Class Notes CD2

Expanded Introduction to Accounting
Class Notes
Lesson 1
Problem 1-1
Respond briefly to the following questions:
Lesson 1
Review of Accounting Environment and the Basic Accounting Cycle
A. Why is accounting sometimes referred to as the "language of business?" B. Financial accounting information is provided through generalpurpose financial statements. i. What are the three general-purpose financial statements required under generally accepted accounting principles? ii. What are the "notes to the financial statements?" iii. Who uses financial statement information and why? C. What is managerial accounting information and who uses it?
Problem 1-1 - Answer
A. Why is accounting sometimes referred to as the "language of business?"

Answer: Language exists to provided a means of communication. Accounting is referred to as the "language of business" because its sole purpose is to communicate business information.
B. Financial accounting information is provided through generalpurpose financial statements. i. What are the three general-purpose financial statements required under generally accepted accounting principles?
Answer: Balance Sheet (sometimes referred to as a Statement of Financial Position) Income Statement (sometimes referred to as a Statement of Earnings, Statement of Operations, Statement of Profits and Losses, or P&L Statement) Statement of Cash Flows Although not required, most companies also provide a Statement of Retained Earnings or a more complete Statement of Owners' Equity, which provides information as to the causes of changes in retained earnings and other elements of owners' equity over a period of time.
B. Financial accounting information is provided through generalpurpose financial statements. ii. What are the "notes to the financial statements?"
Answer: The notes to a company's financial statements provide supplemental information that; (1) explains certain key accounting policies used in the preparation of the financial statements, (2) provides additional detailed information in support of financial statement amounts and (3) discloses other important information not reflected in the financial statements. Most notes to the financial statements are provided in compliance with requirements under generally accepted accounting principles.
B. Financial accounting information is provided through generalpurpose financial statements. iii. Who uses financial statement information and why?
Answer: The primary users of financial statement information are current or potential investors and creditors, analysts providing investment advice and government regulatory bodies such as the Securities and Exchange Commission ("SEC") and Federal Trade Commission ("FTC"). In addition, employee unions, suppliers, prospective employees and the media are among other frequent users of financial statement information. Although management personnel require much more detailed information in administering a company's day-to-day operations, the summarized results provided through a company's financial statements can be helpful to managers in evaluating progress in reaching a company's overall goals. Managers are especially interested in financial statement results if bonuses and raises are predicated on overall performance measures.
1-1
Problem 1-2
C. What is managerial accounting information and who uses it?

Answer: Managerial accounting information refers to all of the various other kinds of information, above and beyond the information found in a company's general-purpose financial statements, which may be used by managers and other company employees in their efforts to successfully operate a company. This information is generally restricted to use by company employees and is not subject to public dissemination. Managerial accounting often involves budgeting and the forecasting of future operations as well as the use of historical data.
Respond briefly to the following questions: A. What is the SEC and what is its role? B. What is GAAP and why is it important to financial statement users? C. Who is legally authorized to determine GAAP? D. What is the FASB and what is its role? E. How do the SEC and the FASB relate to one another? F. What is the IASB and what is its role? G. Why are international accounting standards not allowed for companies whose securities trade in the United States and what would be the benefit if they were allowed?
A. What is the SEC and what is its role?

Answer: The SEC (Securities and Exchange Commission) is a federal regulatory agency charged with the responsibility of regulating the stock and bond ("securities") markets of the United States to insure their fairness and integrity for purposes of protecting the investing public. The SEC's authority extends only to larger businesses that seek capital from large numbers of investors in the United States ("publicly-held businesses"). Many companies in the U.S. today are publicly-held and subject to the SEC's regulations. The SEC seeks to guarantee that investors and creditors have adequate and accurate information to make informed decisions and that rules of fairness in the marketplace are enforced. It does not guarantee that quality decisions are made or guarantee the ultimate success of any business investment. SEC regulations and oversight extend not only to publicly-held companies but to stock exchanges, broker-dealers, investment advisers and others involved in the public capital markets.
B. What is GAAP and why is it important to financial statement users?

Answer: Generally accepted accounting principles ("GAAP") are the methods of accounting and the financial statement disclosures required of SEC-regulated companies. The purpose of GAAP is to improve the comparability and usefulness of financial statement information. Although not required, companies not subject to SEC regulation will also typically prepare financial statements in accordance with GAAP to add credibility for current or potential investors and creditors.
C. Who is legally authorized to determine GAAP?

Answer: The SEC has the legal authority to determine GAAP for companies required to file financial statements with the SEC; however, the SEC currently allows the FASB to function in this capacity.
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D. What is the FASB and what is its role?

Answer: The Financial Accounting Standards Board (FASB) is a private non-profit organization currently responsible for the establishment of GAAP in the United States. The SEC recognizes the pronouncements of the FASB as authoritative. Funding for the organization's operations come from donations from the accounting profession, industry and the financial community along with revenues from the sale of its publications.
F. What is the IASB and what is its role?

Answer: The International Accounting Standards Board (IASB) is a private organization headquartered in London and committed to developing a single set of high quality global accounting standards. In addition, the Board cooperates with national accounting standard setters in an attempt to achieve convergence in accounting standards around the world.
E. How do the SEC and the FASB relate to one another?

Answer: Because the SEC has the ultimate power to determine GAAP, the FASB exists and functions at the SEC's pleasure. As a result, when the SEC talks the FASB listens. The SEC has considerable influence over the pronouncements issued by the FASB.
G. Why are international accounting standards not allowed for companies whose securities trade in the United States and what would be the benefit if they were allowed?
Answer: At this time, the SEC requires the use of FASB accounting standards (GAAP) because it currently deems FASB standards superior in providing fuller and fairer disclosure of financial information. As the IASB continues to develop and improve their standards it is possible that the SEC could modify its position. A clear benefit in the application of international standards among countries is the breakdown of a significant investment and trade barrier. Capital markets will never be truly global until common accounting standards are applied to companies world wide.
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1-2
Problem 1-3
Respond briefly to the following questions: A. Who is responsible for financial statement accuracy and compliance with GAAP? B. What are internal controls and provide examples of common controls over a company's cash. C. How does a person become a CPA and what do CPAs do besides audits of financial statements? D. What is the AICPA and what is its role? E. Why aren't auditors completely independent in the performance of an audit? F. What risks does a CPA face if they knowingly misrepresent the accuracy of a company's financial statements and its compliance with GAAP or are negligent in their performance of an audit.
A. Who is responsible for financial statement accuracy and compliance with GAAP?
Answer: A company's management is primarily responsible for financial statement accuracy and compliance with GAAP. In fact, management failure to provide accurate financial information may constitute a crime under the Foreign Corrupt Practices Act. This act requires management of public companies to safeguard company assets and maintain accurate financial records through the implementation of internal controls. Public companies subject to SEC regulation must also have an annual financial statement audit performed by an independent CPA firm. Such an audit, however, does not relieve management of their primary reporting responsibilities.
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B. What are internal controls and provide examples of common controls over a company's cash.
Answer: Internal controls are policies and procedures designed to safeguard a company's assets, produce accurate accounting records, and promote the effective and efficient operation of the company's business. Some common controls designed to safeguard and improve the management of cash are: (1) segregation of duties in the handling of cash transactions, (2) the use of pre-numbered checks for all cash expenditures, (3) dual-signatures required for all checks written over a certain dollar amount, (4) the monthly preparation of a bank reconciliation, and (5) the use of cash flow budgets to project future cash needs.
C. How does a person become a CPA and what do CPAs do besides audits of financial statements?
Answer: CPA certification is administered by each state. CPAs licensed to practice in a state may be able to practice in other states if reciprocal licensing agreements exist. All states require CPA candidates to be college graduates with credit earned in designated accounting courses. Candidates must also pass a uniform CPA exam administered by the American Institute of Certified Public Accountants (AICPA). In addition, certain supervised work experience with a licensed CPA firm is also required. Subsequent to initial certification, a CPA must complete continuing professional education (CPE) requirements to maintain the right to practice.
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D. What is the AICPA and what is its role?

Answer: The AICPA is a private professional organization made up of CPAs across the nation. In addition to the administration of the CPA exam, the AICPA also determines generally accepted auditing standards (GAAS), which govern the practices and procedures to be used by CPA firms in the conduct of a certified audit of financial statements. Common audit procedures include interviewing of employees, observation of assets, verification of transactions and analytical analysis. The AICPA is also involved in establishing practice standards for CPAs providing tax, consulting, personal financial planning and other services.
E. Why aren't auditors completely independent in the performance of an audit?

Answer: CPA firms conducting financial statement audits are paid by the companies they audit creating an inherent conflict of interest. In most cases, a company's management team is motivated to prepare financial statements that present the most favorable financial impression possible. If management/auditor disagreements arise on financial statement presentation, management may threaten to change auditors. As a result, CPA firms may be tempted to compromise the integrity of their audit work in order to preserve the engagement and resulting fee income. Auditors also create financial conflicts when they engage in consulting projects for the companies they audit. As a result, auditors are now prohibited from performing certain kinds of consulting services for their audit clients.
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1-3
F. What risks does a CPA face if they knowingly misrepresent the accuracy of a company's financial statements and its compliance with GAAP or are negligent in their performance of an audit.
Answer: CPAs who certify misleading financial statements expose themselves to potential investor and creditor lawsuits that may result in the payment of significant financial damages. In addition, the loss of license and professional censure are probable consequences for CPAs who fail the public trust.
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1-4
Problem 1-4
In the "Introduction to Accounting: The Language of Business" a financial practice set was provided for a fictional company referred to as Hot Cars, Inc (HCI), a wholesale distributor of miniature model cars. This review problem continues the HCI story for an additional year through 20X3. HCI's income statement, statement of retained earnings and balance sheet for the years 20X1 and 'X2 (a blank column is left for the 'X3 amounts to be determined in this problem), along with a simplified general ledger reflecting balances in all of the company's accounts as of 1/1/X3 are provided herein for use in completing this problem. More formal ledger formats, special journals and subsidiary ledgers used in the previous Financial Practice Set will not be used in this review.
Problem Requirements:
1. On a blank sheet of paper record the following summarized 'X3 transactions for HCI in basic general journal form as shown below: Account Name Account Name XXX XXX
A. Inventory purchased on account totaled $201,922. B. Customer sales on account and the cost of inventory sold totaled $318,432 and $206,145, respectively. C. Cash purchases of office supplies totaled $4,677. D. Cash payments of utility bills amounted to $7,607 of which $400 had been previously recorded as an expense of the prior year. E. Cash of $50,000 was paid down and a $250,000 mortgage note payable executed in the purchase of land and a building on 10/1/X3. The 30-year fully amortizing mortgage note bears 8% annual interest with monthly payments of $1,834. Monthly cash payments on the note totaled $5,502 for the year of which $507 was applied to principal and the rest to interest. The amount of principal due over the next 12 months amounts to $2,130. F. Paid off a $10,000 note payable (bank loan) plus interest of $1,500 of which $99 had been previously recorded as an expense in 20X2. G. Paid off $4,000 of principal on a note payable (equipment loan) plus interest of $1,440, of which $79 had been previously recorded as an expense in 20X2. The remaining $8,000 of principal on this note is due in two equal $4,000 installments over the next two years. H. Cash payments of employee salaries totaled $53,409. (Ignore payroll withholdings and employer payroll taxes for this problem.)
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1-5
Continued...
I. Insurance premiums prepaid during the year totaled $4,313. J. Cash collections of accounts receivable amounted to $310,406. K. Paid the $6,408 of 20X2 income taxes payable at 1/1X3. L. Cash payments on accounts payable totaled $163,407. M. Cash dividends paid to stockholders amounted to $12,000. N. Payments of miscellaneous expenses totaled $617. O. Payments of postage expenses totaled $373. P. Cash purchases of warehouse equipment totaled $13,456. Q. Warehouse equipment having an original cost of $10,000 and associated accumulated depreciation of $2,000 was sold for $10,000 cash. 2. Post the 20X3 summarized journal entries to the HCI general ledger. 3. Prepare the 12/31/X3 year-end adjusting entries given the following information: a. Unpaid and unrecorded December, 20X3 salaries payable in January, 20X4 totaled $7,280. b. Unpaid and unrecorded December 20X3 utility costs payable in January, 20X4 totaled $937. c. Unearned rent revenue totaling $280 as of 12/31/X2 was earned in 20X3. d. Unpaid and unrecorded 20X3 interest costs payable in the following year totaled $53. e. Prepaid insurance applicable to 20X4 operations totals $2,368 at 12/31/X3 f. Depreciation on warehouse equipment and the newly purchased building amount to $6,985 for the year. g. All 12/31/X2 prepaid rent expired in 20X3. h. Unpaid and unrecorded 20X3 income taxes payable in the following year totaled $4,747. i. A physical count of office supplies on hand at 12/31/X3 totaled $1,962. 4. Post the 12/31/X3 adjusting entries to the HCI general ledger and determine the 12/31/X3 balance for each account. 5. Prepare a 12/31/X3 adjusted trial balance. 6. Extend the enclosed HCI income statements, statements of retained earnings and balance sheets for the additional year ended 12/31/X3 so the statements reflect comparative amounts for the last three years. 7. Prepare the required closing entries at 12/31/X3 and post the entries to the general ledger.
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1-6
Problem 1-4
Hot Cars, Inc. Income Statement for the years ended December 31, 20X1, 20X2 and 20X3
20X1 Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Rental Revenue Interest Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share $ 185,043 111,026 74,017 49,500 3,893 4,150 6,345 1,436 1,055 900 298 67,577 6,440 0 135 ( 0) 6,575 1,644 4,931 2.05
20X2
$ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ $
Hot Cars, Inc. Statement of Retained Earnings for the years ended December 31, 20X1, 20X2 and 20X3
20X1 Balance at beginning of year Net Income for the year Less: Dividends Balance at end of year $ 7,821 4,931 (1,250) $ 11,502
20X2
$ 11,502 19,224 (675) $ 30,051
20X3
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1-7
Problem 1-4
Hot Cars, Inc. Balance Sheet December 31, 20X1, 20X2 and 20X3
Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable Building Warehouse Equipment Less: Accumulated Depreciation Total Assets 12/31/X1 12/31/X2 12/31/X3
$ 12,665 11,750 11,432 470 350 4,400 750 41,817 0 18,466 (3,766) $ 56,517
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067 12/31/X2 12/31/X3
12/31/X1 Liabilities & Equity Current Liabilities: Accounts Payable $ 13,511 Salaries Payable 4,125 Income Tax Payable 1,644 Dividend Payable 1,250 Unearned Rent Revenue 0 Utilities Payable 485 Interest Payable 0 Current Portion of Long-Term Debt 0 21,015 Equipment Note Payable 0 Mortgage Note Payable 0 Total Liabilities 21,015 Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity
$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516
24,000 11,502 35,502 $ 56,517
42,500 30,051 72,551 $ 124,067

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1-8
Cash
1/1/X3 21,808 1/1/X3
Office Supplies
750
Prepaid Insurance
1/1/X3 400
Prepaid Rent
1/1/X3 4,400
Notes Receivable
1/1/X3 0
Accounts Receivable
1/1/X3 34,315
Land & Building

1/1/X3 0
Inventory
1/1/X3 25,000
Warehouse Equipment
1/1/X3 42,800
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1-9
Accumulated Depreciation
5,406 1/1/X3
Utilities Payable
400 1/1/X3
Accounts Payable
22,250 1/1/X3
Interest Payable
178 1/1/X3
Salaries Payable
0 1/1/X3
Bank Note Payable

10,000 1/1/X3
Income Tax Payable

6,408 1/1/X3
Equipment Note Payable

12,000 1/1/X3
Dividend Payable
0 1/1/X3
Mortgage Note Payable

0 1/1/X3
Unearned Rent Revenue

280 1/1/X3
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Capital Stock
42,500 1/1/X3
Interest Revenue
0 1/1/X3
Retained Earnings
30,051 1/1/X3 1/1/X3
Cost of Goods Sold

0
Dividends
1/1/X3 0 1/1/X3
Salaries Expense
0
Sales Revenues
0 1/1/X3
Office Supplies Expense

1/1/X3 0
Rental Revenue
0 1/1/X3 1/1/X3
Rent Expense
0
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Utilities Expense
1/1/X3 0 1/1/X3
Interest Expense
0
Depreciation Expense
1/1/X3 0
Gain on Sale
0 1/1/X3
Miscellaneous Expense
1/1/X3 0 1/1/X3
Income Tax Expense

0
Insurance Expense
1/1/X3 0
Postage Expense
1/1/X3 0
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1-12
1. A. Inventory Accounts Payable B. Accounts Receivable Sales Revenues Cost of Goods Sold Inventory C. Office Supplies Cash D. Utilities Payable Utilities Expense Cash
DR
201,922 318,432 206,145 4,677 400 7,207
CR
201,922 318,432 206,145 4,677
1. (continued) E. Land and Building Cash Mortgage Note Payable Interest Expense Mortgage Note Payable Cash F. Bank Note Payable Cash Interest Expense Interest Payable Cash
DR
300,000
CR
50,000 250,000
4,995 507 10,000 1,401 99
5,502 10,000
7,607
1,500
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1. (continued) G. Equipment Note Payable Cash Interest Expense Interest Payable Cash H. Salaries Expense Cash I. Prepaid Insurance Cash J. Cash Accounts Receivable K. Income Tax Payable Cash
DR
4,000 1,361 79
CR
4,000
1. (continued) L. Accounts Payable Cash M. Dividends Cash N. Miscellaneous Expense Cash O. Postage Expense Cash P. Warehouse Equipment Cash Q. Cash Accumulated Depreciation Warehouse Equipment Gain on Sale
DR
163,407 12,000
CR
163,407 12,000
1,440 53,409 53,409 4,313 310,406 310,406 6,408 6,408 4,313
617 373 13,456
617 373 13,456
10,000 2,000 10,000 2,000
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2.
Cash
1/1/X3 J. Q. 21,808 310,406 10,000 4,677 7,607 50,000 5,502 10,000 1,500 4,000 1,440 53,409 4,313 6,408 163,407 12,000 617 373 13,456
2. (continued)
Prepaid Insurance
1/1/X3 310,406 J. I. 400 4,313 34,315 318,432
Accounts Receivable
1/1/X3 C. D. E. E. F. F. G. G. H. I. K. L. M. N. O. P. 1/1/X3 C. 1/1/X3 A. B.
Land & Building

1/1/X3 E. 0 300,000
Inventory
25,000 201,922 206,145 B. 1/1/X3
Prepaid Rent
4,400 1/1/X3 P.
Warehouse Equipment
42,800 13,456 10,000 Q.
Office Supplies
750 4,677 1/1/X3
Notes Receivable
0
5,406 Q. 2,000 1/1/X3
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1-13
2. (continued)
Accounts Payable
22,250 L. 163,407 201,922
2. (continued)
Dividend Payable Interest Payable
1/1/X3 F. G. 99 79 178 0

1/1/X3 E. 507 0 250,000 1/1/X3 E.
1/1/X3 A.
Unearned Rent Revenue Salaries Payable

0 1/1/X3 F. 280 1/1/X3
Bank Note Payable

10,000 10,000 1/1/X3
Capital Stock
42,500 1/1/X3
Utilities Payable Income Tax Payable

6,408 K. 6,408 G. 4,000 1/1/X3 400 1/1/X3
Retained Earnings Equipment Note Payable

12,000 1/1/X3 30,051 1/1/X3
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2. (continued)
Dividends
1/1/X3 M. 0 12,000
2. (continued)
Rental Revenue
0 1/1/X3 1/1/X3 H.
Salaries Expense
0 53,409 1/1/X3
Rent Expense
0
Interest Revenue Sales Revenues

0 318,432 1/1/X3 B. 0 1/1/X3
Utilities Expense Office Supplies Expense

1/1/X3 0 1/1/X3 D. 0 7,207
Cost of Goods Sold

1/1/X3 B. 0 206,145
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2. (continued)
1/1/X3 0
2. (continued)
Postage Expense Gain on Sale
0 2,000 0 373
1/1/X3 O.
Income Tax Expense

1/1/X3 Q. 1/1/X3 0
1/1/X3 N. 0 617 1/1/X3 E. F. G.
Interest Expense
0 4,995 1,401 1,361
Insurance Expense
1/1/X3 0
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1-14
3. a. Salaries Expense Salaries Payable b. Utilities Expense Utilities Payable c. Unearned Rent Revenue Rental Revenue d. Interest Expense Interest Payable e. Insurance Expense Prepaid Insurance
DR
7,280 937
CR
7,280 937
3. (continued) f. Depreciation Expense Accumulated Depreciation g. Rent Expense Prepaid Rent h. Income Tax Expense Income Tax Payable i. Office Supplies Expense Office Supplies
DR
6,985 4,400
CR
6,985 4,400
280 53
280 53
4,747 3,465
4,747 3,465
2,345
2,345
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4.
Cash
1/1/X3 J. Q. 21,808 310,406 10,000 4,677 7,607 50,000 5,502 10,000 1,500 4,000 1,440 53,409 4,313 6,408 163,407 12,000 617 373 13,456 12/31/X3 3,505
4. (continued)
Prepaid Insurance
1/1/X3 310,406 J. I. 12/31/X3 400 4,313 2,368 2,345 34,315 318,432 42,341
Accounts Receivable
1/1/X3 C. D. E. E. F. F. G. G. H. I. K. L. M. N. O. P. 1/1/X3 C. 12/31/X3 12/31/X3 20,777 12/31/X3 1/1/X3 A. 12/31/X3 B.
Land & Building

1/1/X3 e. E. 0 300,000
12/31/X3 300,000
Inventory
25,000 201,922 206,145 B. 1/1/X3
Prepaid Rent
4,400 4,400 0 g. 1/1/X3 P.
Warehouse Equipment
42,800 13,456 46,256 10,000 Q.
12/31/X3
Office Supplies
750 4,677 1,962 3,465 i. 12/31/X3 1/1/X3
Notes Receivable
0
5,406 Q. 2,000 6,985 10,391 1/1/X3 f. 12/31/X3
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4. (continued)
Accounts Payable
22,250 L. 163,407 201,922 60,765
4. (continued)
Dividend Payable Interest Payable
1/1/X3 F. 0 12/31/X3 G. 99 79 53 178 0

1/1/X3 d. E. 507 249,493 12/31/X3 0 250,000 1/1/X3 E.
1/1/X3 A. 12/31/X3
Unearned Rent Revenue Salaries Payable

0 7,280 1/1/X3 a. 0 7,280 12/31/X3 12/31/X3 F. 10,000 c. 280 280 1/1/X3
53 12/31/X3
Bank Note Payable

10,000 1/1/X3
Capital Stock
42,500 42,500 1/1/X3 12/31/X3
Utilities Payable Income Tax Payable

6,408 K. 6,408 4,747 1/1/X3 h. 937 4,747 12/31/X3 12/31/X3 G. 4,000 d. 400 400 937 1/1/X3 b.
0 12/31/X3

12,000 1/1/X3 30,051 1/1/X3
8,000 12/31/X3
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4. (continued)
Dividends
1/1/X3 M. 12/31/X3 0 12,000 12,000
4. (continued)
Rental Revenue
0 280 1/1/X3 c. 1/1/X3 H. a. 12/31/X3
Salaries Expense
0 53,409 7,280 60,689 1/1/X3 g. 12/31/X3
Rent Expense
0 4,400 4,400
280 12/31/X3
Interest Revenue Sales Revenues

0 318,432 1/1/X3 B. 0 1/1/X3 0 12/31/X3 i. 12/31/X3

1/1/X3 0 3,465 3,465 1/1/X3 D. b. 12/31/X3 0 7,207 937 8,144
318,432 12/31/X3
Cost of Goods Sold

1/1/X3 B. 0 206,145
12/31/X3 206,145
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4. (continued)
1/1/X3 f. 12/31/X3 0 6,985 6,985
4. (continued)
Postage Expense Gain on Sale
0 2,000 0 373 373
1/1/X3 O. 12/31/X3
Income Tax Expense

1/1/X3 Q. 1/1/X3 h. 12/31/X3 0 4,747 4,747
2,000 12/31/X3
1/1/X3 N. 12/31/X3 0 617 617 1/1/X3 E. F. G. d. 12/31/X3
Interest Expense
0 4,995 1,401 1,361 53 7,810
Insurance Expense
1/1/X3 e. 12/31/X3 0 2,345 2,345
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5.Adjusted Trial Balance

Accounts: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable Warehouse Equipment Land and Building Accumulated Depreciation Accounts Payable Salaries Payable Income Tax Payable Dividend Payable Unearned Rent Revenue Utilities Payable Interest Payable Bank Note Payable Equipment Note Payable Mortgage Note Payable Capital Stock Retained Earnings (1/1/X3) Dividends DR 3,505 42,341 20,777 1,962 2,368 0 0 46,256 300,000 10,391 60,765 7,280 4,747 0 0 937 53 0 8,000 249,493 42,500 30,051 12,000
6.
DR
CR
Accounts (cont): Sales Revenues Rental Revenue Interest Revenue Cost of Goods Sold Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Misc. Expense Insurance Expense Postage Expense Interest Expense Gain on Sale Income Tax Expense Totals
CR
318,432 280 0
Problem 1-4 - Answer Hot Cars, Inc. Income Statement for the years ended December 31, 20X1, 20X2 and 20X3
20X1 Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share $ 185,043 111,026 74,017 49,500 3,893 4,150 6,345 1,436 1,055 900 298 67,577 6,440 0 0 135 ( 0) 6,575 1,644 4,931 2.05
20X2
$ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53
206,145 60,689 3,465 4,400 8,144 6,985 617 2,345 373 7,810 2,000 4,747 734,929 734,929
$ $
44
45
1-16
6. (continued)
Problem 1-4 - Answer Hot Cars, Inc. Statement of Retained Earnings for the years ended December 31, 20X1, 20X2 and 20X3
20X1
Problem 1-4 - Answer Hot Cars, Inc. Balance Sheet December 31, 20X1, 20X2 and 20X3
Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable Building Warehouse Equipment Less: Accumulated Depreciation Total Assets 12/31/X1 12/31/X2 12/31/X3 12/31/X1 Liabilities & Equity Current Liabilities: Accounts Payable $ 13,511 Salaries Payable 4,125 Income Tax Payable 1,644 Dividend Payable 1,250 Unearned Rent Revenue 0 Utilities Payable 485 Interest Payable 0 Current Portion of Long-Term Debt 0 21,015 Equipment Note Payable 0 Mortgage Note Payable 0 Total Liabilities 21,015 Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
20X2
$ 11,502 19,224 (675) $ 30,051
20X3
$ 30,051 14,992 (12,000) $ 33,043
Balance at beginning of year Net Income for the year Less: Dividends Balance at end of year
7,821 4,931 (1,250) $ 11,502
$ 12,665 11,750 11,432 470 350 4,400 750 41,817 0 18,466 (3,766) $ 56,517
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
$ 22,250 $ 60,765 7,280 0 4,747 6,408 0 0 0 280 937 400 53 178 6,130 14,000 79,912 43,516 4,000 8,000 247,363 0 331,275 51,516
24,000 11,502 35,502 $ 56,517
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,543 $ 406,818
46
47
7. Closing Entires: Sales Revenues Rental Revenue Gain on Sale Cost of Goods Sold Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Misc. Expense Insurance Expense Postage Expense Interest Expense Income Tax Expense Retained Earnings Retained Earnings Dividends
DR
318,432 280 2,000
CR
7. (continued)
Cash
1/1/X3 J. Q. 21,808 310,406 10,000 4,677 7,607 50,000 5,502 10,000 1,500 4,000 1,440 53,409 4,313 6,408 163,407 12,000 617 373 13,456 12/31/X3 3,505
Accounts Receivable
1/1/X3 C. D. E. E. F. F. G. G. H. I. K. L. M. N. O. P. 1/1/X3 C. 12/31/X3 12/31/X3 20,777 1/1/X3 A. 12/31/X3 42,341 B. 34,315 318,432 310,406 J.
206,145 60,689 3,465 4,400 8,144 6,985 617 2,345 373 7,810 4,747 14,992 12,000
Inventory
25,000 201,922 206,145 B.
Office Supplies
750 4,677 1,962 3,465 i.
12,000
48
49
7. (continued)
Prepaid Insurance
1/1/X3 I. 12/31/X3 400 4,313 2,368 2,345
7. (continued)
Land & Building Accounts Payable
22,250 L. 163,407 201,922 60,765 0 300,000
Dividend Payable
1/1/X3 A. 0 12/31/X3 12/31/X3 0 1/1/X3
1/1/X3 e. E.
12/31/X3 300,000
Unearned Rent Revenue Prepaid Rent

1/1/X3 4,400 4,400 12/31/X3 0 g. 1/1/X3 P. 12/31/X3
Warehouse Equipment
42,800 13,456 46,256 10,000 Q.
Salaries Payable
0 7,280 1/1/X3 a. c. 280
280
1/1/X3
0 7,280 12/31/X3
12/31/X3
Utilities Payable Notes Receivable

1/1/X3 12/31/X3 0 Q. 0 10,391 12/31/X3 4,747 12/31/X3 2,000
5,406 6,985 1/1/X3 f. K.
Income Tax Payable

6,408 6,408 4,747 1/1/X3 h. d. 400
400 937 937
1/1/X3 b. 12/31/X3
50
51
1-17
7. (continued)
Interest Payable
178 F. G. 99 79 53 53
7. (continued)
Dividends
1/1/X3 M. 12/31/X3 0 12,000 12,000 12,000 1/1/X4 0 E. 0 250,000 1/1/X3

1/1/X3 d. 12/31/X3 E. 507
Rental Revenue
0 280 close close 280 0 1/1/X4 1/1/X3 c.
280 12/31/X3 249,493 12/31/X3
Bank Note Payable

10,000 F. 10,000 1/1/X3
Capital Stock
42,500 42,500 1/1/X3 12/31/X3 close 1/1/X3 close 12/31/X3
Interest Revenue
0 1/1/X3 0 318,432 1/1/X3 B. close 0 0 1/1/X4 0 12/31/X3
Sales Revenues
0 12/31/X3
318,432 12/31/X3

12,000 G. 4,000 8,000 12/31/X3 1/1/X3 Dividends 12,000 33,043 30,051 14,992
318,432 0 1/1/X4 1/1/X3 B.
Cost of Goods Sold

0 206,145 206,145 1/1/X4 0 close
12/31/X3 206,145
52
53
7. (continued)
Salaries Expense
1/1/X3 H. a. 12/31/X3 1/1/X4 0 53,409 7,280 60,689 60,689 0
7. (continued)
Rent Expense
0 4,400 4,400 4,400 close 1/1/X4 0 0 1/1/X3 f. 12/31/X3 0 6,985 6,985 6,985
1/1/X3 O. 12/31/X3 close 1/1/X4
Postage Expense
0 373 373 373 0 close
1/1/X3 g. 12/31/X3 close 1/1/X4

1/1/X3 i. 12/31/X3 1/1/X4 0 3,465 3,465 3,465 0 close 1/1/X4 0 1/1/X3 e. 1/1/X3 D. b. 12/31/X3 0 7,207 937 8,144 8,144 close 1/1/X3 N.
0 617 617 617 1/1/X4 0 close 1/1/X3 E. F. G. d. 12/31/X3 1/1/X4
Interest Expense
0 4,995 1,401 1,361 53 7,810 7,810 0 close
12/31/X3
Insurance Expense
0 2,345 2,345 2,345 1/1/X4 0 close
12/31/X3
54
55
7. (continued)
Gain on Sale
0 2,000 close 2,000 0
Income Tax Expense

1/1/X3 Q. 1/1/X3 h. 12/31/X3 1/1/X4 0 4,747 4,747 4,747 1/1/X4 0 close
Accounting for Adjustments of Prepaid Expenses and Unearned Revenues

Example: Assume on 10/1/X1, Berry, Inc. prepays a $1,200 insurance premium providing fire insurance coverage through 9/30/X2. Previously discussed accounting:
10/1/X1 Original Entry:
2,000 12/31/X3
Prepaid Insurance Expense Cash

12/31/X1 Adjusting Entry:
1,200
1,200
Insurance Expense Prepaid Insurance Expense $300 Insurance Expense
300
300
$900 Prepaid Insurance
56
57
1-18
Now, assume that the original entry made on October 1st to record the $1,200 prepayment was made to insurance expense rather than to the asset, prepaid insurance.
Example: Assume Jones Real Estate Company receives $24,000 rent in advance from a tenant on a one year lease beginning at the time of the rent receipt, 8/1/X1.
Insurance Expense Cash
1,200
1,200
Cash
Unearned Rent Revenue
24,000
24,000
In this case what adjusting entry could be made on 12/31, three months later, to properly adjust the books and accurately reflect the company's expenses for the year and prepaid insurance at the end of the year?
Unearned Rent Revenue Rent Revenue

$10,000 Rent Revenues
10,000
10,000
$14,000 Unearned Revenues
Prepaid Insurance Expense Insurance Expense $300 Insurance Expense
900
900
$900 Prepaid Insurance
58
59
Problem 1-5
Problem 1-5
A. Cobb Industries prepays 3-month warehouse rental costs on 12/1/X1 amounting to $15,000. 1. Prepare the original and 12/31/X1 adjusting entries assuming the payment is originally recorded as an asset. 2. Prepare the original and 12/31/X1 adjusting entries assuming the payment is originally recorded as an expense. 3. Assuming the original entry was made to an expense what would be the effect on Cobb's financial position if no adjusting entry was made? What principle of accounting mandates an adjusting entry in this case? Which approach to the original entry and resulting adjustment is preferred?
B. On 12/15/X1 Cobb collects $10,000 in advance on a customer order for goods to be shipped as soon as possible. Assume that 30% of the ordered goods are actually shipped by Cobb on 12/31/X1 with the remainder to be shipped the first week of January. 1. Prepare the original and 12/31/X1 adjusting entries assuming the cash receipt is originally recorded as unearned revenue. 2. Prepare the original and 12/31/X1 adjusting entries assuming the payment is originally recorded as revenue. 3. What principle of accounting mandates an adjusting entry in this case?
60
61
A. Cobb Industries prepays 3-month warehouse rental costs on 12/1/X1 amounting to $15,000. 1. Prepare the original and 12/31/X1 adjusting entries assuming the payment is originally recorded as an asset.
2. Prepare the original and 12/31/X1 adjusting entries assuming the payment is originally recorded as an expense.
Rent Expense Cash Prepaid Rent Expense Cash

15,000
15,000
15,000
15,000
Prepaid Rent Expense Rent Expense
10,000
10,000
Rent Expense Prepaid Rent Expense
5,000
5,000
62
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3. Assuming the original entry was made to an expense, what would be the effect on Cobb's financial position if no adjusting entry was made?
Expenses Net Income Retained Earnings Owners' Equity Assets Overstated Understated Understated Understated Understated
B. On 12/15/X1 Cobb collects $10,000 in advance on a customer order for goods to be shipped as soon as possible. Assume that 30% of the ordered goods are actually shipped by Cobb on 12/31/X1 with the remainder to be shipped the first week of January. 1. Prepare the original and 12/31/X1 adjusting entries assuming the cash receipt is originally recorded as unearned revenue.
What principle of accounting mandates an adjusting entry in this case?

Answer: The matching principle of accrual basis accounting mandates the year-end adjusting entry to properly record expenses in both 'X1 and 'X2.
Cash
Unearned Sales Revenue
10,000
10,000
Which approach to the original entry and resulting adjustment is preferred?

Answer: Both approaches produce the same financial statement results at year-end..no preference.
Unearned Sales Revenue Sales Revenue Cost of Goods Sold Inventory
3,000 ?
3,000 ?
64
65
2. Prepare the original and 12/31/X1 adjusting entries assuming the payment is originally recorded as revenue.
Cash
Sales Revenue
10,000
10,000
Sales Revenue Unearned Sales Revenue Cost of Goods Sold Inventory
7,000 ?
7,000 ?
3. What principle of accounting mandates an adjusting entry in this case?

Answer: The revenue recognition principle mandates the adjusting entry in this case.
66
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Lesson 2
Users of Financial Statements
1. Financial analysts and managers who work for banks, investment companies, insurance companies, broker/dealers, financial advisors, mutual funds and other companies that provide investment advice or actually make their own stock market investments. 2. SEC and other government agencies. The SEC's Division of Corporate Finance reviews the annual and quarterly financial statements included in the 10-K (annual) and 10-Q (quarterly) filings of publicly held companies. 3. Management. 4. The media. 5. Suppliers, employees, and union officials. 6. Individual investors like you and me.
Lesson 2
Expanded Financial Statement Analysis
Technical Analysts:
Rely almost exclusively on complicated mathematical models using market data, such as trading volume and interest rates. In this approach, a company's intrinsic or real value and its financial statements are pretty much ignored.
Fundamental Analysts:
The bottom line in fundamental analysis is to make accurate forecasts of a company's future EPS as the basis for evaluating a company's current stock price and its prospects for the future. Some of the techniques used in fundamental analysis involve:
1. Hands on evaluations of a company's products and services. Market research can be an important tool. 2. Research on general and industry economic trends. 3. Meet and communicate with key management personnel. 4. Review and analyze financial statements - ratios and other calculations and comparisons of numbers that are found in the financial statements.
Utilizing a company's financial statements to try and predict a company's future is what this lesson is all about.
Problem 2-1
Review of Liquidity Measures Using the HCI financial statements prepared in Lesson 1 and provided on the pages that follow: A. Calculate HCI's current ratio at 12/31/X2 and 'X3. B. Calculate HCI's acid-test ("quick") ratio at 12/31/X2 and 'X3.
Liquidity, or the extent of working capital, refers to a company's ability to pay its obligations in the short-term.
Working Capital = Current Assets - Current Liabilities
C. Calculate the percentage increase (decrease) in total current assets and total current liabilities from 12/31/X2 to 12/31/X3. D. What is an adequate current and acid-test ratio and can a company operate effectively at a less than 1 to 1 current ratio?
2-1
Problem 2-1 Hot Cars, Inc. Income Statement for the years ended December 31, 20X1, 20X2 and 20X3
Problem 2-1 Hot Cars, Inc. Balance Sheet December 31, 20X1, 20X2 and 20X3
12/31/X1 Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable 12/31/X2 12/31/X3 12/31/X1 Liabilities & Equity Current Liabilities: Accounts Payable $ 13,511 Salaries Payable 4,125 Income Tax Payable 1,644 Dividend Payable 1,250 Unearned Rent Revenue 0 Utilities Payable 485 Interest Payable 0 Current Portion of Long-Term Debt 0 21,015 Equipment Note Payable 0 Mortgage Note Payable 0 Total Liabilities 21,015 Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
20X2
$ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53
$ 12,665 11,750 11,432 470 350 4,400 750 41,817 0 Land and Building 18,466 Warehouse Equipment Less: Accumulated Depreciation (3,766) $ 56,517 Total Assets
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516
60,765 7,280 4,747 0 0 937 53 6,130 79,912 4,000 247,363 331,275
24,000 11,502 35,502 $ 56,517
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
$ $
Review of Liquidity Measures A. Calculate HCI's current ratio at 12/31/X2 and 'X3.
C. Calculate the percentage increase (decrease) in total current assets and total current liabilities from 12/31/X2 to 12/31/X3.
Total Current Assts Total Current Liabilities

12/31/X2:
Change in Total Current Assets Base Year Amount of Total Current Assets
$ 70,953 = 0.89 $ 79,912
Total Current Assets: $ 70,953 - $ 86,673
$ 86,673 = 1.99 $ 43,516
12/31/X3:
$ 86,673 ($ 15,720) = 18% decrease $ 86,673

Total Current Liabilities: $ 79,912 - $ 43,516
B. Calculate HCI's acid-test ("quick") ratio at 12/31/X2 and 'X3.
Selected Current Assets (Cash, Marketable Securities, Accounts Receivable) Total Current Liabilities
12/31/X2:
$ 43,516 $ 36,396 = 84% increase $ 43,516
$ 56,123 = 1.29 $ 43,516
12/31/X3:
$ 45,846 = 0.57 $ 79,912
10
D. What is an adequate current and acid-test ratio and can a company operate effectively at a less than 1 to 1 current ratio?
Answer: A current ratio of "1 to 1" is considered adequate liquidity for most companies and an acid-test (quick) ratio of "1 to 1" is probably more than adequate. The higher the ratios, the greater a company's liquidity; however, excessive liquidity may actually indicate poor management of a company's assets and financing. In some cases excess current assets may be more productively used if converted to cash and used to payoff interest bearing debts or purchase capital assets (buildings, equipment, etc.). A company's goal should be to maximize profits, not liquidity. On the other hand, companies must be able to meet obligations as they come due to retain credibility with suppliers and other provider's of capital. Adequate liquidity is essential for effective operations and should be monitored closely. Whether a company can operate effectively at a less than 1 to 1 current ratio depends on the nature of the company's business. If a company sells its inventory at high margins and turns its inventory frequently, significant additional cash can be generated to meet current obligations. In other words, profits can be a new and constant source of cash to supplement existing current assets in satisfying current debts. Highly profitable companies with frequent inventory turnover can usually operate effectively at relatively low current ratios.
Acid-Test (Quick) Ratio:

12/31/X2 1.25 12/31/X3 0.57
Current Assets Current Liabilities
18% 84%
A company's statement of cash flows, which reports sources and uses of cash during the year, can be really helpful in understanding the causes of changing liquidity and can help spot dangerous trends that could impact a company's future.
11
12
2-2
12/31/X1 Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable 12/31/X2 12/31/X3 12/31/X1 Liabilities & Equity Current Liabilities: Accounts Payable $ 13,511 Salaries Payable 4,125 Income Tax Payable 1,644 Dividend Payable 1,250 Unearned Rent Revenue 0 Utilities Payable 485 Interest Payable 0 Current Portion of Long-Term Debt 0 21,015 Equipment Note Payable 0 Mortgage Note Payable 0 Total Liabilities 21,015 Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
Problem 2-2
Review of A/R and Inventory Turnover Measures

$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516 $ 60,765 7,280 4,747 0 0 937 53 6,130 79,912 4,000 247,363 331,275
$ 12,665 11,750 11,432 470 350 4,400 750 41,817 Land and Building 0 Warehouse Equipment 18,466 Less: Accumulated Depreciation (3,766) Total Assets $ 56,517
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
Using HCI's financial statements provided on the following pages: A. Calculate HCI's A/R turnover and days sales in A/R for 20X2 and 20X3 and interpret the results. B. Calculate HCI's inventory turnover and days sales in inventory for 20X2 and 20X3 and interpret the results.
24,000 11,502 35,502 $ 56,517
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
13
14
Problem 2-2 Hot Cars, Inc. Balance Sheet December 31, 20X1, 20X2 and 20X3
12/31/X1 Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable 12/31/X2 12/31/X3 12/31/X1 Liabilities & Equity Current Liabilities: $ 13,511 Accounts Payable 4,125 Salaries Payable 1,644 Income Tax Payable 1,250 Dividend Payable 0 Unearned Rent Revenue 485 Utilities Payable 0 Interest Payable Current Portion of Long-Term Debt 0 21,015 0 Equipment Note Payable 0 Mortgage Note Payable 21,015 Total Liabilities Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
20X2
$ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516
60,765 7,280 4,747 0 0 937 53 6,130 79,912 4,000 247,363 331,275
24,000 11,502 35,502 $ 56,517
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
$ $
15
16
Review of A/R and Inventory Turnover Measures A. Calculate HCI's A/R turnover and days sales in A/R for 20X2 and 20X3 and interpret the results.
Accounts Receivable Turnover: 20X2: 20X3:
Sales Revenues (Beginning A/R + Ending A/R) 2
This is a negative trend. Generally speaking higher turnover is preferred unless profits are compromised in the process. The timeliness of cash collections from customers could be improved by refusing to make credit sales, but that would be foolish if the company lost half of its customers as a result. The ultimate goal should always be to maximize profit not A/R turnover, but all things being equal, the collection of receivables sooner rather than later is a good thing. The increase in days sales in A/R (average collection period) from 32 days in 20X2 to 44 days in 20X3 may reflect the following:
1. Management's failure to properly enforce existing credit policies. 2. Implementation of liberalized credit policies put in place in an attempt to increase customers and improve sales volume. 3. Less aggressive collection efforts or poor management of the collection process. 4. Customer cash flow problems arising from a slowing economy or other customer problems. 5. Customer dissatisfaction with products or services.
$ 261,950 = 11.4 times ($ 11,750 + $34,315) 2 $ 318,432 = 8.3 times ($ 34,315 + $42,341) 2
Days Sales in Accounts Receivable: 20X2: 20X3:
365 = 32.1 days 11.37 365 = 43.9 days 8.31
365 A/R Turnover
Generally speaking, a 30 day collection period is good and a 43 day period may still be acceptable; however, a more useful evaluation would result from comparison of these numbers against those of competitors and companies in a similar business. Certainly the trend for HCI is of some concern and direct questioning of management as to the cause would be appropriate under the circumstances.
17
18
2-3
B. Calculate HCI's inventory turnover and days sales in inventory for 20X2 and 20X3 and interpret the results.
Inventory Turnover: 20X2: 20X3:
By pure coincidence, HCI's days sales in inventory (average inventory holding period) was exactly the same in 20X2 and 20X3. This means that on average HCI has maintained fairly consistent inventory levels relative to sales volume. Generally speaking, the higher the inventory turnover the better as long as efforts to improve turnover do not negatively affect a company's profits. The ultimate goal is to maximize profits not inventory turnover, however, financing and maintaining inventory can be expensive and the sooner inventory is sold the better. In most cases improving inventory turnover should increase a company's profits unless customer sales are lost in the process. By the way, this can actually happen. One way to improve inventory turnover is to simply reduce inventory levels, but if customers become dissatisfied with limited product selection or delays in delivery, then sales and profits might suffer. Generally speaking, a 41-day inventory holding period would not seem excessive for a toy wholesaler; however, 41 days for a grocery store would probably spell disaster. For an automobile dealership, a 41-day holding period might indicate exceptional inventory management. In order to really evaluate HCI inventory management, comparison with other companies in its industry and analysis of the effect of changing inventory levels on sales volume would probably be necessary.
Cost of Goods Sold (Beginning Inventory + Ending Inventory) / 2
$ 164,026 = 9.0 times ($ 11,432 + $25,000) / 2 $ 206,145 = 9.0 times ($ 25,000 + $20,777) / 2
Days Sales in Inventory:
365 Inventory Turnover 20X2: 365 = 40.6 days 9

20X3:
365 = 40.6 days 9
19
20
Accounts Payable Turnover:
Inventory Purchases (Beginning A/P + Ending A/P) / 2

20X2:
Inventory 1/1/X2 Purchased 12/31/X2 11,432 ? 164,026 25,000 Sold
$ 177,594 = 9.9 times ($ 13,511 + $22,250) / 2

Days Purchases in Accounts Payable:
11,432 + X - 164,026 = 25,000 X = 177,594
365 = 36.9 days 9.9
21
22
12/31/X1 Assets Current Assets: C as h Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable 12/31/X2 12/31/X3 12/31/X1 Liabilities & Equity Current Liabilities: $ 13,511 Accounts Payable 4,125 Salaries Payable 1,644 I n c om e T ax P aya b l e 1,250 Dividend Payable 0 Unearned Rent Revenue 485 Utilities Payable 0 Interest Payable Current Portion of Long-Term Debt 0 21,015 0 Equipment Note Payable 0 M o r tg a g e N o te P a y a b l e 21,015 Total Liabilities Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
20X3:
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516
60,765 7,280 4,747 0 0 937 53 6,130 79,912 4,000 247,363 331,275
$ 201,922 = 4.9 times ($ 22,250 + $ 60,765) / 2

Days Purchases in Accounts:
365 = 74.5 days 4.9
24,000 11,502 35,502 $ 56,517
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
Liquidity Problem!
23
24
2-4
Operating Cycle
Inventory Purchase Inventory Sales Cash Collections on Sales Inventory Purchase
Operating Cycle
Pay for Inventory Inventory Sales Cash Collections on Sales
41 days # day's sales in inventory
41 days 85 days
44 days # day's sales in recievables
85 days
41 days # day's sales in inventory
41 days
44 days # day's sales in recievables
85 days
75 days # day's purchases in A/P
10 days Required Financing
25
26
All companies engage in three kinds of business activities.

Inventory Purchase Inventory Sales
TM
Pay for Inventory 30 days
3-5 days
Financing Activities - The raising of capital through either borrowing, or debt financing, or through the contributions of owners, which is referred to as equity financing. Any transactions involving payoffs of loans, or return of capital to owners, or the payment of dividends to shareholders is also part of a company's financing activities. Investing Activities - The acquisition of any long-term assets such as property, plant and equipment. Any subsequent disposition of those assets is also part of a company's investing activities. Operating Activities - The recurring day-to-day providing of goods or services to customers. All transactions involving sales and any collections of cash from sales along with all incurring and payment of expenses constitute a company's operating activities. The business process in a nutshell: Obtaining financing to invest in assets that allow you to operate and provide goods or services to customers.
Cash Collections
No Financing Required!
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Hot Cars, Inc. Balance Sheet December 31, 20X2 and 20X3
12/31/X2 A s s e ts Current Assets: C as h Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable Land and Building Warehouse Equipment Less: Accumulated Depreciation Total Assets 12/31/X3 Liabilities & Equity Current Liabilities: Accounts Payable Salaries Payable Income Tax Payable Dividend Payable Unearned Rent Revenue Utilities Payable Interest Payable Current Portion of Long-Term Debt Equipment Note Payable Mortgage Note Payable Total Liabilities Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
Statement of Cash Flows
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516
60,765 7,280 4,747 0 0 937 53 6,130 79,912 4,000 247,363 331,275
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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2-5
Hot Cars, Inc. Statement of Cash Flows for the year ended December 31, 20X3
Cash flows from operating activities: Cash Receipts from: Customer sales Rental revenues Interest revenues Cash payments for: Inventory Salaries expense Rent expense Utilities expense Office supplies expense Insurance expense Postage and misc. expense Income tax expense Interest expense Net cash flows provided from operating activities Cash flows from investing activities: Cash receipt from sale of warehouse equipment Cash payments for purchase of land and building Cash payment for purchase of warehouse equipment Net cash flows used in investing activities Cash flows from financing activities: Cash payments for: Dividends Equipment note principal Mortgage note principal Bank note principal Net cash flows used in financing activities Net increase (decrease) in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year
Problem 2-3
Accounts Payable Turnover

20X3
$310,406 0 0 (163,407) (53,409) 0 (7,607) (4,677) (4,313) (990) (6,408) (7,935) 61,660 10,000 (50,000) (13,456) (53,456) (12,000) (4,000) (507) (10,000) (26,507) (18,303) 21,808 $ 3,505
Calculate Z Corporation's accounts payable turnover and days purchases in accounts payable for the year 20X7 given the following information:
12/31/X6 Cash Accounts Receivable Inventory Accounts Payable Sales Revenues Cost of Goods Sold $ 54,000 $122,000 $156,000 $177,000 $888,000 $722,000 12/31/X7 $ 72,000 $145,000 $184,000 $204,000 $958,000 $782,000
Is a higher accounts payable turnover typically a good or a bad sign for a company?
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Accounts Payable Turnover

Accounts Payable Turnover: Inventory Purchases:
1/1/X7 Purchases 12/31/X7
Inventory Purchases (Beginning A/P + Ending A/P)

Inventory
156,000 ? 782,000 Cost of Goods Sold 184,000
Question: 2 Is a higher accounts payable turnover typically a good or a bad sign for a company?
Answer: This depends. A higher accounts payable turnover means payables are being paid off over a shorter period of time. This usually results in happier suppliers and a better credit rating for the company. Generally speaking, higher turnover and the lower the # of days purchases in accounts payable reflects an improving liquidity position for a company. On the other hand, slower payments allow companies to keep their own cash longer and is, in effect, free financing until suppliers begin to charge penalties and interest on delinquent accounts.
20X7:
156,000 + X - 782,000 = 184,000 X = 810,000 $ 810,000 = 4.3 times ($177,000 + $204,000) / 2 (rounded) 365 4.3 = 85 days (rounded)
Days Purchases in Accounts Payable :
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Problem 2-4
Statement of Cash Flows

Identify the statement of cash flow category to which each of the following transactions or events would be assigned: Categories:
"O" "I" "F" = Operating activities = Investing activities = Financing activities
Transaction 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. Cash received from sale of building Cash payments on inventory purchases Cash collected on issuance of bonds Utilities payable recorded Cash payments on utility bills Cash collections on customer accounts Cash sales to customers Cash payments of interest Cash payments of principal on notes payable Cash payments in purchase of equipment Depreciation expense Cash collections of tenant rent Cash payment of employee salaries Cash purchase of copyrights Cash received from issuance of stock Cash payment made on loans to employees Cash prepayment of insurance premium Expiration of prepaid insurance Land acquired with mortgage loan Cash payment of dividends Category I O F N/A O O O O F I N/A O O I F I O N/A N/A* F
Statement of Cash Flows Categories:

"O" "I" "F" = Operating activities = Investing activities = Financing activities
Transaction Category I O F N/A O O O O F I N/A O O I F I O N/A N/A* F 1. Cash received from sale of building 2. Cash payments on inventory purchases 3. Cash collected on issuance of bonds 4. Utilities payable recorded 5. Cash payments on utility bills 6. Cash collections on customer accounts 7. Cash sales to customers 8. Cash payments of interest 9. Cash payments of principal on notes payable 10. Cash payments in purchase of equipment 11. Depreciation expense 12. Cash collections of tenant rent 13. Cash payment of employee salaries 14. Cash purchase of copyrights 15. Cash received from issuance of stock 16. Cash payment made on loans to employees 17. Cash prepayment of insurance premium 18. Expiration of prepaid insurance 19. Land acquired with mortgage loan 20. Cash payment of dividends * To be disclosed in notes to the financial statements.
"N/A" = Not on cash flow statement
"N/A" = Not on cash flow statement
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Problem 2-5
Statement of Cash Flow Analysis Given the following statement of cash flow information for five companies (Company X, Y, Q, R and Z), summarize in your own words what happened for each company during the year. Look to the sample solution for "X" below for an example.
X Cash flows from or used in operating activities + Cash flows from or used in investing activities Cash flows from or used in financing activities + Net cash flows for the period Y + + Q + + + R + Z + + +
Statement of Cash Flow Analysis

X Cash flows from or used in operating activities + Cash flows from or used in investing activities Cash flows from or used in financing activities + Net cash flows for the period Y + + Q + + + R + Z + + +
Company X: Sufficient cash was generated from operations to finance increased investment in buildings, land or other assets, make dividend payments to stockholders and/or reduce debts, and build its cash balance during the period. This is probably the most favorable situation possible for a company. Company Y: Cash flows from operations and additional debt or equity financing were used up in the purchase of buildings, equipment and/or long-term assets. In fact, the company's investment in long-term assets also consumed a portion of the company's existing cash. Obviously, this is a profitable growing company, but it appears that continued growth at the current rate will depend on the availability of additional future financing.
Sample Solution Company X: Sufficient cash was generated from operations to finance increased investment in buildings, land or other assets, make dividend payments to stockholders and/or reduce debts, and build its cash balance during the period. This is probably the most favorable situation possible for a company.
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Problem 2-5 - Answer X Cash flows from or used in operating activities + Cash flows from or used in investing activities Cash flows from or used in financing activities + Net cash flows for the period Y + + Q + + + R + Z + + +
A company's ability to obtain additional financing for investing and operating activities usually depends to a great extent on its existing financial position. Companies that are highly leveraged, or burdened with considerable debt relative to their assets will usually have problems finding additional financing. Debt can be a useful tool in the financing of a business and it can enhance profits as long as the borrowed assets generate earnings in excess of interest costs, but too much debt can often put companies at risk.
Company Q: Cash flows from the sale of land, buildings and/or other long-term assets plus additional debt or equity financing were used to finance operations and build the company's cash balance. Anytime a company fails to generate positive cash flows from operations it's a cause for concern. When that's combined with the sale or liquidation of long-term assets there is probable cause for concern. Company R: Cash flows from debt or equity financing were used to increase investments in building, land or other long-term assets and finance negative cash flows from operations. This situation is very common in start up companies that rely on outside financing to grow assets until the company becomes profitable. Company Z: Cash flows from operations and the sale of assets were used to make dividend payments to stockholders and/or reduce debts, and build its cash balance during the period. This is probably a positive situation although the liquidation of long-term assets may precede slower future growth.
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Problem 2-6
Review of Leverage Measures
Using the HCI financial statements prepared in Lesson 1 and provided on the pages that follow: A. Calculate HCI's debt ratio (total debt to total assets) at 12/31/X2 and 'X3. B. Calculate HCI's debt to equity ratio as of 12/31/X2 and 'X3. C. Calculate the percentage increase (decrease) in total assets from 12/31/X2 to 12/31/X3. D. How should these results be interpreted? E. Can a company operate effectively at a high debt ratio?
Problem 2-6 Hot Cars, Inc. Income Statement for the years ended December 31, 20X2 and 20X3
20X2
Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share $ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53
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2-7
Problem 2-6 Hot Cars, Inc. Balance Sheet December 31, 20X2 and 20X3
12/31/X2 A s s e ts Current Assets: C as h Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent Notes Receivable Land and Building Warehouse Equipment Less: Accumulated Depreciation Total Assets 12/31/X3 Liabilities & Equity Current Liabilities: Accounts Payable Salaries Payable Income Tax Payable Dividend Payable Unearned Rent Revenue Utilities Payable Interest Payable Current Portion of Long-Term Debt Equipment Note Payable Mortgage Note Payable Total Liabilities Equity Capital Stock (2,400 and 4,250 shares, respectively) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X2 12/31/X3
Review of Leverage Measures A. Calculate HCI's debt ratio (total debt to total assets) at
12/31/X1, 'X2 and 'X3.
$ 21,808 34,315 25,000 750 400 4,400 0 86,673 0 42,800 (5,406) $ 124,067
3,505 42,341 20,777 1,962 2,368 0 0 70,953 300,000 46,256 (10,391) $ 406,818
$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516
60,765 7,280 4,747 0 0 937 53 6,130 79,912 4,000 247,363 331,275
Total Liabilities Total Assets

12/31/X2:
$ 51,516 = 0.42 $ 124,067
12/31/X1:
$ 331,275 = 0.81 $ 406,818
B. Calculate HCI's debt to equity ratio as of 12/31/X2 and 'X3.
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
Total Liabilities Total Equity

12/31/X2:
$ 51,516 = 0.71 $ 72,551
12/31/X1:
$ 331,275 = 4.41 $ 75,043
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C. Calculate the percentage increase (decrease) in total assets from 12/31/X2 to 12/31/X3.
D. How should these results be interpreted?

Answer: HCI experienced a huge growth in total assets in 20X3 primarily as a result of the purchase of land and building ($300,000). This purchase was financed principally through debt, a $250,000 mortgage loan. The cash required for the down payment on the building ($50,000) was financed primarily from operations by deferring payments to suppliers on accounts payable explaining the large increase in days purchases in accounts payable and the company's declining liquidity. The company's current high level of leverage may limit the company's ability to raise capital in the future through either additional debt or equity financing and could affect its ability to grow.
Change in Total Assets Base Year Amount of Total Assets

$ 406,818 - $ 124,067 $ 124,067 $ 282,751 = 2.27 or 227% $ 124,067
E. Can a company operate effectively at a high debt ratio?

Answer: Companies can operate effectively at a high debt ratio as long as they can generate sufficient cash flow from operations to cover the interest costs. Some companies, like banks and other financial institutions, are actually designed to operate with a high debt ratio.
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Hot Cars, Inc. Income Statement for the years ended December 31, 20X2 and 20X3
20X2 20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53 Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share $ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
Times Interest Earned Ratio:
Income before Interest Expense and Income Taxes Interest Expense

12/31/X3:
$ 14,992 + $ 7,810 + $ 4,747 = 3.5 times $ 7,810
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2-8
Problem 2-7
Times Interest Earned Calculate Z Corporation's times interest earned given the following income statement for the year ended 12/31/X7:
Times Interest Earned Ratio:
Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses Operating Income Interest Expense Income Before Income Taxes Income Tax Expense Net Income $ 355,000 (178,000) 177,000 122,000 55,000 21,000 34,000 10,000 $ 24,000
Income plus Interest Expense and Income Taxes Interest Expense

12/31/X3:
$ 14,992 + $ 7,810 + $ 4,747 = 3.5 times $ 7,810
Question: Does the company's 20X7 times interest earned seem adequate?
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Times Interest Earned Income before Interest Expense and Income Taxes Interest Expense
12/31/X2: $ 24,000 + $ 21,000 + $ 10,000 = 2.6 times $ 21,000
How effectively is the company utilizing its assets to create sales of goods and services to customers and produce profits for the company's owners?
Question: Does the company's 20X7 times interest earned seem adequate?
Answer: Obviously, the higher a company's times interest earned the better. What's adequate will depend on the expectations of each individual investor. Investors who prefer leveraged investments will often have a lower threshold in their expectation of times interest earned.
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Ratios commonly used in evaluating a company's profit performance

Net Income Total Assets
"Return on Assets" (ROA) 12/31/X2: $ 19,224 = 0.155 or 15.5% return on assets $ 124,067 12/31/X3: $ 14,992 = 0.037 or 3.7% return on assets $ 406,818
Ratios commonly used in evaluating a company's profit performance

Net Income Total Assets
"Return on Assets" (ROA) 12/31/X2: $ 19,224 = 0.155 or 15.5% return on assets $ 124,067 12/31/X3: $ 14,992 = 0.077 or 7.7% return on assets $ 194,755 Weighted average balance of total assets: (9 x $124,067) + (3 x $406,818) = $194,755 12 months
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"Return on Equity" (ROE)
Why is HCI's return on equity in both 20X2 and 20X3 so much higher than the company's return of assets? Net Income $ XXX
Net Income Total Equity

12/31/X2: $ 19,224 = 0.265 or 26.5% $ 72,551 12/31/X3: $ 14,992 = 0.20 or 20% $ 75,043
= % Return
Owners are better off if equal or greater profits can be achieved with less invested capital. Using other peoples' money to produce profits for yourself is what's going on here.
Leverage
If a company can borrow assets and produce a return on those assets in excess of the costs of borrowing those assets, then owners benefit and the company's return on equity goes up.
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DuPont Framework
HCI
ROA ROE
(Performance Analysis)
Efficiency
(sales on assets)
ROE = Profitability x
(profit margin)
Leverage
(use of borrowed assets)
Net Income Sales Revenues 20X2: 26.5 % = 20X3: 20.0% = $19,224 $261,950 0.073 $14,992 $318,432 0.047
Sales Revenues Total Assets $261,950 $124,067
Total Assets Total Equity $124,067 $72,551
20X2: 20X3:
15.5% 7.7%
26.5% 20.0%
2.11 $318,432 $406,818
1.71 $406,818 $75,043
0.78
5.42
Improvements: Product price increases Cuts in expenses
Improvements: Increase sales volume Downsize assets
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(Earnings Per Share)

Basic EPS:
EPS
Net Income # Shares of Stock Outstanding
Net Income - Preferred Dividends # Shares of Common Stock Outstanding (weighted average)
Example of weighted average - Assume a company has 100,000 shares of common stock outstanding as of 1/1/X6 and an additional 20,000 shares are issued at 4/1/X6. The weighted average to be used in the EPS calculation for the year ended 12/31/X6 would be:
Diluted EPS: Calculated the same way as earning per share except that any common shares that could have been issued during the year through existing stock options or any other commitment, are added to the weighted average number of shares outstanding in the denominator. Diluted EPS will always be lower than basic EPS and reflects what EPS would have been if all commitments to issue common stock had been fulfilled during the year. HCI's 20X3 EPS:
$ 14,992 = $3.53 per share 4,250 shares
(100,000 x 3 mo.) + (120,000 x 9 mo.) = 115,000 shares 12 mo.
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Shareholders generate profits on their stock investments in two ways:

Dividends Gains on the subsequent sale of their stock.
_ Dividends + Increase or Decrease in Stock Price Stockholder's Return = on Investment Original Stock Purchase Price
Dividend Payout Ratio:
Because stock prices change daily, an investor's return on investment is a constantly fluctuating amount. In fact, stockholder returns are never actually realized until a stock is finally sold.
Dividends Net Income

Dividend Yield:
When should a stock be sold?
Dividends per Share Price Paid per Share 61 62
Price Earnings or P/E Ratio: Stock prices will always move based upon changing investor expectations of a company's future earnings.
Market Price Per Share EPS
HCI's 12/31/X3 P/E Ratio:
$ 60 = 17 times P/E multiple $3.53 Is $60 per share or a 17 to 1 price earnings multiple too high for HCI stock, and why do some stocks sell at much higher multiples, in some cases, in excess of 30 or even 60 times a dollar of earnings? 63
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The stock of stagnant companies with no expectation of future increased earnings will often be priced at P/E ratios of 10 to 1, or less. $1 of EPS = 10% return on investment $10 Investment The stock of companies with declining prospects for earnings will probably sell at a P/E ratio of less than 10 to 1.
20X2 20X3
Problem 2-8
Performance and Value Measures

Given the information for Staley Industries for the year ended 12/31/X5:
Staley Industries
12/31/X5
1. Calculate:
A. Return on Assets B. Return on Equity C. Return on Equity using the DuPont Framework D. EPS (Assume no new shares were issued in 20X5.) E. Dividends Per Share F. Dividend Payout Ratio G. Dividend Yield H. P/E Ratio
HCI's EPS
$4.52
$3.53
What would HCI's stock price be at a 10 times P/E ratio? Price Per Share = 10 $ 3.53 Price Per Share = $35
Where are HCI's future profits headed?

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Cash Total Current Assets Total Assets Total Current Liabilities Total Liabilities Retained Earnings (beginning) Common Stock (10,000 shares) Sales Revenues Gross Margin Operating Income Net Income Retained Earnings (ending) Current Stock Price per Share
$ 32,000 $125,000 $743,000 $ 94,000 $450,000 $148,000 $100,000 $997,000 $367,000 $ 94,000 $ 65,000 $193,000 $ 91
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Problem 2-8
Performance and Value Measures 2. Respond to the following questions:

A. Given Staley's ratio results in Part 1, i. Evaluate the company's 20X5 operating performance, to the extent possible. ii. How do you think investors view the company's prospects for the future. B. What conclusions can be drawn from the company's dividend payout ratio? C. Which of the following is a good measure of a stock investor's real return on investment; (a) return on assets, (b) return on equity, or (c) dividend yield.
1. Calculation of ratios:
A. Return on Assets: Net Income
Total Assets
B. Return on Equity: Net Income
$ 65,000 = 8.7% $743,000 $65,000 = 22.2% $293,000
Total Equity
C. Return on Equity using the DuPont Framework:
Efficiency Leverage Profitability ROE = (profit margin) x (sales on assets) x (use of borrowed assets)
Net Income Sales Revenues Total Assets x x Sales Revenues Total Assets Total Equity $65,000 $997,000 22.2 % = 0.0652
x x
$997,000 $743,000 1.342
x x
$743,000 $293,000 2.536
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D. EPS:
Net Income # Shares of Stock Outstanding $65,000 = $6.50 per share 10,000 shares Dividends # of Shares of Stock Outstanding $20,000 = $2.00 10,000 EPS $ 2.00 = 31% $ 6.50 $ 2.00 = 2.2% $ 91 $ 91 = 14 $ 6.50
2. Respond to the following questions:

A. Given Staley's ratio results in Part 1, i. Evaluate the company's 20X5 operating performance, to the extent possible.
Answer: Without prior year information, ratios of other companies in a similar business, or industry averages, it is difficult to reach meaningful conclusions on Staley's operating performance in 20X5. We know the company's profitable with $6.50 of EPS, and the return on equity of 22.2% seems good, but is that up or down from the prior year? If the company's 20X4 return on equity was 50%, then the 20X5 return of 22% would probably be a major disappointment. The DuPont framework helps us note that a big part of Staley's 22% return on equity is its leverage. About 60% of the company's assets have been financed by debt, but again, it's difficult to evaluate the company's profitability and efficiency in the use of assets without comparative data.
E. Dividends Per Share:
F. Dividend Payout Ratio: Dividends Per Share
G. Dividend Yield:
Dividends per Share Market Price per Share EPS
H. P/E Ratio: Market Price per Share
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ii. How do you think investors view the company's prospects for the future.
Answer: Stock values are based on investor expectations for future profits. The fact that Staley's P/E ratio is only 14 does not suggest high expectations for future growth in profits. High growth companies often trade at P/E multiples of 30 or more. The modest investor expectation's for Staley's future earnings may be a result of one or a number of things including the following: a. A trend of slow or unstable earnings growth. b. Slowing growth or recession in Staley's industry. c. Slowing growth or recession in the country's overall economy. d. Some national, industry or company event that has created uncertainty in investors minds relative to the future.
B. What conclusions can be drawn from the company's dividend payout ratio?
Answer: In 20X5, Staley paid out 31% of it earnings as a dividend to stockholders. Without comparative information from prior years it's impossible to establish the company's historical or ongoing dividend policy. Fast growing companies often pay no dividends, retaining all of their earnings to help finance their growth. A 31% dividend payout may be consistent for a company experiencing modest growth, however, there really isn't sufficient data to draw any real conclusions in this case.
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C. Which of the following is a good measure of a stock investor's real return on investment; (a) return on assets, (b) return on equity, or (c) dividend yield.
Answer: A stock investor's real return on investment includes any dividends received plus or minus any gain or loss on the sale of the stock (the difference between the stock's purchase and subsequent sales price). This return on investment cannot be determined until the stock is ultimately sold. Prior to actual sale a tentative return on investment would be the amount of any dividends received plus or minus any increase or decrease in the stock's current value relative to its original purchase price. None of the measures provided in this question reflect this return on stock investment. Return on assets (ROA) reflects a company's earnings on its total assets. It is not a measure of investor or stockholder returns. Return on equity (ROE) measures the company's earnings on the assets provided through capital contributions and retained earnings. It is not a measure of investor or stockholder returns. Dividend yield measures only a portion of an investor's return based on the stock's current pricing rather than the amount of a stockholder's actual investment.
The ultimate goal of financial statement analysis is to utilize a company's financial statements to predict its future.
For Stock Investors:

The goal is to predict a company's future dividends and stock value to assess its potential return on investment. The key to good predictions of future dividends and stock values are good predictions of a company's future earnings.
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Problem 2-9
Review of Income Statement Analysis Using the HCI financial statements prepared in Lesson 1 and provided on the following pages:
One of the better tools available to analysts in trying to formulate forecasts of a company's future earnings is vertical analysis of its past earnings, which is sometimes referred to as the use of a common-sized income statement. It's done by taking each element of the income statement as a percentage of net sales revenues and then analyzing those results over time.
A. Calculate HCI's cost of goods sold, gross margin, operating expenses, operating income, interest expense, income before income taxes, income taxes and net income, each as a percentage of sales revenues for the years 20X1, 'X2 and 'X3. B. What might be the cause of the declining gross margin percentage over the years? C. Calculate the percentage growth in sales revenues in 20X2 and 20X3. What might be the cause of the declining growth of sales revenues and discuss the significance of the results relative to HCI's future. D. What is your opinion on the outlook for future HCI earnings given this income statement analysis?
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A.
Review of Income Statement Analysis

20X1 Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share $ 185,043 111,026 74,017 49,500 3,893 4,150 6,345 1,436 1,055 900 298 67,577 6,440 0 0 135 ( 0) 6,575 1,644 4,931 2.05 .60 .40
20X2
$ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53
20X2
$ 261,950 164,026 97,924 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 25,338 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52 .63 .37
20X3
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53 .65 .35
.37 .03
.28 .10
.27 .08
$ $
$ $
.00 .03 .01 .02
.00 .10 .02 .07
.02 .06 .01 .05
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B. What might be the cause of the declining gross margin percentage over the years?
Answer: The declining gross margin percentage could be the result of the following: 1. The company's product costs increased and the company elected to hold back on a corresponding price increase to customers. In fact, the company may have actually reduced, left unchanged, or increased their customer pricing and generated this percentage trend as long as any price increase was less than the increase in costs. 2. The company's product costs have not changed over time, but the company has reduced its sales pricing to improve sales volume. 3. The company's product costs may have actually gone down over the years but the company has implemented even larger price reductions for its customers. Further information from HCI management would be necessary to understand the precise cause for this decline in the gross margin percentage and its impact on the company's future. In any case, a decreasing gross margin percentage is usually a sign of increasing competition or decreasing customer demand, neither of which is a good sign for future growth in profits.
C. Calculate the percentage growth in sales revenues in 20X2 and 20X3.

Growth in Sales Revenues: 20X2: $ 261,950 - $ 185,043
$ 185,043
20X3: $ 318,432 - $ 261,950
= 0.42 = 0.22
$ 261,950
What might be the cause of the declining growth of sales revenues and discuss the significance of the results relative to HCI's future.
Answer: The declining growth in sales revenues could be the simple result of slowing growth in the volume of sales, sales price reductions, or some combination of the two. In any case, declining growth in sales revenues is a sign of increased competition or slowing growth in customer demand. Hopefully this trend can be reversed through product improvements or better marketing, if not, the only hope for increased growth in future earnings will be through better management of the company's costs, which can only go so far.
79
80
$60/share x 4,250 shares
= $255,000
D. What is your opinion on the outlook for future HCI earnings given this income statement analysis?
Answer: HCI's declining net income in 20X3 was caused primarily by its lower gross margin percentage and increased interest costs associated with the purchase of land and building. The prospects for improved earnings in 20X4 are not good given the expected increases in interest and depreciation, even though rent expenses will be eliminated. The decision to purchase the land and building in the face of declining growth in sales and lower margins seems, at best, questionable. Maybe management can provide some explanation and offer a plan for improved performance, but the results from this last year are not encouraging.
Market Capitalization (Market Cap)

Book Value = Assets - Liabilities = $406,818 - $331,275 = $75,043 Book Value Per Share:
Book Value # Shares of Stock Outstanding

$75,043 = $17.66 per share 4,250
81
82
20X1 Sales Revenues $ 185,043 Cost of Goods Sold 111,026 Gross Margin 74,017 Operating Expenses: 49,500 Salaries Expense Office Supplies Expense 3,893 4,150 Rent Expense 6,345 Utilities Expense Depreciation Expense 1,436 1,055 Insurance Expense 900 Miscellaneous Expense 298 Postage Expense 67,577 Operating Expenses Operating Income 6,440 Other Revenue and (Expense) 0 Gain on Sale Rental Revenue 0 Interest Revenue 135 Interest Expense ( 0) Income Before Income Taxes 6,575 Income Tax Expense 1,644 Net Income $ 4,931 Earnings Per Share $ 2.05 .60 .40
20X2
$ 261,950 164,026 .63 97,924 .37 53,600 3,958 4,800 6,850 1,640 1,105 312 321 72,586 .28 25,338 .10 0 420 52 (178) 25,632 6,408 $ 19,224 $ 4.52
20X3
$ 318,432 206,145 .65 112,287 .35 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 .27 25,269 .08 2,000 280 0 (7,810) 19,739 4,747 $ 14,992 $ 3.53
.37 .03
.00 .03 .01 .02
.00 .10 .02 .07
.02 .06 .01 .05
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2-14
Lesson 3
A statement of cash flows can be useful to investors, creditors and analysts in
Lesson 3
The Statement of Cash Flows
1. Understanding the causes of a company's changing cash position and overall liquidity. 2. Helping to understand the extent and nature of a company's financing and investing activities. 3. Evaluating a company's ability to generate cash from its operations.
Cash flows from (used in ) operating activities: Cash Receipts from: Customer sales Cash payments for: Inventory Salaries expense Rent expense Utilities expense Office supplies expense Insurance expense Postage and misc. expense Income tax expense Interest expense Net cash flows provided from operating activities Cash flows from (used in) investing activities: Cash payment for purchase of land and building Cash payment for purchase of warehouse equipment Cash receipt from sale of warehouse equipment Net cash flows used in investing activities Cash flows from (used in) financing activities: Payment of mortgage note principal Payment of equipment note principal Payment of dividends Net cash flows used in financing activities Net increase (decrease) in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year
Profitable and growing companies:

20X3
$310,406 (163,407) (53,409) 0 (7,607) (4,677) (4,313) (990) (6,408) (7,935) 61,660 (50,000) (13,456) 10,000 (53,456) (507) (14,000) (12,000) (26,507) (18,303) 21,808 $ 3,505
Cash from operating activities Cash used in investing activities
Companies that generate enough net cash flow from operations to not only fund their investments, but also pay down debts and distribute dividends to owners are the best cash performers and are often referred to as "cash cows."
3
20X3
$310,406 (163,407) (53,409) 0 (7,607) (4,677) (4,313) (990) (6,408) (7,935) 61,660 (50,000) (13,456) 10,000 (53,456) (507) (14,000) (12,000) (26,507) (18,303) 21,808 $ 3,505
Cash: Coins, paper currency, immediately depositable instruments such as checks, money orders, cashiers checks and traveler's checks on-hand, plus, the balances of any demand deposits, which include checking, savings and money market accounts. Cash Equivalents: Short-term, highly liquid investments that can be easily converted to cash with no real risk of changing values. These include such things as certificates of deposit, savings certificates, U.S. Treasury bills and commercial paper with a less than three-month maturity.
3-1
Cash
1/1/X3 Customer sales Sale of warehouse equip. 21,808 310,406 10,000 4,677 7,607 50,000 507 4,995 10,000 1,500 4,000 1,440 53,409 4,313 6,408 163,407 12,000 617 373 13,456 12/31/X3 3,505 Office supplies expense Utilities expense Purchase land & building Payments on mortgage note Payment of mortgage interest Payment of bank note Payment of bank note interest Payment on equipment note Payment of equip. note interest Salaries expense Insurance expense Income tax expense Purchase of inventory Payment of dividends Miscellaneous expense Postage expense Purchase of warehouse equip.
20X3
$310,406 (163,407) (53,409) 0 (7,607) (4,677) (4,313) (990) (6,408) (7,935) 61,660 (50,000) (13,456) 10,000 (53,456) (507) (14,000) (12,000) (26,507) (18,303) 21,808 $ 3,505
Problem 3-1
Interpreting a Statement of Cash Flows

Given the following information for companies A, B, C and D:
Net cash flows from (used in)
A is a business in distress. The company is selling assets and accessing additional financing to fund its negative cash flows from operations.
A
($102,000) $60,000 $75,000
B
$144,000 ($25,000) ($205,000)
C
($53,000) ($433,000) $750,000
D
$150,000 ($505,000) $370,000
Operations Investing Activities Financing Activities
B is a mature cash cow. Relatively large cash flows from operations are sufficient to fund modest growth in assets but are used primarily for debt reduction, return of capital or the payment of dividends. C is a start-up company. Large infusions of capital are required to acquire necessary assets and fund operations until the company begins to generate positive cash flows from profitable operations on its own. D is a profitable growing business. Cash flows from operations and additional debt or equity financing is used to fund a major increase in the company's capital assets.
Identify which of the four companies is a start-up business. a mature cash cow. a profitable growing business. a business in distress.
10
Problem 3-2
Preparing a Statement of Cash Flows: Direct Method

Given the summarized general ledger cash account for Harrison Furniture Co., prepare the company's statement of cash flows for the year-ended 12/31/X3.
Cash
1/1/X3 Cash sales Cash collections on A/R Interest income Proceeds on equipment sale Proceeds on issuance of stock Proceeds from issuance of bonds 15,733 85,327 494,572 3,288 38,355 100,000 500,000 15,432 Cash purchases of inventory 275,387 Payments on A/P 3,512 Purchase of office supplies 25,489 Interest payments 104,995 Principal payments on note payable 22,875 Utility payments 456,025 Purchase of equipment 136,905 Salary and wage payments 8,736 Insurance payments 50,000 Payment of dividends 22,400 Income tax payments 15,000 Loans made to employees 18,366 Payments on other operating costs
Problem 3-2 - Answer Harrison Furniture Co. Statement of Cash Flows for the year ended December 31, 20X3
Cash flows from (used in) operating activities: Cash receipts from: Customer sales (85,327 + 494,572) Interest income Cash payments for: Inventory (15,432 + 275,387) Salaries and wages Utilities Insurance Office supplies Other operating costs Interest Income taxes Net cash flows from operating activities Cash from (used in) investing activities: Cash receipt from equipment sale Cash payments on purchase of equipment Cash loans made to employees Net cash flows used in investing activities Cash flows from(used in) financing activities: Cash received from issuance of stock Cash received from issuance of bonds Dividends paid Cash payment on principal of note payable Net cash flows from financing activities Net increase (decrease) in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year
20X3
$579,899 3,288 583,187 (290,819) (136,905) (22,875) (8,736) (3,512) (18,366) (25,489) (22,400) (529,102) 54,085 38,355 (456,025) (15,000) (432,670) 100,000 500,000 (50,000) (104,995) 445,005 66,420 15,733 $ 82,153
12/31/X3
82,153
Question: What is your general reaction if Harrison asked you for a $300,000 loan ?
11
12
3-2
Question: What is your general reaction if Harrison asked you for a $300,000 loan?
Answer: The statement of cash flows indicates that Harrison is a growing company. That's evidenced by the large expenditure of cash in investing activities, which totaled almost $433,000 on a net basis. The company bought a substantial amount of equipment during the year. This growth was financed primarily through capital contributions from owners and a large amount of new debt, the issuance of over $500,000 of bonds. The company generated positive cash flows from operations during the year, and that's good, but what really matters most to new potential creditors is the company's ability to generate operating cash flows in the future. Will all that newly purchased equipment create enough additional profits to cover the increasing interest costs associated with the newly issued bonds? At this point, that's not really clear, but that would certainly be a major concern for any potential new creditor. Additional review and analysis of the company's balance sheet to determine the company's overall financial position and liquidity would also be a necessary part of any decision to extend a $300,000 loan.
Indirect Method:
A way to come up with the same net cash flow results by relying primarily on the information already provided in the other two general purpose financial statements, the income statement and the balance sheet. Cash flows from operating activities: Cash inflows less outflows resulting from activities that produce a company's revenues and expenses. Since all of a company's revenues and expenses appear on its income statement, the indirect method takes the net income amount from that statement and adjusts it to reflect net cash flows from operations.
13
14
Hot Cars, Inc. Income Statement for the years ended December 31, 20X3
20X3
Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share $ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 (7,810) 19,739 4,747 $ 14,992 $ 3.53
20X3
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16
12/31/X2 12/31/X3
$ 3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
Sales Revenues
318,432
12/31/X2 12/31/X3
$ 60,765 7,280 4,747 0 937 53 6,130 79,912 4,000 247,363 331,275
318,432 12/31/X3
Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent
$ 21,808 34,315 25,000 750 400 4,400 86,673 0 Land and Building 42,800 Warehouse Equipment (5,406) Less: Accumulated Depreciation Total Assets $ 124,067
Liabilities & Equity Current Liabilities: Accounts Payable $ 22,250 Salaries Payable 0 Income Tax Payable 6,408 Unearned Rent Revenue 280 Utilities Payable 400 Interest Payable 178 Current Portion of Long-Term Debt 14,000 43,516 Equipment Note Payable 8,000 Mortgage Note Payable 0 Total Liabilities 51,516 Equity Capital Stock (4,250 shares outstanding) Retained Earnings Total Equity Total Liabilities & Equity
Accounts Receivable
1/1/X3 34,315 318,432 310,406 Collected 12/31/X3 42,341
Cash
310,406
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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18
3-3
Assume that of the $318,432 of total sales revenues for the year, $124,516 were from cash sales and the remaining $193,916 were from sales made on account.
Sales Revenues
Net cash flows from (used in) operations: Net income (loss) Adjustments (accrual to cash basis): $ 14,992 (8,026) Net cash flows from operating activities Recorded Sales Revenues Customer Cash Collections ?
318,432 310,406 8,026 12/31/X3 1/1/X3 34,315 193,916
318,432 318,432 12/31/X3
Accounts Receivable
185,890 Collected 42,341
Cash
124,516 185,890
$318,432 ($8,026)
$310,406
310,406
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20
When determining the adjustment to convert a company's net income to its net cash flows from operations for the difference between accrual and cash basis sales revenues the basic rule is this:
20X3
A/R = Adjust net income A/R = Adjust net income

Think of it this way:
There is no difference in accrual and cash basis sales revenues for a company's cash sales. The only difference comes from sales made on account, and A/R means recorded sales on account exceeded cash collections, and net income must be adjusted down to reflect the lower cash flows. A/R means more cash was collected than sales made on account and net income must be adjusted up to show the higher resulting cash flows.
Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 (7,810) 19,739 4,747 $ 14,992 $ 3.53
21
22
Cost of Goods Sold

1/1/X3 12/31/X3 0 206,145 206,145
Accounts Payable
22,250 Cash Paid 163,407 60,765 12/31/X3 1/1/X3 201,922 Purchases
Inventory
1/1/X3 25,000 206,145 Goods Sold 12/31/X3 20,777
Net cash flows from (used in) operations: Net income (loss) Adjustments (accrual to cash basis): Increase in A/R $ 14,992 (8,026) 42,738 ?
Cash
163,407 Paid A/P
Purchases 201,922
Cash vs. Accrual difference = $42,738

Increase in A/P $38,515 Decrease in Inventory 4,223 $42,738
Net cash flows from operating activities
Basic Rules: A/P
NI , A/P NI Inventory NI , Inventory
NI
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24
3-4
20X3
Sales Revenues Cost of Goods Sold Gross Margin Operating Expenses: Salaries Expense Office Supplies Expense Rent Expense Utilities Expense Depreciation Expense Insurance Expense Miscellaneous Expense Postage Expense Operating Expenses Operating Income Other Revenue and (Expense) Gain on Sale Rental Revenue Interest Expense Income Before Income Taxes Income Tax Expense Net Income Earnings Per Share
Salaries Expense
1/1/X3 12/31/X3 0 60,689 60,689
$ 318,432 206,145 112,287 60,689 3,465 4,400 8,144 6,985 2,345 617 373 87,018 25,269 2,000 280 (7,810) 19,739 4,747 $ 14,992 $ 3.53
Salaries Payable
0 1/1/X3 60,689 Salaries incurred
Paid salaries
53,409
7,280 12/31/X3
Cash
53,409
Paid salaries
Accrual over Cash = $7,280 Basic Rules: Salaries Payable NI , Salaries Payable
NI
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26
Salaries Expense
1/1/X3 12/31/X3 0 60,689 60,689
Salaries Payable
0 1/1/X3 60,689 Salaries incurred
Net cash flows from (used in) operations: Net income (loss) Adjustments (accrual to cash basis): Increase in A/R Increase in A/P Decrease in Inventory $ 14,992 (8,026) 38,515 4,223 7,280 ?
Paid salaries
53,409
7,280 12/31/X3
Cash
53,409
Paid salaries
Net cash flows from operating activities Accrual over Cash = $7,280 Basic Rules: Salaries Payable NI , Salaries Payable
NI
27
28
20X3
12/31/X2 12/31/X3
$ 3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
Liabilities & Equity Current Liabilities: Accounts Payable $ 22,250 Salaries Payable 0 Income Tax Payable 6,408 Unearned Rent Revenue 280 Utilities Payable 400 Interest Payable 178 Current Portion of Long-Term Debt 14,000 43,516 Equipment Note Payable 8,000 Mortgage Note Payable 0 Total Liabilities 51,516 Equity Capital Stock (4,250 shares outstanding) Retained Earnings Total Equity Total Liabilities & Equity
12/31/X2
12/31/X3
$ 60,765 7,280 4,747 0 937 53 6,130 79,912 4,000 247,363 331,275
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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30
3-5
Under this indirect approach to preparing a statement of cash flows, a company's net cash flows from operations can be easily determined by taking a company's net income for the period and adjusting it for changes in the company's balance sheet accounts associated with the company's operating activities.
12/31/X2 Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent
12/31/X3
Change
Adj. NI
$ 21,808 34,315 25,000 750 400 4,400 86,673 0 Land and Building 42,800 Warehouse Equipment Less: Accumulated Depreciation (5,406) $ 124,067 Total Assets
3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
8,026 4,223 1,212 1,968 4,400
12/31/X2 Liabilities & Equity Current Liabilities: $ 22,250 Accounts Payable 0 Salaries Payable 6,408 Income Tax Payable 280 Unearned Rent Revenue 400 Utilities Payable 178 Interest Payable Current Portion of Long-Term Debt 14,000 43,516 8,000 Equipment Note Payable 0 Mortgage Note Payable 51,516 Total Liabilities Equity Capital Stock (4,250 shares outstanding) Retained Earnings Total Equity Total Liabilities & Equity
12/31/X3
Change
Adj. NI
60,765 7,280 4,747 0 937 53 6,130 79,912 4,000 247,363 331,275
38,515 7,280 1,661 280 537 125
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
31
32
Basic Rules: Assets Assets Liabilities Liabilities Net income Net income Net income Net income
12/31/X2 Assets Current Assets: Cash Accounts Receivable Inventory Office Supplies Prepaid Insurance Prepaid Rent 12/31/X3 Change Adj. NI 12/31/X2 Liabilities & Equity Current Liabilities: Accounts Payable $ 22,250 Salaries Payable 0 Income Tax Payable 6,408 Unearned Rent Revenue 280 400 Utilities Payable Interest Payable 178 Current Portion of Long-Term Debt 14,000 43,516 Equipment Note Payable 8,000 Mortgage Note Payable 0 Total Liabilities 51,516 Equity Capital Stock (4,250 shares outstanding) Retained Earnings Total Equity Total Liabilities & Equity 12/31/X3 Change Adj. NI
* Assume that all asset changes arise from the cash purchase or cash sale of the asset. Given this assumption, an increasing asset balance during the year means that more assets were purchased with cash than were sold Cash purchases of assets use up cash and reduce a company's cash balance. Increasing assets have a decreasing effect on cash because you are in effect buying assets with cash. Decreasing assets result from asset sales which produce cash and increase a company's cash balance. Decreasing assets have an increasing effect on cash. * Assume that all increasing liabilities occur from additional cash borrowings, which increase a company's cash balance, and decreasing liabilities reflect cash payoffs of debt, which decreases a company's cash.
$ 21,808 34,315 25,000 750 400 4,400 86,673 Land and Building 0 Warehouse Equipment 42,800 Less: Accumulated Depreciation (5,406) Total Assets $ 124,067
3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
8,026 4,223 1,212 1,968 4,400
60,765 7,280 4,747 0 937 53 6,130 79,912 4,000 247,363 331,275
38,515 7,280 1,661 280 537 125
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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34
20X3
$310,406 (163,407) (53,409) 0 (7,607) (4,677) (4,313) (990) (6,408) (7,935) 61,660 (50,000) (13,456) 10,000 (53,456) (507) (14,000) (12,000) (26,507) (18,303) 21,808 $ 3,505
Net cash flows from (used in) operations: Net income (loss) Adjustments (accrual to cash basis): Increase in A/R Increase in A/P Decrease in inventory Increase in salaries payable Increase in prepaid insurance Increase in office supplies Decrease in prepaid rent Decrease in income taxes payable Decrease in unearned rent revenue Increase in utilities payable Decrease in interest payable Net cash flows from operating activities $ 14,992 (8,026) 38,515 4,223 7,280 (1,968) (1,212) 4,400 (1,661) (280) 537 (125) $ 56,675
35
36
3-6
20X3
Net cash flows from (used in) operations: Net income (loss) Adjustments (accrual to cash basis): Increase in A/R Increase in A/P Decrease in inventory Increase in salaries payable Increase in prepaid insurance Increase in office supplies Decrease in prepaid rent Decrease in income taxes payable Decrease in unearned rent revenue Increase in utilities payable Decrease in interest payable Depreciation expense Net cash flows from operating activities $ 14,992 (8,026) 38,515 4,223 7,280 (1,968) (1,212) 4,400 (1,661) (280) 537 (125) 6,985 $ 56,675
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38
20X3
Net cash flows from (used in) operations: Net income (loss) Adjustments (accrual to cash basis): Increase in A/R Increase in A/P Decrease in inventory Increase in salaries payable Increase in prepaid insurance Increase in office supplies Decrease in prepaid rent Decrease in income taxes payable Decrease in unearned rent revenue Increase in utilities payable Decrease in interest payable Depreciation expense Gain on sale Net cash flows from operating activities $ 14,992 (8,026) 38,515 4,223 7,280 (1,968) (1,212) 4,400 (1,661) (280) 537 (125) 6,985 (2,000) $ 63,660
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40
Problem 3-3
Basic Steps and Rules of the Indirect Method

1. Under this indirect approach to preparing a statement of cash flows, a company's net cash flows from operations can be easily determined by taking a company's net income for the period and adjusting it for changes in the company's balance sheet accounts associated with the company's operating activities. 2. Any increase in an asset should be deducted from net income and any decrease should be added back. Any increase in a liability should be added back to net income and any decrease should be deducted. 3. Add back any non-cash expenses such as depreciation or amortization expense. 4. Deduct any gains on sale or add back any losses on sale of long-term assets such as property plant and equipment that are otherwise noted in investing cash inflows or outflows.
Indirectly Determined Cash Flows from Operating Activities

Given the following information for Jordan Enterprises provided from their balance sheet and income statement:
12/31/X6 12/31/X7
Cash Accounts receivable Inventory Sales revenues Accounts payable Cost of goods sold Prepaid insurance Insurance expense
$ 15,355 $ 37,962 $ 87,444 $316,793 $ 45,686 $158,432 $ 7,494 $ 15,764
$ 17,382 $ 51,362 $ 76,263 $344,211 $ 42,543 $175,488 $ 8,646 $ 16,468
Determine Jordan's 20X7: A. Total cash collections from customers. B. Total cash payments on inventory purchases. C. Total cash payments of insurance premiums.
41
42
3-7
A.
Sales Revenues
344,211 344,211 12/31/X7
B.
Cost of Goods Sold
12/31/X7 175,488 175,488
Inventory
12/31/X6 87,444 164,307 175,488 12/31/X7 76,263
Accounts Receivable
12/31/X6 37,962 344,211 330,811 12/31/X7 51,362
Accounts Payable
45,686 164,307 167,450 42,543 12/31/X7 12/31/X6
Cash
12/31/X6 Cash collections from customers 12/31/X7 15,355 330,811 17,382
12/31/X6 12/31/X7
Cash
15,355 167,450 Cash payments on inventory purchases 17,382 Alternative approach: Cost of goods sold ($175,488) Adjust for decrease in inventory (87,444 - 76,263) 11,181 Adjust for decrease in A/P (45,686 - 42,543) ( 3,143) ($167,450)
Alternative approach: Sales revenues $344,211 Less increase in A/R (51,362 - 37,962) ( 13,400) $330,811
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44
Problem 3-4
C.
Insurance Expense
16,468 12/31/X7 16,468
Cash Flows from Operations: Indirect Method

Given the following balance sheet and supplemental information for Morris, Inc.:
A. Prepare the cash flows from operating activities section of a statement of cash flows for the year ended 20X3. B. Describe the major causes for the difference in Morris' net income and cash flows from operations in 20X3. Morris, Inc. Balance Sheet December 31, 20X2 and 20X3
Assets Current Assets: Cash Accounts Receivable Inventory Prepaid Insurance Other Assets
Prepaid Insurance
12/31/X6 7,494 17,620 16,468 12/31/X7 8,646
12/31/X2
12/31/X3
$ 42,368 68,122 300,468 6,000 12,368 429,326 602,256 (192,166) $ 839,416
Cash
12/31/X6 12/31/X7 15,355 17,620 17,382 Cash payments of insurance
$ 37,818 90,166 254,567 5,202 12,456 400,209 Property, Plant and Equipment 588,324 Less: Accumulated Depreciation (168,044) $ 820,489 Total Assets
Alternative approach: Insurance expense ($ 16,468) Deduct: Increase in Prepaid (8,646 - 7,494) ( 1,152) ($ 17,620)
12/31/X2 Liabilities & Equity Current Liabilities: Accounts Payable $ 96,155 Salaries Payable 20,673 Other Payables 16,996 Unearned Revenues 12,465 Current Portion of Notes Payable 20,000 166,280 Notes Payable 400,000 Total Liabilities 566,280 Equity Capital Stock 150,000 Retained Earnings 104,209 Total Equity 254,209 Total Liabilities & Equity $ 820,489
12/31/X3
$ 125,919 17,280 20,144 15,686 20,000 199,029 380,000 579,029 150,000 110,387 260,387 $ 839,416
Net income for the year ended 12/31/X3 totaled $56,178 after $24,122 of depreciation expense and a $1,000 loss on sale of property, plant and equipment.
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46
A.
Cash flows from (used in) operating activities: Net income (loss) $ 56,178 Add (deduct) adjustments to cash basis: Decrease in accounts receivable 22,044 Increase in inventory (45,901) Increase in prepaid insurance (798) Decrease in other assets 88 Increase in accounts payable 29,764 Decrease in salaries payable (3,393) Increase in other payables 3,148 Increase in unearned revenues 3,221 Depreciation expense 24,122 Loss on sale 1,000 Net cash flows from operating activities $ 89,473
What is the best measure of a company's profit?

Accrual Basis Net Income or Net Cash Flows from Operations
B. Describe the major causes for the difference in Morris' net income and cash flows from operations in 20X3.
Answer: Morris, Inc. generated $89,473 of cash flows from operating activities, yet recorded only $56,178 of net income. The higher actual cash flows from operations were due primarily to higher cash collections of A/R, deferrals of payments on A/P and the $24,122 non-cash depreciation expense that was deducted in determining net income. The effect of these items were significantly offset by the cash used in the company's build-up of inventory.
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48
3-8
EBITDA
(Earnings before interest, taxes, depreciation and amortiazation)
Cash flows from (used in) operating activities: Net income Adjustments: Increase in accounts receivable Increase in accounts payable Decrease in inventory Increase in salaries payable Increase in prepaid insurance Increase in office supplies Decrease in prepaid rent Decrease in income taxes payable Decrease in unearned rent revenue Increase in utilities payable Decrease in interest payable Depreciation expense Gain on sale Net cash flows from operating activities
$ 14,992 (8,026) 38,515 4,223 7,280 (1,968) (1,212) 4,400 (1,661) (280) 537 (125) 6,985 (2,000) $ 61,660
Which number is a better measure of HCI's operating performance for the year, the $14,992 of net income or the $61,660 of net cash flows from operations?
49
50
The presentation of the indirect adjustment of net income to net cash flows from operations is required either in the body of the statement of cash flows, or, if the direct approach is used, then in the notes to the financial statements or a supplemental disclosure at the bottom of the cash flow statement. Almost all publicly held companies use the indirect method in the body of their statement of cash flows.
12/31/X2
12/31/X3
$ 3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
Liabilities & Equity Current Liabilities: Accounts Payable $ 22,250 Salaries Payable 0 Income Tax Payable 6,408 Unearned Rent Revenue 280 Utilities Payable 400 Interest Payable 178 Current Portion of Long-Term Debt 0 43,516 Equipment Note Payable 22,000 Mortgage Note Payable 0 Total Liabilities 51,516 Equity Capital Stock (4,250 shares outstanding) Retained Earnings Total Equity Total Liabilities & Equity
12/31/X2
12/31/X3
$ 60,765 7,280 4,747 0 937 53 0 79,912 8,000 247,363 331,275
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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Land & Building

1/1/X3 Purchase 12/31/X3 0 300,000 Sale 300,000
Net cash flows from (used in) operations: Net income (loss) $ 14,992 Adjustments: Increase in A/R (8,026) Increase in A/P 38,515 Decrease in inventory 4,223 Increase in salaries payable 7,280 Increase in prepaid insurance (1,968) Increase in office supplies (1,212) Decrease in prepaid rent 4,400 Decrease in income taxes payable (1,661) Decrease in unearned rent revenue (280) Increase in utilities payable 537 Decrease in interest payable (125) Depreciation expense 6,985 Gain on sale (2,000) Net cash flows from operating activities $ 61,660 Cash flows from (used in) investing activities: Cash payment for purchase of land and building (50,000) Cash flows from (used in) financing activities: (507) Payment of mortgage note principal Supplemental Information Non-cash flow investing and financing activities: Land and building totaling $300,000 was purchased with a $50,000 cash down payment and the execution of a $250,000 mortgage note payable.

0 Principal payment 507 249,493 12/31/X3 1/1/X3 250,000 Land & Bldg. purchase
Cash
50,000 507 Down payment Principal payment
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3-9
12/31/X2 12/31/X3
$ 3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
Warehouse Equipment
1/1/X3 Purchases
12/31/X2 12/31/X3
$ 60,765 7,280 4,747 0 937 53 0 79,912 8,000 249,493 331,275
42,800 13,456 10,000 Disposal or sale 46,256
Liabilities & Equity Current Liabilities: Accounts Payable $ 22,250 0 Salaries Payable 6,408 Income Tax Payable 280 Unearned Rent Revenue 400 Utilities Payable 178 Interest Payable Current Portion of Long-Term Debt 0 43,516 22,000 Equipment Note Payable 0 Mortgage Note Payable Total Liabilities 51,516 Equity Capital Stock (4,250 shares outstanding) Retained Earnings Total Equity Total Liabilities & Equity
12/31/X3
5,406 6,985 Disposal or sale 2,000 10,391 12/31/X3 1/1/X3 Depreciation Expense
To determine the total amount of cash received on the sale of equipment, we have to go back into HCI's accounting records and identify the specific transaction(s) involving equipment sales. In HCI's case, there was only one such transaction: a $10,000 cash sale of equipment that had an original cost of $10,000 and accumulated depreciation of $2,000.
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
Journal entry to record the sale of equipment:

Cash Accumulated Depreciation Warehouse Equipment Gain on Sale 10,000 2,000 10,000 2,000
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56
Warehouse Equipment
1/1/X3 Purchases 12/31/X3 42,800 13,456 10,000 46,256 Disposal or sale
Net cash flows from (used in) operations: Net income (loss) $ 14,992 Adjustments: Increase in A/R (8,026) Increase in A/P 38,515 Decrease in inventory 4,223 Increase in salaries payable 7,280 Increase in prepaid insurance (1,968) Increase in office supplies (1,212) Decrease in prepaid rent 4,400 Decrease in income taxes payable (1,661) Decrease in unearned rent revenue (280) Increase in utilities payable 537 Decrease in interest payable (125) Depreciation expense 6,985 Gain on sale (2,000) Net cash flows from operating activities $ 61,660 Cash flows from (used in) investing activities: (50,000) Cash payment for purchase of land and building Cash payment for purchase of warehouse equipment (13,456) 10,000 Cash receipt from sale of warehouse equipment Cash flows from (used in) financing activities: Payment of mortgage note principal (507)
5,406 6,985 Disposal or sale 2,000 10,391 12/31/X3 1/1/X3 Depreciation Expense
Cash
Equipment sale 10,000 13,456 Equipment purchases
Journal entry to record the sale of equipment:

Cash Accumulated Depreciation Warehouse Equipment Gain on Sale 10,000 2,000 10,000 2,000
Supplemental Information Non-cash flow investing and financing activities: Land and building totaling $300,000 was purchased with a $50,000 cash down payment and the execution of a $250,000 mortgage note payable.
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12/31/X2 12/31/X3
$ 3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
Net cash flows from (used in) operations: Cash flows from (used in) investing activities: (50,000) Cash payment for purchase of land and building Cash payment for purchase of warehouse equipment (13,456) 10,000 Cash receipt from sale of warehouse equipment Cash flows from (used in) financing activities: Payment of mortgage note principal Payment of equipment note principal (507) (14,000)
12/31/X2
12/31/X3
$ 60,765 7,280 4,747 0 937 53 0 79,912 8,000 249,493 331,275
Net income (loss) $ 14,992 Adjustments: Increase in A/R (8,026) Increase in A/P 38,515 Decrease in inventory 4,223 Increase in salaries payable 7,280 Increase in prepaid insurance (1,968) Increase in office supplies (1,212) Decrease in prepaid rent 4,400 Decrease in income taxes payable (1,661) Decrease in unearned rent revenue (280) Increase in utilities payable 537 Decrease in interest payable (125) Depreciation expense 6,985 Gain on sale (2,000) Net cash flows from operating activities $ 61,660
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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3-10
12/31/X2 12/31/X3
$ 3,505 42,341 20,777 1,962 2,368 0 70,953 300,000 46,256 (10,391) $ 406,818
Retained Earnings
30,051 14,992
12/31/X2 12/31/X3
$ 60,765 7,280 4,747 0 937 53 0 79,912 8,000 249,493 331,275
1/1/X3 Net Income 12/31/X3
Dividends
12,000 33,043
Cash
12,000 Dividends payments
42,500 30,051 72,551 $ 124,067
42,500 33,043 75,043 $ 406,818
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Net cash flows from (used in) operations: Net income (loss) $ 14,992 Adjustments: Increase in A/R (8,026) Increase in A/P 38,515 Decrease in inventory 4,223 Increase in salaries payable 7,280 Increase in prepaid insurance (1,968) Increase in office supplies (1,212) Decrease in prepaid rent 4,400 Decrease in income taxes payable (1,661) Decrease in unearned rent revenue (280) Increase in utilities payable 537 Decrease in interest payable (125) Depreciation expense 6,985 Gain on sale (2,000) Net cash flows from operating activities $ 61,660 Cash flows from (used in) investing activities: (50,000) Cash payment for purchase of land and building Cash payment for purchase of warehouse equipment (13,456) 10,000 Cash receipt from sale of warehouse equipment (53,456) Net cash flows used in investing activities Cash flows from (used in) financing activities: Payment of mortgage note principal Payment of equipment note principal Payment of dividends Net cash flows used in financing activities Net increase (decrease) in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year (507) (14,000) (12,000) (26,507) (18,303) 21,808 $ 3,505
Basic Steps and Rules of the Indirect Method

1. Begin with net income for the year and adjust it to reflect net cash flows from operations. Adjust NI for current assets and current liabilities . Adjust NI for current assets and current liabilities . Adjust NI for any non-cash expenses (depreciation). Adjust NI for any gains on sale of L/T assets. Adjust NI for any losses on sale of L/T assets. 2. Next all of the other asset, liability and owner's equity accounts must be analyzed to determine the changes in those accounts resulting from cash transactions. Those cash flows are then classified under either investing or financing activities. In addition, any changes in the accounts arising from noncash transactions must be supplementally disclosed in the financial statement notes or at the bottom of the actual cash flow statement. 3. Finally, net cash flows from operating, investing and financing activities are subtotaled and added together to determine the net increase or decrease in cash for the period. That amount is then summed with the beginning balance of cash to determine the ending cash balance, which must agree with the balance shown on the company's balance sheet.
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Problem 3-5
Analyzing Long-Term Assets

Given the following information for ABA, Inc.:
12/31/X6 12/31/X7
A. Cash received on the sale of equipment = $13,000

Journal entry to record sale of equipment:
Cash Accumulated Depreciation Loss on Sale Equipment 13,000 25,000 12,000 50,000
Equipment Accumulated Depreciation
$ 305,000 (100,000)
$ 375,000 (105,000)
T-account analysis: Equipment

12/31/X6 Cash purchase Debt purchase 12/31/X7 305,000 20,000 100,000 50,000 375,000 Equipment sale
For the year ended 12/31/X7: Depreciation expense Loss on sale of equipment Cash purchases of equipment
$ 30,000 $ 12,000 $ 20,000
A. Determine the amount of cash received on the sale of equipment during the year ended 12/31/X7 assuming $100,000 of equipment was purchased with debt financing during the year. B. Describe the impact of the information provided in this problem on ABA's statement of cash flows and associated disclosures.
100,000 30,000 Equipment sale 25,000 105,000 12/31/X7 12/31/X6 Depreciation expense
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3-11
Problem 3-6
B. Describe the impact of the information provided in this problem on ABA's statement of cash flows and associated disclosures.
Preparing a Statement of Cash Flows, Indirect Method

Given the following income statement, balance sheet and supplemental information for WRM Corporation, prepare the company's statement of cash flows for the year ended 12/31/X5 using the indirect method. Provide any required supplemental disclosures.
WRM Corporation Income Statement for the years ended December 31, 20X4 and 20X5
20X4 $ 757,904 Sales Revenues 227,371 Cost of Goods Sold 530,533 Gross Margin Operating Expenses: Salaries Expense 254,887 Other Operating Expenses 223,056 Operating Income 52,590 Interest Expense 10,255 Income Before Income Taxes 42,335 Income Tax Expense 4,266 Net Income $ 38,069 Earnings Per Share $ 3.81 20X5 $ 910,987 255,076 655,911 273,684 235,993 146,234 12,646 133,588 26,717 $ 106,871 $ 10.69
Answer: ABA's depreciation expense (($30,000) and loss on sale ($12,000)

would be added back to net income in order to determine the amount of net cash flows derived from or used for operating activities under the indirect method. If the indirect method was not used in the actual statement of cash flows, it would be provided as supplemental information at the end of the statement or in the notes to the financial statements. The $20,000 cash expenditure made in the purchase of equipment and the $13,000 cash receipt from the sale of equipment would both be reflected in the "investing activities" section of the statement of cash flows. Supplemental disclosure, either in the notes to the financial statements or at the end of the cash flow statement, must be made of the $100,000 purchase of equipment through debt financing.
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Problem 3-6 WRM Corporation Balance Sheet December 31, 20X4 and 20X5
Assets Current Assets: Cash Accounts Receivable Inventory Other Assets
Problem 3-6 - Answer WRM Corporation Statement of Cash Flows for the year ended December 31, 20X5
Cash flows from operating activities:
$ 29,678 21,548 100,000 151,226 200,000 351,226
12/31/X4
12/31/X5
$ 35,821 72,321 206,544 8,806 23,492 220,544 46,256 (88,022) 178,778 $ 502,270
$ 12,045 58,466 194,608 8,366 173,485 184,368 Trucks Equipment 42,800 Less: Accumulated Depreciation (64,032) 163,136 $ 436,621 Total Assets
Liabilities & Equity Current Liabilities: Accounts Payable $ 24,404 Other Payables 18,044 Current Portion of Long-Term Notes 100,000 142,448 Long-Term Notes Payable 150,000 Total Liabilities 292,448 Equity Common Stock (10,000 shares) Retained Earnings Total Equity Total Liabilities & Equity
12/31/X4
12/31/X5
Cash flows from (used in) investing activities: Cash payments for: Trucks Equipment Net cash flows used in investing activities Cash flows from(used in) financing activities: Cash receipt from bank loan Cash payments for: Dividends Notes payable Net cash flows used in financing activities Net increase (decrease) in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year 120,000 (100,000) (100,000) (80,000) 23,776 12,045 $ 35,821 (6,176) (3,456) (9,632)
100,000 44,173 144,173 $ 436,621
100,000 51,044 151,044 $ 502,270
Net income $ 106,871 Add (Deduct) adjustments: Increase in accounts receivable (13,855) Increase in inventory (11,936) Increase in other assets (440) Increase in accounts payable 5,274 Increase in other payables 3,504 Depreciation expense 23,990 Net cash flows from operating activities 113,408
Supplemental information for the year: Depreciation expense for the period amounted to $23,990. Trucks purchased through the incurring of notes payable totaled $30,000. No trucks or equipment were sold or disposed of. Cash payments on principal of notes payable totaled $100,000
Supplemental disclosure: Trucks purchased through the incurring of notes payable amounted to $30,000 for the period.
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Problem 3-7
Analysis of the Statement of Cash Flows

What do you know about WRM Corporation by reviewing its statement of cash flows.
WRM Corporation Statement of Cash Flows for the year ended December 31, 20X5
Cash flows from operating activities: Net income $ 106,871 Add (Deduct) adjustments: Increase in accounts receivable (13,855) Increase in inventory (11,936) Increase in other assets (440) Increase in accounts payable 5,274 Increase in other payables 3,504 Depreciation expense 23,990 Net cash flows from operating activities 113,408 Cash flows from (used in) investing activities: Cash payments for: Trucks Equipment Net cash flows used in investing activities Cash flows from(used in) financing activities: Cash receipt from bank loan Cash payments for: Dividends Notes payable Net cash flows used in financing activities Net increase (decrease) in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year 120,000 (100,000) (100,000) (80,000) 23,776 12,045 $ 35,821 (6,176) (3,456) (9,632)
What do you know about WRM Corporation by reviewing its statement of cash flows. Answer: WRM is a profitable company that generated significant cash flows from operations, almost all of which was paid out to shareholders in the form of a dividend. The company also modestly increased its long-term assets financed primarily through some additional debt. It also appears the company did some refinancing of its debt during the year. $120,000 was borrowed on a bank loan, the proceeds of which were used to pay down $100,000 of existing debt. The fact that the company chose to pay shareholders a substantial dividend rather than retain earnings may indicate that the company is in a more mature, non-growth oriented business.
Supplemental disclosure: Trucks purchased through the incurring of notes payable amounted to $30,000 for the period.
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3-12
Transaction Register
Date
1/3 1/5 1/6 1/8 1022 1023 Debit
Ck. #
Description
Balance forward Check from Mom Provo Utilities Jones Apartment (Rent) Harmon's Groceries
Payment
Deposit
$ 1,000
Balance
$ 577 $ 1,577 $ 1,519 $ $ 969 901
$ $
58 68
$ 550
Bank Reconciliation
Many people get lazy and end up simply relying on the bank to determine their balance of cash.
Problems
1. The bank's reported balance will not reflect the impact of any deposits in transit or outstanding checks. Without knowing the amount of deposits in transit and outstanding checks, it's impossible to really know exactly where you stand in terms of available cash. 2. Any bank errors or mistakes will probably end up going undetected.
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Internal Controls Bank Reconciliation

Compares the cash balance you have per your records with the amount reflected in bank's records to identify differences and make any necessary corrections or adjustments. For a business, a bank reconciliation identifies any differences in a company's general ledger cash balance at the end of each month with the balance reflected in the corresponding monthly bank statement. 75 Policies and procedures designed and implemented by management to safeguard a company's assets and ensure accurate accounting records. Some controls over cash:
The required use of checking, savings and other bank accounts for the holding and administration of cash. Segregation of employee duties in the handling and recording of cash transactions. The requirement that all disbursements over a certain amount be made by pre-numbered check with more than one signature. Preparation of a monthly bank reconciliation by a person not involved in the handling and recording of cash transactions.
76
General Ledger
Cash
12/1/X3 12/7 Deposit 8,800 7,332 400 12,398 3,357 455 3,789 2,777 1,532 984 5,212 1,777 1,245 545 Ck 3499 Ck 3500 Ck 3501 Ck 3502 Ck 3503 Ck 3504 Ck 3505 Ck 3506 Ck 3507 Ck 3508 Ck 3509 Ck 3510
12/15
Deposit
8,455
The bank statement is prepared by the bank from the bank's perspective and is a reflection of the amount the bank owes the depositor if the account is closed.
On the bank's books, the journal entry to record:
The receipt of a deposit: Cash Payable to Depositor XXX XXX
12/23
Deposit
12,000
12/31 Deposit 12/31/X3
3,389 5,505
Bank Statement
Balance 12/1/X3: $ 3,411
12/23 12/31
Balance 12/31/X3: $14,520

12,000 (a) 16 #3503 #3506 3,789 984
Deposits and Other Credits 12/7 7,332 12/15 8,455 12/28 5,000 12/31 3,389 Checks and Other Debits #3499 400 #3500 12,398 12/12 (b) 400 #3504 2,577 #3507 5,212 #3509 1,245
(a) Interest earned on account
Checks written against the account: Payable to Depositor Cash XXX XXX
#3501 3,357 12/15 (c) 100 12/31 (d) 10

(c) NSF check
(b) ATM withdrawal
(d) Bank charge
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3-13
General Ledger
Cash
Bank Reconciliation
True Cash Balance Approach:
Balance per books: Add: Customer direct deposit Interest earned on account Less: True cash balance Balance per bank: Add: Less:
#3503 #3506 3,789 984
12/15
Deposit
8,455
$ 5,505 5,000 16 200
12/23
Deposit
12,000
12/31 Deposit 12/31/X3
3,389 5,505
$ 14,520
Bank Statement
Balance 12/1/X3: $ 3,411
12/23 12/31
Balance 12/31/X3: $14,520

12,000 (a) 16
#3501 3,357 12/15 (c) 100 12/31 (d) 10

(c) NSF check
(b) ATM withdrawal
(d) Bank charge
True cash balance
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80
General Ledger
Cash
Bank Reconciliation
Balance per books: Add: Customer direct deposit Interest earned on account Error in recording ck # 3504 Less: True cash balance Balance per bank: Add: Less: $ 14,520 $ 5,505 5,000 16 200
12/15
Deposit
8,455
12/23
Deposit
12,000
12/31 Deposit 12/31/X3
3,389 5,505
Bank Statement
Balance 12/1/X3: $ 3,411
12/23 12/31
Balance 12/31/X3: $14,520

12,000 (a) 16 #3503 #3506 3,789 984
#3501 3,357 12/15 (c) 100 12/31 (d) 10

(c) NSF check
(b) ATM withdrawal
(d) Bank charge
True cash balance
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82
General Ledger
Cash
Bank Reconciliation
Balance per books: Add: Customer direct deposit Interest earned on account Error in recording ck # 3504 Less: True cash balance Balance per bank: Add: Less: Outstanding checks: #3502 $ 455 #3505 1,532 #3508 1,777 #3510 545 True cash balance $ 14,520 $ 5,505 5,000 16 200
12/15
Deposit
8,455
12/23
Deposit
12,000
12/31 Deposit 12/31/X3
3,389 5,505
Bank Statement
Balance 12/1/X3: $ 3,411
12/23 12/31
Balance 12/31/X3: $14,520

12,000 (a) 16 #3503 #3506 3,789 984
#3501 3,357 12/15 (c) 100 12/31 (d) 10

(c) NSF check
(4,309)
(b) ATM withdrawal
(d) Bank charge
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3-14
General Ledger
Cash
Bank Reconciliation
Balance per books: $ 5,505 Add: Customer direct deposit 5,000 Interest earned on account 16 Error in recording ck # 3504 200 Less: ATM withdrawal (400) Bank service charge (10) NSF check ( 100) $ 10,211 True cash balance Balance per bank: Add: Less: Outstanding checks: #3502 $ 455 #3505 1,532 #3508 1,777 #3510 545 True cash balance $ 14,520
12/15
Deposit
8,455
12/23
Deposit
12,000
12/31 Deposit 12/31/X3
3,389 5,505
Bank Statement
Balance 12/1/X3: $ 3,411
12/23 12/31
Balance 12/31/X3: $14,520

12,000 (a) 16 #3503 #3506 3,789 984
#3501 3,357 12/15 (c) 100 12/31 (d) 10

(c) NSF check
(b) ATM withdrawal
(d) Bank charge
(4,309) $ 10,211
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Balance per books: $ 5,505 Add: Customer direct deposit 5,000 Interest earned on account 16 Error in recording ck # 3504 200 Less: ATM withdrawal (400) Bank service charge (10) NSF check (100) $ 10,211 True cash balance
Customer direct deposit: Cash A/R Interest earned: Cash Interest Revenue Error in recording check #3504 Cash Utilities Expense 200 200 16 16 5,000 5,000
ATM withdrawal for employee Christmas gifts:
Problem 3-8
Bank Reconciliation
A comparison of Davar, Inc.'s 1/31/X1 checking account bank statement with an ending balance of $10,489 to its corresponding general ledger account with an ending balance of $6,305 revealed the following reconciling items:
1. A $126 NSF check from a cash customer who could not be subsequently located. 2. A $30 NSF check from a cash customer who agreed to pay the amount in full plus a $10 penalty within by 2/28/X1. 3. Outstanding checks totaling $10,144. 4. Bank service charges for December amounting to $25. 5. December interest earned on the account amounting to $86.
10 10
Employee Gift Expense Cash Bank service charge: Bank Charge Expense Cash NSF check: Accounts Receivable Cash
400 400
6. Deposits in transit totaling $5,665. 7. A bank error from the under-recording of a deposit by $500. The bank acknowledged and agreed to correct the account. 8. A $300 customer direct deposit unrecorded in Davar's books.
100 100
Determine Davar's true cash balance at 1/31/X1 for this checking account and prepare the appropriate correcting entries.
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Balance per books: Add: Direct deposit Interest earned Less: Bank service charge NSF check NSF check True cash balance Balance per bank: Add: Deposit in transit Bank error Less: Outstanding checks True cash balance
$ 6,305 300 86 (25) (126) ( 30) $ 6,510 $10,489 5,665 500 (10,144) $ 6,510
Correcting entries:
1. Direct deposit: Cash A/R 2. Interest earned: Cash Interest Revenue 3. Bank service charge: Miscellaneous expense Cash 4. NSF check: Bad check expense Cash 5. NSF check: A/R Cash NSF fee income 300 300
86 86
25 25
126 126
40 30 10
89
90
3-15
Lesson 4
Sales Revenues
Definition: The amount of assets received on the sale of goods or services to customers. Those assets typically come in the form of cash or accounts receivable.
Lesson 4
Sales and Receivables
Revenue Recognition Principle: Revenues are to be recognized in the period earned and not necessarily when cash is received from customers.
When are revenues earned?

When are revenues earned on sales that offer customers a full refund for up to a year if they aren't completely satisfied with the product? What about a fitness center's revenues on the sale of a two-year membership contract?
Under current accounting standards, revenues are to be recorded when earned, and revenues are earned when both of the following have occurred: 1. The acts associated with the providing of goods or services have been substantially completed. 2. The collection of cash or other assets from the customer is reasonably assured. This means a company has to actually finish doing something that legally obligates a financially capable customer to pay now or in the future. With the sale of goods, this usually takes place when product ownership actually transfers to the customer, which is usually when the customer takes physical possession of the goods.
When merchandise is shipped to a customer, whether revenues are recognized at the time of shipment or at the time of subsequent customer receipt, will depend on the contract terms of shipment. FOB destination ("free on board" delivery): Ownership doesn't transfer and revenues are deferred until the goods are actually received by the customer. FOB shipping point: Ownership transfers and revenues are recognized when goods are loaded for shipment from the company's dock.
Consignment Sales
Supplier
(Consignor)
Merchandiser
(Consignee)
Customer
Traveling to Customer
12/31/X7 FOB Shipping Point
Sales Revenues ?
1/3/X8 FOB Destination
4-1
Consignment Sales
Supplier
(Consignor)
Consignment Sales
Customer Supplier
(Consignor)
Merchandiser
(Consignee) For Sale!
Merchandiser
(Consignee)
Customer
No legal ownership No obligation
No legal ownership No obligation
No sales revenues are recognized until the sale is made to the final customer. 7 8
Long-Term Construction or Service Contracts

Companies that are involved in consulting or other service contracts, or major projects involving the construction of bridges, dams and other facilities that take a number of years to complete, may be allowed to recognize a portion of the total contract revenue at the end of each year based on a percentage of the completed work, as long as: 1. The percentage of completion can be reasonably estimated. 2. Collection of the revenues recognized can be reasonably assured.
When should revenues be recognized on sales that guarantee customer satisfaction for up to a year? Is revenue earned and recorded at, during or one year following the date of sale?
10
It depends!
For companies that can estimate returns with reasonable accuracy, then revenues are typically recognized upon sale and any end-of-the-year estimate of future returns on current period sales are deducted through a year-end adjusting entry. If, however, reasonable estimates of returns aren't possible, then simply deferring revenue recognition until the end of the one-year guarantee period is appropriate.
What about a fitness center's revenues on a two-year membership contract?

Should that revenue be recognized at the time:
Contract is signed? Payment is received? Equal amounts over the 24-month contract?
Generally speaking revenues should be recognized over the period services are rendered regardless of the timing of cash receipts. If the customer pays $480 up front for a 24-month membership, then
$480 11
24 months = $20/month 12
4-2
Problem 4-1
What if the fitness company really needs to increase revenues in the current period and decides to designate $240 of the $480 received as an upfront sign up fee?
Revenue Recognition
Describe the two key criteria for revenue recognition and then respond to the following: A. A dam construction company has a contract to build a dam for $200 million over a three-year period. Collections under the contract are scheduled at the end of each year based on the percentage completed with 10% withheld until 30 days following the full and satisfactory completion of the dam. At the end of the first year, the project stands at 30% completion and $54 million is collected under the contract. How much revenue do you think should be recognized in the first year? B. A CPA firm agrees to prepare an office supply company's tax return over the next three years in exchange for a copy machine received today that retails for $1,500. How much, if any, revenue should the CPA firm recognize upon receipt of the copy machine?
Can $240 be immediately recognized as revenues?
NO
Such fees can be recognized as revenues upfront only if an identifiable service that can be sold separately has been rendered at the time.
Example: If a fitness center separately offers customers an initial fitness evaluation and personal weight loss seminar for $240 and that service is included in the $480 deal, then $240 of the $480 can be recognized as revenues up front at the time the evaluation and seminar are provided, with the remaining $240 spread out evenly over the 24-month period.
Revenues are recognized when services are provided.

13 14
Problem 4-1
Revenue Recognition
C. An appliance company sells a TV for $500 along with a $50 service contract for any parts and labor on repairs not covered under the manufacturer's warranty for two years from the date of sale. Cash amounting to $550 was received at the time of sale. How much revenue do you think should be recognized on this transaction and when? D. Should revenues on goods shipped to a customer "FOB destination" be recognized as revenue on the date of shipment or the date delivered to the customer? Why? E. If a wholesale distributor makes sales to a retail merchandiser on account agreeing that payment is not required until the product is subsequently sold to a customer, should sales revenues be recorded at the time of shipment to the retailer?
The two criteria for revenue recognition are: 1. The providing of goods or services is substantially complete. 2. Collection from the customer is reasonably assured.
A. Assuming the 30% estimate of the percentage of completion has been dependably determined at the end of the first year, the maximum amount of revenue to be recognized is $60 million. Whether the $60 million, $54 million of cash actually received to date, or some lesser amount is actually recognized will depend on the specific terms of the contract and the confidence of management and the company's independent auditors regarding the contractor's ability to complete the contract according to its terms and the customer's likelihood of future payment. B. No revenue should be recognized until services have been performed. Upon receipt of the copier, the firm has a liability equal to the value received, or $1,500. When the first of the three tax returns has been completed, then 1/3 of the value of the asset received should be recognized as revenue.
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C. The $500 received on the TV sale should be recognized as revenue at the time of sale, but the $50 received on the service contract should be recognized over the two-year term of the contract. If service repairs typically occur equally over the two-year period following sale then an equal monthly recognition would probably be appropriate. If, on the other hand, prior experience indicates that most service repairs are performed in the last few months of such contracts, then it may be more appropriate to defer recognition until those final months. D. Revenues on goods shipped to a customer "FOB destination" should be recognized as revenue on the date the goods are delivered to the customer. FOB destination means that ownership has not transferred and the sale is not complete until delivery has been made. E. The answer is no! This is similar to a consignment. Even if legal ownership of a product is transferred, if an agreement exists that payment is not required unless a subsequent event takes place, then revenues are not earned until that event occurs. In this case, goods or services were provided but collection of the sales price is contingent on a future event and not reasonably assured.
Sales of Goods or Services on Account
Accounts Receivable Sales Revenues
XXX XXX
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4-3
Problem 4-2
Problem 4-2
Review of Accounting for Uncollectible Accounts Receivable

An aging of Jordan, Inc.'s $85,300 of accounts receivable as of 12/31/X7 and Jordan's estimate of future uncollectibility of those accounts is reflected below: Estimate of Days Past Due Amount Uncollectibility Current $40,300 3% 1 - 30 days $25,400 6% 31 - 60 days $16,300 20% 61 + days $ 3,300 70% $85,300 A. Prepare the 12/31/X7 adjusting entry for uncollectible accounts receivable under the allowance method assuming Jordan has a $1,402 debit balance in their Allowance for Uncollectible Accounts Receivable account before any adjustment. Why is the amount of uncollectible accounts (bad debt) expense different than the estimate of uncollectible accounts?

An aging of Jordan, Inc.'s $85,300 of accounts receivable as of 12/31/X7 and Jordan's estimate of future uncollectibility of those accounts is reflected below: Estimate of Days Past Due Amount Uncollectibility Current $40,300 3% 1 - 30 days $25,400 6% 31 - 60 days $16,300 20% 61 + days $ 3,300 70% $85,300 B. What journal entry would be made in the subsequent year, 20X8, if Jordan writes-off accounts receivable amounting to $7,500? What is the net effect of this entry on the company's financial statements? Why isn't this write-off recorded as an expense? C. What is the direct write-off method of accounting for uncollectible accounts receivable and why is it an unacceptable accounting method for financial reporting purposes?
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Days Past Due Current 1 - 30 days 31 - 60 days 61 + days Amount $40,300 $25,400 $16,300 $ 3,300 $85,300 Estimate of Uncollectibility 3% 6% 20% 70% = = = = $ 1,209 $ 1,524 $ 3,260 $ 2,310 $ 8,303
B. What journal entry would be made in the subsequent year, 20X8, if Jordan writes-off accounts receivable amounting to $7,500?
Allowance for Uncollectible A/R Accounts Receivable 7,500 7,500
A. Adjusting entry at 12/31/X7:

Uncollectible Accounts Expense Allowance for Uncollectible A/R 9,705 9,705
What is the net effect of this entry on the company's financial statements? Why isn't this write-off recorded as an expense?
Answer: There is no net effect on the company's financial statements as a result of this entry. The reduction in assets is offset by the reduction in the contra-asset. All this entry did was clean up the company's books by removing the "bad" accounts receivable. The reason this write-off is not recorded as an expense is that these bad debts were effectively part of the $8,303 estimate of uncollectibles in 20X7 and included in the expense recorded at that time. In fact, that 20X7 expense was actually overstated given that only $7,500 of those receivables ultimately proved to be uncollectible. This overstatement will have to be compensated for in the adjustment to record bad debt expense in 20X8 by understating the estimated expense.
Allowance for Uncollectible Accounts Receivable

XXX Write-offs 'X6 underestimation XXX 1,402 9,705 8,303 Adjustment 12/31/X7 12/31/X6
Why is the amount of uncollectible accounts (bad debt) expense different (higher) than the estimate of uncollectible accounts?
Answer: It must be higher in order to compensate for the prior year's $1,402 underestimation of expense.
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C. What is the direct write-off method of accounting for uncollectible accounts receivable and why is it an unacceptable accounting method for financial reporting purposes?
Answer: The direct write-off method of accounting for uncollectible A/R calls for bad debts to be expensed in the period written-off. This approach is unacceptable because it violates the matching principle, which requires bad debt expenses to be recorded in the same period as the credit sales, which gave rise to the ultimately uncollectible receivables. That's why the allowance method must be used and relies on estimates of future uncollectibility.
The allowance method of accounting for uncollectible accounts receivable relies on estimates of uncollectibility in determining and recording a company's current bad debt expense. Most companies come up with this estimate based on a percentage of ending accounts receivable. In fact, the receivables are usually aged based on how long they've been outstanding with higher percentages of estimated uncollectibility applied to older accounts. An alternative approach that's sometimes used in making this estimate is based on a percentage of sales revenues as opposed to ending A/R. This method is especially helpful when preparing interim monthly or quarterly financial statements.
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4-4
Example: Barlow, Inc.'s prior experience indicates that on average, about 2% of all the company's net credit sales end up being uncollectible. The company's January net credit sales totaled $90,794. In this case, what would be the company's entry to record Bad Debt Expense for the month of January?
Assume Barlow's balance in the allowance account at the beginning of the year totaled $15,500 as a result of the prior year's recording of uncollectible accounts receivable using the 2% of net credit sales estimate. Also assume that actual accounts written off during the current year totaled $26,404.
Allowance for Uncollectible Accounts Receivable
15,500 18,926 Accounts Written-Off 26,404 8,022 13,978 22,000 Ending Balance Adjustment Ending Balance Beg. Balance Bad Debt Expense
2%
$90,794 = $1,816, rounded.

1,816 1,816
Bad Debt Expense Allowance for Uncollectible A/R
If total net credit sales for the year amounted to $946,306, then the total recorded bad debt expense for the year would be:
2%
$946,306 = $18,926.
What if actual bad debts from this year's net credit sales exceeds the 2% estimate? In that case, the allowance for uncollectible accounts receivable will get progressively smaller in amount over time and an adjustment will have to be made to correct the error in estimation.
Assume an aging produces a $22,000 estimate of uncollectible accounts receivable.

Adjustment entry: Bad Debt Expense Allowance for Uncollectible A/R
13,978
13,978
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Problem 4-3
Percentage of Sales Method of Estimating Uncollectible Accounts Receivable Ames Manufacturing wants to prepare monthly financial statements and chooses to estimate monthly bad debt expense using 6% of net credit sales. Given the following information as of 1/31/X6, prepare the appropriate 1/31/X6 adjusting entry to record January's bad debt expense:
Dr (CR)
Percentage of Sales Method of Estimating Uncollectible Accounts Receivable 1/31/X6 adjusting entry to record January's bad debt expense:
Bad Debt Expense Allowance for Uncollectible A/R
* .06 X $487,500 = $29,250
29,250* 29,250
Accounts Receivable $125,432 Net Credit Sales Revenues ($487,500) Bad Debt Expense 0 Allowance for Uncollectible A/R ($8,762) Questions: When using this method of estimating and accounting for uncollectible accounts receivable, what does it mean if the Allowance for Uncollectible A/R gets progressively larger over time? What should be done if such an increase is attributable to prior period overestimation of bad debt expense?
Answer: When using the percentage of sales method of estimating uncollectible accounts receivable, the entry is based on the percentage calculation, as noted above, regardless of the existing balance in the allowance for uncollectible A/R.
Question: When using this method of estimating and accounting for uncollectible accounts receivable, what does it mean if the Allowance for Uncollectible A/R gets progressively larger over time?
Answer: A progressively increasing balance in the Allowance for Uncollectible A/R could be the result of: 1. Overestimation of bad debt expense over time. 2. Actual increasing uncollectible accounts as a result of increasing credit sales, liberalization of credit policies, poor collection efforts, or a declining general economy, among other things.
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Question: What should be done if such an increase is attributable to prior period overestimation of bad debt expense?
Answer: At the end of the year, an aging of accounts receivable should probably be performed to evaluate the ending balance in the allowance for uncollectible accounts receivable with an adjustment made if over or understated. Any over-recording of bad debt expense for the year will result in an overstated allowance account which should be adjusted down with a corresponding decrease in bad debt expense.
A company's criteria in accepting or rejecting credit customers will ultimately have a significant impact on the amount of its bad debt expense. Another factor in the amount of a company's bad debt expense will be the effectiveness of its collection efforts.
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4-5
1/14/X8 For value received, Robert Jones agrees to pay to the order of Barlow, Inc. -------------------------------------------------$4,000.00 four thousand and no/100 dollars, on or before 5/14/X8, with interest from the date hereof at a simple annual rate of 18%, all due at maturity. Signature of maker
Entry to covert an account receivable to a note. Note Receivable Accounts Receivable Note Receivable Sales Revenues Cost of Goods Sold Inventory 4,000 4,000 XXX XXX XXX XXX
1/14/X8 For value received, Robert Jones agrees to pay to the order of Barlow, Inc. -------------------------------------------------$4,000.00 four thousand and no/100 dollars, on or before 5/14/X8, with interest from the date hereof at a simple annual rate of 18%, all due at maturity. Signature of maker
Adjusting entry at 1/31/X8 to record earned interest for the month:
Robert Jones
Robert Jones
$4,000 X .18 X 17/365 = $34

Interest Receivable Interest Revenue Entry upon collection: Cash Interest Receivable 34 34 34 34
Entry to record a sale made in receipt of a note.
Notes receivable arising from the sales of goods or services are traditionally referred to as "trade" notes receivable.
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If a company is desperate for cash, one option is the immediate and outright sale of receivables for cash. Assume a friend of yours has a valid receivable from a company like IBM for $1,000. Given the legal enforceability of the receivable and IBM's ability to pay its debts, would you consider buying the receivable from your friend?
Factoring A/R and Discounting Notes Receivable

Example: Barlow, Inc. factors, without recourse, $20,000 of accounts receivable for $13,000 cash. Assume that Barlow's previously recorded allowance for uncollectible accounts receivable on the factored accounts totaled $2,000. Entry to record factoring of A/R:
Cash Allowance for Uncollectible A/R Loss on Factoring of A/R Accounts Receivable 13,000 2,000 5,000 20,000
What price? Say $900 $100 / $900 = 11% return on a 30-day investment Annualized return = 11% X 12 months = 133%
In other words, if I could do that same deal every month using the same $900 my total return for the year would be $100 per month or $1,200 for the year on an investment of $900.
$1,200 / $900 = 133% annualized return
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Problem 4-4
Factoring A/R and Discounting Notes Receivable

Example: Barlow has a $10,000 note receivable from a customer. Assuming Barlow discounts the note to its bank without recourse for $8,000:
Cash Loss on Discounting of N/R Note Receivable 8,000 2,000
Factoring and Discounting of Receivables

Respond to each of the following: A. Messick, Inc. factors $10,000 of accounts receivable due in 20 days to a financing company for $9,000 cash, without recourse. A $500 allowance for uncollectible accounts on the $10,000 of receivables has been previously recorded and the following journal entry was made to record the factoring:
Cash Allowance for Uncollectible A/R Loss on Factoring Accounts Receivable 9,000 500 500 10,000
10,000
Determine Messick's cost of factoring these A/R in terms of an annualized effective interest rate on the funds received.
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4-6
Problem 4-4

B. Immediately following receipt of a $20,000, 10%, 60-day note receivable on the sale of merchandise to a customer, Messick discounts the note to a local bank for $18,000, without recourse. This discounting was recorded with the following entry:
Cash Loss on Discounting of N/R Note Receivable 18,000 2,000

A. Cost of factoring A/R in terms of an annualized effective interest rate on the funds received:
Answer: Messick has already recognized $500 expense for bad debts on the $10,000 of A/R. Assuming that is an accurate amount, in other words, $500 is truly uncollectible, then the cost of factoring is the $500 difference between the $9,500 net realizable value of the A/R and the cash received upon factoring. This cost could have been avoided if Messick had simply waited an additional 20 days. The cost of getting the $9,000 of immediate cash, stated as an interest percentage is determined by taking the cost of $500 and dividing it by the amount of $9,000 cash received. The resulting 5.56% is a percentage cost over 20 days. This cost can be stated in annual terms by dividing the 5.56% by 20 days and then multiplying by 365 for a 101% annual interest cost. In other words, the cost of this factoring of receivables was effectively the same as if Messick had borrowed $9,000 for twenty days at an annual interest rate of 101%. $500 = 5.56% cost for 20 days $9,000 5.55% = .278% cost per day 20 days
20,000
Determine Messick's effective cost of discounting this note receivable in terms of an annualized interest rate on the funds received. C. Why would Messick do these deals when the effective interest costs are so high? What, if any, financing options might be available to Messick in lieu of these arrangements?
365 days X .277% = 101% annualized interest cost
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B. Effective cost of discounting the note receivable in terms of an annualized interest rate on the funds received:
Answer: The sale of the note for $18,000 of immediate cash means Messick will forgo not only $2,000 of principal on the note but also 10% interest on $20,000 for 60 days. That interest amounts to $329 ($20,000 x .10 x 60/365). The total cost of this discounting is $2,329 over a 60-day period. The effective cost stated in terms of an annual interest rate comes to 78.7% as noted below: $2,329 = 12.94% cost for 60 days $18,000 12.94% = .216% cost per day 60 days
C. Why would Messick do these deals when the effective interest costs are so high?
Answer: Messick is apparently desparate for cash or doesn't understand the effective cost of these transactions.
What, if any, financing options might be available to Messick in lieu of these arrangements?
Answer: Selling accounts and notes receivable can usually be accomplished at a much lower cost if done with recourse. Recourse allows the buyer of the receivables or note to look to the seller for payment in the event of collection problems. Another option might be to simply borrow money from a bank or other lending institution. Even credit card debt at a rate of 18% would be a far cheaper financing option than the sale of these two assets. If Messick is unable to qualify for an unsecured loan, then the providing of collateral in the form of real estate or some other assets might be required. Even the A/R and note may be acceptable collateral for a loan.
365 days X .216% = 78.7% Annualized interest cost

In other words, the cost of the discounting of the note was effectively the same as if Messick had borrowed $18,000 for 60 days at an annual interest rate of almost 79%.
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Sales Denominated in a Foreign Currency
Most foreign sales are denominated, or made, in U.S. dollars. This means the price is set and then paid in dollars and the accounting for sales revenues, A/R and the ultimate collection of cash would be the same as it is for any sale made in the United States. Sometimes, however, these sales are denominated in a foreign currency. When that happens, the accounting can become a bit more complicated.
Example: Assume that on 12/15/X7, a U.S. company makes a credit sale of merchandise costing $2,000 to a customer in Japan at a price of 480,000 Japanese yen when 1 yen is trading for $.008 Since accounting standards in the U.S require financial statement reporting in U.S. dollars, Accounts Receivable 3,840* Sales Revenues 3,840
* 480,000 yen X $.008 = $3,840
Cost of Goods Sold Inventory
2,000 2,000
Assume that at the end of the year, 12/31/X7, the yen has strengthened against the dollar such that 1 yen is now worth $.009.
Current value of the A/R: 480,000 yen
$.009 = $4,320
(Under GAAP, any asset held in a foreign currency must be adjusted and reflected in the financial statements at its current dollar value based on the prevailing exchange rate at the end of the period.) Adjusting Entry at 12/31/X7: Accounts Receivable Foreign Exchange Gain 480 480
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Assume that on 1/15/X8 the company finally receives the 480,000 yen due on account when the value of the yen has plunged to $.007.
There's a significant financial risk involved when entering into transactions denominated in a foreign currency.
Ways to avoid that risk: 1. Simply refuse to do business in anything other than U.S dollars. That effectively shifts the risk of loss to the customer. Example: Assume the customer in Japan agreed to buy the merchandise at the original $3,840 price payable in U.S. dollars rather than yen.
480,000 Yen
$.007 = $3,360
3,360 960
Entry at 1/15/X8: Cash Foreign Exchange Loss Accounts Receivable
4,320
Date of purchase: 480,000 yen at exchange rate of $.008 Date of payment: 548,571 yen at exchange rate of $.007
68,571 yen loss

2. Locking in the currency price at the date of sale through a forward contract with a foreign currency broker. This is commonly referred to as a derivative contract.
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Problem 4-5
Foreign Currency Transaction

Barker Marketing sells lighting fixtures to customers around the world. A. Prepare the appropriate journal entries to record the following transactions: 1/12/X2: Barker makes a credit sale of merchandise costing $6,000 to a customer in Italy at a price of 10,000 euros when one euro trades for $1.07. 2/10/X2: Barker then collects the 10,000 euros from its Italian customer. Assume the euro has strengthened such that one euro now trades for $1.10. B. What would the 2/10/X2 entry have been assuming an exchange rate $1.03 to the euro? C. Questions: Assuming the euro exchange rate to the dollar went from $1.07 at the date of sale to $1.10 at the date of collection, did the dollar get stronger or weaker against the euro and what was the ultimate effect on Barker and his customer? Do you think U.S companies are glad to see a stronger dollar relative to foreign currencies?
Foreign Currency Transaction

A. 1/12/X2: Barker makes a credit sale of merchandise costing $6,000 to a customer in Italy at a price of 10,000 euros when one euro trades for $1.07. Accounts Receivable 10,700* Sales Revenues 10,700
Cost of Goods Sold Inventory
* 10,000 euros X $1.07 = $10,700
6,000 6,000
2/10/X2: Barker then collects the 10,000 euros from its Italian customer. Assume the euro has strengthened such that one euro now trades for $1.10. Cash 11,000 Gain on Foreign Exchange 300 Accounts Receivable 10,700 B. What would the 2/10/X2 entry have been assuming an exchange rate $1.03 to the euro? Cash 10,300 Loss on Foreign Exchange 400 Accounts Receivable 10,700
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C. Questions: Assuming the euro exchange rate to the dollar went from $1.07 at the date of sale to $1.10 at the date of collection, did the dollar get stronger or weaker against the euro and what was the ultimate effect on Barker and his customer?
Answer: This increasing exchange rate implies a stronger euro. At the time of payment, one euro buys more dollars than it used to. A stronger euro means a weaker dollar against the euro. As the euro strengthens, all of Barker's assets denominated in euros, including A/R and cash held in euros, increase in value and any change in value on foreign currency denominated assets are reported in the company's financial statements, in this case, as a foreign exchange gain. As far as the customer is concerned, if we assume their financial statements are prepared in euros for financial reporting in their own country's equity markets, the stronger euro has no effect on their outstanding payables denominated in euros. On their books, 10,000 euros were owed at the time of the merchandise purchase and 10,000 euros were subsequently paid. On the other hand, if the Italian Company prepared financial statements in U.S. dollars, then a payable, initially recorded at $10,700 (10,000 euros X $1.07) would be paid off with euros worth $11,000 (10,000 euros X $1.10) and a $300 loss would be recognized given the payoff of the obligation with more valuable euros.
Do you think U.S companies are glad to see a stronger dollar relative to foreign currencies?
Answer: It depends. Companies that buy and sell goods and operate their business exclusively in the United States are unaffected by changing exchange rates. Companies that buy goods or services from other countries would in theory like a stronger dollar if it allowed them to buy more for their dollar. However, that isn't automatically the case. Many foreign suppliers will effectively increase prices to compensate for their weaker currency. This can be done by simply setting and maintaining prices in U.S. dollars, or, by actually increasing prices charged in their own currency.
In selling goods to foreign customers, a stronger dollar may result in lower sales volume if those customers can no longer afford to buy U.S. products given their weaker currency. As a result, companies may be forced to effectively cut prices in order to maintain sales. This can be done by cutting selling prices stated in U.S. dollars or by simply setting and maintaining prices in the foreign currency. Selling a product at a price of 10,000 euros means a lower effective price if the value of the euro goes down. The only sure result of a stronger dollar for a U.S company is that existing assets, like receivables, denominated in a foreign currency decrease in value with a stronger dollar and existing liabilities denominated in a foreign currency are effectively reduced because they can be paid off with fewer dollars.
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4-8
Lesson 5
Problem 5-1
Review of Perpetual Inventory Accounting and Costing Methods

Respond to the following:
Lesson 5
Cost of Goods Sold and Inventory
1. What does it mean to account for inventory perpetually and what are the benefits of such an approach? 2. What kinds of companies use specific identification in the costing of their inventory and how does it work? 3. What is an inventory cost flow assumption and when is it appropriate for a company to use such an assumption rather than specific identification?
Review of Perpetual Inventory Accounting and Costing Methods

1. What does it mean to account for inventory perpetually and what are the benefits of such an approach?
Answer: Accounting for inventory perpetually means that the company's inventory general ledger account and corresponding subsidiary ledgers maintained for each type of inventory item, are immediately updated for every inventory transaction to keep a running balance of not only the number of units on hand but their associated cost. The primary benefit of perpetual accounting is more effective inventory management. Excess inventory can be expensive. It takes up valuable space, increases handling costs, requires financing and increases the risk of loss from obsolescence and theft. On the other hand, insufficient inventory can result in dissatisfied customers and declining sales volume. Effective inventory management and control is crucial to a company's success, and having immediately available information on inventory quantities and costs is a valuable management tool. Another benefit of perpetual inventory accounting is that it allows companies to determine the amount of inventory loss incurred due to waste, theft or other loss. This is commonly referred to as inventory shrinkage, and the only way it can be quantified is through periodic comparison of a company's perpetual inventory records to an actual physical count. In fact, a periodic physical inventory is required at least once a year, even when using a perpetual inventory system, in order to verify, and, if necessary, adjust a company's inventory records to reflect actual quantities on hand.
2. What kinds of companies use specific identification in the costing of their inventory and how does it work?
Answer: Specific identification is an inventory costing method used by companies that have distinctive inventory where each item is different in nature or cost from every other item in stock. For example, a used car dealership uses specific identification to cost its inventory because every car in stock is different from the others and has its own specific cost. Fine art dealers also use specific identification because of the unique nature and cost of each item of inventory. Actual implementation of specific identification requires that the cost of each inventory item purchased be recorded and included in inventory until its sale, at which time that specific cost is removed from inventory and accounted for as the cost of goods sold.
Problem 5-2
3. What is an inventory cost flow assumption and when is it appropriate for a company to use such an assumption rather than specific identification?
Answer: Companies that sell products that are similar in nature and cost will often account for their inventory and cost of goods sold using an inventory cost flow assumption, such as FIFO (first-in, first-out), LIFO (last-in, first-out) or some weighted average. In these cases, a cost is assigned to the units sold that may not be that specific unit's cost. This is justified on the basis that the costs are not significantly different, and, in some cases, keeping a record of the specific cost of each individual item of inventory may be difficult, if not impossible. For example, a jelly bean retailer will find it pretty much impossible to accountant for inventory and cost of goods sold using specific identification. How do you keep track of the cost of each individual jelly bean? Instead, either the cost of the first units purchased, the last units purchased or an average cost of the units purchased and available for sale will be used for the cost of goods sold.
Review of Perpetual Inventory Accounting and Cost Flows

Harris Appliances has the following inventory balance of EZ Clean washing machines as of 1/1/X4: 8 units @ $192/unit (purchased 10/21/X3) 20 units @ $194/unit (purchased 12/15/X3) 28 units on hand at 1/1/X4 A. Prepare journal entries to record the transactions noted below assuming Harris uses a perpetual FIFO inventory accounting method:
1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on account, terms of 2/10, n/30. 1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount. 1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry Services for $400/unit on account, terms of 2/10, n/30, FOB shipping point. 1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on account. The machines are unused and can be resold at full price. 1/31 Harris receives payment in full, net of the discount on the 1/20 sale to Jim's.
B. Determine Harris' gross margin, gross margin percentage and percentage markup on the sale to Jim's Laundry Services.
5-1
Problem 5-2
C. If Harris had incurred freight costs in the purchase and receipt of EZ Clean washing machines and delivery costs in the subsequent sale to Jim's, how would such costs have been accounted for and what effect would they have had on Harris' gross margin? D. Determine the gross margin on the sale to Jim's if the (1) perpetual LIFO method, and (2) moving-weighted average (MWA) methods had been used? Which method (FIFO, LIFO, MWA) would have produced the highest gross margin? Which method (FIFO, LIFO, MWA) would have produced the highest gross margin if there had been decreasing inventory costs over time (deflation) instead of inflation? Which method would have produced the highest gross margin if all inventory had been sold during the period? E. Which inventory cost flow assumption is required for financial reporting purposes? Which inventory cost flow assumption is required for income tax purposes? Which assumption would be best for a private company that typically faces increasing inventory costs and is interested in minimizing its cash outflows? Would the use of LIFO in a time of rising inventory costs tend to over or understate the company's assets relative to current costs?
Review of Perpetual Inventory Accounting and Cost Flows

A.
1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on account, terms of 2/10, n/30.
Inventory Accounts Payable
10,000 10,000
1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount.
Accounts Payable Cash Inventory
10,000 9,800 200
A. (Continued)
1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry Services for $400/unit on account, terms of 2/10, n/30, FOB shipping point.
A. (Continued)
1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on account. The machines are unused and can be resold at full price.
Accounts Receivable Sales Revenues Cost of Goods Sold Inventory
16,000 7,768* 16,000 7,768
Sales Returns and Allowances Accounts Receivable Inventory (2 units @196) Cost of Goods Sold
800 392 800 392
* Inventory available for sale: 8 units @ $192/unit (purchased 10/21/X3) 20 units @ $194/unit (purchased 12/15/X3) 50 units @ $196/unit (purchased 1/5/X4) Cost of Goods Sold (FIFO): 8 units @ $192/unit = $ 1,536 3,880 20 units @ $194/unit = 2,352 12 units @ $196/unit = $ 7,768 40
1/31 Harris receives payment in full, net of the discount on the 1/20 sale to Jim's.
Cash ($15,200 x 98%) Sales Discounts ($15,200 x 2%) Accounts Receivable
14,896 304
15,200
10
B. Sales Revenues $ 16,000 Less: Sales Returns (800) Sales Discounts (304) Net Sales Revenues 14,896 Less: Cost of Goods Sold (7,376) Gross Margin $ 7,520
C. If Harris had incurred freight costs in the purchase and receipt of EZ Clean washing machines and delivery costs in the subsequent sale to Jim's, how would such costs have been accounted for and what effect would they have had on Harris' gross margin? Answer: Any costs incurred in the acquisition of an asset, such as inventory, and any costs associated with getting that asset ready for its original intended use (ready to sell) are to be capitalized as part of the asset's original historical cost. As a result, any freight costs incurred in receiving the inventory should be included as part of the inventory's cost and debited to the inventory account. This would ultimately reduce Harris' gross margin in that cost of goods sold would be higher upon the sale of that inventory. Costs incurred in the delivery of inventory sold to a customer are not costs incurred in the acquisition of the inventory. Such delivery costs are actually selling costs and are reported as operating expenses below gross margin on a multi-step formatted income statement.
Gross margin percentage:
Percentage markup:
Gross Margin Net Sales Revenues

$ 7,520 = 50% $ 14,896
Gross Margin Cost of Goods Sold

$ 7,520 = 102% $ 7,376
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5-2
D. Determine the gross margin on the sale to Jim's if the (1) perpetual LIFO method, and (2) moving-weighted average (MWA) methods had been used? Which method (FIFO, LIFO, MWA) would have produced the highest gross margin? LIFO:
D. (Continued) MWA:
Sales Revenues $ 16,000 Less: Sales Returns (800) Sales Discounts (304) Net Sales Revenues 14,896 Less: Cost of Goods Sold (7,448) Gross Margin $ 7,448
Sales Revenues $ 16,000 Less: Sales Returns (800) Sales Discounts (304) Net Sales Revenues 14,896 Less: Cost of Goods Sold (7,413) Gross Margin $ 7,483
Inventory available/sold:
8 units @ $192/unit = $ 1,536 3,880 20 units @ $194/unit = 9,800 50 units @ $196/unit = $15,216 78 MWA: $15,216 78 = $195.08/unit
Inventory available/sold:
8 units @ $192/unit (purchased 10/21/X3) 20 units @ $194/unit (purchased 12/15/X3) 50 units @ $196/unit (purchased 1/5/X4)
Cost of Goods Sold (LIFO):

38 units @ $196/unit = $ 7,448
Cost of Goods Sold (MWA):

38 units @ $195.08/unit = $ 7,413 (rounded)
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D. Which method (FIFO, LIFO, MWA) produced the highest gross margin? Answer: FIFO: $ 7,520 highest LIFO: $ 7,448 MWA: $ 7,483 Which method (FIFO, LIFO, MWA) would have produced the highest gross margin if there had been decreasing inventory costs over time (deflation) instead of inflation? Answer: LIFO, the opposite effect. Which method would have produced the highest gross margin if all inventory was sold during the period? Answer: No difference.
E. Which inventory cost flow assumption is required for financial reporting purposes? Answer: Any of the inventory cost flow assumptions can be used for financial reporting purposes, regardless of the actual physical flow of goods, as long as the method selected is used consistently from year-to-year. Which inventory cost flow assumption is required for income tax purposes? Answer: Current tax law requires that the method used for financial reporting must also be used for income tax purposes. Which assumption would be best for a private company that typically faces increasing inventory costs and is interested in minimizing its cash outflows? Answer: LIFO Would the use of LIFO in a time of rising inventory costs tend to over or understate the company's assets relative to current costs? Answer: Understate ending inventory
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Mary's Hobby Shop

On 12/31/X5, Mary's inventory balance is $40,000 based on an actual physical count of inventory on hand at the end of the year 'X5. Prepare the journal entries for Mary's summarized inventory transactions for the year 20X6, assuming the business uses a periodic instead of a perpetual inventory accounting system. Purchased a total of $200,000 of inventory on account with terms of 2/10, n/30:
Purchases Accounts Payable 200,000 200,000
Periodic Method of Accounting for Inventory
Paid a total of $5,000 of freight costs to have the purchased inventory delivered to her store:
Freight-In Cash 5,000 5,000
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5-3
Returned $20,000 of previously purchased inventory to suppliers receiving full credit on account:
Accounts Payable Purchase Returns 20,000 20,000
Merchandise sold to customers at a price $10,000 is returned to Mary for full credit on account:
Sales Returns and Allowances Accounts Receivable Inventory Cost of Goods Sold 10,000 10,000 XXX XXX
Paid off the $180,000 balance of accounts payable, net of the discount, with a $176,400 cash payment. (98% X $180,000 = $176,400)
Accounts Payable Cash Purchase Discounts* * (2% x $180,000) 180,000 176,400 3,600
Total sales for the year amounted to $320,000, all made on account.
Accounts Receivable Sales Revenues Cost of Goods Sold Inventory 320,000 320,000 XXX XXX
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Inventory
1/1/X6 Purchases Freight-in 40,000 200,000 5,000 20,000 3,600 Purchase returns Purchase discounts
Cost of goods available for sale
Inventory
1/1/X6 Purchases Freight-in 40,000 200,000 5,000 20,000 3,600 221,400 178,400 12/31/X6 43,000 Closing Cost of goods sold Purchase returns Purchase discounts
Purchases
1/1/X6 12/31/X6 0 200,000 0 200,000
Freight-In
1/1/X6 12/31/X6 0 5,000 0 5,000 Closing
Assume that at the end of the year 20X6, a physical inventory is performed and produces a $43,000 total.
Cost of Goods Sold
1/1/X6 12/31/X6 0 178,400 178,400
Purchase Returns
Closing 20,000 0 20,000 0 1/1/X6 12/31/X6
Purchase Discounts
Closing 3,600 0 3,600 0 1/1/X6 12/31/X6
The key to the periodic method is the year-end physical inventory.
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Mary's Hobby Shop

12/31/X6 Physical Inventory:
Inventory Description # of Units
Should the cost of items sold and the cost of any inventory still on hand be determined based on specific identification, or an inventory cost flow assumption?
Porsche Model Car Ferrari Model Car Mustang Model Car
17 25 22
Ferrari Model Car: Beginning inventory: 20 units @ $5.00/ea. = $ 100.00 20X6 Invoices:
Date # Units Cost/Unit
3/5 9/13
30 30
$6.00/ea. $7.00/ea.
= $180.00 = $210.00
Ending Inventory: FIFO assumption: 25 units @ $7.00 = $175.00 LIFO assumption: 20 units @ $5.00 = $100.00 5 units @ $6.00 = $ 30.00 $130.00 W/A assumption: $490 80 units = $6.125/unit 25 units @ $6.125 = $153.13 rounded
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5-4
Problem 5-3
Problem 5-3
Periodic Inventory Accounting

Erickson, Inc., a wholesaler of battery chargers has beginning inventory on 1/1/X8, which includes: 100 units @ $25/unit = $ 2,500 200 units @ $26/unit = 5,200 $ 7, 700 A. Prepare Erickson's journal entries for the transactions provided below using the periodic method of inventory accounting. 1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a $2/unit freight charge, all on account with terms of 2/10, n/30. 1/15: Returned 10 of the 1,200 units purchased for full credit on account at $27/unit. 1/19: Paid the net account payable due on the 1/10 purchase, net of the discount. 1/21: Made a $57,000 sale to a customer on account. 1/29: Purchased and paid cash for 300 units of inventory, at $26/unit with free shipping.
B. Calculate Erickson's cost of goods sold for the month of January under periodic FIFO and LIFO inventory cost flow assumptions, assuming a total of 350 units of ending inventory based on a physical count at the end of the month. C. Explain how a company's cost of inventory theft or waste is determined and accounted for under both the perpetual and periodic inventory accounting methods.
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A.
Periodic Inventory Accounting

1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a $2/unit freight charge, all on account with terms of 2/10, n/30. Purchases (1,200 @ $25/ea.) 30,000 Freight-In (1,200 @ $2/ea.) 2,400 Accounts Payable 32,400 1/15: Returned 10 of the 1,200 units purchased for full credit on account at $27/unit. Accounts Payable (10 @ $27/ea.) 270 Purchase Returns 270 1/19: Paid the net account payable due on the 1/10 purchase, net of the discount. Accounts Payable Cash ($32,130 x 98%) Purchase Discounts 32,130 31,487 643
B.
Cost of Goods Sold (Periodic FIFO): $37,864 Inventory
Beginning balance Purchases Freight-in 7,700 37,800 2,400 270 643 Goods Available Ending balance 46,987 ? 9,123 Cost of goods sold Purchase returns Purchase discounts
1/21: Made a $57,000 sale to a customer on account. Accounts Receivable 57,000 Sales Revenues
57,000
1/29: Purchased and paid cash for 300 units of inventory, at $26/unit with free shipping. Purchases (300 @ $26/ea.) Cash 7,800 7,800
Cost applied to the 350 units of ending inventory: 300 units @ $26/unit = $ 7,800 50 units @ $26.46/unit* = $ 1,323 $ 9,123 350 * ($25 + $2) X .98 = $26.46
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Cost of Goods Sold (Periodic LIFO): $37,964 Inventory

Beginning balance Purchases Freight-in 7,700 37,800 2,400 270 643 Goods Available Ending balance 46,987 ? 9,023 Cost of goods sold Purchase returns Purchase discounts
C. Explain how a company's cost of inventory theft or waste is determined and accounted for under both the perpetual and periodic inventory accounting methods. Answer: Inventory shrinkage can be easily quantified when accounting for inventory perpetually. This is done through a simple comparison of the perpetual records and the physical inventory. Although discrepancies are sometimes the result of accounting errors rather than theft or waste, any adjustment required to lower the perpetual inventory records is accounted for as an expense commonly referred to as inventory shrinkage. This would include the cost of any theft or waste. Under the periodic method, inventory shrinkage can't be determined. Without perpetual records, no comparison of what should be on hand and what's actually on hand is possible. However, any costs of inventory theft and waste are accounted for as an expense under the periodic method through cost of goods sold. Because cost of goods sold is based on the difference between the cost of goods available for sale and the ending physical inventory balance, any cost of inventory shrinkage is automatically included in this amount. It just can't be separately distinguished.
Cost applied to the 350 units of ending inventory: 100 units @ $25/unit = $ 2,500 200 units @ $26/unit = $ 5,200 50 units @ $26.46/unit* = $ 1,323 $ 9,023 350 * ($25 + $2) X .98 = $26.46
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5-5
Gross Margin Method of Estimation

The essence of the method is to estimate a company's ending inventory by first estimating cost of goods sold based on a gross margin percentage.
Net sales revenues Less: Cost of goods sold Gross margin $ XXX XXX $ XXX % Estimate
Problem 5-4
Inventory Estimation
Given the following information for Jonas, Inc for the quarter ended 3/31/X8: Purchases Purchase discounts Freight-out Beginning inventory Net sales revenues Purchase returns Freight-in $ 44,267 $ 2,345 $ 2,486 $ 8,648 $ 83,455 $ 1,512 $ 3,990
Ending inventory (estimated):

Actual cost of goods available for sale: Beginning inventory $ XXX Add: Purchases XXX Freight-in XXX Less: Purchase returns (XXX) Purchase discounts (XXX) XXX Less: Cost of goods sold (estimated) (XXX) Ending inventory (estimated) $ XXX
A. Estimate Jonas' ending inventory and cost of goods sold for the quarter assuming Jonas historically prices their products to produce a 60% gross margin. B. Given the assumptions above, what is Jonas' average markup on cost?
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A. Estimate Jonas' ending inventory and cost of goods sold for the quarter assuming Jonas historically prices their products to produce a 60% gross margin. Cost of goods sold estimate: $33,382 Net sales revenues $83,455 Less: Cost of goods sold 33,382 $50,073 Gross margin Ending inventory estimate: $19,666 Inventory
Beginning balance Purchases Freight-In 8,648 44,267 3,990 1,512 2,345 Goods Available Ending balance 53,048 33,382 19,666 Cost of goods sold Purchase returns Purchase discounts
B. Given the assumptions above, what is Jonas' average markup on cost? Markup on cost:
100% 40% 60%
Gross Margin (markup) $50,073 = = 1.5 or 150% markup $33,382 Cost of Goods Sold
Given that this problem originally indicated that Jonas historically set sales prices to produce a 60% gross margin, then what we're really saying is that a 150% markup on cost produces a 60% gross margin.
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Inventory
1/1/X5 Purchases Freight-in 64,000 320,000 10,000 12,000 3,000 Purchase returns Purchase discounts Cost of Goods Sold
Padding or overstatement of inventory is an easy way to make a company's profits look better than they really are.
Goods Available 12/31/X5
379,000 283,000 96,000
Net Income
Inventory
1/1/X6 Purchases Freight-in 96,000 350,000 12,000 15,000 5,000 Goods Available 12/31/X6 438,000 366,000 72,000 Cost of Goods Sold Purchase returns Purchase discounts
Net Income
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5-6
Sometimes mistakes are made unintentionally when accounting for inventory.

Example: On 12/31/X5, $5,000 of inventory purchased from a supplier is received and properly counted and included in the company's ending physical inventory totaling $76,000. However, the purchase isn't recorded until 1/1/X6.
Inventory
1/1/X5 Purchases Freight-in 64,000 320,000 10,000 12,000 3.000 Goods Available 12/31/X5 379,000 303,000 76,000 Cost of Goods Sold Purchase returns Purchase discounts
Example: Inventory costing $2,000 and selling for $3,000 is shipped FOB destination and is in transit to a customer on 12/31/X5. The sale is recorded on 12/31 and the goods excluded from the year-end physical inventory.
20X5
20X6
understatement understatement understatement
Sales Revenues Cost of Goods Sold Net Income
overstatement overstatement overstatement
$3,000
$3,000
$2,000 $1,000
$2,000 $1,000
20X5: $5,000 overstatement of net income. Inventory

1/1/X6 Purchases Freight-in 76,000 350,000 12,000 15,000 5.000 Goods Available 12/31/X6 418,000 346,000 72,000 Cost of Goods Sold Purchase returns Purchase discounts
20X6: $5,000 understatement of net income.
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Problem 5-5
Effect of Inventory Errors

Calculate the amount of Richin, Inc.'s net income over or understatement in 'X7 and 'X8 given the following: a. Inventory on hand at 12/31/X7 was mistakenly excluded from the yearend physical inventory. The inventory cost was $1,235. b. Goods costing $3,532 were received from a supplier on 1/1/X8 (FOB destination) but recorded as a purchase in 20X7. The goods were excluded from the 12/31/X7 physical inventory. c. Consigned goods from a supplier were included in Richin's 12/31/X7 physical inventory at a cost of $6,000. d. Goods in transit from a supplier on 12/31/X7 were excluded from purchases and the ending 12/31/X7 physical inventory. The goods cost $5,245 and were shipped FOB shipping point. e. Goods costing $3,222 in transit to a customer at 12/31/X7, FOB destination, were recorded as a sales at their $5,486 sales price in 'X7 and excluded from the 12/31/X7 physical inventory.
Effect of Inventory Errors

Effect of errors in 20X7 (under or overstated ):
Sales Revenues Cost of Goods Sold Net Income Ending Inventory
a. b. c. d. e. 5,486
1,235 3,532 6,000 5,245 5,245 3,222
1,235 1,235 3,532 6,000 6,000 5,245 5,245 5,245 5,486 3,222 3,222 3,497 (Net income overstated)
Net Income Beginning Inventory
Effect of errors in 20X8 (under or overstated ):

Sales Revenues Cost of Goods Sold
a. b. c. d. e. 5,486
1,235 3,532 6,000 5,245 5,245 3,222
1,235 1,235 3,532 6,000 6,000 5,245 5,245 5,245 5,486 3,222 3,222 3,497 (Net income understated)
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The performance and accuracy of a company's physical inventory is the sole responsibility of management. The external auditor's role is to independently review and observe the process and then spot check enough of the actual counts so that they can express an opinion as to the overall accuracy of the company's financial statements.
In addition to a correct inventory count, an accurate physical inventory requires the application of an appropriate cost to each item of inventory counted. That cost is based on specific identification, or, a LIFO, FIFO or weighted average cost flow assumption, except in those cases where the inventory is damaged, obsolete, or simply worth less than it's original historical cost. In those cases, the inventory's lower current market value is used.
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5-7
Lower of Cost or Market or "LCM" Rule

Requires the use of historical cost in accounting for inventory unless its market value has dropped below that cost. What are market values and how are they determined? Ceiling Not higher than the item's current net realizable value. (The price the inventory could be sold for today, in its current condition, less any selling costs.). Replacement Cost: The cost that would be paid today to buy that identical item. Not lower than its net realizable value less a normal profit margin.
Assume a retailer of high tech consumer products has an inventory item on hand that cost $200, but can now be purchased for $180 due to increased competition among suppliers. Also assume the retailer can sell the product for $300, paying a 10% sales commission and normally makes about a 20% profit margin on the sale of such a product after all other costs are considered. LCM Rule: NRV $270 ($300 - $30) Market Value $210
Cost $200
Replacement Cost $180
Market Value =
NRV - Profit $210 ($270 - $60) This product had a declining replacement cost but hadn't lost its resale value in the marketplace. In this case, no write-down is necessary given the higher expected future benefit.
Floor
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Consider the lower of cost or market value to be used for an inventory item that originally sold to customers for $150, but is now technically obsolete and is currently offered at a discounted price of just $20. The item was purchased at a cost of $90 and replacement units, if they can be found, cost $5 or less. Assume a 10% sales commission and a normal profit margin of 20% on this product. NRV $18 ($20 - $2) Cost $90 Market Value $14
Assume used inventory is on hand at the end of the year that can be sold for $450. Its original cost was $500 and inventory in a similar "used" condition can be bought from suppliers at a cost of $350. Assume a 10% sales commission and a normal profit margin of 16% on this product. NRV $405 ($450 - $45) Cost $500 Market Value $350
Replacement Cost $350
Replacement Cost $5 NRV - Profit $333 ($405 - $72) NRV - Profit $14 ($18 - $4) This used inventory is written down because it's worth less than its original cost. When writing inventory down it's valued at its replacement cost, but never above its resale value, net of selling costs, and never below that net realizable value less a normal profit margin.
In this case the obsolete inventory is written down to what it can be sold for, net of selling costs and a normal profit margin.
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Inventory Items 2
Inventory Items 2
Cost per unit Market value per unit Replacement Cost NRV NRV - Profit LCM per unit # of units Inventory at cost Inventory at LCM Write-down (item-by-item) Total inventory at market: Replacement cost NRV NRV - Profit Inventory at LCM (total inventory) Write-down (total inventory) Adjusting Entry: (Item by item basis) Adjusting Entry: (Total inventory basis)
$200 $210 $180 $270 $210 $200 100 $20,000 $20,000 0 $18,000 $27,000 $21,000
$90 $14 $5 $18 $14 $14 10 $900 $140 $760 $50 $180 $140
$500 $350 $350 $405 $333 $350 20 $10,000 $7,000 $3,000 $7,000 $8,100 $6,660
Totals
Cost per unit Market value per unit Replacement Cost NRV NRV - Profit LCM per unit # of units Inventory at cost Inventory at LCM Write-down (item-by-item) Total inventory at market: Replacement cost NRV NRV - Profit Inventory at LCM (total inventory) Write-down (total inventory) Adjusting Entry: (Item by item basis) Adjusting Entry: (Total inventory basis)
$200 $210 $180 $270 $210 $200 100 $20,000 $20,000 0 $18,000 $27,000 $21,000
$90 $14 $5 $18 $14 $14 10 $900 $140 $760 $50 $180 $140
$500 $350 $350 $405 $333 $350 20 $10,000 $7,000 $3,000 $7,000 $8,100 $6,660
Totals
$30,900 $27,140 $3,760 $ $ $ $ xxxx xxxx xxxx xxxx
$30,900 $27,140 $3,760 $27,800 $25,050 $35,280 $27,800 $27,800 $3,100
$ xxxx $3,100 3,760 3,760 3,100 3,100
Loss on Inventory Write-Down Inventory Loss on Inventory Write-Down Inventory
3,760 3,760 3,100 3,100
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5-8
Problem 5-6
Inventory Write-Down for Lower of Cost or Market

Given the following information for ZZZ Company at 12/31/X5:
Inventory Items # of units Cost per unit (FIFO) Replacement cost Selling price Selling costs Normal profit margin A 200 $200 $225 $400 $80 $120 B 150 $100 $90 $200 $40 $60 C 550 $300 $250 $275 $100 $50 D 300 $80 $70 $140 $30 $50
Inventory Write-Down for Lower of Cost or Market

A Inventory Items B C D
Prepare the adjusting journal entries to write-down inventory to lower of cost or market: A. Using the item-by-item approach. B. Using the total inventory approach. Questions: 1. Which inventory item was the primary cause of the inventory write-down and why? What are some of the possible causes for its declining value? 2. Why do you think an inventory item's market value is not allowed to go below its net realizable value less a normal profit margin, even if its replacement cost is lower?
Cost per unit Market value per unit Replacement Cost NRV NRV - Profit LCM per unit # of units Inventory at cost Inventory at LCM Write-down (item-by-item) Total inventory at market: Replacement cost NRV NRV - Profit Total inventory at LCM Write-down (total inventory) Item by item: Total inventory:
$200 $225 $225 $320 $200 $200 200 $40,000 $40,000 0 $45,000 $64,000 $40,000
$100 $100 $90 $160 $100 $100 150 $15,000 $15,000 0 $13,500 $24,000 $15,000
$300 $175 $250 $175 $125 $175 550 $165,000 $96,250 $68,750 $137,500 $96,250 $68,750
$80 $70 $70 $110 $60 $70 300 $24,000 $21,000 $3,000 $21,000 $33,000 $12,000
Totals
$244,000 $172,250 $71,750 $217,000 $217,000 $217,250 $141,750 $217,000 $27,000
71,750 71,750 27,000 27,000
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Questions: 1. Which inventory item was the primary cause of the inventory writedown and why? What are some of the possible causes for its declining value?
Answer: Almost all of the write-down was attributable to item C. With a net realizable value of only $175 per unit, this item is clearly worth a lot less than its original $300 per unit cost. Because the item's replacement cost is still relatively high, the lower net resale value, after selling costs, is most likely due to falling customer demand due to changing tastes rather than any physical damage to the inventory itself.
2. Why do you think an inventory item's market value is not allowed to go below its net realizable value less a normal profit margin, even if its replacement cost is lower?
Answer: This floor on the market value of inventory prevents companies from grossly overstating losses in one period in order to realize substantial gains in the next. In some cases, company's experiencing a difficult year will seek to maximize asset write-offs in that year. The thinking is that if things are going to look bad, we might as well make them look really bad, especially if those write-offs can make it easier to show higher profits upon the sale of those assets next year.
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Lesson 6
Employee Compensation
Salary and wages
Lesson 6
Accounting for Employee Compensation, Taxes, Contingencies, and Other Items
Health insurance Paid vacation and sick days Bonuses Stock options Pensions Other postretirement benefits.
1 2
Problem 6-1
Review of Payroll Accounting Given the following totals for Jorgenson, Inc.'s December, 20X4 payroll:
Gross Wages Employee FICA Withholdings Federal Income Tax Withholding State Income Tax Withholding Net Wages
Review of Payroll Accounting

Wage Expense Employee FICA Withholdings Payable Employee FIT Withholdings Payable Employee SIT Withholdings Payable Wages Payable Employer Payroll Tax Expense Employer FICA Payable Employer FUI Payable Employer SUI Payable 10,000 600 2,000 900 6,500 1,100 600 300 200
$10,000
$600
$2,000
$900
$6,500
Federal Unemployment Insurance
State Unemployment Insurance
$300
$200
Prepare the December 31st year-end adjusting entry(ies) assuming actual payment isn't made until 1/15/X5.
Remember: Employers have two types of payroll related expenses. The first is salary or wage expense equal to the gross amount of employee salaries or wages regardless of the nature and amount of withholdings to be paid on behalf of the employee. The second expense is the employer's payroll tax expense in the amount of employer FICA and unemployment taxes (federal and state). This expense is effectively a tax on employers for the privilege of having employees. The payables are subsequently debited upon payment to the employee and the various federal and state taxing authorities.
Health Insurance
Companies paying health insurance premiums on behalf of employees account for those costs as an expense in the period incurred under the terms of the policy.
Employee Health Insurance Expense Cash or Premiums Payable XXX XXX
Paid Vacation, Sick Days or Family Leave

(Compensated Absences)
Example: Assume a company provides employees with one paid sick day for every full month that's worked. When should the cost of that paid sick day be accounted for as an expense? Under the matching principle, the cost of compensated absences for sick days, vacations and family leave are expensed when earned by the employee.
At the end of each month: Salary or Wage Expense Sick Days Payable XXX XXX
In some cases, employees are offered a choice of insurance plans and are required to make a small contribution to the cost of those plans themselves, above and beyond the employers' contribution.
Wage Expense Employee FICA Withholdings Payable Employee FIT Withholdings Payable Employee SIT Withholdings Payable Health Insurance Withholdings Payable Wages Payable XXX XXX XXX XXX XXX XXX
6-1
When employees subsequently take their sick days, payment is made through the company's regular payroll.
Salary or Wage Expense Sick Days Payable Employee FICA Withholdings Payable Employee FIT Withholdings Payable Employee SIT Withholdings Payable Wages Payable XXX XXX
Bonuses
(Amounts over and above their base salary or wage, if the employee or the company reaches certain specified goals.)
Bonuses can be a great way to motivate employees to accomplish a company's goals and objectives. However, they can also increase the incentives for fraudulent financial reporting. In fact, the existence of employee bonus plans must be considered when an auditor evaluates the risks of fraud in a company's financial statements. The accounting for bonuses requires the recording of an expense in the period the bonuses are earned by employees regardless of when they're paid.
Employee Bonus Expense Employee FICA Withholdings Payable Employee FIT Withholdings Payable Employee SIT Withholdings Payable Bonus Payable XXX XXX XXX XXX XXX
XXX XXX XXX XXX
Its possible that some employees will never take their sick days or when they do, their pay rate may have changed. As a result, the net balance of sick days payable reported as a liability on a company's balance sheet, is an estimated future obligation that may require some periodic adjustment if the amount becomes inadequate or overstated with the passage of time.
Stock Options
(Rights to purchase shares of stock in a company at a set price over a period of time.)
When stock options are granted, employees are usually then required to work for a period of time before the options actually "vest" or become exercisable. This is referred to as the service period, and under the matching principle, the value of options granted should be recorded as an expense over that period of time. How should the value of options be determined, or in other words, what is the amount of expense to be recorded? Example: If options to buy 1,000 shares of stock for five years at a price of $10 a share are granted to an employee when the market price of the stock is $10, then do the options have any real value? The right to buy shares at a set $10 price over the next five years has real value, given that stock values may rise over time. Actually determining what an option is worth at the date of grant, its fair market value, can be highly subjective, but mathematical models can be used to come up with amounts that are acceptable for accounting purposes.
Entry to record the granting of stock options: Compensation or Stock Option Expense Paid-in Capital, Stock Options When employees subsequently exercise options: Cash Paid-in Capital, Stock Options Common Stock XXX XXX XXX XXX
XXX
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Pension Plans
(Provide retirement benefits for employees)
Two categories:
1. Defined contribution plans 2. Defined benefit plans Defined contribution plans: Call for a company to make specified contributions into an independent fund on behalf of each participating employee. The fund assets are typically invested in stocks and bonds and are then available for distribution to employees upon retirement in amounts equal to the contributions made plus any investment earnings. Annual entry: Pension Expense Cash XXX XXX
Defined benefit plans: Create an obligation for a company to provide certain specified benefits to employees in retirement. The determination and recording of that obligation requires complicated actuarial calculations that take into effect not only the benefits promised, but also estimates of employee turnover, future salary increases, employee life spans, and other factors. Defined benefit plans also require company contributions into an independently managed fund, however, in this case the balance of those funds including any investment earnings are reflected on the company's balance sheet as an offset against the company's recorded pension obligation. To the extent the obligation is under funded the net amount is reflected as a long-term liability. In the event of over funding the net amount is reflected as a long-term asset. On the income statement, the amount of pension expense recorded each year under a defined benefit plan is equal to the net amount of: (1) the increase in the company's, pension obligation arising from the employees' current year's service, plus (2) imputed interest expense on the pension obligation, less (3) any earnings on, the pension fund assets.
Because the fund assets are maintained and managed by a separate legal entity assuming full responsibility for future payments to retirees, the fund balance is not reflected as a company asset and no obligation to make future retirement payments to employees is recorded.
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6-2
Other Postretirement Benefits

(Continuing health and life insurance)
The accounting is similar to that used for defined benefit pension plans requiring companies to currently recognize the expense and long-term liability associated with the benefits earned by employees in the current period. A. Health insurance
Problem 6-2
Employee Benefits
Briefly summarize, in your own words, the accounting requirements for:
B. Compensated absences (paid vacation and sick days) C. Stock options D. Defined contribution pension plan E. Defined benefit pension plan F. Postretirement benefits other than pensions (life and health insurance)
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Employee Benefits
Briefly summarize, in your own words, the accounting requirements for:
B. Compensated absences (paid vacation and sick days)

Answer: Compensated absences are recorded as a liability and an expense at the employee's current salary or wage rate as the employee earns those benefits.
Salaries or Wage Expense Vacation Days Payable XXX XXX
A. Health insurance
Answer: Health insurance paid by a company on behalf of employees is recognized as an expense when incurred, regardless of the timing of payment. Any contributions to the cost of health insurance paid by employees is typically withheld from the employees' gross salary and wage and paid on their behalf directly to the health insurance provider.
When employees subsequently take their vacation or sick days, payment is made through the company's regular payroll and the previously recorded liability is debited for the cost of vacation or sick days taken.
Wage Expense Vacation Days Payable Employee FICA Payable Employee FIT Payable Employee SIT Payable Wages Payable XXX XXX
XXX XXX XXX XXX
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C. Stock options
Answer: The fair market value of stock options at the time granted to employees is accounted for as an expense over the period in which employment is required before the options become exercisable. The fair market value is typically calculated using a complex mathematical model based on a number of factors including the option price and the current market price of the stock. Entry to record option expense in the current period:
Compensation or Stock Option Expense Paid-in Capital, Stock Options XXX XXX
D. Defined contribution pension plan

Answer: Under a defined contribution plan, a company contributes a designated amount to a fund separately owned and operated on behalf of employees. The company does not guarantee returns on the invested funds and therefore does not guarantee the amount that will ultimately be available from the fund to its retiring employees. The company's accounting is limited to the recording of an expense when contributions are required under the plan. In this case, the only time a liability is recorded is if the annual contribution isn't made at the time it's required.
Pension Expense Cash or Pension Payable XXX XXX
When employees subsequently exercise options:

Cash Paid-in Capital, Stock Options Common Stock XXX XXX
XXX
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6-3
E. Defined benefit pension plan

Answer: Under a defined pension plan, a company agrees to pay certain specified benefits to retiring employees based on a number of factors including the employee's number of years of employment and compensation level at or near the time of retirement. The amount of this future obligation is actuarilly determined each year and recorded as a long-term liability on the company's balance sheet net of any fund balance set up to pay this future obligation. In the event the funds exceed the obligation the net amount is recorded as a long-term asset. An annual expense is also recorded under defined benefit plans equal to the increase in the pension obligation as a result of the current year's employment, plus imputed interest on the pension obligation for the year, less any current earnings on the invested funds.
F. Postretirement benefits other than pensions (life and health insurance)

Answer: The method used to account for employer promises to cover retiree's health and life insurance costs is similar to that used for defined benefit pension plans. Estimated future obligations are recorded as long-term liabilities net of any funds set up to pay those costs, and an annual expense is recorded to the extent of any current year increase in that obligation plus imputed interest and less any fund investment earnings.
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Problem 6-3
Review of Sales and Property Taxes Respond to the following For Landon, Inc., a clothing retailer. A. Prepare journal entries to record the following:
11/1/X1: Made cash sales totaling $10,000 collecting an additional 4% state sales tax ($400) at the time of sale. 11/1/X1: Paid $2,400 of property taxes for the six month period from 11/1/X1 to 4/30/X2.
Review of Sales and Property Taxes A. 11/1/X1 Entry to record cash sales and collection of sales tax:
Cash Sales Revenues Sales Taxes Payable 10,400 10,000 400
Assuming perpetual inventory accounting, an additional entry would be required to record cost of goods sold. In this case no amount was provided.
Cost of Goods Sold Inventory XXX XXX
B. What journal entry would be made to record any subsequent payment of collected sales taxes to the state? Why is no sales tax revenue or expense recorded on the company's books? C. Prepare the adjusting entry required at the company's 12/31/X1 year-end to properly account for the property taxes prepaid on 11/1.
11/1/X1: Entry to record payment of property taxes:

Prepaid Property Tax Expense Cash 2,400 2,400
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B. What journal entry would be made to record any subsequent payment of collected sales taxes to the state?
Sales Taxes Payable Cash XXX XXX
C. Prepare the adjusting entry required at the company's 12/31/X1 year-end to properly account for the property taxes prepaid on 11/1.
Property Tax Expense Prepaid Property Tax Expense 800* 800
Why is no sales tax revenue or expense recorded on the company's books?

Answer: Sales taxes are an expense of the customer and revenue of the state. The role of the company is simply to act as an agent of the state in collecting the tax from customers and then remitting it to the government. From the company's perspective no revenues are earned and no expenses incurred when collecting and paying these taxes. Upon collection of the tax the company incurs an obligation to the state and then subsequently pays that obligation. There's nothing more to it.
* Property tax expense for the two months from 11/1 to 12/31: ($2,400 6 mo. = $400/mo., then 2 mo. $400 = $800)
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6-4
Corporate Income Taxes
Assume a corporation has net income for financial reporting purposes of $10 million and at that income level the combined federal and state income tax rate is 30%. Let's also assume that for tax purposes an additional $1 million dollar expense is allowed for accelerated depreciation of equipment, producing taxable income of $9 million.
Financial Reporting Income Tax Reporting
In accounting, it's important to note that the laws governing the determination of taxable income often differ from accounting standards used for financial reporting purposes. This can create differences in the amount of income before income taxes and income tax expense reported on a company's income statement and the amount of taxable income and actual taxes payable to the government.
Net Income Tax Rate
$10,000,000 30% $ 3,000,000 (Expense)
$ 9,000,000 30% $ 2,700,000 (Payable) 3,000,000 2,700,000 300,000
Income Tax Expense Income Taxes Payable Deferred Income Tax Liability
In the later years of the equipment's useful life:

Income Tax Expense Deferred Income Tax Income Taxes Payable "Lower" XXX
"Higher"
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Problem 6-4
Deferred Income Taxes A. Describe deferred income taxes in your own words.
On occasion, a company's deferred income tax account may actually end the year with a net debit balance. When that happens, it's the result of tax laws that created higher cumulative taxes payable to date than reported income tax expense. That difference will ultimately reverse itself resulting in lower tax payments in the future. The right to lower tax payments in the future is an asset to a company and, as a result, any net debit balance is reported as a longterm asset called a "deferred tax benefit."
B. In essence, the difference between income tax expense and income taxes payable that gives rise to deferred income taxes is the result of timing differences that reverse themselves over time. In that case, why not just report income taxes as an expense in the amount that's currently payable eliminating the need for the deferred income tax account?
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Deferred Income Taxes

A. Describe deferred income taxes in your own words.
Answer: Deferred income taxes are the difference between the amount of income tax expense reported in the company's income statement and the amount actually payable to the government. In the event the recorded income tax expense is greater than the amount payable to the government, then the deferred amount is a long-term liability representing taxes payable in the future. If the taxes currently payable exceed the expense, the deferred taxes are a long-term asset, in effect a benefit that will reduce the amount payable in the future.
Contingent Assets and Liabilities

Contingent assets and gains: Never recorded until they're fully realized, meaning that no future uncertainty remains and cash or some other property or enforceable right has been received. Contingent liabilities and losses: May be recognized before final resolution takes place depending on the perceived probability of the outcome.
Probable losses, where the future event is likely to occur and the amount of the loss can be reasonably estimated, should be recorded in the current period with a debit to an expense or loss and a credit to a liability, along with detailed disclosure in the notes to the financial statements. Future obligations that are reasonably possible but are not yet probable in their outcome or subject to reasonable estimation must be disclosed in the notes to the financial statements but are not recorded as liabilities and losses in the financial statements. Claims that are unlikely to result in any future obligation do not need to be recorded or disclosed anywhere in the financial statements.
B. In essence, the difference between income tax expense and income taxes payable that gives rise to deferred income taxes is the result of timing differences that reverse themselves over time. In that case, why not just report income taxes as an expense in the amount that's currently payable eliminating the need for the deferred income tax account?
Answer: That would violate the matching principle. Under the matching principle, the amount of income tax expense recorded in the current year should be based on the company's reported net income.
Generally speaking, an auditor will request and rely on the written representations of the company's legal counsel in evaluating the adequacy of its accounting and disclosures relative to contingent legal liabilities.
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6-5
Product Warranties
(Promises made by a company to repair or replace merchandise sold to customers if the product malfunctions.)
Example: Assume Harris Appliances provides a free six-month warranty on any EZ Clean washing machines sold. The warranty covers parts and labor to fix any machine breakdown for up to six months following sale. Also assume that Harris contracts out all product warranty work to a local repair shop and based on prior experience Harris estimates that 10% of all EZ Clean machines sold will require warranty service at an average contract cost of $75 per unit. In the month of January, the company's net sales of EZ Clean machines amounted to 100 units. Estimated future warranty costs: 100 units X 10% X $75/unit = $750 Warranty Expense Warranty Obligations 750 750
January actual costs February actual costs March actual cost April actual costs May actual costs June actual costs
Warranty Obligations
xxx 1/1/X4 Balance Estimated costs from: xxx xxx xxx xxx xxx xxx 750 January sales xxx February sales xxx March sales xxx April sales xxx May sales xxx June sales xxx 6/30/X4 Balance
If we assume each month's sales are made on the last day of each month and actual costs are incurred equally over the six-month warranty period, then the balance at 6/30 should be equal to the sum of:
One month of estimated costs from January sales Two months of estimated costs from February sales Three months of estimated costs from March sales Four months of estimated costs from April sales Five months of estimated costs from May sales Six months of estimated costs from June sales $ XXX XXX XXX XXX XXX XXX $ XXX
As machines subsequently breakdown and require warranty work: Warranty Obligations Cash XXX XXX
This would be true if the estimates used by the company in projecting and recording future costs were accurate.
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Problem 6-5
Under current accounting standards, any errors in prior year estimates should be compensated for in the current year. That means that if the ending balance of warranty obligations is too high based on previous overestimations, then:
Adjusting entry at the end of the current period: Warranty Obligations Warranty Expense XXX XXX
Accounting for Contingent Liabilities Describe the accounting and disclosure requirements given the following contingencies. A. A customer who slipped and fell on company property has filed suit for $100,000 of damages. The company's legal counsel believes it's probable the company will have to pay $25,000 to settle the claim. B. A disgruntled former employee has filed a wrongful termination suit against the company. Given that the employee was fired for illegal drug use on the job, the company's legal counsel and management are confident no liability will result from this claim. C. A company has been sued for $1 million by the federal government for an alleged violation of pollution emission standards. The company's legal counsel believes there is a 50% chance the government will prevail.
An even better approach is to continually monitor the balance in the warranty obligation and simply adjust the estimates along the way to maintain a balance that is reasonable given actual recent experience.
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Problem 6-6

A. Answer: In this case, a $25,000 liability and expense should be recorded with a supplemental explanation provided in the notes to the financial statements. In reality, this situation is quite rare. Even if a company's legal position is considered weak, a company's legal counsel will rarely indicate a probable future loss on a pending case. To do so and record a liability in the financial statements would severely weaken the company's case in court. Most outstanding lawsuits are disclosed in the notes to the financial statements without the recording of a specific future obligation, at least until a final judgment or settlement has been reached. B. Answer: In situations where future losses are unlikely or remote no financial statement disclosure is required. C. Answer: In a case such as this, where a loss is possible, disclosure in the notes to the financial statements is required but no liability and expense are recorded.
Accounting for Warranty Obligations Jones TV Sales and Service sells used television sets and provides one-month of free repairs on all such sales. Jones' warranty obligation account has a $2,150 credit balance at 4/30/X1. Sales of used TVs in the month of May totaled $34,000 and actual warranty repair costs amounted to $1,500 ($1,000 labor and $500 parts), $1,000 of which was for sets sold in April. Jones estimates that warranty costs on sales of used sets runs at about 5% of sales revenues. A. Prepare the journal entry to record Jones' warranty expense for the month of May. B. Determine the balance of Jones' warranty obligation account at 5/31/X1. C. Do you think this warranty obligation account balance is over or understated? If so, what should be done to correct the account?
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6-6
Accounting for Warranty Obligations A. Prepare the journal entry to record Jones' warranty expense for the month of May.
Warranty Expense ($34,000 x 5%) Warranty Obligation 1,700 1,700
C. Do you think this warranty obligation account balance is over or understated? If so, what should be done to correct the account?
Answer: The warranty obligation appears to be overstated. In fact, we know that the $2,150 balance at 4/30/X1 was overstated by $1,150 given that the warranty period is limited to 30 days and the actual warranty costs incurred in May to repair TV sets sold in April amounted to $1,000. That also means that the percentage currently used to estimate warranty costs is probably excessive. To correct the prior overstatement, an adjusting entry can be made debiting the warranty obligation and crediting warranty expense for $1,150. In addition the 5% estimate should probably be adjusted down for the current and all future months. Alternatively, some companies might forgo the adjusting entry and simply lower the % estimate for future months with the expectation that in time the balance will decline to a more appropriate level. Frankly, the use of such an approach is acceptable as long as the amount of the overstatement is not significant at the end of any accounting period.
B. Determine the balance of Jones' warranty obligation account at 5/31/X1.

Warranty Obligations
2,150 Repairs performed 1,500* 1,700 2,350 4/30/X1 Warranty expense 5/31/X1
* Entry to record costs of repair work performed:

Warranty Obligation Cash or Wages Payable Cash or Inventory 1,500 1,000 500
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NRN Corporation Income Statement for the year ended December 31, 20X7 (in thousands) 20X7 Net sales revenues $105,000 Cost of goods sold 65,000 Gross margin 40,000 Operating expenses 24,000 Operating income 16,000 Other revenues (expenses) (1,000) Income before income taxes 15,000 Income tax expense 3,000 12,000 Income before extraordinary item Extraordinary loss, net of tax (4,000) Net income $ 8,000
Extraordinary Item
(Occurs infrequently and is unusual)
Gains and losses that qualify as extraordinary typically result from:
Casualties due to fire, flood, earthquakes or other natural disasters. Expropriations of assets by a government. Specific prohibitions under newly enacted laws or regulations.
It's also important to note that in determining whether an event is extraordinary or not, the place and circumstances in which a company operates must be taken into account.
Earning per share (1,000,000 shares): Income before extraordinary items Extraordinary gain (loss), net of tax Net income
$ 12 $ 12 (4) $ 8
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Gain or Loss from Discontinued Operations

(Gain or loss from the sale or disposal of some clearly distinguishable segment of a company's business.)
NRN Corporation Income Statement for the year ended December 31, 20X7 (in thousands)
Change in Accounting Principle

For example, a company may decide to convert from a FIFO to a LIFO inventory costing method because they believe LIFO will do a better job of representing the company's operating results. In that case, the company is required to determine and separately disclose the cumulative effect such a change would have had on the company's prior years' net income if the new method had been retroactively applied.
NRN Corporation Income Statement for the year ended December 31, 20X7 (in thousands)
Net sales revenues Cost of goods sold Gross margin Operating expenses Operating income Other revenues (expenses) Income before income taxes Income tax expense Income before cumulative effect of a change in accounting principle Cumulative effect of change in accounting principle, net of tax Net income Earning per share (1,000,000 shares): Income before the cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net of tax Net income
20X7
Net sales revenues $105,000 Cost of goods sold 65,000 Gross margin 40,000 Operating expenses 24,000 Operating income 16,000 Other revenues (expenses) (1,000) Income before income taxes 15,000 Income tax expense 3,000 12,000 Income from continuing operations Discontinued operations: Income or (loss) on the discontinued segment's current operations, net of tax (1,000) Gain or loss on the disposal of the segment, net of tax (3,000) Net income $ 8,000 Earning per share (1,000,000 shares): Income from continuing operations Income or loss on the discontinued segment's current operations, net of tax Gain or loss on the disposal of the segment, net of tax Net income
20X7 $105,000 65,000 40,000 24,000 16,000 (1,000) 15,000 3,000 12,000 (1,000) $ 11,000
$ 12 (1) (3) $ 8
$ 12 (1) $ 11
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6-7
Restructuring Charges
NRN Corporation Income Statement for the year ended December 31, 20X7 (in thousands) 20X7 Net sales revenues Cost of goods sold Gross margin Operating expenses Operating income Other revenues (expenses) Income before income taxes Income tax expense Net income Earning per share (1,000,000 shares) $105,000 65,000 40,000 24,000 16,000 (1,000) 15,000 3,000 $ 12,000 $ 12
Problem 6-7
Extraordinary and Other Irregular Items

A. Identify the proper income statement disclosure for the following items:
1. A loss is incurred on a plant destroyed during a coup in a foreign country. This is the first time such a change in government has taken place in the country, and nothing like this has happened in the company's previous experience. 2. A large loss results from an employee strike. 3. A change is made in the percentage used for estimating uncollectible accounts receivable. 4. A toy manufacturer incurs significant costs in dropping a product line from it board game division. 5. A change is made from the straight-line to a units-of-production method of depreciating equipment.
B. Prepare the section of an income statement that discloses a company's $5 million of income before extraordinary items and $1 million extraordinary loss, given an income tax rate of 30% and one million shares of stock outstanding.
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A. 1. Answer: This loss would qualify as an extraordinary loss given its unusual nature and infrequent occurrence. Extraordinary losses are reported separately, net of any related tax benefit, below the company's income after income taxes. It's also reported separately on a per share basis in the earnings per share disclosure. 2. Answer: This is not an extraordinary loss. Strikes are specifically disallowed as extraordinary items on the basis that they are a normal although somewhat infrequent event in the operation of a business. This loss would be noted above income tax expense in the category of other revenues and expenses or as a separately reported item. 3. Answer: This is not a change in accounting principle, it's a change in accounting estimate and any change in estimate is accounted for currently with no retroactive application. Bad debt expense is a normal recurring expense included in a company's income statement under "operating expenses."
4. Answer: The costs incurred in eliminating a product line within a division are restructuring charges reported in the income statement above income tax expense. If the entire game board division had been sold or disposed of, then any gain or loss in that case would have qualified for separate net of tax disclosure as a discontinued operation, below income after income taxes and on a per share basis. 5. Answer: This is a change in accounting principle and the cumulative effect of that change on prior years' net income would be shown, net of tax, below income after income taxes and on a separate per share basis. B.
(in thousands) Income before extraordinary items Extraordinary loss, net of tax Net income Earning per share (1,000,000 shares): Income before extraordinary items Extraordinary gain (loss), net of tax Net income $ 5,000 (700) $ 4,300 $ 5.00 (.70) $ 4.30
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6-8
Lesson 7
A dollar today is worth more than a dollar tomorrow. Which would you prefer, a $1,000 today or a $1,000 a year from now?
$1,000 today!
Lesson 7
The Time Value of Money
Take the money and invest it. It's a sure thing. Inflation can negatively affect the value of money over time. Money today is worth more than the same amount of money tomorrow.
That's the time value of money!
A financial calculator is required for this course. Hewlett-Packard, HP10bii Texas Instruments, TI BA II Plus Any calculator that has these keys noted here,
N
How much is a $1,000 a year from now actually worth in today's dollars?
or
How much would you be willing to pay today for the right to receive $1,000 a year from now?
PV
PMT
FV
CFj
and is capable of calculating internal rates of return on uneven cash flows and will probably get the job done. In this lesson, all of the examples that we'll be working on will refer to keystrokes used on the HP (10bii) calculator and all of the solutions to homework problems will include both the HP (10bii) and the TI (BA II Plus) keystrokes.
Set decimal places on the calculator's display: Clear memory:

C ALL
DISP
How much would you be willing to pay today for the right to receive $1,000 a year from now?
(The present value of a single cash flow or lump sum of $1,000.)
1 0 1,000 12
N PMT
: Number of periods involved. : Annuity payment (a series of two or more payments made in equal amounts over equal intervals of time) : Future value.
FV
I/YR : Interest rate per year
7-1
Set decimal places on the calculator's display: Clear memory:

C ALL
DISP
Compounding means that the amount of interest earned during each compounding period is based on both the amount of the original investment and any previously earned but unpaid interest to date. In effect, it means that interest is earned on interest. In this case, we'll calculate the present value of the $1,000 receivable in one year using 12 percent interest, compounding annually.
1 0 1,000 12 1
N PMT
: Number of periods involved. : Annuity payment (a series of two or more payments made in equal amounts over equal intervals of time) : Future value. : Reset to reflect annual compounding : Present value.
FV

P/YR PV
-892.86
An investment of $892.86 today grows to $1,000 at the end of a year at an interest rate 12% compounding annually. $892.86 + (12% x $892.86 x 1 yr) $892.86 + $107.14 = $1,000 That $1,000 total could also be characterized as the future value in a year of an $892.86 single cash outflow today at a rate of 12% compounding annually.
Clear memory:
C ALL
Determine the future value of the same $892.86 for one year at an interest rate of 12%, but instead of annual compounding, let's assume interest compounds quarterly. Clear memory:
C ALL
1 0 892.86 1
+/-
N PMT
: Number of periods involved. : Annuity payment (a series of two or more payments made in equal amounts over equal intervals of time) : Present value. : Reset to reflect annual compounding : Future value.
PV
892.86 4
4 0
+/-
N PMT PV
: Number of compounding periods : Annuity payment : Present value. : Reset compounding periods per year. : Future value
12

P/YR FV
12
I/YR : Interest rate

P/YR FV
1,000.00
In summary, $892.86 of cash invested today at an interest rate of 12% compounding annually will grow to $1,000 at the end of a year.
1,004.92
Verify compounding mathematically: $892.86 + (12% x $892.86 x 3/12 yr.) = $ 919.65 1st Quarter $919.65 + (12% x $919.65 x 3/12 yr.) = $ 947.24 2nd Quarter $947.24 + (12% x $947.24 x 3/12 yr.) = $ 975.65 3rd Quarter $975.65 + (12% x $975.65 x 3/12 yr.) = $1,004.92 4th Quarter Total interest earned on this investment for the entire year: $1,004.92 - $892.86 = $112.06 $112.06 $892.86 = 12.55% effective rate or APR* * Annual Percentage Rate
10
What would the effective interest rate or APR have been in the previous example if the12% interest rate had compounded daily rather than quarterly?
Clear memory:
C ALL
How much would a person have to invest today in an account that earns 5% interest compounding monthly, if they wished to accumulate $50,000 at the start of their daughter's college education in 4 years.
365 0 892.86 365

+/-
N PMT PV
: Number of compounding periods (total). : Annuity payment : Present value. : Interest rate. : Reset compounding periods per year. : Future value.
Clear memory:
C ALL
12
I/YR
P/YR FV
54 0 50,000 5 12
N PMT FV
: Number of compounding periods (total). : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
I/YR
P/YR PV
1,006.68
Interest earned on this investment:
-39,944.48
$113.82 ($1,006.68 - $892.86) $113.82 = 12.78% APR $892.86
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7-2
Determine the interest rate that would be required to double a $1,000 investment in 5 years, assuming interest compounds annually.
How long would it take to double our money if the best investment we could find produced a 10% return, compounding monthly?
Clear memory:
C ALL
Clear memory:
N
C ALL
5 0 2,000 1 1,000
N PMT FV
: Number of compounding periods (total). : Annuity payment. : Future value. : Interest rate. 14.87% : Reset compounding periods per year. : Present value.
: Number of compounding periods (total). 83.52 12 = 6.97 years : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
I/YR
P/YR
0 2,000 10 12 1,000
+/-
PMT FV
I/YR
P/YR PV
+/-
PV
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Problem 7-1
Calculations Using Single Cash Flows Respond to each of the following:

A. Determine the present value of a single future cash flow of $10,000, due in 20 years at 7% compounding semi-annually. B. If an investment account is opened with a deposit of $1,000, how much will that account be worth in 30 years assuming an expected return on investment of 12% compounding annually? C. What rate of return, compounding monthly, would have to be earned on a $100,000 investment in order to accumulate $1 million in 30 years? D. How many years would it take to accumulate $1,000,000 on a $100,000 investment, assuming an 8% return compounding monthly? E. Compute the future value of $100,000 in 30 years at 10% compounding daily (ignore the effect of leap years). F. An investor is considering the purchase of a 5-year, $20,000 note receivable, which bears interest, all due at maturity, at a rate of 8% compounding annually. If the investor were to buy the note at a time when there are four years left to maturity, how much would the investor pay to achieve a 12% rate of return, compounding quarterly?
Calculations Using Single Cash Flows

A. Determine the present value of a single future cash flow of $10,000, due in 20 years at 7% compounding semi-annually. Answer: $2,525.72 (The negative sign is ignored in this case.)
HP10bii:
C ALL
: Clear memory. : Number of compounding periods : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
40 0 10,000 7 2
Press
N PMT FV
I/YR
P/YR PV
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16
TI BAII Plus:
C/CE
2nd
CLR TVM N PMT FV
: Clear all Time-Value-of-Money values. : Number of compounding periods. : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
2nd
P/Y
40 0 10,000 7 2 ENTER
CPT
** Note for users of other calculators: Some financial calculators are set to one compounding period per year and don't allow modification of that setting. That is easily overcome by always inputting the interest rate as the interest rate per compounding period, rather the annual interest rate
Other calculators:
(See manual) : Clear memory:
I/Y
C/CE
PV
40 0 10,000 3.5
N PMT FV
: Number of compounding periods : Annuity payment. : Future value. : Interest rate. : Present value. (See manual for compute function.)
I
PV
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7-3
B. If an investment account is opened with a deposit of $1,000, how much will that account be worth in 30 years assuming an expected return on investment of 12% compounding annually? Answer: $29,959.92
B. If an investment account is opened with a deposit of $1,000, how much will that account be worth in 30 years assuming an expected return on investment of 12% compounding annually? Answer: $29,959.92
HP10bii:
C ALL
TI BAII Plus:
: Clear memory: : Number of compounding periods : Annuity payment. : Present value. : Interest rate. : Reset compounding periods per year. : Future value.
2nd P/Y
C/CE
2nd
CLR TVM
: Clear all Time-Value-of-Money values : Number of compounding periods : Annuity payment. : Present value. : Interest rate. : Reset compounding periods per year. : Future value.
30 0 1,000 1
Press
+/-
N PMT PV
30 0 1,000 1
+/-
N PMT PV
12
I/YR
P/YR FV
12
ENTER
I/Y
C/CE
CPT
FV
19
20
C. What rate of return, compounding monthly, would have to be earned on a $100,000 investment in order to accumulate $1 million in 30 years? Answer: 7.70%
C. What rate of return, compounding monthly, would have to be earned on a $100,000 investment in order to accumulate $1 million in 30 years? Answer: 7.70%
HP10bii:
C ALL
TI BAII Plus:
: Clear memory: : Number of compounding periods. : Annuity payment. : Future value. : Present value. : Reset compounding periods per year.
2nd
C/CE
2nd
CLR TVM N PMT FV PV

C/CE
: Clear all Time-Value-of-Money values : Number of compounding periods. : Annuity payment. : Future value. : Present value. : Reset compounding periods per year. : Interest rate.
360 0 1,000,000 100,000 +/12
N PMT FV PV P/YR
360 0 1,000,000 100,000 +/P/Y 12 ENTER

CPT
Press I/YR : Interest rate.*
I/Y
* For calculators set to one compounding period per year, then the solution will appear as .64%, which is a monthly interest rate and must be multiplied by 12 to get the 7.70% annual rate.
21
22
D. How many years would it take to accumulate $1,000,000 on a $100,000 investment, assuming an 8% return compounding monthly? Answer: 28.88 years (346.54 mo. 12)
D. How many years would it take to accumulate $1,000,000 on a $100,000 investment, assuming an 8% return compounding monthly? Answer: 28.88 years (346.54 mo. 12)
HP10bii:
C ALL
TI BAII Plus:
: Clear memory: : Annuity payment. : Future value. : Present value : Interest rate.* : Reset compounding periods per year. : Number of compounding periods.
2nd
C/CE
2nd
CLR TVM PMT FV PV
: Clear all Time-Value-of-Money values : Annuity payment. : Future value. : Present value : Interest rate. : Reset compounding periods per year. : Number of compounding periods.
0 1,000,000 100,000 +/8 12

Press
PMT FV PV
I/YR
P/YR N
0 1,000,000 100,000 +/8 P/Y 12 ENTER

CPT
I/Y
C/CE
* For calculators set to one compounding period per year, the interest rate to be input is the monthly interest rate of .6667% (8% 12)
23
24
7-4
E. Compute the future value of $100,000 in 30 years at 10% compounding daily (ignore the effect of leap years). Answer: $2,007,728.58
E. Compute the future value of $100,000 in 30 years at 10% compounding daily (ignore the effect of leap years). Answer: $2,007,728.58
HP10bii:
C ALL
TI BAII Plus:
: Clear memory: : Number of compounding periods. : Annuity payment. : Present value. : Interest rate.* : Reset compounding periods per year. : Future value.
2nd
C/CE
2nd
CLR TVM N PMT PV
: Clear all Time-Value-of-Money values : Number of compounding periods : Annuity payment. : Present value. : Interest rate. : Reset compounding periods per year. : Future value.
10,950 0 100,000 +/10 365

Press
N PMT PV
I/YR
P/YR FV
10,950 0 100,000 +/10 P/Y 365 ENTER

CPT
I/Y
C/CE
FV
* For calculators set to one compounding period per year, the interest rate to be input is the daily rate of .0274% (10 365)
25
26
F. An investor is considering the purchase of a 5-year, $20,000 note receivable, which bears interest, all due at maturity, at a rate of 8% compounding annually. If the investor were to buy the note at a time when there are four years left to maturity, how much would the investor pay to achieve a 12% rate of return, compounding quarterly? Answer: In this problem you first calculate the future value of the note receivable at maturity ($29,386.56) and then determine the present value of that future amount. $18,312.73 (Ignore the negative sign in this case.)
HP10bii: First
C ALL
HP10bii: Then
: Clear memory: : Number of compounding periods. : Annuity payment. : Present value. : Interest rate. : Reset compounding periods per year. : Future value.
C ALL
: Clear memory: : Number of compounding periods. : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
5 0 20,000 1
Press
+/-
N PMT PV
I/YR
P/YR FV
16 0 29,386.56 12 4
Press
N PMT FV
I/YR
P/YR PV
27
28
TI BAII Plus: First

C/CE
TI BAII Plus: Then

CLR TVM
2nd
: Clear all Time-Value-of-Money values : Number of compounding periods. : Annuity payment. : Present value. : Interest rate. : Reset compounding periods per year. : Future value.
2nd
C/CE
2nd
CLR TVM N PMT FV
: Clear all Time-Value-of-Money values : Number of compounding periods. : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
5 0 20,000
2nd P/Y
N PMT PV
+/-
8 1
ENTER
I/Y
C/CE
16 0 29,386.56 12 P/Y 4 ENTER

CPT
I/Y
C/CE
CPT
FV
PV
29
30
7-5
How much would you have for retirement in 30 years, if you invested $100 at the end of each month at an interest rate of 7% compounding monthly? In other words, what's the future value of this $100 annuity? HP 10bii calculator: Clear memory:
C ALL
Annuity
(A series of equal cash payments over equal intervals of time.)
360 100
+/-
N PMT PV
: Number of payments. : Annuity payment. : Present value. : Set compounding periods per year. : Future value.
0 7 12
I/YR : Interest rate.

P/YR FV
121,997.10
31
32
How much would accumulate if you could afford $300 at the end of each month and could somehow find an investment that generated a 12% return, compounding monthly? Clear memory:
C ALL
Calculate the future value of the $300 annuity assuming payments at the beginning rather than the end of each month for 30 years. Clear memory:
C ALL
360 300
+/-
N PMT PV
Reset the end of the period payment schedule to the beginning of BEG/END the period by:
360 300
+/-
N PMT PV
0 12 12

P/YR FV
0 12 12

P/YR FV
1,048,489.24
1,058,974.13 $1,058,974.13 vs. $1,048,489.24

($10,484.89 additional interest)
This amount is equal to the amount of interest earned on a single investment of $300 for 30 years at 12% compounding monthly.
33
34
Assume you wish to set up an investment account from which you'll be able to withdraw $10,000 at the end of each year for the next 20 years. Assuming the account will earn interest at a rate of 8% compounding annually how much will have to be invested today to accommodate those future withdrawals? Clear memory:
C ALL BEG/END
Assume your expecting your first child and want to invest an equal amount at the beginning of each month for 18 years to help cover the anticipated costs of college. Assuming an 8% return on investment, compounding monthly, how much must the monthly investment be to have $50,000 at the end of that 18-year period? Clear memory:
C ALL BEG/END
Reset to end of the period payments:
20 10,000 0 8 1
N PMT FV
: Number of payments. : Annuity payments. : Future value. : Set compounding periods per year. : Present value.

P/YR PV
216 50,000 0 8 12
N FV PV
: Number of payments. : Future value. : Present value. : Set compounding periods per year. : Annuity payment.

P/YR PMT
-98,181.47
-103.46
35
36
7-6
How much longer will it take to accumulate the $50,000 given a monthly payment of $75 a month? Clear memory:
N
C ALL
Calculate the rate that would have to be achieved to meet the original 18-year timetable given payments of $75 a month. Clear memory:
C ALL
Check display to verify beginning of the period payments are set.

: Number of payments.
Check display to verify beginning of the period payments are set.
254.22
12 = 21.19 years
50,000 0 8 12 75 +/-
FV PV
: Future value. : Present value. : Set compounding periods per year. : Annuity payment.
216 50,000 0
N FV PV
: Number of payments. : Future value. : Present value.

P/YR PMT
10.83
12 75
P/YR
: Set compounding periods per year. : Annuity payment.
+/-
PMT
37
38
Assume your considering the purchase of a $170,000 home with a $20,000 cash down payment and a $150,000 mortgage loan.
Problem 7-2
Calculations with Annuities

Respond to each of the following:
A. Determine the present value of an annuity of $1,000 at the end of each quarter for 5 years at 9% compounding quarterly. B. Determine the future value of an annuity of $100 at the beginning of each month for 10 years, at 7% compounding monthly. C. If $200,000 is needed for retirement in 10 years, how much must be invested at the beginning of each year, at an interest rate of 10% compounding annually, to reach that goal? D. Determine the amount of the equal monthly mortgage payment on a $100,000, 30-year, fully amortizing mortgage, bearing interest at a fixed 7% rate, compounding monthly. (Mortgage payments are made at the end of each month.) Then make the journal entries to record the first two monthly payments. E. Determine the fixed interest rate that will produce a monthly mortgage payment of $750 on a $120,000, 30 year, fully amortizing mortgage. F. The parents of a newborn daughter anticipate they'll need $10,000 at the beginning of each year for four years to pay her annual college tuition beginning on her 18th birthday. How much must be invested at the beginning of each year for 18 years (beginning on her date of birth) to accumulate the funds necessary to make those annual payments assuming a 7% return on investment, compounding annually?
What's the monthly mortgage payment?

Assuming a traditional 30-year, fixed rate, fully amortizing mortgage, an equal monthly payment is established in an amount that pays off the entire principal and interest due on the loan over the 30-year period. This fixed monthly payment is an annuity that can be easily determined using a financial calculator.
Clear memory:
C ALL BEG/END
360 0 150,000 7 12
N FV PV
: Number of payments. : Future value. : Present value. : Set compounding periods per year. : Annuity payment.

P/YR PMT
-997.95
39
40

A. Determine the present value of an annuity of $1,000 at the end of each quarter for 5 years at 9% compounding quarterly.

A. Determine the present value of an annuity of $1,000 at the end of each quarter for 5 years at 9% compounding quarterly.
Answer: $15,963.71 (ignore the negative sign)
HP10bii:
Check display to make sure end of the period payments are set. ("Begin" does not appear.) If this needs to be changed then enter:
C ALL BEG/END
TI BAII Plus:
Check display to make sure end of the period payments are set. ("BGN" does not appear.) If this needs to be changed then enter:
C/CE
2nd
BGN
2nd
SET
C/CE
: Clear memory : Number of payments. : Annuity payment. : Future value. : Interest rate. : Set compounding periods per year. : Present value.
2nd
2nd
CLR TVM N PMT FV
: Clear all Time-Value-of-Money values. : Number of payments. : Annuity payment. : Future value. : Interest rate. : Set compounding periods per year. : Present value.
20 1,000 0 9 4
Press
N PMT FV
I/YR
P/YR PV
P/Y
20 1,000 0 9 4 ENTER
CPT
I/Y
C/CE
PV
41
42
7-7
B. Determine the future value of an annuity of $100 at the beginning of each month for 10 years, at 7% compounding monthly.
B. Determine the future value of an annuity of $100 at the beginning of each month for 10 years, at 7% compounding monthly.
HP10bii:
Check display to make sure beginning of the period payments are set. ("Begin" appears.) If this needs to be changed then enter:
C ALL BEG/END
TI BAII Plus:
Check display to make sure beginning of the period payments are set. ("BGN" appears.) If this needs to be changed then enter:
C/CE
2nd
BGN
2nd
SET
C/CE
: Clear memory : Number of payments. : Annuity payment. : Present value. : Interest rate. : Set compounding periods per year. : Future value.
2nd
2nd
CLR TVM N PMT PV
: Clear all Time-Value-of-Money values. : Number of payments. : Annuity payment. : Present value. : Interest rate. : Set compounding periods per year. : Future value.
120 100 0 7 12
Press
N PMT PV
I/YR
P/YR FV
120 100 0 7
P/Y
I/Y
C/CE
12
ENTER
CPT
FV
43
44
C. If $200,000 is needed for retirement in 10 years, how much must be invested at the beginning of each year, at an interest rate of 10% compounding annually, to reach that goal?
C. If $200,000 is needed for retirement in 10 years, how much must be invested at the beginning of each year, at an interest rate of 10% compounding annually, to reach that goal?
Answer: -$11,408.25
Answer: -$11,408.25
HP10bii:
C ALL BEG/END
TI BAII Plus:
C/CE
2nd
BGN
2nd
SET
C/CE
: Clear memory : Number of payments. : Present value. : Future value. : Interest rate. : Set compounding periods per year. : Annuity payment.
2nd
2nd
CLR TVM N PV FV
: Clear all Time-Value-of-Money values. : Number of payments. : Present value. : Future value. : Interest rate. : Set compounding periods per year. : Annuity payment.
10 0 200,000 10 1
Press
N PV FV
I/YR
P/YR PMT
P/Y
10 0 200,000 10 1 ENTER
CPT
I/Y
C/CE
PMT
45
46
D. Determine the amount of the equal monthly mortgage payment on a $100,000, 30-year, fully amortizing mortgage, bearing interest at a fixed 7% rate, compounding monthly. (Mortgage payments are made at the end of each month.) Then make the journal entries to record the first two monthly payments.
D. Determine the amount of the equal monthly mortgage payment on a $100,000, 30-year, fully amortizing mortgage, bearing interest at a fixed 7% rate, compounding monthly. (Mortgage payments are made at the end of each month.) Then make the journal entries to record the first two monthly payments.
Answer: -$665.30
Answer: -$665.30
HP10bii:
C ALL BEG/END
TI BAII Plus:
C/CE
2nd
BGN
2nd
SET
C/CE
: Clear memory : Number of payments. : Present value. : Future value. : Interest rate. : Set compounding periods per year. : Annuity payment.
2nd
2nd
CLR TVM N PV FV
: Clear all Time-Value-of-Money values. : Number of payments. : Present value. : Future value. : Interest rate. : Set compounding periods per year. : Annuity payment.
360 100,000 0 7 12
Press
N PV FV
I/YR
P/YR PMT
P/Y
360 100,000 0 7 12 ENTER

CPT
I/Y
C/CE
PMT
47
48
7-8
E. Determine the fixed interest rate that will produce a monthly mortgage payment of $750 on a $120,000, 30 year, fully amortizing mortgage.
E. Determine the fixed interest rate that will produce a monthly mortgage payment of $750 on a $120,000, 30 year, fully amortizing mortgage.
Answer: 6.39%
Answer: 6.39%
HP10bii:
C ALL BEG/END
TI BAII Plus:
C/CE
2nd
BGN
2nd
SET
C/CE
: Clear memory : Number of payments. : Annuity payment. : Future value. : Present value. : Set compounding periods per year. : Interest rate.
2nd
2nd
CLR TVM N PMT FV PV

C/CE
: Clear all Time-Value-of-Money values. : Number of payments. : Annuity payment. : Future value. : Present value : Set compounding periods per year. : Interest rate.
360 750
+/-
N PMT FV PV P/YR
360 750
+/-
0 120,000 12
P/Y
0 120,000 12 ENTER
CPT
Press I/YR
I/Y
49
50
F. The parents of a newborn daughter anticipate they'll need $10,000 at the beginning of each year for four years to pay her annual college tuition beginning on her 18th birthday. How much must be invested at the beginning of each year for 18 years (beginning on her date of birth) to accumulate the funds necessary to make those annual payments assuming a 7% return on investment, compounding annually?
HP10bii:
BEG/END
Answer: -$996.27 (ignore the negative sign) (This solution requires a two-part process. First, the present value of a $10,000 annual annuity with payments made at the beginning of each year must be determined at a 7% rate compounding annually. Then that present value will be used as the future value amount in determining the annual investment required at the beginning of each year for 18 years at the same 7% rate) See pages that follow for calculation:
First
C ALL
: Clear memory : Number of payments. : Annuity payment. : Future value. : Interest rate. : Set compounding periods per year. : Present value.
4 10,000 0 7 1
Press
N PMT FV
I/YR
P/YR PV
-36,243.16
51
52
HP10bii:
TI BAII Plus:
C ALL
Then
: Clear memory : Number of payments. : Future value. : Present value. : Interest rate. : Set compounding periods per year. : Annuity payment.
2nd BGN 2nd SET
C/CE
18 36,243.16 0 7 1
Press
N FV PV
First
C/CE
2nd
CLR TVM N PMT FV
: Clear all Time-Value-of-Money values. : Number of payments. : Annuity payment. : Future value. : Interest rate. : Set compounding periods per year. : Present value.
I/YR
P/YR PMT
-996.27
2nd
P/Y
4 10,000 0 7 1 ENTER
CPT
I/Y
C/CE
PV
-36,243.16
53
54
7-9
TI BAII Plus:
The present or future value of multiple cash flows is simply the sum of the present or future values of all cash flows involved.
Determine the future value of an investment at the end of three years that includes contributions of $1,000 today, $2,000 a year from now, and $3,000 a year after that, assuming the investment earns a 10% return compounding annually.
FV = ? -$1,000 -$2,000 -$3,000 FV = $1,331 FV = $2,420 FV = $3,300 $7,051 FV = ? -$1,000 $1,000 -$1,000 -$1,000 $2,000 -$1,000 -$1,000 -$1,000 $3,000 FV = $3,641 FV = $2,310 FV = $1,100 $7,051 FV = ? -$1,000 -$2,000 $1,000 $2,000 -$2,000 -$1,000 $3,000 FV = $1,331 FV = $4,620 FV = $1,100 $7,051
Then
C/CE
2nd
CLR TVM N FV PV
: Clear all Time-Value-of-Money values. : Number of payments. : Future value. : Present value. : Interest rate. : Set compounding periods per year. : Annuity payment.
2nd
18 36,243.16 0 7 P/Y 1 ENTER

CPT
I/Y
C/CE
PMT
-996.27
The future value of uneven cash flows is simply the sum of the future values of each single cash flow or any combination of single or annuity cash flows involved. That's also true when applied to present values.
55
56
Determine how much would have to be invested in an account today, if, at the beginning of the 5th year following investment, you wished to withdraw $1,000 a month for 12 months plus the lump-sum amount of $10,000 at the end of that 12th month. Assume an 8% return on investment, compounding monthly.
Determine how much would have to be invested in an account today, if, at the beginning of the 5th year following investment, you wished to withdraw $1,000 a month for 12 months plus the lump-sum amount of $10,000 at the end of that 12th month. Assume an 8% return on investment, compounding monthly.
PV = ?
60
61
62
70
71
72 Months
PV = ?
60
61
62
70
71
72 Months
PV = -671.21 PV = -666.76 PV = -662.35 . . . -13,965.23
1,000 1,000 1,000
1,000 1,000 10,000
PV = -7,767.53 PV = -6,197.70 -13,965.23
1,000 1,000 1,000 PV = 11,572.42
1,000 1,000 10,000
57
58
Problem 7-3
Problem 7-3
PV and FV Calculations with Uneven Cash Flows

Respond to each of the following: A. If withdrawals of $10,000, $12,000 and $15,000 are needed from an investment account at the end of each year for the next three years, respectively, how much must be invested today assuming a 10% return on investment, compounding annually. (Make this calculation two ways. Use an annuity in at least in one of your computations.) B. The parents of a newborn daughter anticipate they'll need the following amounts to fund their daughters' future college education and wedding: $15,000 at 18th birthday $16,000 at 19th birthday $17,000 at 20th birthday $18,000 at 21st birthday $25,000 at 26th birthday How much will have to be invested at the beginning of each year for 18 years (starting at the date of birth) to accumulate the funds necessary to meet these anticipated future obligations? (Assume a 7% return on investment, compounding annually.)

C. If you open an investment account and expect to earn 12% compounding monthly, how much will you have for retirement in 30 years if you invest the following amounts at the beginning of each month? $ 250/mo. for the first 5 years $ 500/mo. for the next 10 years $1,000/mo. for the final 15 years
59
60
7-10

Respond to each of the following: A. If withdrawals of $10,000, $12,000 and $15,000 are needed from an investment account at the end of each year for the next three years, respectively, how much must be invested today assuming a 10% return on investment, compounding annually. (Make this calculation two ways. Use an annuity in at least in one of your computations.) Answer: -$30,277.98 (ignore the negative sign)
PV = ? PV = $ 9,090.90 PV = $ 9,917.36 PV = $11,269.72 $30,277.98 PV = ? PV = $24,868.52 PV = $ 1,652.89 PV = $ 3,756.57 $30,277.98 $10,000 $10,000 $10,000 $ 2,000 $12,000 $10,000 $ 5,000 $15,000 $10,000 $12,000 $15,000
0
?
B. The parents of a newborn daughter anticipate they'll need the following amounts to fund their daughters' future college education and wedding:
$15,000 at 18th birthday $16,000 at 19th birthday $17,000 at 20th birthday $18,000 at 21st birthday $25,000 at 26th birthday
How much will have to be invested at the beginning of each year for 18 years (starting at the date of birth) to accumulate the funds necessary to meet these anticipated future obligations? (Assume a 7% return on investment, compounding annually.)
Answer: $2,035.39 at the beginning of each year for 18 years, with interest at 7% compounding annually produces a FV of $74,095.32 at the end of the 18th year.
1
?
2
?
16
?
17
?
18
19
20
21
22
23
24
25
26 years
25,000
15,000 16,000 17,000 18,000
PV = -15,000.00 PV = -14,953.27 PV = -14,848.46 PV = -14,693.36 PV = -14,550.23 -74,045.32
61
62
C. If you open an investment account and expect to earn 12% compounding monthly, how much will you have for retirement in 30 years if you invest the following amounts at the beginning of each month? $ 250/mo. for the first 5 years $ 500/mo. for the next 10 years $1,000/mo. for the final 15 years Answer: $1,609,175.21 FV of -$250 annuity at the beginning of 360 months = $882,478.44 FV of -$250 annuity at the beginning of 300 months = $474,408.77 FV of -$500 annuity at the beginning of 180 months = $252,288.00 $1,609,175.21
63
7-11
Lesson 8
Property, Plant and Equipment
Lesson 8
Long-Term Assets
Intangible Assets Natural Resources
Problem 8-1
Property, Plant and Equipment

(Fixed Assets)
Review of Accounting for Property, Plant and Equipment On 4/1/X1, Elder Company purchased a used truck for $30,000 paying $10,000 cash down and signing a note to pay the difference with interest over time. In addition, Elder paid a 6% sales tax on the total purchase price, overhauled the engine for $1,200 and paid $2,000 for a paint job deemed necessary before putting the truck in service. Elder also prepaid $2,400 of insurance premiums for one year's coverage on the truck.
A. What does it mean to "capitalize" an expenditure and what are the criteria for capitalization of costs incurred in the acquisition of property, plant and equipment? Prepare the 4/1/X1 journal entry or entries required for the purchase of the truck and all associated expenditures including insurance. B. Prepare the 12/31/X1 adjusting entry for the truck's 'X1 depreciation using the straight-line method and estimations of a $5,000 salvage value at the end of a 5-year useful life. What kind of account is "Accumulated Depreciation" and where does it appear on a company's financial statements?
Land Land improvements Buildings Equipment Machinery Vehicles Office equipment Furniture Etc. 3
Problem 8-1
C. Prepare the journal entry in 'X2 to record a $500 cash purchase of new tires for the truck. When does an expenditure qualify as an "improvement" that's to be capitalized as part of the cost of the truck? D. Prepare the 12/31/X2 adjusting entry for the truck's 'X2 depreciation. E. Determine the book value of the truck at 12/31/X2. F. Prepare the journal entry to record the sale of the truck at 12/31/X2 for $28,000 cash. What would the entry be assuming the truck sold for $20,000 cash? What would the entry be assuming the truck was simply used up and disposed of at 12/31/X2? Where would a gain or loss on the sale of an asset appear in the company's income statement? G. Recalculate the truck's 12/31/X1 depreciation using the units of production method under the following assumptions: 100,000 miles of anticipated usage, $5,000 estimated salvage value, and 10,000 miles of actual usage from 4/1/X1 to 12/31/X1.
Review of Accounting for Property, Plant and Equipment

A. What does it mean to "capitalize" an expenditure and what are the criteria for capitalization of costs incurred in the acquisition of property, plant and equipment?
Capitalization of an expenditure means to account for an expenditure as an asset or part of the cost of an asset rather than as an expense. In the case of property, plant and equipment, any cost incurred in acquiring or getting an asset ready for its original intended use is capitalized as part of the cost of the asset.
Prepare the 4/1/X1 journal entry or entries required for the purchase of the truck and all associated expenditures including insurance.
Truck Cash Note Payable Prepaid Insurance Cash 35,000* 15,000 20,000 2,400 2,400 *Capitalized cost of the truck: $ 30,000 Purchase price Sales tax (6% X $30,000) 1,800 1,200 Engine overhaul 2,000 Paint job $ 35,000
(The prepaid insurance is accounted for as a separate asset because it's the cost of future insurance coverage and not a cost incurred in acquiring the truck or getting it ready for its original intended use.)
8-1
B. Prepare the 12/31/X1 adjusting entry for the truck's 'X1 depreciation using the straight-line method and estimations of a $5,000 salvage value at the end of a 5-year useful life.
Depreciation Expense Accumulated Depreciation 4,500* 4,500
C. Prepare the journal entry in 'X2 to record a $500 cash purchase of new tires for the truck.
Repairs & Maintenance Expense Cash 500 500
* $35,000 - $5,000 9 = $6,000/year X of a year = $4,500 5 years 12 What kind of account is "Accumulated Depreciation" and where does it appear on a company's financial statements? Answer: Accumulated depreciation is a contra-asset account that appears in a company's balance sheet as an offset to the capitalized cost of the asset being depreciated.
When does an expenditure qualify as an "improvement" that's to be capitalized as part of the cost of the truck? Answer: Expenditures are capitalized improvements when they either extend the originally estimated useful life of the asset or increase the asset's productivity. In this case, the purchase of new tires is not capitalized because tire replacement is part of the normal recurring maintenance of a vehicle and does not meet the criteria for capitalization. If, however, something like a refrigeration system were added to the truck, that cost would be capitalized given the change in the truck's function and productivity. When such improvements are made, depreciation from that point on must be recalculated given the asset's new capitalized cost.
D. Prepare the 12/31/X2 adjusting entry for the truck's 'X2 depreciation.
Depreciation Expense Accumulated Depreciation 6,000 6,000
F. Prepare the journal entry to record the sale of the truck at 12/31/X2 for $28,000 cash. Cash 28,000 Accumulated Depreciation 10,500 Truck 35,000 Gain on Sale 3,500 What would the entry be assuming the truck sold for $20,000 cash?
Cash Accumulated Depreciation Loss on Sale Truck 20,000 10,500 4,500 35,000
(This reflects a full year's depreciation on the truck) E. Determine the book value of the truck at 12/31/X2. Truck (capitalized cost) Less: Accumulated depreciation Book value $35,000 ( 10,500) $24,500
4,500 6,000 10,500 'X1 entry 'X2 entry 12/31/X2
What would the entry be assuming the truck was simply used up and disposed of at 12/31/X2? Accumulated Depreciation 10,500 Loss on Disposal 24,500 Truck 35,000 Where would a gain or loss on the sale of an asset appear in the company's income statement? Answer: Gains and losses on the sale of long-term assets are included in "other revenues and expenses" on a multi-step formatted income statement. Such sales are not part of a company's normal operating activities.
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G. Recalculate the truck's 12/31/X1 depreciation using the units of production method under the following assumptions: 100,000 miles of anticipated usage, $5,000 estimated salvage value, and 10,000 miles of actual usage from 4/1/X1 to 12/31/X1. $35,000 - $5,000 = $.30/mile X 10,000 miles = $3,000 100,000 miles
It's not uncommon for companies to acquire more than one asset in a single purchase.
Basket Purchases of Assets

The allocation of cost among the various assets purchased is typically done based on the relative current values of the assets involved based on recent appraisals.
Example: Assume that a building and the land its located on are purchased for $1,000,000 cash.
Land Building Cash ? ? 1,000,000
Assume a recent appraisal valued the land and building separately at $200,000 and $600,000, respectively.
Appraised Value % of Total
Land Building Total
$200,000 $600,000 $800,000
25% 75% 100%
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8-2
Problem 8-2
Basket Purchase of Assets

In a recent liquidation sale, Horace, Inc. paid $10,000 cash for all of the assets listed below at their pre-liquidation prices.
Pre-Liquidation Prices
Basket Purchase of Assets

Journal entry to record the purchase:
Office Furniture Office Equipment Supplies Cash 3,000 6,000 1,000 10,000
Office furniture Office equipment Supplies
$15,000 $30,000 $ 5,000
Prepare the journal entry to record this purchase. Why do you think management might wish to disproportionately allocate more cost in a basket purchase to land or longer-lived assets than to assets with shorter useful lives?
Pre-Liquidation Prices
% of Total
Purchase Price
Allocated Price
$15,000 $30,000 $ 5,000 $50,000
30% X $10,000 = $ 3,000 60% X $10,000 = $ 6,000 10% X $10,000 = $ 1,000 $10,000 100%
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Question: Why do you think management might wish to disproportionately allocate more cost in a basket purchase to land or longer-lived assets than to assets with shorter useful lives?
Self-Constructed Assets
When companies choose to make or manufacture a fixed asset for their own future use, then all of the costs incurred in the construction or manufacturing process should be capitalized as part of the cost of that asset.
Materials. Labor. Additional overhead costs (utilities, rent, depreciation of equipment and any other costs associated with the construction process). Interest on construction loans or interest that could have been saved if the company's own money used on construction had been applied to the payoff of other outstanding debts, should be capitalized as part of the cost of the building.
Answer: Since management is often evaluated based on a company's reported earnings, managers will sometimes push for accounting treatments that improve a company's net income. In a basket purchase of assets, any costs allocated to depreciating assets will ultimately be accounted for as depreciation expense and will reduce the company's net income. If those costs can be allocated instead to a non-depreciating asset like land, then those costs are never expensed and reported net income will be higher. Likewise, if costs are allocated to assets with longer rather than shorter useful lives, the amount of annual depreciation expense will be lower as costs are spread out over a longer useful life. This will improve a company's net income in the early years but will ultimately be offset when depreciation expense is recorded in the later additional years of the longer-lived assets.
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Problem 8-3
Respond to the following questions: 1. How does the capitalization of interest on a self-constructed asset comply with the matching principle? 2. What justifies the capitalization of interest that could have been saved if a company's own money, used in construction of an asset, had been applied to the payoff of other outstanding debts? 3. Which of the following do you think is most likely to have capitalized interest as a result of self-constructed assets? Boat manufacturer Public utility company Clothing retailer
Respond to the following questions: 1. How does the capitalization of interest on a self-constructed asset comply with the matching principle?
Answer: The matching principle requires the expensing of costs in the same period those costs help to produce a company's revenues. Frankly, assets under construction rarely contribute to the production of a company's revenues until they're completed and put to use. As a result, all costs of construction are properly deferred, and in this case, capitalized and then allocated to expense over the asset's productive or useful life. That's done through depreciation of the asset's capitalized costs, which properly include interest costs incurred on construction financing.
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8-3
2. What justifies the capitalization of interest that could have been saved if a company's own money, used in construction of an asset, had been applied to the payoff of other outstanding debts?
Answer: Under the historical cost principle, all costs incurred in constructing an asset, even costs incurred in financing that construction, should be capitalized as part of the cost of the asset. This includes not only direct costs of construction but also any costs that could have otherwise been avoided if the construction had not taken place. Interest costs incurred on debts that could have been paid off if no construction had occurred qualify as part of the legitimate historical cost of a self-constructed asset.
3. Which of the following do you think is most likely to have capitalized interest as a result of self-constructed assets? Boat manufacturer Public utility company Clothing retailer
Answer: Public utilities are often involved in the construction of their own power generating equipment and facilities and will usually capitalize a considerable amount of their interest costs. Although a boat manufacturer is involved in construction or manufacturing activities, those activities are directed to the building of boats for sale to customers. A boat manufacturer would rarely be involved in the construction of its own fixed assets. The same would be true of any merchandiser such as a clothing retailer.
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Operating Leases
(Typically documented in rental contracts or lease agreements that specify that the lessee is taking temporary possession of the lessor's property in exchange for periodic payments of rent.)
Assume Herd Enterprises wants to buy a building and is willing to pay the seller's full $800,000 asking price, requiring $80,000 cash down and the signing of a $720,000 30-year fully amortizing mortgage note payable. Given a fixed interest rate of 8% compounding monthly, the monthly payment of principal and interest on the note would amount to $5,283.10.
As lease payments are made: As lease payments are made:

Rent Expense Cash XXX XXX Building Cash Mortgage Note Payable 800,000 80,000 720,000
These operating leases provide what is often referred to as off-balance sheet financing because they allow a company to, in effect, borrow and use a resource without having to record any related debt.
Also assume that Herd hopes to raise some additional equity financing over the next few years and is concerned that that mortgage note payable will make the company appear less attractive to investors. To avoid that, Herd offers to lease the property rather than buy it outright. The terms of his proposed lease include an initial up front payment of $80,000 as a non-refundable deposit, with subsequent monthly rental payments of $5,283.10 per month for 30-years. The lease would be non-cancelable and property ownership would automatically transfer to Herd at the end of the lease.
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Generally accepted accounting principles require that transactions be accounted for based on their actual economic substance rather than the legal form of the transaction.
Current accounting standards provide that if a lease is non-cancelable and meets any one of four criteria that are indicators of an effective purchase, then the leased property must be capitalized and accounted for as if it had actually been purchased with long-term debt.
Present value of the proposed lease's anticipated payments:

Present Value
Non-refundable deposit of $80,000 Monthly rental payments of $5,283.10 for 30-years
$ 80,000 $ 720,000 $ 800,000
Four Criteria:
Capital Lease
The interest rate to be used in determining the present value of those future payments is the rate that the lessee would have incurred to borrow the funds necessary to buy the property with repayment terms similar to the payment schedule called for under the lease. In this case that was 8%, the same rate provided for under the original mortgage note financing.
1. The lease provides the lessee with full ownership of the property at the end of the lease. 2. The lease provides the lessee with an option to buy the property at a bargain price at the end of the lease such that a transfer of ownership is virtually assured. 3. The lease term is equal to or greater than 75% of the estimated economic useful life of the property. 4. The present value of all amounts due under the lease is equal to or greater than 90% of the current fair market value of the property
Under current accounting standards the capitalized cost of the leased asset is to be recorded at the combined PV of all anticipated payments under the lease, including any expected payments under a bargain purchase option.
Leased Building Cash Lease Liability 800,000 80,000 720,000
The balance of any lease liability recorded under a capital lease should always be equal to the present value of any anticipated future payments to be made under the lease.
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8-4
Subsequent to the recording of this capitalized lease, the leased property is subject to depreciation just like any other property, plant, and equipment. That's recorded through an adjusting entry at the end of each accounting period:
Depreciation Expense Accumulated Depreciation XXX XXX
With each payment made under the lease, a portion of that payment represents the effective cost of borrowing, or the cost of interest, and the remainder is payment on the outstanding principal amount of the lease liability. At the end of the first month:
Interest Expense Lease Liability Cash 4,800.00 483.10 5,283.10
Leases are capitalized when they meet any one of the four criteria that imply a purchase in economic substance. Leases that do not meet those criteria are accounted for as simple operating leases with rent expense recorded with each lease payment made. However, because these operating leases often involve significant long-term commitments, GAAP requires supplemental disclosure of any future amounts due in the notes to the financial statements.
Interest Calculation: $720,000 X 8% X 1/12 = $4,800.00
At the end of the second month:

Interest Expense Lease Liability Cash 4,796.78 486.32 5,283.10
Interest Calculation: 719,516.90 ($720,000 - $483.10) $719,516.90 X 8% X 1/12 = $4,796.78
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Problem 8-4
Lease Accounting
Zee Corporation wants to lease computer equipment and is considering alternative lease contracts for the same equipment. Both are noncancelable and require payment of a $1,000 up-front transaction fee. One calls for lease payments of $1,000 at the end of each month over a two-year term, while the other is a five-year lease requiring payments of $700 a month. The estimated economic life of the asset is 5 years. There is no automatic transfer of ownership or bargain purchase option at the end of either lease. The cost of purchasing the equipment in today's market would be $37,000 with an 8% interest cost on any associated debt financing. Assuming a 12/1/X5 starting date, prepare the required journal entries under each lease at 12/1/X5, 12/31/X5 and 1/31/X6. (For any capitalized lease equipment, depreciation is to be calculated using the straight-line method assuming a 5-year estimated useful life and a $1,000 salvage value.) Question: Why might the company choose to rent for two years even though it requires higher cash payments on a monthly basis?
Lease Accounting
Two-year lease: (This lease is accounted for as an operating lease because it does not meet any of the four criteria of a capital lease: (1) automatic transfer of ownership, (2) a bargain purchase option, (3) a lease term equal to or greater than 75% of the equipment's estimated economic life, or (4) a present value of the future lease payments equal to or greater than 90% of the equipment's current fair market value.)
12/1/X5:
Equipment Rent Expense Cash 1,000 1,000
12/31/X5:
1/31/X6:
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Five-year lease: (This lease is accounted for as capital lease given that its non-cancelable
and the lease term of five years is greater than 75% of the equipment's estimated economic useful life which is also 5 years. In addition, the present value of the $1,000 upfront fee and the future lease payments totals $35,523* and is greater than 90% of the equipment's current fair market value of $37,000.) * PV of a $700 annuity at the end of each month for 5 years at a rate of 8% compounding monthly ($34,523 rounded), plus the PV of the $1,000 up-front payment ($1,000).
1/31/X6:
Interest Expense Lease Liability Cash 227* 473 700
* Interest: $34,053 X 8% X 1/12 = $227 rounded
12/1/X5:
Leased Equipment Lease Liability Cash 35,523 34,523 1,000
If Zee prepares monthly financial statements a monthly adjustment to record depreciation expense would be required:
Depreciation Expense Accumulated Depreciation 575 575
12/31/X5:
Interest Expense 230* Lease Liability 470 Cash * Interest: $34,523 X 8% X 1/12 = $230 rounded Depreciation Expense Accumulated Depreciation 575* 575 700
Question: Why might the company choose to rent for two years even though it requires higher cash payments on a monthly basis?
Advantages of the two-year lease include: 1. A shorter-term commitment, both financially and from a technology standpoint. When it comes to computers a short-term lease allows for greater flexibility if improved technology comes along. 2. From an accounting standpoint an operating lease is simpler and avoids the recording of debt that can negatively affect a company's reported financial position.
* ($35,523 - $1,000 salvage value)
60 months = $575 rounded
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8-5
Accelerated Depreciation Methods

Sum-of-the-years'-digits method Declining-balance method
(They're referred to as accelerated methods because they both expedite the depreciation process allocating higher amounts to expense in the early years and smaller amounts in the later years of an asset's useful life.)
Sum-of-the-Years'-Digits Method
Example: Jones Printing Company purchased and installed a new printing
press on 1/1/X3 at a total capitalized cost of $15,000. The press has a 5-year estimated useful life with a projected salvage value of $3,000.
Depreciable cost = $12,000 ($15,000 - $3,000) Straight-line method: $12,000 Sum-of-the-years-digits method:
Annual Depreciable Period Cost Depreciation Fraction Depreciation Expense Book Value of Asset
5 years = $2,400/yr
1 2 3 4 5
$12,000 $12,000 $12,000 $12,000 $12,000
x x x x x
5/15* 4/15 3/15 2/15 1/15
= = = = =
$4,000 $3,200 $2,400 $1,600 $ 800
$11,000 $ 7,800 $ 5,400 $ 3,800 $ 3,000
* Sum of the year's digits given the asset's estimated 5-year useful life: (1 + 2 + 3 + 4 + 5 = 15) or n(n + 1)/2 = 5(5 +1)/2 = 15
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Let's assume this equipment was purchased on 4/1/X3 rather than 1/1/X3.
Years Partial Year Calculations Total
Declining-Balance Method
Instead of a declining fraction applied to an asset's depreciable cost, this method applies a fixed fraction or rate of depreciation to an asset's declining book value to get its accelerated effect. The fixed rate of depreciation used can vary depending upon the desired acceleration relative to each asset's straight-line rate of depreciation. Straight-line rate of depreciation: The annual percentage of an asset's depreciable cost that's allocated evenly to expense each year under the straight-line method of depreciation. This rate depends on each individual asset's estimated useful life. For example, an asset with a: 5-year life = 1/5th or 20% straight-line rate of depreciation 10-year life = 1/10th or 10% straight-line rate of depreciation 15-year life = 1/15th or 6.67% straight-line rate of depreciation Under the declining-balance method, the highest rate of depreciation used is 200% or double the straight-line rate of depreciation. That means that for an asset with a useful life of 5 years, the depreciation rate will be 40%, which is 200% or double the 20% straight-line rate.
'X3 'X4 'X5 'X6 'X7 'X8
9/12 3/12 9/12 3/12 9/12 3/12 9/12 3/12 9/12 3/12
x x x x x x x x x x
$4,000 $4,000 $3,200 $3,200 $2,400 $2,400 $1,600 $1,600 $ 800 $ 800
= = = = = = = = = =
$3,000 $1,000 $2,400 $ 800 $1,800 $ 600 $1,200 $ 400 $ 600 $ 200 Total
$ 3,000 $ 3,400 $ 2,600 $ 1,800 $ 1,000 $ 200 $12,000
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Double (or 200%) - declining - balance method:

Annual Period Beginning Book Value Annual Rate of Depreciation Depreciation Expense Ending Book Value
150% - declining - balance method:

1 2 3 4 5
$15,000 $ 9,000 $ 5,400 $ 3,240 $ 3,000
x x x x x
40%* 40% 40%
= = = = =
$6,000 $3,600 $2,160 $ 240
$ 9,000 $ 5,400 $ 3,240 $ 3,000 $ 3,000
1 2 3 4 5
$15,000 $10,500 $ 7,350 $ 5,145 $ 3,601
x x x x x
30%* 30% 30% 30%
= = = = =
$4,500 $3,150 $2,205 $1,544 $ 601
$10,500 $ 7,350 $ 5,145 $ 3,601 $ 3,000
* 150% of the 20% straight-line rate of depreciation given the asset's 5-year estimated useful life.
* Double the straight-line rate of depreciation given the asset's 5-year estimated useful life.
Using 150%-declining-balance numbers and assuming an asset purchase on 4/1/X3 rather than 1/1/X3.
'X3 'X4 'X5 'X6 'X7 'X8
9/12 3/12 9/12 3/12 9/12 3/12 9/12 3/12 9/12 3/12
x x x x x x x x x x
$4,500 $4,500 $3,150 $3,150 $2,205 $2,205 $1,544 $1,544 $ 601 $ 601
= = = = = = = = = =
$3,375 $1,125 $2,363 $ 787 $1,654 $ 551 $1,158 $ 386 $ 451 $ 150
$ 3,375 $ 3,488 $ 2,441 $ 1,709 $ 837 $ 150
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8-6
Which of all these methods, including the straight-line and units of production methods, would be best for a company's financial reporting?
Under GAAP all of these methods are acceptable. In fact, different methods can be used for different assets of the same company and the only requirement is that the method selected be consistently applied over the asset's depreciable life. Most publicly held companies use the straight-line method for all of their depreciation of property, plant and equipment. Its easy to use and even more importantly it has a leveling effect on a company's net income. Accelerated methods provide the best results from an income tax perspective. Under current income tax laws in the United States, companies are allowed to use different depreciation methods for tax and financial reporting purposes. In fact, current tax laws actually require the use of specified accelerated methods, with shorter designated lives and zero salvage values for assets falling into certain categories.
A few final observations.

The amount of depreciation expense reported on a company's income statement is a highly subjective number. It can be easily manipulated. Most analysts today simply ignore depreciation expense in their investment analysis.
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Problem 8-5
Accelerated Depreciation Methods On 10/1/X7, Hansen, Inc. purchased equipment having a total capitalized cost of $25,000. Assuming the equipment has a 7-year estimated useful life with an anticipated salvage value of $5,000,
A. Determine the equipment's book value at 12/31/X8 under (1) the sum-of-the-years'-digits, (2) the double-declining-balance, and (3) the 175%-declining-balance methods of depreciation. (Round all calculations to the nearest dollar.) B. What is the equipment's book value at the end of its 7-year useful life under each of the methods used above? Question: Is there an ethical dilemma in a company's maintenance of a separate set of books (accounting records) for depreciation taken as a deduction for income tax purposes?
Accelerated Depreciation Methods

A. Sum-of-the-Years'-Digits Method:
Annual Depreciable Period Cost Depreciation Fraction Depreciation Expense
1 2
$20,000 $20,000
x x
7/28* 6/28
= =
$ 5,000 $ 4,286
* Sum of the year's digits given the asset's estimated 7-year useful life: 7 + 6 + 5 + 4 + 3 + 2 + 1 = 28, or n(n + 1)/2 = 7(7 + 1)/2 = 28
'X7 'X8
3/12 9/12 3/12
x x x
$5,000 $5,000 $4,286
= = =
$1,250 $3,750 $1,072
$ 1,250 $ 4,822 $ 6,072
Accumulated depreciation
Book value at 12/31/X8: $25,000 - $6,072 = $18,928
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Double-Declining-Balance Method:
175%-Declining-Balance Method:
1 2
$25,000 $17,850
x x
28.6%* 28.6%
= =
$7,150 $5,105
$ 17,850
1 2
$25,000 $18,750
x x
25%* 25%
= =
$6,250 $4,688
$ 18,750
* Double the 1/7th or 14.3 % straight-line rate of depreciation given the asset's 7-year estimated useful life.
* 175% of the 1/7th or 14.3 % straight-line rate of depreciation given the asset's 7-year estimated useful life.
'X7 'X8
3/12 9/12 3/12
x x x
$7,150 $7,150 $5,105
= = =
$1,788 $5,362 $1,276
$ 1,788 $ 6,639 $ 8,427
'X7 'X8
3/12 9/12 3/12
x x x
$6,250 $6,250 $4,688
= = =
$1,563 $4,687 $1,172
$ 1,563 $ 5,859 $ 7,422
Book value at 12/31/X8: $25,000 - $8,427 = $16,573
Book value at 12/31/X8: $25,000 - $7,422 = $17,578
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8-7
Problem 8-6
Change in Depreciation Estimates

B. What is the equipment's book value at the end of its 7-year useful life under each of the methods used above? Answer: Under each of the methods the book value at the end of the 7-year useful life would be equal to the salvage value of $5,000. (Any discrepancies due to rounding would be adjusted for in the last year of recorded depreciation) Question: Is there an ethical dilemma in a company's maintenance of a separate set of books (accounting records) for depreciation taken as a deduction for income tax purposes? Answer: Current tax law in the U.S. allows different depreciation methods to be used for financial statement reporting and income tax purposes. As a result it is ethical and common for companies to keep two sets of records for depreciation of property, plant and equipment. On 1/1/X1, Scott Company purchased equipment at a cost of $50,000 and calculated depreciation for 20X1 and 20X2 using the doubledeclining-balance method based on a 5-year estimated useful life and $10,000 salvage value. Beginning in 20X3 the company revised its estimates for the equipment to a 12-year useful life (10 years remaining from 1/1/X3) and $2,000 salvage value. Given these changing estimates, calculate the equipment's 20X3 depreciation expense.
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Answer: $3,600
Accounting for Changing Values of Long-Term Assets

$30,000 $18,000
20X1 20X2
$50,000 $30,000
x x
40%* 40%
= =
$20,000 $12,000
* Double the 1/5th or 20 % straight-line rate of depreciation given the asset's 5-year estimated useful life.
The recording of any increase or appreciation in the value of long-term assets is deferred until the property is sold and the gain is realized. Any loss associated with impaired assets is to be recorded immediately.
(International standards aren't nearly as conservative in this area. Although they do require write-downs on impairment, they also allow for the recording of increased values when a gain can be established with reasonable assurance.)
Assuming a 1/1/X3 change in estimate that provides for a remaining 10-year useful life, the rate of depreciation for those 10 years is 20% (double the 1/10th or 10% straight-line rate of depreciation given a the 10-year remaining useful life).
20X3
$18,000
20%
$3,600
$14,400
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Impairment
Under U.S. GAAP, an asset is impaired when the sum of its expected future cash flows no longer covers the asset's current book value. Accounting for impairment of a long-term asset is a two-step process:
1. Impairment must be established by comparing an asset's current book value with the sum of the expected net future cash flows without consideration for the time value of money. 2. Then the asset is written-down to its fair market value and the loss is recorded. (The fair market value of an asset is the price the asset would bring if sold in the current market place or, if that's not determinable, it's the present value of the expected net future cash flows of the asset.)
Example: Assume a recently purchased hotel will not be nearly as profitable

as originally thought due to the cancellation of plans for the development of a nearby amusement park.
Given the hotel's capitalized cost of $10,000,000, accumulated depreciation to date totaling $200,000, current fair market value of $7,500,000 and the sum of projected net future cash flows of $8,000,000 anticipated over a 10-year holding period, prepare the journal entry that's necessary to record the hotel's impairment.
1. Establish whether the standard for recording impairment has been met.
Book Value
vs.
Sum of Expected Net Future Cash Flows
$9,800,000
($10,000,000 - $200,000)
$8,000,000
Impairment!
2. Record the write-down of the asset to its fair value. ($7,500,000)
Book value Less: Current value Loss $9,800,000 (7,500,000) $2,300,000
Once a loss due to impairment has been recorded, no subsequent increase in value or recovery of that loss is recorded until the asset's ultimate sale.
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8-8
Journal entry to record this write-down:

Loss on Impairment Accumulated Depreciation Hotel 2,300,000 200,000
Problem 8-7
Accounting for Asset Impairment

2,500,000
Zircon Industries has decided to permanently cut back on the production of one of its products. As a result, the value of certain machinery and equipment used exclusively in the manufacture of that product has been greatly diminished. Given the following information for this machinery and equipment:
Capitalized cost Sum of the expected net future cash flows Accumulated depreciation Present value of the expected net future cash flows $150,000 $ 40,000 $ 90,000 $ 25,000
Hotel
10,000,000 2,500,000 7,500,000
200,000 200,000 0
A. Prepare the journal entry required to record asset impairment. B. Prepare the entry if the sum of the expected net future cash flows was $70,000 with a $40,000 present value.
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Accounting for Asset Impairment

A.
Loss on Impairment Accumulated Depreciation Machinery and Equipment 35,000 90,000
125,000
B. No entry would be made in this case. There is no impairment if the sum of the expected net future cash flows ($70,000) is in excess of the book value of the asset ($60,000). That's true even if the fair value of the asset or the present value of the expected net future cash flows is less than the asset's book value. This requirement imposes a higher standard of assurance that an impairment has taken place before its actually recorded.
Long-Term Intangible Assets and Natural Resources
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Problem 8-8
Problem 8-8
Accounting for Intangibles and Natural Resources

A. Identify some of the more common intangible assets that might be classified with a company's long-term assets. B. Briefly describe the accounting for:
(1) Research and development, advertising and other costs incurred in the development or improvement of an intangible asset. (2) Costs incurred in the purchase of an intangible asset from an unrelated third-party. (3) The allocation of an intangible asset's capitalized cost to expense over time. (4) Impairment of an intangible asset. (5) Gains or losses on the sale of an intangible asset.
D. Define "goodwill." When is it recorded as an asset? Record the $1,000,000 cash purchase of a business with assets having a combined fair market value of $500,000 (book value on the seller's books of $350,000) and liabilities to be assumed by the buyer in the amount of $50,000. How should the recorded asset "Goodwill" be subsequently accounted for? E. Are capitalized costs incurred in the acquisition and improvement of natural resources ever recorded as an expense and if so, how?
C. Should $20,000 in legal fees paid in actually applying for a patent and $100,000 in legal fees paid in the prosecution of a patent infringement case be capitalized or expensed when incurred?
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8-9
Accounting for Intangibles and Natural Resources

A. Identify some of the more common intangible assets that might be classified with a company's long-term assets. Answer: Copyrights, Trademarks, Patents, Franchise Rights, License Rights, Goodwill B. Briefly describe the accounting for:
(1) Research and development, advertising and other costs incurred in the development or improvement of an intangible asset. Answer: All costs incurred in the development or improvement of intangible assets, including R&D (research and development) and advertising costs are expensed when incurred. This accounting reflects the fact that it's impossible to know for sure whether such costs will ultimately benefit a company's future operating performance. As a result, the capitalization of such costs as assets is inappropriate. (2) Costs incurred in the purchase of an intangible asset from an unrelated third-party. Answer: All costs incurred in the purchase of an intangible asset are capitalized, or, in other words, they're accounted for as an asset.
(3) The allocation of an intangible asset's capitalized cost to expense over time. Answer: Except in the case of goodwill, the capitalized costs of intangible assets are allocated or "amortized" to expense on a straight-line basis over the lesser of the legal or estimated useful life of the asset. Goodwill is never amortized. The adjusting entry to record the periodic amortization of an intangible asset includes:
Amortization Expense Accumulated Amortization* XXX XXX
* The intangible asset account is often credited directly. (4) Impairment of an intangible asset. Answer: An intangible asset, like other long-term assets, becomes impaired when the sum of its expected net future cash flows falls below its book value. When that happens a loss is recorded as the asset is written-down to its fair value or the present value of its expected net future cash flows. Such losses are typically reflected with "other revenues and expenses" on a company's income statement. Any gains due to increasing asset values are deferred until the asset is actually sold.
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(5) Gains or losses on the sale of an intangible asset. Answer: Upon sale of an intangible asset, a gain or loss is recorded equal to the difference between the sales price and the asset's book value. Any such gain or loss is usually reported with a company's "other revenues and expenses" on its income statement.
D. Define "goodwill." When is it recorded as an asset? Record the $1,000,000 cash purchase of a business with assets having a combined fair market value of $500,000 (book value on the seller's books of $350,000) and liabilities to be assumed by the buyer in the amount of $50,000. How should the recorded asset "Goodwill" be subsequently accounted for?
Answer: From an accounting standpoint, goodwill refers to the excess of a company's overall fair market value above the fair market value of its total assets less liabilities. This excess value may be attributable to favorable customer relations or other factors that allow the company to generate above-average profits on its assets. Under GAAP, the only time this excess value is recorded as an asset itself, is when its purchased, or, in other words, when one company buys another and pays a price in excess of the fair market value of the assets purchased less any liabilities assumed. Assets* Goodwill Liabilities* Cash 500,000 550,000
C. Should $20,000 in legal fees paid in actually applying for a patent and $100,000 in legal fees paid in the prosecution of a patent infringement case be capitalized or expensed when incurred? Answer: If the patent application is approved, all legal costs and fees incurred in the process are capitalized as an intangible asset ("patent"). This is not a cost of patent development, it's a cost incurred to finalize a legal right arising from completed development. Legal costs incurred in a successful prosecution affirming patent rights are also capitalized; however, in the event of an unsuccessful prosecution, any associated legal costs should be expensed and the value of the patent may become impaired requiring a write-down of any previously capitalized costs.
50,000 1,000,000
* In actual practice, each asset purchased would be separately identified and recorded at its relative fair market value and, each liability would be separately identified and recorded. Important Note: Up until 1/1/02, any goodwill recorded in the purchase of a business was subject to amortization over a period not to exceed 40 years. Now, no amortization is recorded and the FASB requires an annual re-evaluation of the "fair market value" of the business purchased with a loss recorded in the event the value of goodwill has decreased or become impaired. Subsequent gains in the value of goodwill are never recorded.
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E. Are capitalized costs incurred in the acquisition and improvement of natural resources ever recorded as an expense and if so, how? Answer: The capitalized costs of natural resources are accounted for as "depletion expense" over the asset's productive life using the units of production method. The entry to record this depletion is:
Depletion Expense Accumulated Depletion* XXX XXX
* The natural resource asset account is often credited directly.
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8-10
Lesson 9
Bond Basics
Bonds are, in essence, notes payable issued by companies borrowing money from the general public rather than from some bank or other financial institution. Most bonds are issued by publicly-held companies and typically involve large amounts of money borrowed on a long-term basis.
Lesson 9
Bond Financing
The actual issuance or sale of bonds to investors is usually done through investment banking companies and is facilitated by dividing up the total face or par value of the bonds, or, in other words, the total principal amount payable under the bonds, into smaller bond certificates with denominations that are typically set at $1,000 each. $100,000,000 = 100,000 X $1,000 bonds Once issued, investors will sometimes sell their bonds to other investors in a secondary market. Registered bonds require any change in ownership to be registered with the issuer before payments are made to the new investor. Coupon or "bearer" bonds require no such registration and payments are simply made to those who have physical possession of the bonds. The detailed terms and conditions of a bond are documented in a written agreement referred to as a bond indenture that's held and enforced by a designated trustee acting on behalf of all bondholders.
Term bonds refer to bonds that provide for payment of the entire principal or face value of the bonds at a specified date. Serial bonds provide for principal payments in installments over time. Secured bonds pledge specific assets as collateral in the event of an issuer's default. Debentures are unsecured bonds. Senior or subordinated bonds specify certain priorities of claims that bondholders may have against the assets of the issuer relative to the claims of other creditors. Callable bonds allow an issuer to make payoffs at agreed amounts prior to maturity. Convertible bonds allow bondholders to convert their bonds to stock after a specified period of time. Junk bonds are bonds issued by companies with low credit ratings. (High-yield bonds) The interest rate payable on a bond or its stated rate is affected by more than just a company's credit rating. Generally speaking, shorter-term, convertible, secured bonds, issued by triple-A rated companies will pay lower rates of interest, than longer term unsecured bonds.
Problem 9-1
Bonds Issued at Face Value On 11/1/X3, Stagg Corporation issued $10,000,000 of 5-year term bonds at face value. Assuming a 7% stated interest rate, payable semiannually, prepare journal entries to record the following:
a. Issuance of bonds on 11/1/X3. b. 20X3 interest expense given a calendar year-end. c. Payment of interest on 5/1/X4. d. Payment of interest on 11/1/X4. e. Final payment of interest and principal on 11/1/X8
Bonds Issued at Face Value

a. Issuance of bonds on 11/1/X3.
Cash Bonds Payable 10,000,000 10,000,000
d. Payment of interest on 11/1/X4.

Interest Expense Cash 350,000 350,000
b. 20X3 interest expense given a calendar year-end.

Interest Expense* Interest Payable 116,667 116,667
e. Final payment of interest and principal on 11/1/X8

Interest Expense Bonds Payable Cash 350,000 10,000,000 10,350,000
* $10,000,000 x 7% x 2/12 months = $116,667
c. Payment of interest on 5/1/X4.

Interest Payable 116,667 Interest Expense 233,333 Cash* * $10,000,000 x 7% x 6/12 months = $350,000 350,000
9-1
Bonds are often issued at a premium or a discount.

This happens when a bond's stated rate of interest differs from the market rate demanded by investors at the time the bonds are issued. Example: On 12/15/X4, Jordan, Inc. finalizes its bond indenture and prints certificates for a planned 12/31 issuance of $1,000,000 of 3-year term bonds bearing interest at a stated rate of 6% payable annually. This 6% rate is based on market rates at the time the indenture is finalized On the date issuance 16 days later, market interest rates have increased and investors are now demanding a 7% return on any investment in the bonds. Jordan now has $1,000,000 of bonds with no interested investors. In most cases, companies solve this problem by offering the bonds at a discount, or, in this case, Jordan would simply offer the bonds at a price below the $1,000,000 face value to provide investors with an effective 7% return on their investment.
Today - $1,000,000
(investors' return = 6%)
Year 1 $60,000
Year 2 $60,000
Year 3 $60,000 $1,000,000
Today - $980,000
(investors' return = higher than 6%)
Year 1 $60,000
Year 2 $60,000
Year 3 $60,000 $1,000,000
Today
PV of Annuity @ 7% = $157,459 PV of SCF @ 7% = $816,298 $973,757
Year 1 $60,000
Year 2 $60,000
Year 3 $60,000 $1,000,000
Current Market Value or Price of the Bonds

(97.4 rounded or 97.4% of the $1 million face value of the bonds)
The issuance of the bonds at a discount, or an amount less than the face value of the bonds, is a way to increase an investors' return over and above the stated 6% rate. How much of a discount is required to produce a 7% rate of return? How much would someone have to invest today earning an annual rate of 7% to generate the cash flows promised under the 6% bond? What is the present value of those future cash flows at an interest rate of 7% compounding annually?
(97.4 rounded or 97.4% of the $1 million face value of the bonds)

The issuance of the bonds at a discount, or an amount less than the face value of the bonds, is a way to increase an investors' return over and above the stated 6% rate. How much of a discount is required to produce a 7% rate of return? How much would someone have to invest today earning an annual rate of 7% to generate the cash flows promised under the 6% bond? What is the present value of those future cash flows at an interest rate of 7% compounding annually?
10
Jordan's accounting for the issuance of these bonds if we assume the bonds are issued at $973,757 on 12/31/X4:
Cash Discount on Bonds Bonds Payable 973,757 26,243 1,000,000
Combined entry at 12/31/X5:

Interest Expense Discount on Bonds Cash 68,163 8,163 60,000
Amortization of discount at the end of each period:

Interest Expense Discount on Bonds 8,748 8,748
$68,748 $973,757 = .071

(Cost of borrowing was about 7%.) True interest cost at an effective 7% rate: $973,757 x 7% x 1 year = $68,163
Straight-line approach: $26,243 3 years = $8,748/yr. (This straight-line method is acceptable only if the $8,748 amount doesn't differ significantly with results that would otherwise be obtained under a more accurate effective-interest method, which takes into account the time value of money.)
Payment of interest on 12/31/X5:

Interest Expense Cash 60,000 60,000
The process of effective interest amortization begins with the calculation and recording of total interest expense for the period based on the effective interest rate times the actual amount borrowed, and then the difference between that amount and the amount of interest actually paid is the amount of discount amortization recorded for the period.
Stated interest: 6% x $1,000,000 x 1 year = $60,000
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9-2
Effective Interest Method of Bond Discount Amortization

Annual Bonds Period Payable Balance of Bond Discount Effective Net Interest Amount Rate Total Interest Expense Interest Paid Discount Amort.
Effective Interest Method of Bond Discount Amortization

Annual Bonds Period Payable Balance of Bond Discount Net Amount Effective Interest Rate Total Interest Expense Interest Paid Discount Amort.
1 2 3
1,000,000 - 26,243 = 973,757 x 7% = 68,163 - 60,000 = 8,163 1,000,000 - 18,080 = 981,920 x 7% = 68,734 - 60,000 = 8,734 1,000,000 - 9,346 = 990,654 x 7% = 69,346 - 60,000 = 9,346
Jordan, Inc. Balance Sheet 1/1/X6
Long-term liabilities: Bonds payable, less $18,080 discount balance Bond carrying value at 1/1/X6: Amount originally borrowed Add: First year's discount amortization $981,920
1 2 3
1,000,000 - 26,243 = 973,757 x 7% = 68,163 - 60,000 = 8,163 1,000,000 - 18,080 = 981,920 x 7% = 68,734 - 60,000 = 8,734 1,000,000 - 9,346 = 990,654 x 7% = 69,346 - 60,000 = 9,346
Entry at 12/31/X6:
Interest Expense Discount on Bonds Cash 68,734 8,734 60,000
$973,757 8,163 $981,920 GAAP: Long-term liabilities should always be reported at the present value of the future cash flows payable. PV of the $60,000 annuity for two years $108,481 PV of the $1,000,000 single cash flow at end of 2nd year 873,439 $981,920
Entry at 12/31/X7:
Interest Expense Discount on Bonds Cash Bonds Payable Cash 69,346 9,346 60,000 1,000,000 1,000,000
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Problem 9-2
Accounting for Bonds Issued at a Discount

On 10/1/X4, Owens Corporation issued $10,000,000 of bonds at a price of 98. Assuming the bonds have a four-year term and bear interest at a stated rate of 6% payable semi-annually, prepare journal entries to record the: a. Issuance of bonds on 10/1/X4. b. 12/31/X4 adjustment for 20X4 interest expense. (Use the straight-line method of bond discount amortization.) c. Payment of interest on 4/1/X5 d. Payment of interest on 10/1/X5. e. 12/31/X5 adjustment for 20X5 interest expense. Questions: 1. What is the carrying value of the bonds payable on Owens' 12/31/X4 and 12/31/X5 balance sheets and why does it increase over time? 2. Is the effective interest rate on these bonds higher or lower than the stated 6% rate? What was Owens' total interest expense in 20X5 and how does it compare with the stated interest actually paid?

Cash Discount on Bonds Bonds Payable 9,800,000 200,000 10,000,000
b. 12/31/X4 adjustment for 20X4 interest expense. (Use the straight-line method of bond discount amortization.)
Interest Expense Discount on Bonds** Interest Payable* 162,500 12,500 150,000
* $10,000,000 x 6% x 3/12 months = $150,000 ** $200,000 48 months = $4,167/mo. x 3 = $12,500

Interest Payable Interest Expense Discount on Bonds** Cash* 150,000 162,500 12,500 300,000
* $10,000,000 x 6% x 6/12 months = $300,000 ** $4,167/mo. x 3 = $12,500
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16

Interest Expense Discount on Bonds** Cash* 325,000 25,000 300,000
Questions: 1. What is the carrying value of the bonds payable on Owens' 12/31/X4 and 12/31/X5 balance sheets and why does it increase over time?
12/31/X4 12/31/X5
* $10,000,000 x 6% x 6/12 months = $300,000 ** $4,167/mo. x 6 = $25,000
e. 12/31/X5 adjustment for 20X5 interest expense.

Bonds payable Less: Discount on bonds
$10,000,000 (187,500) $ 9,812,500
$10,000,000 (137,500) $ 9,862,500
Discount on Bonds
10/1/X4 12/31/X4 200,000 12,500 187,500 12,500 25,000 12,500 12/31/X5 137,500 4/1/X5 10/1/X5 12/31/X5 'X4 Adjustment
* $10,000,000 x 6% x 3/12 months = $150,000 ** $4,167/mo. x 3 = $12,500
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9-3
Questions: 2. Is the effective interest rate on these bonds higher or lower than the stated 6% rate? Since the carrying value is equal to the face value of the bonds less the balance of any bond discount, the amortization and reduction of that discount over time will automatically increase the bonds' carrying value. In fact, when the bonds finally mature and the discount is fully amortized, the carrying value will equal the full face value of the bonds or the amount due at maturity. This carrying value can also be determined by adding the amount of any unpaid interest expense to the amount originally borrowed under the bonds. In other words, the bonds' carrying value is also equal to the amount of discount amortization to date plus the amount of cash received upon original issuance and since the total amount of amortized discount increases over time the carrying value automatically increases as well.
HIGHER
What was Owens' total interest expense in 20X5 and how does it compare with the stated interest actually paid? 20X5: Total interest expense recorded at 4/1/X5 $162,500 at 10/1/X5 325,000 at 12/31/X5 162,500 $650,000 Total stated interest paid $600,000
The actual (effective) interest cost is higher than the stated interest paid due to the $50,000 discount amortization.
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Problem 9-3

For the same Owens Corporation bonds noted in the preceding problem, Face value: $10,000,000 Term: 4 years Stated interest rate: 6% payable semi-annually Prepare journal entries for the following assuming issuance at a price to yield an effective interest rate of 7% compounding semi-annually: a. Issuance of bonds on 10/1/X4. b. The 12/31/X4 adjustment for 20X4 interest expense. (Use the effective interest method of bond discount amortization) c. Payment of interest on 4/1/X5. d. Payment of interest on 10/1/X5. e. The 12/31/X5 adjustment for 20X5 interest expense. Questions: Why are bonds sometimes issued at a discount rather than their face or par value?

Cash Discount on Bonds Bonds Payable 9,656,303* 343,697 10,000,000
* Pricing of bonds to yield 7% compounding semi-annually: PV of a $300,000 annuity at the end of every 6-months for 4 years $ 2,062,187 PV of a $10,000,000 single cash flow at the end of the 4th year $ 7,594,116 $ 9,656,303
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Calculations: PV of a $300,000 annuity at the end of every 6-months for 4 years at a rate of 7% compounding semi-annually. HP10bii:
C ALL
Calculations: PV of a $300,000 annuity at the end of every 6-months for 4 years at a rate of 7% compounding semi-annually. TI BAII Plus:
2nd
C/CE
2nd
CLR TVM N PMT FV
8 -300,000 0 7 2
N PMT FV
I/YR
P/YR PV
8 -300,000 0 7 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
2,062,187
2,062,187
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24
9-4
Calculations: PV of a $10,000,000 single cash flow at the end of the 4th year at 7% compounding semi-annually. HP10bii:
C ALL
Calculations: PV of a $10,000,000 single cash flow at the end of the 4th year at 7% compounding semi-annually. TI BAII Plus:
2nd
C/CE
2nd
CLR TVM N PMT FV
8 0 -10,000,000 7 2
N PMT FV
I/YR
P/YR PV
8 0 -10,000,000 7 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
7,594,116
7,594,116
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b. The 12/31/X4 adjustment for 20X4 interest expense. (Use the effective interest method of bond discount amortization)

Interest Expense Discount on Bonds** Cash* 339,300 39,300 300,000
* $10,000,000 x 6% x 3/12 months = $150,000 ** Effective Interest Amortization:

6-Month Period Bonds Payable Balance of Bond Discount Carrying Value Effect. Rate Total Interest Expense Stated Interest Discount Amort. 6-Month Period

Bonds Payable Balance of Bond Discount Net Amount Effect. Rate Total Interest Expense Stated Interest Discount Amort.
1,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971 Discount amortization for the three months of October - December of 'X4: $37,971 x 3/6 months. = $18,986
1 2
10,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971 10,000,000 - 305,726 = 9,694,274 x 3.5% = 339,300 - 300,000 = 39,300

Interest Payable Interest Expense Discount on Bonds** Cash* 150,000 168,985 18,985 300,000
* $10,000,000 x 6% x 6/12 months = $300,000 ** $37,971 x 3/6 mos. = $18,985
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e. The 12/31/X5 adjustment for 20X5 interest expense.

Questions: Why are bonds sometimes issued at a discount rather than their face or par value? Answer: If market interest rates increase above a bond's stated rate prior to the bond's actual issuance, investors will not buy the bonds unless they're offered at a discount sufficient to yield the current market rate of interest. If market rates are equal to the stated interest, then the bonds will be issued at their face or par value.

6-Month Period Bonds Payable Balance of Bond Discount Net Amount Effect. Rate Total Interest Expense Stated Interest Discount Amort.
1 2 3
10,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971 10,000,000 - 305,726 = 9,694,274 x 3.5% = 339,300 - 300,000 = 39,300 10,000,000 - 266,426 = 9,733,574 x 3.5% = 340,675 - 300,000 = 40,675 Amortization for first 3 months of the 3rd semi-annual period: $40,675 x 3/6 months. = $20,338
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9-5
If market interest rates decrease prior to funding, the bonds will be issued at a premium. This means the price of the bonds, or in other words, the amount of cash received from investors upon issuance, will be greater than the face or maturity value of the bonds. Assume Jordan, Inc. finalizes its documentation for the issuance of 3-year term bonds with a total face value of $1,000,000, bearing interest at a stated rate of 6%, payable annually. If market interest rates decrease to 5% prior to actual issuance, Jordan will want to adjust the bonds' interest rate down before the bonds are issued. In actual practice, rather than change the stated interest rate of the bonds, issuance at a price above the face value of the bonds will create the same economic effect. PV of the bonds future cash flows at an interest rate of 5% compounding annually:
- Annuity of $60,000 or 6% stated interest payable at the end of each year for three years - $1,000,000 single cash flow at the end of three years
Present Value at 5%
Effective Interest Method of Bond Premium Amortization

Bonds Period Payable Balance of Bond Premium Carrying Value Effective Total Interest Interest Rate Expense Interest Paid Premium Amort.
1 2 3
1,000,000 + 27,233 = 1,027,233 x 5% = 51,362 - 60,000 = 8,638 1,000,000 + 18,595 = 1,018,595 x 5% = 50,930 - 60,000 = 9,070 1,000,000 + 9,525 = 1,009,525 x 5% = 50,475 - 60,000 = 9,525
Entry to record interest expense for the year ended 12/31/X5:

Interest Expense Premium on Bonds Cash
Jordan, Inc. Balance Sheet 1/1/X5
51,362 8,638
$163,395 863,838 $1,027,233
60,000
Accounting for the issuance of these bonds at a price of $1,027,233 on 1/1/X5:
Long-term liabilities: Bonds payable, including $18,595 premium balance
$1,018,595
Cash Premium on Bonds Bonds Payable
1,027,233 27,233 1,000,000
In essence, any premium balance is an unearned offset against future interest costs, which is substantially the same as unearned revenue.
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Problem 9-4
Effective Interest Method of Bond Premium Amortization

Bonds Period Payable Balance of Bond Premium Carrying Value Effective Total Interest Interest Rate Expense Interest Paid Premium Amort.
Determining a Bond's Price at Issuance

On May 1, 20X5, Harrison Corp. issued 2-year term bonds with a total face value of $10,000,000 bearing interest at 8%, compounding semiannually. The bond indenture provides for interest payments to be made on 11/1 and 5/1 of each year through maturity on May 1, 20X7. Calculate the issuing price of the bonds if they are priced to generate an effective interest rate to investors of: A. 7.5% compounding semiannually B. 8.0% compounding semiannually
1 2 3
1,000,000 + 27,233 = 1,027,233 x 5% = 51,362 - 60,000 = 8,638 1,000,000 + 18,595 = 1,018,595 x 5% = 50,930 - 60,000 = 9,070 1,000,000 + 9,525 = 1,009,525 x 5% = 50,475 - 60,000 = 9,525
Entry to record interest expense for the year ended 12/31/X6:

Interest Expense Premium on Bonds Cash 50,930 9,070
60,000
Entries at 12/31/X6:
Interest Expense Premium on Bonds Cash Bonds Payable Cash 50,475 9,525 1,000,000 1,000,000
C. 8.5% compounding semiannually

60,000
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A. Price of bonds to yield 7.5% effective interest rate compounding semiannually = $10,091,285 The sum of: PV of a $400,000 annuity at the end of every 6-months for 2 years at a rate of 7.5% compounding semi-annually. HP10bii:
C ALL

A. Price of bonds to yield 7.5% effective interest rate compounding semiannually = $10,091,285 The sum of: PV of a $400,000 annuity at the end of every 6-months for 2 years at a rate of 7.5% compounding semi-annually. TI BAII Plus:
C/CE
2nd
2nd
CLR TVM N PMT FV
: Clear all Time-Value-of-Money values : Number of compounding periods : Annuity payment. : Future value. : Interest rate. : Reset compounding periods per year. : Present value.
4 -400,000 0 7.5 2
Press
N PMT FV
I/YR
P/YR PV
4 -400,000 0 7.5 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
1,460,554
1,460,554
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9-6
PV of a $10,000,000 single cash flow at the end of 2 years at 7.5%, compounding semiannually = $8,630,731 (rounded) HP10bii:
C ALL
PV of a $10,000,000 single cash flow at the end of 2 years at 7.5%, compounding semiannually = $8,630,731 (rounded) TI BAII Plus:
C/CE
2nd
2nd
CLR TVM N PMT FV
4 0 -10,000,000 7.5 2
Press
N PMT FV
I/YR
P/YR PV
4 0 -10,000,000 7.5 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
8,630,731
8,630,731
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B. Price of bonds to yield 8.0 % effective interest rate compounding semiannually = $10,000,000. The sum of: PV of an annuity of $400,000 at the end of 4 6-month periods at a rate of 8.0% compounding semiannually = $1,451,958 (rounded) HP10bii:
C ALL

B. Price of bonds to yield 8.0 % effective interest rate compounding semiannually = $10,000,000. The sum of: PV of an annuity of $400,000 at the end of 4 6-month periods at a rate of 8.0% compounding semiannually = $1,451,958 (rounded) TI BAII Plus:
C/CE
2nd
2nd
CLR TVM N PMT FV
4 -400,000 0 8 2
Press
N PMT FV
I/YR
P/YR PV
4 -400,000 0 8 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
1,451,958
1,451,958
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C ALL
C/CE
2nd
2nd
CLR TVM N PMT FV
4 0 -10,000,000 8 2
Press
N PMT FV
I/YR
P/YR PV
4 0 -10,000,000 8 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
8,548,042
8,548,042
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9-7

C. Price of bonds to yield 8.5% effective interest rate compounding semiannually = $9,909,785 The sum of: PV of an annuity of $400,000 at the end of 4 6-month periods at a rate of 8.5% compounding semiannually = $1,443,444 (rounded) HP10bii:
C ALL

C. Price of bonds to yield 8.5% effective interest rate compounding semiannually = $9,909,785 The sum of: PV of an annuity of $400,000 at the end of 4 6-month periods at a rate of 8.5% compounding semiannually = $1,443,444 (rounded) TI BAII Plus:
C/CE
2nd
2nd
CLR TVM N PMT FV
4 -400,000 0 8.5 2
Press
N PMT FV
I/YR
P/YR PV
4 -400,000 0 8.5 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
1,443,444
1,443,444
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C ALL
C/CE
2nd
2nd
CLR TVM N PMT FV
4 0 -10,000,000 8.5 2
Press
N PMT FV
I/YR
P/YR PV
4 0 -10,000,000 8.5 P/Y 2 ENTER

CPT
I/Y
C/CE
PV
8,466,341
8,466,341
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Problem 9-5
Accounting for Bonds Issued at a Premium

For the Harrison Corp. bonds described in the previous problem, "On May 1, 20X5, Harrison Corp. issued 2-year term bonds with a total face value of $10,000,000 bearing interest at 8%. The bond indenture provides for interest payments to be made on 11/1 and 5/1 of each year through maturity on May 1, 20X7." Assume the bonds are issued at a price of $10,091,285 to yield an effective interest rate of 7.5% compounding semi-annually and prepare the required journal entries for: a. Issuance of the bonds on 5/1/X5. b. Payment of interest on 11/1/X5. (Use the effective interest method of bond premium amortization) c. The 12/31/X5 adjustment for 20X5 interest expense. Determine the carrying value of bonds payable on Harrison's 12/31/X5 balance sheet. Prepare the journal entries to be made with Harrison's final payment of interest and the payment of principal on 5/1/X7.
Accounting for Bonds Issued at a Premium

Cash Premium on Bonds Bonds Payable 10,091,285 91,285 10,000,000
b. Payment of interest on 11/1/X5.

Interest Expense Premium on Bonds Cash* 378,423 21,577 400,000

6-Month Bonds Period Payable Balance of Bond Premium Carrying Value Effect. Rate Total Interest Expense Stated Interest Premium Amort.
10,000,000 - 91,285 = 10,091,285 x 3.75% = 378,423 - 400,000 = 21,577
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c. The 12/31/X5 adjustment for 20X5 interest expense.

Interest Expense Premium on Bonds** Interest Payable* 125,871 7,462 133,333
Determine the carrying value of bonds payable on Harrison's 12/31/X5 balance sheet.
12/31/X4

6-Month Bonds Period Payable Stated Interest x 3.75% = 378,423 - 400,000 = 10,000,000 - 91,285 = 10,091,285 10,000,000 - 69,708 = 10,069,708 x 3.75% = 377,614 - 400,000 = Balance of Bond Premium Carrying Value Effect. Rate Total Interest Expense Premium Amort.
Bonds payable Less: Premium on bonds
$10,000,000 62,246 $10,062,246
Premium on Bonds
91,285 11/1/X5 12/31/X5 21,577 7,462 62,246 12/31/X5 5/1/X5
1 2
21,577 22,386
Premium amortization for two months (Nov. - Dec.): $22,386 x 2/6 months. = $7,462
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Prepare the journal entries to be made with Harrison's final payment of interest and the payment of principal on 5/1/X7. Payment of interest:
Interest Payable* Interest Expense*** Premium on Bonds** Cash 133,333 250,603 16,064
The payoff and early retirement of bonds is generally prohibited, except in the case of callable bonds.
Successful issuance of callable bonds usually requires payment of a higher rate of interest and a call or redemption price that's greater than the face value of the bonds due at maturity. As a result, callable bonds are rarely issued unless a company truly believes future refinancing will be available at a lower rate of interest. Example: Jordan, Inc issues at face value, $10,000,000 of 8% interest bearing, 5-year term bonds, callable at a price of 103 or $10,300,000. Two years after issuance, interest rates fall from 8% to 5% and Jordan decides to refinance or payoff the old bonds by issuing $10,000,000 of new bonds at the current 5% rate. Journal entry to record the bond retirement:
Bonds Payable Loss on Bond Retirement Cash 10,000,000 300,000
400,000 * Reflects the payment of 2 months of stated interest payable for November and December of 20X6 that would have been previously recorded at 12/31/X6. ** Amortization schedule: Balance Total
6-Month Period Bonds Payable of Bond Premium Carrying Value Effect. Rate
x x x x
Interest Expense
Stated Interest
Premium Amort.
1 2 3 4
10,000,000 10,000,000 10,000,000 10,000,000
91,285 69,708 47,321 24,096
= = = =
10,091,285 10,069,708 10,047,321 10,024,096
3.75% 3.75% 3.75% 3.75%
= = = =
378,423 377,614 376,775 375,904
400,000 400,000 400,000 400,000
= = = =
21,577 22,386 23,225 24,096
Premium amortization for 4 months (Jan. - April):

Less: Premium amortization.
$24,096 x 4/6 months. = $16,064 (16,064) $250,603
*** Interest expense: 4 months of stated interest at 8% $266,667
Payment of principal:
Bonds Payable Cash
10,000,000
10,000,000
10,300,000
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Assume that Jordan's 8% bonds were originally issued on April 1, 20X4 at a $100,000 discount. Assuming interest is payable annually and the discount is amortized on a straight-line basis, what entries would be required upon early retirement of the bonds on 7/1/X6? Update the bond interest expense through the date of retirement:
Problem 9-6
Early Retirement of Bonds

On 12/31/X5, Cook Corporation purchased and retired $1,000,000 of its previously issued bonds for $970,000 cash, including $10,000 of interest payable at the time of retirement. Assuming Cook's premium on bonds account has a remaining balance of $20,000, prepare Cook's journal entry to record the purchase of the bonds. Questions: - Why would the current purchase price of the bonds be lower than their face value when the bonds were originally issued at a premium? - How does this early retirement of bonds improve Cook's financial position?
* $10,000,000 x 8% x 3/12 months = $200,000 ** $100,000 x 3/60 mos. = $5,000
Payoff of the bonds:

Interest Payable Bonds Payable Loss on Bond Retirement Discount on Bonds** Cash* 200,000 10,000,000 355,000 55,000 10,500,000
* $10,300,000 + $200,000 = $10,500,000 ** $100,000 - (100,000 x 27/60 mos.) = $55,000
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9-9
Early Retirement of Bonds

Entry to record the purchase of bonds:
Interest Payable * 10,000 Bonds Payable 1,000,000 Premium on Bonds 20,000 Gain on Bond Retirement 60,000 Cash 970,000 * Assumes the expense was previously recorded Questions: - Why would the current purchase price of the bonds be lower than their face value when the bonds were originally issued at a premium? Answer: Bond prices are a reflection of market values and a bonds' market value fluctuates over time with changes in the effective interest rates demanded by investors. Those effective rates are influenced by a number of things including the overall state of the economy and a company's changing prospects and perceived risk. In this case the declining market value of Cook's bonds over time means effective interest rates demanded by investors have increased since the bonds original issuance. In fact, the effective rate at the date of purchase has apparently increased above the bond's stated interest rate if the bonds are now worth less than their face value. That could be the result of higher interest rates in the overall economy or greater perceived risk in Cook Corporation.
Questions: - How does this early retirement of bonds improve Cook's financial position? Answer: Payoffs of debt lower a company's debt ratio or the amount of total debt to total assets. Generally speaking companies that have lower levels of debt relative to their total assets have greater financial flexibility in the future. In addition, lower debts can improve a company's profits if the interest costs saved through debt reduction are greater than the earnings that could have alternatively been achieved through investment of the surplus cash.
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9-10
Lesson 10
Problem 10-1
Review Questions Respond to the following:

A. What are the two ways owners provide capital to a business?
Lesson 10
Equity Financing
B. What is the most significant advantage of equity vs. debt financing? What is the most significant disadvantage? C. What is a corporation and what are the key advantages and disadvantages of the corporate form to that of a proprietorship or partnership? D. What is common stock and what's the significance of its par or stated value? How is the market value of stock determined? E. What is preferred stock and what's the significance of its par value?
Review Questions Respond to the following:

A. What are the two ways owners provide capital to a business?
1. By contributing resources to the business in exchange for ownership rights. In a corporation, ownership rights are evidenced through shares of stock and the amount contributed is referred to as contributed capital or capital stock. 2. By allowing assets created through the company's profitable operations to be retained in the business. This is referred to as retained earnings.
B. What is the most significant advantage of equity vs. debt financing?

The key advantage of equity financing is that it never has to be repaid. Debt financing requires repayment of borrowed assets at specified future dates regardless of the company's ability to pay. That's not the case with capital contributions and retained earnings. In fact, the only time a company is obligated to pay its owners is upon official declaration of dividends by a corporation's board of directors, or upon termination and liquidation of the business. In the event of business liquidation, all company assets are distributed to owners following the payoff of any creditor claims.
What is the most significant disadvantage?

From the perspective of a company's original founders, the major disadvantage of financing provided by outside investors is the sharing of ownership rights; most significantly, the right to share in profits and the right to vote in company affairs. If a business is successful, the sharing of profits may very well exceed the interest costs that otherwise would have been incurred if debt financing had been used. In other words, equity financing can ultimately be a more expensive source of capital.
C. What is a corporation and what are the key advantages and disadvantages of the corporate form to that of a proprietorship or partnership?
A corporation is a separate legal entity authorized and governed by the laws and requirements of the state in which it's incorporated. That means a corporation can buy, own and sell property in its own name and can enter into contracts on its own behalf. It may also sue and be sued. Because a corporation operates as a separate entity distinct from its owners, no owner has a right to act on behalf of the corporation unless he or she is duly appointed and authorized as it's legal agent. The most significant benefit of the corporate form is limited legal liability. That means the personal assets of its owners or stockholders are shielded from any claims against the business. In other words, the most a corporate stockholder can lose is the amount of their invested capital. Other personal assets, like a home, are not at risk. That's not the case, however, with a proprietorship or partnership. In fact, in a general partnership, all partners are personally liable for any claims against the business and the acts of any other partner if it appears that partner's operating within the scope of the business. (Continued...)
The corporate form also facilitates the transfer of ownership interests and allows a company to continue its operations in spite of any owner's withdrawal, death or incapacity. In a corporation, stockholders are free to sell their ownership rights or shares of stock without corporate approval. That's not the case in a partnership. Any transfer of partnership rights typically requires partner approval and if a partner withdraws, dies or is otherwise unable to function, the partnership automatically dissolves. Because of the benefits of limited legal liability and easy transfer of ownership, the corporate form is the clear choice for any business that must raise a significant amount of capital from a large number of investors. Most equity investors prefer dealing in corporate stocks to partnership interests. The downside of a corporation is the additional legal red tape required in its formation and other government regulation and restrictions. In addition, corporations may be subject to additional taxation given their separate legal status.
10-1
D. What is common stock and what's the significance of its par or stated value? How is the market value of stock determined?
Common stock is a certificate that represents general ownership in a corporation. All corporations issue common stock providing owners with four basic rights: the right to vote in certain corporate matters including the election of the board of directors; the right to share equally on a per share basis in any declared dividends; the pre-emptive first right of refusal to buy an equal proportion of any newly issued shares; and the right to share equally on a per share basis in any distributions in the event of business termination. The par value of common stock is usually a nominal amount established by a company's founders in accordance with the laws of the incorporating state. Some states allow the use of a stated value in lieu of par, but in either case the amount has nothing to do with the issuance price of the stock or its subsequent market or trading value. Its only purpose is the establishment of the company's legal capital, which is designed to protect the interests of creditors by limiting any return of previously contributed capital to shareholders. The fact is, however, that par or stated values are typically set so low, that no real creditor protection exists. In many (Continued...) cases, par values are set at one penny per share or less, and frankly, creditors have other better ways to protect their interests. By the way, the securities laws of many states now allow corporations to issue no par stock. The market value of common stock is simply the amount agreed upon by a willing buyer and seller of the stock. If a company tries to issue stock at a price no one is willing to pay, then clearly the stock has a lower market value. Because economic conditions and investor attitudes can change from one minute to the next, a stock's market value can likewise change at any time.
Problem 10-2
E. What is preferred stock and what's the significance of its par value?
In addition to common stock, companies may also issue preferred stock, which typically has no voting rights but provides preferential rights to limited amounts of dividends and distributions in the event of liquidation. In other words, in the event a company declares dividends or makes a final distribution of assets upon its termination and liquidation, the preferred shareholders get a specified amount before any distributions are made to common stockholders. In addition, it's not unusual for preferred stock to be issued with other rights including the right to convert preferred shares to common at a specified rate. If the market value of a company's common stock increases significantly, this option can create big gains for preferred shareholders. Although par values on common stock have no real significance, the par value of preferred stock is critical in that it serves as the basis for determining both the stock's dividend preference and rights to any liquidating distribution. Annual dividend preferences are typically calculated as a percentage of the stock's par value.
Issuance of Common and Preferred Stock Prepare journal entries to record the following for Parker Corp.:
10/1/X3: The company was formed with 100,000 shares of $.01 par value common stock and 10,000 shares of 10% $20 par value preferred stock authorized by the state for future issuance. 10/2/X3: The company issued 25,000 shares of its common stock for $10 a share. 10/30/X3: The company issued 100 shares of its preferred stock to a CPA for $3,000 worth of consulting services. 11/11/X3: The company issued 3,600 shares of common stock to Maverick Truck Sales for the purchase of a delivery truck. (The current fair market value of the common stock is $10/share.)
Prepare the stockholders' (owners') equity section of Parker's balance sheet after having made the above entries. Prepare the journal entries for the 10/2 and 11/11 transactions assuming the common stock authorized had: (A) a $1 stated value per share as opposed to a $.01 par value. (B) no par or stated value.
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Issuance of Common and Preferred Stock

10/1/X3: No entry made upon stock authorization. No assets have actually
been received.
Prepare the owners' equity section of Parker's balance sheet after having made the above entries. Stockholders' Equity: Capital contributionsPreferred stock, $20 par value, (100 shares issued and outstanding) $ 2,000 Common stock, $.01 par value (28,600 shares issued and outstanding) 286 Paid-in capital in excess of par, preferred stock 1,000 Paid-in capital in excess of par, common stock 285,714 289,000 Retained earnings xxx $ xxx,xxx
10/2/X3:
Cash Common Stock, $.01 Par Value Paid-In Capital in Excess of Par, Common Stock Consulting Expense Preferred Stock, $20 Par Value Paid-In Capital in Excess of Par, Preferred Stock
250,000 250 249,750 3,000 2,000 1,000
10/30/X3:
When stock is issued in exchange for goods or services rather than cash, the cost of those goods or services should be recorded at the current fair market value of the stock given up. However, if that fair market value cannot be determined, then the market value of the goods or services received should be used.
11/11/X3:
Truck Common Stock, $.01 Par Value Paid-In Capital in Excess of Par, Common Stock
36,000 36 35,964
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10-2
Prepare the journal entries for the 10/2 and 11/11 transactions assuming the common stock authorized had a $1 stated value per share as opposed to a $.01 par value. 10/2/X3:
Cash Common Stock, $1 Stated Value Paid-In Capital in Excess of Stated Value, Common Stock Truck Common Stock, $1 Stated Value Paid-In Capital in Excess of Stated Value, Common Stock 250,000 25,000 225,000 36,000 3,600 32,400
Prepare the journal entries for the 10/2 and 11/11 transactions assuming the common stock authorized had no par or stated value. 10/2/X3:
Cash Common Stock, no par value 250,000 250,000
11/11/X3:
Truck Common Stock, no par value
36,000 36,000
11/11/X3:
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Problem 10-3
Problem 10-3
Dividend Calculations and Entries

Johnson, Inc has the following stock outstanding throughout the years 20X3 and 'X4:
Preferred stock (7%, $20 par value, 10,000 shares) Common stock ($1 par value, 50,000 shares) Paid-in capital in excess of par, preferred stock Paid-in capital in excess of par, common stock $200,000 $ 50,000 $ 20,000 $550,000

Johnson, Inc has the following stock outstanding throughout the years 20X3 and 'X4:
Preferred stock (7%, $20 par value, 10,000 shares) Common stock ($1 par value, 50,000 shares) Paid-in capital in excess of par, preferred stock Paid-in capital in excess of par, common stock $200,000 $ 50,000 $ 20,000 $550,000
Assume that in each year prior to 20X3, Johnson paid dividends in excess of the annual preferred stock dividend preference; however, no dividends were declared in 20X3.
A. Assuming the preferred stock is cumulative: i. Determine the amount of dividends in arrears at 12/31/X3. How are these dividends in arrears to be accounted for at that time? ii. Record the following 20X4 events: 2/5/X4: Declared a $50,000 dividend to stockholders of record at 3/5/X4, payable on 4/5/X4 3/5/X4: Date of record. 4/5/X4: Paid dividends declared on 2/5/X4.
Assume that in each year prior to 20X3, Johnson paid dividends in excess of the annual preferred stock dividend preference; however, no dividends were declared in 20X3.
B. Assuming the preferred stock is non-cumulative: i. Determine the amount of dividends in arrears at 12/31/X3. ii. Determine the distribution of the 20X4 $50,000 dividend payable between preferred and common stockholders. C. Would an investor hoping to make big returns on investment opt to invest in preferred or common stock, and why?
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A. i. Determine the amount of dividends in arrears at 12/31/X3. $14,000 (7% x $20 par value/share x 10,000 shares) How are these dividends in arrears to be accounted for at that time? The preferential rights to dividends under preferred stock, whether they are rights to dividends in the current year or carryover rights to dividends in arrears, are rights to dividends that exist only if dividends are declared. Because companies are never obligated to declare and pay dividends, a liability for dividends in arrears exists only when and to the extent those dividends are subsequently declared. Disclosure of dividends in arrears is limited to the notes to the financial statements until dividend declaration. A. ii. Record the following 20X4 events:
2/5/X4: Declared a $50,000 dividend to stockholders of record at 3/5/X4, payable on 4/5/X4.
Dividends - Preferred Stock Dividends - Common Stock Dividends Payable 28,000* 22,000 50,000
* Dividends in arrears of $14,000 plus the current year dividend preference of $14,000.
3/5/X4: Date of record.
No entry made. At this date the holders of the company's stock are noted. They will be the ultimate recipients of the dividend when payment is made on 4/5/X4.
4/5/X4: Paid dividends declared on 2/5/X4.
Dividends Payable Cash 50,000 50,000
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10-3
B. Assuming the preferred stock is non-cumulative: i. Determine the amount of dividends in arrears at 12/31/X3. If the preferred stock is non-cumulative there are never dividends in arrears. There are no carryover rights on non-cumulative preferred stock. ii. Determine the distribution of the 20X4 $50,000 dividend payable between preferred and common stockholders.
Preferred Stock $14,000 Common Stock $36,000 $50,000
C. Would an investor hoping to make big returns on investment opt to invest in preferred or common stock, and why? Common stock offers potentially large returns if a company generates significant profits. Preferred shareholders are limited in their access to dividends, whereas common shareholders have unlimited potential subject to the company's earnings and dividend declarations. As a result, the fair market value of common stock tends to be much more volatile than preferred stock values. Conservative investors desiring a steady fixed rate of return with limited risk often choose to invest in preferred stock issued by quality companies. Common stockholders may earn big returns but they also face the possibility of significant losses if the company fails to perform up to expectations and market values fall.
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Stock Dividend
Example: Assume Clark Corporation has 100,000 shares of $1 par value common stock outstanding. In this case, the declaration of a 10% stock dividend means that every stockholder of the company will receive an additional one share of stock for every 10 shares currently held.
Before the 10% stock dividend: 100,000 Total Shares

20,000 Shares 20,000 Shares 20,000 Shares 20,000 Shares 20,000 Shares (20%)
100,000 shares x 10% = 10,000 shares

(In the event a shareholder owns less than 10 shares or some number more than any increment of ten, a fractional share warrant will usually be issued. These warrants can then be bought and sold and ultimately combined with other warrants to claim a full share from the company.)
Following the dividend: 110,000 Total Shares

22,000 Shares 22,000 Shares 22,000 Shares 22,000 Shares 22,000 Shares (20%)
No change in any shareholder's relative rights to share in the company's future profits. No change in voting influence. No change in relative rights to future distributions in the event of business liquidation.
Do stockholders actually get anything of value when they receive a stock dividend?
No company assets are distributed in a stock dividend.
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Accounting for this 10% stock dividend

Assume a $15 market value for the stock:
Retained Earnings Common Stock, $1 par value Paid-in Capital in Excess of Par, Common Stock 150,000 10,000 140,000
Stock Split
(A company's replacement of existing shares of stock with a higher number of new shares.) Example: A 2-for-1 stock split means
1 New Share $.50 par 1 New Share $.50 par
The same as if the company had actually paid a $150,000 cash dividend:
Retained Earnings Cash 150,000 150,000
Stockholder 1 Old Share $1.00 par Stockholder 1 1 Old Share Old Share $1.00 par $1.00 par
A 3-for-2 stock split means

1 New Share $.66 par 1 New Share $.66 par 1 New Share $.66 par
With the shareholders immediately buying 10,000 newly issued shares at the $15 market price per share.
Cash Common Stock, $1 par value Paid-in Capital in Excess of Par, Common Stock 150,000 10,000 140,000
A 3-for-2 stock split has the same ultimate effect as a 50% stock dividend.
A 50% stock dividend means

1 Share $1.00 par
A stock dividend is sometimes referred to as the capitalization of retained earnings. There is no net affect on the company's overall financial position, but the amount of retained earnings available for future dividend distributions has been reduced.
Stockholder 1 1 Share Share $1.00 par $1.00 par
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10-4
These kinds of stock splits or large stock dividends are usually motivated by a company's desire to lower the stock's market price per share in hopes that this will increase trading in the company's stock and lift its overall value over time.
From an accounting standpoint, even though stock splits may enhance the value of a stockholder's investment portfolio, there's no change in the issuing company's financial position or the composition of its stockholders' equity. Disclosure of the new par value and increased number of shares issued and outstanding is required, but no journal entry is necessary to adjust the company's account balances.
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Large Stock Dividend

No entry is made, except to record any resulting increase in the company's total outstanding par value from the additionally issued shares.
Retained Earnings Common Stock, at par value XXX XXX
Summarizing Points
Small Stock Dividend
(less than 20 to 25%)
Retained earnings capitalized @ Market value of the additionally issued shares
Large Stock Dividend

(more than 20 to 25%)
Retained earnings capitalized @ Par value of the additionally issued shares In a large dividend, no entry is recorded if the stock has no par value.
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Problem 10-4
Accounting for Stock Dividends and Splits

The following reflects all stockholders' equity accounts for Layton, Inc. at the beginning of the year 20X7:
1/1/X7
Accounting for Stock Dividends and Splits

A. 3/1 Layton declared and issued a 5% stock dividend when the stock's market
value was $12 per share. Retained Earnings * Common Stock, $.10 par value Paid-in Capital in Excess of Par, Common Stock 120,000 1,000 119,000
Common stock, $.10 par value Paid-in capital in excess of par, common stock Retained earnings
$ 20,000 $1,980,000 $ 495,000
A. Prepare journal entries to record the following 20X7 transactions:

3/1 Layton declared and issued a 5% stock dividend when the stock's market value was $12 per share. 6/12 Layton split its stock 2 for 1. Assume the newly issued stock was assigned a $.05 par value and had a post-split market value of $7 per share. 12/1 Layton declared and issued a 25% stock dividend when the stock's market value was $10 per share.
* 5% x 200,000 shares = 10,000 dividend shares 10,000 shares x $12/share = $120,000

6/12 Layton split its stock 2 for 1. Assume the newly issued stock was assigned a $.05 par value and had a post-split market value of $7 per share.
No entry made. (420,000 new shares issued, $.05 par value per share)
12/1 Layton declared and issued a 25% stock dividend when the stock's market value was $10 per share. Retained Earnings * Common Stock, $.05 par value 5,250 5,250
B. Prepare the stockholders' equity section of Layton's 12/31/X7 balance sheet assuming no other dividends were paid in 20X7 and net income for the year amounted to $20,000. C. Compare Layton's total stockholders' equity at the beginning and end of the year and explain any difference.
* 25% x 420,000 shares = 105,000 shares 105,000 shares x $.05/share par value = $5,250
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B. Stockholders' Equity:
Contributed capitalCommon stock, $.05 par value,525,000 shares Paid-in capital in excess of par, common stock Retained earnings Total Stockholders' Equity
12/31/X7 $ 26,250 2,099,000 2,125,250 389,750 $ 2,515,000 12/31/X7
In business today, it's not all that uncommon for companies to actually go into a secondary market and actually buy back their own previously issued stock.
Treasury Stock
Why would a company do this?
1. Good investment. (The purchase and subsequent reissuance of stock at a higher price is a way to generate more capital contributions on previously issued shares.) 2. Send a message of confidence to other potential investors. 3. Lift a stock's market price. 4. Get rid of certain unwanted shareholders. 5. Help prevent unfriendly or hostile takeovers. 6. Obtain previously issued stock for use in employee bonus or stock option plans.
C. Stockholders' Equity:
1/1/X7
Contributed capitalCommon stock, $.10 and $.05 par value, and 200,000 and 525,000 shares, respectively $ 20,000 Paid-in capital in excess of par, common stock 1,980,000 2,000,000 Retained earnings 495,000 Total Stockholders' Equity $2,495,000
26,250
2,099,000 2,125,250 389,750 $ 2,515,000 $20,000 Difference
The difference is attributable to the $20,000 of net income for the year. Stock dividends and stock splits change the composition within stockholders' equity but have no net effect on the total.
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Example: At 1/1/X7, Bing Corporation's capital contributions include:

Common stock, $.01 par value, 200,000 shares Paid-in capital in excess of par, common stock $ 2,000 2,998,000 $ 3,000,000
Bing Corporation Balance Sheet As of January 15, 20X7
1/15/X7: Bing takes $500,000 of excess cash and buys 25,000 of its own previously issued common shares at a market price of $20 per share.
Treasury Stock Cash 500,000 500,000
Owners' Equity: Capital contributionsCommon stock, $.01 par value, 200,000 shares issued and 175,000 shares outstanding Paid-in capital in excess of par, common stock Retained earnings Less: Treasury stock Total owners' equity
2,000 2,998,000 3,000,000
Legally a company can't own itself. As a result, this treasury stock has no voting, dividend or other rights in the company. Without those rights, this stock is not an asset.
(500,000) $
What kind of account is this treasury stock account?
Contra-Equity Account
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3/15/X7: Bing sells (reissues) 5,000 of the treasury shares at a market price of $22 a share.
Cash ($22 x 5,000 shares) Treasury Stock ($20 x 5,000) Paid-In Capital - Treasury Stock
Bing Corporation Balance Sheet As of March 15, 20X7
7/1/X7: Bing reissues an additional 5,000 shares at a market price of $17 a share.
Cash ($17 x 5,000 shares) Paid-In Capital - Treasury Stock Retained Earnings Treasury Stock ($20 x 5,000) 85,000 10,000 5,000
110,000
100,000 10,000
100,000
Owners' Equity: Capital contributionsCommon stock, $.01 par value, 200,000 shares issued and 180,000 shares outstanding Paid-in capital in excess of par, common stock Paid-in capital, treasury stock Retained earnings Less: Treasury stock Total owners' equity
2,000 2,998,000 10,000 3,010,000
(400,000) $
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10-6
9/1/X7: Bing reissues an additional 7,000 treasury shares when the stock's market price has increased to $25 a share.
Cash ($25 x 7,000 shares) Paid-In Capital - Treasury Stock Treasury Stock ($20 x 7,000)
Bing Corporation Balance Sheet As of September 1, 20X7
175,000
Paid-In Capital - Treasury Stock
35,000 140,000
10,000 7/1/X7 10,000 35,000 35,000
3/15/X7 9/1/X7
2,000 2,998,000 35,000 3,035,000
(160,000) $
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9/1/X7: Bing reissues an additional 7,000 treasury shares when the stock's market price has increased to $25 a share.
Cash ($25 x 7,000 shares) Paid-In Capital - Treasury Stock Treasury Stock ($20 x 7,000)
Bing Corporation Balance Sheet As of September 1, 20X7
Treasury Stock
1/15/X7 500,000 100,000 100,000 140,000 (8,000 x $20) 160,000 3/15/X7 7/1/X7 9/1/X7
175,000
35,000 140,000
2,000 2,998,000 35,000 3,035,000
(160,000) $
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Problem 10-5
Treasury Stock Transactions

As of 12/31/X1, Martin Electronic 's balance sheet includes the following:
Common stock, $.01 par value, 100,000 shares $ 1,000 issued and outstanding Paid-in capital in excess of par, common stock $ 999,000 $ 245,000 Retained earnings
Treasury Stock Transactions

A. 1/15/X2: Reacquired 10,000 shares as treasury stock at a price of $8 per share.
Treasury Stock Cash 80,000 80,000
2/15/X2: Reissued 1,000 treasury shares at $7 a share.

Cash Retained Earnings Treasury Stock ($8 x 1,000) 7,000 1,000 8,000
Given this information:

A. Prepare Martin's journal entries for the following 20X2 transactions: 1/15/X2: Reacquired 10,000 shares as treasury stock at a price of $8 per share. 2/15/X2: Reissued 1,000 treasury shares at $7 a share. 6/10/X2: Reissued 4,000 treasury shares at $10 a share. 9/3/X2: Reissued 2,000 treasury shares at $7 a share. B. Prepare the stockholders' equity section of Martin's 12/31/X2 balance sheet assuming net income and dividends for the year amounted to $95,000 and $20,000, respectively.

Cash Treasury Stock ($8 x 4,000) Paid-In Capital - Treasury Stock 40,000 32,000 8,000

Cash Paid-In Capital - Treasury Stock Treasury Stock ($8 x 2,000) 14,000 2,000 16,000
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10-7
B.
Stockholders' Equity: Contributed capitalCommon stock, $.01 par value, 100,000 shares issued, 97,000 shares outstanding Paid-in capital in excess of par, common stock Paid-in capital, treasury stock Total contributed capital Retained earnings Total contributed capital and retained earnings Less: Treasury stock, 3,000 common shares at cost Total stockholders' equity
Retained Earnings
245,000 2/15/X2 Dividends 1,000 95,000 20,000 319,000
1,000 999,000 6,000 1,006,000 319,000
Retained Earnings:
+ Net Income
1,325,000 (24,000) $1,301,000
- Dividends (paid in cash or other assets) - Stock Dividends - Treasury Stock Losses (in some cases)
12/31/X1 Net Income 12/31/X2
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Prior-Period Adjustment
A direct entry made to retained earnings to correct a prior-year accounting error. A mathematical error. An improper application of an accounting principle. An error due to incorrect information.
In most states the balance in a corporation's retained earnings account represents the maximum amount available to stockholders for distribution of dividends. Sometimes lenders will demand additional restrictions on dividend distributions before agreeing to fund a loan. These restrictions are written into the loan documents and become part of the debt covenants agreed to by the company. Any such restrictions on the payment of dividends must be disclosed in a company's notes to the financial statements.
Not an error in estimation. (Prior year errors in estimation are corrected through compensating entries made in the current year.)
If a company discovers an understatement of prior-year depreciation due to a mathematical error, that understatement is corrected through a prior-period adjustment: Retained Earnings Accumulated Depreciation XXX XXX
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Stockholders' Equity: Capital contributions Preferred stock, 5% $20 par value, 20,000 shares issued and outstanding $400,000 Common stock, $.01 par value, 100,000 shares issued, 90,000 shares outstanding 1,000 Paid-in capital in excess of par - preferred stock 20,000 Paid-in capital in excess of par - common stock 220,000 Paid-in capital - treasury stock 30,000 671,000 Retained earnings 241,250 Accumulated other comprehensive income: Cumulative foreign currency translation adjustments (24,000) Unrealized gain (loss) on investment securities (57,500) 830,750 Less: Treasury stock, 10,000 shares of common stock (30,000) Total stockholders' equity $800,750
ABC Corporation Balance Sheet As of December 31, 20X9
Foreign currency translation adjustment: The result of changes in currency exchange rates affecting the valuation of a company's investment in foreign subsidiaries. Unrealized gains and losses on investment securities: Involves increases and decreases in the market value of certain stocks and bonds of other companies held as an investment.
Statement of Retained Earnings for the year ended December 31, 20X9
Retained earnings at beginning of the year $192,905 Add: Net income for the year 125,345 Less: Dividends, preferred stock (20,000) Dividends, common stock (5,000) Stock dividends, common stock (15,000) Treasury stock loss (2,000) Prior-period adjustment - correction of revenues (35,000) Retained earnings at the end of the year $241,250
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10-8
Comprehensive income for the year ended 12/31/X9:

Net income Foreign currency translation adjustment Unrealized gain (loss) on investment Other items Comprehensive income $125,345 (12,350) (22,456) 0 $ 90,539
Collins, Inc. Statement of Stockholders' Equity For the year ended December 31, 20X4
Paid-in Capital Excess of Par Paid-in Capital, Treasury Stock
Common Stock
Retained Earnings
Treasury Stock
Total
Balance at beginning of year $ 5,000 Net income for the year Cash dividends paid at $.20 per share Stock dividend (10%) Treasury stock purchase Sale of treasury stock Balance at end of year $ 5,000
$495,000
$ 50,000
$150,000 70,000 (20,000) (30,000)
($40,000)
$495,000
2,000 $ 52,000
$170,000
(30,000) 10,000 ($ 60,000)
$660,000 70,000 (20,000) (30,000) (30,000) 12,000 $662,000
This is useful information to most investors and although not required, most companies provide this statement of stockholders' equity with their other general-purpose financial statements.
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Problem 10-6
Other Complications in Stockholders' Equity

Given the following information for Otis, Inc. as of 12/31/X5, prepare the stockholders' equity section of the company's 12/31/X5 balance sheet:
Retained earnings at 1/1/X5 Net income for the year ended 12/31/X5 Common stock, $1 par value, 50,000 shares issued Preferred stock, 8% $10 par value, 10,000 shares issued and outstanding Treasury stock, 5,000 shares of common stock Prior-period adjustment - correction of previously understated employee compensation expense Paid-in capital - treasury stock Paid-in capital in excess of par - preferred stock Dividends, common stock Unrealized gain on investment securities Paid-in capital in excess of par - common stock Foreign currency translation adjustments, increase Dividends, preferred stock $126,355 $ 72,344 $ 50,000 $100,000 $ 20,000 $ 25,421 $ 12,000 $ 10,000 $ 32,000 $ 14,367 $450,000 $ 3,420 $ 8,000
Other Complications in Stockholders' Equity

Stockholders' Equity: Contributed capital Preferred stock, 8% $10 par value, 10,000 shares $100,000 issued and outstanding Common stock, $1 par value, 50,000 shares issued, 50,000 45,000 shares outstanding 10,000 Paid-in capital in excess of par - preferred stock 450,000 Paid-in capital in excess of par - common stock 12,000 Paid-in capital - treasury stock 622,000 133,278 Retained earnings* Accumulated other comprehensive income: 14,367 Unrealized gain on investment securities 3,420 Foreign currency translation adjustments 773,065 (20,000) Less: Treasury stock, 5,000 shares of common stock Total stockholders' equity $753,065 *Calculation of Retained Earnings at 12/31/X5: Retained earnings at the beginning of the year Add: Net income for the year Less: Dividends, preferred stock Dividends, common stock Prior-period adjustment - correction of previously understated employee compensation expense Retained earnings at the end of the year $126,355 72,344 (8,000) (32,000) (25,421) $133,278
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A legal partnership can be formed based on a simple oral agreement. No signed document is required. However, a lot of potential problems can be avoided if partners will take the time to put together a written agreement.
Equity Financing in Partnerships and Proprietorships
A good partnership agreement will typically address such things as:
The rights and duties of the partners. The amount of any required capital contributions. The profit and loss sharing arrangement. Rights and procedures in asset distributions and withdrawals. Provisions for the buyout of partnership interests. Procedures to be used in resolving partnership disputes.
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10-9
Partnership Accounting
All of the business transactions of a partnership, including the buying and selling of inventory, accounting for the purchase and use of property, plant and equipment, recording of revenues and expenses and the like, are accounted for the same as if the business was operated as a corporation. The only differences are in the accounting for transactions affecting owners' equity accounts appearing in the balance sheet and any payments of salaries or wages to partners. Example: Two friends, Linda Jones and Cindy Palmer, form a partnership to operate a catering business called Lindy's Catering. To start the business, Linda contributes $5,000 cash, and Cindy contributes an additional $1,000 plus a $4,000 used van. Journal entry: Cash Van Linda Jones, Capital Cindy Palmer, Capital
6,000 4,000 5,000 5,000
If, the following reflects Lindy's first month's revenues and expenses,
Debit Sales Revenues Food Expense Supplies Expense Misc. Expense 7,000 2,500 500 Credit 15,000
and partnership profits are to be allocated monthly on a 50/50 basis, Closing entry:
Sales Revenues Food Expense Supplies Expense Misc. Expense Linda Jones, Capital Cindy Palmer, Capital 15,000 7,000 2,500 500 2,500 2,500
Contributed assets are to be recorded at a fair market value agreed upon by all partners involved.
Sometimes partners agree that certain partners are to receive compensation for time spent working in the business. Because partners are never employees, this kind of compensation is accounted for as a priority distribution of profits. Similar distributions are sometimes agreed to for partners providing larger capital contributions than their relative partnership interest. In this case, the priority is typically calculated like interest on a loan with the partner receiving first profits equal to some percentage of their additionally contributed capital.
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Any payments made to partners are traditionally recorded in a separate withdrawal or drawings account maintained for each partner. Assume Linda needs $1,000 of allocated partnership profit distributed for her own personal use:
Linda Jones, Drawings Cash 1,000 1,000
Lindy's Catering Balance Sheet
Owners' Equity: Linda Jones, Capital Cindy Palmer, Capital
6,500 7,500 $14,000
At the end of each accounting period this drawings account is then closed:
Linda Jones, Capital Linda Jones, Drawings
Linda Jones, Capital
5,000 2,500 Withdrawals 1,000 6,500 Ending balance Capital contributions Profit allocation
Lindy's Catering Statement of Partners' Capital

Linda Jones Cindy Palmer Total
1,000
1,000
Beginning balance $ 0 Add: Capital contributions 5,000 Net income 2,500 Less: Withdrawals (1,000) Ending balance $6,500
$ 0 5,000 2,500 0 $7,500
$ 0 10,000 5,000 (1,000) $14,000
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Problem 10-7
Marty Clements and George Barnes share profits and losses on a 60/40 basis as partners in a small retail store. At the beginning of May their capital account balances were $22,000 and $26,000, respectively.
Accounting for a proprietorship is exactly the same as it is for a partnership except that there's only one capital account maintained for the business' sole owner.
Given the following information for the month of May, determine the partners' ending capital account balances assuming Barnes has a monthly priority right to $3,000 of profits for time spent actually managing the store.
Store Revenues Store Expenses Clements cash drawings Barnes cash drawings $50,000 $35,000 $10,000 $ 3,000
Questions: Does it make sense that Clements' drawings for the month were higher than Barnes? If the partnership were to liquidate at the end of May producing $100,000 of distributable cash to the owners after the payoff of all liabilities, how much should go to each partner? If the distributable cash in liquidation amounted to only $30,000, how much do you think would go to each partner?
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10-10
Statement of Partners' Capital for the month of May
Clements Barnes
If the partnership were to liquidate at the end of May producing $100,000 of distributable cash to the owners after the payoff of all liabilities, how much should go to each partner?
Clements Barnes Total
Beginning balance Profit allocation Barnes priority 60/40 split Drawings Ending balance
$22,000 7,200 (10,000) $19,200
$26,000 3,000 4,800 (3,000) $30,800
Capital balances Add: Gain on liquidation (60/40) Adjusted capital balances Distribution:
$19,200 30,000 $49,200 $49,200
$30,800 20,000 $50,800 $50,800
$50,000 50,000 $100,000 $100,000
Question: Does it make sense that Clements' drawings for the month were higher than Barnes?
Answer: It does seem a bit odd that Clement's would draw out of the business more than his monthly profit allocation while Barnes draws out less. The extent and timing of allowed withdrawals is something that should be addressed in the partnership agreement. Partner draws are usually limited to profit allocations, but that obviously wasn't the case for this partnership.
If the distributable cash in liquidation amounted to only $30,000, how much do you think would go to each partner?
Clements Barnes Total
Capital balances Less: Loss on liquidation (60/40) Adjusted capital balances Distribution:
$19,200 (12,000) $ 7,200 $ 7,200
$30,800 (8,000) $22,800 $22,800
$50,000 (20,000) $30,000 $30,000
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10-11
Lesson 11
An investment in equity securities refers to an investment in or the purchase of a company's common or preferred stock. Stocks are called equity securities because they provide holders with ownership rights or equity interests in a company. When stocks are purchased, returns on investment come in the form of dividends and any gains on the subsequent sale of the stock. An investment in debt securities refers to an investment in or the purchase of corporate or government issued bonds. They're referred to as debt securities because upon issuance a liability, or debt, is recorded on the books of the issuing company or governmental entity. When bonds are purchased, the investor becomes an owner of debt, or, in effect, a lender with rights to receive future payments of principal and interest.
Lesson 11
Investments in Equity and Debt Securities
In some cases, companies invest in the securities of other companies to simply make better use of excess cash, or cash that's temporarily available due to seasonal operations. For example, a company manufacturing sporting goods sold primarily in the summer months will probably experience an annual cash flow cycle that looks something like this: Excess cash available
for short-term investment.
Some companies invest in the stocks and bonds of other companies, because that's the essence of their business. Investment companies and mutual funds exist solely to make investments in debt and equity securities of other companies. Mutual funds take in cash obtained from investors upon issuance of their own stock and then invest those funds in the stocks and/or bonds of other companies. Investors in mutual funds benefit when the value of the stocks and bonds held by the fund increase in value, or dividends and interest are earned. Some companies also invest in the stock of other companies for strategic reasons. If enough shares are purchased a company can obtain significant influence or even outright control over another company's operations. That's why some company's wishing to enter into new industries, or seeking to secure necessary supplies or outlets for distribution, will often acquire large percentages of the outstanding shares of other companies.
Mar.
June
Sept.
Dec.
Mar.
Short-term financing required to cover cash shortfalls.
Accounting for Investments in Equity Securities

Under current accounting standards, companies may use different methods of accounting for investments in equity securities depending on the intent behind the investment. That intent's reflected in the following classifications used to determine an investment's appropriate accounting method: Trading Securities: Includes all shares of stock purchased as part of an active trading program. That means these shares are frequently bought and sold based on short-term price fluctuations. Companies investing in trading securities are, in effect, playing the market in an attempt to maximize investment returns. Available-for-Sale Securities: Includes all shares of stock held with the intent to sell if future cash needs arise. No effort is made to take advantage of temporary price fluctuations. The strategy here is to buy and hold for a more extended period of time. (This classification specifically excludes any shares that may provide a company with significant influence or control over another company.)
Accounting for Investments in Equity Securities

Under current accounting standards, companies may use different methods of accounting for investments in equity securities depending on the intent behind the investment. That intent's reflected in the following classifications used to determine an investment's appropriate accounting method: Securities that provide a company with significant influence over another company's operations: Significant influence is generally assumed when 20-50% of the outstanding common stock of another company is owned. However, other criteria may also be considered when making this determination. (These securities are also sometimes called "equity method securities" because they're accounted for using an equity method of accounting.) Securities that provide a company with a controlling interest over another company: This usually requires ownership of at least 51% of a company's outstanding common stock, although effective control can sometimes be achieved with a lower percentage.
11-1
Investment in Trading Securities

Example: On November 15th, 20X7, Crown Investments purchased 1,000 shares of IBM common stock at a price of $20 a share, plus brokerage fees of $400. The shares are classified by Crown as trading securities given plans to sell the stock as soon as the price increases and shares can be sold at a profit. Journal entry to record purchase:
Investment in Trading Securities Cash 20,400 20,400
In most cases, companies invest in a portfolio of stocks.

General Ledger
12/31/X6 0 xxx xxx 12/31/X7 122,000 xxx xxx
Subsidiary Ledger
IBM
12/31/X6 11/15/X7 12/31/X7 0 20,400 20,400 12/31/X6 6/12/X7 12/31/X7
ATT
0 35,200 35,200
All costs incurred in the purchase of an asset are included as part of the asset's historical cost.
Intel
12/31/X6 5/11/X6 12/31/X7 0 40,800 40,800 12/31/X6 2/26/X7 12/31/X7
Microsoft
0 25,600 25,600
Adjust Crown's investment in trading securities to its fair market value given the following market values on 12/31/X7
At 12/31/X7:
IBM FMV $21,000 Historical cost $20,400 Increase (decrease) $ 600 ATT $40,500 $35,200 $ 5,300 Intel $35,300 $40,800 ($5,500) MSoft $31,200 $25,600 $ 5,600 Total $128,000 $122,000 $ 6,000
For financial reporting purposes, any increase or decrease in the fair market value of a company's investment in trading securities is to be reported in the company's financial statements.
12/31/X7 adjusting entry to record the effect of this net increase in value:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities 6,000 6,000
Because these securities remain unsold at the end of the year, the increased value is "unrealized," but it is recognized (recorded) and included on the company's income statement under the category of other revenues and expenses.
Crown Investments Balance Sheet 12/31/X7
Current Assets: Investments in trading securities Add: Market adjustment
$122,000 $ 6,000 $128,000
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Assume for just a moment that the fair market value of the investment had actually declined to $120,000 from its $122,000 historical cost. 12/31/X7 adjusting entry:
Unrealized Loss - Trading Securities Market Adjustment - Trading Securities
Why use this Market Adjustment account? Why not just debit and credit the Investment in Trading Securities account directly when adjusting it for changing values? This approach allows the investment general ledger control account and its related subsidiary ledger accounts to be maintained at historical costs, and having those costs readily available can facilitate our subsequent accounting when the stock is actually sold and also helps in the preparation of a company's income tax return. For income taxes, no gains or losses are recorded until securities are sold, and the amount of the gain or loss is then based on the difference between the selling price and the stock's original cost. Having the investment account serve as a record of that original cost can be beneficial.
2,000 2,000
Current Assets: Investments in trading securities Less: Market adjustment
$122,000 (2,000) $120,000
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11-2
On 1/20/X8, Crown sells its IBM shares at a price of $23 a share less a $500 brokerage commission. Journal entry:
Cash ($23,000 - $500) Investments in Trading Securities Realized Gain on Sale of Trading Securities 22,500 20,400 2,100
Assume that no other trading securities are bought or sold during the current year 20X8 except for the IBM shares we've just accounted for. Also assume that the market value of Crown's remaining trading securities based on exchange prices at 12/31/X8 are as follows:
ATT FMV at 12/31/X7 $40,500 FMV at 12/31/X8 $34,500 Unrealized gain (loss) ($ 6,000) Intel MSoft $35,300 $31,200 $41,500 $28,000 $ 6,200 ($ 3,200) Total $107,000 $104,000 ($ 3,000)
At 12/31/X7:
IBM FMV $21,000 Historical cost $20,400 Increase (decrease) $ 600
ATT $40,500 $35,200 $ 5,300
Intel $35,300 $40,800 ($5,500)
MSoft $31,200 $25,600 $ 5,600
Total $128,000 $122,000 $ 6,000
12/31/X8 Adjusting entry:

Unrealized Loss - Trading Securities Market Adjustment - Trading Securities 3,600* 3,600
* Include the correction of the $600 of over-recorded gain.
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There's an even easier way to come up with this same adjustment. that's done by taking the balances in the company's investment and market adjustment accounts before any adjusting entry, and then making the adjustment that's necessary to properly state those accounts in the company's balance sheet.
12/31/X7 12/31/X8 122,000 20,400 Sold IBM shares 101,600
Summary of balance sheet approach to adjustment: 1. Identify the ending balances in the investment in trading securities and market adjustment accounts before the year-end adjustment. 2. Determine the appropriate ending balance for the market adjustment account (the amount of the difference between the market value and historical cost of the company's investment in trading securities at the end of the year).
Market Adjustment - Trading Securities

12/31/X7 12/31/X8 6,000 3,600 Adjusting entry 2,400
FMV at 12/31/X8 Historical cost Differences
ATT $34,500 $35,200 $ 5,300
Intel $41,500 $40,800 ($5,500)
MSoft $28,000 $25,600 $ 5,600
Total $104,000 $101,600 $ 2,400
3. An entry is then made to adjust the market adjustment account to that balance with any increase or decrease recorded as an unrealized gain or loss, respectively.
12/31/X8 Adjusting entry:

Unrealized Loss - Trading Securities Market Adjustment - Trading Securities 3,600 3,600
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Problem #11-1
Classifications of Investments in Equity Securities On occasion, a company making an investment in trading securities will receive dividends on their investment. When that happens: Journal entry:
Cash Dividend Revenues XXX XXX
Note the four possible securities classifications requiring different methods of accounting for an investment in the stock of another company and describe the criteria for classification.
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11-3
Problem #11-2
Classifications of Investments in Equity Securities

1. Trading Securities: Stock purchased with the intent to make a return on investment in the short-term. 2. Available-for-Sale Securities: Stock purchased and held with the intent to sell if and when future cash needs arise. Although investors in availablefor-sale securities hope for increasing stock values over time, the timing of sale is based on cash needs rather than on short-term market fluctuations in price. (This classification excludes shares that provide a company with significant influence or control over the affairs of another company.) 3. Securities that provide significant influence in another company's operations (Equity Method Securities): Stock purchased and held with the intent to significantly influence the operations of the company invested in. Unless there is evidence to the contrary, ownership of at least 20% and not more than 50% of a company's outstanding common stock represents the ability to significantly influence a company. 4. Securities that provide a controlling interest over another company: Stock purchased and held to exercise effective control over another company (usually more than 50% ownership).

Prepare journal entries to record the following investment transactions entered into by the Clark Company:
20X5: 2/15 Purchased 1,000 shares of General Motors ("GM") stock at a price of
$60 a share, plus a 1% brokerage commission. Clark has no significant influence over GM affairs and classifies the stock as trading securities. 8/10 Sold 200 GM shares for $70 a share, less a $100 brokerage fee. 9/30 Received a $400 cash dividend on the GM stock. 12/31 GM shares are trading on the NYSE at $55 a share. (Clark has no investment in trading securities other than the GM shares.)
20X6: 3/11 Sold 200 GM shares for $58 a share, less a $100 brokerage fee.
9/30 Received a $200 cash dividend on the GM stock. 12/31 GM shares are selling on the NYSE at $75 a share. (Clark has no investment in trading securities other than the GM shares.)
Prepare: 1. Clark's balance sheet presentation of the investment in trading securities at 12/31/X6 2. Clark's income statement presentation of all revenues and expenses associated with the investment in trading securities for the year ended 12/31/X6
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20X5 Entries: 2/15 Purchased 1,000 shares of General Motors ("GM") stock at a price of $60 a share, plus a 1% brokerage commission.
Investment in Trading Securities Cash ($60,000 + $600) 60,600 60,600
12/31 GM shares are trading on the NYSE at $55 a share. (Clark has no investment in trading securities other than the GM shares.)
FMV at 12/31/X5 (800 shares x $55) $44,000 Historical cost (800 shares x $60.60) $48,480 ($4,480) Decrease in value
8/10 Sold 200 GM shares for $70 a share, less a $100 brokerage fee.
Cash ($14,000 - $100) Investment in Trading Securities Realized Gain on Sale of Trading Securities
* $60,600 1,000 shares = $60.60 cost per share $60.60/share x 200 shares = $12,120
20X5 Entries: 3/11 Sold 200 GM shares for $58 a share, less a $100 brokerage fee.
Cash ($11,600 - $100) Realized Loss on Sale of Trading Securities Investment in Trading Securities
* $60.60/share x 200 shares = $12,120
13,900 12,120* 1,780
11,500 620
12,120*
9/30 Received a $400 cash dividend on the GM stock.

Cash Dividend Revenues 400 400
9/30 Received a $200 cash dividend on the GM stock.

Cash Dividend Revenues 200 200
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Problem 11-2 - Answer Clark Company Balance Sheet 12/31/X6
12/31 GM shares are trading on the NYSE at $75 a share. (Clark has no investment in trading securities other than the GM shares.)
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities
FMV at 12/31/X6 (600 shares x $75) Historical cost (600 shares x $60.60) Market adjustment
13,120 13,120
$45,000 $36,360 $ 8,640
Current Assets: Investments in trading securities Add: Market adjustment

or
$ 36,360 $ 8,640 $ 45,000
Current Assets: Investment in trading securities, at market $ 45,000 Investment in Trading Securities

4,480 4,480 Adjusting entry 13,120 12/31/X6 8,640 Adjusting entry 12/31/X5
2/15/X5 12/31/X5 12/31/X6
60,600 12,120 48,480 12,120 36,360 3/11/X6 8/10/X5

4,480 Adjusting entry 4,480 Adjusting entry 13,120 12/31/X6 8,640 12/31/X5
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11-4
Problem 11-2 - Answer Clark Company Income Statement for the year ended 12/31/X6
Problem #11-3
Investment in Trading Securities Given the following balances for Cross, Inc at 12/31/X3:
DR $ 200 (620) 13,120 $ 12,700 CR
Other revenues and expenses: Dividend revenues Realized loss on sale of trading securities Unrealized gain - trading securities
Investment in trading securities Market adjustment - trading securities
$ 84,000 $ 4,000
Prepare the year-end adjustments to record any unrealized gains or losses on trading securities at 12/31/X4 and 'X5 given the following information:
Securities held at 12/31/X4
Historical cost FMV at 12/31/X4 A $20,000 $22,000 B $30,000 $26,000 C $25,000 $25,000 Total $75,000 $73,000

Historical cost FMV at 12/31/X5 A $20,000 $27,000 C $25,000 $26,000 D $10,000 $17,000 Total $55,000 $70,000
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Adjustment at 12/31/X4:

Adjustment at 12/31/X5:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities 17,000 17,000

12/31/X3 4,000 6,000 Adjusting entry 2,000 12/31/X4

12/31/X3 4,000 6,000 Adjusting entry 2,000 Adjusting entry 17,000 12/31/X5 15,000 12/31/X4

Historical cost FMV at 12/31/X4 A $20,000 $22,000 B $30,000 $26,000 C $25,000 $25,000 Total $75,000 $73,000 ($2,000)

Historical cost FMV at 12/31/X5 A $20,000 $27,000 C $25,000 $26,000 D $10,000 $17,000 Total $55,000 $70,000 $15,000
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Investment in Available-for-Sale Securities

(Equity securities included in this category are stocks bought and held with the intent to sell when future cash needs arise.)
The accounting for an investment in available-for-sale securities is almost exactly the same as it is for an investment in trading securities. In fact, the only distinction is in the disclosure of unrealized gains or losses on changing stock values over time.
Available-for-sale securities are recorded as an investment at the purchase price paid plus any additional incidental costs of acquisition including brokerage or other fees. Any realized gains and losses on the subsequent sale of shares are included with other revenues and expenses on the company's income statement along with any dividend revenues. A market adjustment account is used to adjust the historical cost of the company's investment to its current fair market value at the end of each accounting period. However, with available-for-sale securities, the resulting unrealized gain or loss associated with that adjustment is not reflected in the company's income statement and closed to retained earnings. Instead, it bypasses the income statement and is reflected directly on a cumulative basis in the owners' equity section of the balance sheet as part of accumulated other comprehensive income.
Example: Assume that at the end of 20X6, NRN Corporation has:

DR CR
Investment in available-for-sale securities Market adjustment - available-for-sale securities 12/31/X6: FMV of securities Historical cost
$100,000 $ 5,000
$105,000 $100,000
Also assume that at the end of 20X7, the investment account has the same $100,000 balance but the fair market value of the securities held has increased to $113,000.
Market Adjustment - Available-for-Sale Securities
12/31/X6 Adjusting entry 12/31/X7 5,000 8,000 13,000
Entry at Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities 12/31/X7:
Unrealized Gain/Loss - Available-for-Sale Securities
5,000 8,000 13,000 12/31/X6 Adjusting entry 12/31/X7
8,000 8,000
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11-5
Problem #11-4
Accounting for Trading vs. Available-for-Sale Securities

On 12/31/X1, Moore Company owned 1,000 shares of stock in General Electric ("GE") with an original cost of $30 and a fair market value of $28 per share.
Assuming the shares are classified as:
Assets:
Investment in available-for-sale securities Plus: Market adjustment $ 100,000 13,000 $ 113,000
A. Trading securities B. Available-for-sale securities
Owners' Equity:
Accumulated other comprehensive income: Unrealized gain on available-for-sale securities $ 13,000
1. Prepare entries to record Moore's 20X2 sale of 300 GE shares at a price of $32/share along with the appropriate year-end adjustment given a market price of $35/share at 12/31/X2. (Assume the company has no other investments in equity securities and entered into no other transactions involving GE stock during the year.) 2. Prepare Moore's 12/31/X2 balance sheet and income statement disclosures. Question: Why might a company experiencing declining values on newly purchased equity securities be inclined to classify them as available-for-sale rather than trading securities regardless of their future plans? What kind of problem might this present to the company's auditor?
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Accounting for Trading vs. Available-for-Sale Securities

A. Trading securities: 1. Entry to record the sale of 300 GE shares at $32/share:
Cash (300 x $32) Investment in Trading Securities (300 x $30) Realized Gain on Sale of Trading Securities * $30 x 300 shares = $9,000 9,600 9,000* 600
2.
Moore Company Balance Sheet 12/31/X2 Investment in trading securities, at market $ 24,500
Current Assets:
12/31/X2 adjusting entry to reflect market value of investment:

Market Adjustment - Trading Securities Unrealized Gain - Trading Securities Market Adjustment - Trading Securities
2,000 Adjusting entry 12/31/X2 5,500 3,500 12/31/X1
5,500 5,500
Moore Company Income Statement for the year ended 12/31/X2
Other revenues and expenses:

Realized gain on sale of trading securities Unrealized gain - trading securities $ $ 600 5,500 6,100
12/31/X2: Historical cost (700 x $30) FMV at 12/31/X2 (700 x $35) Adjustment
GE
$21,000 $24,500 $ 3,500
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B. Available-for-sale securities: 1. Entry to record the sale of 300 GE shares at $32/share:

Cash (300 x $32) Investment in Available-for-Sale Securities Realized Gain on Sale of Available-for-Sale Securities * $30 x 300 shares = $9,000 9,600 9,000* 600
2.
Assets: Stockholders' Equity:
Moore Company Balance Sheet 12/31/X2 $ 24,500
Investment in available-for-sale securities, at market Accumulated other comprehensive income: Unrealized gain on available for sale securities
Unrealized Gain/Loss - Available-for-Sale Securities
12/31/X1 2,000 5,500 3,500 Adjusting entry 12/31/X2
12/31/X2 adjusting entry to reflect market value of investment:

Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities 5,500 5,500
$ 3,500

2,000 Adjusting entry 12/31/X2 5,500 3,500 12/31/X1
12/31/X2: Historical cost (700 x $30) FMV at 12/31/X2 (700 x $35) Adjustment
GE
$21,000 $24,500 $ 3,500
Moore Company Income Statement for the year ended 12/31/X2 Other revenues and expenses: Realized gain on sale of available-for-sale securities $ 600
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11-6
Equity Method of Accounting

The required approach when a company acquires significant influence over the affairs of another company. Significant influence is presumed when 2050% of a company's outstanding common stock is owned, although other criteria may be considered when making this determination.
Under the equity method: 1. An investment in the securities of another company is initially recorded at its cost. 2. That cost is then subsequently adjusted up for the investor's percentage interest in the company's reported profits and down for its share of reported losses. 3. Any dividend receipts are accounted for as reductions in the investment's adjusted cost. 4. No year-end adjustment is made for changing stock values unless a permanent decline occurs. 5. Upon sale of shares, the difference between net proceeds received and the stocks' book value (adjusted cost) is recorded as a realized gain or loss.
Question: Why might a company experiencing declining values on newly purchased equity securities be inclined to classify them as available-for-sale rather than trading securities regardless of their future plans?
Answer: Classification as available-for-sale securities would allow the company to exclude any unrealized losses from its income statement and EPS calculations. The inclusion of those losses in reported net income might negatively influence the public's perception of management performance and cause a decline in the company's stock valuation.
What kind of problem might this present to the company's auditor?

Answer: Since accounting for unrealized gain and losses depends on management intent, auditors may be forced to rely on management's word rather than any tangible evidence in expressing an opinion on the appropriateness of the company's financial reporting. An auditor might look to a company's past trading history, current liquidity and future cash flow projections to try and verify management's stated intent, but ultimately a certain degree of trust will have to be involved.
The key elements in this equity method approach are the adjustments made the investment's cost for percentage interests in reported profits and losses, along with reductions made for dividend receipts.
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Example: Assume Bass Enterprises buys significant influence over a supplier of merchandise with the 40% purchase of its outstanding common stock for $200,000 cash.
Investment in Equity Method Securities Cash 200,000 200,000
The supplier's reported profits for the year totaled $30,000.

Investment in Equity Method Securities Investment Revenues (40% x $30,000) 12,000 12,000
A $5,000 cash dividend is received on the investment.

Cash Investment in Equity Method Securities 5,000 5,000
When a company buys more than 50% of another company's stock or otherwise has effective control over its operations, then consolidated financial statements are prepared in which all of the assets, liabilities, revenues and expenses of the subsidiary are combined on the financial statements of the parent company.
The entire investment is sold for $230,000 cash.

Cash Investment in Equity Method Securities Gain on Sale of Investment
* $200,000 + $12,000 - $5,000 = $207,000
230,000 207,000* 23,000
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Problem #11-5
Comparison of Methods of Accounting for Investments in Equity Securities
Comparison of Methods of Accounting for Investments in Equity Securities
During the year 20X8, Jordan, Inc. purchased 20% of the common stock of Carson Corporation at a price of $112,000, net of all brokerage fees. Assuming:
1. Carson's reported net income for the year amounted to $60,000. 2. Jordan received $6,000 of cash dividends on its investment in the Carson stock. 3. The Carson shares have a $120,000 market value at the end of the year. 4. Jordan had no other investments in securities during the year.
A. Available-for-sale securities
Purchased securities:
Investment in Available-for-Sale Securities Cash 112,000 112,000
Received dividends:
Cash Dividend Revenues 6,000 6,000
Prepare all of Jordan's investment-related entries for the year if the Carson shares:
A. Are classified as available-for-sale securities. B. Provide Jordan with significant influence over Carson's affairs.
Year-end valuation adjustment:

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11-7
B. Significant influence
Purchased securities:
Investment in Equity Method Securities Cash 112,000 112,000
Recognized share of Carson's reported net income:

Investment in Equity Method Securities Investment Revenues (20% x $60,000) 12,000 12,000
Debt Securities
(Bonds issued by other companies or governmental entities.)
Received dividends:
Cash Investment in Equity Method Securities 6,000 6,000
Year-end valuation adjustment:
No entry
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Accounting for an Investment in Bonds

Depends on the company's intent reflected in three possible classifications. Trading Securities: The company's intent is to actively buy and sell bonds to maximize returns on investment. Available-for-Sale Securities: The company's intent is to buy and hold the bonds until future cash needs arise. Held-to-Maturity Securities: The company's intent is to hold the bonds until the final principal payment is received.

Example: On September 30th, 20X6, Damron, Inc. purchased in a secondary market, $100,000 of 8%, 3-year, term bonds with interest payable semi-annually on June 30th and December 31st of each year through maturity on December 31st, 20X7. Upon purchase, Damron paid a price of 97 (97% of the $100,000 face value), plus $2,000 of accrued interest.
Bonds Issued 1/1/X5 Bonds Purchased 6/30 9/30 12/31/X6
$4,000
6/30 $4,000
12/31/X5 $4,000
6/30 $4,000
Bonds Mature 12/31/X7
($2,000) ($97,000)
$4,000
$4,000 $100,000
Journal entry to record the purchase of the bonds:
Investment in Trading Securities Interest Receivable Cash
97,000 2,000
99,000
Bonds purchased at a discount produce a higher effective rate of return than the stated interest rate provided for in the bonds. In fact, bonds are priced at a discount when market interest rates exceed the bond's stated rate. When market rates are lower than the stated interest rate then bonds are priced at a premium. From an accounting standpoint, this $3,000 discount, or additional interest should be recognized or amortized to revenue over the remaining 15-month term of the bonds.
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12/31/X6 interest receipt:

Cash Interest Receivable Interest Revenue 4,000 2,000 2,000
Assume that on 12/31/X6 the fair market value of the bonds, or in other words, the price these bonds could be sold for in a secondary market, has increased from 97 to 101 or 101% of their $100,000 face value.
If Damron sold the bonds at this point in time:

Cash Investment in Trading Securities Realized Gain on the Sale of Trading Securities 101,000 97,600 3,400
12/31/X6 discount amortization:

Investment in Trading Securities Interest Revenue 600 600
Straight-line amortization: $3,000 15 months = $200/month $200 x 3 months = $600 Effective Interest Method: Assuming the $97,000 purchase price produced an effective interest rate of 10.62% compounding semiannually.
Bond Face Value Unamort. Discount Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Discount Amort.
This increase in the value of the bonds to $101,000 is a direct result of decreasing effective interest rates demanded by investors. As market interest rates the value of existing bonds Think of it this way; if bonds bearing 8% interest are attractive when market interest rates are at 8%, consider how much more attractive those bonds are when market interest rates are only 6%. On the other hand, if rates rise to 10%, no one wants 8% bonds unless they're priced at a discount. As market interest rates the value of existing bonds In this case, where the $100,000 of bonds have increased in value from $97,000 in September to $101,000 at the end of December, market interest rates must have decreased making the 8% bonds more attractive to investors.
Period
3 mo. 100,000 - 3,000 = 6 mo. 100,000 - 2,425 = 6 mo. 100,000 - 1,244 =
97,000 x 10.62% x 3/12 = 2,575 - 2,000 = 575 97,575 x 10.62% x 6/12 = 5,181 - 4,000 = 1,181 98,756 x 10.62% x 6/12 = 5,244 - 4,000 = 1,244
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11-8
Assume these bonds increased in value but are not sold based on Damron's belief that short-term interest rates will continue to fall and the bonds will be worth even more in the near future. Given that these bonds are included in the classification of trading securities on the company's balance sheet, an adjustment must be made to reflect these bonds along with all of the other trading securities at their current fair market value. If these bonds are the only trading securities held during the year, Adjusting entry at 12/31/X6:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities
FMV of bonds Historical cost Difference $101,000 $ 97,600 $ 3,400
Damron, Inc Balance Sheet 12/31/X6
Assets:
Investment in trading securities Add: Market adjustment Damron, Inc Income Statement for the year ended 12/31/X6 $ 97,600 3,400 $101,000
3,400 3,400
Other revenues and expenses:

Interest revenues Unrealized gain - trading securities $ $ 2,600 3,400 6,000

12/31/X5 Adjusting entry 12/31/X6 0 3,400 3,400
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Investment in Bonds Classified as Available-for-Sale Securities

In this case, the accounting is exactly the same as it was for bonds classified as trading securities, except for the disclosures required for unrealized gains or losses on changing bond values over time. When accounting for bonds classified as available-for-sale securities, the total net unrealized gain or loss on stocks and bonds included in that classification is reported on a cumulative basis in the owners' equity section of the company's balance sheet.
Held-to-Maturity Securities
The accounting for an investment in bonds classified as held-tomaturity securities is exactly the same as it is for trading and available-for-sale securities except that no adjustment is made to reflect the bonds at their current fair market value at the end of an accounting period. As a result, no unrealized gains or losses are ever recorded.
Upon final collection of the principal:
Cash Investment in Held-to-Maturity Securities XXX XXX
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Problem #11-6
3/1/X5: Bond purchase-

49,000 500 49,500 1,500 500 1,000 400 400
Investment in Held-to-Maturity Securities Interest Receivable ($50,000 x 6% x 2/12) Cash
On 3/1/X5, Otto, Inc. paid $49,000 (yielding 8.53% effective interest) plus accrued interest to acquire $50,000 of previously issued, 6% term bonds, maturing on December 31st of the current year. Assuming the bonds are held to maturity and semi-annual interest payments are received on June 30th and December 31st, prepare all of Otto's bond-related entries for the year-ended 20X5.
6/30/X5: Interest receiptCash ($50,000 x 6% x 6/12) Interest Receivable Interest Revenue
Discount amortization*Investment in Held-to-Maturity Securities Interest Revenue
Straight-line amortization: $1,000 discount 10 months = $100/month $100 x 4 months = $400

Effective Interest Method:
Period Bond Face Value Unamort. Discount Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Discount Amort.
4 mo. 50,000 - 1,000 = 49,000 x 8.53% x 4/12 = 1,393 - 1,000 = 393 6 mo. 50,000 607 = 49,393 x 8.53% x 6/12 = 2,107 - 1,500 = 607 * This entry on 6/30 is not mandatory. A single entry made on 12/31/X5 for the full $1,000 discount would be an acceptable alternative under both methods.
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11-9
Problem #11-7
12/31/X5: Interest receiptCash Interest Revenue 1,500 1,500

On May 1, 20X5, ATT issued bonds with a total face value of $100,000,000 bearing interest at 8%. The bond indenture provides for interest payments to be made on 11/1 and 5/1 of each year through maturity, May 1, 20X9. Prepare journal entries on the dates noted below from the standpoint of an investor acquiring $20,000 of the ATT bonds for $20,480 on the date of issuance yielding an effective interest rate of 7.3%. (Assume the bonds are classified as available-for-sale securities.)
Discount amortizationCash Interest Revenue 1,500 1,500
Straight-line amortization: $100 x 6 months = $600

Period Bond Face Value Unamort. Discount Carrying Value of Investment
1. 2. 3. 4.
Bond issuance on 5/1/X5. Collection of interest and effective interest amortization of the bond premium on 11/1/X5. Adjusting entry(ies) required for the bond interest earned on 12/31/X5. Adjusting entry at 12/31/X5 assuming an existing $4,000 credit balance in the investor's market adjustment account and the following information:
Available-for-Sale Securities
Effect. Rate Effect. Interest Stated Interest Discount Amort.
GM Stock GE Stock ATT Bonds Total
4 mo. 6 mo.
50,000 - 1,000 = 50,000 607 =
49,000 x 8.53% x 4/12 = 1,393 - 1,000 = 49,393 x 8.53% x 6/12 = 2,107 - 1,500 =
393 607
Receipt of principal:
Cash Investment in Held-to-Maturity Securities 50,000 50,000
Historical cost $15,000 $19,000 $20,410 $54,410 FMV at 12/31/X5 $13,000 $17,000 $22,000 $52,000 5. Collection of interest and amortization of the bond premium on 5/1/X6. 6. Sale of the bonds on 5/1/X6 at a price of 105. 7. Adjusting entry at 12/31/X6 given the following information: Available-for-Sale Securities
GM Stock GE Stock Total
Historical cost FMV at 12/31/X6
$15,000 $17,000
$19,000 $20,000
$34,000 $37,000
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Problem #11-7
Questions: A. What is the balance in the investor's Unrealized Gain/Loss - Availablefor-Sale Securities account at 12/31/X6 and where does it appear on the company's financial statements? B. If the ATT bonds had been classified with the investor's trading securities, how would the accounting in this problem have been different? C. Why is no adjustment made for current year-end fair market values when bonds are classified as held-to-maturity securities?

1. Bond issuance on 5/1/X5.
Investment in Available-for-Sale Securities Cash 20,480 20,480
2. Collection of interest and straight-line amortization of the bond premium on 11/1/X5.

Cash (20,000 x 8% x 6/12) Interest Revenues Interest Revenues Investment in Available-for-Sale Securities 800 800 52 52

Period Bond Face Value Unamort. Premium Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Premium Amort.
6 mo.
20,000 +
480
20,480 x
7.3%
x 6/12 =
748
800
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3. Adjusting entry(ies) required for bond interest earned on 12/31/X5.

Interest Receivable (20,000 x 8% x 2/12) Interest Revenues Interest Revenues Investment in Available-for-Sale Securities 267 267 18 18
4. Adjusting entry at 12/31/X5 assuming a $4,000 credit balance in the investor's market adjustment account and the following information: Available-for-Sale Securities
GM Stock GE Stock ATT Bonds Total

Period Bond Face Value Unamort. Premium Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Premium Amort.
$15,000 $13,000
$19,000 $20,410 $17,000 $22,000 Difference
$54,410 $52,000 ($2,410)

4,000 Adjusting entry 1,590 2,410 12/31/X5 12/31/X5
6 mo. 6 mo.
20,000 + 20,000 +
480 428
= =
20,480 x 20,428 x
7.3% 7.3%
x 6/12 = x 6/12 =
748 746
800 800
= =
52 54
Amortization for two months of 2nd 6-month period: $54 x 2/6 = $18 Adjusting entry:
Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities
1,590 1,590
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5. Collection of interest and amortization of the bond premium on 5/1/X6.

Cash (20,000 x 8% x 6/12) Interest Receivable Interest Revenues Interest Revenues Investment in Available-for-Sale Securities 800 267 533 36 36
6. Sale of the bonds on 5/1/X6 at a price of 105.

Cash Investment in Available-for-Sale Securities Realized Gain on the Sale of Available-for-Sale Securities 21,000 20,374 626
ATT Bonds

Period Bond Face Value Unamort. Premium Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Discount Amort.
5/1/X5
20,480 52 18 11/1/X5 12/31/X5 5/1/X6
6 mo. 6 mo.
20,000 + 20,000 +
480 428
= =
20,480 x 20,428 x
7.3% 7.3%
x 6/12 = x 6/12 =
748 746
800 800
= =
52 54
12/31/X5 5/1/X6
20,410 36 20,374
Amortization for last four months of 2nd 6-month period: $54 x 4/6 = $36
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Questions:
7. Adjusting entry at 12/31/X6 given the following information: Available-for-Sale Securities
GM Stock GE Stock Total
A. What is the balance in the investor's Unrealized Gain/Loss - Availablefor-Sale Securities account at 12/31/X6 and where does it appear on the company's financial statements?
Answer: The unrealized gain or loss account is a balance sheet account that maintains a corresponding balance to the investment's market adjustment account, except that it's opposite in terms of debits and credits. Given this market adjustment account balance at 12/31/X6,
4,000 Adjusting entry Adjusting entry 12/31/X6 1,590 2,410 5,410 3,000 12/31/X5 12/31/X5
$15,000 $19,000 $17,000 $20,000 Difference
$34,000 $37,000 $ 3,000

4,000 Adjusting entry Adjusting entry 12/31/X6 1,590 2,410 5,410 3,000 12/31/X5 12/31/X5
Adjusting entry:
the unrealized gain/loss account balance has a credit balance or cumulative gain to date of $3,000, appearing as part of the company's accumulated other comprehensive income in the owners' equity section of its balance sheet.
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Problem #11-8
Question
B. If the ATT bonds had been classified with the investor's trading securities, how would the accounting in this problem have been different?
Answer: Besides the use of different account titles, the bonds would have been excluded from any adjustment of available-for-sale securities to their FMV and included in any adjustment for the company's trading securities. That means the change in the difference between the bonds' adjusted historical cost and FMV would have been included in the company's income statement and ending retained earnings balance.
If you thought interest rates were going to increase in the future, would you buy bonds today?
C. Why is no adjustment made for current year-end fair market values when bonds are classified as held-to-maturity securities?
Answer: No adjustment is made because no gain or loss will ever be incurred if the bonds are held to maturity. Ultimately the full book value of the bonds will be collected at maturity.,
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Question If you thought interest rates were going to increase in the future, would you buy bonds today?
Answer: It depends. If you plan to sell the bonds prior to maturity, then the value of the bonds will decrease as interest rates rise and a loss will be incurred upon sale. That loss will offset a portion of interest earned and reduces the investment's overall return. If you plan to hold the bonds to maturity, then no gain or loss will be incurred but you will earn a lower interest rate over the term of the bonds than you would have otherwise earned if you had waited for rates to rise before making the investment. The problem with waiting, however, is that no interest is earned prior to the bond purchase unless an alternative investment can be made in the interim. If, however, an investor plans to hold a bond to maturity and is satisfied in earning today's effective interest rate over the term of the bonds, then an investment today probably makes sense.
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Lesson 14
The accurate determination of a company's product costs provides managers with valuable information that can be used in a variety of ways to improve a company's performance. It's especially useful in helping management control its product costs. For example, a simple comparison of a company's costs per unit of production from one period to the next might highlight increasing costs that could be easily avoided through more focused management effort.
Lesson 14
Standard Costs and Responsibility Accounting
Although this simple monitoring of changing costs over time can be an effective tool in helping managers control costs, an additional and probably even more useful approach would involve the comparison of current costs with some budgeted amount reflecting management's goals and expectations. When comparing actual costs over time, increases and decreases can be identified and acted upon, but there's no assurance that any prior month's costs represent a benchmark or standard of what management believes is the lowest cost possible under the circumstances. All a comparison with prior costs does is indicate whether those costs have gone up or down. That's important to know, but its even more important to know how those costs compare to what management thinks those costs really should be if the company was operating at the highest level of performance possible.
Standard Costs
Standard costs represent management's goals relative to a product's cost per unit of production. In most cases, those costs are determined based on the combined input of all of a company's managers having some responsibility or control over product costs, including managers involved in product design, raw material purchases, the hiring of production personnel and the general operation of the production department. In addition, a company's general manager and controller will also usually be involved in the final determination of a product's standard cost. In effect, standard costs are a company's budgeted costs per unit of production.
Perry Shirt Manufacturing Standard Cost Card - Basic Extra-Large Men's T-Shirt
Standard Quantity Standard Price or Rate Cost/Unit
In the establishment of a product's standard costs, should those standards be set at levels that reflect ideal performance that will seldom if ever be achieved, or should they be set at more reasonable levels? Most companies choose "tight but attainable" standards on the belief that such standards can actually have a greater motivating influence on employees. When actual performance is compared against attainable standards, any resulting unfavorable variances highlight opportunities for improvement. If unrealistically high standards are set, then unfavorable variances become the norm rather than the exception, and, as a result, such variances lose their significance as a managerial tool.
Direct materials Direct labor Mfg. overhead *
1.5 yards (Grade A cotton fabric) .10 hour .10 hour
x x x
$1.40/yd.* $16/hr. $8/hr. Total
= = =
$2.10 $1.60 $ .80 $4.50
Includes the purchase price plus any freight and other costs associated with the purchase and receipt of the materials used.
"Management by Exception"
An approach that emphasizes the comparison of actual results to standards, budgets and other expected or desired measures of performance to highlight deviations that call for management attention.
A comparison of standard versus actual costs incurred in Perry Shirt Manufacturing's production of its Basic Extra-Large Men's T-Shirt in the month of October, 20X5. Actual Costs/October
Production Costs # Units Produced Cost per Unit Quantity Usage Quantity per Unit Price or Rate
Direct materials Direct labor Manufacturing Overhead Total
$240,000 $165,000 $ 87,000 $492,000
100,000 100,000 100,000
$2.40 $1.65 $ .87 $4.92
160,000 yds. 11,000 hours 11,000 hours
1.6 yds. .11 hr. .11 hr.
$1.50/yd. $15.00/hr. $7.91/hr.
Standard Cost Card - Basic Extra-Large Men's T-Shirt

Direct materials Direct labor Mfg. overhead
1.5 yards .10 hour .10 hour
$1.40/yd. $16/hr. $8/hr. Total Variance Analysis = = = = =

Variance per Unit
x x x
= = =
$2.10 $1.60 $ .80 $4.50
Actual Cost/Unit
Total Breakdown: Direct materials Direct labor Mfg. overhead
$4.92 $2.40 $1.65 $ .87
Standard Cost/Unit
# Units
$4.50 $2.10 $1.60 $ .80
$.42 (U) $.30 (U) $.05 (U) $.07 (U)
x Produced x 100,000 x x x 100,000 100,000 100,000
Variance = = $42,000 (U)
= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)
14-1
Who is it in the company's management that's really responsible for this direct material variance? That depends. It depends on whether this variance is the result of higher than expected material prices or the use of excess materials in the production process. If the variance is the result of higher than expected prices, then the company's purchasing manager will probably be the one responsible for addressing this variance and improving the company's future performance. On the other hand, if the problem was due to excess material usage, then the production manager is probably the one responsible for solving this problem. What we really need to do here is figure out what portion, if any, of this $30,000 variance is attributable to higher than expected prices and what portion is due to excess material usage.
Actual Costs/October
$240,000 $165,000 $ 87,000 $492,000
100,000 100,000 100,000
$2.40 $1.65 $ .87 $4.92
160,000 yds. 11,000 hours 11,000 hours
1.6 yds. .11 hr. .11 hr.
$1.50/yd. $15.00/hr. $7.91/hr.

x x x
$1.40/yd. $16/hr. $8/hr. Total
= = =
$2.10 $1.60 $ .80 $4.50
Variance Analysis
Actual Cost/Unit
$4.92 $2.40 $1.65 $ .87
Standard Cost/Unit
$4.50 $2.10 $1.60 $ .80
= = = = =
Variance per Unit
# Units
$.42 (U) $.30 (U) $.05 (U) $.07 (U)
x Produced x 100,000 x x x 100,000 100,000 100,000
Variance = = $42,000 (U)
= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)
Materials Price Variance ( Actual Price - Standard Price ) ( $1.50/yd. - $1.40/yd. ) $.10/yd. x Actual Quantity x 160,000 yds.
$16,000 Unfavorable Materials Quantity (Usage) Variance ( Actual Quantity - Standard Quantity ) ( 160,000 yd. - 150,000 yd.* ) 10,000 yd. $14,000 Unfavorable * Based on the standard of 1.5 yards per shirt x 100,000 shirts produced. x x Standard Price $1.40/yd.
These variances are then separately accounted for through a journal entry made to record the transfer of direct materials from raw materials inventory to WIP:
WIP Inventory ($1.40/yd. x 150,000 yds.) Materials Price Variance ($ .10 x 160,000 yds.) Materials Quantity Variance (10,000 yds. x $1.40) Raw Materials Inventory ($1.50/yd. x 160,000 yds.) 210,000 16,000 14,000 240,000
These variance accounts serve a useful managerial purpose, but for financial reporting purposes, any balances in these variance accounts at the end of the period must be closed out to either WIP, finished goods and/or cost of goods sold, based on the relative amount of direct materials included in the ending balances of those accounts. In actual practice, the total amounts of these variances are usually closed out to cost of goods sold based on the fact that most of a company's WIP inventory is completed and sold by the end of the period. However, when that's not the case, an allocation of some portion of these variance amounts should be made to WIP and finished goods as well as cost of goods sold.
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Our ultimate goal here is to use this variance information to better control the company's product costs. That requires a company's management to identify and act on the underlying causes behind those variances. For Perry Shirt Manufacturing, the company's unfavorable materials price variance could be the result of higher than expected supplier prices, failure to take advantage of available volume or purchase discounts, and/or as higher than expected freight costs. Generally speaking, the company's purchasing manager would be the one responsible for investigating and ferreting out the source of this unfavorable variance, and then taking action, if possible, to improve the company's future performance. However, in some cases, higher material prices and freight costs result from rush orders caused by poor production planning. In that case, the responsibility for this variance might properly fall to the company's production manager. Unfavorable material quantity variances typically reflect higher than expected material waste or spoilage in the production process incurred as a result of untrained workers, poor supervision, malfunctioning equipment and/or the use of inferior materials. In most cases, the production manager is the one to address these problems; however, responsibility for inferior materials might rest with a company's purchasing department. In some cases, a company's price and quantity standards may simply be unrealistic. In those cases, more reasonable standards should be considered to produce variances that highlight real opportunities for improved performance.
Labor Rate Variance ( Actual Rate ( $15/hr. - Standard Rate ) x - $16/hr. ) x $1/hr. $11,000 Favorable Actual Hours 11,000 hrs.
Labor Efficiency (Quantity) Variance ( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $16,000 Unfavorable Standard Rate $16/hr.
* .10 standard hours per shirt x 100,000 shirts produced.
Journal entry to record these labor costs:

WIP Inventory ($16/hr. x 10,000 hrs.) Labor Efficiency Variance 1,000 hrs. x $16 hrs. Labor Rate Variance $1 x 11,000 hrs. Cash or Wages Payable ($15/hr. x 11,000 hrs.) 160,000 16,000 11,000 165,000
These variance accounts are, in effect, temporary accounts used to highlight variances for management use, but at the end of the period they must be closed out to WIP, finished goods and/or cost of goods sold as appropriate to reflect those amounts at their actual cost. In most cases, these accounts are simply closed out to cost of goods sold.
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14-2
Problem 14-1
In most cases, an unfavorable labor efficiency variance results when employees lack proper supervision, are poorly trained or lack adequate motivation. In addition, equipment breakdowns, poor quality of materials and unreasonable standards can contribute to unmet goals in terms of labor hours. Generally speaking, a company's production manager assumes responsibility for addressing these variances as long they fall within his/her control. However, if inferior materials are the cause of production slowdowns, then the purchasing manager is probably the one to follow up on that problem. Labor rate variances often result when a company uses higher or lower skilled employees for certain production jobs. In this case, Perry's favorable labor rate variance may be the result of lower skilled and lower paid employees put to work in tasks that typically require higher skilled employees. If that's true, then that may also explain the cause behind the higher than expected labor hours worked during the period. Lower skilled workers will usually take more time to complete a task. If that's the case, then the labor rate and efficiency variances should probably be evaluated on a combined basis to determine their net affect on the company's profits. In some cases, unfavorable labor rate variances are caused by higher than expected overtime pay or the unplanned use of higher paid temporary employees. If that's the result of poor production planning then a company's production manager will assume responsibility for future improvement. However, if production scheduling is complicated by inaccurate sales forecasts then improved projections from the company's sales manager may be the solution to this problem.
Material and Labor Variances

Given the following information for Carmack, Inc. for the month of June, 20X8:
Actual costs incurred in the production of 400 units: $ 7,000 Direct materials purchased (1,000 lbs. at $7/lb.) 900 lbs. Direct materials used $11,000 Direct labor incurred (550 hours at $20/hr.) Standard costs per unit: Direct materials (2lbs. at $7.50/lb.) Direct labor (1.4 hours. at $18/hr.) $15.00 $25.20
Determine the company's: a. Materials price variance recorded at the time of purchase. b. Material quantity variance. c. Labor rate variance. d. Labor efficiency variance. Prepare journal entries to record the company's purchase and use of materials as well as its labor costs so that all inventories are carried at standard and all variances are separately recorded. Prepare closing entries for all of the recorded variances assuming they are all closed to cost of goods sold at the end of the period.
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a. Materials price variance recorded at the time of purchase:
( Actual Price - Standard Price ) ( $7.00/lb. - $7.50/lb. ) $ .50/lb. $500 Favorable x Actual Quantity x 1,000 lbs. x 1,000 lbs.

c. Labor rate variance:
( Actual Rate ( $20/hr. - Standard Rate ) x - $18/hr. ) x x $2/hr. $1,100 Unfavorable Actual Hours 550 hrs. 550 hrs.
b. Material quantity variance:

( Actual Quantity ( 900 lbs. - Standard Quantity ) - 800 lbs.* ) 100 lbs. $750 Unfavorable * 2 lbs. per unit x 400 units produced. x x x Standard Price $7.50/lb. $7.50/lb.
d. Labor efficiency variance:

( Actual Hours ( 550 hrs. - Standard Hours ) - 560 hrs.* ) 10 hrs. $180 Favorable x x x Standard Rate $18/hr. $18/hr.
* 1.4 standard hours per unit x 400 units produced.
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Journal entry to record the purchase of materials:

Raw Materials Inventory $7.50/lb. x 1,000 lbs. Materials Price Variance $.50 x 1,000 lbs. Cash or A/P $7.00/lb. x 1,000 lbs. 7,500 500 7,000
Closing entries:
Materials Price Variance Cost of Goods Sold Cost of Goods Sold Materials Quantity Variance Cost of Goods Sold Labor Rate Variance
500 750 1,100 180
500 750 1,100 180
Journal entry to record the use of materials:

WIP Inventory 800 lbs. x $7.50/lb. Materials Quantity Variance 100 lbs. x $7.50/lb. Raw Materials Inventory 900 lbs. x $7.50/lb. 6,000 750 6,750
Labor Efficiency Variance Cost of Goods Sold

Or combined closing entry:
Journal entry to record labor costs:

WIP Inventory $18/hr. x 560 hrs.* Labor Rate Variance $2/hour x 550 hrs. Labor Efficiency Variance 10 hrs. x $18/hr. Cash or Wages Payable $20/hr. x 550 hrs. * 1.4 standard hours per unit x 400 units. 10,080 1,100 180 11,000
Materials Price Variance Labor Efficiency Variance Cost of Goods Sold Materials Quantity Variance Labor Rate Variance
500 180 1,170 750 1,100
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14-3
Problem 14-2
Problem 14-2

Given the following information for Harkin Company.
Actual results: Number of direct material yards purchased Total cost of direct labor incurred Total cost of direct material yards purchased Number of units produced Number of direct material yards used Direct labor rate per hour Standard costs: Price per yard of direct materials Number of direct material yards per unit Direct labor rate per hour Number of direct labor hours per unit 20,000 yards. $46,000 $84,000 12,000 units 22,000 yards $23.00 $4.00 1.5 yards $21.00 0.15 hours

Given the following information for Harkin Company.
Actual results: Number of direct material yards purchased Total cost of direct labor incurred Total cost of direct material yards purchased Number of units produced Number of direct material yards used Direct labor rate per hour Standard costs: Price per yard of direct materials Number of direct material yards per unit Direct labor rate per hour Number of direct labor hours per unit 20,000 yards. $46,000 $84,000 12,000 units 22,000 yards $23.00 $4.00 1.5 yards $21.00 0.15 hours
Determine the company's: a. Materials price variance recorded at the time of purchase. b. Material quantity variance. c. Labor rate variance. d. Labor efficiency variance.
Questions: Who would typically be responsible for a company's unfavorable materials price variance and what might be some of the causes for that variance? Who would typically be responsible for a company's unfavorable materials quantity variance and what might be some of the causes for that variance?
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a. Materials price variance recorded at the time of purchase:
( Actual Price - Standard Price ) ( $4.20/yd - $4/yd. ) $ .20/yd x Actual Quantity x 20,000 yds. x 20,000 yds.

c. Labor rate variance:
( Actual Rate ( $23/hr. - Standard Rate ) x - $21/hr. ) x x $2/hr. $4,000 Unfavorable Actual Hours 2,000 hrs. 2,000 hrs.
$4,000 Unfavorable
b. Material quantity variance:

( Actual Quantity - Standard Quantity ) ( 22,000 yds. - 18,000 yds.* ) 4,000 yds. $16,000 Unfavorable * 1.5 standard yards per unit x 12,000 units produced. x x x Standard Price $4/yd. $4/yd.
d. Labor efficiency variance:

( Actual Hours ( 2,000 hrs. - Standard Hours ) x - 1,800 hrs.* ) x x 10 hrs. $4,200 Unfavorable Standard Price $21/hr. $21/hr.
* .15 standard hours x 12,000 units produced.
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Questions: Who would typically be responsible for a company's unfavorable materials price variance and what might be some of the causes for that variance? Answer: Generally speaking a company's purchasing manager is responsible for any unfavorable materials price variance.
Because material prices may depend on the supplier used, the number of units purchased, payment terms, and the mode and timing of delivery, some common causes of this variance might be: 1. Higher than expected supplier prices. 2. Failure to take advantage of volume or purchase discounts. 3. Higher than expected freight costs. In some cases higher prices and delivery costs may be associated with rush orders that are actually the result of poor production scheduling. In that case the production manager would be the responsible party rather than the purchasing manager. Sometimes this variance is simply the result of unreasonable standards.
Questions: Who would typically be responsible for a company's unfavorable materials quantity variance and what might be some of the causes for that variance? Answer: Generally speaking a company's production manager is responsible for any unfavorable materials quantity variance.
In most cases this variance indicates higher than expected material waste or spoilage resulting from inexperienced and untrained workers, poor planning and supervision, and/or mechanical breakdowns in the production process. In the event waste or spoilage is the result of poor quality materials, then the purchasing manager may be the one responsible for the failure to meet expectations. In some cases, the company's standards may simply be unreasonable.
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14-4
Perry Shirt Manufacturing

Actual Costs/October Basic Extra-Large Men's T-Shirt
Manufacturing Overhead
Actual costs 87,000 80,000 Application to WIP ($8/hr. 10,000 hrs. *) * .10 hrs/unit 100,000 units
$240,000 $165,000 $ 87,000 $492,000
100,000 100,000 100,000
$2.40 $1.65 $ .87 $4.92
160,000 yds. 11,000 hours 11,000 hours
1.6 yds. .11 hr. .11 hr.
$1.50/yd. $15.00/hr. $7.91/hr.

Under-applied overhead (Unfavorable variance)
7,000 7,000 0 Closing entry

Variance per Unit
x x x
= = =
$2.10 $1.60 $ .80 $4.50
Closing entry:
Actual Cost/Unit
$4.92 $2.40 $1.65 $ .87
Standard Cost/Unit
# Units
$4.50 $2.10 $1.60 $ .80
$.42 (U) $.30 (U) $.05 (U) $.07 (U)
x Produced x 100,000 x x x 100,000 100,000 100,000
Variance = = $42,000 (U)
Cost of Goods Sold Manufacturing Overhead
7,000
7,000
= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)
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Standard = $8/hr. predetermined x .10 hrs/unit = $ .80/unit Overhead Cost overhead rate
Which of the company's various overhead costs exceeded management's budgeted goals?
To answer that question, we're going to need a further breakdown of the $7,000 variance, which requires a more detailed breakdown of both the company's standard and actual manufacturing overhead costs.
Predetermined = Overhead Rate
Total budgeted overhead costs for the upcoming period Total budget for a measurable activity or cost that correlates with or drives overhead costs over the same period of time
In this case, we'll assume the company's $8 rate was determined at the beginning of the year (20X5) based on management's budgeted costs and direct labor hours for the upcoming year. We'll also assume the company plans to produce 960,000 shirts during the course of the year, and based on that amount, has budgeted manufacturing overhead costs at a total of $768,000. In addition, the company's budgeted direct labor hours, based on its .10 standard direct labor hours per unit, comes to 96,000 hours. Given that information:
$8/hr. =
$768,000 96,000 hours
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Detailed Manufacturing Overhead Budget For the year, 20X5

Budget per Hour Total Budgeted Hours Total Budgeted Costs
Variable Manufacturing Overhead Variances October

Actual
Costs* Hours Rate/hr. Rate/hr.
Standard/Budget
Hours Costs
Variable costs per hour: Indirect materials Factory utilities Repairs and maintenance Total variable
$1.00/hr. 2.00/hr. .50/hr. $3.50/hr.

Budget per Month
x x x
96,000 hrs. 96,000 hrs. 96,000 hrs.
= = =
$ 96,000 192,000 48,000 $336,000
Variable costs: x 10,000** $14,000 - 11,000 = $1.27 $1.00 Indirect materials x 10,000 21,000 - 11,000 = 1.91 2.00 Factory utilities x 10,000 15,000 - 11,000 = 1.36 .50 Repair/maintenance $50,000 $4.54 $3.50 Total variable * Actual costs incurred in the company's production of 100,000 shirts. ** 100,000 shirts at a standard of .10 hours per shirt
= = =
$10,000 20,000 5,000 $35,000
Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable
Variable Manufacturing Overhead Spending Variance

x x x 12 months 12 months 12 months = = = $240,000 48,000 144,000 $432,000 $768,000 ( Actual Rate ( $4.54/hr. - Standard Rate ) x - $3.50/hr. ) x $1.04/hr. $11,440 Unfavorable
($11,500 if no rounding error)
Fixed costs per month: Indirect labor Equipment depreciation Building rent Total fixed costs Total costs
Actual Hours 11,000 hrs.
$20,000/mo. 4,000/mo. 12,000/mo. $36,000/mo.
Variable Manufacturing Overhead Efficiency (Quantity) Variance

( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $3,500 Unfavorable Standard Rate $3.50/hr.
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14-5

Actual
Costs* Hours Rate/hr. Rate/hr.

Actual
Costs Costs* Hours Rate/hr. Rate/hr.
Standard/Budget
Hours
Standard/Budget
Hours Costs
= = =
$10,000 20,000 5,000 $35,000
= = =
$10,000 20,000 5,000 $35,000
Indirect Materials Spending Variance

( Actual Rate ( $1.27/hr. - Standard Rate ) x - $1.00/hr. ) x $ .27/hr. $2,970 Unfavorable
Repairs and Maintenance Spending Variance

( Actual Rate ( $1.36/hr. - Standard Rate ) x - $ .50/hr. ) x $ .86/hr. $9,460 Unfavorable
Indirect Materials Efficiency Variance

( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $1,000 Unfavorable Standard Rate $1.00/hr.
Repairs and Maintenance Efficiency Variance

( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $500 Unfavorable Standard Rate $ .50/hr.
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Fixed Manufacturing Overhead Variances October

Fixed costs: Indirect labor Equip. depreciation Building rent Total fixed costs
Actual Costs Standard/ Budgeted Costs
Costs Applied to WIP
Summary of Total Manufacturing Overhead Variances October
$20,000 5,000 12,000 $37,000
$20,000 4,000 12,000 $36,000
$45,000*
Fixed Manufacturing Overhead Budget Variance = $1,000 Unfavorable Fixed Manufacturing Overhead Volume Variance = $9,000 Favorable**
* Fixed manufacturing overhead costs that were included in the company's total application of overhead to WIP during the period. That amount's based on: Total application of overhead ($8.hr. x 10,000 hours) Deduct: Applied overhead attributable to variable costs ($3.50/hr. x 10,000 hours) Fixed costs included in the application of overhead to WIP $80,000 (35,000) $45,000
Variable: Spending variance Efficiency variance Fixed: Budget variance Volume variance Total
$11,500 (U) 3,500 (U) 1,000 (U) 9,000 (F) 7,000 (U) *
* The difference between the total actual overhead costs incurred and the total standard overhead cost applied to WIP.
** Reflects the benefit of having fixed costs in a period of higher than expected production volume. A company's fixed cost per unit goes down with increasing volume. That's because a company's fixed costs are effectively spread out over more units, resulting in a lower cost per unit. In this case, the company's average monthly production was budgeted at 80,000 shirts per month (960,000 total shirts 12 months). However, in the month of October, the company's actual production was 100,000 shirts, which effectively reduced the company's fixed costs per unit for the period.
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Actual Costs/October Basic Extra-Large Men's T-Shirt
Problem 14-3
Variable Manufacturing Overhead Variances

Given the following information for Harper, Inc. in the year 20X6:
Budgeted amounts for the year:
Total direct labor hours Total variable manufacturing overhead costs Total fixed manufacturing overhead costs Total units of production 200,000 hours $400,000 $300,000 10,000 units 1,000 units 800 units $34,200 $26,500 15,000 hours
1.6 yds. .11 hr. .11 hr. $1.50/yd. $15.00/hr. $7.91/hr.
$240,000 $165,000 $ 87,000 $492,000
100,000 100,000 100,000
$2.40 $1.65 $ .87 $4.92
160,000 yds. 11,000 hours 11,000 hours

Data provided for the month of March:

Budgeted units of production Actual number of units produced Actual variable manufacturing overhead costs Actual fixed manufacturing overhead costs Actual direct labor hours worked

Variance per Unit
x x x
= = =
$2.10 $1.60 $ .80 $4.50
Determine the following for the month of March assuming the company applies manufacturing overhead to WIP on the basis of direct labor hours:
A. Variable manufacturing overhead rate used in the application of variable manufacturing overhead costs to WIP inventory. B. Variable manufacturing overhead spending variance. C. Variable manufacturing overhead efficiency variance.
Actual Cost/Unit
$4.92 $2.40 $1.65 $ .87
Standard Cost/Unit
$4.50 $2.10 $1.60 $ .80
$.42 (U) $.30 (U) $.05 (U) $.07 (U)
x x x x x
# Units Produced
100,000 100,000 100,000 100,000
Variance = = $42,000 (U)
= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)
Question: Generally speaking, what causes an unfavorable variable manufacturing overhead efficiency variance?
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14-6
Variable Manufacturing Overhead Variances

A. Variable manufacturing overhead rate used in the application of variable manufacturing overhead costs to WIP inventory.
Variable manufacturing overhead rate: $400,000 200,000 hrs. = $2.00/hr.
Question: Generally speaking, what causes an unfavorable variable manufacturing overhead efficiency variance?
Answer: The basic cause of an unfavorable efficiency variance is a higher than budgeted level of direct labor hours, or other activity or cost serving as the basis for the company's standard predetermined overhead rate. Whether that basis is direct labor hours, machine hours, direct material costs or any other activity or cost that drives the company's manufacturing overhead, an unfavorable variance results if more of those hours or costs are incurred in the production process than would be expected given the company's current level of production.
B. Variable manufacturing overhead spending variance.

( Actual Rate - Standard Rate ) x Actual Hours ( $2.28/hr. - $2.00/hr. ) 15,000 hrs. x $ .28/hr. 15,000 hrs. x $4,200 Unfavorable
C. Variable manufacturing overhead efficiency variance.

( Actual Hours - Standard Hours ) x ( 15,000 hrs. - 16,000 hrs.* ) x 1,000 hrs. x $2,000 Favorable Standard Price $2.00/hr. $2.00/hr.
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Problem 14-4
Closing Variance Accounts

Given the following information for Corbin, Inc. at the end of the year:
Cost of goods sold (before closing entries) . . . . . . $730,000 Labor rate variance . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 favorable Labor efficiency variance . . . . . . . . . . . . . . . . . . . . $9,000 unfavorable Materials price variance . . . . . . . . . . . . . . . . . . . . . $14,000 unfavorable Materials quantity variance . . . . . . . . . . . . . . . . . . $8,000 favorable Over-applied manufacturing overhead . . . . . . . . . . $30,000
Closing entries:
Labor Rate Variance Cost of Goods Sold Cost of Goods Sold Labor Efficiency Variance Cost of Goods Sold Materials Price Variance Materials Quantity Variance Cost of Goods Sold Manufacturing Overhead Cost of Goods Sold 12,000 12,000 9,000 9,000 14,000 14,000 8,000 8,000 30,000 30,000
Compute Corbin's final cost of goods sold for financial reporting purposes assuming the company originally records its inventory and cost of goods sold at standard costs. (Also assume the company's entire WIP inventory is completed and sold as of the end of the year.)
Or combined closing entry:

Labor Rate Variance Materials Quantity Variance Manufacturing Overhead Cost of Goods Sold Labor Efficiency Variance Materials Price Variance 12,000 8,000 30,000 27,000 9,000 14,000
Cost of Goods Sold = $730,000 - $27,000 = $703,000
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Advantages of a Standard Cost System

1. Simply involving various management personnel in the establishment of a company's standard costs can encourage improved communication and coordination among a company's various departments. In fact, the actual process of setting standards can often help identify opportunities for improved performance even before those costs are implemented in a standard cost system. 2. Standards that are viewed as reasonable and achievable can motivate employees to reach higher levels of performance. The key is having standards employees accept and then evaluating performance based on factors within the employee's control. 3. The timely determination of variances between actual and standard costs can help management prioritize and focus their efforts on problem areas that present the greatest opportunities for improvement. 4. The use of standards costs can facilitate the preparation of a company's operating budgets with respect to future purchases of direct materials and projected expenditures for direct labor and manufacturing overhead. Those budgets are crucial in the determination of a company's future cash needs and the use of standard costs can simplify those projections and often improve their accuracy.
Disadvantages and Potential Pitfalls of a Standard Cost System

1. The cost associated with implementation. The process of establishing and regularly updating a company's standard costs can take considerable time and effort, and as a result, the costs of setting up and effectively running a standard cost system can be substantial. 2. Variances between actual and standard costs can often be misinterpreted and misused in a way that can have actually have a negative affect on employee morale. If unfavorable variances are used to browbeat workers rather than identify opportunities for improvement, then the use of standards could ultimately prove to be detrimental to a company's overall performance. 3. In some cases, employee efforts to avoid unfavorable variances can also have unintended consequences. For example, employees seeking to avoid unfavorable labor efficiency variances might seek shortcuts in the manufacturing process that could negatively affect the product's quality. That could lead to customer dissatisfaction and ultimately to declining sales. 4. Meeting a company's established standards may actually discourage continuous improvement if those standards are not set and updated in a way that stretches management's creativity and effort.
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14-7
Responsibility Accounting
Refers to an information system designed to provide reports that assess the performance of management personnel assigned to specific areas of responsibility within the company. Such reports are necessary when companies increase in size and complexity over time leading to the decentralization of management responsibilities. Decentralization refers to the delegation or spreading out of management decision making to lower levels of a company's management personnel.
Benefits of decentralization: 1. Free up top management to concentrate on more important matters involving business strategy. 2. Moves the day-to-day operating decisions to those who are closer to the action and may be in a position to make better decisions. 3. Can improve the job satisfaction of lower level employees and provide enhanced opportunities for their personal growth in the company. Disadvantages of decentralization: 1. Some decisions will be made at lower levels without consideration for the overall affect on the company's goals and objectives. 2. Can make the coordination of operations between a company's various departments more difficult.
In a decentralized company, responsibility accounting is absolutely crucial. Management reports identifying an employee's area of responsibility and his or her performance relative to established standards or goals are invaluable when decision making is dispersed among a large number of employees.
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Clark Clothing International
Cost center - A department or organizational unit in which the assigned manager has control over and is accountable for the costs incurred in the operation of that department or unit.
Far East Operations
Western European Operations
North American Operations
Profit center - A department or organizational unit which has both revenues and costs over which the assigned manager has ultimate control and accountability. Investment center - An organizational unit over which the assigned manager has accountability for the allocation and use of assets as well as revenues and costs.
Burnett Shoes
Jordan Jeans
Sales Department
Production Department
Purchasing Department
Personnel Department
Accounting Department
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Clark Clothing International
Clark Clothing International North American Division Segment-Margin Income Statement October, 20X5
North American Division Burnett Shoes
Segment Breakdown
Perry Shirt Mfg. Jordan Jeans
Western European Operations
North American Operations
Far East Operations
Sales revenues Less: Direct costs of each segment Cost of goods sold Selling and admin. expenses Segment margin/profit Less: Indirect/uncontrollable costs Net income (loss)
$6,972,000 (4,365,000) (1,725,000) 882,000 150,000 $ 732,000
$2,556,000
$828,000
$3,588,000
(1,740,000) (492,000) (2,133,000) (582,000) (90,000) (1,053,000) $ 234,000 $ 246,000 $ 402,000
Burnett Shoes
Jordan Jeans
Total assets Returns on investment (ROI)
$1,170,000 $1,025,000 24% 20%
$1,909,000 22%
Budgeted vs. Actual Income Statement Sales Department Production Department Purchasing Department Personnel Department Variance Reports Accounting Department
Let's also assume that each of these three segments is considered an investment center given that their general managers have responsibility for and control over each subsidiary's assets. In that case, each segment's return on investment or ROI would be a useful measure of performance. Return on Investment (ROI) = Segment Margin Segment Total Assets
If the North American division was given an additional $500,000 for expansion of one or all of its three segments, that money would best be put to use expanding Perry Shirt Manufacturing's operation assuming its manager could continue to generate a comparable rate of return on those additionally invested assets.
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14-8
Let's assume for a moment that Clark Clothing International's overall return on investment, or in other words, return on its total assets invested in all of its division's worldwide, amounted to 14%. Obviously, in that case, the North American division is doing very well compared to the results achieved in the company's other divisions. Let's also assume that the North American general manager has become aware of an investment opportunity that would yield the company a rate of return amounting to 18%. In that case, the general manager may decide that it's not in his or her best interests to pursue this investment on behalf of the company because it would lower the division's overall rate of return, even though it would have a positive affect on Clark Clothing International's total rate of return. In this case, the use of ROI to measure the performance of division managers may actually work against the company's overall best interests. As a result, most companies today choose to measure performance based on what's referred to as residual income, which is the amount of profit a division or investment center generates above the company's established minimum rate of return. For example, if a division manager controls $10,000,000 of assets and the company's minimum ROI is set at 15% then the manager will be evaluated on the amount of profit generated in excess of 15% of $10,000,000 or $1,500,000. In this case, the overall rate of return is not the goal; it's the dollar amount of profits over $1,500,000. Under this approach, managers are motivated to achieve results that are consistent with the company's overall goals and objectives.
Standard costs and responsibility accounting are all about setting goals and expectations for a company's managers and employees, and, if properly used, they can be effective tools in improving a company's operating performance.
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Problem 14-5
Questions
Briefly respond to the following questions: 1. What are the major advantages and disadvantages of a standard cost system? 2. Why is responsibility accounting important for most businesses? 3. When might responsibility accounting have a negative affect on employee morale? 4. What distinguishes cost, profit and investment centers and which of the following reports or measures is most commonly associated each? a. Variance reports on actual versus standard costs. b. ROI or residual income. c. Segment-margin income statements. 5. Why is residual income often considered a more useful measure of an investment center's performance than ROI?
Questions
1. What are the major advantages and disadvantages of a standard cost system? Advantages: 1. Improved communication and coordination among department managers. 2. Potential source of motivation. 3. More efficient management by exception (variance analysis). 4. Facilitates operational budgeting. Disadvantages: 1. High cost of implementation. 2. Possible misuse resulting in decreasing employee morale. 3. Possible misinterpretation of results. 4. Could actually discourage continuous improvement.
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2. Why is responsibility accounting important for most businesses? Answer: Most businesses rely on a certain degree of decentralization to operate effectively. When management responsibilities are spread out among various personnel, some means of evaluating performance is essential. Responsibility accounting is the means whereby delegated responsibilities are measured and performance is assessed. 3. When might responsibility accounting have a negative affect on employee morale? Answer: If employees perceive that goals and standards exist to punish rather than encourage improved performance, those goals can have a detrimental affect on employee morale. Standards and goals must also be viewed as reasonable and employees should not be held accountable for results they can't control.
4. What distinguishes cost, profit and investment centers and which of the following reports or measures is most commonly associated each? a. Variance reports on actual versus standard costs. b. ROI or residual income. c. Segment-margin income statements. Answer: The distinguishing characteristic between cost, profit and investment centers is the extent of the related manager's responsibility and control over the costs, revenues and assets of the department or organizational unit. In a cost center, the manager's control is limited to costs, and variance reports are commonly used to help improve performance in that area. Managers of profit centers are responsible for both revenues and costs and segment-margin income statements are often used to measure the performance of those units. Finally, managers of investment centers have responsibility over assets, revenues, and costs and the key performance measure is the center's ROI or residual income.
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14-9
5. Why is residual income often considered a more useful measure of an investment center's performance than ROI? Answer: Most businesses rely on a certain degree of decentralization to operate effectively. When management responsibilities are spread out among various personnel, some means of evaluating performance is essential. Responsibility accounting is the means whereby delegated responsibilities are measured and performance is assessed.
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Lesson 16
CVP analysis is used to project the impact of changing sales volume on a company's costs and profits. For startup companies, that means it can be used to determine the volume of sales required to reach breakeven or some targeted amount of net income. Figuring out how many units must be sold for a company to simply breakeven or reach a minimum amount of profits is extremely useful in analyzing the feasibility of any new business. In addition, CVP analysis can be used to project the impact of different business strategies and proposals on a company's profits. For example, the potential impact on profits associated with a sales manager's proposal to increase sales volume through increased advertising expenditures can be analyzed through the use of CVP analysis.
Lesson 16
Cost-Volume-Profit (CVP) Analysis
Problem 16-1
Cost Behaviors with Changing Volume

Define the following costs, give an example of each and provide a graph reflecting that example. (Note any assumptions made for purposes of CVP analysis.)
The key to effective implementation of this management tool is to first understand how a company's costs behave with changes in volume. In fact, the first step required in any CVP analysis is to first identify all of a company's operating costs, including both product and period costs, and then distinguish them as either fixed or variable costs given changes in volume.
Variable costs Fixed costs Stepped costs Mixed costs
Problem 16-1 - Answer Few costs are ever perfectly variable given that significant changes in volume can often have an impact on the amount of the variable cost per unit. For example, if materials are purchased in especially large quantities, then purchase discounts can usually be negotiated reducing the cost per unit of production. However, CVP analysis can be greatly simplified if a company's variable costs are assumed to be perfectly variable with unchanging variable costs per unit within the company's relevant range of production. Relevant range refers to a company's reasonably anticipated range of production or sales volume for the period. Fixed costs - Any costs that remain unchanged in amount over a period of time regardless of the volume of production or sales. For example, an equipment lease that costs $2,000 per month, regardless of the number of units a company produces or sells, would be a fixed cost.
Total Equipment Lease Costs per Month (y) $3,000 $2,000 $1,000 (x) Volume (x) Volume 1,000 units 2,000 units 3,000 units 4,000 units

Variable costs - Any costs that change in total over a period of time with changes in a company's volume of production or sales. For example, if a manufacturing company's direct material costs amount to $5 per unit, the monthly total of direct material costs will vary based on the number of units produced during the period. If the company produces 1,000 units, the total direct material cost will amount to $5,000. On the other hand, if the volume of production is 2,000 units, the total cost of direct materials will be $10,000. Obviously, in this case, direct material costs are variable given that the total cost varies with any changes in the volume of production.
Total Direct Material Costs per Month (y) $15,000 $10,000 $5,000
Slope = Variable Cost/Unit = = Rise Run $5,000 = $5/unit 1,000 units
1,000 units
2,000 units
3,000 units
4,000 units
16-1

In reality, no cost is ever perfectly fixed under conditions of unlimited volume. If a company triples production, additional equipment will probably be required increasing the company's total lease costs for the period. However, for CVP analysis, fixed costs are assumed to be perfectly fixed within a company's relevant range. Stepped costs - Costs that aren't fixed or variable in their behavior with changes in volume. A stepped cost tends to be fixed over a range of volume, but then increases to new higher amount as certain increased levels of production or sales are reached. An example of such a cost would be a progressively higher bonus paid to sales personnel as they reach various benchmark levels of sales volume.
Total Sales Bonuses per Month (y) $8,000 $6,000 $4,000 $2,000 100,000 units 200,000 units 300,000 units 400,000 units (x) Volume
Problem 16-1 - Answer Any CVP analysis that includes a stepped cost will be inherently imprecise in its ultimate results. However, as long as we can get close in distinguishing a company's total costs as either fixed or variable, the results generated through CVP analysis should be useful for most management decisions. Mixed costs - Costs that have both a fixed and variable cost component. For example, utility costs are often mixed given that the monthly cost typically includes a fixed hookup fee plus additional charges based on the volume of usage.
Total Utility Costs per Month (y) $6,000 $4,000 $2,000 (x) Volume 2,000 units 4,000 units 6,000 units
Slope = $1 Variable Cost Per Unit
For purposes of CVP analysis, which requires that all costs be classified and quantified as either perfectly fixed or perfectly variable, this kind of stepped cost presents real problems. The solution is to evaluate the cost's behavior within the relevant range and then subjectively determine whether that cost appears to be more fixed or variable. In this case, if the relevant range is 100,000 to 200,000 units of sales, then the bonus is a fixed cost equal to $4,000. However, if the relevant range is 100,000 to 300,000 units, the cost is neither fixed nor variable and management will be forced to assume the cost is either perfectly fixed at an average cost of $5,000 per month, or perfectly variable at a rate of 2 cents per unit sold.
For purposes of CVP analysis, all of a company's mixed costs must be broken down into their fixed and variable components to determine the company's total fixed and total variable costs for the period.
Problem 16-2
Mixed Cost Analysis - Scattergraph, High-Low Methods

Given the following information for a company's total utility costs over its last four months of actual operations:
Months Actual Production Volume Actual Utility Costs

a. How would one apply the scattergraph method to determine the fixed and variable cost components of this mixed cost?
Plot each month on a graph with the vertical and horizontal axes designated as "Monthly Utility Cost" and "Monthly Production Volume", respectively. Then visually fit a straight line through the points trying to minimize the average distance between all of the points and the line. The slope of this line is the variable cost per unit component of the mixed cost and the point of intersection with the vertical axis is the fixed cost component.
February March April May
10,000 units 8,000 units 15,000 units 12,000 units
$30,000 $21,000 $35,000 $32,000
a. How would one apply the scattergraph method to determine the fixed and variable cost components of this mixed cost? b. Determine the fixed and variable cost components of this mixed cost using the high-low method. If June's budgeted volume of production is 20,000 units, what would be the amount of total utility costs budgeted for the month? c. Which of the two methods noted above is the best approach for the real world? . . . for an exam?
b. Determine the fixed and variable cost components of this mixed cost using the high-low method.
At the high and low point in terms of volume: Change in costs $14,000 = $2 VC per unit = Change in volume 7,000 units Fixed cost component at high point: + Fixed cost Total cost = Variable cost $35,000 = ($2 15,000 units) + FC FC $5,000* =
* The same fixed cost amount would result if calculated at the low point.
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Least Squares or Linear Regression Method

This is probably the best of all the methods given that it uses all of the data reflected in the scattergraph and applies an objective statistical approach to determine the one straight-line that best fits, given all of the graph's plotted points.
Monthly Utility Costs (y) $40,000 $32,000 $24,000
March Feb May April
If June's budgeted volume of production is 20,000 units, what would be the amount of total utility costs budgeted for the month?
Budgeted utility cost at a volume of 20,000 units of production: + Fixed cost Total cost = Variable cost TC = ($2 x 20,000) + $5,000 = $45,000
c. Which of the two methods noted above is the best approach for the real world? . . . for an exam?
The scattergraph method uses more data and is therefore less susceptible to faulty results from unusually high or low monthly costs and volume. However, the high-low method is better for exams because it is entirely objective.
Slope
$16,000 $8,000
Intercept
(x) Volume 4,000 units 8,000 units 12,000 units 16,000 units 20,000 units
Using keystrokes on an HP calculator, let's now determine the y-intercept or fixed cost component, and slope or variable cost component of this mixed utility cost.
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16-2
Months
Actual Production Volume ("x")
Actual Utility Costs ("y")
February March April May
10,000 units 8,000 units 15,000 units 12,000 units

CL
$30,000 $21,000 $35,000 $32,000
First the calculator's statistical register is cleared by pressing: Next the volume and cost values of all data points are entered:
A 1.0 coefficient ("R") implies a perfect 100% correlation where every data point on the graph is on the regression line.
+ + + +
10,000 8,000 15,000 12,000 0
INPUT INPUT INPUT INPUT
30,000 21,000 35,000 32,000

y,m
SWAP
The regression line's y-intercept or the fixed cost component can be determined by:
8,682 1.85 0.917

"R Squared" Correlation Coefficient
The slope of the line or variable cost per unit can then be determined: A coefficient measuring the quality of the correlation between the number of units produced and the utility costs incurred, can be determined
By the way, a zero R means the regression line is a poor fit, or in other words, there is no correlation between the company's production volume and utility costs. Obviously, the higher this coefficient (up to a maximum 1.0) the better in terms of accurately breaking down the fixed and variable utility cost components and predicting any future utility costs based on projected production volume.
x,r
SWAP
In this case, it means there's a 91.7% correlation between the company's production volume and utility costs.
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Problem 16-3
Mixed Cost Analysis - Least Squares Method

Given the following information for a company's total manufacturing overhead costs over the last five months:
Months Actual Production Volume Actual Total Manufacturing Overhead Costs
Mixed Cost Analysis - Least Squares Method

Parts A and B: Fixed cost component - $8,773 (rounded) Variable cost component - $6.64 per unit (rounded) Correlation coefficient (R) - .93 (rounded) (Using HP10BII)
First the calculator's statistical register is cleared by pressing:
CL
January February March April May
1,200 units 800 units 1,000 units 1,500 units 900 units
$17,900 $14,300 $15,300 $18,200 $14,000
Next the volume and cost values of all data points are entered:
A. Using your financial calculator, apply the least squares method to determine the fixed and variable cost components of the company's total manufacturing overhead costs. B. What is the correlation coefficient (R) given the above information and interpret its meaning. C. Determine the total anticipated manufacturing overhead costs for the month of June assuming 1,400 units of budgeted production. D. Do you think the June projection would be more reliable if actual data from the preceding 12 months were available?
1,200 800 1,000 1,500 900 0
INPUT INPUT INPUT INPUT INPUT
17,900 14,300 15,300 18,200 14,000

y,m
SWAP
+ + + + +
The regression line's y-intercept can be determined by:
8,773 6.64 0.93
displayed displayed displayed
The slope of the line can then be determined by: The correlation coefficient (R) is then determined by:
x,r
SWAP
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(Using TI BA II Plus)
Select statistics worksheet:
2nd 2nd
DATA
CLR WORK
The calculator's statistical register is cleared by pressing: Next the volume and cost values of all data points are entered:
1,200 800 1,000 1,500 900

Then
Press Press Press
ENTER ENTER ENTER ENTER ENTER
17,900 14,300 15,300 18,200 14,000

STAT
ENTER ENTER ENTER ENTER ENTER
Interpret the correlation coefficient: A .93 or 93% correlation coefficient indicates a strong correlation between the number of units produced and the company's total manufacturing overhead costs. A 100% (R) would be a perfect correlation and 0% would indicate no correlation. In this case 93% of the change in total manufacturing overhead costs is explained by the change in production volume.
2nd
2nd
CLR WORK
The regression line's y-intercept can be determined by:
until you find on diplay until you find on diplay until you find on diplay
a = b = r =
8,773 6.64 0.93
displayed displayed displayed
The slope of the line can then be determined by:
The correlation coefficient (R) is then determined by:
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16-3
Problem 16-4
Contribution Margin Income Statement

Part C. Determine the total anticipated manufacturing overhead costs for the month of June assuming 1,400 units of budgeted production.
Total cost TC TC TC = = = = Variable cost + ($6.64 x 1,400) + $9,296 + $18,069 Fixed cost $8,773 $8,773
Given the following information for Plaxco, Inc. for the year ended 12/31/X5:
Accounts Receivable Fixed Selling and Admin. Expenses Sales Revenues Variable Portion of Costs of Goods Sold Fixed Portion of Costs of Goods Sold Variable Selling and Admin. Expenses Accounts Payable $ 50,000 $ 125,000 $ 760,000 $ 346,000 $ 127,000 $ 85,000 $ 47,000
Part D. Do you think the June projection would be more reliable if actual data from the preceding 12 months were available?
Generally speaking, the more data the better, although older data may become progressively less reliable in projecting future correlating relationships. In most cases, however, data from a company's previous 12 months of operations is probably still relevant in predicting current and future costs and would probably improve the quality of the company's June projection.
a. b. c. d.
Prepare a contribution margin income statement. What is the company's variable cost ratio? What is the company's contribution margin ratio? Does it make sense that the variable cost ratio plus the contribution margin ratio is equal to 100%? e. If Plaxco sold 100,000 units during the year, what was the company's sales price per unit, variable cost per unit, contribution margin per unit, and the fixed cost per unit of sales? Do variable and fixed costs per unit change with changes in volume?
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Contribution Margin Income Statement

a. Prepare a contribution margin income statement.
Sales Revenues Less: Variable COGS Variable Selling & Admin. Contribution Margin Less: Fixed COGS Fixed Selling & Admin. Net Income $760,000 (346,000) (85,000) 329,000 (127,000) (125,000) $ 77,000 = .57 or 57%
e. If Plaxco sold 100,000 units during the year, what was the company's sales price per unit, variable cost per unit, contribution margin per unit, and the fixed cost per unit of sales?
SP/unit VC/unit CM/unit FC/unit = = = = $760,000 $431,000 $329,000 $252,000 100,000 units 100,000 units 100,000 units 100,000 units = = = = $7.60 $4.31 $3.29 $2.52
Do variable and fixed costs per unit change with changes in volume?
In performing CVP analysis, an assumption is made that variable cost per unit remain unchanged within the company's relevant range. As far as fixed costs are concerned, fixed costs are never incurred on a per unit basis. However, if a company's fixed costs are divided by the volume of production or sales during the period, a fixed cost per unit amount can be calculated, although that amount will change with any changes in volume. In effect, a company's fixed cost per unit reflects the sales price that would have to be charged to cover total fixed costs without consideration for any of the company's other costs. For example, if a bicycle manufacturer's building rent is fixed at $20,000 a month, at a volume of 1 bike produced during the entire month that bike would have to sell for $20,000 to simply cover the company's cost of building rent. On the other hand, if the company produced 100,000 bikes during the period, then the price per bike required to cover the building rent would fall to 20 cents. In other words, with increasing volume fixed costs per unit go down and vice versa.
b. What is the company's variable cost ratio?

Total Variable Costs Total Sales Revenues = $431,000 $760,000 $329,000 $760,000
c. What is the company's contribution margin ratio?

Contribution Margin = Total Sales Revenues = .43 or 43%
d. Does it make sense that the variable cost ratio plus the contribution margin ratio is equal to 100%? Yes, since the contribution margin is the difference between sales
revenues and variable costs, the contribution margin plus variable costs is equal to 100% of sales revenues.
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Basic CVP Equation
Problem 16-5
CVP Analysis
Utilize this information provided from the previous problem for Plaxco, Inc.
Sales revenues (SR) - Variable costs (VC) - Fixed costs (FC) = Net income(NI) (SP/unit x #Units) - (VC /unit x #Units) (VC Ratio x SR) FC = NI
Ratios
$/Unit
Sales revenues (SR) - Variable costs (VC) - Fixed costs (FC) = Net income(NI) Contribution margin (CM) (CM/unit x #units) (CM Ratio x SR) FC = NI
Sales Revenues Less: Variable COGS Variable Selling & Admin. Contribution Margin Less: Fixed COGS Fixed Selling & Admin. Net Income
$760,000 (346,000) (85,000) 329,000 (127,000) (125,000) $ 77,000
} 57% }
100%
$7.60 4.31 3.29 2.52 $ .77
43%
To determine: A.The company's breakeven point in # of units and sales revenues. B.The volume of sales (in # of units) required to reach a targeted net income of $100,000 C. The sales price per unit required to reach the $100,000 targeted net income at a volume of 100,000 units.
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16-4
Problem 16-6
CVP Analysis
A. The company's breakeven point in # of units and sales revenues. SR ($7.60 X) VC ($4.31 X) FC $252,000 $3.29 X X = = = = NI 0 $252,000 76,595.74 units 76,596 units
CVP Analysis
Respond to each of the following scenarios: A. Given the following:
Variable cost ratio Total fixed costs for the period 45% $100,000
What must sales revenues be for the period to generate a $1,000,000 profit?
Breakeven sales revenues: $7.60/unit 76,596 units = $582,130 rounded

B. The volume of sales (in # of units) required to reach a targeted net income of $100,000 SR VC FC = NI ($7.60 X) - ($4.31 X) - $252,000 = $100,000 $3.29 X = $352,000 X = 106,990.88 units 106,991 units C. The sales price per unit required to reach the $100,000 targeted net income at a volume of 100,000 units. SR VC (X 100,000) - ($4.31 100,000) 100,000 X $431,000 FC $252,000 $252,000 100,000 X X = = = = = NI $100,000 $100,000 $783,000 $7.83/unit
B. Given the following:

Contribution margin per unit Total fixed costs for the period $ 70 $ 50,000
How many units must be sold to reach breakeven?
C. Given the following:

Sales price per unit Breakeven volume Total fixed costs $ 100 1,000 units $ 30,000
Determine the volume required to achieve a targeted net income of $180,000.
D. Given the following:

Sales price per unit Variable cost per unit Breakeven sales revenues $ 120 $ 80 $360,000
Determine the number of units that must be sold to achieve a profit of $100,000.
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CVP Analysis
A. SR
SR VC (.45 SR) FC $100,000 .55 SR SR FC FC $50,000 $70 X X = = = = = = = = = NI $1,000,000 $1,100,000 $2,000,000 NI NI 0 $50,000 $715 units (rounded up) FC $30,000 FC $30,000 $30,000 1,000 Y Y $30,000 $30,000 $30 X X = = = = = = = = = = = NI $180,000 NI 0 0 $70,000 $70/unit $180,000 $180,000 $210,000 7,000 units
D.
SR $120 X
VC $80 X
FC FC FC FC FC $120,000
= = = = = =
NI $100,000 NI 0 0 FC
B. SR
CM $70 X
VC
First determine FC at breakeven: SR VC $360,000 - ($80 x 3,000*) $360,000 $240,000
* $360,000 $120 SP/unit = 3,000 breakeven units
SR VC C. $100 X VC First determine VC/unit at breakeven: SR VC ($100 x 1,000) - (VC/unit x 1,000) $100,000 1,000 Y Then complete the original equation: $100 X $100 X VC $70 X
Then complete the original equation: $120 X $120 X $80 X $80 X FC $120,000 $40 X X = = = = $100,000 $100,000 $220,000 5,500 units
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Problem 16-7
CVP Analysis - Changes in Variables

Barton, Inc.'s budget for the upcoming year reflects the following:
Sales price Sales volume Direct material costs Direct labor costs Variable manufacturing overhead costs Fixed manufacturing overhead costs Variable selling & administrative costs Fixed selling & administrative costs $36 per unit 200,000 units $12 per unit $7 per unit $4 per unit $800,000 $3 per unit $400,000
CVP Analysis - Changes in Variables

Both proposals generate less projected net income
A. The company's sales manager believes that sales volume can be increased by 20% with a 5% decrease in the sales price per unit and an additional 3% commission paid to sales personnel on total sales revenues. Projected net income before proposal:
SR ($36 200,000) $7,200,000 VC ($26 200,000) $5,200,000 = NI FC - $1,200,000 = NI - $1,200,000 = $800,000
Projected net income with proposal:

= NI SR FC VC ($34.20 240,000) - [($26 240,000) + (.03 $8,208,000)] - $1,200,000 = NI - $1,200,000 = $521,760 $8,208,000 $6,486,240
Which of the following two proposals presents the best opportunity for improved profits in the upcoming year? A. The company's sales manager believes that sales volume can be increased by 20% with a 5% decrease in the sales price per unit and an additional 3% commission paid to sales personnel on total sales revenues. B. The company's production manager believes that direct labor and variable manufacturing overhead costs could be decreased by 10% if new equipment is leased at an annual cost of $250,000.
B. The company's production manager believes that direct labor and variable manufacturing overhead costs could be decreased by 10% if new equipment is leased at an annual cost of $250,000. Projected net income with proposal:
SR ($36 200,000) $7,200,000 VC ($24.90* 200,000) $4,980,000 = NI FC - $1,450,000 = NI - $1,450,000 = $770,000
* Direct labor costs ($7/unit) and variable manufacturing overhead costs ($4/unit) = $11/unit, a 10% reduction equals a $ 1.10 decrease in total variable costs per unit.
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16-5
Problem 16-8
Graphical CVP Analysis

Using the graph below respond to the following:
Total Revenues And Costs (y) $500,000 $400,000 $300,000 $200,000 $100,000 (x) Volume 4,000 units 8,000 units 12,000 units
Graphical CVP Analysis

1. - 3.
Total Revenues And Costs (y) $500,000 $400,000 $300,000 $200,000 $100,000 Variable Costs $100,000 Fixed Costs $200,000 4,000 units Total Sales Revenues Slope = Sales Price Per Unit = $50 Total Costs Slope = Variable Cost Per Unit = $16.67 Breakeven Point: Volume - 6,000 units Revenues - $300,000 (x) Volume 8,000 units 12,000 units
1. 2. 3. 4.
Identify the total revenue and total cost lines. Determine the sales price per unit, variable cost per unit and total fixed costs. Determine the breakeven point in both # of units and total sales revenues. At a sales volume of 4,000 units, determine the company's fixed costs, approximate variable costs and profit. 5. At a sales volume of 8,000 units, determine the company's fixed costs, approximate variable costs and profit.
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4.
Total Revenues And Costs (y) $500,000 $400,000 $300,000 $200,000 $100,000
Variable Costs $67,000
5.
Total Sales Revenues Total Revenues And Costs (y) $500,000 $400,000 $300,000 $200,000 $100,000
Net Income = $67,000 Approx. Variable Costs $133,000 Approx.
Total Sales Revenues Total Revenues = $400,000
Total Costs Total Costs = $333,000 Total Revenues = $200,000 Net Loss = $67,000 Approx. (x) Volume 4,000 units 8,000 units 12,000 units
Total Costs Total Costs = $333,000
Net Income = $67,000 Approx. Fixed Costs $200,000 Fixed Costs $200,000 (x) Volume 4,000 units 8,000 units 12,000 units
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Operating Leverage
Airline Company
Total Revenues And Costs Total Revenues
Total Costs
Companies with higher fixed costs and lower variable costs have higher operating leverage which results in greater potential profits and increased risk of loss with any changes in volume. As a result, many companies seeking to increase profits as quickly as possible will often seek to convert their variable costs to a fixed cost basis, whereas, companies wishing to avoid the risk of significant losses will do the reverse and seek to convert their fixed costs to variable costs.
Volume
Window Washing Company

Total Revenues And Costs Total Revenues Total Costs
Volume
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16-6
Problem 16-9
Operating Leverage
Given the following graph for ABC Company:
Total Revenues And Costs $400,000 $300,000 $200,000 $100,000 Volume 5,000 units 10,000 units Total Revenues Total Costs Total Revenues And Costs $400,000
Operating Leverage
Given the following graph for ABC Company:
Total Revenues Total Costs
Net Income = $85,000 Approx.
$300,000 $200,000 $100,000
Volume 5,000 units 10,000 units
A. Determine the company's approximate amount of profit at a sales volume of 10,000 units. B. If management converted all of its sales personnel from a salary-based to "commission only" compensation plan (based on sales volume), how would this graph be affected assuming the breakeven point remained unchanged? Given this change, is the company's operating leverage higher or lower? C. Given the change in B above, would the company's profits be higher or lower at a volume of 10,000 units? D. Why would management ever implement such a "commission only" plan if it results in lower profits?
A. Determine the company's approximate amount of profit at a sales volume of 10,000 units. $85,000 Approximately
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Problem 16-9 - Answer B. If management converted all of its sales personnel from a salary-based to "commission only" compensation plan (based on sales volume), how would this graph be affected assuming the breakeven point remained unchanged?
Total Revenues And Costs $400,000 $300,000 $200,000 $100,000 Volume 5,000 units 10,000 units Total Revenues New Total Costs Total Costs
Problem 16-9 - Answer C. Given the change in B above, would the company's profits be higher or lower at a volume of 10,000 units? Answer: Lower. D. Why would management ever implement such a "commission only" plan if it results in lower profits? Answer: This change results in lower profits at every level of volume above breakeven, but it reduces the extent of losses below breakeven. The only reason management would implement this shift to a "commission only" plan would be to reduce future anticipated losses.
Given this change, is the company's operating leverage higher or lower? Answer: Lower. Operating leverage refers to the extent of fixed costs relative to variable costs. In this case, fixed costs were reduced and variable costs increased.
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Limiting Assumptions
To Simplify the Process of CVP Analysis
1. In all of our examples we've assumed the company's sales price per unit is the same regardless of the number of units sold. 2. In addition, we've assumed that all costs are either perfectly variable or perfectly fixed and behave on a linear basis within the company's relevant range. 3. We've also assumed that any mixed costs can be broken down accurately into their fixed and variable cost components. As a result of these various assumptions, the results produced through a company's CVP analysis won't be entirely accurate. However, in most cases the results are probably close enough to reality to provide useful information to management
A final additional assumption has been implicit in all of our previous CVP problems and examples to date. In each and every case, we've assumed the company sold a single product. Basic CVP Equation
SR (SP/unit x #Units) VC FC = NI
Most companies sell a variety of products having different sales prices and different variable costs per unit. In that case, this basic CVP equation can still be used, but the sales price and variable cost per unit must be adjusted to reflect the average price and cost of each unit sold given the company's sales mix. Sales mix refers to the proportion of total sales associated with each of the company's various products.
Product A Product B
Sales price per unit Variable cost per unit Sales mix Weighted average: Sales price per unit Variable cost per unit
$5.00 $3.00 40%
$4.00 $2.50 60%

Total
$2.00 $1.20
$2.40 $1.50
$4.40 $2.70
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16-7
Breakeven units and sales revenues:

SR VC ($4.40 X) - ($2.70 X) $1.70 X FC $170,000 $170,000 $1.70 X X = = = = = NI 0 0 $170,000 100,000 units
Problem 16-10
Changing Sales Mix

Johnson Industries sells a premium and standard brand of potato chips. The following schedule reflects the company's budget for the upcoming month of operations:
Premium Standard
Breakeven number of units and sales revenues:

Product A: 100,000 units 40% 40,000 units $5.00/unit 60% 100,000 units 60,000 units $4.00/unit 100,000 units $4.40/unit = = = = = 40,000 units $200,000 60,000 units $240,000 $440,000
Sales price per unit Variable cost per unit Sales mix
$3.00 $2.20 20%
$2.00 $1.60 80%
Given total budgeted fixed costs for the month amounting to $96,000, determine the company's: A. Breakeven point in terms of units and sales dollars by product. B. Breakeven point in terms of units and sales dollars by product, assuming a sales mix of 50% for the premium brand and 50% for the standard brand. C. Why is the breakeven point lower in terms of total sales dollars under the sales mix in A versus B. D. If the company decided to spend $50,000 on a new marketing campaign, which of the two products should be emphasized?
Product B:
Total:
When more than one product is involved, a company's sales mix must also be assumed in any calculations projecting the volume of sales required for that company to reach breakeven or some targeted amount of net income.
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Changing Sales Mix

A. Breakeven point in terms of units and sales dollars by product.
Sales price per unit Variable cost per unit Sales mix Weighted average: Sales price per unit Variable cost per unit Premium $3.00 $2.20 20% $0.60 $0.44 FC $96,000 $96,000 $0.48 X X $2.20/unit Standard $2.00 $1.60 80% Total $1.60 $1.28 = = = = = = $2.20 $1.72 NI 0 0 $96,000 200,000 units $440,000
B. Breakeven point in terms of units and sales dollars by product, assuming a sales mix of 50% for the premium brand and 50% for the standard brand.
Sales price per unit Variable cost per unit Sales mix Weighted average: Sales price per unit Variable cost per unit Premium $3.00 $2.20 50% $1.50 $1.10 Standard $2.00 $1.60 50% Total $1.00 $0.80 = = = = = = $2.50 $1.90 NI 0 0 $96,000 160,000 units $400,000
Breakeven point in total units:

SR ($2.20 X) $0.48 X VC ($1.72 X)
Breakeven point in total units:

SR ($2.50 X) $0.60 X VC ($1.90 X) FC $96,000 $96,000 $0.60 X X $2.50/unit
Breakeven point in total sales dollars (revenues):

200,000 units
Breakeven point in total sales dollars (revenues):

160,000 units
Breakeven point by product:

Premium brand Standard brand 200,000 units 40,000 units 20% $3.00/unit 80% $2.00/unit = = = = 40,000 units $120,000 160,000 units $320,000
Breakeven point by product:

Premium brand Standard brand 160,000 units 80,000 units 50% $3.00/unit 50% $2.00/unit = = = = 80,000 units $240,000 80,000 units $160,000
- 200,000 units 160,000 units
- 160,000 units 80,000 units
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C. Why is the breakeven point lower in terms of total sales dollars under the sales mix in A versus B.
Answer: The contribution margin per unit for the Premium brand is higher than it is for the Standard brand. As a result, any increase in the sales mix towards the Premium brand improves the company's weighted average contribution margin and reduces the total number of units that must be sold to reach breakeven.
D. If the company decided to spend $50,000 on a new marketing campaign, which of the two products should be emphasized?
Answer: It depends. If the marketing campaign promises an equal increase in sales volume for either brand, then the company would be better off emphasizing the premium brand given its higher contribution margin per unit ($.80/unit vs. $.40/unit). On the other hand, if the marketing campaign promises to produce 2 or more units of increased sales of the standard brand for every 1 unit of increased sales of the premium brand, then emphasis on the standard brand will produce equal or better results given it's equal or higher weighted average contribution margin per unit of sales.
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16-8
Lesson 12
Problem 12-1
Managerial vs. Financial Accounting
Respond to the following questions:
Lesson 12
Introduction to Managerial Accounting and Review of Product Costing
1. What is the primary purpose behind managerial as opposed to financial accounting and note some of the key distinguishing characteristics of each? 2. Why do you suppose some people suggest that the development of a company's managerial accounting information is the result of an evolutionary process over time?
Managerial vs. Financial Accounting

1. What is the primary purpose behind managerial as opposed to financial accounting and note some of the key distinguishing characteristics of each?
Answer: The primary purpose behind financial accounting is to provide useful information to external users (investors, creditors, analysts, government regulatory agencies and others). This is done through a company's general-purpose financial statements, its balance sheet, income statement, statement of cash flows and supplemental notes prepared in accordance with standardized rules of accounting or generally accepted accounting principles. These statements provide summarized information reflecting a company's financial position and results of operations for recently completed periods. The primary purpose behind managerial accounting is to provide a company's management personnel with the kind of information that's needed to successfully plan, control, and evaluate a business' day-to-day operations. Now, it's true that managers are interested in the summarized historical results reported in a company's periodic financial statements, but good managers need detailed and immediate information to successfully manage a company. That's what managerial accounting is all about and it involves the development and use of forecasts and budgets as well historical data arising from a company's current and past transactions. In managerial accounting there are no governing rules or standards of presentation, the bottom-line is the development of information that gives managers the ability to lead a company in today's competitive and dynamic business environment.
2. Why do you suppose some people suggest that the development of a company's managerial accounting information is the result of an evolutionary process over time?
Answer: In a constantly changing and competitive marketplace, only those companies that adapt and continually improve ultimately survive. A big part of any company's continuous improvement is the ongoing development of better and more-timely management information. As companies experiment with new systems, access new data and explore new methods of analysis, information tools that add competitive value are incorporated and those that don't are quickly discarded. Even in the arena of information, only the strong survive.
Regardless of the kind of business a company engages in, whether it involves manufacturing, merchandising or the providing of services, all of a company's operating costs can be categorized as either
Product or Period Costs.
Much of managerial accounting focuses on a company's costs.

The goal is to plan for, control and evaluate costs in a way that helps maximize a company's profits.
Product costs: All costs incurred in the acquisition or manufacture of goods offered for sale, or costs incurred in the providing of services to a customer.
Merchandiser - Costs of goods acquired from suppliers for sale to customers. Manufacturer - All the costs of direct materials, direct labor and manufacturing overhead (indirect materials, indirect labor and other costs) incurred in the manufacturing process of its products. Service company - Costs of any salary, wages, supplies and other costs incurred in providing services to customers.
For financial reporting purposes, all product costs are accounted for as assets (inventory or unbilled service costs) until the product is sold or services are billed to the customer, at which time the costs become an expense (cost of goods sold or cost of services sold).
12-1
Problem 12-2
Product vs. Period Costs

Hit-it-Long, Inc. (HIL) manufactures custom golf clubs for customers interested in hitting a golf ball exceptionally long distances. During the production process, HIL incurs the following types of costs. Identify each cost as either a period or a product cost and for each product cost, indicate whether its part of direct materials, direct labor, or manufacturing overhead. In the case of manufacturing overhead, also distinguish the cost as an indirect material, indirect labor or other cost of manufacturing overhead.
A. Depreciation of equipment used to shape golf clubs. B. Advertising costs. C. Wages for janitors responsible for keeping the factory production floor clean. D. Freight-in costs on direct materials used in the manufacture of the golf clubs. E. Cost of oil and grease used to maintain the manufacturing equipment. F. Cost of steel, graphite, titanium and other materials incorporated in the final product. G. Freight-out costs of shipping finished goods to customers.
Period costs: All of the non-product costs incurred in the operation of a business. This includes the costs of marketing and selling the company's products or services, plus any costs incurred in the general administration of the business. (Selling and administrative costs) For financial reporting purposes, these period costs are simply accounted for as an expense in the period incurred.
Problem 12-2

Hit-it-Long, Inc. (HIL) manufactures custom golf clubs for customers interested in hitting a golf ball exceptionally long distances. During the production process, HIL incurs the following types of costs. Identify each cost as either a period or a product cost and for each product cost, indicate whether its part of direct materials, direct labor, or manufacturing overhead. In the case of manufacturing overhead, also distinguish the cost as an indirect material, indirect labor or other cost of manufacturing overhead.
H. Wages for company accountants. I. Commissions for sales personnel. J. Wages for golf club assemblers. K. Salaries of factory supervisors. L. Wages of production quality control personnel. M. Factory utility costs. N. Corporate office utility costs. O. Factory property taxes. P. Corporate office property taxes. Q. CEO salary.

Description Product vs. Period Cost Type of Product Cost
A. Depreciation of equipment used to shape golf clubs. B. Advertising costs. C. Wages for janitors responsible for keeping the factory production floor clean. D. Freight-in costs on direct materials used in the manufacture of the golf clubs. E. Cost of oil and grease used to maintain the manufacturing equipment. F. Cost of steel, graphite, titanium and other materials incorporated in the final product. G. Freight-out costs of shipping finished goods to customers. H. Wages for company accountants.
Product Period Product Product Product Product Period Period
Mfg. Overhead (other cost) Mfg. Overhead (indirect labor) Direct Materials Mfg. Overhead (indirect mtls.) Direct Materials
10

Description Product vs. Period Cost Type of Product Cost
I. Commissions for sales personnel. J. Wages for golf club assemblers. K. Salaries of factory supervisors. L. Wages of production quality control personnel. M. Factory utility costs. N. Corporate office utility costs. O. Factory property taxes. P. Corporate office property taxes. Q. CEO salary
Period Product Product Product Product Period Product Period Period Mfg. Overhead (other costs) Direct Labor Mfg. Overhead (indirect labor) Mfg. Overhead (indirect labor) Mfg. Overhead (other costs)
It's absolutely crucial for a company to understand and accurately accumulate and account for its product costs.
For financial accounting purposes a company's product costs affect the amount of inventory reported on the company's balance sheet and the cost of goods sold reflected in its income statement. From a managerial standpoint, knowing a product's cost of production is essential in setting sales prices, understanding operating results and coming up with plans for improved performance.
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12-2
The two methods used by manufacturing companies to accumulate and account for their product costs:
Process costing - Typically used by companies that manufacture a common product in a separate manufacturing facility or process.
Job order costing - Typically used by companies producing a variety of products from a common factory or manufacturing process.
Wheaties Factory
Direct Materials + Direct Labor + Manufacturing Overhead Total Costs ($) # of Boxes Produced
cheerios
Cheerios Factory
Direct Materials + Direct Labor + Manufacturing Overhead Total Costs ($) # of Boxes Produced Tables
Furniture Factory
Bookcases Chairs
Cost
Cost
Allocate the factory's direct material, direct labor and manufacturing overhead costs based on the relative costs incurred in the production of each product.
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Problem 12-4
Problem 12-4
Review of Job-Order Costing

Custom Boat Manufacturing ("CBM") uses a job order cost system to account for its product costs. A. Prepare journal entries to record the following CBM transactions and events during the month of January, 20X4: a. CBM purchases on account $100,000 of direct materials (lumber, sails, glue, nails, paint, etc.) and $10,000 of indirect materials (factory supplies, sandpaper, paint brushes, etc.) b. On January 4th, CBM receives a customer order for two "Bullet" sailboats and initiates a manufacturing job (job order #303) to produce four boats to meet the current order and build inventory for future sales. The following job cost record is set up for job #303:
Job Cost Record

Job Order #: 303 Product Description: Bullet sailboat # of Units: 4 Direct Materials:
Date Requisition Number Time Cards Number Hours Amount
Date Started: 1/4/X4 Date Completed:
Direct Labor:
Date
Rate
Amount
Manufacturing Overhead:
Date Rate Labor Hours Amount
Total Cost Cost Per Unit:
= $
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Problem 12-4
Problem 12-4
c. On January 5th, direct materials costing $12,000 are requisitioned from raw materials (Requisition # 2255) and placed into production exclusively for job #303. (Also make an appropriate entry to the Job #303 Job Cost Record) d. Indirect materials amounting to $3,000 (sandpaper, paint brushes, etc.) are requisitioned for used in the production of Job #303 and other jobs. e. Nails and glue costing $1,500 are requisitioned and placed into production for Job #303 and other jobs. f. Total wages paid to direct manufacturing employees for the month amount to $50,000 (2,500 total hours at an average rate of $20/hr.) of which time card #'s 222 and 224 show a total of 320 hours at a rate of $20/hour for Job #303. (Ignore payroll tax withholdings and employer payroll taxes. Also make an appropriate entry to the Job #303 Job Cost Record)
g. Total manufacturing supervisor and production maintenance salaries paid for the month amount to $30,000. (Ignore payroll tax withholdings and employer payroll taxes.) h. Total factory utility, rent, insurance, property taxes and other costs amounting to $40,000 for the month are paid. i. Depreciation of factory equipment for the month amounts to $8,000. j. Assume manufacturing overhead is applied to WIP jobs based on a predetermined rate of $32 per direct labor hour. (Also make an appropriate entry to the Job #303 Job Cost Sheet) k. Job #303 's production is completed. l. Two of the four Bullet boats completed in Job #303 are shipped to the customer. The customer has agreed to pay a price of $15,000 each for the boats within 30 days of delivery.
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12-3
Problem 12-4
B. Determine the gross margin made on this sale. Is this the amount of net income made by CBM on these two boats? C. Prepare journal entries for the following: a. Sales, accounting and all administrative salaries and wages for the month totaling $40,000 are paid. b. Total selling and administrative building rent, utilities, supplies, insurance, property taxes, and other costs amounting to $25,000 are paid during the month. c. The manufacturing overhead account is closed-out at the end of the month. D. What journal entry would be required at the end of the month if manufacturing overhead had been over-applied by $2,500.
A.
Review of Job-Order Costing

a. CBM purchases on account $100,000 of direct materials (lumber, sails, glue, nails, paint, etc.) and $10,000 of indirect materials (factory supplies, sandpaper, paint brushes, etc.)
Raw Materials Inventory Accounts Payable 110,000 110,000
b. On January 4th, CBM receives a customer order for two "Bullet" sailboats and initiates a manufacturing job (job order #303) to produce four boats to meet the current order and build inventory for future sales. No journal entry is made. c. On January 5th, direct materials costing $12,000 are requisitioned from raw materials (Requisition # 2255) and placed into production exclusively for job #303. (Also make an appropriate entry to the Job #303 Job Cost Record)
WIP Inventory Raw Materials Inventory 12,000 12,000
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Job Cost Record

Date Requisition Number Amount
d. Indirect materials amounting to $3,000 (sandpaper, paint brushes, etc.) are requisitioned for used in the production of Job #303 and other jobs.
Manufacturing Overhead Raw Materials Inventory 3,000 3,000
1/5/X4 Direct Labor:

Date
2255
Time Cards Number Hours Rate
$12,000
Amount
e. Nails and glue costing $1,500 are requisitioned and placed into production for Job #303 and other jobs.
Manufacturing Overhead Raw Materials Inventory 1,500 1,500
Date Rate Labor Hours Amount
f. Total wages paid to direct manufacturing employees for the month amount to $50,000 (2,500 total hours at an average rate of $20/hr.) of which time card #'s 222 and 224 show a total of 320 hours at a rate of $20/hour for Job #303. (Ignore payroll tax withholdings and employer payroll taxes. Also make an appropriate entry to the Job #303 Job Cost Record)
WIP Inventory Cash 50,000 50,000
= $
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Job Cost Record

g. Total manufacturing supervisor and production maintenance salaries paid for the month amount to $30,000. (Ignore payroll tax withholdings and employer payroll taxes.)
Manufacturing Overhead Cash 30,000 30,000
h. Total factory utility, rent, insurance, property taxes and other costs amounting to $40,000 for the month are paid.
Manufacturing Overhead Cash 40,000 40,000

Date
2255
$12,000
Amount
1/31/X4
Date
222, 224
Rate
320
$20
Labor Hours
$6,400
Amount
i. Depreciation of factory equipment for the month amounts to $8,000.

Manufacturing Overhead Accumulated Depreciation 8,000 8,000
j. Assume manufacturing overhead is applied to WIP jobs based on a predetermined rate of $32 per direct labor hour. (Also make an appropriate entry to the Job #303 Job Cost Sheet)
WIP Inventory ($32 x 2,500 hours) Manufacturing Overhead 80,000 80,000
= $
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12-4
Job Cost Record

k. Job #303 's production is completed.

Finished Goods Inventory WIP Inventory 28,640 28,640
l. Two of the four Bullet boats completed in Job #303 are shipped to the customer. The customer has agreed to pay a price of $15,000 each for the boats within 30 days of delivery.
Accounts Receivable Sales Revenues Cost of Goods Sold ($7,160 x 2) Finished Goods Inventory 30,000 30,000 14,320 14,320

Date
2255
$12,000
Amount
1/31/X4
Date
222, 224
Rate
320
$20
Labor Hours
$6,400
Amount
Manufacturing Overhead: 1/31/X4 $32 320 Total Cost Cost Per Unit: 28,640 $10,240 $ 28,640 7,160
B. Determine the gross margin made on this sale. Sales revenues $ 30,000 Less: Cost of goods sold 14,320 Gross margin $ 15,680 Is this the amount of net income made by CBM on these two boats? No. (It doesn't take into consideration selling and administrative costs.)
4 = $
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C. Prepare journal entries for the following: a. Sales, accounting and all administrative salaries and wages for the month totaling $40,000 are paid.
Selling and Administrative Expense Cash 40,000 40,000
D. What journal entry would be required at the end of the month if manufacturing overhead had been over-applied by $2,500.
Manufacturing Overhead Cost of Goods Sold Manufacturing Overhead
3,000 1,500 30,000 40,000 8,000 Adjustment 2,500 0 85,000 2,500 Over-applied
2,500 2,500
b. Total selling and administrative building rent, utilities, supplies, insurance, property taxes, and other costs amounting to $25,000 are paid during the month.
Selling and Administrative Expense Cash 25,000 25,000
c. The manufacturing overhead account is closed-out at the end of the month.

3,000 1,500 30,000 40,000 8,000 Under-applied 2,500 0
2,500 2,500
80,000 2,500 adjustment
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In a job order cost system, the allocation of direct material and direct labor costs on a job-by-job basis is simplified through the use of material requisition forms and employee time cards that provide breakdowns by job of the materials used and time worked on each job. Where things become difficult is in the allocation of manufacturing overhead costs. Generally speaking, as these costs are incurred, no job-by-job breakdown is provided.
Example: A company's factory utility bill doesn't designate utility usage by job; the amount payable is typically stated in a single monthly amount.
A correlating relationship between a company's direct labor hours and manufacturing overhead costs is fairly common. For some companies with more automated manufacturing facilities, manufacturing overhead costs may correlate more directly with machine hours (the number of hours the company's manufacturing equipment is in operation) than with direct labor hours. In other cases, the amount of direct materials used may be the primary driving force behind a company's overhead costs. In those cases, the predetermined overhead rate should be based on machine hours or direct material costs as long as those hours or costs can be determined on a per job basis. Total budgeted manufacturing overhead costs for the upcoming period Predetermined Overhead Rate = Total budget for the measurable activity or cost that correlates with or drives overhead costs over the same period Example: If a company's total budget for manufacturing overhead costs for the next year amounts to $500,000 and total budgeted machine hours, the company's measurable cost driver of overhead for the same period, is 25,000 hours, then: $500,000 Predetermined Overhead Rate = 25,000 hrs. = $20 per machine hour If a specific job is processed using 100 machine hours: 100 hrs. x $20 = $2,000 allocated to that job
As a result, the allocation of such costs must be made on an estimated basis, usually through the use of a predetermined overhead rate.
Example: In the previous problem for Custom Boat Manufacturing ("CBM"), overhead was applied to work-in-process jobs at a rate of $32 per direct labor hour. This means that based on the company's past experience, there's an apparent correlation between the number of direct labor hours worked and the amount of manufacturing overhead costs incurred. The more direct laborers work, the higher the company's overhead costs. In fact, for CBM, that correlation apparently runs at a rate of about $32 per direct labor hour and by keeping track of the number of direct labor hours worked on each job, a reasonable allocation of total overhead costs can be made to specific jobs.
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12-5
Problem 12-5
Problem 12-5
Predetermined Manufacturing Overhead Rates Jones Manufacturing, Inc. provides the following data from its last three years of operations:
20X3 20X4 20X5
Predetermined Manufacturing Overhead Rates Jones Manufacturing, Inc. provides the following data from its last three years of operations:
20X3 20X4 20X5
Manufacturing overhead costs Machine hours Direct material costs Direct labor hours
$305,000 15,000 $600,000 17,000
$450,000 12,000 $800,000 25,000
$640,000 10,000 $750,000 35,000
Manufacturing overhead costs Machine hours Direct material costs Direct labor hours
$305,000 15,000 $600,000 17,000
$450,000 12,000 $800,000 25,000
$640,000 10,000 $750,000 35,000
A. Based on the above information, identify the measurable activity that best correlates with or seems to drive manufacturing overhead costs and, as a result, would best serve as the basis for the company's predetermined manufacturing overhead rate in 20X6. B. Compute the predetermined overhead rate to be used in applying manufacturing overhead to jobs in progress for the upcoming year 20X6 if budgeted manufacturing overhead costs and direct-labor hours are projected at $765,000 and 42,000 hours, respectively.
C. How much manufacturing overhead cost should be applied to Job #111 in 20X6 using the data provided in part B above, if 50 total direct labor hours are incurred on the job? D. Prepare the 20X6 year-end adjusting entry to close out the company's manufacturing overhead account if actual manufacturing overhead costs for the year amounted to $784,000 and actual direct labor totaled 43,200 hours.
Questions: What was the actual manufacturing overhead rate for the year 20X6? Why use a predetermined overhead rate to allocate overhead costs when the actual rate can be determined at the end of the period?
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Predetermined Manufacturing Overhead Rates

A. Direct labor hours reflect the most consistent correlating relationship with total manufacturing overhead costs.
20X3 20X4 20X5
D.
Actual costs 784,000 786,672 Applied costs (43,200 hrs. x $18.21) 2,672 Adjusting entry 2,672 0
Manufacturing overhead costs Machine hours Direct material costs Direct labor hours Overhead cost/ machine hour Overhead cost/ $ of direct matls. Overhead cost/ direct labor hour B. 20X6:
Predetermined Overhead Rate =
$305,000 15,000 $600,000 17,000 $20.33 $ .51 $17.94
$450,000 12,000 $800,000 25,000 $37.50 $ .56 $18.00
$640,000 10,000 $750,000 35,000 $64.00 $ .85 $18.29
Adjusting entry:
Manufacturing Overhead Cost of Goods Sold 2,672 2,672
Questions: What was the actual manufacturing overhead rate for the year 20X6?
Actual Overhead Rate = $784,000 = $18.15 per direct labor hour 43,200 hrs.
$765,000 = $18.21 per direct labor hour 42,000 hrs.
C. Manufacturing overhead allocated to Job #111: 50 hours x $18.21 = $910.50
Why use a predetermined overhead rate to allocate overhead costs when the actual rate can be determined at the end of the period?
Answer: Management simply can't afford to wait around until the end of the year to determine and account for its product costs. Management information is always better sooner rather than later as long as it's reasonably accurate.
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Custom Boat Manufacturing, Inc. January, 20X4

Raw Materials Inventory
Beg. Balance Purchases End Balance 30,000 110,000 35,000 Ind. Mtls. 4,500 105,000 To Production Beg. Balance Dir. Labor Applied OH End Balance
Custom Boat Manufacturing Cost of Goods Manufactured Schedule For the month of January, 20X4
Direct Materials: Beginning raw materials inventory, 1/1/X4 Add: Raw materials purchased Total raw materials available Less: Ending raw materials inventory, 1/31/X4 Total raw materials put into production Less: Indirect materials put into production Direct materials input to WIP Direct Labor Manufacturing Overhead: Indirect materials Indirect labor Utilities Rent Depreciation Other manufacturing overhead costs Actual manufacturing overhead costs Less: Under-applied overhead Manufacturing overhead applied to WIP Total manufacturing costs added to WIP Beginning WIP inventory, 1/1/X4 Total costs of goods in process Less: Ending WIP inventory, 1/31/X4 Total cost of goods manufactured $ 30,000 110,000 140,000 (35,000) 105,000 (4,500) $ 100,500 50,000 $ 4,500 30,000 10,000 20,000 8,000 10,000 82,500 (2,500) 80,000 230,500 40,000 270,500 (50,000) $220,500
WIP Inventroy
40,000 220,500 Completed 110,000 80,000 50,000 Dir. Materials 100,500
Ind. Materials Ind. Labor Utilities Rent Depreciation Other Under Applied 4,500 30,000 10,000 20,000 8,000 10,000 2,500 2,500 Closed 0 Goods Sold Under Applied 80,000 Applied to WIP
Finished Goods Inventory

Beg. Balance Completed End Balance 35,000 220,500 30,000 225,500 Goods Sold
Cost of Goods Sold

225,500 2,500 228,000
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12-6
Problem 12-6
Custom Boat Manufacturing Cost of Goods Sold Schedule For the month of January, 20X4
Cost of goods manufactured Add: Beginning finished goods inventory, 1/1/X4 Goods available for sale Less: Ending finished goods inventory Unadjusted cost of goods sold Add: Under-applied overhead Cost of goods sold $220,500 35,000 255,500 (30,000) 225,500 2,500 $228,000
Schedules for Cost of Goods Manufactured and Cost of Goods

For Johnson Industries, use the information provided below to prepare schedules reflecting the company's September, 20X1 cost of goods manufactured and cost of goods sold. Johnson applies manufacturing overhead to work-in-process jobs on the basis of direct labor hours. The 20X1 budgets for manufacturing overhead costs and direct labor hours were:
Manufacturing overhead $2,400,000 Direct labor hours 400,000
September, 20X1 events and transactions:

Raw materials purchased Direct labor costs incurred (40,000 hrs. x $15/hr.) Indirect labor costs incurred Indirect materials put into production Selling, general and administrative expenses Manufacturing overhead costs incurred: Plant depreciation (factory) Equipment depreciation (factory) Utilities (factory) Factory maintenance Factory taxes and insurance Miscellaneous manufacturing overhead $630,000 $600,000 $ 75,000 $ 70,000 $200,000 $ 40,000 $ 16,000 $ 12,000 $ 6,000 $ 7,000 $ 9,000
Inventory balances:
Raw materials Work-in-process Finished goods
9/1/X1
9/30/X1
$44,000 $75,000 $65,000
$34,000 $87,000 $85,000
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Schedules for Cost of Goods Manufactured and Cost of Goods

Johnson Industries Cost of Goods Manufactured Schedule For the month of September, 20X1
Direct Materials: Beginning raw materials inventory, 9/1/X1 Add: Raw materials purchased Total raw materials available Less: Ending raw materials inventory, 9/30/X1 Total raw materials put into production Less: Indirect materials put into production Direct materials input to WIP Direct Labor Manufacturing Overhead: Indirect materials Indirect labor Plant depreciation (factory) Equipment depreciation (factory) Utilities (factory) Factory maintenance Factory taxes and insurance Miscellaneous manufacturing overhead Add over-applied overhead* Manufacturing overhead applied to WIP Total manufacturing costs added to WIP Beginning WIP inventory, 1/1/X4 Total costs of goods in process Less: Ending WIP inventory, 1/31/X4 Total cost of goods manufactured $ 44,000 630,000 674,000 (34,000) 640,000 (70,000) $ 570,000 600,000 $ 70,000 75,000 40,000 16,000 12,000 6,000 7,000 9,000 5,000 240,000 1,410,000 75,000 1,485,000 (87,000) $1,398,000
Johnson Industries Cost of Goods Sold Schedule For the month of September, 20X1
$1,398,000 Cost of goods manufactured 65,000 Add: Beginning finished goods inventory, 9/1/X1 1,463,000 Goods available for sale (85,000) Less: Ending finished goods inventory, 9/30/X1 1,378,000 Unadjusted cost of goods sold (5,000) Less: Over-applied overhead $1,373,000 Cost of goods sold
$235,000 * Actual overhead costs Applied overhead costs ($6/hr. x 40,000 hrs.) 240,000 Over-applied $ 5,000
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12-7
Lesson 13
Process Costing in a Manufacturing Business
Job order costing is a system of accounting used by manufacturing companies producing a variety of different products from a common manufacturing facility or process. Process costing is a system of accounting used by companies that operate factories or manufacturing processes that produce the same product over and over on a continuous basis. The two key characteristics that call for the use of process costing as opposed to job order costing are:
1. The company's manufacturing procedures are essentially the same for every unit produced, and 2. The final completed units are all basically the same.
Lesson 13
Product Costing Continued
Companies that use process costing are typically businesses that massproduce their products through some kind of a production line or standardized manufacturing process. Businesses that make their products using an assembly line, including automobile manufacturers, or makers of appliances like washing machines or television sets, will typically use process costing, at least to some extent, to determine the cost of each unit produced. Oil refineries, mining companies, food processors, pharmaceutical companies and other businesses involved in the mass production of standardized products will all typically use process costing.
Direct labor costs incurred:
Completion of production:*
WIP Inventory Cash or Wages Payable

Indirect labor costs incurred:
XXX
XXX
Finished Goods Inventory WIP Inventory

Sale of finished units:
XXX
XXX
Manufacturing Overhead Cash or Salaries/Wages Payable
XXX
XXX
Cost of Goods Sold Finished Goods Inventory
XXX
XXX
Other indirect costs, including factory rent, utilities, depreciation, and other overhead costs incurred:
Manufacturing Overhead Cash Utilities or Other Payables Accumulated Depreciation
XXX
* In a job order cost system this entry is made as each separate job is completed with the amount transferred to finished goods taken from the job cost record maintained for each completed job. In a process cost system, because production is continuous, this entry is made once at the end of each accounting period, and assuming all units in production are completed at the end of the period, the full amount included in the WIP account is credited out and transferred to finished goods. Cost Per Unit = of Production Total cost transferred to finished goods Total number of units completed during the period
XXX XXX XXX
Manufacturing overhead costs applied (predetermined overhead rate):
WIP Inventory Manufacturing Overhead
XXX
XXX
If there are unfinished units in ending WIP, this process costing approach becomes a lot more complicated. In that case, a portion of the production costs added to WIP must be left in the WIP inventory account at the end of the period to reflect the costs incurred to date on unfinished units. In other words, when there's ending WIP inventory, a company's total production costs must be allocated between the finished and unfinished units to determine the cost of units transferred to finished goods and the costs of units in ending WIP.
Allocation of direct material costs: First determineCost per finished = equivalent Then allocateTo the 98,000 units transferred to finished goods98,000 units x $1.20 per unit = $117,600 To the 2,000 units in ending WIP1,600 units x $1.20 per unit = $1,920 $119,520 = $1.20 cost per unit 99,600 units (98,000 + 1,600)
How should a company's product costs, including its direct materials, direct labor and applied manufacturing overhead costs, be allocated between its finished and unfinished units at the end of the period?
13-1
Direct Labor and Applied Manufacturing Overhead Costs ("Conversion Costs"): Assume Kreamy Peanut Butter's total conversion costs for the month of June amounted to $49,400 and the 2,000 units in ending WIP are only 40% complete in terms of those conversion costs. That means the allocation of a portion of the $49,400 to those 2,000 units will be based on 2,000 units x 40% = 800 finished equivalent units
Allocate the $49,400 of conversion costs between finished goods and WIP:
Direct material costs Conversion costs Total
Finished Goods Inventory Costs $117,600 $ 49,000 $166,600 # Units 98,000 98,000 Cost/ Unit $1.20 $ .50 $1.70
WIP Inventory Costs $1,920 $ 400 $2,320 # FE Units 1,600 800 Cost/ Unit $1.20 $ .50 $1.70
First determineCost per finished equivalent Then allocate= $49,400 98,800 units (98,000 + 800) = $ .50 cost per unit
Journal entry to record the completed production for the month: Finished Goods Inventory 166,600 WIP Inventory 166,600
To the 98,000 units transferred to finished goods98,000 units x $ .50 per unit = $49,000 To the 2,000 units in ending WIP800 units x $ .50 per unit = $400
Journal entry to record any subsequent sale of the finished units: XXX Cost of Goods Sold (# units sold x $1.70) XXX Finished Goods Inventory
A final complicating factor:

In this case, we'll assume that in addition to the 98,000 units of production started and completed in the month of June, and 2,000 partially completed units in process at the end of the month, an additional 3,000 unfinished units were carried over from the prior month's production and finished in the current period. In other words, we'll assume the company had 3,000 units in beginning WIP that were then completed in the current period and transferred to finished goods. We'll also assume that at the beginning of the period, those 3,000 units were 80% complete as to direct materials at a cost of $2,832, and 70% complete as to conversion, at a cost of $987. In addition, we'll assume the total costs of production for the month increased from $119,520 to $120,240 for direct materials and from $49,400 to $49,850 for conversion costs given the additional costs required to complete the 3,000 units of beginning inventory. Direct Materials Conversion # of % % Units Completed Completed Costs Costs
Beginning WIP inventory Units started and completed Costs added during the month Ending WIP inventory 3,000 98,000 2,000 80% 80% $2,832 $120,240 40% 70% $987 $49,850
Production Cost Report (June, 20X5)
Finished Equivalent Units of Production for the Month

Direct Material Costs
# of Units % Completed in Current Period Finished Equivalent Units
Conversion Costs
% Completed in Current Period Finished Equivalent Units
Beginning WIP Started and completed Ending WIP
3,000 98,000 2,000
20% 100% 80%
600 98,000 1,600 100,200
30% 100% 40%
900 98,000 800 99,700
Cost Per Unit of Production

Current Period: Direct material costs Conversion costs
Total Costs Equivalent Units Cost per Unit
$120,240 $ 49,850 $170,090
100,200 99,700
= =
$1.20 $ .50 $1.70 $1.18 $ .47 $1.65
Begin by calculating Kreamy Peanut Butter's current cost per unit of production.
Beginning WIP (3,000 units) Direct material costs $ 2,832 Conversion costs $ 987 $ 3,819 $173,909
2,400 (80%) 2,100 (70%)
= =
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Production Cost Report (continued)
WIP Inventory - Mixing Department

Beginning inventory Cost added during the month: Direct material costs Conversion costs Ending inventory XXX XXX XXX XXX XXX Completed production
Allocation of Costs to Finished Goods

Beginning WIP (3,000 units): Costs from prior period Direct material costs Conversion costs Costs from current period: Direct material costs Conversion costs Started and completed (98,000 units) Total allocation
Cost per Unit Equivalent Units Allocated Cost
$ $1.20 $ .50 $1.70 x x x 600 (20%) 900 (30%) 98,000 = = =
2,832 987
WIP Inventory - Baking Department

Beginning inventory Production from mixing dept. Cost added during the month: Direct material costs Conversion costs Ending inventory XXX XXX XXX XXX XXX XXX Completed production
720 450 166,600 $ 171,589

Allocated Cost
Allocation of Costs to Ending WIP

Ending WIP (2,000 units): Direct material costs Conversion costs Total allocation Grand total
Cost per Unit Equivalent Units
WIP Inventory - Packaging Department

Beginning inventory Production from baking dept. Cost added during the month: Direct material costs Conversion costs Ending inventory XXX XXX XXX XXX XXX XXX Completed production
$1.20 $ .50
x x
1,600 (80%) 800 (40%)
= =
$ $
1,920 400 2,320
$ 173,909
Journal entry to record the completed production for the month: Finished Goods Inventory 171,589 WIP Inventory 171,589
Finished Goods Inventory

Beginning inventory Production from packaging dept. Ending inventory XXX XXX XXX XXX Cost of goods sold
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13-2
Actual costs: Utilities Rent Indirect Labor Indirect materials Depreciation Etc. Balance before adjustment (under-applied) XXX XXX XXX XXX XXX XXX XXX XXX Applications to WIP
Summary
The primary purpose behind both job order and process costing is the determination of a company's cost per unit of production. That's crucial information from both a managerial as well as a financial accounting perspective. Without an accurate knowledge of a company's cost per unit of production successful management of a company's operations is virtually impossible. From a financial reporting standpoint, a company's costs of goods transferred to finished goods and resulting balances in ending WIP, finished goods and cost of goods sold are ultimately based on a company's costs per unit of production. In a job order cost system used by companies that manufacture a variety of products from a common factory or process, this per unit cost is determined through job cost records maintained for each separate batch of units produced. In a process cost system used by companies that continuously produce the same product, the cost per unit of production is determined through production cost reports prepared for each of product's manufacturing processes.
Adjusting entry:
XXX
XXX
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The basic steps reflected in those production cost reports include:

1. The determination of the number of units produced during the period. (If there are partially completed units in beginning and ending WIP inventory then the number of units produced for the period must be stated in terms of finished equivalent units of production as to both direct materials and conversion costs. 2. The company's actual direct material and conversion costs added to production during the period are then divided by those finished equivalent units to determine the company's cost per unit of production. 3. For managerial purposes, that cost per unit of production is then usually compared to the prior period cost per unit for purposes of evaluation. 4. For financial reporting purposes, the cost of units completed and transferred to finished goods during the period is determined by adding any costs of beginning WIP, the costs incurred in completing those units and costs incurred on new units started and completed during the current period at the current period's cost per unit of production. The cost of ending WIP inventory can also be determined by using that same cost per unit times the finished equivalent units in WIP at the end of the period.
Problem 13-1
Production Cost Report

After reviewing the production cost report provided below, respond to the requirements that follow: Excel Industries Production Cost Report (April, 20X9) Direct Material Costs
# of Units 500 8,000 600 % Completed in Current Period 30% 100% 80% Finished Equivalent Units 150 8,000 480 8,630
Finished Equivalent Units of Production for the Period

Conversion Costs
% Completed in Current Period 40% 100% 50% Finished Equivalent Units 200 8,000 300 8,500

Current Period: Direct material costs Conversion costs Beginning WIP (500 units) Direct material costs Conversion costs
Total Costs $ 72,492 $ 44,200 $116,692 Equivalent Units 8,630 8,500
= =
Cost per Unit $ 8.40 $ 5.20 $13.60
$ 2,940 $ 1,530 $ 4,470 $121,162
350 (70%) 300 (60%)
= =
$ 8.40 $ 5.10 $13.50
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Problem 13-1 Production Cost Report (continued)
Problem 13-1
Requirements: A. Identify the following for Excel Industries for the month of April, 20X9:
1. Percentages of completion in beginning WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. 2. Percentages of completion in ending WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. 3. Finished equivalents units of production in the current period to complete the beginning WIP inventory in terms of both direct materials and conversion costs. 4. Total finished equivalent units of production for the month in terms of both direct materials and conversion costs. 5. Direct material cost per unit of production during the month. 6. Conversion cost per unit of production during the month. 7. Total cost of beginning WIP inventory. 8. Total costs added to WIP during the month. 9. Total cost of units completed during the month. 10. Total cost of ending WIP inventory.
Allocation of Costs to Finished Goods

Beginning WIP (500 units): Costs from prior period Direct material costs Conversion costs Costs from current period: Direct material costs Conversion costs Started and completed (8,000 units) Total allocation
$ $8.40 $5.20 $13.60 x x x 150 (30%) 200 (40%) 8,000 = = =
2,940 1,530
1,260 1,040 108,800 $ 115,570

Allocated Cost
Allocation of Costs to Ending WIP

Ending WIP (600 units): Direct material costs Conversion costs Total allocation Grand total
Cost per Unit Equivalent Units
$8.40 $5.20
x x
480 (80%) 300 (50%)
= =
$ $
4,032 1,560 5,592
B. What is the combined cost of beginning WIP inventory and costs added to WIP during the period and does that amount equal the combined cost of units completed during the period and ending WIP inventory? Will those amounts always be same and why? C. What journal entry would be made to record the company's completed production for the month? D. How did the company's April production costs per unit compare to the same costs in March?
$ 121,162
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13-3
Production Cost Report

A. Identify the following for Excel Industries for the month of April, 20X9:
1. Percentages of completion in beginning WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. Direct material cost: 70% Conversion costs (including direct labor and manufacturing overhead): 60% 2. Percentages of completion in ending WIP inventory in terms of direct materials, direct labor and manufacturing overhead costs. Direct material cost: 80% Conversion costs (including direct labor and manufacturing overhead): 50% 3. Finished equivalents units of production in the current period to complete the beginning WIP inventory in terms of both direct materials and conversion costs. Direct material cost: 150 units Conversion costs : 200 units 4. Total finished equivalent units of production for the month in terms of both direct materials and conversion costs. Direct material cost: 8,630 units Conversion costs : 8,500 units
5. Direct material cost per unit of production during the month. $8.40 6. Conversion cost per unit of production during the month. $5.20 7. Total cost of beginning WIP inventory. $4,470 8. Total costs added to WIP during the month. $116,692 9. Total cost of units completed during the month. $115,570 10. Total cost of ending WIP inventory. $5,592 B. What is the combined cost of beginning WIP inventory and costs added to WIP during the period and does that amount equal the combined cost of units completed during the period and ending WIP inventory? $121,162 Will those amounts always be same and why? Answer: Yes, assuming the production cost report is accurately prepared. The total cost of beginning WIP inventory plus costs added during the period must be equal to the costs transferred out of WIP (cost of completed production) and costs left in ending inventory.
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Problem 13-2
C. What journal entry would be made to record the company's completed production for the month?
Process Costing
Adams, Inc. utilizes two process centers (processing and packaging) to manufacture boxes of laundry detergent. Assuming all direct materials used in the processing department are added at the beginning of the production process, and given the following information for the center's September, 20X8 activities:
Direct Material Costs $18,600 $894,900 5,000 70%
Finished Goods Inventory WIP Inventory
115,570
115,570
D. How did the company's April production costs per unit compare to the same costs in March? Answer: The same for direct material costs and higher for conversion costs. Costs Per Unit of Production
March April
Conversion
% Completed 60% Costs $5,400 $434,568
# of Units Beginning WIP inventory Units started and completed Costs added during the month Ending WIP inventory 6,000 280,000
$8.40 5.10 $13.50
$8.40 5.20 $13.60
A. Prepare the company's journal entry to record the processing center's completed production for the month of September. B. Compare the processing center's September costs per unit of production with the costs from the prior month and explain what could give rise to the increase or decrease.
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Problem 13-2 - Answer Production Cost Report - Processing Center (September, 20X8)
Process Costing
A. Prepare the company's journal entry to record the processing center's completed production for the month of September.
Finished Equivalent Units of Production for the Period

Direct Material Costs Conversion Costs
% Completed in Current Period 40% 100% 70% Finished Equivalent Units 2,400 280,000 3,500 285,900 % Completed in Current Period 0% 100% 100% Finished Equivalent Units 0 280,000 5,000 285,000
WIP Inventory - Packaging Center WIP Inventory - Processing Center
1,332,448
1,332,448
B. Compare the processing center's September costs per unit of production with the costs from the prior month and explain what could give rise to the increase or decrease. Costs Per Unit of Production
August September
# of Units 6,000 280,000 5,000
$3.10 1.50 $4.60
$3.14 1.52 $4.66

Current Period: Direct material costs Conversion costs Beginning WIP (500 units) Direct material costs Conversion costs
Total Costs $ 894,900 $ 434,568 $1,329,468 Equivalent Units 285,000 285,900
Answer: The increasing cost of direct materials could be the result of increasing material prices or less efficient use of the materials in the production process as a result of increased waste or other factors. The increasing conversion costs could be the result of increasing wage rates, increasing overhead costs or less efficiency in the production process.
= =
Cost per Unit $3.14 $1.52 $4.66
18,600 5,400 $ 24,000 $1,353,468
6,000 (100%) 3,600 (60%)
= =
$3.10 $1.50 $4.60
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13-4
Problem 13-2 - Answer Production Cost Report - Processing Center (continued)
Allocation of Costs to Completed Units Transferred to Packaging Center

Beginning WIP (6,000 units): Costs from prior period Direct material costs Conversion costs Costs from current period: Direct material costs Conversion costs Started and completed (280,000 units) Total allocation
$ $3.14 $1.52 $4.66 x x x 0 2,400 (40%) 280,000 = = =
18,600 5,400
3,648 1,304,800 $1,332,448
All of the process costing examples and problems we've used in this lesson up to this point in time have assumed a first-in first-out, or FIFO, inventory cost flow. That means we've assumed all units in beginning WIP were completed first in the current period before any new units were started in the production process. As a result, all costs in beginning WIP inventory were allocated to units completed during the period. No beginning WIP costs were carried over to ending WIP inventory.
Allocation of Costs to Ending WIP - Processing Center

$3.14 $1.52
x x
5,000 (100%) = 3,500 (70%) =
$ $
15,700 5,320 21,020
$1,353,468
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Production Cost Report - Processing Center
Allocation of Costs to Completed Units Transferred to Packaging Center

Beginning WIP (6,000 units): Costs from prior period Direct material costs Conversion costs Costs to complete in current period: Direct material costs Conversion costs Started and completed (280,000 units) Total allocation
$ $3.14 $1.52 $4.66 x x x 0 2,400 (40%) 280,000 = = =
18,600 5,400
3,648 1,304,800 $1,332,448
Allocation of Costs to Ending WIP - Processing Center

An alternative to this FIFO process costing assumption is a weighted average approach which assumes that all beginning WIP units and costs are simply mixed in with the new units started in the current period, such that the beginning costs are spread out evenly over both finished and unfinished units at the end of the period. Although this approach is sometimes used for financial reporting purposes to smooth out the effect of changing costs over time, from a managerial perspective this weighted average approach really doesn't make much sense. It ignores the actual physical flow of goods and fails to reflect the true cost per unit of production from one period to the next.
$3.14 $1.52
x x
5,000 (100%) = 3,500 (70%) =
$ $
15,700 5,320 21,020
$1,353,468
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In some cases, companies will actually use a combination of both process and job order costing to determine their costs per unit of production. When companies manufacture a variety of similar products in batches or jobs that undergo a number of common manufacturing processes, then both job order and process costing methods will be used to determine the cost of each unit produced.
For example, a clothing manufacturer making the same shirt in a variety of different fabrics will use a combination of both process and job order costing to determine their total production cost per shirt. If the cutting and sewing of each shirt is exactly the same regardless of the fabric used, then process costing will be used to determine the company's cutting and sewing, or conversion costs per unit. On the other hand, direct material costs will depend on the specific fabric used to make each shirt. Assuming batches of shirts are produced according to the fabric used, then job order costing will be used to determine the direct material cost per unit. The combined total of both the direct material costs and conversion costs per unit will then be added together to determine each shirt's total cost.
Merchandising Businesses
Serve as channels of distribution in getting a manufacturer's finished product to its final end user or consumer.
Wholesale distributors are in the business of buying finished products from manufacturers and then selling those products to a large number of different retail merchandisers. Most wholesalers focus on products in a particular industry. To operate effectively, wholesalers typically enter into distribution contracts with key manufacturers that provide favorable pricing on large volume purchases. The wholesaler then makes a profit if they're able to sell the products to retailers at a price that covers not only the cost of the merchandise purchased but also all of the company's other operating costs, including costs incurred in the handling and shipping of merchandise. Handling refers to the process of breaking down large shipments from manufacturers and then picking and re-packaging those goods for smaller deliveries to specific retail customers. A wholesaler's ability to perform this function efficiently and then ship the goods at the lowest possible cost is crucial to the company's ultimate success. That's why most wholesale distributors operate from large warehouses located near airports, train yards, shipping docks or major freeways. Retail distributors operate stores and shops that typically buy goods from a large number of different wholesale distributors or purchase goods directly from manufacturers and then sell those goods to final customers.
The point here is that both process and job order costing can be used on a combined basis in a company's product cost system. The determination of which method should be used for each of a company's specific costs will depend entirely on the nature of the company's products and production processes.
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13-5
The Flow of Product Costs in a Merchandising Business

Inventory
Beginning balance Cost of merchandise purchased* Ending balance XXX XXX Cost of merchandise sold
Example: A wholesaler of landscape maintenance equipment and garden tools purchased 1,000 lawn mowers from a Chinese manufacturer at a price of $75 dollars per unit.
Purchase price Freight costs Import fees and duties In-transit insurance Total Total cost per unit $75,000 5,000 2,000 500 $82,500 1,000 units $ 82.50
Cost of Goods Sold

Cost of merchandise sold XXX
* Includes the net price paid to suppliers plus any freight costs, import fees, insurance premiums paid to cover the risk of lost or damaged goods in transit from the supplier, and any other direct costs incurred in the acquisition and receipt of the purchased goods.
A merchandising company should probably also include in this cost some allocation of costs associated with the company's purchasing department, plus other costs incurred in the handling and storing of purchased goods. Those are certainly costs incurred to acquire the merchandise and get it ready for its intended use. to be shipped or provided for sale to customers. Although that makes sense in theory, in actual practice most companies simply expense those costs when incurred as part of the company's general and administrative expenses. Meaningful allocations of those costs to specific products are difficult and efforts to understand and control those costs can be more effectively accomplished through a method referred to as activity based costing, which will be discussing in a subsequent lesson.
Total Cost Per Unit =
Total Capitalized Costs Total Number of Units Purchased
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Problem 13-3
Merchandising Questions
1. Some manufacturers successfully sell their products direct to final end users or consumers. For example, Dell is a personal computer manufacturer that uses no wholesalers or retailers in the distribution of its products. All sales are made direct to hundreds of thousands of individual customers. Why do you suppose, most manufacturers limit their channels of distribution to wholesale and/or retail distributors, when higher prices could be charged on direct sales to end users and consumers? 2. Why do you think a retail business might choose to buy products from a wholesaler, when the same product could be purchased direct from the manufacturer at a lower price?
Merchandising Questions
1. Some manufacturers successfully sell their products direct to final end users or consumers. For example, Dell is a personal computer manufacturer that uses no wholesalers or retailers in the distribution of its products. All sales are made direct to hundreds of thousands of individual customers. Why do you suppose, most manufacturers limit their channels of distribution to wholesale and/or retail distributors, when higher prices could be charged on direct sales to end users and consumers?
Answer: Direct sales to end users and consumers usually takes a significant investment of resources and requires management expertise that may be very different from that typically found in a manufacturing business. In short, the costs incurred in a successful direct sales effort could easily exceed any additional revenues earned on higher prices. The fact is Dell is an unusual company. In fact, its really two companies in one. It's combines both manufacturing and merchandising and is totally committed in terms of management effort and resources to both phases of the business. In today's world most manufacturers have chosen to focus their efforts and limited resources on what they do best manufacture quality products at the lowest possible cost. In effect, they've decided to leave the merchandising to other company's that specialize in the distribution process. In most cases that's not a bad decision, and in many ways that makes a lot of sense in terms of a more efficient and cost effective economy. The effective distribution of goods can be an expensive and complicated logistical process, and the development of companies that specialize in that process is a big reason why the US economy is as prosperous as it is.
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2. Why do you think a retail business might choose to buy products from a wholesaler, when the same product could be purchased direct from the manufacturer at a lower price?
Answer: Wholesalers may provide a variety of services that can more than compensate for their product's higher price. For one, wholesalers usually offer a wide variety of merchandise that can greatly simplify a retailer's purchasing process. The savings in terms of time and effort in dealing with a few wholesalers as opposed to numerous manufacturers can be significant. In addition, wholesalers are usually set up to make smaller more frequent shipments of merchandise. This allows retailers to reduce the amount of inventory that must be maintained at any point in time to meet continuing customer demand. The maintenance of excess inventory can be extremely expensive; it eats up valuable floor space, increases handling and financing costs and can sometimes result in increased write-downs due to product obsolescence. The use of wholesalers to reduce a company's inventory levels and related costs might more than offset a wholesaler's higher product prices.
Service Businesses
A service business is any company that doesn't manufacture or distribute a physical product, or at least that's not its primary purpose.
Common service businesses include:

CPA firms Law firms Hospitals and other medical service providers Banks Real estate brokerage firms Insurance companies Consulting firms Software programming companies Airlines Trucking and delivery companies Educational institutions Etc.
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13-6
Effective management of a service company requires a knowledge and understanding of the company's product costs, just as it does for a manufacturing or merchandising business. However, in this case, product costs refer to the costs incurred in providing the company's services rather than the costs associated with the manufacture or purchase of a physical product. Example: A hospital's product costs will include all of the costs incurred in providing patient services, including:
Direct labor costs - Salaries and wages of any doctors, nurses or other employees of the hospital involved in the direct care of patients. Overhead costs* - Any salaries and wages of indirect support personnel, depreciation of buildings, equipment rent, utilities, insurance, and all of the other costs associated with the operation of the hospital.
For most service companies, direct material costs are relatively insignificant, if they exist at all. For example, a law firm may use miscellaneous office supplies in the performance of its services but those costs aren't significant enough to account for them separately as raw materials inventory or even as an asset ("Supplies"). Instead those costs are simply included as part of the company's overhead costs. For some service businesses, like a hospital, certain supplies including drugs, syringes, bandages and other items may be accounted for separately as materials inventory or supplies due to their considerable cost. When those items are then requisitioned and used in a patient's care, those costs become a direct material cost of the service provided. In fact, those costs are usually reflected in a patient's billing as a separately recorded charge.
* In many cases, service companies will also include any general and administrative costs as part of their product overhead costs. For example, a hospital may include the costs of its accounting department and other administrative personnel as part of the product overhead costs allocated to its various services. That way billing rates for those services or procedures can be set in a way that's designed to cover all of the hospital's anticipated costs. For example, the billing rate for an X-ray may be set at an amount to cover not only the direct costs associated with the X-ray but also a portion of all of the other costs of the hospital.
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Flow of Product Costs In A Service Business

Supplies
Supplies Purchased XXX XXX XXX Supplies Used Direct Labor Applied Overhead
WIP - Services
XXX XXX XXX Completed Services XXX
XXX
Overhead
Actual Overhead Under-Applied XXX XXX Applied Overhead XXX XXX Over-Applied Under-Applied Overhead
Cost of Services
Completed Services XXX XXX XXX XXX Over-Applied Overhead
Close Over-Applied XXX XXX Close Under-Applied
Any balance in the WIP - Services Account represents the company's investment in partially completed services that will ultimately produce future economic benefit when those services are completed and provided to customers. That sounds like an asset to me, and the expensing of those costs when services are finally complete and revenues are recognized from customers is consistent with the requirements of the matching principle.
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Product Costing Example for a Service Business

Our ultimate goal from a managerial standpoint is the determination of a company's cost per service provided. That's important information in determining the price of services to customers, as well as efforts to monitor and control costs, evaluate performance and prepare budgets for the future. Similar to a manufacturing company, the actual accounting used to determine the cost of services provided will naturally require the use of either a process or job ordercosting approach, or some combination of the two depending on the nature of the services provided. For example, a bank's determination of the costs incurred in processing each of its customer checks will naturally use a process costing approach where all of the direct and indirect costs associated with the operation of the bank's check processing department are accumulated and then divided by the number of checks processed during the period. On the other hand, the determination of a CPA firm's costs associated with the performance of a financial statement audit will require the use of a job order cost system. The costs of auditing the financial statements of General Motors will be different from the costs incurred in the performance of an audit of a small start-up company. There is no standardization of procedures in the performance of audits, and in that case, a separate job cost record will be maintained for each of the firm's various jobs. In reality, most service companies use job order costing because most services are tailored to meet the individual and unique needs of each customer.
Example: Use job order costing to do the accounting for the Jones & Company, CPA firm and determine the costs incurred in their performance of a financial statement audit for the Jordan Company for a fee of $25,000. Job Cost Record
Job Description: Jordan Company Audit Date Started: 1/5/X6 Amount of Fee: $25,000 Date Completed: Direct Labor:
Date Name Time Sheets Employee Hours
Rate
Amount
Applied Overhead:
Date Rate
Direct Labor Costs
Amount
Total Cost
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13-7
Accounting given the following transactions and events:

Salaries paid by the firm to its professional employees totaled $50,000 for the month. Based on time sheets, the portion of that total associated with the Jordan Company audit amounted to $14,000.
Work-in Process - Services* Cash 50,000 50,000
Job Cost Record

Date Started: 1/5/X6 Job Description: Jordan Company Audit Amount of Fee: $25,000 Date Completed: Direct Labor:
Rate
Amount
* Sometimes referred to as "Unbilled Service Costs."
$14,000 Applied Overhead:

Date Rate Direct Labor Costs
In addition to this entry, the company's individual job cost records maintained for each of its various jobs will be updated for each job's respective share of the $50,000 total.
Amount
Total Cost
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Total budgeted overhead costs for the upcoming period Predetermined = Overhead Rate Total budget for the measurable activity or cost that correlates with or drives overhead costs over the same period
Assume that the Jones & Company CPA firm allocates its overhead on the basis of direct labor costs, and the firm's budgeted overhead costs for the year amounted to $350,000 with direct labor costs budgeted at $620,000.
$350,000 Predetermined = = $ .56 per direct labor dollar Overhead Rate $620,000 In the current month, the firm's total overhead application: $50,000 direct labor costs (x) $ .56 = $28,000
Work-in Process - Services Overhead 28,000 28,000
For many service companies the measurable activity or cost used in determining its overhead rate also serves as the basis for billing customers or establishing the price of its services. Such an approach makes sense given that profitable companies must charge a price for each service that covers all of its direct costs and all of its overhead costs allocated on a job-by-job basis. If the same basis used for allocating overhead is also used to establish billing rates and prices, then coverage of those costs can be reasonably assured.
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Job Cost Record

Assume the firm's audit of the Jordan Company financial statement is completed at the end of the month at which time a bill is sent out for the firm's $25,000 fee.
Accounts Receivable Fee Revenues Cost of Services Work-in Process - Services 25,000 25,000 21,840 21,840
Rate
Amount

Amount
$ .56
$14,000 Total Cost $
$ 7,840
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13-8
Job Cost Record

Assume the firm's audit of the Jordan Company financial statement is completed at the end of the month at which time a bill is sent out for the firm's $25,000 fee.
Accounts Receivable Fee Revenues 25,000 25,000 21,840 21,840
Rate
Amount

Cost of Services Work-in Process - Services
Amount
Gross profit earned = $3,160
$ .56
$14,000 Total Cost
$ 7,840 $ 21,840
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Problem 13-4
At the end of firm's accounting period, the temporary overhead account should be closed out for any over or under-application of overhead made during the period.
Overhead
Actual costs 25,800 28,000 2,200 Applied overhead ($50,000 x $ .56) Over-applied
Job Order Costing in a Service Company

Custom Software, Inc. provides software programming services to customers and bills those customers based on hourly rates associated with each of its three programmers. The hourly billing rate for each programmer is equal to 200% of the combined amount of the programmer's hourly wage rate plus allocated overhead costs. Allocations of overhead are made based on the company's total budgeted overhead costs for the year as a percentage of total anticipated programmer wages (direct labor costs). A. Given the following information, determine the hourly billing rate to be charged to customers for each programmer's services during the current year.
Programmer Budget for the Year Overhead Budget for the Year
Building rent Utilities Office salaries Office supplies Office equipment depreciation Taxes and insurance Other costs Total $ 12,000 4,200 28,000 8,800 2,400 6,600 7,600 $ 69,600
Closing entry: Overhead Cost of Services 2,200 2,200
Programmer
Wage Rate
Anticipated Hours
Mary Hart Bob Smith Eric Smart
$40/hr. $30/hr. $25/hr.
2,000 1,800 1,600
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Problem 13-4
B. Prepare journal entries for the following during the month of January:
1. Purchased $1,000 of supplies on account. (Assume a separate asset account "Supplies" is used to account for supplies on hand.) 2. Paid programmer wages totaling $14,000. 3. Paid various overhead costs including, rent, utilities, office salaries, etc. totaling $4,800. 4. Recorded $200 of depreciation on office equipment. 5. The cost of supplies used up totaled $700. 6. Applied overhead to customer projects. 7. Billed customer (Axim Enterprises) for project started and completed during the month. (Total programmer hours incurred: Mary Hart - 120 hrs., Eric Smart - 30 hrs.)
Job Order Costing in a Service Company

A. Given the following information, determine the hourly billing rate to be charged to customers for each programmer's services during the current year.
Billing Rates for the Year
Programmer Wage Rate Overhead at 40%* of Wage Rate Wage and Overhead Rate Billing Rate
$40/hr. $30/hr. $25/hr.
+ + +
$16/hr. $12/hr. $10/hr.
= = =
$56/hr. $42/hr. $35/hr.
x x x
200% 200% 200%
= $112/hr. = $84/ hr. = $70/hr.
* Overhead Rate =
Total Budgeted Overhead Costs Total Anticipated Programmer Wages
C. What was the company's markup on cost used in establishing billing rates and determine the gross margin percentage earned on the Axim Enterprises project. D. Prepare the closing entry at the end of the year if total actual overhead costs incurred during the year amounted to $70,750 and total wages paid to programmers came to $180,000.
$69,600 = 40 % of wages $174,000** **

Programmer Wage Rate Anticipated Hours Total Anticipated Wages
$40/hr. $30/hr. $25/hr.
x x x
2,000 1,800 1,600
= = =
$ 80,000 $ 54,000 $ 40,000 $174,000
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13-9
B. Prepare journal entries for the following during the month of January:
1. Purchased $1,000 of supplies on account. (Assume a separate asset account "Supplies" is used to account for supplies on hand.) Supplies Accounts Payable 2. Paid programmer wages totaling $14,000. Work-in-Process Services Cash 14,000 14,000 1,000 1,000
6. Applied overhead to customer projects. Work-in-Process Services Overhead 5,600* 5,600
* $14,000 (programmer wages) x 40% = $5,600
7. Billed customer (Axim Enterprises) for project started and completed during the month. (Total programmer hours incurred: Mary Hart - 120 hrs., Eric Smart - 30 hrs.) Accounts Receivable* Fee Revenues
*Axim Enterprises Billing
Mary Hart Eric Smart 120 hrs. 30 hrs. x x $112/hr. $70/hr. = = $13,440 $ 2,100 $15,540
15,540 15,540
3. Paid various overhead costs including, rent, utilities, office salaries, etc. totaling $4,800. Overhead Cash Overhead Accumulated Depreciation 5. The cost of supplies used up totaled $700. Overhead Supplies 700 700 4,800 4,800 200 200
4. Recorded $200 of depreciation on office equipment.
Cost of Services** Work-in-Process Services

Direct Labor: Mary Hart Eric Smart Overhead Applied Total Cost
7,770 7,770
**Axim Enterprises Job Cost Record

120 hrs 30 hrs. $5,550 x x x $40/hr. $25/hr. 40% = = = $4,800 750 5,550 2,220 $7,770
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C. What was the company's markup on cost used in establishing billing rates and determine the gross margin percentage earned on the Axim Enterprises project. Fee revenues Less: Cost of services Gross margin or profit $15,540 7,770 $ 7,770
D. Prepare the closing entry at the end of the year if total actual overhead costs incurred during the year amounted to $70,750 and total wages paid to programmers came to $180,000.
Closing entry:
50% gross margin/profit $7,770 = 100% $7,770

Actual costs
Overhead Cost of Services Overhead

70,750 1,250 0
1,250 1,250
Markup Markup on Cost = = Cost
72,000 Applied overhead ($180,000 x 40%) 1,250 Over-applied
Answer: Billing rates based on 200% of cost produce a 100% markup and a 50% gross margin.
Closing entry
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13-10
Lesson 15
How much does it cost to make my product?
Traditional product costing
Direct Materials Direct Labor
Lesson 15
ACTIVITY-BASED COSTING
ABC: Innovative method of assigning overhead costs to products
Overhead Overhead - Allocated in proportion to Direct Labor cost.
Activity-based costing
Direct Materials Direct Labor Overhead Overhead - Identify specific activities that cause overhead costs.
Example
Example
Computing the total cost of cooking Chinese food in the Stice kitchen
Traditional approach
Direct Materials - chicken, vegetables, tofu. Direct Labor - time required for the chef (Ramona) to combine and monitor. Overhead - allocate a portion of overall kitchen overhead:
Use of spices, seasonings, etc. Cutting, chopping and other preparation. CLEANING. Serving. Many different courses.
Computing the total cost of cooking Chinese food in the Stice kitchen
ABC approach
Direct Materials - chicken, vegetables, tofu. Direct Labor - time required for the chef (Ramona) to combine and monitor. Overhead - allocate a portion of overall kitchen overhead:
Use of spices, seasonings, etc. Cutting, chopping and other preparation. CLEANING. Serving. Many different courses.
Allocate a portion of total kitchen overhead based on how much chef time (direct labor) is taken in cooking the Chinese meal. ASSUMES that the amount of direct labor time spent by the chef is proportionate to the amount of overhead created. Vastly UNDERSTATES overhead created by the cooking of Chinese food in the Stice kitchen.
Assign overhead based on the specific activities that create overhead cost: Count the number of spices and seasonsings used. Count the number of courses. Count the number of pots, pans, dishes, and utensils used. The ABC approach to assigning overhead costs gives a better reflection of the economic cost created in the production of a particular product or service.
Some Cautions
1. For many products and services, the amount of direct labor time is a good reflection of the amount of overhead created.
If all products are similar, then the direct labor time is probably proportionate to the amount of overhead created. The advantage of an ABC system comes when the types of products and services differ substantially.
More Detailed Example
Lily's Ice Cream Company

Lily manufactures ice cream. Traditionally has produced and sold just plain vanilla. Solid profits. Lily has decided to start making and selling her own flavors of gourmet ice cream.
2. An ABC accounting system typically is more expensive to operate. 3. The objective is to make better business decisions.
The cost to acquire additional, better data must be weighed against the benefit in terms of better decisions.
New overhead costs:

Flavor chemist. Many new quality control inspectors. - Inspection at start and end of every batch. New machine workers, setup for the many new batches. Machines need to be cleaned more frequently. Accounting costs have gone up (had to hire more people). - Ordering different ingredients.
15-1

Traditionally, Lily has had a very simple method of overhead allocation.
Total overhead divided by number of gallons of ice cream produced. Each gallon of ice cream allocated the same amount of overhead.

Here are Lily's problems:
Overall profitability has slipped since the introduction of the new flavors. The vanilla ice cream is now being sold at a loss.
Lily is considering whether to stop selling vanilla ice cream.

She first wants to do a more detailed overhead cost analysis using the ABC approach.
Five Steps in implementing and using an ABC system

1. Identify overhead cost activities. 2. Analyze individual overhead costs in terms of cost activities. 3. Identify measurable cost drivers. 4. Assign overhead. 5. Use the ABC data to make decisions.
Step 1
Identify overhead cost activities

Total overhead for Lily Ice Cream Company for the most recent year is $1,740,000. The number of gallons of ice cream produced during the year was 1,500,000. Traditional overhead assigned to each gallon of ice cream. ($1,740,000 / 1,500,000 gallons)
$1.16 per gallon

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10
This total of $1,740,000 in overhead cost is broken down into the following categories.
Overhead Costs
Electricity $200,000 Machine depreciation 400,000 Factory cleaners 300,000 Machine repairpersons 100,000 Production supervisor 200,000 Flavor chemist 170,000 Accounting department 150,000 Building depreciation 80,000 Security guards 90,000 Building insurance 50,000 Total $1,740,000
We need a better understanding of the key production activities that create overhead costs!!!!
Lily has created the following list of key overhead cost activities.
1. Operating the ice cream production process. 2. Producing a specific batch of ice cream. 3. Servicing the special needs of each individual ice cream flavor. 4. Keeping the factory open.
Does the production of a gallon of each flavor:

Use the same amount of electricity? Create same amount of factory cleanup? Require the same amount of ingredient testing by the chemist?
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15-2
Operating the ice cream production process

Electricity to operate the machines. Wear and tear on the machines themselves. Mess that the factory cleaners must clean. Machine repair. Production supervision. Accounting - preparation of production reports.
Producing a specific batch of ice cream

Clean out the old flavor residue. More stopping, more machine repairs. Production supervisor quality inspection of each batch. Accounting - tracking costs, supplies and creating reports for each batch.
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Servicing the special needs of each individual ice cream flavor

Hire flavor chemist. Production supervisor monitors recipes. Accounting - ordering various ingredients.
Keeping the factory open

Accounting -- prepare financial statements, periodic income tax filings, payroll tax reports. Building depreciation Insurance Security
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We need a better understanding of the key production activities that create overhead costs!!!!
Lily has created the following list of key overhead cost activities.
1. Operating the ice cream production process. 2. Producing a specific batch of ice cream. 3. Servicing the special needs of each individual ice cream flavor. 4. Keeping the factory open.
The four general categories of overhead cost activities are:

1. 2. 3. 4. Unit level
Machine maintenance Machine depreciation Electricity and other energy costs.
Unit Batch Product line Facility support Batch level

Inspections Machine setups Movement of and accounting for materials.
Product line
Engineering product design. Managing by a special supervisor of all activities associated with a particular product line. Storage in special warehouses. Ordering, purchasing, and receiving materials unique to a particular product line.
Facility support
Property taxes Factory insurance Security Landscaping General accounting General factory administration
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15-3
Problem 15-1
Identifying overhead cost activities

Below is a list of overhead cost activities. For each activity, determine whether it is a Unit Level, Batch Level, Product Line, or Facility Support activity.
1. Employee training. Employees need special training to work with each of the company's different products. 2. Product inspection. No inspection is performed on each unit produced. Instead, a sample of units from each production batch is inspected. 3. Electricity. The production machines are powered by electricity. 4. Liability insurance. Because of hazardous chemicals used throughout the plant, the company is required to buy a liability insurance policy. 5. Product design. A staff of design engineers generates refinements to the designs of each of the products. 6. Vice president in charge of production. This company vice president has specific responsibility for overseeing all aspects of the production facility. 7. Machine setup. The production machines must be repositioned and inspected at the beginning of each production batch. 8. Machine setup. The production machines must be repositioned and inspected only when production is changed from one type of product to another. 9. Product inspection. An inspection is performed on each unit produced. 10. Machine maintenance. The production machines need constant preventative maintenance in order to extend their operating lives.
Identifying overhead cost activities 1. Employee training . . . . . . . . . . . . . . . . . . . . Product Line 2. Product inspection . . . . . . . . . . . . . . . . . . . . Batch Level 3. Electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . Unit Level 4. Liability insurance . . . . . . . . . . . . . . . . . . . . Facility Support 5. Product design . . . . . . . . . . . . . . . . . . . . . . . Product Line 6. Vice president in charge of production . . . . Facility Support 7. Machine setup . . . . . . . . . . . . . . . . . . . . . . . Batch Level 8. Machine setup . . . . . . . . . . . . . . . . . . . . . . . Product Line 9. Product inspection . . . . . . . . . . . . . . . . . . . . Unit Level 10. Machine maintenance . . . . . . . . . . . . . . . . . Unit Level
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Step 2
Analyze individual overhead costs in terms of cost activities

Lily Ice Cream Company overhead costs
Overhead Costs
Overhead Costs and Overhead Cost Activities

Overhead Cost Overhead Cost Activity
Four identified overhead cost activities.
1. Operating the ice cream production process. 2. Producing a specific batch of ice cream. 3. Servicing the special needs of each individual ice cream flavor. 4. Keeping the factory open
Electricity Machine depreciation Building depreciation Security guards Building insurance
Operating the ice cream production process Operating the ice cream production process Keeping the factory open Keeping the factory open Keeping the factory open
Electricity Machine depreciation Factory cleaners Machine repairpersons Production supervisor Flavor chemist Accounting department Building depreciation Security guards Building insurance Total
$200,000 400,000 300,000 100,000 200,000 170,000 150,000 80,000 90,000 50,000 $1,740,000
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Summary of ABC overhead analysis to this point

Overhead Cost Activities
Overhead Costs Ice Cream Production Ice Cream Batches Ice Cream Flavors Keeping Factory Open
Percentage of Time Spent on Each Activity

Ice Cream Production Ice Cream Batches Ice Cream Flavors Keeping Factory Open
$200,000 400,000 ??? ??? ??? ??? ??? 0 0 0
$0 0 ??? ??? ??? ??? ??? 0 0 0
$0 0 ??? ??? ??? ??? ??? 0 0 0
$0 0 ??? ??? ??? ??? ??? 80,000 90,000 50,000
Factory cleaners Machine repairpersons Production supervisor Flavor chemist Accounting department
30% 15% 15% 0% 10%
70% 85% 50% 0% 30%
0% 0% 35% 100% 20%
0% 0% 0% 0% 40%
Example -- Factory Cleaners Overhead Cost: Ice cream production Ice cream batches $300,000 0.30 = $90,000 $300,000 0.70 = $210,000
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15-4
Complete Analysis of Overhead Cost Items

Overhead Cost Activities
Problem 15-2
Computing cost pools

Percentage of Time Spent on Each Activity
Repairing Equipment Hiring and Training Workers Inspecting Clothing Ordering Materials Creating Clothing Designs
$200,000 400,000 90,000 15,000 30,000 0 15,000 0 0 0 $750,000
$0 0 210,000 85,000 100,000 0 45,000 0 0 0 $440,000
$0 0 0 0 70,000 170,000 30,000 0 0 0 $270,000
$0 0 0 0 0 0 60,000 80,000 90,000 50,000 $280,000
Maintenance people Production foreman Accounting department Design staff Factory superintendent
100% 10% 0% 0% 0%
0% 60% 50% 0% 30%
0% 20% 0% 10% 40%
0% 10% 50% 20% 10%
0% 0% 0% 70% 20%
The total overhead cost associated with each of the categories of factory employee is as follows.
Maintenance people . . . . . $100,000 Production foreman . . . . . . . . 80,000 Accounting department . . . . 150,000 Design staff . . . . . . . . . . . . . 200,000 Factory superintendent . . . . 120,000
Cost Pools
Compute the amount of each of the five cost pools.
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26
Computing cost pools

Repairing Equipment Hiring and Training Workers Inspecting Clothing Ordering Materials Creating Clothing Designs
Step 3
Identify measurable cost drivers
Maintenance people $100,000 Production foreman 80,000 Accounting department 150,000 Design staff 200,000 Factory superintendent 120,000 Total $650,000
$100,000 8,000 0 0 0 $108,000
$0 48,000 75,000 0 36,000 $159,000
$0 16,000 0 20,000 48,000 $84,000
$0 8,000 75,000 40,000 12,000 $135,000
$0 0 0 140,000 24,000 $164,000
Cost driver
Numerical measure of the amount of effort involved in each overhead cost activity.
Accounting department Factory superintendent Maintenance people $100,000 1.00 = $100,000 $150,000 0.50 = $75,000 $120,000 0.30 = $36,000 $150,000 0.50 = $75,000 $120,000 0.40 = $48,000 $120,000 0.10 = $12,000 Production foreman $80,000 0.10 = $8,000 $120,000 0.20 = $24,000 Design staff $80,000 0.60 = $48,000 $200,000 0.10 = $20,000 $80,000 0.20 = $16,000 $200,000 0.20 = $40,000 $80,000 0.10 = $8,000 $200,000 0.70 = $140,000
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Cost Activity
Overhead Cost Driver
Lily Ice Cream Company makes six flavors of ice cream.

Vanilla Marshmallow Caramel Delight Gingerbread Cheesecake Supreme Strawberry Banana Surprise Double Dutch Chocolate Brownie Peanut Butter Swirl
Cost Activity Overhead Cost Driver
Operating the ice cream production process. Producing a specific batch of ice cream. Servicing the special needs of each individual ice cream flavor.
Gallons of ice cream produced. Batches produced.
Operating the ice cream production process. Producing a specific batch of ice cream. Servicing the special needs of each individual ice cream flavor.
Gallons of ice cream produced. Batches produced. Number of ingredients.
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15-5
Cost Activity
Overhead Cost Driver
Operating the ice cream production process. Producing a specific batch of ice cream. Servicing the special needs of each individual ice cream flavor. Keeping the factory open.
Gallons of ice cream produced. Batches produced.
Five Steps in implementing and using an ABC system

1. Identify overhead cost activities. 2. Analyze individual overhead costs in terms of cost activities. 3. Identify measurable cost drivers. 4. Assign overhead.
Number of ingredients.
Not applicable.
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Step 4
Assign overhead
Summary of the analysis of the individual overhead items. Overhead Cost Activities
Cost Drivers
Cost driver Number of cost driver events
$200,000 400,000 90,000 15,000 30,000 0 15,000 0 0 0 $750,000
$0 0 210,000 85,000 100,000 0 45,000 0 0 0 $440,000
$0 0 0 0 70,000 170,000 30,000 0 0 0 $270,000
$0 0 0 0 0 0 60,000 80,000 90,000 50,000 $280,000
Gallons of ice cream produced Batches produced Number of ingredients
1,500,000 gallons 500 batches 100 ingredients
Cost Pools
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Flavors
Number of Gallons
Number of Batches
Number of Ingredients
Overhead cost activity
Cost Pool Amount
Number of Cost Driver Events
Overhead Cost per Cost Driver Event
Ice cream production Ice cream batches Ice cream flavors Keeping the factory open
$750,000 440,000 270,000 280,000
1,500,000 gallons 500 batches 100 ingredients not assigned
$0.50 per gallon $880 per batch $2,700 per ingredient not assigned
Vanilla Marshmallow Caramel Delight Gingerbread Cheesecake Supreme Strawberry Banana Surprise Double Dutch Chocolate Brownie Peanut Butter Swirl Total
500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
25 50 235 60 30 100 500
5 20 25 10 10 30 100
Overhead Cost Assigned to Gingerbread Cheesecake Supreme

Ice cream production: 200,000 gallons $0.50 per gallon Ice cream batches: 235 batches $880 per batch Ice cream ingredients: 25 ingredients $2,700 per ingredient Total overhead assigned to Gingerbread Cheesecake Supreme $100,000 206,800 67,500 $374,300
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15-6
Overhead Assigned to Each Ice Cream Flavor

Flavors Ice Cream Production Ice Cream Batches Ice Cream Ingredients Total Overhead Assigned
Problem 15-3
Using Cost Drivers

Manufacturing Overhead Cost Pools
Division 1
Division 2
Vanilla Marshmallow Caramel Delight Gingerbread Cheesecake Supreme Strawberry Banana Surprise Double Dutch Chocolate Brownie Peanut Butter Swirl Total
$250,000 125,000 100,000 25,000 200,000 50,000 $750,000
$22,000 44,000 206,800 52,800 26,400 88,000 $440,000
$13,500 54,000 67,500 27,000 27,000 81,000 $270,000
$285,500 223,000 374,300 104,800 253,400 219,000 $1,460,000 - $1,740,000 $280,000
Unit-level overhead Batch-level overhead Product line overhead
$210,000 $280,000 $210,000 $700,000
7,500 units 13,500 units 50 batches 90 batches 10 lines 18 lines
Using an ABC analysis, compute how much of the $700,000 in total overhead cost should be assigned to each of the two divisions.
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Using Cost Drivers

Overhead cost activity Cost Pool Amount Total Number of Cost Driver Events Overhead Cost per Cost Driver Event
Step 5
Use the ABC data to make decisions

Vanilla Marshmallow Gingerbread Strawberry Caramel Cheesecake Banana Delight Supreme Surprise Double Dutch Chocolate Brownie Peanut Butter Swirl Total
$210,000 280,000 210,000
21,000 units 140 batches 28 product lines
$10 per unit $2,000 per batch $7,500 per product line
Number of gallons Sales Production cost:

Direct materials Direct labor Overhead ($1.16 per gallon)
500,000 $750,000
200,000 125,000 580,000
250,000 $625,000
200,000 100,000 290,000
200,000
50,000
400,000
100,000
1,500,000
$600,000 $125,000
250,000 100,000 232,000 50,000 15,000 58,000
$800,000 $350,000 $3,250,000

300,000 200,000 464,000 150,000 50,000 116,000 1,150,000 590,000 1,740,000
Overhead Cost Assigned to Division 1

Unit-level overhead: 7,500 units $10 per unit Batch-level overhead: 50 batches $2,000 per batch Product line overhead: 10 product lines $7,500 per line Total overhead assigned to Division 1 $75,000 100,000 75,000 $250,000
Total flavor production cost Flavor gross profit
905,000 ($155,000)
590,000 $35,000
582,000 $18,000
123,000
964,000
316,000 $34,000
3,480,000 ($230,000)
$2,000 ($164,000)
Overhead Cost Assigned to Division 2

Unit-level overhead: 13,500 units $10 per unit $135,000 Batch-level overhead: 90 batches $2,000 per batch 180,000 Product line overhead: 18 product lines $7,500 per line 135,000 Total overhead assigned to Division 2 $450,000
Four items of concern for Lily Ice Cream Company.

1. 2. 3. 4. Overall company gross profit is actually a loss of $230,000. The historical backbone of the company, Vanilla ice cream, is reporting a loss of $155,000. One of the new flavors, Double Dutch Chocolate Brownie, is also reporting a loss. The two money-losing flavors are also the two flavors with the highest sales volume 500,000 gallons for Vanilla and 400,000 gallons for Double Dutch Chocolate Brownie.
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Flavor Profitability Report Based on the ABC Analysis

Vanilla Marshmallow Gingerbread Caramel Cheesecake Delight Supreme Strawberry Banana Surprise Double Dutch Chocolate Brownie Peanut Butter Swirl Total
Flavor Gross Profit

Flavors Traditional ABC

Direct materials Direct labor Overhead (using ABC): Gallons of ice cream Number of batches Number of ingredients
500,000 $750,000
200,000 125,000 250,000 22,000 13,500
250,000 $625,000
200,000 100,000 125,000 44,000 54,000
200,000 $600,000
250,000 100,000 100,000 206,800 67,500
50,000 $125,000
50,000 15,000 25,000 52,800 27,000
400,000 $800,000
300,000 200,000 200,000 26,400 27,000
100,000
1,500,000
$350,000 $3,250,000
150,000 50,000 50,000 88,000 81,000 1,150,000 590,000 750,000 440,000 270,000
Total flavor production cost Flavor gross profit Facility support costs Company gross profit
610,500 $139,500
523,000 $102,000
724,300 ($124,300)
169,800 ($44,800)
753,400 $46,600
419,000 ($69,000)
3,200,000 $50,000 280,000 ($230,000)
(155,000) 35,000 18,000 2,000 (164,000) 34,000 ($230,000)
139,500 102,000 (124,300) (44,800) 46,600 (69,000) $50,000 - $280,000 ($230,000)
Marshmallow Caramel Delight

Selling price per gallon is $2.50 ($625,000 / 250,000 gallons) Direct materials cost of $0.80 per gallon ($200,000 / 250,000 gallons) Direct labor cost of $0.40 per gallon ($100,000 / 250,000 gallons) Overhead
Ice cream production: 250,000 gallons $0.50 per gallon = $125,000 Ice cream batches: 50 batches $880 per batch = $44,000 Ice cream ingredients: 20 ingredients $2,700 per ingredient = $54,000
Flavor gross profit: $625,000 - $523,000 = $102,000
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15-7
Flavor Profitability Report Based on the Traditional System

Average size of the ice cream batches

Flavors Gallons Batches Gallons Per Batch

500,000 $750,000
200,000 125,000 580,000
250,000 $625,000
200,000 100,000 290,000
200,000 $600,000
250,000 100,000 232,000
50,000 $125,000
50,000 15,000 58,000
400,000 $800,000
300,000 200,000 464,000
100,000
1,500,000
$350,000 $3,250,000
150,000 50,000 116,000 1,150,000 590,000 1,740,000
905,000 ($155,000)
590,000 $35,000
582,000 $18,000
123,000
964,000
316,000 $34,000
3,480,000 ($230,000)
$2,000 ($164,000)


500,000 $750,000
200,000 125,000 250,000 22,000 13,500
250,000 $625,000
200,000 100,000 125,000 44,000 54,000
200,000 $600,000
250,000 100,000 100,000 206,800 67,500
50,000 $125,000
50,000 15,000 25,000 52,800 27,000
400,000 $800,000
300,000 200,000 200,000 26,400 27,000
100,000
1,500,000
$350,000 $3,250,000
150,000 50,000 50,000 88,000 81,000 1,150,000 590,000 750,000 440,000 270,000
500,000 250,000 200,000 50,000 400,000 100,000
25 50 235 60 30 100
20,000 5,000 851 833 13,333 10,000
610,500 $139,500
523,000 $102,000
724,300 ($124,300)
169,800 ($44,800)
753,400 $46,600
419,000 ($69,000)
3,200,000 $50,000 280,000 ($230,000)
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Flavor Profitability Report Based on the Traditional System


500,000 $750,000
200,000 125,000 250,000 22,000 13,500
250,000 $625,000
200,000 100,000 125,000 44,000 54,000
200,000 $600,000
250,000 100,000 100,000 206,800 67,500
50,000 $125,000
50,000 15,000 25,000 52,800 27,000
400,000 $800,000
300,000 200,000 200,000 26,400 27,000
100,000
1,500,000
$350,000 $3,250,000
150,000 50,000 50,000 88,000 81,000 1,150,000 590,000 750,000 440,000 270,000

500,000 $750,000
200,000 125,000 580,000
250,000 $625,000
200,000 100,000 290,000
200,000 $600,000
250,000 100,000 232,000
50,000 $125,000
50,000 15,000 58,000
400,000 $800,000
300,000 200,000 464,000
100,000
1,500,000
$350,000 $3,250,000
150,000 50,000 116,000 1,150,000 590,000 1,740,000
905,000 ($155,000)
590,000 $35,000
582,000 $18,000
123,000
964,000
316,000 $34,000
3,480,000 ($230,000)
610,500 $139,500
523,000 $102,000
724,300 ($124,300)
169,800 ($44,800)
753,400 $46,600
419,000 ($69,000)
3,200,000 $50,000 280,000 ($230,000)
$2,000 ($164,000)
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What if Lily doesn't want to stop producing these three flavors, but instead wants to do something with the production process to reduce the cost of producing these flavors so that they can be sold at a profit? The ABC overhead system highlights actions that can be taken to improve profitability. Two characteristics of a good managerial accounting measure are that it: 1. Reflects economic reality and 2. Motivates correct behavior.
Overhead Cost per Cost Driver Event

500,000 $750,000
200,000 125,000 250,000 22,000 13,500
250,000 $625,000
200,000 100,000 125,000 44,000 54,000
200,000 $600,000
250,000 100,000 100,000 206,800 67,500
50,000 $125,000
50,000 15,000 25,000 52,800 27,000
400,000 $800,000
300,000 200,000 200,000 26,400 27,000
100,000
1,500,000
$350,000 $3,250,000
150,000 50,000 50,000 88,000 81,000 1,150,000 590,000 750,000 440,000 270,000
610,500 $139,500
523,000 $102,000
724,300 ($124,300)
169,800 ($44,800)
753,400 $46,600
419,000 ($69,000)
3,200,000 $50,000 280,000 ($230,000)
What to do about the three flavors that are losing money?

Lily could increase profits by $124,300 by stopping the production of Gingerbread Cheesecake Supreme, by another $44,800 by stopping the production of Strawberry Banana Surprise, and by another $69,000 by stopping the production of Peanut Butter Swirl.
$0.50 per gallon $880 per batch $2,700 per ingredient
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15-8
Problem 15-4
Two characteristics of a good managerial accounting measure
Using ABC to compute product costs and make decisions

The company makes two products - guns and butter. Production cost data are as follows.
Production volume Direct materials Direct labor 1,000 guns $50,000 $120,000
Overhead Cost Pools
500,000 pounds $100,000 $30,000

Guns Butter
1. Reflects economic reality. 2. Motivates correct behavior.
$200,000 50,000 250,000 $500,000
4,000 hours 450 batches 7 models
1,000 hours 50 batches 3 types
The remaining $100,000 in overhead ($600,000 total - $500,000 assigned to the overhead cost pools) was determined to be related to facility support. Total revenue from the sale of guns was $450,000. Total revenue from the sale of butter was $500,000. Using the ABC overhead analysis, do the following. 1. Compute the gross profit from the sale of guns 2. Compute the gross profit from the sale of butter 3. Compute overall company gross profit 4. Estimate what gun gross profit would be if only two gun models were produced.
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50

Cost Pool Number of Cost Driver Events Cost per Cost Driver Event

Company profitability report
Guns Butter
Answers: 1. Guns lost $100,000 2. Butter made $250,000 $950,000

150,000 150,000 200,000 50,000 250,000
Unit level Batch level Product line
$200,000 50,000 250,000

Guns
5,000 500 10
$40 100 25,000

Butter
Number of units Sales Production cost:

Direct materials Direct labor Overhead (using ABC): Unit-level Batch-level Product line
1,000 guns $450,000

50,000 120,000 160,000 45,000 175,000
500,000 pounds $500,000

100,000 30,000 40,000 5,000 75,000
3. Total company profit was $50,000 4. If only two gun models were produced, the ABC analysis suggests that the amount of overhead assigned to the production of guns would decrease by $125,000, computed as follows. 7 gun models x $25,000 per line $175,000 2 gun models x $25,000 per line Decrease in overhead assigned 50,000 $125,000
Unit level overhead

4,000 hours x $40 per hour = $160,000 1,000 hours x $40 per hour = $40,000
Total production cost Gross profit Facility support costs
550,000 ($100,000)
250,000 $250,000
800,000 $150,000 100,000 $50,000
Batch level overhead

450 batches x $100 per batch = $45,000 50 batches x $100 per batch = $5,000
Company gross profit
This decrease in overhead would increase gun gross profit by $125,000, from a loss of $100,000 to a profit of $25,000.
Product line overhead

7 models x $25,000 per line = $175,000 3 types x $25,000 per line = $75,000
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Summary and Conclusion

The five steps in implementing and using an ABC system are as follows: 1. Identify overhead cost activities. 2. Analyze individual overhead costs in terms of cost activities. 3. Identify measurable cost drivers. 4. Assign overhead. 5. Use the ABC data to make decisions. The ABC overhead analysis results in overhead cost assignments that accomplish two things that are characteristics of a good managerial accounting measure. 1. Reflects economic reality. 2. Motivates correct behavior.
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15-9
Lesson 17
Example
Should we make the building more energy efficient?

At a cost of $300,000, an office building can be made more energy efficient. It is estimated that the company owning the building will save $20,000 per year in energy costs. The building will last for 20 more years.
Lesson 17
CAPITAL BUDGETING
1. Payback period
$300,000 cost / $20,000 annual savings = 15 years to recover the initial cost
2. Unadjusted rate of return (or accounting rate of return)

Net income increase of $20,000 from energy cost savings. Net income decrease of $15,000 ($300,000 / 20 years) from depreciation. $20,000 - $15,000 = net income increase of $5,000 per year. Unadjusted rate of return $5,000 annual net income increase/$300,000 initial investment = 1.7%

Example
Remember that your business calculator has the following keys:

N
PV
PMT
FV
where
N
3. What is the present value of the energy savings? Assume that the interest rate is 10%.
A $20,000 energy savings this year is worth more, in terms of the time value of money, than a $20,000 energy savings to occur 20 years from now. It is incorrect to say that the energy efficiency investment of $300,000 will ultimately save $400,000. ($20,000 per year 20 years) Compute the present value of the $20,000 savings each year for 20 years.
is the number of periods involved. is the interest rate per period. is the present value of the cash flows. is the amount of a series of equal payments made each period. is the future value of the cash flows.
PV
PMT
FV

Example
Example

Clear memory:
C ALL
20 10 20,000 0
: 20 because the length of the cash savings interval is 20 years. : 10% which was given as the appropriate interest rate. : $20,000 which is the amount of the annual cash savings. : $0 because there is no additional cash savings at the end of the project. : For the answer.
I
PMT FV PV
Net Present Value = Present value of the cash inflows minus (or NPV) present value of the cash outflows. = $170,271 - $300,000 = negative $129,729
$170,271
17-1
Example

Four different capital budgeting techniques:
1. Payback period 2. Unadjusted rate of return 3. Net present value, or NPV 4. Internal rate of return, or IRR
4. After adjusting for the time value of money, what rate of return will be earned on the $300,000 investment in energy efficiency equipment? C ALL Clear memory:
300,000 +/20,000 20 0
PV
: Negative $300,000 to represent the initial cash outflow.
PMT : Positive $20,000 which is the amount of the annual cash inflow. N FV
: 20 because the length of the cash savings interval is 20 years. : $0 because there is no additional cash savings at the end of the project. : For the answer.
2.91%
INTERNAL RATE OF RETURN (or IRR)
Example
Example
Buying a Weekend Car in Hong Kong

A few years ago my family and I lived in Hong Kong. When we arrived, we considered buying a car. We didn't really want a good car; we just intended to use it for family trips on weekends. We found that the cost of a cheap weekend car was HK$40,000.
Note: There are about 7.7 Hong Kong dollars to one U.S. dollar, so HK$40,000 is the equivalent of $5,195.

We estimated that our family of seven could save HK$10,000 per year in bus, taxi, and MTR (subway) costs by buying the weekend car. The car was expected to last for 5 years. Should we have purchased the car?
1. Payback period
HK$40,000 cost / HK$10,000 annual savings = 4 years to recover the cost of the car
3. Net Present Value (NPV)
Clear memory:
C ALL
2. Unadjusted rate of return (or accounting rate of return)

Net income increase of HK$10,000 from energy cost savings. Net income decrease of HK$8,000 (HK$40,000 / 5 years) from depreciation. HK$10,000 - HK$8,000 = net income increase of HK$2,000 per year. Unadjusted rate of return: $HK$2,000 annual net income increase/HK$40,000 initial investment = 5.0%
5 10 10,000 0
: 5 years : 10% : HK$10,000 which is the amount of the annual cash savings. : $0 because there is no additional cash savings at the end of the project. : For the answer.
I
PMT FV PV
HK$37,908
10
Example

Example

3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
Clear memory:
C ALL
Net Present Value = Present value of the cash inflows minus (or NPV) present value of the cash outflows. = HK$37,908 - HK$40,000 = negative HK$2,092
40,000 10,000 5 0
+/-
PV
: Negative HK$40,000 to represent the initial cash outflow. inflow.
PMT : Positive HK$10,000 which is the amount of the annual cash N FV
: 5 because the expected life of the car is 5 years. : $0 because there is no additional cash savings at the end of the project. : For the answer.
7.93%
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12
17-2
Example

Review of time value of money calculations

The essence of the concept of the time value of money is as follows:
A dollar received now is worth more than a dollar to be received in the future because the dollar received now can be invested and will grow in value. For example, if the interest rate is 10%, receiving a dollar now is the same as receiving $1.10 one year from now; the dollar received now can be invested and will have grown in value to $1.10 by the end of the year.
1. Payback period: 4 years to recover the cost of the car. 2. Unadjusted rate of return (or accounting rate of return): 5.0% 3. Net Present Value (NPV):
$1.00 Now
$1.10 One Year
Negative HK$2,092
4. Internal Rate of Return (IRR): 7.93%
Present Value = $1.00 Interest Rate = 10%
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14
Computing the present value of a single amount

1. What is the present value of $10,000 to be received 4 years from now if the interest rate is 12%?
??? Now Year 1 Year 2 Year 3 $10,000 Year 4
Examples
Examples
Computing the present value of a single amount

2. What is the present value of $100,000 to be received 25 years from now if the interest rate is 14%?
To compute the present value, we input the following into the calculator:
Clear memory:
C ALL
Clear memory:
C ALL
4 12 0 10,000
: 4 because the time until we receive the cash is 4 years. : 12% which was given as the appropriate interest rate. : $0 because this is a one-time cash flow, not a series of equal cash flows. : $10,000 because this is the amount of cash we will receive in the future. : For the answer.
I
PMT FV PV
25 14 0 100,000
I
PMT FV PV
$6,355
$3,779
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16
Examples
Examples
Computing the present value of an annuity, or series of equal payments

1. What is the present value of $10,000 to be received at the end of each year for the next 4 years? The interest rate is 7%.
??? Now $10,000 Year 1 $10,000 Year 2 $10,000 Year 3 $10,000 Year 4
Computing the present value of an annuity, or series of equal payments

2. You expect to receive $8,000 at the end of each year for the next 4 years. In addition, you expect to receive an additional payment of $25,000 at the end of 4 years. What is the present value of these payments? The interest rate is 11%.
??? Now $8,000 Year 1 $8,000 Year 2 $8,000 Year 3 $25,000 $8,000 Year 4
Clear memory:
C ALL
Clear memory:
C ALL
4 7 10,000 0
: 4 because four equal payments are expected in the future. : 7% which was given as the appropriate interest rate. : $10,000 which is the amount of each equal cash flow. : $0 because no extra amount is received at the end of 4 years when the final annuity payment of $10,000 is received. : For the answer.
I
PMT FV PV
4 11 8,000 25,000
: 4 because four equal payments are expected in the future, and the additional payment occurs at the end of 4 years. : 11% which was given as the appropriate interest rate. : $8,000 which is the amount of each equal cash flow. : $25,000 which is the amount of the extra payment at the end of 4 years. : For the answer.
I
PMT FV PV
$33,872
$41,288
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18
17-3
Examples
Examples
Computing the internal rate of return

1. You have $10,000 you wish to invest in an account. You want to be able to withdraw $15,000 from the account at the end of 5 years. What rate of return on the account would make this possible?
$10,000 Now Year 1 Year 2 Year 3 Year 4 $15,000 Year 5

2. You have $100,000 you wish to invest in one of two business projects. Project 1 will pay you a lump sum of $220,000 at the end of 10 years. Project 2 will pay you $17,000 at the end of each year for 10 years. Which project offers the higher internal rate of return?
$100,000 $220,000 Year 1 Year 2 Year 3 Year 10
Project 1:
Now
To compute the internal rate of return, we input the following into the calculator:
Clear memory:
C ALL
To compute the internal rate of return on Project 1, we input the following into the calculator:
Clear memory:
C ALL
10,000
+/-
PV
0 5 15,000
PMT : $0 because we are not expecting yearly withdrawals. N FV
100,000
+/-
PV
: 5 because we want to be able to withdraw the $15,000 at the end of 5 years. : $15,000 because this is the amount of the cash inflow at the end of 5 years. : For the answer.
0 10 220,000
PMT : $0 because we are not expecting yearly cash flows. N FV
: 10 because we expect the $220,000 cash flow at the end of 10 years. : $220,000 because this is the amount of the cash inflow at the end of 10 years. : For the answer.
8.45%
8.20%
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20

$100,000 $17,000 Year 1 $17,000 Year 2 $17,000 Year 3 $17,000 Year 10
Examples
Examples

Project 2:
Now
Project 2
IRR = 11.03% Total Cash Inflow = $170,000 ($17,000 x 10 years)
To compute the internal rate of return on Project 2, we input the following into the calculator:
Clear memory:
C ALL
100,000 +/17,000 10 0
PV
PMT : $17,000 because this is the amount of the yearly cash inflows. N FV
: 10 because we expect the $17,000 yearly cash inflows for 10 years. : $0 because there is no extra cash inflow at the end of 10 years. : For the answer.
Project 1
IRR = 8.20% Total Cash Inflow = $220,000
11.03%
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Problem 17-1
Review of present value calculations

Compute the following: 1. The present value of $40,000 to be received 8 years from now if the interest rate is 15%. 2. The present value of $40,000 to be received 8 years from now if the interest rate is 9%. 3. The present value of $21,000 to be received at the end of each year for the next 50 years if the interest rate is 18%. 4. The present value of $21,000 to be received at the end of each year for the next 60 years if the interest rate is 18%. 5. The internal rate of return on a business project that requires an initial investment of $600,000. The project will generate cash flows of $75,000 at the end of each year for the next 14 years. 6. The internal rate of return on a business project that requires an initial investment of $600,000. The project will generate cash flows of $105,000 at the end of each year for the next 10 years.

1. The present value of $40,000 to be received 8 years from now if the interest rate is 15%.
Clear memory:
C ALL
8 15 0 40,000
I
PMT FV PV
$13,076
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24
17-4

2. The present value of $40,000 to be received 8 years from now if the interest rate is 9%.

3. The present value of $21,000 to be received at the end of each year for the next 50 years if the interest rate is 18%.
??? Now $21,000 Year 1 $21,000 Year 2 $21,000 Year 3 $21,000 Year 50
Clear memory:
C ALL
Clear memory:
C ALL
8 9 0 40,000
I
PMT FV PV
50 18 21,000 0
: 50 because fifty equal payments are expected in the future. : 18% which was given as the appropriate interest rate. : $21,000 which is the amount of each equal cash flow. : $0 because no extra amount is received at the end of 50 years when the final annuity payment of $21,000 is received. : For the answer.
I
PMT FV PV
$20,075
$116,637
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26

4. The present value of $21,000 to be received at the end of each year for the next 60 years if the interest rate is 18%.
??? Now $21,000 Year 1 $21,000 Year 2 $21,000 Year 3 $21,000 Year 60 Now

5. The internal rate of return on a business project that requires an initial investment of $600,000. The project will generate cash flows of $75,000 at the end of each year for the next 14 years.
$600,000 $75,000 Year 1 $75,000 Year 2 $75,000 Year 3 $75,000 Year 14
Clear memory:
C ALL
To compute the internal rate of return on the project, we input the following into the calculator:
Clear memory:
C ALL
60 18 21,000 0
: 60 because fifty equal payments are expected in the future. : 18% which was given as the appropriate interest rate. : $21,000 which is the amount of each equal cash flow. : $0 because no extra amount is received at the end of 60 years when the final annuity payment of $21,000 is received. : For the answer.
I
PMT FV PV
600,000 +/75,000 14 0
PV
: 14 because we expect the $75,000 yearly cash flows for 14 years. : $0 because there is no extra cash inflow at the end of 14 years. : For the answer.
$116,661
8.52%
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6. The internal rate of return on a business project that requires an initial investment of $600,000. The project will generate cash flows of $105,000 at the end of each year for the next 10 years.
$600,000 Now $105,000 Year 1 $105,000 Year 2 $105,000 Year 3 $105,000 Year 10
Payback Period and Unadjusted Rate of Return

Capital Budgeting Technique Computation Decision Rule
Payback Period
Compute the length of time until total net cash inflow equals the initial investment cost. Compute the additional yearly accounting earnings, divided by the initial investment cost.
Accept the project if the computed payback period is less than a predetermined length of time. Accept the project if the computed unadjusted rate of return is greater than a predetermined percentage.
To compute the internal rate of return on the project, we input the following into the calculator:
Clear memory:
C ALL
Unadjusted Rate of Return
600,000 +/105,000 14 0
PV
: 10 because we expect the $105,000 yearly cash flows for 10 years. : $0 because there is no extra cash inflow at the end of 10 years. : For the answer.
Advantages: Easy to understand and easy to compute. Disadvantage: Do not take into account the time value of money.
Net Present Value

and
11.73%
Internal Rate of Return
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17-5
Payback Period
Project A costs $50,000 and will provide net cash inflows each year of $10,000. Is Project A a good project?
$50,000 cost = 5 years to recover the initial cost $10,000 annual net cash inflow

Example: You are considering purchasing a new machine to increase your production. The machine costs $80,000. Operation of the machine will generate cash revenues of $40,000 per year and cash expenses of $12,000. The machine is expected to last for 10 years. The estimated impact of this machine on annual net income is computed as follows. Net income increase of $28,000 ($40,000 - $12,000) from the cash revenues and expenses. Net income decrease of $8,000 ($80,000 / 10 years) from depreciation. $28,000 - $8,000 = net income increase of $20,000 per year.
Is 5 years a sufficiently quick payback period? Well, that depends on the nature of the project. Consider the following two scenarios.
Scenario 1: Project A is an investment in an office building. The cash inflows will come from annual rent payments to be received. Scenario 2: Project A is an investment in a Web-based order tracking system that is expected to save $10,000 each year in order tracking costs.
$20,000 annual net income increase = 25% $80,000 initial investment
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Problem 17-2
Computation of payback period and unadjusted rate of return For each of the following long-term projects, compute: (a) the payback period and (b) the unadjusted rate of return. Also, for each project state whether you think that the company should or should not undertake the project:
Annual Cash Revenues Annual Cash Expenses
Computation of payback period and unadjusted rate of return

a. Computation of payback period:
Initial Cost Annual Cash Revenues Annual Cash Expenses Annual Net Cash Inflow Payback Period [Cost / Inflow]
Project 1 Project 2 Project 3 Project 4
$100,000 400,000 700,000 800,000
$45,000 50,000 110,000 205,000
$30,000 5,000 40,000 15,000
$15,000 45,000 70,000 190,000
6.7 years 8.9 years 10.0 years 4.2 years

Unadjusted Rate of Return [Income/Cost]
Initial Cost
Project Life
b. Computation of unadjusted rate of return:

Initial Cost Annual Net Cash Inflow Project Life Annual Depreciation [Cost/Life] Increase in Annual Net Income
$100,000 400,000 700,000 800,000
$45,000 50,000 110,000 205,000
$30,000 5,000 40,000 15,000
8 years 10 years 10 years 20 years

$100,000 400,000 700,000 800,000
$15,000 45,000 70,000 190,000
8 years 10 years 10 years 20 years
$12,500 40,000 70,000 40,000
$2,500 5,000 0 150,000
2.50% 1.30% 0.00% 18.80%
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Computation of payback period and unadjusted rate of return

For each project state whether you think that the company should or should not undertake the project:
Answer: Project 1 and Project 2 both have relatively long payback periods compared to the total expected life of the projects. This is confirmed by the low unadjusted rates of return for both projects (2.5% and 1.3%). Project 3 is even worse; the payback period is exactly the same length of time as the expected project life, so even if the projects lasts as long as it is expected to last, you still will have just barely recovered your initial investment in the project. This bad news is confirmed with an unadjusted rate of return of 0.0%. So these numbers suggest that you should reject Project 1, Project 2, and Project 3. Project 4 has a quick payback period of just 4.2 years, especially compared to the 20-year expected life of the project. Project 4 also has a relatively high unadjusted rate of return of 18.8%. These numbers suggest that it is a good idea to go ahead with Project 4.
Net Present Value

Net Present Value (NPV)
Compute the present value of all cash inflows and outflows and add them together.
Accept the project if the net present value (NPV) is greater than zero.
There are five general steps associated with Net Present Value (NPV) analysis. 1. Estimate the amount and timing of all cash inflows and outflows associated with the project. 2. Evaluate the riskiness of the project in order to select an appropriate required rate of return. 3. Use time value of money calculations to adjust all cash flows to a common point in time in order to make the cash flows comparable. "Now" is the point in time traditionally used. 4. Add up the discounted cash flows. 5. Make a decision. If the total of the discounted cash flows is positive, the project is a good one, meaning that it generates an above-normal return and thus adds value to the company.
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17-6
1. Estimate the amount and timing of all cash inflows and outflows associated with the project.
Since we can't tell the future the best we can do is estimate the amount and timing of all future cash flows. This requires a very thorough understanding of: the project. the market for my products. the markets for my raw materials. my workers. other important inputs into my production process.
2. Evaluate the riskiness of the project in order to select an appropriate required rate of return.
High Risk: A project that could result in very good cash flows or very bad cash flows.
Example: Developing commercial spacecraft to cater to space tourists.
Evaluated using: High Intrest Rates. Low Risk: A project that will result in about the same cash flows no matter whether things turn out very well or very poorly is said to have .
Example: Building a McDonald's location in a high-traffic area.
Evaluated using: Low Intrest Rates. We will usually just assume a certain interest rate, although we will briefly discuss one technique (the weighted-average cost of capital) that is used in computing an interest rate that can be used in an NPV analysis.
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3. Use time value of money calculations to adjust all cash flows to a common point in time in order to make the cash flows comparable.
"Now" is the point in time traditionally used.
The reason we compute the present value of the cash flows is that we need to line up all of the cash flows at the same point in time for them to be comparable. Remember that the key insight of the concept of the time value of money is that a dollar in cash flow today is not the same as a dollar in cash flow next year, and is certainly not the same as a dollar in cash flow 20 years from now. By using time value of money computations to adjust all of the cash flows to a common point in time, we can then be comfortable about comparing them. When first doing an NPV analysis, many students grasp the importance of the time value of money computations, but they want to compute the value of all of the cash flows as of the END of the project rather than as of the beginning of the project. NFV (or Net Future Value) Analysis The reason that we do an NPV, or present value, analysis rather than an NFV, or future value, analysis, is twofold:
1. The tradition for NPV analysis is deeply ingrained. 2. An NPV analysis makes sense because it involves computing the value of all of the project's cash flows in terms of "right now" dollars.
4. Add up the discounted cash flows.

We learned how to do this years ago in second grade.
We just add up the numbers.

Be careful to treat:
The cash outflows as negative numbers. and The cash inflows as positive numbers.
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5. Make a decision. If the total of the discounted cash flows is positive, the project is a good one, meaning that it generates an above-normal return and thus adds value to the company.
A positive NPV project; is one that we should do. The project earns a normal rate of return, as represented by the interest rate used in the present value calculations, plus some extra. A negative NPV project; is one that we should not do because it earns less than a normal rate of return. A NPV of exactly zero; should we do it or not? For a zero NPV project, it doesn't matter whether the company does it or not; the project earns a normal rate of return, but we could get that same return from any number of other "normal" projects. Another way to interpret the amount of a project's NPV is that this is the amount by which the value of the entire company changes the instant that the decision is made to go forward with the project. The theoretical value of a company is the present value of the future cash flows expected to be generated by the company. The instant that a company decides to undertake a positive NPV project, the present value of the future cash flows to be generated by that company have increased, so the value of the company itself increases.
Purchase of equipment
Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. Ryan Company uses straight-line depreciation. The appropriate interest rate is 10%.
($500,000) Now $150,000 Year 1 $150,000 Year 2 $150,000 Year 3 $150,000 Year 4 $150,000 Year 5
Example
The present value of the annuity of $150,000 for 5 years is computed as follows. Clear memory:
C ALL
5 10 150,000 0
: 5 because five equal payments are expected in the future. : 10% which was given as the appropriate interest rate.
PMT : $150,000 which is the amount of each equal cash flow. FV PV
: $0 because no extra amount is received at the end of 5 years when the final annual cash inflow of $150,000 is generated. : For the answer.
$568,618
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17-7
Example
Example
Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. Ryan Company uses straight-line depreciation. The appropriate interest rate is 10%.
($500,000) Now $150,000 Year 1 $150,000 Year 2 $150,000 Year 3 $150,000 Year 4 $150,000 Year 5 Now
Purchase of a doughnut-making machine

Franklin Bakery is considering buying a new doughnut-making machine. The cost of the machine is $10,000. The machine will last for ten years and is expected to be worth $1,000 as scrap at that time. The new machine will reduce operating costs by $700 per year. In addition, the new machine will allow for an increase in production of 10,000 doughnuts per year. Franklin makes 10 cents in contribution margin on each doughnut it sells. The required rate of return on this project is 16 percent.
($10,000) $1,000 $700 Year 1 $1,000 $700 Year 2 $1,000 $700 Year 3 Salvage value of $1,000 $1,000 $700 Year 10
The present value calculations with respect to this piece of equipment are summarized in this table.
Interest rate is 10% Amount Present Value
$700 Annual Cost Savings:
Clear memory:
C ALL
Original Cost ($500,000 now) Net cash inflows ($150,000 per year) Net Present Value (or NPV)
(500,000) $150,000 5 yrs
(500,000) 568,618 68,618
10 16 700 0
: 10 because ten equal payments are expected in the future. : 16% which was given as the appropriate interest rate.
PMT : $700 which is the amount of each equal cost savings cash inflow. FV PV
: $0 because no extra cost savings is realized at the end of 10 years when the final cost savings amount of $700 is generated. : For the answer.
Depreciation expense each year is $100,000 ($500,000 cost / 5-year life).
$3,383
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($10,000) Now $1,000 $700 Year 1 $1,000 $700 Year 2 $1,000 $700 Year 3 Salvage value of $1,000 $1,000 $700 Year 10
Example
Example

$1,000 Annual Contribution Margin Increase:
Clear memory:
C ALL
The $1,000 salvage value at the end of 10 years is a one-time cash inflow. The present value of this cash inflow is computed as follows.
10 16 1,000 0
: 10 because ten equal payments are expected in the future. : 16% which was given as the appropriate interest rate.
Clear memory:
C ALL
PMT : $1,000 which is the amount of each annual increase in contribution margin. FV PV
: $0 because no extra contribution margin is realized at the end of 10 years when the final increased contribution margin amount of $1,000 is generated. : For the answer.
10 16 0 1,000
: 10 because the time until we receive the salvage value is 10 years. : 16% which was given as the appropriate interest rate.
PMT : $0 because this is a one-time cash flow, not a series of equal cash flows. FV
: $1,000 because this is the amount of cash we will receive in the future. : For the answer.
$4,833
$227
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Example

Computation of the Weighted-Average Cost of Capital

There are two ways to think of this choice of the correct interest rate.
1. Use the interest rate that can be earned on comparable investments. This is an OPPORTUNITY COST approach. 2. Use the weighted-average cost of acquiring the funds to finance the project. This is an OUT-OF-POCKET COST approach.
Cost of debt. The cost of borrowing is reflected in the interest rate that must be paid on the debt. Cost of new equity. In order to induce investors to purchase newly-issued shares of stock, the investors must expect a return on their investment. Accordingly, the issuance price of the shares must be low enough so that investors can expect the share price to rise over time, on average, to give them a return on their investment. This return that investors expect can be thought of as the implicit cost associated with capital raised through issuance of new shares of stock. Cost of retained earnings. A very convenient way for a company to raise new capital is to simply retain some or all of the company's profits. At first glance, this may seem like a costless way to raise financing. However, the shareholders, to whom all of the profits belong, expect some return on the profits that are retained in the business. This expected return can be thought of as the implicit cost of financing obtained through retaining earnings.
The present value calculations with respect to the doughnut machine are summarized in this table.
Original Cost ($10,000 now) Scrap Value ($1,000 after 10 years) Operating Cost Savings ($700 per year for 10 years) Increased Profits from Sales (10,000 units @ $.10) Net Present Value (or NPV)
(10,000) 1,000 $700 10 yrs $1,000 10 yrs
(10,000) 227 3,383 4,833 (1,557)
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17-8
Example
Problem 17-3
Computation of the weighted-average cost of capital (WACC)

Twenty percent of a company's total capital is debt, 35 percent is from the issuance of stock, and 45 percent is equity from retained earnings. The company has determined that the cost of its debt capital is 8 percent and the cost of its equity capital is 20 percent from stock and 15 percent from retained earnings. Compute the company's weighted-average COST OF CAPITAL.
Cost of Capital Average Cost of Capital
Computation of NPV MaScare Company is considering whether to purchase a new store. The store will cost $2,500,000. The store will generate net cash inflows of $400,000 at the end of each year for the next 20 years. At the end of 20 years, it is expected that the store can be sold for $700,000. The appropriate interest rate is 14%. Compute the net present value (NPV) of the store purchase and state whether you think MaScare Company should purchase the store.
Type
Weight
Debt . . . . . . . . . . . . . . . . . . . . Equity (retained earnings) . . . WACC
8% 15%
x x x
20% 35% 45% 100%
= = =
1.60% 7.00% 6.75% 15.35%
Equity (stocks) . . . . . . . . . . . . 20%
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Computation of NPV
A timeline of the cash flows associated with this store is as follows. Note that the initial purchase price of $2,500,000 is shown on the timeline as a negative amount representing a cash outflow.
(2,500,000) Now $400,000 Year 1 $400,000 Year 2 $400,000 Year 3 Salvage value of $700,000 $400,000 Year 20
Computation of NPV
Clear memory:
C ALL
20 14 400,000 700,000
: 20 because the length of the operating life of the store is 20 years. : 14% which was given as the appropriate interest rate. : $400,000 which is the amount of each equal net cash inflow. : $700,000 because this additional cash inflow is to be received at the end of 20 years when the store is sold. : For the answer.
I
PMT FV PV
Three cash flows are associated with the store - the immediate $2,500,000 cash outflow to purchase the store, the $400,000 net cash inflow per year for 20 years that will be generated by the store, and the $700,000 cash inflow at the end of 20 years from the sale of the store. Of course, computation of the present value of the immediate $2,500,000 cash outflow is easy - the present value of $2,500,000 out right now is just $2,500,000. The combined present value of the annuity of $400,000 for 20 years as well as the $700,000 selling price of the store at the end of 20 years is computed as follows.
$2,700,185
Note that we took a little shortcut here and computed the present value of the $400,000 annual cash inflows and the present value of the $700,000 to be received at the end of 20 years all in one step. This works because the length of the annuity is 20 years and the time until the store is sold is also 20 years. If the store were to be sold at, say, the end of 21 years, then we would have to compute these two present values in separate steps.
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Problem 17-4
Computation of NPV
Computation of WACC
Harold Company receives its financing from four different sources in various proportions, as follows.
Proportion of Total Financing
Original Cost ($2,500,000 now) Net cash inflows
(2,500,000) $400,000 20 yrs $700,000 at end of 20 yrs
(2,500,000) 2,700,185 $200,185
Short-term debt Long-term debt New stock issues Retained earnings Total
10% 45% 15% 30% 100%
Net Present Value (or NPV)
Because the present value of the cash inflows ($2,700,185) is greater than the present value of the cash outflows ($2,500,000), the project has a positive NPV and should be undertaken.
The cost of short-term debt is 6 percent; the cost of long-term debt is 9 percent. In addition, Harold Company has estimated the cost of its equity capital to be 22 percent from stock and 16 percent from retained earnings. Compute Harold Company's weighted-average COST OF CAPITAL (WACC).
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17-9
Problem 17-5
Computation of WACC
Harold Company's weighted-average cost of capital (WACC) is 12.75%, as shown below.
Cost of Capital Average Cost of Capital
NPV and a Least-Cost Decision Kamili Company is required to install a new piece of safety equipment. The company has two alternatives for the equipment. One alternative would cost $260,000 immediately but would not add to operating costs over the five-year life of the equipment. The second alternative costs $75,000 immediately but would add $45,000 to annual operating costs for five years. Kamili Company uses an 8 percent interest rate in evaluating long-term projects. Which alternative should Kamili Company purchase?
Type
Weight
Short-term debt . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . Equity (retained earnings) . . . WACC
6% 9% 16%
x x x
10% 45% 15% 30% 100%
= = =
0.60% 4.05% 3.30% 4.80% 12.75%
Equity (stocks) . . . . . . . . . . . . 22%
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NPV and a Least-Cost Decision

Kamili Company should choose the second alternative because it has a lower outlay cost, in present value terms, as shown below.
Clear memory:
C ALL
Internal rate of return

Internal Rate of Return (IRR)
5 8 45,000 0
: 5 because operating costs are increased in each year for 5 years. : 8% which was given as the appropriate interest rate. costs.
Compute the interest rate that makes the present value of the cash inflows equal to the present value of the cash outflows.
Accept the project if the internal rate of return (IRR) is greater than a predetermined hurdle rate.
PMT : $45,000 which is the amount of the increase in annual operating FV PV
: $0 because no extra cost exists at the end of 5 years. : For the answer.
Internal rate of return, or IRR, is the interest rate that makes the present value of the cash inflows equal to the present value of the cash outflows. In other words, the IRR is the interest rate that causes the NPV to be equal to zero.
Savings Account: 0.5% Intrest Certificate of Deposit: 3.5% Intrest

The internal rate of return, or IRR, is the measure of what rate of return you can earn on a long-term project.
$179,672
The first alternative costs $260,000. The second alternative costs just $254,672 ($75,000 + $179,672) in present value terms.
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Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. The appropriate interest rate is 10%.
Example
Example
NPV = $68,618
To compute the NPV of this project with an interest rate of 20%, we compute the present value of the annuity of $150,000 each year for 5 years, as follows.
Clear memory:
C ALL
NPV = $68,618
5 20 150,000 0
: 5 because five equal payments are expected in the future. : 20% which is the interest rate that we are trying.
Interest rate is 20% Amount
Present Value
(500,000) $150,000 5 yrs
(500,000) 448,592 (51,408)
$448,592
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17-10
Example
Example
NPV with a return of 10% = $68,618 NPV with a return of 20% = ($51,408)
It looks like the return that will result in an NPV of exactly zero will be somewhere around 15%, but we can compute this return exactly, as follows.
Clear memory:
C ALL
Let's verify this by computing the present value of the $150,000 annuity using an interest rate of 15.2382%.
Clear memory:
C ALL
500,000 +/150,000 5 0
PV PMT N FV
: Negative $500,000 to represent the initial cash cost of the project. : Positive $150,000 which is the amount of the annual cash inflow. : 5 because the length of the project is 5 years. : $0 because there is no additional cash inflow at the end of the project. : For the answer.
5 15.2382 150,000 0
: 5 because five equal payments are expected in the future. : 15.2382% which is the interest rate that we are trying.
PMT : $150,000 which is the amount of each equal cash flow. FV
15.2382%
$500,000
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Example
Example
Computing the IRR of a business project

A business project requires the initial outlay of $200,000 in cash. The project will generate cash inflows of $40,000 at the end of each year for the next 15 years. What is the internal rate of return of this project? The following inputs into our business calculator will allow us to compute the IRR.
Clear memory:
C ALL
The present value calculations with respect to this piece of equipment, with an interest rate of 15.2382%, are summarized in this table.
Interest rate is 15.2382% Amount Present Value
200,000
+/-
PV PMT N FV
: Negative $200,000 to represent the initial cash cost of the project. : Positive $40,000 which is the amount of the annual cash inflow. : 15 because the length of the project is 15 years. : $0 because there is no additional cash inflow at the end of the project. : For the answer.
40,000 15 0
(500,000) $150,000 5 yrs
(500,000) 500,000 -0-
18.41546%
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A business project requires the initial outlay of $200,000 in cash. The project will generate cash inflows of $40,000 at the end of each year for the next 15 years. What is the internal rate of return of this project? Let's check this answer to see whether the interest rate 18.41546% does indeed yield an NPV of zero. We compute the present value of the annuity of $40,000 per year as follows.
Clear memory:
C ALL
Example

A business project requires the initial outlay of $200,000 in cash. The project will generate cash inflows of $40,000 at the end of each year for the next 15 years. What is the internal rate of return of this project? The present value calculations with respect to this piece of equipment, with an interest rate of 18.41546%, are summarized in this table.
Interest rate is 18.41546% Amount Present Value
Example
15 18.41546 40,000 0
: 15 because fifteen equal cash flows are expected in the future. : 18.41546% which is the interest rate that we are trying.
Original Cost ($200,000 now) Net cash inflows ($40,000 per year for 15 years) Net Present Value (or NPV)
(200,000) $40,000 15 yrs
(200,000) 200,000 -0-
$200,000
If the minimum rate of return is 15%, then we should undertake this project. If the minimum rate of return is 20%, then we should reject this project.
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17-11
Example
Problem 17-6
Computing the IRR of a piece of equipment

Aina Company is considering whether to invest in a piece of equipment that requires an investment of $250,000 today. The project will provide net cash inflows of $50,000 per year for eight years, and it will have a salvage value of $51,509 at the end of eight years. Calculate the INTERNAL RATE OF RETURN. The following inputs into our business calculator will allow us to compute the IRR.
Clear memory:
C ALL
Computation of IRR MaScare Company is considering whether to purchase a new store. The store will cost $2,500,000. The store will generate net cash inflows of $400,000 at the end of each year for the next 20 years. At the end of 20 years, it is expected that the store can be sold for $700,000. The minimum required rate of return on projects such as this is 14%. Compute the internal rate of return (IRR) of the store purchase and state whether you think MaScare Company should purchase the store.
250,000 +/50,000 8 51,509
PV PMT N FV
: Negative $250,000 to represent the initial cash cost of the project. : Positive $50,000 which is the amount of the annual cash inflow. : 8 because the life of the equipment is 8 years. : Positive $51,509 because this is an additional cash inflow at the end of 8 years. : For the answer.
14.0%
If the minimum rate of return is 15%, then we should buy this equipment. If the minimum rate of return is 20%, then we should we should not buy the equipment.
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Computation of IRR
The following business calculator inputs will allow us to compute the IRR.
Capital Rationing (ranking projects)
Clear memory:
C ALL
2,500,000 +/400,000 20 700,000
PV PMT N FV
: Negative $2,500,000 to represent the initial cash cost of the store. : Positive $400,000 which is the amount of the annual cash inflow. : 20 because the life of the store is 20 years. : Positive $700,000 because this is the amount for which the store can be sold at the end of 20 years. : For the answer.
Screening
Identifying which projects are good and which are bad.
15.3%
The internal rate of return, or IRR, for this project is 15.3%; this is the interest rate that yields an NPV of exactly zero. Because the minimum rate of return on a project such as this is 14%, then these IRR calculations suggest that we should buy the store. You may recall that this is exactly the same capital budgeting decision that we examined in Walkthrough Problem 17-3. In that problem we computed the NPV of the store purchase; the NPV, with an interest rate of 14%, is positive $200,185 indicating that we should buy the store. In this problem we computed the IRR of the store purchase to be 15.3%; when compared to the minimum rate of return of 14%, we see that the decision is again that we should buy the store. The NPV and the IRR calculations will always identify the same projects as being attractive and the same projects as being ones that we should reject.
Ranking
Choosing the best among a set of good projects.
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The Good News

We don't have to learn any new time value of money tools in order to rank projects.
Internal Rate of Return (IRR) - excellent tool for ranking projects.
The one with the highest IRR is the best.
Ranking Capital Budgeting Projects

Mimi Company is considering three projects. Mimi has already determined that each of the projects has a positive NPV. However, Mimi can only undertake one of the projects, so she would like to identify which one of the projects is the best. Each of the projects involves an initial investment and results in an annuity of cash inflows in the future. The details for each of the three projects are as follows.
Initial Investment Annual Cash Inflow Length of Project
Example
Net Present Value (NPV) - not a good measure to use for ranking.
The biggest project, or the project with the largest initial investment. Always gives preference to LARGE projects, when a series of small projects could yield a higher overall NPV.
Profitability Index
Easier to compute the NPV of a project than it is to compute the project's IRR. The project evaluation systems of many companies are designed around the computation of NPV. It is often the case that we know the NPV of a project but we don't know the project's IRR.
In these cases, we can easily compute the project's Profitability Index from the NPV.
Project 1 Project 2 Project 3
$200,000 300,000 170,000
$35,000 60,000 27,000
8 years 7 years 10 years
Which one of the projects should Mimi Company undertake?

Note: Mimi Company has established a minimum required rate of return of 8%.
Initial Investment IRR NPV Profitability Index
Project 1 Project 2 Project 3
$200,000 300,000 170,000
8.15% 9.20% 9.44%
$1,132 12,382 11,172
1.006 1.041 1.066
Profitability Index = (NPV / Initial Investment) + 1
Profitability Index = (NPV / Initial Investment) + 1
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17-12
Screening
Which projects have a positive NPV. Which projects have a negative NPV. Which projects have IRR above or below the required rate of return.
Problem 17-7
Ranking Long-term Projects A real estate company is considering four different investments. Each of the investments involves an initial cash outflow now with a single cash inflow a number of years in the future. The company's required rate of return is 12%. Your job is to rank the investments. To do so, compute both the IRR and the Profitability Index for each of the four investments.
Initial Investment Single Cash Inflow Years Until Cash Inflow
Ranking
Rank projects to pick the best one using either: IRR Profitability Index
Investment 1 Investment 2 Investment 3 Investment 4
$10,000 10,000 100,000 100,000
$37,000 90,000 400,000 700,000
10 15 10 15
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Ranking Long-term Projects

We can use our business calculators to calculate the NPV and the IRR of each of the projects.
Initial Investment NPV IRR
Ranking Long-term Projects

Profitability Index computations for each of the four investments reveal the following.
Initial Investment NPV Profitability Index
$10,000 10,000 100,000 100,000
$1,913 6,443 28,789 27,887
13.98% 15.78% 14.87% 13.85%
$10,000 10,000 100,000 100,000
$1,913 6,443 28,789 27,887
1.1913 1.6443 1.2879 1.2789
Using the IRR numbers, we see that Investment 2, with an IRR of 15.78%, is the best of the four investments and is the one investment that we should choose if we can only choose one of the four investments. Note again that all of the investments are good in that they all have a positive NPV and an IRR above the minimum required rate of return of 12%, but Investment 2 is the best of the four.
Again we see that Investment 2 is the best of the four investments because it has the highest Profitability Index. So whether we use the IRR or the Profitability Index, Investment 2 is shown to be the best.
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The impact of income taxes on NPV and IRR analysis

The two primary impacts of income taxes:
After-tax cash flow = Before-tax cash flow (1 - Tax Rate) Depreciation tax shield = Depreciation Deduction (Tax Rate)
Impact of Income Taxes on Cash Revenues and Cash Expenses

The existence of income taxes makes good news not so good and bad news not so bad. Example: Assume that you have earned $1,000. Assume that the income tax rate is 40%.
Your before-tax earnings Income tax (40%) After-tax earnings $1,000 (400) $600
We can express this in a formula: After-tax earnings = Before-tax earnings (1 - Tax Rate) After-tax earnings = $1,000 (1 - 0.40) After-tax earnings = $600
After-Tax Cash Flows 77 78
17-13
Example
After-tax earnings
You earn $100. The income tax rate is 99%.
Impact of Income Taxes on Cash Revenues and Cash Expenses

The existence of income taxes makes good news not so good and bad news not so bad. Example: You pay $1,000 for advertising. The income tax rate is 40%. What is the after-tax cost of the advertising?
Before-tax cost Reduction in taxes After-tax cost $1,000 (400) $600
What are your after-tax earnings?

After-tax earnings = Before-tax earnings (1 - Tax Rate) After-tax earnings = $100 (1 - 0.99) After-tax earnings = $1
In doing a capital budgeting analysis, the only relevant number is the after-tax earnings which is what you get to keep.
We can express this in a formula: After-tax cost = Before-tax cost (1 - Tax Rate) After-tax cost = $1,000 (1 - 0.40) After-tax cost = $600
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Example
After-tax cost
You pay $100 for advertising. The income tax rate is 99%.
What is the after-tax cost of the advertising?

After-tax cost = Before-tax cost (1 - Tax Rate) After-tax cost = $100 (1 - 0.99) After-tax cost = $1
The existence of income taxes means that you don't get to keep all of the cash inflows that you generate, but you also get a tax subsidy (in essence) for all of your tax-deductible business expenses.
In doing a capital budgeting analysis, the only relevant number is the after-tax cost which is what you end up paying.
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Depreciation Tax Shield

Example: Assume that you report a $1,000 depreciation deduction on your tax form. The income tax rate is 40%. How much does this depreciation deduction save you in income taxes? By lowering your taxable income by $1,000, the depreciation deduction will save you $400 ($1,000 0.40) in income taxes. A formula to compute the amount of the depreciation tax savings is as follows.
Remember, depreciation is a non-cash expense.

Thus, in doing time value of money calculations, we ignore depreciation because it doesn't involve any cash flow. Except when we are considering the impact of income taxes. When you write down the amount of the non-cash depreciation expense on your income tax form, you reduce your taxable income and therefore reduce the amount of income tax that you pay. So in the specific context of income taxes, depreciation does result in a cash inflow in the form of an income tax savings.
Depreciation tax savings = Depreciation Deduction (Tax Rate)

= $1,000 0.40 = $400
Example: You report a $100 depreciation deduction on your tax form. The income tax rate is 99%. How much does this depreciation deduction save you in income taxes?
Depreciation tax savings = Depreciation Deduction (Tax Rate) Depreciation tax savings = $100 0.99 Depreciation tax savings = $99
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17-14
Example
Example
Computing NPV in a setting with income taxes

Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net before-tax operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%. The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of equipment and state whether the equipment should be purchased. 1. Cash outflow of $500,000 today for the purchase of the equipment.
The existence of income taxes does not change this amount. The deduction does not occur immediately. The $500,000 cost of the equipment is deducted as depreciation expense over the 5-year life of the equipment.

Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net before-tax operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%. The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of equipment and state whether the equipment should be purchased. The after-tax operating cash inflow of $105,000 is an annuity with a present value of $398,033 computed as follows.
Clear memory:
C ALL
2. After-tax operating cash inflow of $105,000 at the end of each year for five years. After-tax operating cash inflow = Before-tax operating cash inflow (1 - Tax Rate) After-tax operating cash inflow = $150,000 (1 - 0.30) After-tax operating cash inflow = $150,000 0.70 After-tax operating cash inflow = $105,000 3. Annual depreciation tax shield of $30,000 at the end of each year for five years. The anual amount of depreciation is $100,000 ($500,000/5 years). Depreciation tax savings = Depreciation Deduction (Tax Rate) Depreciation tax savings = $100,000 0.30 Depreciation tax savings = $30,000
5 10 105,000 0
: 5 because five equal cash inflows are expected in the future. : 10% which is given as the appropriate interest rate.
PMT : $105,000 which is the amount of each after-tax cash inflow. FV PV
: $0 because no extra amount is received at the end of 5 years when the final annual after-tax cash inflow of $105,000 is generated. : For the answer.
$398,033
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Example
Example

Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net before-tax operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%. The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of equipment and state whether the equipment should be purchased. The depreciation tax shield of $30,000 is also an annuity with a present value of $113,724 computed as follows.

Ryan Company is considering whether to invest in a piece of equipment that requires an investment of $500,000 today. The project will provide net before-tax operating cash inflows of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%. The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of equipment and state whether the equipment should be purchased. These present value calculations are summarized in this table.
Clear memory:
C ALL
5 10 30,000 0
: 5 because five equal cash inflows (from tax savings) are expected in the future. : 10% which is given as the appropriate interest rate.
Original Cost ($500,000 now) Depreciation tax shield ($100,000 depreciation 0.30)
(500,000) $30,000 5 yrs
(500,000) 113,724 398,033 11,757
PMT : $30,000 which is the amount of each depreciation tax savings. FV PV
Net cash inflows ($150,000 [1 0.30]) $105,000 5 yrs Net Present Value (or NPV)
: $0 because no extra depreciation tax savings is generated at the end of 5 years. : For the answer.
$113,724
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Example

1. In the absence of income taxes, this same project has a net present value of $68,618. Introduction of income taxes has lowered the NPV of this project. With an income tax rate of 40% the NPV for this project would be negative. It is an important fact of business to remember that higher income tax rates can transform attractive projects into unattractive projects. 2. In this problem, note that without the income tax savings generated by the depreciation tax shield, this project would have a negative NPV rather than a positive NPV. The depreciation tax shield is an important part of the cash inflows associated with many projects. In recognition of this fact, government bodies all over the world often allow companies to depreciate the cost of their capital projects very quickly in order to increase the present value of the depreciation tax savings.
In the United States, Congress allows companies to use double-declining-balance depreciation in computing their depreciation deductions for income tax purposes. By allowing more rapid depreciation, the present value of the depreciation tax savings is increased, even though the total amount of depreciation tax savings is the same.
Example
Computing IRR in a setting with income taxes

Lorien Company is considering whether to invest in a piece of equipment that requires an investment of $600,000 today. The project will provide net before-tax operating cash inflows of $150,000 at the end of each year for 10 years, and it will have a salvage value of $0 at the end of 10 years. Lorien Company uses straight-line depreciation. The minimum required rate of return is 12%. The income tax rate is 60%. Calculate the INTERNAL RATE OF RETURN of the piece of equipment and state whether the equipment should be purchased.
1. Cash outflow of $600,000 today for the purchase of the equipment. 2. After-tax operating cash inflow of $60,000 at the end of each year for 10 years. With an income tax rate of 60%, the after-tax operating cash inflow is computed as follows. After-tax operating cash inflow = Before-tax operating cash inflow (1 - Tax Rate) After-tax operating cash inflow = $150,000 (1 - 0.60) After-tax operating cash inflow = $60,000 3. Annual depreciation tax shield of $36,000 at the end of each year for 10 years. The annual amount of straight-line depreciation is $60,000 ($600,000 / 10 years). With an income tax rate of 60%, the amount of the depreciation tax shield is computed as follows. Depreciation tax savings = Depreciation Deduction (Tax Rate) Depreciation tax savings = $60,000 0.60 Depreciation tax savings = $36,000
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90
17-15
Example
Problem 17-8
Computing IRR in a setting with income taxes

Lorien Company is considering whether to invest in a piece of equipment that requires an investment of $600,000 today. The project will provide net before-tax operating cash inflows of $150,000 at the end of each year for 10 years, and it will have a salvage value of $0 at the end of 10 years. Lorien Company uses straight-line depreciation. The minimum required rate of return is 12%. The income tax rate is 60%. Calculate the INTERNAL RATE OF RETURN of the piece of equipment and state whether the equipment should be purchased. The following inputs into our business calculator will allow us to compute the IRR. Clear memory:
C ALL
Computing NPV and IRR with income taxes

Lily Company is considering purchasing a machine. The associated cash inflows and outflows are as follows: a. Cost of the machine is $100,000. b. Net before-tax cash inflows from the output from the machine are expected to be $40,000 per year for 5 years. c. The required rate of return on this project is 10%. d. All cash flows occur at the end of the appropriate year, except for the $100,000 initial cost. e. The machine will be depreciated for tax purposes on a straight-line basis with an assumed salvage value of $0. f. The tax rate is 40%. COMPUTE: 1. The net present value (NPV) of this machine. 2. The internal rate of return (IRR) of this machine.
600,000 +/96,000 10 0
PV PMT N FV
: Negative $600,000 to represent the initial cash cost of the project. : Positive $96,000 which is the sum of the $60,000 after-tax operating cash inflow and the $36,000 depreciation tax savings. : 10 because the life of the equipment is 10 years. : $0 because there is no additional cash inflow at the end of 10 years. : For the answer.
9.61%
91
92

First, let's calculate the amount of each of the three types of cash flow associated with this equipment.
a. Cash outflow of $100,000 today for the purchase of the machine. b. After-tax operating cash inflow of $24,000 at the end of each year for five years. The amount of the before-tax operating cash inflow is $40,000 per year. With an income tax rate of 40%, the after-tax operating cash inflow is computed as follows. After-tax operating cash inflow = Before-tax operating cash inflow (1 - Tax Rate) After-tax operating cash inflow = $40,000 (1 - 0.40) After-tax operating cash inflow = $24,000 c. Annual depreciation tax shield of $8,000 at the end of each year for five years. The annual amount of straight-line depreciation is $20,000 ($100,000 / 5 years). With an income tax rate of 40%, the amount of the depreciation tax shield is computed as follows. Depreciation tax savings = Depreciation Deduction (Tax Rate) Depreciation tax savings = $20,000 0.40 Depreciation tax savings = $8,000

1. Compute the net present value (NPV) of this machine. Now that we have computed the amount of the cash flows, we can compute their present values. The present value of the $100,000 purchase price is just $100,000. The after-tax operating cash inflow of $24,000 is an annuity with a present value of $90,979 computed as follows.
Clear memory:
C ALL
5 10 24,000 0
: 5 because five equal cash inflows are expected in the future. : 10% which is given as the appropriate interest rate : $24,000 which is the amount of each after-tax cash inflow. : $0 because no extra amount is received at the end of 5 years when the final annual after-tax cash inflow of $24,000 is generated. : For the answer.
I
PMT FV
PV
$90,979
93
94

1. Compute the net present value (NPV) of this machine. The depreciation tax shield of $8,000 is also an annuity with a present value of $30,326 computed as follows.
Clear memory:
C ALL

1. Compute the net present value (NPV) of this machine. These present value calculations are summarized in this table.
5 10 8,000 0
: 5 because five equal cash inflows (from tax savings) are expected in the future. : 10% which is given as the appropriate interest rate. : $8,000 which is the amount of each depreciation tax savings. : $0 because no extra depreciation tax savings is generated at the end of 5 years. : For the answer.
Original Cost($100,000 now) Depreciation tax shield($20,000 depreciation 0.40) Net cash inflows($40,000 [1 0.40]) Net Present Value (or NPV)
(100,000) $8,000 5 yrs $24,000 5 yrs
(100,000) 30,326 90,979 21,305
I
PMT FV PV
We see that this project has a positive NPV so we should undertake it.
$30,326
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17-16
Problem 17-9

2. Compute the internal rate of return (IRR) of this machine. The following inputs into our business calculator will allow us to compute the IRR.
Clear memory:
C ALL
Impact of depreciation rules on NPV

Hilly Pice Company is considering whether to invest in a piece of equipment that requires an investment of $600,000 today. The project will provide net before-tax operating cash inflows of $120,000 at the end of each year for 10 years, and it will have a salvage value of $0 at the end of 10 years. The minimum required rate of return is 12%. The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of equipment and state whether the equipment should be purchased under each of the following two assumptions about depreciation. 1. Hilly Pice Company uses straight-line depreciation for income tax purposes. 2. Instead of using straight-line depreciation, Hilly Pice Company is able to deduct the entire cost of the equipment as an expense in the year the equipment is purchased. The equipment is paid for at the beginning of the first year, but the tax savings from being able to deduct the cost of the equipment don't occur until the end of the first year.
100,000
+/-
PV
: Negative $100,000 to represent the initial cash cost of the project operating cash inflow and the $8,000 depreciation tax savings.
32,000 5 0
PMT : Positive $32,000 which is the sum of the $24,000 after-tax N FV
: 5 because the life of the machine is 5 years. : $0 because there is no additional cash inflow at the end of 5 years. : For the answer.
18.03%
The internal rate of return, or IRR, for this project is 18.03%. Because the minimum rate of return on a project such as this is 10%, these IRR calculations suggest that we should buy this equipment.
97
98

1. Straight-line depreciation Let's start by computing the amount of the three cash flows associated with the purchase of this equipment.
a. Cash outflow of $600,000 today for the purchase of the equipment. b. After-tax operating cash inflow of $84,000 at the end of each year for 10 years. With an income tax rate of 30%, the after-tax operating cash inflow is computed as follows. After-tax operating cash inflow = Before-tax operating cash inflow (1 - Tax Rate) After-tax operating cash inflow = $120,000 (1 - 0.30) After-tax operating cash inflow = $84,000 c. Annual depreciation tax shield of $18,000 at the end of each year for 10 years. The annual amount of straight-line depreciation is $60,000 ($600,000 / 10 years). With an income tax rate of 30%, the amount of the depreciation tax shield is computed as follows. Depreciation tax savings = Depreciation Deduction (Tax Rate) Depreciation tax savings = $60,000 0.30 Depreciation tax savings = $18,000

1. Straight-line depreciation Now that we have computed the amount of the cash flows, we can compute their present values. The present value of the $600,000 purchase price is just $600,000. The after-tax operating cash inflow of $84,000 is an annuity with a present value of $474,619 computed as follows.
Clear memory:
C ALL
10 12 84,000 0
: 10 because ten equal cash inflows are expected in the future. : 12% which is given as the appropriate interest rate. : $84,000 which is the amount of each after-tax cash inflow. : $0 because no extra amount is received at the end of 10 years when the final annual after-tax cash inflow of $84,000 is generated. : For the answer.
I
PMT FV
PV
$474,619
99
100

1. Straight-line depreciation The depreciation tax shield of $18,000 is also an annuity with a present value of $101,704 computed as follows.
Clear memory:
C ALL

1. Straight-line depreciation These present value calculations are summarized in this table.
10 12 18,000 0
: 10 because ten equal cash inflows (from tax savings) are expected in the future. : 12% which is given as the appropriate interest rate. : $18,000 which is the amount of each depreciation tax savings. : $0 because no extra depreciation tax savings is generated at the end of 10 years. : For the answer.
Original Cost ($600,000 now)
(600,000)
(600,000) 101,704 474,619 (23,677)
Depreciation tax shield ($60,000 depreciation 0.30) $18,000 10 yrs Net cash inflows ($120,000 [1 0.30]) $84,000 10 yrs Net Present Value (or NPV)
I
PMT FV PV
We see that this project has a negative NPV so we should reject it.
$101,704
101
102
17-17

2. Immediate depreciation of equipment cost instead of straight-line depreciation. Again, let's start by computing the amount of the three cash flows associated with the purchase of this equipment.
a. Cash outflow of $600,000 today for the purchase of the equipment. b. After-tax operating cash inflow of $84,000 at the end of each year for 10 years. With an income tax rate of 30%, the after-tax operating cash inflow is computed as follows. After-tax operating cash inflow = Before-tax operating cash inflow (1 - Tax Rate) After-tax operating cash inflow = $120,000 (1 - 0.30) After-tax operating cash inflow = $84,000 c. Immediate depreciation tax shield of $180,000 at the end of the first year. With this special tax arrangement, Hilly Pice Company is allowed to deduct the entire $600,000 cost of the equipment in the year that it is purchased. You can think of this as immediate depreciation. With an income tax rate of 30%, the amount of this first-year depreciation tax shield is computed as follows.. Depreciation tax savings = Depreciation Deduction (Tax Rate) Depreciation tax savings = $600,000 0.30 Depreciation tax savings = $180,000

2. Immediate depreciation of equipment cost instead of straight-line depreciation. Now that we have computed the amount of the cash flows, we can compute their present values. The present value of the $600,000 purchase price is just $600,000. The after-tax operating cash inflow of $84,000 is an annuity with a present value of $474,619 computed as follows.
Clear memory:
C ALL
10 12 84,000 0
: 10 because ten equal cash inflows are expected in the future. : 12% which is given as the appropriate interest rate. : $84,000 which is the amount of each after-tax cash inflow. : $0 because no extra amount is received at the end of 10 years when the final annual after-tax cash inflow of $84,000 is generated. : For the answer.
I
PMT FV
PV
$474,619
103
104

2. Immediate depreciation of equipment cost instead of straight-line depreciation. The first-year depreciation tax shield of $180,000 is a one-time cash flow with a present value of $160,714 computed as follows.
Clear memory:
C ALL

2. Immediate depreciation of equipment cost instead of straight-line depreciation. These present value calculations are summarized in this table.
1 12 0 180,000
: 1 because with this special immediate depreciation deduction the tax savings all occur at the end of the first year. : 12% which is given as the appropriate interest rate. : $0 because this is a one-time cash flow. : $180,000 because the depreciation tax savings is generated in one lump at the end of the first year. : For the answer.
Original Cost ($600,000 now) Depreciation tax shield ($600,000 depreciation 0.30) Net cash inflows ($120,000 [1 0.30]) Net Present Value (or NPV)
(600,000) $180,000 at end of first year $84,000 10 yrs
(600,000) 160,714 474,619 35,333
I
PMT FV PV
$160,714
We see that this project has a positive NPV so we should undertake it. The only difference between (1), when the project had a negative NPV, and (2), when the project had a positive NPV, is depreciation policy. You can see that allowing companies to rapidly depreciate the cost of their capital equipment increases the NPV of the equipment. Governments all over the world allow rapid depreciation (although not usually as rapid as this example) in order to increase the NPVs of capital projects, causing companies to undertake more projects and thus stimulating the economy.
105
106
Summary
Summary
Accept the project if the computed payback period is less than a predetermined length of time. Accept the project if the computed unadjusted rate of return is greater than a predetermined percentage. Accept the project if the net present value (NPV) is greater than zero. Accept the project if the internal rate of return (IRR) is greater than a predetermined hurdle rate.
Payback Period
Compute the length of time until total net cash inflow equals the initial investment cost. Compute the additional yearly accounting earnings, divided by the initial investment cost. Compute the present value of all cash inflows and outflows and add them together. Compute the interest rate that makes the present value of the cash inflows equal to the present value of the cash outflows.
Both Net Present Value (NPV) and Internal Rate of Return (IRR) involve present value calculations, so this lesson involved an extensive review of how to use our business calculators. Screening capital budgeting projects involves separating the good projects from the bad projects. Ranking those projects involves identifying the best among a set of good projects.
Both IRR and Profitability Index can be used to identify the best project.
Net Present Value (NPV)
In this lesson we learned how income taxes impact the cash flows associated with a long-term project. We learned how to compute after-tax cash flows and also how to compute the amount of the depreciation tax shield. Capital budgeting involves making decisions with respect to long-term decisions. By definition, the consequences of a capital budgeting decision will be with a company for many years. For this reason, these decisions must be made only after careful analysis. This lesson has given you an introduction to the common techniques for doing this analysis.
Internal Rate of Return (IRR)
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17-18

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Expanded Introduction to Accounting

Respond briefly to the following questions:

Problem 1-1 - Answer

Problem 1-1 - Answer

A. Why is accounting sometimes referred to as the "language of business?"

Problem 1-1 - Answer

Problem 1-1 - Answer

Problem 1-1 - Answer

C. What is managerial accounting information and who uses it?

Problem 1-2 - Answer

Problem 1-2 - Answer

A. What is the SEC and what is its role?

B. What is GAAP and why is it important to financial statement users?

C. Who is legally authorized to determine GAAP?

Problem 1-2 - Answer

Problem 1-2 - Answer

D. What is the FASB and what is its role?

F. What is the IASB and what is its role?

E. How do the SEC and the FASB relate to one another?

Problem 1-3 - Answer

Problem 1-3 - Answer

Problem 1-3 - Answer

Problem 1-3 - Answer

Problem 1-3 - Answer

D. What is the AICPA and what is its role?

E. Why aren't auditors completely independent in the performance of an audit?

Problem 1-3 - Answer

$ 22,250 0 6,408 0 280 400 178 14,000 43,516 8,000 0 51,516

24,000 11,502 35,502 $ 56,517

42,500 30,051 72,551 $ 124,067

Land & Building

Bank Note Payable

Income Tax Payable

Equipment Note Payable

Mortgage Note Payable

Unearned Rent Revenue

Cost of Goods Sold

Office Supplies Expense

Income Tax Expense

Problem 1-4 - Answer

Problem 1-4 - Answer

4,995 507 10,000 1,401 99

Problem 1-4 - Answer

Problem 1-4 - Answer

1,440 53,409 53,409 4,313 310,406 310,406 6,408 6,408 4,313

617 373 13,456

617 373 13,456

10,000 2,000 10,000 2,000

Problem 1-4 - Answer

Problem 1-4 - Answer

Land & Building

Problem 1-4 - Answer

Problem 1-4 - Answer

Mortgage Note Payable

Unearned Rent Revenue Salaries Payable

Bank Note Payable

Utilities Payable Income Tax Payable

Retained Earnings Equipment Note Payable

Problem 1-4 - Answer

Problem 1-4 - Answer

Interest Revenue Sales Revenues

Utilities Expense Office Supplies Expense

Cost of Goods Sold