statement analysis Application of analytical tools to financial statements and related data for making business decisions. (497)

Financial statements Includes the balance sheet, income statement, statement of owner’s (or stockholders’) equity, and statement of cash flows.

Financing activities Transactions with owners and creditors that include obtaining cash from issuing debt, repaying amounts bor- rowed, and obtaining cash from or distributing cash to owners. (457)

Finished Goods Inventory Account that controls the finished goods files, which acts as a subsidiary ledger (of the Inventory account) in which the costs of finished goods that are ready for sale are recorded. (543, 573)

First-in, first-out (FIFO) Method to assign cost to inventory that assumes items are sold in the order acquired; earliest items purchased are the first sold. (195, 210)

Fiscal year Consecutive 12-month (or 52-week) period chosen as the organization’s annual accounting period. (85)

Fixed budget Planning budget based on a single predicted amount of volume; unsuitable for evaluations if the actual volume differs from predicted volume; also called a static budget. (821)

Fixed budget performance report Report that compares actual revenues and costs with fixed budgeted amounts and identifies the differences as favorable or unfavorable variances. (822)

Fixed cost Cost that does not change in total with changes in the volume of activity. (539)

Fixed overhead cost deferred in inventory The portion of the fixed manufacturing overhead cost of a period that goes into inven- tory under the absorption costing method as a result of production exceeding sales. (746)

Fixed overhead cost recognized from inventory The portion of the fixed manufacturing overhead cost of a prior period that becomes an expense of the current period under the absorption costing method as a result of sales exceeding production. (746)

Flexibility principle Information system principle that prescribes an accounting system be able to adapt to changes in the company, business operations, and needs of decision makers.

Flexible budget Planning budget based on several predicted amounts of sales or other activity measure; also called a variable budget. (821)

Flexible budget performance report Report that compares actual revenues and costs with their variable budgeted amounts based on actual sales volume (or other level of activity) and identifies the differences as variances. (825)

FOB Abbreviation for free on board; the point when ownership of goods passes to the buyer; FOB shipping point (or factory) means the buyer pays shipping costs and accepts ownership of goods when the seller transfers goods to the carrier; FOB destination means the seller pays shipping costs and the buyer accepts ownership of goods at the buyer’s place of business. (148)

Foreign exchange rate Price of one currency stated in terms of another currency.

Form 10-K (or 10-KSB) Annual report form filed with the SEC by businesses (small businesses) with publicly traded securities.

Form 940 IRS form used to report an employer’s federal unemploy- ment taxes (FUTA) on an annual filing basis. (356)

Form 941 IRS form filed to report FICA taxes owed and remitted. (356)

Form W-2 Annual report by an employer to each employee showing the employee’s wages subject to FICA and federal income taxes along with amounts withheld. (357)

Form W-4 Withholding allowance certificate, filed with the employer, identifying the number of withholding allowances claimed. (360)

Glossary G-9

Franchises Privileges granted by a company or government to sell a product or service under specified conditions; also called licenses. (318)

Full costing Costing method that assigns both variable and fixed manufacturing costs to products; this method is required under U.S. GAAP; also called absorption costing.

Full disclosure principle Principle that prescribes financial state- ments (including notes) to report all relevant information about an entity’s operations and financial condition. (8)

GAAP (generally accepted accounting principles) Rules that specify acceptable accounting practices. (7)

General accounting system Accounting system for manufacturing activities based on the periodic inventory system.

General and administrative expense budget Plan that shows predicted operating expenses not included in the selling expenses or manufacturing budgets. (780)

General and administrative expenses Expenses that support the operating activities of a business. (156)

General journal All-purpose journal for recording the debits and credits of transactions and events. (51)

General ledger Record containing all accounts (with amounts) for a business; also called ledger. (45)

General partner Partner who assumes unlimited liability for the debts of the partnership; responsible for partnership management.

General partnership Partnership in which all partners have mutual agency and unlimited liability for partnership debts.

General-purpose financial statements Statements published peri- odically for use by a variety of interested parties; include the income statement, balance sheet, statement of owner’s equity (or statement of retained earnings for a corporation), statement of cash flows, and notes to these statements. (498)

Generally accepted accounting principles (GAAP) Rules that specify acceptable accounting practices. (7)

Generally accepted auditing standards (GAAS) Rules that spec- ify acceptable auditing practices.

Going-concern assumption Principle that prescribes financial statements to reflect the assumption that the business will continue operating. (8)

Goodwill Amount by which a company’s (or a segment’s) value exceeds the value of its individual assets less its liabilities. (318)

Gross margin Net sales minus cost of goods sold; also called gross profit. (144)

Gross margin ratio Gross margin (net sales minus cost of goods sold) divided by net sales; also called gross profit ratio. (159)

Gross method Method of recording purchases at the full invoice price without deducting any cash discounts. (147, 168)

Gross pay Total compensation earned by an employee. (346)

Gross profit Net sales minus cost of goods sold; also called gross margin. (144)

Gross profit method Procedure to estimate inventory by using the past gross profit rate to estimate cost of goods sold, which is then subtracted from the cost of goods available for sale. (215)

Held-to-maturity (HTM) securities Debt securities that a company has the intent and ability to hold until they mature. (C-4)

High-low method Procedure that yields an estimated line of cost behavior by using the costs associated with the highest and lowest sales volume. (702)

Horizontal analysis Comparison of a company’s financial condi- tion and performance across time. (498)

Hurdle rate Minimum acceptable rate of return (set by manage- ment) for an investment. (952)

Hybrid costing system A costing system that contains features of both process and job order costing systems; also called operation costing system. (627)

Impairment Permanent diminishment of an asset’s value. (310, 317)

Imprest system Method to account for petty cash; maintains a constant balance in the fund, which equals cash plus petty cash receipts.

Inadequacy Condition in which the capacity of plant assets is too small to meet the company’s production demands. (306)

Income Amount earned after subtracting all expenses necessary for and matched with sales for a period; also called net income, profit, or earnings.

Income statement Financial statement that subtracts expenses from revenues to yield a net income or loss over a specified period of time; also includes any gains or losses. (15)

Income Summary Temporary account used only in the closing pro- cess to which the balances of revenue and expense accounts (includ- ing any gains or losses) are transferred; its balance is transferred to the capital account (or retained earnings for a corporation). (101)

Incremental cost Additional cost incurred only if a company pursues a specific course of action. (914)

Incremental revenue Additional revenue generated by taking one course of action over another. (914)

Indefinite life Asset life that is not limited by legal, regulatory, contractual, competitive, economic, or other factors. (317)

Indirect costs Costs incurred for the benefit of more than one cost object. (539)

Indirect expenses Expenses incurred for the joint benefit of more than one department (or cost object). (873)

Indirect labor Work of production employees who do not work specifically on converting direct materials into finished products and who are not clearly identified with specific units or batches of product. (542)

Indirect labor costs Labor costs that cannot be physically traced to production of a product or service; included as part of overhead. (542)

Indirect materials Materials used to support the production process but not clearly identified with products or batches of product. (542)

Indirect method Presentation that reports net income and then adjusts it by adding and subtracting items to yield net cash from operating activities on the statement of cash flows. (457)

Information processor Component of an accounting system that interprets, transforms, and summarizes information for use in analysis and reporting.

G-10 Glossary

Information storage Component of an accounting system that keeps data in a form accessible to information processors.

Infrequent gain or loss Gain or loss not expected to recur given the operating environment of the business.

Input device Means of capturing information from source docu- ments that enables its transfer to information processors.

Installment note Liability requiring a series of periodic payments to the lender. (390)

Institute of Management Accountants (IMA) A professional association of management accountants. (537)

Intangible assets Long-term assets (resources) used to produce or sell products or services; usually lack physical form and have uncertain benefits. (107, 317)

Integrated reporting A short report that shows how an organization’s strategy, governance, and performance relate to value creation. (838)

Interest Charge for using money (or other assets) loaned from one entity to another. (282)

Interim financial statements Financial statements covering peri- ods of less than one year; usually based on one-, three-, or six-month periods. (85, 214)

Interim statements Financial statements covering periods of less than one year; usually based on one-, three-, or six-month periods; also called interim financial statements. (85, 214)

Internal controls or internal control system All policies and proce- dures used to protect assets, ensure reliable accounting, promote effi- cient operations, and urge adherence to company policies. (6, 235, 537)

Internal rate of return (IRR) Rate used to evaluate the acceptabil- ity of an investment; equals the rate that yields a net present value of zero for an investment. (956)

Internal transactions Activities within an organization that can affect the accounting equation. (11)

Internal users Persons using accounting information who are directly involved in managing the organization. (4)

International Accounting Standards Board (IASB) Group that identifies preferred accounting practices and encourages global acceptance; issues International Financial Reporting Standards (IFRS). (7)

International Financial Reporting Standards (IFRS) Set of inter- national accounting standards explaining how types of transactions and events are reported in financial statements; IFRS are issued by the International Accounting Standards Board. (7)

International Integrated Reporting Council A global coalition that is establishing integrated reporting guidelines. (838)

Inventory Goods a company owns and expects to produce and/or sell in its normal operations. (144)

Inventory Returns Estimated Current asset account reporting the inventory estimated to be returned; this account has a normal debit balance. (166)

Inventory turnover Number of times a company’s average inven- tory is sold during a period; computed by dividing cost of goods sold by average inventory; also called merchandise turnover. (203)

Investing activities Transactions that involve purchasing and selling long-term assets; includes making and collecting notes receivable and investments in other than cash equivalents. (454)

Investment center Center of which a manager is responsible for revenues, costs, and asset investments. (869)

Investment turnover The efficiency with which a company gener- ates sales from its available assets; computed as sales divided by average invested assets. (880)

Invoice Itemized record of goods prepared by the vendor that lists the customer’s name, items sold, sales prices, and terms of sale. (252)

Invoice approval Document containing a checklist of steps neces- sary for approving the recording and payment of an invoice; also called check authorization. (253)

ISO 9000 standards International standards for quality manage- ment and quality assurance. (550)

Job Production of a customized product or service. (571)

Job cost sheet Separate record maintained for each job. (573)

Job lot Production of more than one unit of a customized product or service. (571)

Job order costing system Cost accounting system to determine the cost of producing each job or job lot. (573, 613)

Job order production Production of special-order products; also called customized production. (571)

Joint cost Cost incurred to produce or purchase two or more prod- ucts at the same time. (890)

Journal Record in which transactions are entered before they are posted to ledger accounts; also called book of original entry. (51)

Journalizing Process of recording transactions in a journal. (51)

Just-in-time (JIT) manufacturing Process of acquiring or produc- ing inventory only when needed. (550)

Known liabilities Obligations of a company with little uncertainty; set by agreements, contracts, or laws; also called definitely determin- able liabilities. (342)

Land improvements Assets that increase the benefits of land, have a limited useful life, and are depreciated. (304)

Large stock dividend Stock dividend that is more than 25% of the previously outstanding shares. (423)

Last-in, first-out (LIFO) Method for assigning cost to inventory that assumes costs for the most recent items purchased are sold first and charged to cost of goods sold. (195, 211)

Lean accounting System designed to eliminate waste in the accounting process and better reflect the benefits of lean manufac- turing techniques. (671)

Lean business model Practice of eliminating waste while meeting customer needs and yielding positive company returns. (550, D-2)

Lease Contract specifying the rental of property. (318, 398)

Leasehold Rights the lessor grants to the lessee under the terms of a lease. (318)

Leasehold improvements Alterations or improvements to leased property such as partitions and storefronts. (318)

Least-squares regression Statistical method for deriving an esti- mated line of cost behavior that is more precise than the high-low method and the scatter diagram. (702)

Glossary G-11

Ledger Record containing all accounts (with amounts) for a business; also called general ledger. (45)

Lessee Party to a lease who secures the right to possess and use the property from another party (the lessor). (318)

Lessor Party to a lease who grants another party (the lessee) the right to possess and use its property. (318)

Liabilities Creditors’ claims on an organization’s assets; involves a probable future payment of assets, products, or services that a company is obligated to make due to past transactions or events. (9)

Licenses Privileges granted by a company or government to sell a prod- uct or service under specified conditions; also called franchises. (318)

Limited liability Owner can lose no more than the amount invested.

Limited liability company (LLC) Organization form that combines select features of a corporation and a limited partnership; provides limited liability to its members (owners), is free of business tax, and allows members to actively participate in management. (8)

Limited liability partnership (LLP) Partnership in which a part- ner is not personally liable for malpractice or negligence unless that partner is responsible for providing the service that resulted in the claim.

Limited life Length of time an asset will be productively used in the operations of a business; also called service life or useful life. (317)

Limited partners Partners who have no personal liability for partner- ship debts beyond the amounts they invested in the partnership.

Limited partnership Partnership that has two classes of partners, limited partners and general partners.

Liquid assets Resources such as cash that are easily converted into other assets or used to pay for goods, services, or liabilities. (238)

Liquidating cash dividend Distribution of assets that returns part of the original investment to stockholders; deducted from contrib- uted capital accounts. (423)

Liquidation Process of going out of business; involves selling assets, paying liabilities, and distributing the remainder to owners.

Liquidity Availability of resources to meet short-term cash requirements. (238, 497)

List price Catalog (full) price of an item before any trade discount is deducted. (145)

Long-term investments Long-term assets not used in operating activities such as notes receivable and investments in stocks and bonds. (106, C-1)

Long-term liabilities Obligations not due to be paid within one year or the operating cycle, whichever is longer. (107, 342)

Lower of cost or market (LCM) Required method to report inven- tory at market replacement cost when that market cost is lower than recorded cost. (200)

Maker of the note Entity who signs a note and promises to pay it at maturity. (282)

Management by exception Management process that focuses on significant variances and gives less attention to areas where perfor- mance is close to the standard. (827)

Managerial accounting Area of accounting aimed mainly at serv- ing the decision-making needs of internal users; also called manage- ment accounting. (4, 535)

Manufacturer Company that uses labor and operating assets to convert raw materials to finished goods.

Manufacturing budget Plan that shows the predicted costs for direct materials, direct labor, and overhead to be incurred in manu- facturing units in the production budget.

Manufacturing margin Sales minus variable production costs. (742)

Margin of safety Excess of expected sales over the level of break-even sales. (707)

Marginal costing Costing method that includes only variable man- ufacturing costs (direct materials, direct labor, and variable manufac- turing overhead) in unit product costs; also called direct or variable costing.

Market-based transfer price A transfer pricing system based on the market price of the goods or services being transferred across divisions within the same company. (890)

Market prospects Expectations (both good and bad) about a com- pany’s future performance as assessed by users and other interested parties. (497)

Market rate Interest rate that borrowers are willing to pay and lend- ers are willing to accept for a specific lending agreement given the borrowers’ risk level. (383)

Market value per share Price at which stock is bought or sold. (419)

Markup Amount added to cost per unit in computing a selling price. (921)

Master budget Comprehensive business plan that includes specific plans for expected sales, product units to be produced, merchandise (or materials) to be purchased, expenses to be incurred, plant assets to be purchased, and amounts of cash to be borrowed or loans to be re- paid, as well as a budgeted income statement and balance sheet. (773)

Matching (or expense recognition) principle Prescribes expenses to be reported in the same period as the revenues that were earned as a result of the expenses. (8)

Materiality constraint Prescribes that an entity account for items that significantly impact financial statements.

Materials consumption report Document that summarizes the materi- als a department uses during a reporting period; replaces materials requisitions when materials move continuously through a process. (626)

Materials ledger card Perpetual record updated each time materials are purchased or issued for production use. (574)

Materials markup A percentage of materials cost that includes materials-related overhead costs and a profit margin. Used in time and materials pricing. (925)

Materials requisition Source document production managers use to request materials for production; used to assign materials costs to specific jobs or overhead. (575)

Maturity date of a note Date when a note’s final principal payment is due. (282)

Measurement principle Principle that prescribes financial statement information, and its underlying transactions and events, be based on relevant measures of valuation; also called the cost principle. (7)

Members Owners of a limited liability company (LLC); rights and responsibilities are specified in the operating agreement and by state LLC regulations. (8)

G-12 Glossary

Merchandise Goods that a company owns and expects to sell to customers; also called merchandise inventory or inventory. (143)

Merchandise inventory Goods that a company owns and expects to sell to customers; also called merchandise or inventory. (144)

Merchandise purchases budget Plan that shows the units or costs of merchandise to be purchased by a merchandising company during the budget period. (795)

Merchandiser Entity that earns income by buying and selling merchandise. (143)

Merit rating Rating assigned to an employer by a state based on the employer’s record of employment. (348)

Minimum legal capital Amount of assets defined by law that stock- holders must (potentially) invest in a corporation; usually defined as par value of the stock; intended to protect creditors. (419)

Mixed cost Cost that includes both fixed and variable costs. (698)

Modified Accelerated Cost Recovery System (MACRS) Depreciation system required by federal income tax law. (309)

Monetary unit assumption Principle that assumes transactions and events can be expressed in money units. (8)

Mortgage Legal loan agreement that protects a lender by giving the lender the right to be paid from the cash proceeds from the sale of a borrower’s assets identified in the mortgage. (391)

Multinational Company that operates in several countries.

Multiple-step income statement Income statement format that shows subtotals between sales and net income, categorizes expenses, and often reports the details of net sales and expenses. (156)

Mutual agency Legal relationship among partners whereby each partner is an agent of the partnership and is able to bind the partner- ship to contracts within the scope of the partnership’s business.

Natural business year Twelve-month period that ends when a company’s sales activities are at their lowest point. (86)

Natural resources Assets physically consumed when used; exam- ples are timber, mineral deposits, and oil and gas fields; also called wasting assets. (315)

Negotiated transfer price A system where division managers negotiate to determine the price to use to record transfers of goods or services across divisions within the same company. (890)

Net assets Owner’s claim on the assets of a business; equals the residual interest in an entity’s assets after deducting liabilities; also called equity or owner’s equity.

Net income Amount earned after subtracting all expenses necessary for and matched with sales for a period; also called income, profit, or earnings. (15)

Net loss Excess of expenses over revenues for a period. (15)

Net method Method of recording purchases at the full invoice price less any cash discounts. (151, 168)

Net pay Gross pay less all deductions; also called take-home pay. (346)

Net present value (NPV) Dollar estimate of an asset’s value that is used to evaluate the acceptability of an investment; computed by discounting future cash flows from the investment at the hurdle rate and then subtracting the initial cost of the investment. (952)

Net realizable value Expected selling price (value) of an item minus the cost of making the sale. (192)

Noncumulative preferred stock Preferred stock on which the right to receive dividends is lost for any period when dividends are not declared. (427)

Noninterest-bearing note Note with no stated (contract) rate of interest; interest is implicitly included in the note’s face value.

Nonparticipating preferred stock Preferred stock on which dividends are limited to a maximum amount each year. (427)

Nonsufficient funds (NSF) check Maker’s bank account has insuf- ficient money to pay the check; also called bounced check or hot check.

Non-value-added time The portion of cycle time that is not directed at producing a product or service; equals the sum of inspection time, move time, and wait time. (D-4)

No-par value stock Stock class that has not been assigned a par (or stated) value by the corporate charter. (419)

Note Written promise to pay a specified amount either on demand or at a definite future date; is a note receivable for the lender but a note payable for the lendee; also called promissory note.

Note payable Liability expressed by a written promise to pay a definite sum of money on demand or on a specific future date(s).

Note receivable Asset consisting of a written promise to receive a definite sum of money on demand or on a specific future date(s).

Objectivity Concept that prescribes independent, unbiased evidence to support financial statement information.

Obsolescence Condition in which, because of new inventions and improvements, a plant asset can no longer be used to produce goods or services with a competitive advantage. (306)

Off-balance-sheet financing Acquisition of assets by agreeing to liabilities not reported on the balance sheet.

Online processing Approach to inputting data from source documents as soon as the information is available.

Operating activities Activities that involve the production or pur- chase of merchandise and the sale of goods or services to customers, including expenditures related to administering the business. (454)

Operating cycle Normal time between paying cash for merchandise or employee services and receiving cash from customers. (106)

Operating lease Short-term (or cancelable) lease in which the lessor retains risks and rewards of ownership. (399)

Operating leverage Extent, or relative size, of fixed costs in the total cost structure. (714)

Operation costing system A costing system that contains features of both process and job order costing systems; also called hybrid costing system. (627)

Opportunity cost Potential benefit lost by choosing a specific action from two or more alternatives.

Ordinary repairs Repairs to keep a plant asset in normal, good operating condition; treated as a revenue expenditure and immedi- ately expensed. (312)

Organization expenses (costs) Costs such as legal fees and promoter fees to bring an entity into existence. (418)

Glossary G-13

Other comprehensive income Net change in equity for a period, excluding owner investments and distributions; also called comprehensive income. (C-12)

Out-of-pocket cost Cost incurred or avoided as a result of manage- ment’s decisions. (914)

Output devices Means by which information is taken out of the accounting system and made available for use.

Outsourcing Manager decision to buy a product or service from another entity; part of a make or buy decision; also called make or buy. (915)

Outstanding checks Checks written and recorded by the depositor but not yet paid by the bank at the bank statement date. (247)

Outstanding stock Corporation’s stock held by its shareholders.

Overapplied overhead Amount by which the overhead applied to production in a period using the predetermined overhead rate exceeds the actual overhead cost incurred in a period. (585)

Overhead cost variance Difference between the total overhead cost applied to products and the total overhead cost actually incurred. (835)

Owner, Capital Account showing the owner’s (sole proprietor or partner) claim on company assets; equals owner investments plus net income (or less net losses) minus owner withdrawals since the company’s inception; also referred to as equity.

Owner, Withdrawals Account used to record asset distributions to the owner (sole proprietor or partner); also called withdrawals.

Owner investments Assets put into the business by the owner. (10)

Owner withdrawals Resources such as cash that an owner (sole proprietor or partner) takes from the company for personal use.

Owner’s equity Owner’s claim on the assets of a business; equals the residual interest in an entity’s assets after deducting liabilities; also called equity or net assets.

Paid-in capital Total amount of cash and other assets received from stockholders in exchange for stock; also called contributed capital. (420)

Paid-in capital in excess of par value Amount received from issu- ance of stock that is in excess of the stock’s par value. (420)

Par value Value assigned a share of stock by the corporate charter when the stock is authorized. (419)

Par value of a bond Amount the bond issuer agrees to pay at maturity and the amount on which cash interest payments are based; also called face amount or face value of a bond. (381)

Par value stock Class of stock assigned a par value by the corporate charter. (419)

Parent Company that owns a controlling interest in a corporation (requires more than 50% of voting stock). (C-12)

Participating preferred stock Preferred stock that shares with common stockholders any dividends paid in excess of the percent stated on preferred stock. (427)

Partner return on equity Partner net income divided by average partner equity for the period.

Partnership Unincorporated association of two or more persons to pursue a business for profit as co-owners. (8)

Partnership contract Agreement among partners that sets terms under which the affairs of the partnership are conducted; also called articles of partnership.

Partnership liquidation Dissolution of a partnership by (1) selling noncash assets and allocating any gain or loss according to partners’ income-and-loss ratio, (2) paying liabilities, and (3) distributing any remaining cash according to partners’ capital balances.

Patent Exclusive right granted to its owner to produce and sell an item or to use a process for 20 years. (317)

Payback period (PBP) Time-based measurement used to evaluate the acceptability of an investment; equals the time expected to pass before an investment’s net cash flows equal its initial cost. (948)

Payee of the note Entity to whom a note is made payable. (282)

Payroll bank account Bank account used solely for paying employ- ees; each pay period, an amount equal to the total employees’ net pay is deposited in it and the payroll checks are drawn on it. (360)

Payroll deductions Amounts withheld from an employee’s gross pay; also called withholdings. (346)

Payroll register Record for a pay period that shows the pay period dates, regular and overtime hours worked, gross pay, net pay, and deductions. (358)

Pension plan Contractual agreement between an employer and its employees for the employer to provide benefits to employees after they retire; expensed when incurred. (400)

Period costs Expenditures identified more with a time period than with finished product costs; include selling and general administra- tive expenses. (540)

Periodic inventory system Method that records the cost of inven- tory purchased but does not continuously track the quantity available or sold to customers; records are updated at the end of each period to reflect the physical count and costs of goods available. (144)

Permanent accounts Accounts that reflect activities related to one or more future periods; balance sheet accounts whose balances are not closed. (101)

Perpetual inventory system Method that maintains continuous records of the cost of inventory available and the cost of goods sold. (144)

Petty cash Small amount of cash in a fund to pay minor expenses; accounted for using an imprest system. (242)

Planning Process of setting goals and preparing to achieve them. (535)

Plant asset age Plant asset age is an approximation of the age of plant assets, which is estimated by dividing accumulated deprecia- tion by depreciation expense.

Plant asset useful life Ratio that estimates the productive life of an asset; equals the plant asset cost divided by depreciation expense.

Plant assets Tangible long-lived assets used to produce or sell products and services; also called property, plant and equipment (PP&E) or fixed assets. (89, 303)

Pledged assets to secured liabilities Ratio of the book value of a company’s pledged assets to the book value of its secured liabilities.

Post-closing trial balance List of permanent accounts and their balances from the ledger after all closing entries are journalized and posted. (104)

Postaudit An evaluation of a project’s actual results versus its projected results. (958)

Posting Process of transferring journal entry information to the ledger; computerized systems automate this process. (51)

G-14 Glossary

Posting reference (PR) column A column in journals in which individual ledger account numbers are entered when entries are posted to those ledger accounts. (51)

Predetermined overhead rate Rate established prior to the begin- ning of a period that divides estimated overhead cost by an estimated activity base, such as estimated direct labor; used to apply overhead cost to production. (579)

Preemptive right Stockholders’ right to maintain their propor- tionate interest in a corporation with any additional shares issued. (418)

Preferred stock Stock with a priority status over common stock- holders in one or more ways, such as paying dividends or distributing assets. (426)

Premium on bonds Difference between a bond’s par value and its higher carrying value; occurs when the contract rate is higher than the market rate; also called bond premium. (386)

Premium on stock Difference between the par value of stock and its issue price when issued at a price above par; also called contributed capital in excess of par value. (420)

Prepaid expenses Items paid for in advance of receiving their benefits; classified as assets. (87)

Price-earnings (PE) ratio Ratio of a company’s current market value per share to its earnings per share; also called price-to- earnings. (432)

Price-setter Entity with more control to set prices due to its unique prices and brands. (921)

Price-taker Entity with no control to set prices. (921)

Price variance Difference between actual and budgeted revenue or cost caused by the difference between the actual price per unit and the budgeted price per unit. (830)

Prime costs Expenditures directly identified with the production of fin- ished goods; include direct materials costs and direct labor costs. (543)

Principal of a note Amount that the signer of a note agrees to pay back when it matures, not including interest. (282)

Principles of internal control Principles prescribing management to establish responsibility, maintain records, insure assets, separate recordkeeping from custody of assets, divide responsibility for related transactions, apply technological controls, and perform reviews. (236)

Prior period adjustment Correction of an error in a prior year that is reported in the statement of retained earnings (or statement of stockholders’ equity) net of any income tax effects. (431)

Pro forma financial statements Statements that show the effects of proposed transactions and events as if they had occurred. (115)

Process cost summary Report of costs charged to a department, its equivalent units of production achieved, and the costs assigned to its output. (619)

Process costing system System of assigning direct materials, direct labor, and overhead to specific processes; total costs associated with each process are then divided by the number of units passing through that process to determine the cost per equivalent unit. (613)

Process operations Processing of products in a continuous (sequential) flow of steps; also called process manufacturing or process production. (572, 611)

Product costs Costs that are capitalized as inventory because they produce benefits expected to have future value; include direct materials, direct labor, and overhead. (540)

Product-level activities Activities that relate to specific products that must be carried out regardless of how many units are produced and sold or batches run. (669)

Production budget Plan that shows the units to be produced each period. (775)

Profit Amount earned after subtracting all expenses necessary for and matched with sales for a period; also called net income, income, or earnings.

Profit center Business unit that incurs costs and generates revenues. (869)

Profit margin Ratio of a company’s net income to its net sales; the percent of income in each dollar of revenue; also called net profit margin. (108, 880, C-13)

Profitability Company’s ability to generate an adequate return on invested capital. (497)

Profitability index Relation between the expected benefits of a proj- ect and its investment, computed as the present value of expected future cash flows from the investment divided by the cost of the investment; a higher value (above 1) indicates a more desirable invest- ment, and a value below 1 indicates an unacceptable project. (955)

Promissory note (or note) Written promise to pay a specified amount either on demand or at a definite future date; it is a note receivable for the lender but a note payable for the lendee. (281)

Proprietorship Business owned by one person that is not organized as a corporation; also called sole proprietorship. (8)

Proxy Legal document giving a stockholder’s agent the power to exercise the stockholder’s voting rights. (418)

Pull production A production system that begins with a customer order. Goods are pulled in a just-in-time method and delivered directly to customers upon completion. (D-3)

Purchase order Document used by the purchasing department to place an order with a seller (vendor). (252)

Purchase requisition Document listing merchandise needed by a department and requesting it be purchased. (252)

Purchases discount Term used by a purchaser to describe a cash discount granted to the purchaser for paying within the discount period. (146)

Purchases journal Journal normally used to record all purchases on credit.

Push production A production system that begins with a sales forecast. Goods are produced and pushed into Finished Goods Inventory. (D-3)

Quantity variance Difference between actual and budgeted revenue or cost caused by the difference between the actual number of units and the budgeted number of units. (830)

Ratio analysis Determination of key relations between financial statement items as reflected in numerical measures. (498)

Raw materials inventory Goods a company acquires to use in making products. (543)

Raw materials inventory turnover Measure of how many times a company turns over (uses in production) its raw materials inventory during a period; defined as raw materials used divided by average raw materials inventory. (552)

Glossary G-15

Realizable value Expected proceeds from converting an asset into cash. (276)

Receiving report Form used to report that ordered goods were received and to describe their quantity and condition. (253, 574)

Recordkeeping Part of accounting that involves recording transac- tions and events, either manually or electronically; also called bookkeeping. (3)

Registered bonds Bonds owned by investors whose names and addresses are recorded by the issuer; interest payments are made to the registered owners. (392)

Relevance principle Information system principle prescribing that its reports be useful, understandable, timely, and pertinent for decision making.

Relevant benefits Additional or incremental revenue generated by selecting a particular course of action over another.

Relevant range of operations Company’s normal operating range; excludes extremely high and low volumes not likely to occur. (698)

Report form balance sheet Balance sheet that lists accounts vertically in the order of assets, liabilities, and equity.

Research and development costs Research expenditures are those incurred in gaining new knowledge, and development expenditures are the application of knowledge before commercial production or use; examples of research costs are tests of new vaccines or any other scientific or technical knowledge, and examples of development costs are plans or designs for improved materials, devices, processes, or services. (319)

Residual income The net income an investment center earns above a target return on average invested assets. (878)

Responsibility accounting System that provides information that management can use to evaluate the performance of a department’s manager. (869)

Responsibility accounting budget Report of expected costs and expenses under a manager’s control.

Responsibility accounting performance report Report that com- pares actual costs and expenses for a department with budgeted amounts. (870)

Restricted retained earnings Retained earnings not available for dividends because of legal or contractual limitations. (431)

Retail inventory method Method for estimating ending inventory based on the ratio of the amount of goods for sale at cost to the amount of goods for sale at retail. (214)

Retailer Intermediary that buys products from manufacturers or wholesalers and sells them to consumers. (143)

Retained earnings Cumulative income less cumulative losses and dividends. (10, 420)

Retained earnings deficit Debit (abnormal) balance in Retained Earnings; occurs when cumulative losses and dividends exceed cumulative income; also called accumulated deficit. (423)

Return Monies received from an investment; often in percent form. (21)

Return on assets (ROA) Ratio reflecting operating efficiency; defined as net income divided by average total assets for the period; also called return on total assets or return on investment. (18)

Return on equity Ratio of net income to average equity for the period.

Return on investment (ROI) Ratio reflecting operating efficiency; defined as net income divided by average total assets for the period; also called return on assets or return on total assets. (878)

Return on total assets Ratio reflecting operating efficiency; defined as net income divided by average total assets for the period; also called return on assets or return on investment. (C-13)

Revenue expenditures Expenditures reported on the current income statement as an expense because they do not provide benefits in future periods. (311)

Revenue recognition principle The principle prescribing that reve- nue is recognized when goods or services are delivered to customers. (7, 87)

Revenues Gross increase in equity from a company’s business activities that earn income; also called sales. (10)

Reverse stock split Occurs when a corporation calls in its stock and replaces each share with less than one new share; increases both market value per share and any par or stated value per share. (425)

Reversing entries Optional entries recorded at the beginning of a period that prepare the accounts for the usual journal entries as if adjusting entries had not occurred in the prior period. (115)

Risk Uncertainty about an expected return. (21)

Rolling budget New set of budgets a firm adds for the next period (with revisions) to replace the ones that have lapsed. (773)

S corporation Corporation that meets special tax qualifications to be treated like a partnership for income tax purposes.

Safety stock Quantity of inventory or materials over the minimum needed to satisfy budgeted demand. (775)

Sales Gross increase in equity from a company’s business activities that earn income; also called revenues.

Sales budget Plan showing the units of goods to be sold or services to be provided; the starting point in the budgeting process for most departments. (775)

Sales discount Term used by a seller to describe a cash discount granted to buyers who pay within the discount period. (146)

Sales journal Journal normally used to record sales of goods on credit.

Sales mix Ratio of sales volumes for the various products sold by a company. (711)

Sales Refund Payable A current liability account reflecting the amount of sales expected to be refunded to customers. (166)

Sales Returns and Allowances Refunds or credits given to custom- ers for unsatisfactory merchandise are recorded (debited) in Sales Returns and Allowances, a contra account to Sales. In addition, esti- mates of future sales returns and allowances (related to current- period sales) are made with an adjusting entry that debits Sales Returns and Allowances; this results in sales being recorded net of expected returns and allowances. Sales Returns and Allowances is a temporary account that is closed each period. (151)

Salvage value Estimate of amount to be recovered at the end of an asset’s useful life; also called residual value or scrap value. (305)

Sarbanes-Oxley Act (SOX) Legislation that created the Public Company Accounting Oversight Board, regulates analyst conflicts, imposes corporate governance requirements, enhances accounting and control disclosures, impacts insider transactions and executive loans, establishes new types of criminal conduct, and expands penal- ties for violations of federal securities laws. (6, 235, 538)

G-16 Glossary

Scatter diagram Graph used to display data about past cost behavior and sales as points on a diagram. (701)

Schedule of accounts payable List of the balances of all accounts in the accounts payable ledger and their totals.

Schedule of accounts receivable List of the balances of all accounts in the accounts receivable ledger and their totals.

Schedule of cost of goods manufactured Report that summarizes the types and amounts of costs incurred in a company’s production process for a period; also called manufacturing statement or cost of goods manufactured statement. (547)

Section 404 (of SOX) Section 404 of SOX requires management and the external auditor to report on the adequacy of the company’s internal control on financial reporting, which is the most costly aspect of SOX for companies to implement as documenting and testing important fi- nancial manual and automated controls require enormous efforts. Section 404 also requires management to produce an “internal control report” as part of each annual SEC report that affirms “the responsibil- ity of management for establishing and maintaining an adequate inter- nal control structure and procedures for financial reporting.”

Secured bonds Bonds that have specific assets of the issuer pledged as collateral. (392)

Securities and Exchange Commission (SEC) Federal agency Congress has charged to set reporting rules for organizations that sell ownership shares to the public. (7)

Segment return on assets Segment operating income divided by segment average (identifiable) assets for the period.

Selling expense budget Plan that lists the types and amounts of selling expenses expected in the budget period. (779)

Selling expenses Expenses of promoting sales, such as displaying and advertising merchandise, making sales, and delivering goods to customers. (156)

Serial bonds Bonds consisting of separate amounts that mature at different dates. (392)

Service company Organization that provides services instead of tangible products.

Service life Length of time an asset will be productively used in the operations of a business; also called limited life or useful life.

Services in Process Inventory Account that records the cost of partially completed services. (586)

Services Overhead Account that records the overhead costs of providing services. (586)

Setup time The amount of time to prepare a process for production. (D-4)

Shareholders Owners of a corporation; also called stockholders. (8)

Shares Equity of a corporation divided into ownership units; also called stock. (8)

Short-term investments Debt and equity securities that manage- ment expects to convert to cash within the next 3 to 12 months (or the operating cycle if longer); also called temporary investments or marketable securities. (C-1)

Short-term lease Lease with a term of 12 months or less that does not have a long-term purchase option; the lessee records such lease payments as expenses. (400)

Short-term note payable Current obligation in the form of a written promissory note. (343)

Shrinkage Inventory losses that occur as a result of theft or deterioration. (153)

Signature card Includes the signature of each person authorized to sign checks on the bank account. (245)

Simple capital structure Capital structure that consists of only common stock and nonconvertible preferred stock; consists of no dilutive securities.

Single-step income statement Income statement format that subtracts total expenses, including cost of goods sold, from total revenues with no other subtotals. (157)

Sinking fund bonds Bonds that require the issuer to make deposits to a separate account; bondholders are repaid at maturity from that account. (392)

Small stock dividend Stock dividend that is 25% or less of a corporation’s previously outstanding shares. (423)

Social responsibility Being accountable for the impact that one’s actions might have on society.

Sole proprietorship Business owned by one person that is not organized as a corporation; also called proprietorship. (8)

Solvency Company’s long-run financial viability and its ability to cover long-term obligations. (497)

Source documents Source of information for accounting entries that can be in either paper or electronic form; also called business papers. (45)

Special journal Any journal used for recording and posting transac- tions of a similar type.

Specific identification (SI) Method for assigning cost to inventory when the purchase cost of each item in inventory is identified and used to compute cost of goods sold and/or cost of inventory. (194, 210)

Spending variance Difference between the actual price of an item and its standard price. (844)

Spreadsheet Computer program that organizes data by means of formulas and format; also called electronic work sheet.

Standard costing income statement Income statement that reports sales and cost of goods sold at their standard amounts and then lists the individual sales and cost variances to compute gross profit at actual cost. (847)

Standard costs Costs that should be incurred under normal condi- tions to produce a product or component or to perform a service. (827)

State Unemployment Tax Act (SUTA) State payroll taxes on employers to support its unemployment programs. (347)

Stated value stock No-par stock assigned a stated value per share; this amount is recorded in the stock account when the stock is issued. (419)

Statement of cash flows A financial statement that lists cash inflows (receipts) and cash outflows (payments) during a period; arranged by operating, investing, and financing. (15, 453)

Statement of owner’s equity Report of changes in equity over a period; adjusted for increases (owner investment and net income) and for decreases (withdrawals and net loss).

Statement of partners’ equity Financial statement that shows total capital balances at the beginning of the period, any additional invest- ment by partners, the income or loss of the period, the partners’ withdrawals, and the partners’ ending capital balances; also called statement of partners’ capital.

Glossary G-17

Statement of retained earnings Report of changes in retained earn- ings over a period; adjusted for increases (net income), for decreases (dividends and net loss), and for any prior period adjustment. (15)

Statement of stockholders’ equity Financial statement that lists the beginning and ending balances of each major equity account and describes all changes in those accounts. (432)

Statements of Financial Accounting Standards (SFAS) FASB publications that establish U.S. GAAP.

Step-wise cost Cost that remains fixed over limited ranges of volumes but changes by a lump sum when volume changes occur outside these limited ranges. (699)

Stock Equity of a corporation divided into ownership units; also called shares. (8)

Stock dividend Corporation’s distribution of its own stock to its stockholders without the receipt of any payment. (423)

Stock options Rights to purchase common stock at a fixed price over a specified period of time.

Stock split Occurs when a corporation calls in its stock and replaces each share with more than one new share; decreases both the market value per share and any par or stated value per share. (425)

Stock subscription Investor’s contractual commitment to purchase unissued shares at future dates and prices.

Stockholders Owners of a corporation; also called shareholders. (8)

Stockholders’ equity A corporation’s equity; also called share- holders’ equity or corporate capital. (419)

Straight-line bond amortization Method allocating an equal amount of bond interest expense to each period of the bond life. (385)

Straight-line depreciation Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each accounting period in its useful life. (89, 306)

Subsidiary Entity controlled by another entity (parent) in which the parent owns more than 50% of the subsidiary’s voting stock. (C-12)

Subsidiary ledger List of individual subaccounts and amounts with a common characteristic; linked to a controlling account in the general ledger.

Sunk cost Cost already incurred that cannot be avoided or changed.

Supplementary records Information outside the usual accounting records; also called supplemental records. (149)

Supply chain Linkages of services or goods extending from suppli- ers, to the company itself, and on to customers.

Supply chain management The coordination and control of goods, services, and information as they move from suppliers to consumers. (672, D-5)

Sustainability The ability of an item or activity to continue end- lessly; for a business, it usually refers to that company’s environmen- tal, social, and governance aspects.

Sustainability Accounting Standards Board (SASB) A nonprofit entity engaged in creating and disseminating sustainability account- ing standards for use by companies. (551)

T-account Tool used to show the effects of transactions and events on individual accounts; shaped in the form of a T. (49)

Target cost Maximum allowable cost for a product or service; defined as expected selling price less the desired profit. (573)

Temporary accounts Accounts used to record revenues, expenses, and withdrawals (dividends for a corporation); they are closed at the end of each period. (101)

Term bonds Bonds scheduled for payment (maturity) at a single specified date. (392)

Throughput time A measure of the time to produce a product or service, which is the sum of process time, inspection time, move time, and wait time; also called cycle time.

Time and materials pricing Method used in pricing services; price is based on direct labor, direct materials, and overhead costs, plus a desired profit margin. (925)

Time period assumption Assumption that an organization’s activities can be divided into specific time periods such as months, quarters, or years. (8, 85)

Time ticket Source document used to report the time an employee spent working on a job or on overhead activities and then to deter- mine the amount of direct labor to charge to the job or the amount of indirect labor to charge to overhead. (577)

Times interest earned Ratio of income before interest expense (and any income taxes) divided by interest expense; reflects risk of cover- ing interest commitments when income varies. (354)

Total asset turnover Measure of a company’s ability to use its assets to generate sales; computed by dividing net sales by average total assets. (320, C-12)

Total cost method A pricing method in which all of the costs of a good or service are included in determining the selling price. (921)

Total quality management (TQM) Concept calling for all manag- ers and employees at all stages of operations to strive toward higher standards and reduce the number of defects. (550)

Trade discount Reduction from a list or catalog price that can vary for wholesalers, retailers, and consumers. (145)

Trademark or trade (brand) name Symbol, name, phrase, or jingle identified with a company, product, or service. (318)

Trading on the equity Earning a higher return on equity by paying dividends on preferred stock or interest on debt at a rate lower than the return earned with the assets from issuing preferred stock or debt; also is the aim of financial leverage.

Trading securities Investments in debt securities that the company intends to actively trade for profit. (C-2)

Transaction Exchange of economic consideration affecting an entity’s financial position that can be reliably measured.

Transfer price The price used to record transfers of goods or services across divisions within the same company. (883)

Treasury stock Corporation’s own stock that it reacquired and still holds. (429)

Trial balance List of ledger accounts and their balances (either debit or credit) at a point in time; total debit balances equal total credit balances. (58)

Triple bottom line A framework for reporting an organization’s performance on social (“people”), environmental (“planet”), and financial factors (“profits”). (551)

Unadjusted trial balance List of accounts and balances prepared before accounting adjustments are recorded and posted. (98)

Unavoidable expense Expense (or cost) that is not relevant for busi- ness decisions; an expense that would continue even if a department, product, or service were eliminated. (919)

G-18 Glossary

Unclassified balance sheet Balance sheet that broadly groups assets, liabilities, and equity accounts. (105)

Uncontrollable costs Costs that a manager does not have the power to determine or strongly influence. (749, 870)

Underapplied overhead Amount by which actual overhead cost incurred in a period exceeds the overhead applied to that period’s production using the predetermined overhead rate. (585)

Unearned revenue Liability created when customers pay in advance for products or services; earned when the products or services are later delivered. (47, 91)

Unfavorable variance Difference in revenues or costs, when the actual amount is compared to the budgeted amount, that contributes to a lower income. (822)

Unit contribution margin Amount by which a product’s unit selling price exceeds its total unit variable cost.

Unit-level activities Activities that arise as a result of the total vol- ume of goods and services that are produced, and that are performed each time a unit is produced. (669)

Units-of-production depreciation Method that charges a varying amount to depreciation expense for each period of an asset’s useful life depending on its usage. (307)

Unlimited liability Legal relationship among general partners that makes each of them responsible for partnership debts if the other partners are unable to pay their shares.

Unrealized gain (loss) Gain (loss) not yet realized by an actual transaction or event such as a sale. (C-3, C-8)

Unsecured bonds Bonds backed only by the issuer’s credit standing; almost always riskier than secured bonds; also called debentures. (392)

Unusual gain or loss Gain or loss that is abnormal or unrelated to the company’s ordinary activities and environment.

Useful life Length of time an asset will be productively used in the operations of a business; also called service life or limited life. (305)

Value-added activities Activities that add value to products or services. (670)

Value-added time The portion of cycle time that is directed at producing a product or service; equals process time. (D-4)

Value-based pricing System where sellers find the maximum price buyers will pay for the goods and services they value. (922)

Value chain Sequential activities that add value to an entity’s prod- ucts or services; includes design, production, marketing, distribution, and service. (551)

Value stream The activities necessary to create customer value. (D-2)

Variable cost Cost that changes in total in proportion to changes in the activity output volume. (539)

Variable costing Costing method that includes only variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) in unit product costs; also called direct or marginal costing. (717, 739)

Variable costing income statement An income statement in which costs are classified as variable or fixed; also called contribution margin income statement. (717)

Variance A difference between an actual amount and a budgeted amount. (822)

Variance analysis Process of examining differences between actual and budgeted revenues or costs and describing them in terms of price and quantity differences. (828)

Vendee Buyer of goods or services. (252)

Vendor Seller of goods or services. (252)

Vertical analysis Evaluation of each financial statement item or group of items in terms of a specific base amount. (498)

Volume variance Difference between two dollar amounts of fixed overhead cost; one amount is the total budgeted overhead cost, and the other is the overhead cost allocated to products using the prede- termined fixed overhead rate. (836)

Voucher Internal file used to store documents and information to control cash disbursements and to ensure that a transaction is properly authorized and recorded. (241)

Voucher register Journal (referred to as book of original entry) in which all vouchers are recorded after they have been approved. (254)

Voucher system Procedures and approvals designed to control cash disbursements and acceptance of obligations. (241)

Wage bracket withholding table Table of the amounts of income tax withheld from employees’ wages. (360)

Warranty Agreement that obligates the seller to correct or replace a product or service when it fails to perform properly within a specified period. (350)

Weighted average (WA) Method for assigning inventory cost to sales; the cost of available-for-sale units is divided by the number of units available to determine per unit cost prior to each sale, which is then multiplied by the units sold to yield the cost of that sale; also called average cost. (196, 211)

Weighted-average contribution margin The contribution margin per composite unit for a company that provides multiple goods or services; also called contribution margin per composite unit.

Weighted-average method Method for assigning inventory cost to sales; the cost of available-for-sale units is divided by the number of units available to determine per unit cost prior to each sale, which is then multiplied by the units sold to yield the cost of that sale; also called weighted average. (614)

Wholesaler Intermediary that buys products from manufacturers or other wholesalers and sells them to retailers or other wholesalers. (143)

Withdrawals Payment of cash or other assets from a proprietorship or partnership to its owner or owners.

Work in Process Inventory Account in which costs are accumu- lated for products that are in the process of being produced but are not yet complete; also called Goods in Process Inventory. (543, 573)

Work sheet Spreadsheet used to draft an unadjusted trial balance, adjusting entries, adjusted trial balance, and financial statements. (113)

Working capital Current assets minus current liabilities at a point in time. (506)

Working papers Analyses and other informal reports prepared by accountants and managers when organizing information for formal reports and financial statements.

Zero-based budgeting A budgeting approach where each budget item must be justified against a zero base, without reference to amounts from prior periods. (773)

  • Cover
  • Title Page
  • Copyright Page
  • Dedication
  • About the Authors
  • Preface
  • Acknowledgments
  • Brief Contents
  • Contents
  • 1 Accounting in Business
    • Importance of Accounting
      • Users of Accounting Information
      • Opportunities in Accounting
    • Fundamentals of Accounting
      • Ethics—A Key Concept
      • Generally Accepted Accounting Principles
      • Conceptual Framework
    • Business Transactions and Accounting
      • Accounting Equation
      • Transaction Analysis
      • Summary of Transactions
    • Communicating with Users
      • Income Statement
      • Statement of Retained Earnings
      • Balance Sheet
      • Statement of Cash Flows
    • Decision Analysis—Return on Assets
    • Appendix 1A Return and Risk
    • Appendix 1B Business Activities
  • 2 Accounting for Business Transactions
    • Basis of Financial Statements
      • Source Documents
      • The “Account” Underlying Financial Statements
      • Ledger and Chart of Accounts
    • Double-Entry Accounting
      • Debits and Credits
      • Double-Entry System
    • Analyzing and Processing Transactions
      • Journalizing and Posting Transactions
      • Processing Transactions—An Example
      • Summarizing Transactions in a Ledger
    • Trial Balance
      • Preparing a Trial Balance
      • Financial Statements Prepared from Trial Balance
    • Decision Analysis—Debt Ratio
  • 3 Adjusting Accounts for Financial Statements
    • Timing and Reporting
      • The Accounting Period
      • Accrual Basis versus Cash Basis
      • Recognizing Revenues and Expenses
      • Framework for Adjustments
    • Deferral of Expense
      • Prepaid Insurance
      • Supplies
      • Other Prepaid Expenses
      • Depreciation
    • Deferral of Revenue
      • Unearned Consulting Revenue
    • Accrued Expense
      • Accrued Salaries Expense
      • Accrued Interest Expense
      • Future Cash Payment of Accrued Expenses
    • Accrued Revenue
      • Accrued Services Revenue
      • Accrued Interest Revenue
      • Future Cash Receipt of Accrued Revenues
      • Links to Financial Statements
    • Trial Balance and Financial Statements
      • Adjusted Trial Balance
      • Preparing Financial Statements
    • Closing Process
      • Temporary and Permanent Accounts
      • Recording Closing Entries
      • Post-Closing Trial Balance
    • Accounting Cycle
    • Classified Balance Sheet
      • Classification Structure
      • Classification Categories
    • Decision Analysis—Profit Margin and Current Ratio
    • Appendix 3A Alternative Accounting for Prepayments
    • Appendix 3B Work Sheet as a Tool
    • Appendix 3C Reversing Entries
  • 4 Accounting for Merchandising Operations
    • Merchandising Activities
      • Reporting Income for a Merchandiser
      • Reporting Inventory for a Merchandiser
      • Operating Cycle for a Merchandiser
      • Inventory Systems
    • Accounting for Merchandise Purchases
      • Purchases without Cash Discounts
      • Purchases with Cash Discounts
      • Purchases with Returns and Allowances
      • Purchases and Transportation Costs
    • Accounting for Merchandise Sales
      • Sales without Cash Discounts
      • Sales with Cash Discounts
      • Sales with Returns and Allowances
    • Adjusting and Closing for Merchandisers
      • Adjusting Entries for Merchandisers
      • Preparing Financial Statements
      • Closing Entries for Merchandisers
      • Summary of Merchandising Entries
    • More on Financial Statement Formats
      • Multiple-Step Income Statement
      • Single-Step Income Statement
      • Classified Balance Sheet
    • Decision Analysis—Acid-Test and Gross Margin Ratios
    • Appendix 4A Periodic Inventory System
    • Appendix 4B Adjusting Entries under New Revenue Recognition Rules
    • Appendix 4C Net Method for Merchandising
  • 5 Inventories and Cost of Sales
    • Inventory Basics
      • Determining Inventory Items
      • Determining Inventory Costs
      • Internal Controls and Taking a Physical Count
    • Inventory Costing under a Perpetual System
      • Inventory Cost Flow Assumptions
      • Inventory Costing Illustration
      • Specific Identification
      • First-In, First-Out
      • Last-In, First-Out
      • Weighted Average
      • Financial Statement Effects of Costing Methods
      • Tax Effects of Costing Methods
    • Valuing Inventory at LCM and the Effects of Inventory Errors
      • Lower of Cost or Market
      • Financial Statement Effects of Inventory Errors
    • Decision Analysis—Inventory Turnover and Days’ Sales in Inventory
    • Appendix 5A Inventory Costing under a Periodic System
    • Appendix 5B Inventory Estimation Methods
  • 6 Cash, Fraud, and Internal Control
    • Fraud and Internal Control
      • Purpose of Internal Control
      • Principles of Internal Control
      • Technology, Fraud, and Internal Control
      • Limitations of Internal Control
    • Control of Cash
      • Cash, Cash Equivalents, and Liquidity
      • Cash Management
      • Control of Cash Receipts
      • Control of Cash Payments
    • Banking Activities as Controls
      • Basic Bank Services
      • Bank Statement
      • Bank Reconciliation
    • Decision Analysis—Days’ Sales Uncollected
    • Appendix 6A Documentation and Verification
  • 7 Accounting for Receivables
    • Valuing Accounts Receivable
    • Direct Write-Off Method
    • Allowance Method
    • Estimating Bad Debts
      • Percent of Sales Method
      • Percent of Receivables Method
      • Aging of Receivables Method
    • Notes Receivable
      • Computing Maturity and Interest
      • Recording Notes Receivable
      • Valuing and Settling Notes
      • Disposal of Receivables
    • Decision Analysis—Accounts Receivable Turnover
  • 8 Accounting for Long-Term Assets
    • SECTION 1—PLANT ASSETS
    • Cost Determination
      • Machinery and Equipment
      • Buildings
      • Land Improvements
      • Land
      • Lump-Sum Purchase
    • Depreciation
      • Factors in Computing Depreciation
      • Depreciation Methods
      • Partial-Year Depreciation
      • Change in Estimates
      • Reporting Depreciation
    • Additional Expenditures
      • Ordinary Repairs
      • Betterments and Extraordinary Repairs
    • Disposals of Plant Assets
      • Discarding Plant Assets
      • Selling Plant Assets
    • SECTION 2—NATURAL RESOURCES
      • Cost Determination and Depletion
      • Plant Assets Tied into Extracting
    • SECTION 3—INTANGIBLE ASSETS
      • Cost Determination and Amortization
      • Types of Intangibles
    • Decision Analysis—Total Asset Turnover
    • Appendix 8A Exchanging Plant Assets
  • 9 Accounting for Current Liabilities
    • Known Liabilities
      • Characteristics of Liabilities
      • Examples of Known Liabilities
      • Accounts Payable
      • Sales Taxes Payable
      • Unearned Revenues
      • Short-Term Notes Payable
    • Payroll Liabilities
      • Employee Payroll and Deductions
      • Employer Payroll Taxes
      • Internal Control of Payroll
      • Multi-Period Known Liabilities
    • Estimated Liabilities
      • Health and Pension Benefits
      • Vacation Benefits
      • Bonus Plans
      • Warranty Liabilities
      • Multi-Period Estimated Liabilities
    • Contingent Liabilities
      • Accounting for Contingent Liabilities
      • Applying Rules of Contingent Liabilities
      • Uncertainties That Are Not Contingencies
    • Decision Analysis—Times Interest Earned Ratio
    • Appendix 9A Payroll Reports, Records, and Procedures
    • Appendix 9B Corporate Income Taxes
  • 10 Accounting for Long-Term Liabilities
    • Basics of Bonds
      • Bond Financing
      • Bond Issuing
      • Bond Trading
    • Par Bonds
    • Discount Bonds
      • Bond Discount or Premium
      • Issuing Bonds at a Discount
    • Premium Bonds
      • Issuing Bonds at a Premium
      • Bond Retirement
    • Long-Term Notes Payable
      • Installment Notes
      • Mortgage Notes and Bonds
    • Decision Analysis—Debt Features and the Debt-to-Equity Ratio
    • Appendix 10A Bond Pricing
    • Appendix 10B Effective Interest Amortization
    • Appendix 10C Leases and Pensions
  • 11 Corporate Reporting and Analysis
    • Corporate Form of Organization
      • Corporate Advantages
      • Corporate Disadvantages
      • Corporate Organization and Management
      • Corporate Stockholders
      • Corporate Stock
    • Common Stock
      • Issuing Par Value Stock
      • Issuing No-Par Value Stock
      • Issuing Stated Value Stock
      • Issuing Stock for Noncash Assets
    • Dividends
      • Cash Dividends
      • Stock Dividends
      • Stock Splits
      • Financial Statement Effects of Dividends and Splits
    • Preferred Stock
      • Issuance of Preferred Stock
      • Dividend Preference of Preferred Stock
      • Reasons for Issuing Preferred Stock
    • Treasury Stock
      • Purchasing Treasury Stock
      • Reissuing Treasury Stock
    • Reporting of Equity
      • Statement of Retained Earnings
      • Statement of Stockholders’ Equity
    • Decision Analysis—Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share
  • 12 Reporting Cash Flows
    • Basics of Cash Flow Reporting
      • Purpose of the Statement of Cash Flows
      • Importance of Cash Flows
      • Measurement of Cash Flows
      • Classification of Cash Flows
      • Noncash Investing and Financing
      • Format of the Statement of Cash Flows
      • Preparing the Statement of Cash Flows
    • Cash Flows from Operating
      • Indirect and Direct Methods of Reporting
      • Applying the Indirect Method
      • Summary of Adjustments for Indirect Method
    • Cash Flows from Investing
      • Three-Step Analysis
      • Analyzing Noncurrent Assets
    • Cash Flows from Financing
      • Three-Step Analysis
      • Analyzing Noncurrent Liabilities
      • Analyzing Equity
      • Proving Cash Balances
    • Summary Using T-Accounts
    • Decision Analysis—Cash Flow Analysis
    • Appendix 12A Spreadsheet Preparation of the Statement of Cash Flows
    • Appendix 12B Direct Method of Reporting Operating Cash Flows
  • 13 Analysis of Financial Statements
    • Basics of Analysis
      • Purpose of Analysis
      • Building Blocks of Analysis
      • Information for Analysis
      • Standards for Comparisons
      • Tools of Analysis
    • Horizontal Analysis
      • Comparative Statements
      • Trend Analysis
    • Vertical Analysis
      • Common-Size Statements
      • Common-Size Graphics
    • Ratio Analysis
      • Liquidity and Efficiency
      • Solvency
      • Profitability
      • Market Prospects
      • Summary of Ratios
    • Decision Analysis—Analysis Reporting
    • Appendix 13A Sustainable Income
  • 14 Managerial Accounting Concepts and Principles
    • Managerial Accounting Basics
      • Purpose of Managerial Accounting
      • Nature of Managerial Accounting
      • Fraud and Ethics in Managerial Accounting
      • Career Paths
    • Managerial Cost Concepts
      • Types of Cost Classifications
      • Identification of Cost Classifications
      • Cost Concepts for Service Companies
    • Managerial Reporting
      • Manufacturing Costs
      • Nonmanufacturing Costs
      • Prime and Conversion Costs
      • Costs and the Balance Sheet
      • Costs and the Income Statement
    • Cost Flows and Cost of Goods Manufactured
      • Flow of Manufacturing Activities
      • Schedule of Cost of Goods Manufactured
      • Trends in Managerial Accounting
    • Decision Analysis—Raw Materials Inventory Turnover and Days’ Sales in Raw Materials Inventory
  • 15 Job Order Costing and Analysis
    • Job Order Costing
      • Cost Accounting System
      • Job Order Production
      • Job Order vs. Process Operations
      • Production Activities in Job Order Costing
      • Cost Flows
      • Job Cost Sheet
    • Materials and Labor Costs
      • Materials Cost Flows and Documents
      • Labor Cost Flows and Documents
    • Overhead Costs
      • Set Predetermined Overhead Rate
      • Apply Estimated Overhead
      • Record Actual Overhead
      • Summary of Cost Flows
      • Using Job Cost Sheets for Managerial Decisions
      • Schedule of Cost of Goods Manufactured
    • Adjusting Overhead
      • Factory Overhead Account
      • Adjust Underapplied or Overapplied Overhead
      • Job Order Costing of Services
    • Decision Analysis—Pricing for Services
  • 16 Process Costing and Analysis
    • Process Operations
      • Organization of Process Operations
      • Comparing Process and Job Order Costing Systems
      • Equivalent Units of Production
    • Process Costing Illustration
      • Overview of GenX Company’s Process Operation
      • Pre-Step: Collect Production and Cost Data
      • Step 1: Determine Physical Flow of Units
      • Step 2: Compute Equivalent Units of Production
      • Step 3: Compute Cost per Equivalent Unit
      • Step 4: Assign and Reconcile Costs
      • Process Cost Summary
    • Accounting for Process Costing
      • Accounting for Materials Costs
      • Accounting for Labor Costs
      • Accounting for Factory Overhead
      • Accounting for Transfers
      • Trends in Process Operations
    • Decision Analysis—Hybrid Costing System
    • Appendix 16A FIFO Method of Process Costing
  • 17 Activity-Based Costing and Analysis
    • Assigning Overhead Costs
      • Alternative Methods of Overhead Allocation
      • Plantwide Overhead Rate Method
      • Departmental Overhead Rate Method
      • Assessing Plantwide and Departmental Overhead Rate Methods
    • Activity-Based Costing
      • Steps in Activity-Based Costing
      • Applying Activity-Based Costing
      • Assessing Activity-Based Costing
    • Activity-Based Management
      • Activity Levels and Cost Management
      • Costs of Quality
      • Lean Manufacturing
      • ABC for Service Providers
    • Decision Analysis—Customer Profitability
  • 18 Cost Behavior and Cost-Volume-Profit Analysis
    • Identifying Cost Behavior
      • Fixed Costs
      • Variable Costs
      • Graphing Fixed and Variable Costs against Volume
      • Mixed Costs
      • Step-wise Costs
      • Curvilinear Costs
    • Measuring Cost Behavior
      • Scatter Diagram
      • High-Low Method
      • Regression
      • Comparing Cost Estimation Methods
    • Contribution Margin and Break-Even Analysis
      • Contribution Margin and Its Measures
      • Break-Even Point
      • Cost-Volume-Profit Chart
      • Changes in Estimates
    • Applying Cost-Volume-Profit Analysis
      • Margin of Safety
      • Computing Income from Sales and Costs
      • Computing Sales for a Target Income
      • Evaluating Strategies
      • Sales Mix and Break-Even
      • Assumptions in Cost-Volume-Profit Analysis
    • Decision Analysis—Degree of Operating Leverage
    • Appendix 18A Using Excel for Cost Estimation
    • Appendix 18B Variable Costing and Performance Reporting
    • Appendix 18C Preparing a CVP Chart
  • 19 Variable Costing and Analysis
    • Introducing Variable Costing and Absorption Costing
      • Computing Unit Product Cost
    • Income Reporting Implications
      • Units Produced Equal Units Sold
      • Units Produced Exceed Units Sold
      • Units Produced Are Less Than Units Sold
      • Summarizing Income Reporting
      • Converting Income under Variable Costing to Absorption Costing
    • Comparing Variable Costing and Absorption Costing
      • Planning Production
      • Setting Prices
      • Controlling Costs
      • CVP Analysis
      • Variable Costing for Service Firms
    • Decision Analysis—Pricing Special Orders
  • 20 Master Budgets and Performance Planning
    • Budget Process and Administration
      • Budgeting Process
      • Benefits of Budgeting
      • Budgeting and Human Behavior
      • Budget Reporting and Timing
      • Master Budget Components
    • Operating Budgets
      • Sales Budget
      • Production Budget
      • Direct Materials Budget
      • Direct Labor Budget
      • Factory Overhead Budget
      • Selling Expense Budget
      • General and Administrative Expense Budget
    • Investing and Financing Budgets
      • Capital Expenditures Budget
      • Cash Budget
    • Budgeted Financial Statements
      • Budgeted Income Statement
      • Budgeted Balance Sheet
      • Using the Master Budget
      • Budgeting for Service Companies
    • Decision Analysis—Activity-Based Budgeting
    • Appendix 20A Merchandise Purchases Budget
  • 21 Flexible Budgets and Standard Costs
    • Fixed and Flexible Budgets
      • Fixed Budget Reports
      • Budget Reports for Evaluation
      • Flexible Budget Reports
    • Standard Costing
      • Standard Costs
      • Setting Standard Costs
      • Cost Variance Analysis
    • Materials and Labor Variances
      • Materials Variances
      • Labor Variances
    • Overhead Standards and Variances
      • Flexible Overhead Budgets
      • Standard Overhead Rate
      • Computing Overhead Cost Variances
      • Standard Costing—Management Considerations
    • Decision Analysis—Sales Variances
    • Appendix 21A Expanded Overhead Variances and Standard Cost Accounting System
  • 22 Performance Measurement and Responsibility Accounting
    • Responsibility Accounting
      • Performance Evaluation
      • Controllable versus Uncontrollable Costs
      • Responsibility Accounting for Cost Centers
    • Profit Centers
      • Direct and Indirect Expenses
      • Expense Allocations
      • Departmental Income Statements
      • Departmental Contribution to Overhead
    • Investment Centers
      • Return-on-Investment and Residual Income
      • Investment Center Profit Margin and Investment Turnover
    • Nonfinancial Performance Evaluation Measures
      • Balanced Scorecard
      • Transfer Pricing
    • Decision Analysis—Cash Conversion Cycle
    • Appendix 22A Cost Allocations
    • Appendix 22B Transfer Pricing
    • Appendix 22C Joint Costs and Their Allocation
  • 23 Relevant Costing for Managerial Decisions
    • Decisions and Information
      • Decision Making
      • Relevant Costs and Benefits
    • Production Decisions
      • Make or Buy
      • Sell or Process Further
      • Sales Mix Selection When Resources Are Constrained
    • Capacity Decisions
      • Segment Elimination
      • Keep or Replace Equipment
    • Pricing Decisions
      • Normal Pricing
      • Special Offers
    • Decision Analysis—Time and Materials Pricing
  • 24 Capital Budgeting and Investment Analysis
    • Capital Budgeting
      • Capital Budgeting Process
      • Capital Investment Cash Flows
    • Methods Not Using Time Value of Money
      • Payback Period
      • Accounting Rate of Return
    • Methods Using Time Value of Money
      • Net Present Value
      • Internal Rate of Return
      • Comparison of Capital Budgeting Methods
      • Postaudit
    • Decision Analysis—Break-Even Time
    • Appendix 24A Using Excel to Compute Net Present Value and Internal Rate of Return
  • Appendix A Financial Statement Information
    • Apple
    • Google
    • Samsung
  • Appendix B Time Value of Money
  • Appendix C Investments
  • Appendix D Lean Principles and Accounting
  • Index
  • Chart of Accounts
  • Brief Review Managerial Analyses and Reports
    • Financial Reports and Tables
      • Selected Transactions and Relations
      • Fundamentals and Analyses
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    2. Preflight Ticket Signature