Core Concepts of Accounting 2nd Edition by Cecily A. Raiborn SOLUTIONS MANUAL

CHAPTER 1 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1. The three general types of business are typically categorized as follows: service, manufacturing and merchandising.

Service example: Manufacturing example: Merchandising example:

airline company, e.g. Southwest steel manufacturing company, e.g. US Steel wholesaler company, e.g. Costco

2. The three common forms of business organizations are sole proprietorships, partnerships and corporations.

The major differences between these forms of business organizations are in terms of ownership, liability and taxation. A sole proprietorship is owned by a single individual, who has unlimited liability; profits of the proprietorship flow through to the owner, who individually pays taxes on those profits. A partnership is owned by two or more individuals, who each have unlimited liability. Profits of the business flow through to the partners, who individually pay taxes on their specific share of those profits. A corporation is owned by stockholders; liability for organizational debts is limited to the amount of funds invested by owners, who cannot be held individually responsible for the debts. A corporation files a tax return and pays taxes. (Stockholders receiving dividends from a corporation commonly must pay taxes on those dividends…even though the corporation paid taxes on the profits from which the dividends are paid. Thus, it is said that corporate profits are effectively taxed twice: once upon being earned and once upon being distributed.)

The most common form of business in the United States is the sole proprietorship.

3. The primary function of a business’s accounting function is to provide quantitative information, primarily financial in nature, about economic entities. The information is intended to be useful in making economic decisions for internal and external users of the information.

4. The four major financial statements are the balance sheet, income statement, statement of cash flows and statement of stockholder’s equity.

Balance Sheet: Summarizes the assets (resources an organization owns), liabilities (debts that the organization owes), and stockholders’ equity (amounts owners have contributed and the net amount that the entity has earned for them) of an entity at a specific time.

Income Statement: Summarizes a business’s revenues and expenses for a specific time period.

Statement of Cash Flows: Reveals how a business generated and spent cash during a given accounting period.

Businesses issue financial statements because financial statements provide information about an organization’s financial performance over a period of time. These statements are useful to third parties such as investors, bankers, CEOs and management during their decision making.

5. This statement is false because a company’s fiscal year may begin on any date. For example, the Walt Disney Company has a fiscal year that runs from October 1 to September 30.

6. The three types of activities are operating, investing, and financing.

Operating activities: Reflect the day-to-day activities of a business that generate revenues by providing products or services and that create the costs of generating those revenues Investing activities: Involve the acquisition and sale of (1) long-term assets used in the business and (2) non-operating investment assets Financing activities: Involve cash inflows and outflows from transactions with creditors and investors.

The Statement of Cash Flows uses the above three business activities as section headings.

7. GAAP is a group of accounting rules, concepts and principles that are used as a standard framework of guidelines in the preparation of financial statements. GAAP’s primary purpose is use as a guideline in conducting and reviewing accounting transactions. The FASB is the principal accounting board in charge of establishing GAAP. 8. Private accounting involves internal work within a business entity, not-for-profit organization, or government agency. Public accounting involves external work as an independent firm with various firms in business.

Individuals in private accounting may have job titles such as controller, internal auditor, financial accountant, cost analyst and tax accountant.

9. Public accounting firms offer auditing, tax preparation and advice, certain types of consulting, and bookkeeping services.

Auditing is the most important service offered by public accounting firms because it involves the determination of the fairness, fullness and compliance with GAAP for financial statements and accounting records of companies. These financial statements provide third parties with vital information in the making of economic decisions.

10. The collapse of the stock market in 1929 led Congress to establish the SEC in the early 1930s with the intent to deter the abusive accounting and financial reporting practices that contributed to the stock market’s collapse. The SEC ensures that publicly owned companies provide third parties with sufficient information to make informed economic decisions regarding the securities these firms sell.

EXERCISES 11.

(a) (b) (c) (d) (e) (f) (g) (h) (i)

(j) (k)

T T F The FASB is the board that issues most of the new accounting rules in the U.S. F Corporations account for the most business revenues each year.

T F The Balance Sheet is a statement of position at a specific point in time; the Income Statement and the Statement of Cash Flows cover a fiscal year.

T T F Accounting contributes significantly to the success of business organizations by providing useful information on the transactions and results of transactions for those entities.

T F Owners of LLPs, LLCs, and Subchapter S corporations pay taxes for their companies.

12. (a) (1) M (2) S (3) S (4) R (5) M (b) (1) Determine the estimated amount of goods needed to be produced to meet the market demand of products. Accountants can provide the inventory accounts balances.

(2) Determine the amount of cash from operations. Accountants can provide the Cash Flow from operating activities statement.

(3) Determine the ability of a customer to repay loans. Accountants can analyze the customer’s financial statements.

(4) Determine the growth in revenues during the last fiscal period. Accountants can compare the income statement of the current fiscal period and the preceding fiscal period.

(5) Determine the cost of manufacturing a product. Accountants can calculate the total costs incurred in the manufacturing of a product.

13. (a) Proprietorship vs. Corporation Advantages ▪ no double taxation ▪ easy to start up

▪ cheap to establish ▪ no particular record keeping requirements ▪ no one to share profits with Disadvantages ▪ self-employment tax rate ▪ unlimited liability ▪ lack of financing strength (b) Partnership vs. Corporation Advantages ▪ no double taxation ▪ easy to set up ▪ can establish with friends or relatives Disadvantages ▪ unlimited liability ▪ joint and several liability (c) LLP (limited liability partnership); LLC (limited liability company); and Subchapter S (Sub S) corporation The distinguishing characteristics of these forms of business organizations are that they possess key features of other forms of business. Each of these business types is a hybrid between a corporation and a partnership. Owners are provided with limited liability (as in a corporation) and are only taxed as individuals (as in a partnership).

14. (a) Net Income – Management Inventory cost per unit – Retailer Total liability – Loan Officer Total sales by geographical area of business operations – Marketing department Five-year trend in total sales – Investor Employee salaries by department – Management (b) To measure profitability of company To determine selling price per unit To measure risk of business To understand the market of product To determine stability of company To allocate payroll by department 15. TO: JIM HARDY FROM: ACCOUNTANTS DATE: JULY 1, 20X1 SUBJECT: FINANCIAL STATEMENTS It has come to our attention that your business, Jim’s Bike Shop, has not been keeping any accounting records of its financial activity since operations commenced.

Financial statements are an integral part of any business organization. These statements reflect the company’s revenues and expenses and, thus, profitability, for a specific period.

The financial statements also show the company’s financial position through detailing the

assets owned, liabilities owed, and the capital balances of the owner. The company’s cash flow is also reflected in the financial statements, so that it is apparent where money is being generated and used. The statements provide readers with useful information necessary to make vital economic decisions. The information needs to be provided in a timely manner for it to be useful. Thus, there is an urgent need for you to prepare monthly financial statements for your business. With reasonably accurate and timely financial statements users can easily determine the profitability and risk of your business.

You can also keep track of your income, expenses, cash flows, assets, and debts.

16. Transactions: (a) Purchased equipment for $12,500 cash (b) Fuente & Demond bought additional $17,000 of stock in firm (c) Paid $1,500 owed to an office supply store for a purchase made the previous month (d) Purchased supplies for $4,000 on credit

Assets

=

Liabilities

+

Equity

+$12,500 – $12,500

=

$0

+

$0

$17,000

=

$0

+

$17,000

-$1,500

=

-$1,500

+

$0

$4,000

=

$4,000

+

$0

PROBLEMS 17. (a) (1) Stockholders: Determine return on investment; estimate future returns and profitability (2) Executives: Determine the next year’s budget; whether the company met its current financial objectives (3) Bankers: Determine ability to repay loans and pay for purchases. (b) (1) Stockholders: Why the rate of return on revenues is so low (2) Executives: The interest rate and tax rate the company is paying; the proportion of operating expenses that is cost of goods sold; what comprises “other revenue” (3) Bankers: Why the rate of return on revenues is so low; how the company intends to decrease costs in future years 18. (a) Lifestyle Magazines Total Net Income = ($207,300,000 + $246,300,000 + $264,000,000) = $717,600,000 Big Win = $45,360,000 Quick & Yummy Foods = $288,019,000 (b) BigWin Hotel & Casino = [(2009 NI – 2007 NI) ÷ 2007 NI] = [$18,745,000 – $10,649,000) ÷ $10,649,000] = $8,096,000 ÷ $10,649,000 = 76.03% Lifestyle Magazines = $56,700,000 ÷ $207,300,000 = 27.35% Quick & Yummy Foods = $29,553,000 ÷ $80,517,000 = 36.70%

(c) Lifestyle Magazine ▪ Customer demand affected by other competitors ▪ Customer demand affected by presence of alternative sources like the internet BigWin Hotel & Casino ▪ Barriers of entry to industry create a monopoly situation ▪ State rules and regulations affect profitability of business Quick & Yummy Foods, Inc. ▪ Easy entry into industry creates competition ▪ Location of restaurants vital to profitability ▪ Food is generally perishable, thus small profit margins are realized by food industry 19. (a)

Assets $510,000 a a

= = = =

Liabilities a $510,000 $200,000

+ + -

Equity $318,000 $318,000

Net Income b b

= = =

Revenues $510,000 $190,000

-

Expenses $320,000

Assets

= = =

Liabilities $430,000 $770,000

+ +

Equity $320,000

Net Income $210,000 d

= = =

Revenues $870,000 $660,000

-

Expenses d

Assets $950,000 e e

= = = =

Liabilities $367,000 $950,000 $583,000

+ + -

Equity e $367,000

Net Income $331,000 f f

= = = =

Revenues f $331,000 $1,009,000

+

Expenses $678,000 $678,000

(b)

(c) c c (d)

(e)

(f)

20. (a) Selling Price – Cost = $3,000,000 = $1,000,000 = $2,000,000 loss (b) $2,000,000 ÷ 5 years = $400,000 per year (c) The special accounting treatment for losses on sale of certain securities is misleading to financial statement users because net income is overstated during the year of loss on sale and understated in succeeding years when the loss is offset by income.

CASES 21. (a) Year begins on December 1st Year ends on November 30th (b) Balance sheet information = 2 years (c) Income statement information = 3 years (d) Cash flow information = 3 years (e) Shareholders’ equity information = 3 years (f) (1) Balance Sheet 2007, Statement of Cash Flows 2007 (2) Statement of Cash Flows 2007, Balance Sheet 2006 (3) Balance Sheet 2007, Statement of Shareholders’ Equity 2007 (4) Income Statement 2007, Statement of Shareholders’ Equity 2007 (5) Balance Sheet 2007, Statement of Shareholders’ Equity 2007 (g) PricewaterhouseCoopers LLP 22. (a) The Securities Exchange Commission has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. (b) Since 1973 (c) The mission of FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. (d) As of November 2009, it was Robert H. Herz. Current board personnel can be checked at http://www.fasb.org. (e) Ways topics are added to the FASB agenda ▪ Pervasiveness of the issue ▪ Alternative solutions ▪ Technical feasibility ▪ Convergence possibilities ▪ Cooperative opportunities ▪ Resources (f) Upon reaching conclusions on researched issues, the FASB prepares a proposed Exposure Draft for consideration by the Board. After further discussion and revisions, Board members vote whether to issue the Exposure Draft. A majority vote of the Board is required to approve a document for issuance as an Exposure Draft.

Alternative views, if any, are explained in the document and posted on the FASB website. The Exposure Draft sets forth the proposed standards of financial accounting and reporting, the proposed effective date and method of transition, background information, and an explanation of the basis for the Board’s conclusions.

At the end of the exposure period, comment letters and position papers are analyzed to search for new information and persuasive arguments regarding the issues (rather than being simply a "nose count" of how many support or oppose a given point of view). In addition to studying this analysis, Board members review the comment letters to help them in reaching conclusions. When the Board is satisfied that all reasonable alternatives have been considered adequately, the staff is directed to prepare a draft of a final document for consideration by the Board.

(g) This answer depends on the point in time that the web site is searched.

CHAPTER 2 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1. The principal focus of financial accounting is to serve the needs of external decisionmakers. These users need financial data about a business to make sound economic decisions. External parties, such as investors, lenders, and other groups (such as the IRS and regulatory bodies) benefit from standardized financial reporting in that information is consistent from year to year and comparable from company to company.

2. The balance sheet equation is Assets = Liabilities + Owners’ Equity Assets represent all the items owned by a company. Assets have future economic value in that they can be converted to cash or used to generate revenues. Most assets are tangible and have some type of physical substance. However, some assets such as accounts receivable, patents, and leases have no true physical substance except to be represented by a document.

Liabilities represent all debts owed by a company to other companies or individuals.

All that a company has (assets) minus all it owes (liabilities) is a company’s worth, which is known as owners’ equity. Equity can come from two sources. It can be contributed by owners; for example, an owner gives $10,000 of his personal money to the company in exchange for $10,000 of company equity. Or equity can also be generated by a profitable company.

3. The operating cycle is determined by the time period between the use of cash for normal business operating activities and the receipt or collection of cash from the entity’s customers. The operating cycle for a homebuilder could be three to six months, while the operating cycle for winery could be over a year or more. The operating cycle for a service firm could be a matter of days or weeks.

On the balance sheet, assets are classified as current (typically listed first in balance sheet order) if those items will be converted into cash, sold, or used up within the next year or operating cycle, whichever is longer.

4. Retained Earnings does not contain cash. This account is a representation of how the equity in a business has increased because of profitable operations. Each year, the net profit is added to Retained Earnings; profit equals revenues earned minus both the costs

of doing business (expenses) and any distributions to owners (dividends). If there is a net loss, it is deducted from Retained Earnings. Therefore, Retained Earnings is the sum of yearly [revenues – expenses – dividends] since the company began.

5. The income statement is a “period-of-time” statement because the statement will reveal what revenues were earned and expenses incurred during a defined period (e.g., a month or a year). The statement of cash flows and the statement of stockholders’ equity are also “period-of-time” statements. In contrast, the balance sheet is a “point-in-time” statement in that it shows the assets, liabilities, and stockholders’ equity at only one specific moment in time. “Period-of-time” statements allow the user to understand what happened over time, while “point-in-time” statements give information that presents a single moment.

6. Revenues are increases in assets or decreases in liabilities that result from the profitoriented activities of the business.

Gross profit is the difference between the net revenues generated and the cost of goods sold during a particular period.

Net income is computed by subtracting operating expenses from gross profit and is also known as the “bottom line” of the income statement. Net income is commonly known as profit.

7. Answers will vary based on companies chosen.

8. The common theme of the three financial reporting objectives of business entities is the need for the financial statements to provide external parties the necessary information to make informed decisions about economic events. Without this information, users of financial statements would not be to make appropriate business and investment decisions.

9. Accounting information that is deemed to be reliable has the following three characteristics: verifiability, neutrality, and representational faithfulness. To be verifiable, accounting information should be able to be validated by more than one person. To be neutral, accounting information must be without bias. To be representationally faithful, accounting information must express the business’s true economic resources, obligations, and transactions.

10. The principal reason that historical cost is used as the basis for assets is that it can be verified thorough documentation (bill of sale, etc.). Current values may differ depending on whose opinion is obtained.

The use of historical costs could result in the undervaluation of assets on the balance sheet. Alternatively, liabilities are generally current amounts. This differentiation in valuations causes a net “book value” that borders on meaningless.

11. Revenues should be both realized (assets exchanged for cash or a claim to cash) and earned (provided a product or service) before they are entered in the accounting records of an entity.

There are some instances where the point of sale rule does not apply. For example, many construction projects create economic impacts over multiple years. In such cases, revenues may need to be spread over several accounting periods rather than recorded totally at the end of the project.

12. A general journal contains a chronological listing of transactions and how these transactions affected individual accounts. A general ledger contains individual accounts and shows all the changes made to the account by transactions.

Two separate records are used because events occur that alter two or more accounts simultaneously. A record of the event is found in the general journal. However financial reporting is done on an account basis, so the general journal is used to track changes to individual accounts. A general ledger facilitates for the posting of journal entries into individual accounts and this easies the process of compiling financial statements.

EXERCISES 13. (a) F Intangible assets are not current assets; they will not be used up or converted to cash within one year. (b) T Unfortunately, however, management may engage in improper accounting to shift revenues and expenses into inappropriate time periods. (c) T (d) F Revenues minus expenses is equal to net income. Or revenues minus cost of goods sold is equal to gross profit. (e) F This statement describes the full-disclosure principle. (f) T (g) F Matching refers to the presentation of expenses related to recognized revenues on the income statement. (h) T (i) F The statement that reconciles beginning and ending cash is the Statement of Cash Flows. (j) T (k) F Business transactions are recorded in the general journal and then posted to the general ledger. (l) F The accounting cycle is not always longer than a company’s operating cycle. For example, construction projects and some food products (such as those that must be aged) may have an accounting cycle that is shorter than the operating cycle.

14. (a) A = L + SE A = L + $2,000,000 2X = X + $2,000,000 X = $1,000,000 = Liabilities A = $2,000,000 (b) SE = $2,000,000 SE = CS + PIC + RE $2,000,000 = $958,000 + RE RE = $1,042,000 15. Intangible assets Accounts payable Inventory Cash Notes payable (due in ten years) Prepaid expenses PPE Common stock Accounts receivable Retained earnings Notes payable (due in six months) Additional paid-in capital

long term asset current liability current asset current asset long term liability current asset long-term asset stockholders’ equity current asset stockholders’ equity current liability stockholders’ equity

16. (a) Cash, Short-term investments, Accounts receivable, Inventory, Prepaid expenses (b) Assets should be listed on the balance sheet in order of liquidity or the ability to turn the assets into cash. The more liquid the asset, the closer to the top of the current asset list it should appear.

17. (a) At the end of the current year, Farewell should report $90,000 as a long-term liability, and $30,000 in the current liability section of the balance sheet. (b) It is important to accurately list the items on the balance sheet so that current and potential creditors and assess the ability of the firm to pay its debts as they come due.

18. (a) Two factors that might contribute to the difference in gross profit for the companies might include the types of shoes that are carried by each wholesaler, the distribution chains that are used by each wholesaler, and the size of the orders placed by each wholesaler’s retailing clients. The stores might also have different suppliers of merchandise, which could contribute to a difference in respective cost of goods sold. (b) As president of Company B, I might investigate the cost of the company’s goods (shoes), try to find more reasonable suppliers of merchandise, investigate the

possibility of reducing overhead or distributions costs, and sell in larger quantities to retailers…all of which should lower some costs.

19. Operating items are generated from operating activities (that is, by providing a product or service to a customer). Nonoperating items are generated from investing and financing activities or by events incidental to the operations of a business. These definitions provide the rationale for the items below.

Sales revenue Cafeteria revenue Interest revenue Cost of goods sold Utility expense FICA (Social Security) matched amounts Shipping expense Income tax expense Property tax expense

operating revenue nonoperating income nonoperating income operating expense operating expense operating expense (part of salaries/wages) operating expense (relates to inventory) nonoperating expense operating expense (assume on property in use in the business, such a manufacturing facility or headquarters)

20. Gross Profit = Revenues – Cost of Goods Sold Gross Profit = $750,000 - $480,000 Gross Profit = $270,000 Gross Profit Percentage = Gross Profit ÷ Revenues Gross Profit Percentage = $270,000 ÷ $750,000 Gross Profit Percentage = 36% Oehlke Co. may not have a high enough markup on the product, especially given how high salary costs are in the business. After paying for the product, Oehlke only has 36% of what customers paid for the goods, and Oehlke still has to pay other expenses out of that.

21. (a) relevance (b) materiality (c) comparability (d) understandability (e) reliability 22. (a) The operating cycle would be 135 days. (90 days + 35 days) (b) Normally, anything that is receivable or payable within the accounting cycle is classified as current; anything receivable or payable beyond the accounting cycle is classified as long term.

23 Several common examples of accrued liabilities at the end of an accounting cycle are salaries owed to employees for work already performed, interest on notes payable, local/state/federal taxes, and utilities.

PROBLEMS 24. (a) Gross Profit = Net Sales – Cost of Goods Sold Gross Profit = $315,000 - $130,750 Gross Profit = $184,250 Operating Income = Gross Profit – SG&A Exp. Operating Income = $184,250 - $90,050 Operating Income = $53,500 Income before Taxes = Operating Income + Interest Revenue Income before Taxes = $53,500 + $5,000 Income before Taxes = $58,500 Net Income = Income before Taxes – Income Tax Expense Net Income = $58,500 - $2,500 Net Income = $56,000

(b)

Valimer Corporation Income Statement For Period Ended Date Net Sales Cost of Goods Sold Gross Profit Selling and Administrative Expenses Operating Income Interest Revenue Income Before Income Taxes Income Tax Expense Net Income

$315,000 (130,750) $184,250 (90,050) $ 94,250 5,000 $ 99,250 2,500 $ 96,750

25. (a) $35,000 ÷ 5 years = $7,000 per year. (b) $7,000 per year x 3 years = $21,000 of Accumulated Depreciation (c) The matching principle requires that revenues generated in a particular accounting cycle be matched with the expenses incurred during that same accounting cycle.

This purchase reflects an item that should be capitalized and depreciated over the life of the asset rather than expensed immediately on the income statement.

26. (a)

Revenue per unit = 2 x cost per unit Revenue per unit = 2 x $27.50 Revenue per unit = $55.00 Sales (2008) = units sold x revenue per unit Sales (2008) = 10,000 units x $55 Sales (2008) = $550,000

(b)

Cost of Goods Sold (CGS) = units sold x cost per unit CGS = 10,000 x $27.50 CGS = $275,000 Gross Profit = Sales (2008) - CGS Gross Profit = $550,000 - $275,000 Gross Profit = $275,000

(c)

Gross Profit = Sales – CGS Sales (2009) = CGS + Gross Profit Sales (2009) = $225,000 + $200,000 Sales (2009) = $425,000 Gross Profit % = Gross Profit ÷ Net Sales Gross Profit % = $200,000 ÷ $425,000 Gross Profit % = 47.1%

27. (a) The ending balances on the Statement of Stockholders’ Equity for Common Stock, Additional Paid-In Capital, and Retained Earnings are presented on the balance sheet in the Stockholders’ Equity section. (b) The sale of common stock accounted for an increase in stockholders’ equity of $540,000 (par value of $240,000 + additional paid-in capital of $300,000).

28. (a) Green Realty Corp. probably uses this format because the real estate industry’s most important asset is its investments. Cash and other types of current assets appear to be almost insignificant amounts to Green Realty. (b) Restricted cash would primarily consist of security deposits held on behalf of tenants as well as capital improvement and real estate tax escrows required under certain loan agreements. (c) Comparability would not exist within the industry if Green Realty Corp. uses a different format for its balance sheet.

29. (a) Potential investors might want to have prior years’ audited financial statements, detailed information about current obligations (both short-term and long-term), and ratio analysis for liquidity. They may also want to see projections for the future, including information about the city/state/country economic health. (b) The audited financial statements should help satisfy the following objectives: (1) providing information that is useful in making investing and lending decisions, (2) providing information about assets, liabilities and other transactions that might impact these items, and (3) providing information to allow decision makers to help predict future cash flows. (c) The income statement would probably be the most useful for potential investors to examine because it indicates the company’s profitability for the period. However, this statement should not be examined without also reviewing the Statement of Cash Flows. Investors would want information about the cash inflows and outflows from operating, investing, and financing activities so as to be able to make judgments about the ability of the firm to meet current obligations as well as determine what type of activities are providing the cash resources that allow the company to meet those obligations.

30. I could not justify inflating sales or net income, even if it meant that possible loss of jobs.

Tim should have the accountant project earning s for the next several years with and without the purchase of this piece of equipment. Tim should then take these projections to the bank with him when he goes to see the banker. Tim possibly does not want to appear at fault because of declining profits over the past years.

31. (a and b) Whitecotton has violated both principles of comparability and consistency with the third change in as many years. These principles make the financial statements more reliable to users, so changing methods of depreciation on a yearly basis might make financial statements unreliable.

Hethcox has followed the principle of full disclosure. Even though the sales happened after the end of the most recent accounting cycle, the operations of these divisions did have an impact on the information being presented currently.

Still Gardening is appropriately applying the lower of cost or market rule (conservatism) for valuing inventory on the balance sheet.

Mason has followed full disclosure of lease payments. This information should be disclosed to financial statement readers and would be of interest to current and potential investors and creditors.

CASES 32. (a) (1) Interest income is separated from is income generated from nonoperating activities like investing and financing activities. Thus, interest income is listed as a separate line item because it is not income generated from the principal activities (providing cruise services) of Carnival.

(2) Carnival primarily provides a service, although the company does sell some products. For this reason, Carnival’s cost of goods sold would be a relatively small portion of its expenses. In fact, the company does not list cost of goods sold separately and does not calculate Gross Profit.

(3) Primary operating revenues are ticket sales for cruises, sales of sightseeing packages, sales of items to passengers, etc. (b) (1) Total Assets = $34,181,000,000 (2) A trademark is a symbol or sign used by a business to identify its product or services. Trademarks distinguish a business’s services and products and have a considerable intangible value. Trademarks are shown as assets because they have the potential to produce future benefits.

(3) Cost of PPE $32,540,000,000 Depreciation $5,901,000,000 (4) The historical cost principal dictates that most assets are shown on the financial statements at their original cost. Use of historical cost as the valuation basis for assets stems from the fact that historical cost is more verifiable and less subject to estimation than current values.

(5) Customer deposits represent money a customer gave Carnival for a future cruise. Until Carnival provides the cruise service to its customer, the money that has been paid by the customer is unearned. Thus, an unearned revenue account is established and this account is classified as current liability because Carnival owes the customer a cruise or a refund.

(6) The current portion of long-term debt is shown in footnote 5 as $1,028,000,000.

This amount represents the portion of long-term debt that comes due within the next accounting period.

(7) Profits generated but not distributed to owners are shown in Retained Earnings.

As of November 30, 2007, Carnival’s Retained Earnings was $12,921,000,000.

During fiscal year 2007, Carnival paid out total dividends of $990,000,000.

33. (a) For accounting information to be useful, it must possess a high degree of relevance by being timely and having feedback and/or predictive value. The information

contained in Note 7 can help predict amounts that Carnival may owe in the future.

Therefore, it is relevant. (b) Materiality refers to the relative importance of specific items of accounting information. An item is deemed material if its size (quantitative materiality) or informational content (qualitative materiality) is significant enough to influence a financial statement user’s decision. The contingent obligations for Carnival Corporation as of November 30, 2007, amounted to $1.07 billion. This amount is significant and it could have adverse effects on the financial statements if recognized. (c) Objective 1: Financial reports should provide information that is useful in making investing, lending, and other economic decisions.

Objective 2: Financial reports should provide information that is useful to decisionmakers in predicting the future cash flows of businesses and future cash dividends from those businesses.

Objective 3: Financial reports should provide information about the assets and liabilities of businesses and the transactions and other events that have resulted in changes in those assets and liabilities. (d) Objective 1 would be violated if Note 7 was omitted. Although the amounts described in Note 7 are uncertain, they have the potential to increase expenses or decrease earnings. An investor or lender would want to know this information before making a decision on investment or lending. Also, an investor may not be interested in investing in a company with a potential lawsuit related to The Americans with Disabilities Act. Objective 2 would also be violated if Note 7 was omitted. Without the information in Note 7, future cash flows might be overestimated.

Objective 3 addresses current and historical numbers. Because the amounts in Note 7 represent the future, Objective 3 would not be violated if Note 7 was omitted.

CHAPTER 3 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1. Assets Liabilities Stockholders’ Equity

Land and Equipment Accounts Payable and Unearned Revenue Common Stock and Retained Earnings

2. The sale of stock in an entity, recording of net income (or net loss) for a period, and dividends declared for company stockholders affect stockholders’ equity.

Example 1: Issued 5,000 shares of XYZ Co.’s $1 par value common stock. Checks totaling $5,000 were received from stockholders.

Example 2: A dividend of $1,000 was declared and paid by the corporation.

3. Common types of source documents include invoices, sales slips, legal contracts, checks, and purchase orders.

Invoices – Purchase transaction details.

Sales slips – Sale transaction detail.

Legal contract – The terms and conditions of the agreement between parties.

Checks – The amount paid, signature of drawer, and name of drawee.

Purchase orders – The quantity and type of goods ordered.

4. The general journal records economic events in chronological order. Posting financial information from the general journal to the general ledger is very important because the information is then presented per account rather than per transaction (as is in the general journal). Posting simplifies the representation of data and increases the efficiency of accounting transactions.

5. A trial balance is a statement listing the debit and credit account balances from the general ledger accounts.

A trial balance’s purpose is to assure that the accounting system is “in balance” (total debits and total credits are equal) at the point in time at which the trial balance is prepared.

The fact that a trial balance is “in balance” does not necessarily mean that all transactions have been recorded correctly. For example, if the debit or credit of a journal entry were posted to an incorrect account, the debit and credit columns of the trial balance would be equal although at least one of the accounts would be incorrect. Additionally, if the wrong amount were recorded in the journal entry, the debit and credit columns of the trial balance would be equal although at least two accounts would be incorrect.

6. A deferred expense is actually an asset that has been created by a prepayment of an expense, such as insurance and property taxes. If a portion of the prepayment has been “used up,” failure to adjust the deferred expense (prepaid asset) at the end of an accounting cycle will cause the balance in the asset account to be overstated and the balance in the expense account to be understated.

7. A deferred revenue is a liability because the organization has received cash in advance of the earning process. Examples of deferred revenues include unearned magazine subscriptions revenues and unearned rental income. If the company earns a portion or all of the deferred revenue, failure to adjust the balance will result in liabilities that are overstated and revenues that are understated.

8. An accrued revenue is an asset because it represents a receivable that has resulted from revenues earned, but not yet received. Examples of accrued revenues include Interest Receivable and Accounts Receivable. If revenues are earned but not accrued, revenues and assets are understated. The adjusting entry corrects these understatements.

9. The net income or net loss for a period must be transferred from the temporary revenue and expense accounts to Retained Earnings (a balance sheet account). This process is necessary so that the balance sheet will be in balance after the temporary accounts are closed.

10. The Retained Earnings account is presented in the stockholders’ equity section of the balance sheet; it is also on the statement of stockholders’ equity. This account represents the earnings of the organization that have not been distributed in the form of dividends to the stockholders.

11. Dividends are distributions to stockholders for their investment in the organization.

Dividends are found on the Statement of Stockholder’ Equity as a reduction of retained earnings. Dividends will also be found on the balance sheet in current liabilities as Dividends Payable if those dividends have been declared but not paid. Dividends are not considered expenses because they are not actual costs of operating a business. Instead, dividends are returns on investments to the business’ investors.

12. Permanent accounts are not closed at the end of the cycle and are found on the balance sheet. Temporary accounts (or nominal) accounts are closed at the end of the accounting cycle. Two temporary accounts (revenues and expenses) are found on the income statement; one temporary account (Dividends) is shown on the Statement of Retained Earnings.

The terms permanent and temporary are appropriate because those terms reflect the degree of continuity of the accounts on the financial statements. Permanent accounts continue from period to period, while temporary accounts are reduced to zero at the end of one period so that completely new information can be recorded in those accounts in the next period.

13. Adjusting entries are made at the end of each accounting cycle to bring all revenue and expense accounts up-to-date so that those accounts reflect the appropriate amounts of revenues earned and expenses incurred during that particular cycle.

Closing entries are made at the end of each accounting cycle to bring all temporary accounts to zero balances, which enable the organization to start the next accounting cycle with a “fresh slate.”

EXERCISES 14. (a) F A journal entry may affect as many accounts as necessary as long as the dollar amount of the debits and credits are equal. (b) F An “in balance” trial balance does not mean that the accounting records are free of error because a misstatement in recording may still exist. (c) T (d) F By not recording a transaction in its entirety, the debits and credits of the business will still be in balance; however, the amounts of certain account balances will be incorrect. (e) T (f) F The closing process starts with preparing closing entries. (g) T (h) T (i) T (j) F Only the temporary accounts of an organization begin the period with zero balances. (k) T (l) F Double-entry bookkeeping is used in countries around the world.

15. a. & b.

Alcoa A DR L CR Q CR X DR R CR

Honeywell L CR A DR A DR X DR A DR

Darden’s Restaurants X DR A DR L CR Q CR A DR

16. (a) Purchased $400 of supplies for cash.

Paid $270 of interest expense in cash.

Purchased $4,000 of equipment by signing a note payable. (b) Instead of increasing Equipment and Notes Payable each by $4,000, the bookkeeper would have decreased both accounts by $4,000. Therefore, both would have been understated by $8,000. Assuming no other transactions in these accounts, Equipment would have had an abnormal credit balance of $4,000 and Notes Payable would have been an abnormal debit balance of $4,000.

(c) The trial balance would still have balanced because equality between debits and credits would have existed, but the trial balance would not have been accurate.

17. (a) Cash Unearned Rent Revenue

24,000

Prepaid Advertising Cash

6,000

24,000

6,000

(b) Prepaid Rent Cash

24,000 24,000

Cash Unearned Advertising Revenue

6,000 6,000

(c) The first transaction increased assets (cash) by $24,000 The second transaction increased one asset (prepaid advertising) by $6,000 and decreased another asset (cash) by $6,000; thus, there was no effect on total assets.

18. (a) Cash would be classified as a current asset and Accounts Payable would be classified as a current liability. (b) Assets have debit balances. Liabilities have credit balances. (c) Cash has a debit balance of $18,400.

Accounts payable has a credit balance of $5,200.

Cash 14,000 9,000 8,000 18,400

10,000 600 2,000 Balance

Accounts Payable 4,000 5,000 1,000 Balance

6,000 8,200 1,000 5,200

(d) The debit to Cash represents an increase to the company’s cash. It could have been a result of an $8,000 payment on account by one of the company’s customers or an $8,000 cash sale. (e) The debit to Accounts Payable represents a reduction to accounts payable. It could have been a result of a $5,000 payment on account by the company or a return of $5,000 of merchandise to a supplier.

19. (a-c)

Cash

Office Supplies

12,400 420 6,750

840 420 1,260

6,350 2,658 9,722 Accounts Receivable 9,300 6,750 2,550

Accounts Payable 14,200 7,560 6,350 15,410

Inventory 6,100 7,560 13,660

Utility Expense 0 2,658 2,658

(d) The purpose of posting journal entries to the ledger accounts is to help consolidate the information by accounts so as to aid in financial statement preparation and to provide specific information on balances in particular accounts.

20. (a-b) The following accounts would likely need an adjusting entry: Property, Plant, and Equipment would necessitate the recording of Depreciation Expense and the increasing of Accumulated Depreciation.

Unearned Rent Revenue would necessitate the recording of the revenue earned during the period by decreasing that account and increasing Rent Revenue.

Prepaid Rent would necessitate the recording of the Rent Expense incurred for the period and the reduction of Prepaid Rent.

Notes Payable would necessitate an adjusting entry to record Interest Expense and Interest Payable for the period. (c)

The non-affected accounts (cash, common stock, land, and retained earnings) are not adjusted because their balances do not change simply by the passage of time.

21. (a) Current liabilities that may have been recorded during the adjusting entry process include accounts payable, accrued compensation, other accrued expenses and income taxes payable. (b) The $200,000,000 of long-term debt that was coming due in the upcoming year would have been transferred from a long-term debt account to a current liability.

(c) Compensation Expense Accrued Compensation Payable

46.4 M 46.4 M

22. (a) Cash Unearned Design Fees

5,000

(b) Accounts Receivable Unearned Design Fees Design Fee Revenue

5,000 5,000

23. (a) Cleaning Supplies Cash (b) Supply Expense Cleaning Supplies Accounts Receivable Fees Earned

5,000

10,000 6,500 6,500 3,100 3,100 4,100,000 4,100,000

(c) The revenue recognition principle would have been violated if the year-end adjusting entry had not been made. Net income (or net loss) for the current period would have been understated (or overstated), while net income (or net loss) for the following period would be overstated (or understated). Revenue should be reported in the period in which it is earned rather than in the period in which it is collected (which represents the cash basis of accounting). (d) By not recording entries that involve revenues and expenses, companies can manipulate their net income. The omission of Harsha’s adjusting entry would have overstated assets and understated expenses, thereby increasing net income. The omission of Silverman & Sachs’ adjusting entry would have understated assets and revenues, thereby reducing net income. Companies might choose to omit entries to mislead the users of the financial statements.

24. (a) Total Assets = Cash + Equipment + Supplies + Land $36,000 = $5,000 + $10,400 + Supplies + $16,400 Supplies = $36,000 – $5,000 – $10,400 – $16,400 Supplies = $4,200 Total Assets = Total Liabilities + Owner’s Equity Total Liabilities + Owner’s Equity = $36,000 Total Liabilities + Owner’s Equity = A/P + N/P + Owner’s Equity $36,000 = A/P + $10,800 + $18,000 A/P = $36,000 – $10,800 – $18,000) A/P = $7,200

(b) Total Liabilities + Owner’s Equity = A/P + N/P + Owner’s Equity $39,800 = A/P + $10,800 + $18,000 A/P = $39,800 – $10,800 – $18,000 A/P = $11,000 Total Assets = Total Liabilities + Owner’s Equity Total Assets = Cash + Equipment + Supplies + Land $39,800 = $5,000 + $10,400 + Supplies + $16,400 Supplies = $39,800 – $5,000 – $10,400 – $16,400) Supplies = $8,000 (c)

Debits Cash Supplies Equipment Land Accounts Payable Notes Payable Owners’ Equity Total

25. (a) Sales Revenue Income Summary

Credits

$5,000 4,200 10,400 16,400

$36,000

$ 7,200 10,800 18,000 $36,000

50,000 50,000

Income Summary Selling Expenses Income Taxes Expense Utilities Expense

26,000

Income Summary Retained Earnings

24,000

12,000 8,000 6,000

24,000

(b) The company earned $24,000. (c) Cash: Current Asset section of the Balance Sheet Accounts Receivable: Current Asset section of the Balance Sheet Unearned Rental Revenue: Current Liability section of the Balance Sheet Accounts Payable: Current Liability section of the Balance Sheet Prepaid Rent: Current Asset section of the Balance Sheet

26. Mr. Restin: Your books need to be adjusted at the end of every accounting cycle to properly account for all the revenues and expenses that impact your business. Generally accepted accounting principles dictate that these procedures be performed to bring all temporary accounts to proper balances to aid in the preparation of financial statements each period.

Once adjusting entries are prepared and posted to the general ledger accounts, your books will be closed to determine your net income or net loss for the accounting period.

Each accounting period, your nominal/temporary accounts must start out with a zero balance to account for the revenues and expenses related to the next period.

PROBLEMS 27. (a)

Collection of cash should increase cash (debit) and decrease accounts receivable (credit). Entry A has reversed the debit and credit.

A purchase of office supplies should decrease cash (credit) and increase office supplies (debit). Entry B has debited Office Equipment (a long-term asset) rather than office supplies (a current asset).

Entry C is correct.

(b)

Cash

4,000

Accounts Receivable To reverse incorrect entry

4,000

Cash

4,000 Accounts Receivable To record collection of accounts receivable

4,000

(An alternative to the two above entries is one debit to Cash for $8,000 and one credit to Accounts Receivable for $8,000.

Office Supplies Office Equipment To correct classification of office supplies as equipment (c)

900 900

Total assets would have been correct, but individual asset accounts (cash, accounts receivable, office supplies, and office equipment) would have been wrong.

28. (a) 12/1 Supplies Cash

300 300

3 Utilities Payable Cash

250

9 Salary Expense Cash

1,200

250

1,200

16 Cash Interest Receivable

600

22 Cash Accounts Receivable

1,700

26 Prepaid Rent Cash

600

1,700 400 400

30 Cash Unearned Revenue

2,500

31 Equipment Accounts Payable

3,000

2,500 3,000

(b) The entries on December 1, 26, and 31 are deferred expenses.

The entry on Dec. 30 is a deferred revenue.

The entry on Dec. 9 is an accrued expense.

29. (a) Jan. 06 Cash

40,000 Note Payable

Jan. 7

Jan. 7

Jan. 7

Jan. 8

40,000

Prepaid Rent Cash

1,000

Inventory Cash

4,000

Equipment Cash

650

Cash

350

1,000

4,000

650

Revenue Jan. 10 Wages Expense Cash

350 360 360

Jan. 10 Cash

800 Revenue

800

(b)

Jan. 8 Jan. 10 Balance

Cash 40,000 Jan. 7 Jan. 7 Jan. 7 Jan. 10 350 800 35,140

Jan. 7

Inventory 4,000

Jan. 7

Equipment 650

Jan. 10

Wages Expense 360

Jan. 6

(c)

1,000 4,000 650 360

Jan. 7

Notes Payable Jan. 6

40,000

Revenue Jan. 8 350 Jan. 10 800 Balance 1,150

Tamara Zeevah Trial Balance January 10, 2009 Cash Inventory Prepaid Rent Equipment Notes Payable Revenue Wages Expense Totals

Prepaid Rent 1,000

Debits $35,140 4,000 1,000 650

Credits

$40,000 1,150 360 $41,150

$41,150

(d) Ms. Zeevah: Your current method of record keeping is not sufficient to provide you with the necessary information needed to prepare financial statements. You should record each transaction in a general journal and then post to ledger accounts to help facilitate financial statement preparation. As you currently record items through your checkbook, the possibility of missing a transaction or event is high. For example, the interest on your bank loan would not be recorded until it was paid rather than in the period in which that expense were incurred. Should a client prefer to be billed (rather than pay in cash), your records would not indicate that revenue until it was received rather than when it was earned.

Please consider amending your current method of record keeping by using the more appropriate accrual method of accounting.

30. (a)

BCI Trial Balance September 30, 2009

Cash Accounts Receivable Inventory Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings Sales Revenue Operating Expenses Totals

$

Debits 50,000 300,000 250,000 450,000

Credits

$ 110,000 350,000 50,000 95,000 100,000 600,000 255,000 $1,305,000

$1,305,000

(b) Three examples are recording the (1) purchase of supplies for cash as a debit to Office Equipment; (2) payment of accounts payable as a debit to Notes Payable, , and (3) the payment of rent expense as a debit to Utility Expense. (c) BCCI could take the following steps to help ensure the accuracy of its accounting records: (1) automate its accounting system, (2) make sure all transactions are recorded in the records, (3) hire qualified accounting professionals.

31. (a) Salary Expense Salary Payable

840

Utility Expense Utility Payable

240

Income Tax Expense Income Tax Payable

800

Unearned Fee Revenue Fee Revenue

100

840

240

800

100

no adjusting entry needed Accounts Receivable Fee Revenue

1,400 1,400

(b) Neither expenses nor payables for salaries, utilities, or income taxes would have been recorded until the cash had been paid. The $300 and $680 would have been recorded as revenue when received; the $1,400 left unbilled would not have shown up on the books at all for December, but rather when received in the future. (c) Accrual accounting provides a better and more appropriate matching of revenues and expenses for a business. It allows the business to properly compute net income or net loss for each accounting period. Cash basis accounting only records transactions when there are cash inflows into or outflows from the business; the cash basis really isn’t conductive to preparing informative financial statements.

32. (a) If the advance payment is credited to a revenue account instead of an unearned revenue account, the income statement will reflect $31,000 of revenue that has not been earned. Balance sheet assets will not be affected by this transaction because cash would be debited in the journal entry whether the transaction were recorded properly or improperly. Liabilities will be understated because the advance payment will not be included as an unearned revenue.

In the second transaction, rent expense will be understated, making net income overstated on the income statement. Liabilities on the balance sheet will be understated because rent payable would not have been recorded. (b) Both the revenue recognition and the matching principles will be violated if the accountant complies with the business owner.

(c) The ethical thing to do is to record the transactions properly in spite of what the owner wants, although doing so will probably put you in out-of-favor with your boss. If you desperately need the job, you may end up doing what the boss asks, but you probably need to ask yourself if you really want to work for this type of person.

The primary people affected by the misrecording of the transaction are the bankers, who will be analyzing incorrect financial statements in determining whether to make the loan.

33. (a)

Schneider Consulting, Inc. Income Statement For the Year Ended December 31, 2009 Revenues Consulting Fees Interest Revenue Total Revenues Expenses Salaries Expense Rent Expense Advertising Expense Depreciation Expense Utilities Expense Interest Expense Total Expenses Operating Income Other Revenues, Gains, Expenses, and Losses Income Tax Expense Net Income

(b)

$460,000 3,000 $463,000 176,000 23,000 22,000 10,000 6,000 5,000 242,000 221,000 (57,000) $164,000

Schneider Consulting, Inc. Statement of Stockholders’ Equity For the Year Ended December 31, 2009 Beginning balance, January 1, 2009 Add: Sale of stock Net income Less: Dividends Ending balance, December 31, 2009

Common Stock $35,000 0

$35,000

Retained Earnings $ 71,000 164,000 (10,000) $225,000

(c)

Schneider Consulting, Inc. Balance Sheet December 31, 2009 ASSETS Current Assets Cash Accounts Receivable Interest Receivable Inventory Prepaid Insurance Total Current Assets Property, Plant, and Equipment Equipment Accumulated Depreciation Total Assets

$ 24,000 71,000 1,000 125,000 6,000 $227,000 $252,000 (41,000)

LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities Accounts Payable Interest Payable Income Taxes Payable Total Current Liabilities Non-Current Liabilities Notes Payable Total Liabilities Stockholders’ Equity Common Stock Retained Earnings Total Liabilities and Stockholders’ Equity

211,000 $438,000

$ 27,000 4,000 57,000 $ 88,000 90,000 $178,000 $ 35,000 225,000

260,000 $438,000

34. (a) Permanent accounts listed are cash, accounts payable, and accumulated depreciation; temporary accounts listed are interest revenue, rental revenue, dividends, salaries expense, and depreciation expense. (b) Interest Revenue Rental Revenue Income Summary

5,000 252,000 257,000

Income Summary Depreciation Expense Salaries Expense

103,000

Income Summary Retained Earnings

154,000

8,000 95,000

154,000

Retained Earnings Dividends

11,000 11,000

(c) Net Income = Total Revenues - Total Expenses Net Income = $257,000 - $103,000 Net Income = $154,000 (d) Ending R/E = Beginning R/E + Net Income – Dividends Ending R/E = $47,000 + $154,000 - $11,000 Ending R/E = $190,000

CASES 35. (a)

3/2

Cash 200,000 Common Stock 200,000 3/3 Supplies 4,000 Accounts Payable 4,000 3/4 Prepaid Rent 3,000 Cash 3,000 3/5 Accounts Receivable 650 Service Revenue 650 3/6 Cash 7,400 Service Revenue 7,400 3/9 Cash 1,000 Unearned Revenue 1,000 (Note: No entry is needed on 3/10 because the printer has only been ordered and not yet received.)

3/11 Accounts Payable 1,200 Cash 1,200 3/12 Cash 450 Accounts Receivable 450 3/13 Salaries Expense 790 Cash 790 3/13 Cash 3,700 Service Revenue 3,700

(b) Cash Debit

3/2 3/4 3/6 3/9 3/11 3/12 3/13 3/13

Issued common stock Paid rent Received revenue Received unearned revenue Paid A/P Collected A/R Paid salaries Received revenue

Credit

200,000 3,000 7,400 1,000 1,200 450 790 3,700

Balance

200,000 197,000 204,400 205,400 204,200 204,650 203,860 207,560

Accounts Receivable Debit

3/5 Provided services 3/12 Received payment

Credit

650 450

Balance

650 200

Supplies Debit

3/3

Bought supplies

Credit

4,000

Balance

4,000

Prepaid Rent Debit

3/4

Paid rent

Credit

3,000

Balance

3,000

Accounts Payable Debit

3/3 Bought supplies 3/11 Paid A/P

Credit

4,000 1,200

Balance

4,000 2,800

Unearned Revenue Debit

3/9

Received unearned revenue

Credit

1,000

Balance

1,000

Common Stock Debit

3/2

Issued common stock

Credit

Balance

200,000

200,000

Credit

Balance

Service Revenue Debit

3/5 Provided services 3/6 Provided services 3/13 Provided services

650 7,400 3,700

650 8,050 11,750

Salaries Expense Debit

3/13 Paid salaries

790

Credit

Balance

790

Cash Accounts Receivable Supplies Prepaid Rent Accounts Payable Unearned Revenue Common Stock Services Revenue Salaries Expense Totals

$207,560 200 4,000 3,000 $

2,800 1,000 200,000 11,750

790 $215,550

$215,550

36. (a) (amounts are in millions) Passenger Ticket Revenues Onboard and Other Revenues Other Revenues Interest Income Income Summary

9,792 2,846 395 67 13,100

Income Summary 10,692 Cruise Commissions, Transportation and Other Expense Cruise Onboard and Other Expense Cruise Payroll and related Expense Cruise Fuel Expense Cruise Food Expense Cruise Ship Other Operating Expense Cruise Other Expense Selling and Administrative Expense Depreciation and Amortization Expense Interest Expense (net) Other Expense (net) Income Tax Expense (net)

1,941 495 1,336 1,096 747 1,717 296 1,579 1,101 367 1 16

Income Summary Retained Earnings

2,408 2,408

Retained Earnings Dividends

1,087 1,087

(b) The balance of Retained Earnings on December 1, 2007, was $11,600,000 (same as the November 30, 2006 balance).

(c)

Retained Earning Beg. balance 11,600 Closed Inc. Summary 2,408 Dividends declared 1,087 Ending balance 12,921

(d) The ending balance of the T-Account ($12,921,000,000) equals that of the Statement of Stockholders’ Equity on November 30, 2007. (e)

Income Summary Closed revenues Closed expenses 10,692 Closed Inc. Summ. 2,408 Ending balance

37. (a) (1)

6/1

6/1 6/2 6/3 6/3 6/5 6/15

6/20 6/25 6/30

6/30 6/30 7/2 7/3

Cash Lawn Mower Common Stock Cash Notes Payable Cash Unearned Revenue No entry needed for supplies order Gasoline Expense Cash Supplies Cash Cash Accounts Receivable Service Revenue Gasoline Expense Cash Prepaid Rent Cash Cash Accounts Receivable Service Revenue Cash Accounts Receivable Salary Expense Cash Repairs Expense Accounts Payable Gasoline Expense Cash

13,100

0 1,200 300 1,500 400 400 150 150 20 20 100 100 1,000 500 1,500 20 20 100 100 1,000 250 1,250 300 300 500 500 60 60 40 40

7/30

7/31 7/31

Cash Accounts Receivable Service Revenue Salary Expense Cash Accounts Payable Cash

2,000 1,250 3,250 800 800 60 60

(a) (2) Cash Debit

6/1 6/1 6/2 6/3 6/5 6/15 6/20 6/25 6/30 6/30 6/30 7/3 7/30 7/31 7/31

Issued common stock Received bank loan Received unearned revenue Bought gas Bought supplies Received revenue Bought gas Prepaid rent Received revenue Collected A/R Paid salary Bought gas Received revenue Paid salary Paid A/P

Credit

1,200 400 150 20 100 1,000 20 100 1,000 300 500 40 2,000 800 60

Balance

1,200 1,600 1,750 1,730 1,630 2,630 2,610 2,510 3,510 3,810 3,310 3,270 5,270 4,470 4,410

Accounts Receivable Debit

6/15 6/30 6/30 7/30

Provided services Provided services Received payment Provided services

Credit

500 250 300 1,250

Balance

500 750 450 1,700

Supplies Debit

6/5

Bought supplies

Credit

100

Balance

100

Prepaid Rent Debit

6/25 Paid rent

Credit

100

100

Lawn Mower Debit

Credit

Balance

Balance

6/1

Contributed lawn mower

300

300

Notes Payable Debit

6/1

Credit

Received bank loan

Balance

400

400

Accounts Payable Debit

7/2 Lawn mower repair 7/31 Paid A/P

Credit

Balance

60 60

60 0

Unearned Revenue Debit

6/2

Credit

Received unearned revenue

150

Balance

150

Common Stock Debit

6/1

Credit

Issued common stock

1,500

Balance

1,500

Service Revenue Debit

Credit

6/15 Provided services 6/30 Provided services 7/31 Provided services

1,500 1,250 3,250

Balance

1,500 2,750 6,000

Gasoline Expense Debit

6/3 Bought gas 6/20 Bought gas 7/3 Bought gas

Credit

20 20 40

Balance

20 40 80

Salaries Expense Debit

6/30 Paid salaries 7/31 Paid salaries

Credit

500 800

Balance

500 1,300

Repairs Expense Debit

7/2

Lawn mower repair

Credit

60

Balance

60

(a) (3)

Trial Balance July 31, 2009 Cash Accounts Receivable Supplies Prepaid Rent Lawn Mower Notes Payable Unearned Revenue Common Stock Service Revenue Gasoline Expense Salaries Expense Repairs Expense Totals

$4,410 1,700 100 100 300 $

80 1,300 60 $8,050

400 150 1,500 6,000

$8,050

(b) (1) 7/31 Supplies Expense 40 Supplies 40 7/31 Prepaid Gasoline 6 6 Gasoline Expense (An alternative would have been to debit Prepaid Gasoline each time Babineaux purchased gas and then record a debit to Gasoline Expense and a credit to Prepaid Gasoline on 7/31 for $74.)

7/31 Unearned Revenue (2 mows @ $50) 100 Service Revenue 100 7/31 Rent Expense 100 Prepaid Rent 100 7/31 Interest Expense ($400 x 0.06 x 2/12) 4 Interest Payable 4 7/31 Depreciation Expense 50 Accumulated Depreciation 50 (b) (2) Only the accounts changed by the adjusting entries are shown.

Supplies Debit

6/5 Bought supplies 7/31 Recorded supplies used

Credit

Balance

100 40

100 60

Prepaid Rent Debit

6/25 Paid rent 7/31 Recorded expiration of prepaid rent

Credit

100 100

Balance

100 0

Prepaid Gasoline Debit

7/31 Recorded unused gasoline

Balance

Credit

6

6

Accumulated Depreciation Debit

Credit

7/31 Recorded two months of depreciation

Balance

50

50

Unearned Revenue Debit

6/2 Received unearned revenue 7/31 Earned revenue

Credit

Balance

150 100

150 50

Interest Payable Debit

Credit

7/31 Recorded two months of interes

Balance

4

4

Service Revenue Debit

6/15 6/30 7/31 7/31

Credit

Provided services Provided services Provided services Earned revenue

Balance

1,500 1,250 3,250 100

1,500 2,750 6,000 6,100

Supplies Expense Debit

7/31 Recorded supplies used

Credit

Balance

40

40

Gasoline Expense Debit

6/3 6/20 7/3 7/31

Bought gas Bought gas Bought gas Recorded unused gasoline

Credit

Balance

20 20 40 6

20 40 80 74

Rent Expense Debit

7/31 Recorded expiration of prepaid rent

100

Credit

Balance

100

Interest Expense Debit

7/31 Recorded two months of interest

Credit

Balance

4

4

Depreciation Expense Debit

7/31 Recorded two months of depreciation

(b) (3)

Cash Accounts Receivable Supplies Prepaid Gasoline Lawn Mower Accumulated Depreciation Notes Payable Unearned Revenue Interest Payable Common Stock Service Revenue Supplies Expense Gasoline Expense Salaries Expense Repairs Expense Rent Expense Interest Expense Depreciation Expense Totals (c) (1)

Credit

50

Trial Balance July 31, 2009 $4,410 1,700 60 6 300 $

40 74 1,300 60 100 4 50 $8,104

50 400 50 4 1,500 6,100

$8,104

Income Statement For Two Months Ended July 31, 2009 Service Revenue Expenses: Supplies Expense Gasoline Expense Salaries Expense Repairs Expense Rent Expense Interest Expense Depreciation Expense Net Income

$6,100 $

40 74 1,300 60 100 4 50

(1,628) $4,472

Balance

50

(c) (2)

Statement of Stockholders’ Equity For Two Months Ended July 31, 2009 6/1 Issued common stock 7/31 Net income 7/31 Ending balances

(c) (3)

Common Stock $1,500 $1,500

Retained Earnings $4,472 $4,472

Balance Sheet July 31, 2009

ASSETS Current Assets Cash Accounts Receivable Supplies Prepaid Gasoline PP&E Lawn Mower Accumulated Depreciation Total Assets

$4,410 1,700 60 6 $ 300 (50)

LIABILITIES & STOCKHOLDERS’ EQUITY Current Liabilities Notes Payable $ 400 Unearned Revenue 50 Interest Payable 4 Stockholders’ Equity Common Stock $1,500 Retained Earnings 4,472 Total Liabilities & Stockholders’ Equity (d) (1) 7/31 Service Revenue Income Summary Income Summary Supplies Expense Gasoline Expense Salaries Expense Repairs Expense Rent Expense Interest Expense Depreciation Expense Income Summary Retained Earning

$6,176

250 $6,426

$ 454

5,972 $6,426 6,100 6,100 1,628 40 74 1,300 60 100 4 50 4,472 4,472

(d) (2) Cash Debit

6/1 6/1 6/2 6/3 6/5 6/15 6/20 6/25 6/30 6/30 6/30 7/3 7/30 7/31 7/31

Issued common stock Received bank loan Received unearned revenue Bought gas Bought supplies Received revenue Bought gas Prepaid rent Received revenue Collected A/R Paid salary Bought gas Received revenue Paid salary Paid A/P

Credit

Balance

1,200 400 150 20 100 1,000 20 100 1,000 300 500 40 2,000 800 60

1,200 1,600 1,750 1,730 1,630 2,630 2,610 2,510 3,510 3,810 3,310 3,270 5,270 4,470 4,410

Accounts Receivable Debit

6/15 6/30 6/30 7/30

Provided services Provided services Received payment Provided services

Credit

Balance

500 250 300 1,250

500 750 450 1,700

Supplies Debit

6/5 Bought supplies 7/31 Recorded supplies used

Credit

Balance

100 40

100 60

Prepaid Rent Debit

6/25 Paid rent 7/31 Recorded expiration of prepaid rent

Credit

100 100

Balance

100 0

Prepaid Gasoline Debit

7/31 Recorded unused gasoline

Credit

6

Balance

6

Lawn Mower Debit

6/1

Contributed lawn mower

Credit

Balance

300

300

Accumulated Depreciation Debit

Credit

7/31 Recorded two months of depreciation

Balance

50

50

Notes Payable Debit

6/1

Credit

Received bank loan

Balance

400

400

Accounts Payable Debit

7/2 Lawn mower repair 7/31 Paid A/P

Credit

Balance

60 60

60 0

Unearned Revenue Debit

6/2 Received unearned revenue 7/31 Earned revenue

Credit

Balance

150 100

150 50

Interest Payable Debit

Credit

7/31 Recorded two months of interest

Balance

4

4

Common Stock Debit

6/1

Issued common stock

Credit

1,500

Balance

1,500

Retained Earnings Debit

7/31 Net income for June & July

Credit

4,472

Balance

4,472

Service Revenue Debit

6/15 6/30 7/31 7/31 7/31

Provided services Provided services Provided services Earned revenue Closing entry

Credit

Balance

1,500 1,250 3,250 100 6,100

1,500 2,750 6,000 6,100 0

Supplies Expense Debit

7/31 Recorded supplies used 7/31 Closing entry

Credit

Balance

40 40

40 0

Gasoline Expense Debit

6/3 6/20 7/3 7/31 7/31

Bought gas Bought gas Bought gas Recorded unused gasoline Closing entry

Credit

Balance

20 20 40 6 74

20 40 80 74 0

Rent Expense Debit

7/31 Recorded expiration of prepaid rent 7/31 Closing entry

Credit

Balance

100 100

100 0

Interest Expense Debit

7/31 Recorded two months of interest 7/31 Closing entry

Credit

Balance

4 4

4 0

Depreciation Expense Debit

7/31 Recorded two months of depreciation 7/31 Closing entry

Credit

Balance

50 50

50 0

Salaries Expense Debit

6/30 Paid salaries 7/31 Paid salaries 7/31 Closing entry

Credit

500 800 1,300

Balance

500 1,300 0

Repairs Expense Debit

Credit

Balance

60

7/2 Lawn mower repair 7/31 Closing entry

60

60 0

Income Summary Debit

7/31 Closing revenues 7/31 Closing expenses 7/31 Closing income summary

(d) (3)

Credit

6,100 1,628 4,472

Balance

6,100 4,472 0

Postclosing Trial Balance July 31, 2009 Cash Accounts Receivable Supplies Prepaid Gasoline Lawn Mower Accumulated Depreciation Notes Payable Unearned Revenue Interest Payable Common Stock Retained Earnings Totals

$4,410 1,700 60 6 300 $

$6,476

50 400 50 4 1,500 4,472 $6,476

SUPPLEMENTAL PROBLEMS 38. (a) 8/1 Equipment Cash 8/2 Office Supplies Cash 8/4 Income Tax Payable Cash 8/4 Cash Service Revenue 8/5 Salaries Expense Cash 8/6 Interest Expense Interest Payable

1,200 1,200 320 320 400 400 450 450 500 500 100 100

(b) Accounting is based on the double-entry system, which requires that the following equation remain in balance at all times: Assets = Liabilities + Equity. As one

account changes, there must be an offsetting change in another account for the equation to remain in balance. For example, when Cash (an asset) decreases, generally a liability or an equity account must decrease or another asset must increase. The opposite is also true.

39. (a) Some accounts have zero balances because the organization has not generated any revenues or incurred any expenses for the current operating cycle and the previous year amounts were closed on 12/31/08. (b) 1/2 Accounts Payable Cash 1/5 Supplies Cash 1/5 Office Equipment Cash 1/6 Cash Fee Revenue 1/7 Selling Expense Cash 1/8 Cash Accounts Receivable 1/9 Salary Expense Cash

30,000 30,000 2,100 2,100 4,700 4,700 16,400 16,400 7,100 7,100 25,000 25,000 15,200 15,200

(c) Cash Debit

1/1 1/2 1/5 1/5 1/6 1/7 1/8 1/9

Beginning balance Paid A/P Bought supplies Bought office equipment Received fee revenue Paid selling expense Collected A/R Paid salaries

Credit

30,000 2,100 4,700 16,400 7,100 25,000 15,200

Balance

80,000 50,000 47,900 43,200 59,600 52,500 77,500 62,300

Accounts Receivable Debit

1/1 1/8

Beginning balance Received payment

Credit

25,000

Balance

85,000 60,000

Supplies Debit

1/1 1/5

Beginning balance Bought supplies

2,100

Credit

Balance

30,000 32,100

Office Equipment Debit

1/1 1/5

Beginning balance Bought equipment

Credit

Balance

325,000 329,700

4,700

Accumulated Depreciation - Office Equipment Debit

1/1

Credit

Beginning balance

Balance

135,000

Accounts Payable Debit

1/1 1/2

Beginning balance Paid A/P

Credit

Balance

70,000 40,000

30,000

Common Stock Debit

1/1

Credit

Beginning balance

Balance

90,000

Retained Earnings Debit

1/1

Credit

Beginning balance

Balance

225,000

Fee Revenue Debit

1/1 1/6

Beginning balance Provided services

Credit

16,400

Balance

0 16,400

Selling Expense Debit

1/1 1/7

Beginning balance Recorded expense

Credit

Balance

0 7,100

7,100

Salary Expense Debit

1/1 1/9

Beginning balance Recorded expense

15,200

Credit

Balance

0 15,200

Supplies Expense Debit

1/1

Trial Balance January 9, 2009 Cash Accounts Receivable Supplies Office Equipment Accumulated Depreciation Accounts Payable Common Stock Retained Earnings Fee Revenue Selling Expense Salary Expense Totals

40.

(a)

$ 62,300 60,000 32,100 329,700 $135,000 40,000 90,000 225,000 16,400 7,100 15,200 $506,400

$506,400

LC & Associates Income Statement For Year Ended December 31, 2009

Fee Revenue Interest Revenue Total Revenues Expenses: Rent Expense Salaries Expense Depreciation Expense Income before Income Tax Income Tax Expense Net Income

Balance

0

Beginning balance

(d)

Credit

$315,000 9,100 $324,100 $69,500 75,000 17,000

(161,500) $162,600 (35,000) $127,600

(b)

LC & Associates Balance Sheet December 31, 2009 ASSETS Current Assets Cash Accounts Receivable Supplies Prepaid Advertising Prepaid Rent PP&E Equipment Accumulated Depreciation Total Assets

$112,500 95,000 12,000 18,000 40,000 $ 90,500 (71,000)

LIABILITIES & STOCKHOLDERS’ EQUITY Current Liabilities Accounts Payable $ 38,000 Salaries Payable 2,400 Interest Payable 70 Unearned Fee Revenue 19,930 Stockholders’ Equity Common Stock $ 75,000 Retained Earnings 161,600 Total Liabilities & Stockholders’ Equity

$277,500

19,500 $297,000

$ 60,400

236,600 $297,000

(c) Three classes of users include bankers, creditors, and investors. If bankers rely on inaccurate financial statements in the process of granting loans, the loans may end up not being repaid. If creditors decide to extend more or initial credit to a firm that has a high degree of debt, the same situation might exist as with the banker. If investors decide to put their money into a firm based on inaccurate financial statements, these investors could lose what they invested.

41. (a)

Shoe Repair Revenue Income Summary Income Summary Utilities Expense Salaries Expense Income Taxes Expense Income Summary Retained Earnings Retained Earnings Dividends

70,000 70,000 42,000 2,000 24,000 16,000 28,000 28,000 2,700 2,700

(b) Net Income = Total Revenue – Total Expenses = $70,000 - $42,000 = $28,000

CHAPTER 4 Solutions to End of Chapter Material

QUESTIONS 1. Cash equivalents include funds invested in certificates of deposit, money market funds, treasury bills, and short-term securities. Usually, these investments mature in 90 or fewer days.

To qualify as a cash equivalent, the invested funds must be convertible to a specified amount of cash virtually on demand. Therefore, these funds are essentially as liquid as cash itself, which is why they are combined with cash on the balance sheet.

2. The purpose of bank reconciliation is to ensure that your general ledger cash account agrees with the bank’s accounting of your money. The bank reconciliation should be prepared soon after it is received for several reasons: (a) your errors or the bank’s errors can be corrected quickly; (b) you become aware of certain items when the statement is received such as drafts, direct deposits, fees and NSF checks; and (c) differences between your records and the bank’s records may assist in locating fraudulent activities perpetrated with your cash account.

For the same reasons as paper statements, bank reconciliations are still important when using online banking. They may even be more important because online banking may often result in a greater number of automatic deposits and payments, the amounts and/or dates of which may be unknown to the customer as those items are occurring.

3. The most common adjustments on an individual’s bank reconciliation including the following: (a) adjusting the bank’s balance down for outstanding checks; (b) adjusting the bank’s balance up for outstanding deposits; (c) adjusting your balance down for service fees, check printing fees, NSF checks and fees, and drafts; and (d) adjusting your balance up for interest earned and direct deposits.

4. The matching principle dictates that companies estimate bad debts each accounting cycle.

The direct write-off method of recording bad debts does not appropriately match the revenues generated in a particular period with the potential and actual bad debt expenses that may be incurred in a future period related to those revenues. The allowance method of estimating bad debts (based on either sales or accounts receivable) attempts to properly match the revenues generated during an accounting cycle with the bad debt expense anticipated for that period.

5. An operating cycle is defined as the time between the spending of money for merchandise by an organization and the collection of cash from that organization’s customers. The longer the operating cycle, the more likely that the company may need to augment its cash in alternative ways, such as through short-term borrowing or (if longterm needs cannot be satisfied) through long-term debt or stock issuances.

6. A company extends credit so that customers who cannot or will not pay cash at the moment will still make a purchase. Companies that extend credit have two credit options: national credit cards and in-house credit.

Accepting national credit cards is the less risky option because the credit card company will usually pay the company before (and whether or not) the customer pays his/her credit card bill. However, there is small fee (a percentage of the sale amount) which is deducted by the credit card company, so the business that accepts national credit cards will realize less cash on a credit sale that a cash sale.

Issuing in-house credit eliminates the fee associated with national credit cards. The issuing company has the right to collect 100% of the sale and, often, interest on unpaid balances. However, new concerns face the issuing company. Customer must be screened and credit issued only to customers with a good credit history. Even with the best customer screening, collection of accounts receivable is complex and many debts are often not collected. Additionally, issuing companies must maintain a higher level of accounting personnel to prepare and issue monthly statements to customers and keep track of the age of the outstanding accounts receivable.

7. Liquidity may mean one of two things. First, in reference to the accounts on a balance sheet, liquidity refers to “nearness to cash.” Liquidity is important in preparing a balance sheet because current assets are listed in order of their nearness to becoming cash and because current assets must be used to pay off current liabilities. Thus, the second definition of liquidity reflects the company’s ability to pay liabilities as they come due and to finance day-to-day operations.

8. Bankers and other creditors are very interested in a firm’s liquidity because they want to know if outstanding debt can be repaid on a timely basis. Stockholders are interested in a firm’s liquidity because, if debts cannot be repaid on time, the firm may have to declare bankruptcy and, thus, stockholders would lose some or all of their investments.

Additionally, to declare a cash dividend, a company must have cash available, which would not be the case if debts were not being repaid in a timely fashion.

9. The quick ratio is computed as (cash + cash equivalents + short-term investments + net amounts of current notes and accounts receivable) divided by total current liabilities.

Lending decisions are often made after assessing a firm’s quick ratio and by comparing these to industry norms for that particular industry.

10. The receivables turnover ratio tells an organization how many times during a cycle that receivables are being collected. The age of receivables indicates how “old” on average the group of receivables is and can be compared to the credit terms of the organization to see whether collections are being made on a timely basis.

EXERCISES 11. (a) T (b) F Quick assets include cash, some notes receivable, accounts receivable, and short-term investments; inventory is not a quick asset. (c) F The direct write-off method records a bad debt expense when an account receivable is deemed uncollectible, which may or may not be in the same period that the sale (revenue) was generated. (d) F The risk of issuing in-house credit is much greater than accepting national credit cards because the responsibility of collection is on the issuing company. (e) T (f) F Errors on the part of the bank are adjustments to the bank balance on the bank reconciliation and do not affect the company’s cash ledger. (g) T (h) T (i) T (j) F Notes receivable can be dated as a daily, monthly, or yearly basis.

12. 6/1

6/5

Accounts Receivable Sales Revenue

400

Allowance for Uncollectible Accounts Accounts Receivable

350

6/15 Accounts Receivable Sales Revenue 6/17 Sales Returns & Allowances Accounts Receivable 6/25 Cash Sales Discounts Accounts Receivable

400

350 1,200 1,200 60 60 1,176 24 1,200

6/29 Accounts Receivable Allowance for Uncollectible Accounts

350 350

Cash Accounts Receivable

350

6/30 Cash Accounts Receivable

340

13. (a)

350

340

Credit Card Receivable-PlasticCard Credit Card Receivable-BanCard Credit Card Receivable-BigCard Sales Revenue

21,000 44,000 74,500

Cash Credit Card Expense Credit Card Receivable-PlasticCard

20,370 630

Cash Credit Card Expense Credit Card Receivable-BanCard

43,120 880

Cash Credit Card Expense Credit Card Receivable-PlasticCard

70,775 3,725

139,500

21,000

44,000

74,500

(Note: Depending on how promptly the credit card companies pay the retailer, The Magic Shoppe may choose to not to record an account receivable for the credit card company and simply make a debit directly to cash.) (b)

Retail stores accept bank credit cards because they offer the stores better collectability than in-house credit accounts. Banks always pay their bills, while retail customers often do not. Accepting credit cards for retail sales will not reduce profit; it may in fact increase profits because customers may buy more using credit.

(c)

The Magic Shoppe may honor Big Card inspire of its higher service fee because many customers in its retail area choose to use that particular card. Choosing not to accept this particular card might reduce sales and, therefore, profits.

14. (a)

(b)

Notes Receivable Accounts Receivable Interest Receivable Interest Revenue ($5,000 x 0.10 x 2/12 = $83.33)

5,000 5,000 83 83

The revenue recognition principle requires that revenues be recorded in the period in which they were earned. Interest is a factor of time and this interest is earned in the three months of the current year. (c)

Because the due date of the note was express in months, the date of the note is March 1, 2010. The collection of Spent’s note and interest can be journalized in two ways: (Alternative #1: one entry) Cash 5,166 Interest Receivable 83 Interest Revenue 83 Notes Receivable 5,000 (Alternative #2: two entries) Interest Receivable Interest Revenue Cash Interest Receivable Notes Receivable

83 83 5,166 166 5,000

15. (a) 2009 Uncollectible Estimate = Credit Sales X 2.5% 2009 Uncollectible Estimate = $1,000,000 X 0.025 2009 Uncollectible Estimate = $25,000 Uncollectible Accounts Expense Allowance for Uncollectible Accounts

(b)

25,000

Allowance for Uncollectible Accounts 2009 Write-offs 12,500 1/1/09 12/31/09 12/31/09

25,000

16,300 25,000 28,800

(c)

$25,000

(d)

The Allowance account is a real account and, as such, its balance continues from year-to-year. Thus, because each year’s estimate is never exact, a balance

remains in the Allowance account at the beginning of each year. In contrast, the Uncollectible Accounts Expense account is a temporary account and is closed to zero at the end of each year. The balance in that account will be whatever the adjusting entry is made for at the end of the year.

16. (a)

Year 1 Quick Ratio = Quick Assets ÷ Current Liabilities = ($8,040 + $4,230 + $29,751) ÷ ($6,007 + $3,492 + $347 + $2,767) = $42,021 ÷ $12,613 = 3.33 Year 2 Quick Ratio = ($19,601 + $7,829 + $90,833) ÷ ($11,364 + $8,956 + $331 + $1,235) = $118,263 ÷ $21,886 = 5.40 The quick ratio improved from year 1 to year 2.

(b)

17. (a)

For the quick ratio to increase, either the numerator must increase (i.e., increase in quick assets) or the denominator must decrease (i.e., decrease in current liabilities). Given the extremely large increase in short-term investments, the ratio’s increase may have been caused by major long-term borrowing by Macromedia. Unless sales have increased substantially, the increase in accounts receivable would be troublesome.

Aliza Corp.

A/R Turnover = $80,000 ÷ $20,000 = 4 Age of A/R = 360 ÷ 4 = 90 days Breta Corp.

A/R Turnover = $60,000 ÷ $5,000 = 12 Age of A/R = 360 ÷ 12 = 30 days

(b)

Assuming that both of the companies have a traditional 30-day payment term for their customers, Breta Corp. is doing a significantly better job of managing its accounts receivable.

PROBLEMS 18. (a) 4/1 Petty Cash Cash (b) 5/1 Miscellaneous Expense Repairs Expense Art Supplies Expense Delivery Expense Gasoline Expense Postage Expense Cash

400.00 400.00 18.21 27.54 82.54 30.75 43.23 10.50 212.77

(c) Cash might have been lower than expected for different reasons. Someone might have accidentally taken the wrong amount or made the wrong change. Someone might have taken petty cash without replacing the receipt in the envelope.

Alternatively, someone might be taking petty cash for personal use—although, given the small amount, this explanation is unlikely.

19. (a) 9/2 Cash Accounts Receivable-VerraExpress Accounts Receivable-United Card Accounts Receivable-MacCard Sales Revenue

778.00 173.00 181.00 150.00

9/3 Cash Accounts Receivable-VerraExpress Accounts Receivable-United Card Accounts Receivable-MacCard Sales Revenue

821.00 552.00 87.00 107.00

9/4 Cash Accounts Receivable-VerraExpress Accounts Receivable-United Card Accounts Receivable-MacCard Sales Revenue

668.00 128.00 344.00 60.00

(b) 9/8 Cash Credit Card Fee Expense Accounts Receivable-VerraExpress

710.50 14.50

Cash Credit Card Fee Expense

1,282.00

1,567.00

1,200.00

725.00 257.28 10.72

Accounts Receivable- United Card Cash Credit Card Fee Expense Accounts Receivable-MacCard

268.00 143.49 5.25 150.00

(c) Verra Express = $14.50 ÷ $725 = 2% United Card = $10.72 ÷ $268 = 4% MacCard = $5.25 ÷ $150 = 3.5% (d) Verra Express is 1.5% lower than MacCard and 2% lower than United Card.

Andree’s might encourage customers to use Verra Express by offering an incentive (e.g., gift-with-purchase, discount on purchase, entry into a drawing, etc.). Any of these ideas could help Andree’s as long as the cost of the incentive was less than the additional credit card fee incurred when customers use other cards.

20. 3/1 3/4

3/6

3/8

Accounts Receivable-Leonard Sales

450.00

Cash Accounts Receivable-Credit Card Sales Revenue

1,124.00 1,643.00

Cash Credit Card Fee Expense Accounts Receivable-Credit Card

1,626.57 16.43

Sales Returns and Allowances Accounts Receivable-Leonard

450.00

2,767.00

1,643.00 50.00 50.00

3/15 Accounts Receivable-Adams Sales Revenue

800.00

3/22 Sales Returns and Allowances Cash

120.00

3/24 Cash Sales Discounts Accounts Receivable-Adams

784.00 16.00

3/25 Cash Accounts Receivable-Leonard

400.00

800.00

120.00

800.00 400.00

21. (a) Full amount is due on October 12, 2009: 18 days in September plus 12 days. (b) Discount of $110 ($5,500 x 0.02) would be available through September 22. She would have been able to pay $5,390.

(c) January 10, 2010: 19 days in October plus 30 days in November plus 31 days in December plus 10 days in January. (d) 9/12

Accounts Receivable Sales Revenue

5,500.00 5,500.00

10/12 Notes Receivable Accounts Receivable

5,500.00

12/31 Interest Receivable Interest Revenue ($5,500 x 0.12 x 80/360)

146.67

1/10

Cash Notes Receivable Interest Receivable Interest Revenue ($5,500 x 0.12 x 10/360)

5,500.00

146.67

5,665.00 5,500.00 146.67 18.33

(e) Essentially, Ronnie’s customers can take four months to pay and still be within the bounds of the Ronnie’s credit policy. Because a customer could make a purchase in one fiscal year, let that account receivable be outstanding for a period of time, and then convert the account receivable into a note in the next fiscal year, Ronnie should estimate uncollectible receivables. Making such an estimate allows the company to match the potential for bad debts expense of bad debts in the same period as the revenue. If no estimate is made, Ronnie Co. will be violating the matching principle.

22. (a)

Xenon, Inc. Bank Reconciliation August 31, 20XX Balance per Bank Add: Deposits in transit Deduct: Outstanding checks Adjusted Bank Balance

$2,567 1,900 (2,250) $2,217

Balance per Books Add: Direct deposit from customer Interest earned Deduct: Error in recording check #345 for insurance NSF customer check Service fee Adjusted Bank Balance

$ 860 $1,400 12 $

15 32 8

1,412

(55) $2,217

(b) Cash

1,400 Accounts Receivable

Cash

1,400 12

Interest Revenue

12

Insurance Expense Cash

15

Accounts Receivable Cash

32

Bank Service Charge Expense Cash

8

15

32

8

(c) Benefits: Security of money, security of transactions (no mailing cash), record of transactions, availability of drafts and electronic funds transfers, interest earned on outstanding balances, third-party verification of balance Drawbacks: Service fee, possibility of overdrawing the account, possibility of fraudulent use of account 23. (a) 6/1 Cash Sales Revenue

5,100 5,100

6/4 Accounts Receivable-JLK Sales Revenue

2,000

6/6 Accounts Receivable-Lee Sales Revenue

300

6/8 Allowance for Uncollectible Accounts Accounts Receivable-W5 Corp.

450

6/12 Sales Returns and Allowances Accounts Receivable-JLK

500

6/14 Cash Sales Discounts Accounts Receivable-JLK

1,470 30

6/20 Accounts Receivable-Rodriguez Sales Revenue

950

6/26 Cash Accounts Receivable-Lee

300

2,000

300

450

500

1,500

950

300

6/29 Accounts Receivable-W5 Corp.

Allowance for Uncollectible Accounts

450

Cash Accounts Receivable-W5 Corp.

450

450

450

(b) Sales = $5,100 + $2,000 + $300 + $950 = $8,350 Sales Discounts = $30 Sales Returns and Allowances = $500 Net Sales = $8,350 - $30 - $500 = $7,820 (c) Beg. bal.

End. bal.

Accounts Receivable 35,000 2,000 300 950 450 35,500 Allowance fo r Uncollectibles 450 Beg. bal.

(d)

450 500 1,500 300 450

3,500 450 3,500

End. bal.

Jenkins, Inc. Partial Balance Sheet June 30, 2009 Accounts Receivable Allowance for Uncollectible Accounts Net Realizable Value

$35,500 (3,500) $32,000

24. (a) Allowance for Uncollectible Accounts Accounts Receivable-Cantole

2,425

Allowance for Uncollectible Accounts Accounts Receivable-Bono

730

2,425

(b) Uncollectible Accounts Expense 327,000 Allowance for Uncollectible Accounts

730 327,000

(c) On the income statement, the conservative estimate would have made Uncollectible Accounts Expense too high (and net income too low). On the balance sheet, the conservative estimate would have made the net realizable value of Accounts Receivable too low. Estimating too high an uncollectible accounts expense may cause investors and bankers to view the business unfavorably for investment purposes or loan negotiations. (d) If the 2009 estimate is too conservative, then EHC will not write off as much as was estimated, leaving a large credit balance in the Allowance account at the end of 2010. If the 2010 estimate is estimated at a smaller-than-expected amount, the Allowance account may become reasonable by the end of that year. However, should such a low estimate be made in 2010, the income for 2010 will (essentially) be overstated because the lower amount of expense compensates for the higher expense (and, thus, lower income) from 2009. (e) Given the accounting principles of matching and conservatism, it is not permissible to intentionally overstate expenses. (f) Accounts Receivable-Bono Allowance for Uncollectible Accounts Cash

730 730 730

Accounts Receivable-Bono

730

25. (a) The quick ratio measures the liquidity of an organization and indicates its ability to pay debts as they come due. Creditors (decision makers) would look at this ratio to determine if it is appropriate to loan the organization additional funds. (b) Year 1 Quick ratio = ($94 + $2 + $578) ÷ $1,465 = $674 ÷ $1,465 = .46 Year 2 Quick ratio = ($63 + $7 + $646) ÷ $1,851 = $716 ÷ $1,851 = .39 Liquidity was significantly stronger in Year 1. (c) MamaMia’s ratios for both years are quite low compared to the 1.2 industry average. (d) MamaMia’s customer might not be paying as rapidly as the industry norm. The company might have paid a large dividend rather than paying off current liabilities.

The company could be contemplating an overseas expansion that would require a large inventory build-up.

26. (a) 2007: A/R turnover = $22,456,000 ÷ [($3,023,000 + $3,003,500) ÷ 2] = $22,456,000 ÷ $3,013,250 = 7.45

Age of A/R = 360 ÷ 7.45 = 48.3 days 2008: A/R turnover = $28,837,500 ÷ [($3,003,500 + $4,679,000) ÷ 2] = $28,837,500 ÷ $3,841,250 = 7.51 Age of A/R = 360 ÷ 7.51 = 47.9 days 2009: A/R turnover = $26,889,500 ÷ [($4,679,000 + $3,501,500) ÷ 2] = $26,889,500 ÷ $4,090,250 = 6.57 Age of A/R = 360 ÷ 6.57 = 54.8 days (b) QL had a better A/R turnover ratio in year 2 than in the other two years. Also, QL has a slighter shorter collection period in year 2 than in year 1, while year 3 shows an extremely slow collection period of 54.8 days.

CASES 27. Erika: Although extending credit to customers may increase your sales, you must be aware of an important potential side effect: the company will experience bad debts related to these sales. Every company that sells on credit must be willing to write off a certain amount of bad debts. Although it is likely that many of your customers will pay within the 60 day period, you will probably have some customers that extend that 60 day period to 70 or 80 days, or even longer. Collection policies must also be in place should this occur. In addition, good cash customers may be bad credit risks. Policies must be established to determine who will get credit and whose credit will be taken away (and for what circumstances). Such a policy, however, could result in the loss of customers.

Some (but, certainly not all) internal control issues that you must confront include: (1) control over Accounts Receivable (making sure that billings and payments are attached to the proper account); (2) control over cash as it is received (making sure that all cash, currency and checks are properly documented and deposited in the checking account); and (3) control over the customers [making certain that the customer who was granted the credit (or his/her representative) is doing the purchasing]. You should also be concerned with bonding of employees who handle cash/checks.

28. (a) 2006 quick ratio = ($1,163 + $280) ÷ $5,415 = $1,443 ÷ $5,415 = 0.27 2007 quick ratio = ($943 + $436) ÷ $7,260 = $1,379 ÷ $7,260 = 0.19 (b) The liquidity of Carnival is very low in both years of operations, which means that Carnival may lack the financial ability to meet its day to day cost of operations. (c) (1) An increase in cash (or any number in the numerator of a ratio) would increase the value of the quick ratio.

(2) A decrease in short-term investments (or any number in the numerator of a ratio) would decrease the quick ratio.

(3) An increase in current liability (the denominator of a ratio) would increase the value of the ratio.

(4) An increase in inventory would have no direct effect on the quick ratio because inventory is not included in the calculation. However, if inventory was purchased on credit, current liabilities (the denominator) would increase, which would decrease the value of the ratio.

(5) An increase in sales revenue would have no direct effect on the quick ratio because sales revenue is not included in the calculation. However, if a portion of the increase in sales caused an increase in accounts receivable, the numerator of the quick ratio would increase, which would increase the value of the ratio. (d) The amount of cash and cash equivalents decreased by $220 million and the amount of short-term investments increased by $156 million. The net effect of the changes was a decrease of $64 million in quick assets. (e) No 29. (a) No. Part 2, Item 7, Page 16 of the Consolidated Financial Statements indicates that Macy’s sold its proprietary credit cards to Citibank. (b) $463 million (c) 2006: $21 million 2007: $112 million (d) The company evaluated the collectability of its proprietary accounts receivable based on a combination of factors, including analysis of historical trends, aging of accounts receivable, write-off experience and expectations of future performance.

Proprietary accounts receivable were considered delinquent if more than one scheduled minimum payment was missed. Delinquent proprietary accounts of Macy’s were generally written off automatically after the passage of 210 days without receiving a full scheduled monthly payment.

(e) ($517 + $463) ÷ 2 = $980 ÷ 2 = $490 million (f) $26,313,000,000 (g) A/R turnover = $26,313,000,000 ÷ $490,000,000 = 53.7 times Age of A/R = 360 ÷ 53.7 = 6.7 days (h) Cash and cash equivalents = $583 million Cash and cash equivalents include cash and liquid investments with original maturities of three months or less.

30. Answers will vary depending on the companies chosen.

SUPPLEMENTAL PROBLEMS 31. (a) 1/2

Petty Cash Cash

200.00

(b) 10/5 Petty Cash Cash

300.00

(c) 12/31 Shipping Expense Entertainment Expense Printing Expense Delivery Expense Cash

79.42 124.30 46.49 30.75

200.00

300.00

280.96

(d) Too little money was in the petty cash envelope. This difference could be a result of making improper change or reimbursing someone too much. Or someone may have taken money from the petty cash fund. Miscalculations are usually a result of calculating in one’s head without the aid of a calculator or adding machine. To prevent this from happening in the future, require an adding machine tape or other verification of calculation and have both parties (the petty cash custodian and petty cash recipient) sign for the exchange of money and receipt.

32. (a) 7/6 Accounts Receivable-Credit Card Sales Revenue (b) 7/13 Cash Credit Card Fee Expense Accounts Receivable-Credit Card (c) $32.24 ÷ $1,612.00 = 2%

520.00 520.00 1,579.76 32.24 1,612.00

(d) Benefits: Customers purchase things that could not be acquired at that time for cash; no discount for processing; may charge interest on existing balances; faster payment than if individual customers paid Costs: Risk of not collecting accounts receivable; additional expense from service charge fee 33. (a)

Radon, Inc. Bank Reconciliation February 28, 20XX Balance per Bank Add: Deposits in transit Error in processing check #657 Deduct: Outstanding checks Adjusted Bank Balance

Balance per Books Add: Interest earned Deduct: Draft for electricity bill Service fee Adjusted Bank Balance (b) Cash

$10,640 $760 180

940 (1,227) $10,353

$10,869 129 $620 25

(645) $10,353

129 Interest Revenue

129

Utility Expense Cash

620

Bank Service Charge Expense Cash

25

620

25

(c) It would be possible for a company to do business without a checking account.

Employees, expenses, accounts payable, and purchases of assets would have to be paid in cash. Practically, having to visit the phone company, electric company, etc. each month to deliver cash would be time consuming. The alternative is mailing cash, which is dangerous because if it never reaches its destination or is improperly handled (stolen) when it arrives, there is no record as there would be with a check.

Additionally, the company would have to have traffic security for cash on hand.

Robbery or fire could be devastating to a company that has a lot of cash on the premises. Banks also provide a third-party verification of how much a company has. Without that reference, borrowing would be impossible.

34. (a) 3/18

6/22

Allowance for Uncollectible Accounts Accounts Receivable-Pick-A-Daisy

1,200

Allowance for Uncollectible Accounts Accounts Receivable-A Touch of Style

1,060

1,200

1,060

11/28 Allowance for Uncollectible Accounts Accounts Receivable-Pick-A-Daisy (b)

680 680

Allowance for Uncollectible Accounts 1,200 Beg. bal.

1,060 680 End. bal.

3,150

210

The balance in the Allowance account indicates that $210 of accounts receivable related to prior period sales are estimated as being uncollectible in the future. (c) Beg. bal.

End. bal.

Accounts Receivable 105,000 2,450,000

2,175,000 1,200 1,060 680

377,060

(d) 2009 estimate = A/R balance x 4% = $377,060 x 0.04 = $15,082 (rounded) NRV

= A/R – Estimate for uncollectibles = $377,060 - $15,082 = $361,978

(e) Desired balance in Allowance account Balance in Allowance account before adjustment Amount needed in adjusting entry

$15,082 210 $14,872

Uncollectible Accounts Expense Allowance for Uncollectible Accounts

14,872

14,872

35. (a) Allowance for Uncollectible Accounts is the difference between A/R-gross and A/R-net. The account is the estimate of A/R that won’t be collected in the coming year.

(b) Year 1: Quick ratio = [($104 + $10 + $622) ÷ $840 = $736 ÷ $840 = 0.88 Year 2: Quick ratio = [($108 + $18 + $580) ÷ $866 = $706 ÷ $866 = 0.82 (c) Receivables turnover = $7,889 ÷ [($654 + $611) ÷ 2] = $7,889 ÷ ($1,265 ÷ 2) = $7,889 ÷ 632.5 = 12.5 times Age of receivables = 360 ÷ 12.5 = 28.8 days (d) To calculate the receivable turnover ratio for year 1, you need an average of the accounts receivable of years 1 and whatever year came before year 1. That information is not available. (e) As people have less money, they will buy more things on credit and take longer to pay for those things. Accounts Receivable will increase and have larger balances for longer. The receivables turnover rate will decrease (balances paid less often) and age of receivables will increase (outstanding balances for longer).

CHAPTER 5 SOLUTIONS TO END OF CHAPTER MATERIAL

QUESTIONS 1. The primary difference between a perpetual and periodic system are (1) the accounts used to record transactions and (2) the timing and manner in which cost of goods sold is determined.

In a periodic inventory system, purchases, purchases discounts, purchases returns and allowances, and freight in accounts are used. Additionally, when a periodic system is used, no cost of goods sold is recorded during the period; that amount is determined as a “plug” figure at the end of the period by subtracting the ending inventory from the cost of goods sold available for sale.

In a perpetual inventory system, all amounts affecting inventory are either debited or credited directly to the inventory account. Each time a sale takes place, an entry is made to record the increase (debit) in cost of goods sold and decrease (credit) to inventory. An individual could, at any time, look at the inventory account and determine the value of inventory on hand (assuming away items such as theft and breakage). Perpetual inventory requires more work than periodic inventory, but provides significantly better internal control for items of high value. Technology such as bar coding has made the use of perpetual inventory much easier and much less expensive to use.

2. Inventory is a current asset because it will be converted into cash within a year or an operating cycle whichever is longer.

3. Inventory cost flows refer to the movement of inventory costs from the Inventory account to the Cost of Goods Sold account. This flow may differ from the physical flow of inventory which refers to the actual movement of goods from inventory to customers.

4. Cost of goods available for sale refers to the cost of all inventory that has been “in-house” during the reporting period; that is, all inventory that a customer could have purchased.

Cost of goods available for sale is calculated by adding net purchases of the period to the cost of inventory on hand at the beginning of the period.

5. Specific identification requires the business track the actual cost of all items sold and items remaining in inventory at the end of the cycle. Specific ID generally requires that inventory be “readily identifiable.”

The FIFO (first-in, first-out) method costs the oldest inventory items to cost of goods sold first, while the most recent purchase costs are left in inventory.

The LIFO (last-in, first-out) method costs the most recent purchases to cost of goods sold first, leaving the costs of the oldest items in inventory.

The moving average inventory method calculates an average cost for all inventory available before each sale, and that cost is used to determine cost of goods sold for that transaction.

6. In periods of rising prices, FIFO will generate the highest ending inventory balance. The older (lower) costs are sent to cost of goods sold, leaving the newer (higher) costs in inventory. In LIFO, the effects are reversed.

7. For balance sheet purposes, FIFO is generally considered more appropriate because the newest costs are reflected in inventory.

For income statement purposes, LIFO is generally considered more appropriate because it provides the matching of current revenues and current costs because the most recent purchases are reflected in cost of goods sold.

8. The choice between FIFO and LIFO affects the dollar amount of cost of goods sold expense. Higher expenses will yield lower net income, which results in lower taxes paid.

In a period of rising prices, the LIFO assumption will cause cost of goods sold to be higher than FIFO. In the U.S., LIFO can only be used for tax purposes if it is used for financial reporting purposes. IFRS does not allow the use of LIFO and, if such accounting rules are adopted by the U.S., a significant tax burden might be imposed on companies that have been using LIFO. 9. Using the retail inventory method, when inventory is received, information on both purchase cost and retail price is gathered. Sales are recorded at retail prices and deducted from inventory at retail price; there is no entry for Cost of Goods Sold. At the end of the period, a physical count of inventory on hand is made at the retail prices. The summation of those retail prices are then compared with the retail prices of the goods that should be on hand (based on cost of goods available and sales information) to determine if breakage or theft occurred.

10. The retail inventory method is a periodic inventory method because information on individual purchases and sales is not maintained. However, the retail inventory method allows a level of internal control not commonly provided by a periodic inventory system.

11. The lower-of-cost-or-market rule requires businesses to calculate inventories at the end of the period using the lower of cost or the current market (replacement) value. This rule reflects the conservatism principle by not overstating inventory (asset) values.

12.

An overstatement of ending inventory in 2009 would have the following effects: (a) Assets and Retained Earnings on the 2009 balance sheet would be overstated. (b) The overstatement of ending inventory would cause an understatement of cost of goods sold on the income statement. That understatement would cause net income on the 2009 income statement to be overstated. (c) The year-end 2010 balance should not be affected because the overstatement of the 2010 beginning inventory will have been eliminated. Additionally, the overstatement of net income in 2009 is eliminated by the understatement of net income in 2010; thus, Retained Earnings is properly stated at the end of 2010. (d) The overstatement of 2009 ending inventory causes an overstatement of the 2010 beginning inventory (since these are the same amount). That overstatement causes overstatements of cost of goods available for sale and cost of goods sold. The overstatement of cost of goods sold will cause understated net income.

13. Decision makers use the inventory turnover ratio to determine how frequently a business sells its inventory. The higher the ratio, the more often the inventory is sold and replaced.

At some point, however, a high ratio means that the company is not keeping sufficient inventory in stock.

The age of inventory indicates how long an inventory item sits in inventory. In this case, the lower the ratio, the better. If inventory sits for a long time in the warehouse or on the shelf, the business is not generating revenue and the inventory has the opportunity to become out-of-date or “stale.”

EXERCISES 14.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k)

F A company may value inventory at the lower of cost or market.

T T T F A lower inventory turnover ratio indicates that inventory stays in the store longer before being sold.

T T F A company may choose any acceptable cost flow assumption.

T T F IFRS prohibits the use of LIFO.

15.

(a) Power Corp. should include the goods costing $2,960 which were sent FOB destination from Power Corp. to a customer. Power Corp. should also include the goods costing $1,957 which were sent FOB shipping point to Power Corp. from a vendor. (b) When goods are shipped FOB shipping point, title to the goods transfers when the goods are put on the delivery truck (at the shipping point). Because Power Corp. was the shipper of the $4,000 of goods, Power Corp. should exclude the items from its inventory as soon as they have been shipped.

When the goods are shipped FOB destination, title to the goods transfers when the goods arrive at their destination. Because Power Corp. was the recipient of the $2,580, Power Corp. should exclude the items from its inventory until they reach their destination.

When goods are shipped FOB destination, title of goods transfers when the goods arrive at their destination. Because Power Corp. was the shipper of the #2,960 of goods, Power Corp. should include the items in its inventory until they reach their destination.

When goods are shipped FOB shipping point, title to the goods transfers when the goods are put on the delivery truck (at the shipping point). Because Power Corp. was the recipient of the $1,957 of goods, Power Corp. should include the items in its inventory as soon as they have been shipped.

16.

(a) (1) increase (2) increase (3) decrease (4) increase (5) decrease (6) no change (7) decrease (8) no change (9) increase (10) no change (b)

No, in a periodic inventory system, the Inventory account is not used during regular monthly transactions. Therefore, none of the transactions would result in a change to the inventory account.

17.

(a)

CGAS = BI + Purchases CGAS = $50,000 + $695,000 CGAS = $745,000 CGS = CGAS – EI CGS = $745,000 - $25,400 CGS = $719,600

(b)

An error could have been made in taking the physical count, employees or customers could have stolen inventory, or an error could have been made in recording purchases and/or sales during the cycle. Minor losses due to theft are typically included as a part of the cost of goods sold. However, significant losses should be accounted for in a separate loss account so that management is aware of such problems.

(c)

Four examples for preventing inventory shrinkage are given below. There are a variety of answers; your may differ.

(1) Inventory could be tagged with magnetic sensor so that an alarm rings if taken form the store. Tagging would help prevent stealing by customers, but because employees can remove tags, it would not help with theft by employees.

(2) Newly received inventory should be counted separately by two employees and compared to the quantities shipped. Independent counts would help prevent inventory thefts by employees before merchandise is taken to the sales floor.

(3) Employee bags and persons could be subject to search when leaving to prevent their removing merchandise from the premises without a receipt.

(4) Security cameras monitored by security personnel would help detect and prevent theft by both customers and employees.

18.

All methods: CGAS = $87 + $89 + $90 + $93 + $95 + $99 + $101 + $104 = $758 Specific ID: CGS: $90 + $95 + $104 = $289 EI = $87 + $89 + $93 + $99 + $101 = $469

FIFO: CGS: $87 + $89 + $90 = $266 EI = $93 + $95 + $99 + $101 + $104 = $492 LIFO: CGS: $99 + $101 + $104 = $304 EI = $87 + $89 + $90 + $93 + $95 = $454

Cost of Goods Available for Sale – Ending Inventory = Cost of Goods Sold Revenues – Cost of Goods Sold = Gross Profit

19.

Specific ID $758 (469) $289 $600 (289) $311

(a)

Beginning inventory 300 x $4.00 February 1 purchase 325 x $4.50 February 8 purchase 375 x $5.00 February 15 purchase 420 x $5.40 February 22 purchase 375 x $5.75 Cost of goods available for sale

(b)

FIFO: Balance: February 1 purchase February 5 sale Balance:

FIFO $758 (492) $266 $600 (266) $334

LIFO $758 (454) $304 $600 (304) $296

$1,200.00 1,462.50 1,875.00 2,268.00 2,156.25 $8,961.75 CGS

February 8 purchase February 12 sale

300 x $4.00 325 x $4.50 250 units 50 x $4.00 325 x $4.50 375 x $5.00 400 units

Balance: February 15 purchase February 19 sale

350 x $5.00 420 x $5.40 397 units

Balance: February 22 purchase February 28 sale

373 x $5.40 375 x $5.75 425 units

250 x $4.00

$1,000.00

50 x $4.00 325 x $4.50 25 x $5.00

200.00 1,462.50 125.00

350 x $5.00 47 x $5.40

1,750.00 253.80

373 x $5.40 52 x $5.75

2,014.20 299.00

Balance:

323 x $5.75 $7,104.50

(c)

LIFO: Balance: February 1 purchase February 5 sale Balance: February 8 purchase February 12 sale Balance: February 15 purchase February 19 sale Balance:

February 22 purchase February 28 sale

Balance:

CGS 300 x $4.00 325 x $4.50 250 units 300 x $4.00 75 x $4.50 375 x $5.00 400 units 300 x $4.00 50 x $4.50 420 x $5.40 397 units 300 x $4.00 50 x $4.50 23 x $5.40 375 x $5.75 425 units

250 x $4.50

$1,125.00

375 x $5.00 25 x $4.50

1,875.00 112.50

397 x $5.40

2,143.80

375 x $5.75 23 x $5.40 27 x $4.50

2,156.25 124.20 121.50

300 x $4.00 23 x $4.50 $7,658.25

(d)

Moving Average: Balance: February 1 purchase February 5 sale Balance: February 8 purchase February 12 sale Balance: February 15 purchase February 19 sale Balance: February 22 purchase February 28 sale Balance:

CGS 300 x $4.00 325 x $4.50 625 x $4.26 (250) units 375 375 x $5.00 750 x $4.63 (400) units 350 420 x $5.40 770 x $5.05 (397) units 373 375 x $5.75 748 x $5.40 (425) units 323

$1,200.00 1,462.50 $2,662.50 250 x $4.26 $1,597.50 1,875.00 $3,472.50 400 x $4.63 $1,620.50 2,268.00 $3,888.50 397 x $5.05 $1,883.65 2,156.25 $4,039.90 425 x $5.40 $1,744.90

$1,065.00

1,852.00

2,004.85

2,295.00 $7,216.85

(e) Net Sales = Units Sold X Sales Price = (250 + 400 + 397 + 425) x $10.50 = 1,472 x $10.50 = $15,456.00 Gross Profit = Net Sales – Cost of Goods Sold GP (FIFO) = $15,456.00 - $7,104.50 = $8,351.50 GP (LIFO) = $15,456.00 - $7,658.25 = $7,797.75 GP (MAC) = $15,456.00 - $7,216.85 = $8,239.15 20.

(a)

CGAS = Cost BI + Cost Purchases CGAS = $136,000 + $662,200 CGAS = $798,200

(b)

Retail GAS = Retail BI + Retail Purchase Retail GAS = $241,000 +$987,000 Retail GAS = $1,228,000 Cost-to-retail percentage = CGAS ÷ Retail GAS Cost-to-retail percentage = $798,200 ÷ $1,228,000 Cost-to-retail percentage = 65%

21.

(c)

Retail EI = Retail GAS – Retail Sales Retail EI = $1,228,000 - $1,040,000 Retail EI = $188,000

(d)

Cost EI = Retail EI X Cost-to-retail percent Cost EI = $188,000 X 65% Cost EI = $122,200

(e)

Actual ending inventory will not be the same as the estimates. Two explanations for the difference are (1) the cost-to-retail percentage is an average of all items and may not be the same for the remaining items, and (2) shrinkage (theft and breakage) might account for there being less inventory than expected.

(a)

Cost EI = (63 x $20) + (40 x $25) + (25 x $28) + (47 x $32) = $1,260 + $1,000 + $700 + $1,504 = $4,464

(b)

Replacement Cost EI = (63 x $23) + (40 x $22) + (25 x $24) + (47 x $31) = $1,449 + $880 + $600 + $1,457 = $4,386

(c)

LCM EI = (63 x $20) + (40 x $22) + (25 x $24) + (47 x $31) = $1,260 + $880 + $600 + $1,457 = $4,197 Adjustment = Cost EI – LCM EI = $4,464 - $4,197 = $267 Cost of Goods Sold Inventory

22.

267

(d)

The inventory on the balance sheet will be $267 lower than it would have been if the adjustment had not been made. Cost of goods sold on the income statement will be $267 higher (resulting in a net income $267 lower) than if the adjustment had not been made.

(a)

If EI is too high, $12,000 that was counted as EI should have been included in CGS. Therefore, CGS should be $105,000 ($93,000 + $12,000).

Sales Cost of Goods Sold Gross Profit Operating Expenses Operating Income Income Tax Expense Net Income

23.

267

$267,000 (105,000) $162,000 (30,000) $132,000 (39,600) $ 92,400

(b)

This error is material (large compared to numbers). By not correcting it, Jericho Co can mislead investors and lenders into believing that gross profit is much higher than it actually is. Those parties are relying on the fact that $267,000 in revenues can generate gross profit of $174,000 when it really only generates gross profit of $162,000. If the error was immaterial, Jericho Co.’s argument could be valid, but with this significant an error, it should be corrected.

(a)

Average Inventory = (BI + EI) ÷ 2 Average Inventory = ($468,000 + $444,000) ÷ 2 Average Inventory = $912,000 ÷ 2 Average Inventory = $456,000

(b)

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory Inventory Turnover = $4,370,400 ÷ $456,000 Inventory Turnover = 9.6 times

(c)

Average Age of Inventory = 360 days ÷ Inventory Turnover Average Age of Inventory = 360 days ÷ 9.6 Average Age of Inventory = 37.5 days

(d)

It would be expected that a majority of Claremont’s sales occur in November and December for Christmas. Thus, at December 31, the inventory is probably depleted from all the sales of toys during the month. Therefore, the ratio is probably averaging the low points in inventory, which will raise the inventory turnover ratio and reduce the average age of inventory.

(e)

Instead of averaging beginning and ending, the monthly ending inventories could be averaged (i.e., Jan EI + Feb EI and so on through December divided by 12 months).

PROBLEMS 24.

4/6 Inventory Accounts Payable

660.00

4/9 Accounts Payable Inventory

220.00

4/13 Accounts Receivable Sales Cost of Goods Sold Inventory

70.00

4/16 Accounts Payable Cash Inventory

440.00

4/17 Inventory Accounts Payable

216.00

4/20 Accounts Receivable Sales Cost of Goods Sold Inventory

35.00

4/21 Sales Returns & Allowances Accounts Receivable or Cash Inventory Cost of Goods Sold

35.00

4/27 Accounts Receivable Sales Cost of Goods Sold Inventory

70.00

4/27 Accounts Payable Cash Inventory

216.00

660.00 220.00 70.00 42.00 42.00 431.20 8.80 216.00 35.00 24.00 24.00 35.00 20.00 20.00

70.00 34.00 34.00 211.58 4.32

25.

(a)

Beginning inventory 400 x $40 January 2 purchase 200 x $44 January 9 purchase 200 x $48 January 18 purchase 200 x $50 January 25 purchase 500 x $52 Cost of goods available for sale

$16,000 8,800 9,600 10,000 26,000 $70,400

Revenues = Units Sold × Selling Price Revenues = (300 × $80) + (350 × $90) + (150 × $90) + (450 × $100) = $24,000 + $31,500 + $13,500 + $45,000 = $114,000 FIFO: Balance: January 2 purchase January 5 sale Balance:

CGS

January 9 purchase January 14 sale

400 x $40 200 x $44 300 units 100 x $40 200 x $44 200 x $48 350 units

Balance: January 18 purchase January 21 sale Balance: January 25 purchase January 31 sale

150 x $48 200 x $50 150 units 200 x $50 500 x $52 450 units

Balance:

300 x $40

$12,000.00

100 x $40 200 x $44 50 x $48

4,000.00 8,800.00 2,400.00

150 x $48

7,200.00

200 x $50 250 x $52 250 x $52 $13,000 EI

10,000.00 13,000.00 $57,400.00

Gross Profit = $114,000 - $57,400 = $56,600

LIFO: Balance: January 2 purchase

CGS 400 x $40 200 x $44

January 5 sale

300 units

Balance: January 9 purchase January 14 sale

300 x $40 200 x $48 350 units

Balance: January 18 purchase January 21 sale Balance:

150 x $40 200 x $50 150 units 150 x $40 50 x $50 500 x $52 450 units 150 x $40 50 x $50 50 x $52

January 25 purchase January 31 sale Balance:

200 x $44 100 x $40

$8,800.00 4,000.00

200 x $48 150 x $40

9,600.00 6,000.00

150 x $50

7,500.00

450 x $52

23,400.00

$11,100 EI $59,300.00

Gross Profit = $114,000 - $59,300 = $54,700 Moving Average: Balance: January 2 purchase

CGS 400 x $40 $16,000 200 x $44 8,800 600 x $41.33 $24,800 January 5 sale (300) units (1/2 of stock) $12,400.00 Balance: 300 $12,400 January 9 purchase 200 x $48 9,600 500 x $44 $22,000 January 14 sale 15,400.00 (350) units 350 x $44 Balance: 150 $ 6,600 January 18 purchase 200 x $50 10,000 350 x $47.43 $16,600 January 21 sale (150) units 150 x $47.43 7,114.50 Balance: 200 $ 9,485.50 January 25 purchase 500 x $52 26,000.00 700 x $50.69 $35,485.50 January 31 sale (450) units 425 x $50.69 21,543.25 Balance: 250 $13,942.25 EI $56,457.75 Gross Profit = $114,000 - $56,457.75 = $57,542.25 (b) FIFO yields the lowest cost of goods sold and the highest gross profit. Therefore, if FIFO is used the net income will be higher that with the other methods. The reason is that costs are increasing and FIFO uses the earlier (lowest) prices for cost of goods sold and the later (highest) prices for ending inventory.

26.

(c)

A company should consider how actual costs flow in its business and how the cost flow methods will affect the accounting records. GAAP does not require the actual cost flow method to match the method used for financial reporting; however, if those flows do match, the figures in the financial statements are more likely to reflect the company’s actual inventory and cost of goods sold. The method used is disclosed in the notes to the financial statements so that decision makers will also know the impact it has on the financial statements.

(a)

CGAS = Cost BI + Cost Purchases CGAS = $250,600 + $1,242,320 CGAS = $1,492,920 Retail GAS = Retail BI + Retail Purchases Retail GAS = $658,000 + $1,916,000 Retail GAS = $2,574,000

(b)

Cost-to-retail percentage = Cost GAS ÷ Retail GAS Cost-to-retail percentage = $1,492,920 ÷ $2,574,000 Cost-to-retail percentage = 58%

(c)

Cost EI = Retail EI x Cost-to-percentage Cost EI = $790,000 x 58% Cost EI = $458,200

(d)

Expected Retail EI = Retail GAS – Retail Sales Expected Retail EI = $2,574,000 - $1,752,000 Expected Retail EI = $822,000 Expected Cost EI = Expected Retail EI x Cost-to-retail Percent Expected Cost EI = $822,000 x 58% Expected Cost EI = $476,760 Cost Inventory Loss = Expected Cost EI – Actual Cost EI Cost Inventory Loss = $476,760 - $458,200 Cost Inventory Loss = $18,560

(e)

It is unlikely that a customer could steal a painting or sculpture because of its size; however, employee theft would be harder to prevent. Another likely cause of loss in that type of inventory is loss due to damage.

(f)

When an employee is bonded, an insurance policy is taken out by his/her employer that would cover amounts stolen by the employee. Bonding is a good way to recover the value of stolen items, but does not necessarily deter employee theft.

However, if an employee plans to move to another job and get bonded there, a claim against their bond would make it nearly impossible for him/her to ever be bonded again.

To deter employee theft, employees should not be left alone at any time. An employee could not steal a large sculpture or painting without co-workers noticing, unless they were colluding. Surveillance cameras that would videotape a theft may also be a good deterrent to employee theft.

27.

(a) # of Units Industrial Strength Item A 100 Item B 150 Medium Strength Item C 75 Item D 110 Low Strength Item E 80 Item F 130

Per Unit Cost

Extended

Per Unit MV

$160 200

$16,000 30,000

$150 205

$15,000 30,750

$15,000 30,000

120 140

9,000 15,400

125 125

9,375 13,750

9,000 13,750

80 75

6,400 9,750 $86,550

80 70

6,400 9,100 $84,375

6,400 9,100 $83,250

LCM Extended Extended

(b)

Applying the LCM rule will cause inventory to be written down from $86,550 to $83,250, which will be shown on the balance sheet. As a result cost of goods sold will be higher than if the LCM rule had not been applied resulting in lower gross profit and net income. Net income is added to retained earnings, so ending retained earnings will also be lower.

(c)

Each student will have a different answer and a different defense of that answer.

However, the lower-of-cost-or-market value allows accountants to use current cost information and conservative valuations so as not to overstate inventory, understate current period losses, or overstate future period profits.

28.

(a)

2007 Inventory turnover ratio = CGS ÷ Average Inventory = $1,122.40 ÷ [($153 + $146) ÷ 2)] = $1,122.40 ÷ $149.50 = 7.5 Age of inventory = 360 ÷ 7.5 = 48 days 2008 Inventory turnover ratio = $996.40 ÷ [($146 + $118.40) ÷ 2] = $996.40 ÷ $132.20 = 7.5 Age of inventory = 360 ÷ 7.5 = 48 days 2009 Inventory turnover ratio = $1,137.90 ÷ [($118.40 + $169.90) ÷ 2] = $1,137.90 ÷ $144.15 = 7.9 Age of inventory = 360 ÷ 7.9 = 46 days

(b)

Aerospace industries usually work on contract from the government and would generally be producing goods that take substantial time to complete. Therefore, a low inventory turnover is reasonable. Once goods have been produced, however, they would be accepted by the government rather than waiting for customers to purchase the goods.

(c)

The ratios held fairly constant. There was a two-day improvement in age of inventory in the third year.

CASES 29.

(a)

3/1 Inventory (15 x $105) Cash

1,575

3/8 Cash Sales Revenue Cost of Goods Sold Inventory (13 x $105)

4,550

3/9 Inventory (10 x $103) Cash

1,030

1,575

4,550 1,365 1,365

1,030

3/13 Cash 5,600 Sales Revenue Cost of Goods Sold 1,680 Inventory (10 x $103) + (2 x $105) + (4 x $110)

(b)

3/16 Inventory (10 x $102) Cash

1,020

3/21 Cash Sales Revenue Cost of Goods Sold Inventory (10 x $102) + (9 x $110)

6,650

3/23 Inventory (15 x $95) Cash

1,425

3/31 Cash Sales Revenue Cost of Goods Sold Inventory (14 x $95)

4,900

5,600 1,680

1,020

6,650 2,010 2,010

1,425

4,900 1,330 1,330

Omega Sales Partial Income Statement For the Month ended March 31, 2003 Revenues (net sales) Cost of Goods Sold Gross Profit

$21,700 6,385 $15,315

(c)

Ending Inventory = (1 x $95) + (7 x $110) = $865

(d)

Sold 62 sets: (20 x $110) + (15 x $105) + (10 x $103) + (10 x $102) + (7 x $95) = $2,200 + $1,575 + $1,030 + $1,020 + $665 = $6,490 CGS EI = (8 x $95) = $760

(e)

LIFO EI = $865 LCM = (8 x $95) = $760 LCM adjustment = $865 - $760 = $105 3/31 Cost of Goods Sold Inventory

105 105

Using LIFO causes older products (with higher prices) to be left in inventory. As prices decline, the market cost gets farther away from the cost in inventory. If FIFO were used, there would be no adjustment because the 8 sets of cookware in inventory would have a cost equal to the market cost. (f)

30.

Increasing cost of goods sold will decrease gross profit and net income. Omega might want to present a higher net income amount. Alternatively, the company may not believe that the adjustment is material to the financial statements.

The method of inventory valuation and the calculation of cost of goods sold used by your company pose several problems. First, the cost of ending inventory derived during your physical inventory will not reflect actual cost, which will cause either an over- or understatement on your balance sheet. This error will also be reflected on your income statement in cost of goods sold. If ending inventory is overstated, cost of goods sold will be understated, and vice versa. Over- and understatements in cost of goods sold result in under- and overstatements of net income, respectively.

In addition, your current system does not allow for a comparison to actual ending inventory and expected ending inventory as you have no records for expected ending inventory. Without the comparison, your cost of goods sold will contain both items sold and items stolen. However, it will be impossible to calculate the portion (in dollars or items) of cost of goods sold that was stolen.

31.

(a)

2007 Inventory turnover ratio = CGS ÷ Average Inventory = $130,885 ÷ [($15,746 + $23,192) ÷ 2)] = $130,885 ÷ $19,469 = 6.7 Age of inventory = 360 ÷ 6.7 = 54 days 2008 Inventory turnover ratio = $171,708÷ [($23,192 + $28,426) ÷ 2] = $171,708 ÷ $25,809 = 6.7 Age of inventory = 360 ÷ 6.7 = 54 days 2009 Inventory turnover ratio = $215,071 ÷ [($28,426 + $41,989) ÷ 2] = $215,071 ÷ $35,207.5 = 6.1 Age of inventory = 360 ÷ 6.1 = 59 days

(b) The turnover ratio is decreasing from year to year indicating that it is taking longer to move items through the business (inventory is not turning over rapidly). The age of inventory is increasing, indicating that inventory is staying on the shelves longer each year. These trends are unfavorable, because a business wants to turn its inventory over as quickly as possible. Given the life of this inventory, the company must be using a substantial quantity of frozen or canned goods in food preparation rather than fresh products.

32.

(c)

In the restraint business, food has only a certain shelf life, after which it must be disposed. Part of the increase in cost of goods sold, might be attributed to the disposal of spoiled food products.

(a)

Cost of Goods Sold = $15,677,000,000

(b)

Average Inventory = (BI + EI) ÷ 2 Average Inventory = ($5,060 + $5,317) ÷ 2 Average Inventory = $10,377 ÷ 2 Average Inventory = $5,188.50

(c)

Inventory Turnover Ratio = CGS ÷ Average Inventory Inventory Turnover Ratio = $15,677 ÷ $5,188.50 Inventory Turnover Ratio = 3.0

Age of inventory = 360 ÷ Inventory Turnover Ratio Age of inventory = 360 ÷ 3.0 Age of inventory = 120 days The inventory turnover ratio indicates that May Company turns its inventory over a little more than three times a year. May sells mostly clothing and accessories. The expectation would be that a clothing store would turn inventory over 4 times (once per season). The lower turnover is probably attributable to clothes left at the end of a season that are in the store longer. On average, items of inventory stay in the store for about 120 days. (d)

Most of May’s inventory is valued using LIFO retail inventory method.

(e)

Yes, merchandise inventories are valued at lower of cost or market.

(f)

Percentage Change = (Latest Year - Base Year) ÷ Base Year Percentage Change in Retail Sales = ($26,313 ÷ $26,960) ÷ $26,960 = -$647 ÷ $26,960 = -2.4% Percent Change in Cost of Goods Sold = ($15,677 - $16,019) ÷ $16,019 = -$342 ÷ $16,019 = -2.1% Percent Change in Inventory = (5,060 - 5,317) ÷ 5,317 = -$257 ÷ 5,317 = -4.8% Sales decreased by 2.4% but cost of goods only decreased by 2.1%. All else being equal, a percent reduction in sales should create an equal percent reduction in cost of goods sold. In this case, the markup on inventory has changed as well; that is, customers are paying a slightly higher markup.

Also, if cost of sales were to decrease, one would expect an increase in inventory if May continued to purchase the same amounts of inventory. In this case, it appears as if May has decreased purchases of inventory to account for a slight drop in sales.

33.

Answers will vary depending on companies chosen.

SUPPLEMENTAL PROBLEMS 34.

35.

7/1 Inventory Accounts Payable

250.00

7/5 Accounts Receivable Sales Revenue Cost of Goods Sold Inventory

240.00

7/7 Sales Returns and Allowances Accounts Receivable Inventory Cost of Goods Sold

80.00

7/9 Accounts Payable Inventory

50.00

7/11 Accounts Payable Cash

200.00

7/15 Cash Sales Discounts Accounts Receivable

158.40 1.60

(a)

250.00

240.00 150.00 150.00

80.00 50.00 50.00

50.00

200.00

160.00

Beginning inventory 120 x $5 May 3 purchase 300 x $6 May 9 purchase 675 x $7 May 16 purchase 410 x $8 May 25 purchase 620 x $9 Cost of goods available for sale

$

600 1,800 4,725 3,280 5,580 $15,985

Revenues = Units Sold × Selling Price Revenues = (400 × $11) + (350 × $12) + (500 × $14) + (730 × $14) = $4,400 + $4,200 + $7,000 + $10,220 = $25,820 FIFO: Balance: May 3 purchase May 7 sale

CGS 120 x $5 300 x $6 400 units

Balance: May 9 purchase May 14 sale

20 x $6 675 x $7 350 units

120 x $5 280 x $6

20 x $6 330 x $7

$

600.00 1,680.00

120.00 2,310.00

Balance: May 16 purchase May 22 sale

345 x $7 410 x $8 500 units

Balance: May 25 purchase May 31 sale

255 x $8 620 x $9 730 units

Balance:

345 x $7 155 x $8

2,415.00 1,240.00

255 x $8 475 x $9 145 x $9 $1,305 EI

2,040.00 4,275.00 $14,680.00

Gross Profit = $25,820 - $14,680 = $11,140 (b)

LIFO: Balance: May 3 purchase May 7 sale Balance: May 9 purchase May 14 sale Balance: May 16 purchase May 22 sale Balance: May 25 purchase May 31 sale Balance:

CGS 120 x $5 300 x $6 400 units 20 x $5 675 x $7 350 units 20 x $5 325 x $7 410 x $8 500 units 20 x $5 235 x $7 620 x $9 730 units 20 x $5 125 x $7

300 x $6 100 x $5

$1,800.00 500.00

350 x $7

2,450.00

410 x $8 90 x $7

3,280.00 630.00

620 x $9 110 x 7

5,580.00 770.00

$975 EI $15,010.00

Gross Profit = $25,820 - $15,010 = $10,810 (c)

Moving Average: Balance: May 2 purchase May 7 sale Balance: May 9 purchase May 14 sale Balance: May 16 purchase

CGS 120 x $5 300 x $6 420 x $5.71 (400) units 20 675 x $7 695 x $6.96 (350) units 345 410 x $8

$ 600 1,800 $2,400 400 x $5.71 $ 114.20 4,725.00 $4,839.20 350 x $6.96 $ 2,401.20 3,280.00

$2,284.00

2,436.00

755 x $7.52 (500) units 255 620 x $9 875 x $8.57 (730) units 145

May 22 sale Balance: May 25 purchase May 31 sale Balance:

$5,681.20 500 x $7.52 $1,917.60 5,580.00 $7,496.60 730 x $8.57 $1,242.65 EI

3,760.00

6,256.10 $14,736.10

Gross Profit = $25,820 - $14,736.10 = $11,083.90 36.

(a) (1) Ending Inventory (LCM per unit) = $6,500

Item Exgots Ingots Ongots Ungots

Original Cost Replacement Per Cost Per Quantity Unit Unit 120 100 200 50

$17 12 15 20

$14 13 13 19

Lower of Cost or Market Per Unit $14 12 13 19

LCM Extended Cost $1,750 1,200 2,600 950 $6,500

(a) (2) Ending Inventory (LCM per unit) = $6,600

Item Exgots Ingots Ongots Ungots

37.

Original Cost Per Quantity Unit 125 100 200 50

$17 12 15 20

Extended Cost $2,125 1,200 3,000 1,000 $7,325

Extended Replacement Replacement Cost Cost $14 13 13 19

$1,750 1,300 2,600 950 $6,600

(b)

Conservatism is the rule that dictates assets and revenues should not be overstated.

Using the lower-of-cost-or-market rule writes down ending inventory to the market cost if the current market (replacement) cost is lower, showing the actual cost of purchasing the current inventory if it were done today.

(a)

Year 1 Inventory turnover ratio = $504,000 ÷ [($60,000 + $80,000) ÷ 2]

Inventory turnover ratio = $504,000 ÷ $70,000 = 7.2 Age of inventory = 360 ÷ 7.2 = 50 days Year 2 Inventory turnover ratio = $585,000 ÷ [($80,000 + $103,000) ÷ 2] Inventory turnover ratio = $585,000 ÷ $91,500 = 6.4 Age of inventory = 360 ÷ 6.4 = 56 days Year 3 Inventory turnover ratio = $673,200 ÷ [($103,000 + $118,000) ÷ 2] Inventory turnover ratio = $673,200 ÷ $110,500 = 6.1 Age of inventory = 360 ÷ 6.1 = 59 days (b)

Inventory is staying on the shelves longer, evidenced by the decrease in the turnover ratio and the fact that the inventory age is increasing. Management is not doing a good job of handling inventory.

(c)

Although the dollar value of sales is increasing from year 1 to through year 3, the percentage of cost of goods sold is also increasing from 60% to 68%. This increase in cost of goods sold will have a decreasing effect on profitability of the firm. Costs need to be investigated to determine the reason for the increase.

CHAPTER 6 SOLUTIONS TO END OF CHAPTER MATERIAL

QUESTIONS 1.

The major types of long-term assets and examples of each are below.

Long-term Investments: Investment in Bonds, Investment in Stock (such as that of a subsidiary) Property, Plant, and Equipment: Land, Building, Equipment, Leasehold Improvement Intangible Assets: Patent, Copyright, Trademark, Goodwill

2.

Depreciation is a method of allocating asset cost (expended when the asset is acquired) over the time that the asset is used and provides benefits to the organization (the useful life). Depreciation expense is the portion of the cost expensed in a given year. Use of depreciation provides proper matching of revenues and expenses.

3.

Using the straight-line method, depreciation expense for a full year is calculated by dividing the depreciable amount (acquisition cost minus salvage value) by the useful life in years. Partial years are adjusted by multiplying by a fraction that indicates the portion of a year the asset was in service. The straight-line rate of depreciation (not needed for calculations) is 100% ÷ useful life in years.

Using the units-of-production method, depreciation expense for a given year is calculated by multiplying the units used in that year by the per-unit depreciation amount. Per-unit depreciation is calculated by dividing the depreciable amount (acquisition cost minus salvage value) by the useful life in units.

Using the double-declining balance method, depreciation expense for a full year is calculated by multiplying the beginning book balance (acquisition cost minus accumulated depreciation from prior years) by the depreciation rate. The depreciation rate is calculated as twice the straight-line depreciation rate. Partial years are adjusted by multiplying by a fraction that indicates the portion of a year the asset was in service.

EXAMPLE [Numerical examples given by students will differ.]

An asset costing $106,000, has a salvage value of $6,000 and a useful life of 10 years.

For the first year (a full year), depreciation expense is calculated using straight-line and double-declining balance methods below.

Straight Line (SL) Method: Depreciable Amount = $106,000 – $6,000 = $100,000 Depreciation Expense = $100,000 ÷ 10 years = $10,000

Double-Declining Balance (DDB) Method: Book Value = $106,000 - $0 = $106,000 Depreciation Rate = 2 x 10% = 20% Depreciation Expense = $106,000 × 20% = $21,200 The SL method yields a higher net income on the income statement because the depreciation expense is lower than if the company used the DDB method. However, the higher expense obtained using the DDB Method would be beneficial for tax purposes because the net income and, therefore, taxes would be lower.

4.

Book value is calculated by subtracting accumulated depreciation from asset cost. Each year an asset’s useful life, depreciation expense is recorded which causes accumulated depreciation to increase and book value to decrease. Other events that might cause an asset’s book value to change include the capitalization of expenditures (such as putting a new motor on a machine) that increase the asset’s value or useful life.

In contrast, fair value is what an asset is actually worth in the market at a specific point in time. Fair values reflect both general and specific price level changes as well as technological advancements or “market interest.” For example, a fully depreciated asset may gain in value because it suddenly becomes a collector’s item.

5.

The gain or loss on the sale of a long-term asset is calculated as cash received for the asset minus the asset’s book value. If the asset is not sold, but “junked” or disposed of, the cash received would be zero. Therefore, the loss would be equal to the book value.

Gains and losses differ, respectively, from revenues and expenses in that the latter two items occur in the normal course of business operations while gains and losses occur from “side-line” activities—those that the business does not view as occurring during the provision of its primary source of operating funds.

6.

When an asset is sold, three events occur that must be reflected in the journal entry: (1) cash is received, (2) the asset is removed from the accounting records, and (3) a gain or loss, if one exists, is recognized. In the journal entry provided, only the first and third events are recorded properly.

The asset has not been removed from the books correctly. The asset’s original cost is in the Equipment account. Therefore, that account should be credited for $89,000, not $29,000. The accumulated depreciation (the difference between cost and book value) is in a contra-asset account entitled Accumulated Depreciation—Equipment, which has a balance of $60,000 ($89,000–$29,000). To remove that account it should be debited for its balance. The correct journal entry is shown below.

Cash Loss on Sale of Equipment Accumulated Depreciation–Equipment Equipment

24,600 4,400 60,000 89,000

7.

Depreciation is used to expense the cost of a PPE asset over its useful life. Depreciation takes into account the asset’s salvage value and its useful life The amount of depreciation taken each year is accumulated in a contra-account.

Depletion is used to expense the cost of a natural resource asset (e.g., trees, oil, coal, etc.). Depletion takes into account the estimated quantity of natural resource that can be obtained from the asset. The amount of depreciation taken each year is accumulated in a contra-account. After the natural resource is completely depleted, the value of the asset should be equal to the value of the land without the resources (or equal to zero if only the right to the resources were purchased).

Amortization, which is similar to straight-line depreciation, is used to expense the cost of an intangible asset. The cost of an intangible asset is expensed over its useful life, legal life, or 40 years, whichever is shorter. There is typically no salvage value for intangible assets, and the cost of the asset is written down directly without the use of a contraaccount.

8.

Identifiable intangible assets include patents, copyrights, trademarks, and other rights to profit from an “idea.” These assets are called intangible because they represent “ideas” as opposed to physical assets (e.g., car).

Goodwill is another intangible asset that represents some “idea” that a company is more valuable than the fair market value of its assets. This intangible asset is usually unidentifiable. It is the culmination of years of business, customer loyalty, etc. However, goodwill cannot be recorded by a business if that goodwill has been internally developed; only goodwill that is purchased (as the excess of cost over FMV of net assets) can be recorded.

Unlike unidentifiable intangibles, identifiable intangible assets usually have a limited life time and are amortized at the end of every accounting period. In contrast, an accountant has to test annually for impairment in the value of unidentifiable intangible assets.

Impairment exists when the carrying value exceeds its fair market value. It is only when the asset is impaired that a write-down occurs.

9.

The FASB requires the immediate expensing of all research and development (R&D) costs because it is generally unknown whether R&D activities will result in a technologically feasible, marketable, or useful product.

The capitalization of development costs is based on recognition criteria that focus on whether: ▪ it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and ▪ the cost of the asset can be measured reliably.

10.

An advantage of using historical cost to value assets is objectivity and verifiability because historical cost can be found in source documents. A disadvantage of using historical cost is that, after some period of ownership and use, the balance sheet amount for an asset will probably be totally unrelated to the actual market values of the assets they purport to represent. Thus, the information would not be considered “timely” nor “representationally faithful.” However, most people do not have the expertise to estimate the value of an asset nor would multiple parties necessarily agree on that estimation; therefore, historical cost is used to eliminate subjectivity.

11.

A company can depart using historical cost when long-term assets become impaired and must be written down to lower values.

The use of the IFRS’s “revaluation method” for PP & E might be difficult because it involves a significant amount of judgment and subjectivity.

12.

Acquisition cost includes all costs that are reasonable and necessary to get the asset into place and ready for its intended use (i.e., purchase price, sales tax, freight, insurance during shipping, and installation costs). Excluded costs (which are expensed rather than capitalized) include costs that are not reasonable or necessary to get the asset into place (e.g., insurance after shipping, yearly registration or license fees, repair costs for damage).

13.

The information needs concerning PPE include the following: (a) disclosure of major types of depreciable assets; (b) historical cost of assets; (c) depreciation methods used; (d) any restrictions on the use of long-term assets; (e) impairments to the fair market value of the asset; (f) average age of assets; and (g) average useful or legal life of assets.

Each student will prioritize these items differently. Such priorities may be affected by the industry in which a particular company in involved.

EXERCISES 14.

(a) F Acquisition cost is the total amount capitalized to acquire the asset. Depreciable cost is acquisition cost minus salvage value. (b) F Even though the salvage value is not used in calculations, the asset cannot be depreciated below salvage value. (c) F Depreciation is the method of expensing cost over useful life (for purposes of proper matching of revenues and expenses) and is not influenced by market value. (d) F Although land is not depreciated, it may decline in value. If such a decline occurs, it is recorded as an impairment loss rather than depreciation. (e) T (f) T

(g) F Intangible assets should be amortized over the shorter of legal life, useful life, or 40 years. (h) F Intangible assets are presented at the unamortized portion of historical cost. (i) T (j) F Expenditures made to a PP&E asset after it has been in service for a number of years can be expensed. Expenditures are capitalized only if they add value for more than one year or additional useful life to the asset. (k) T

15.

(a) Purchase price ($300,000 × .85) Delivery cost Installation and testing Installation and testing supplies Total Acquisition Cost (b) Computer Cash (or Accounts Payable)

$255,000 2,750 1,870 135 $259,755 259,755 259,755

(c) Because of the accounting principle of verifiability, historical cost is still the best value to use for depreciable assets in spite of rapid changes in technology. For assets that decline in value so quickly, it is appropriate to choose a declining-balance depreciation method. Therefore, even though the historical cost is shown on the balance sheet, the book value would reflect the big reduction due to depreciation.

However, if the assets have had substantial declines in value, conservatism would require writing those items down to their impaired values.

16.

(a) ($22,800 – $3,000]) ÷ 5 yrs = $19,800 = $3,960 per year (b) Units of Production SL Year Beg. BV Depr End. BV 2009 $22,800 $3,960 $18,840 2010 18,840 3,960 14,880 DDB Year 2009 2010 2011 2012 2013 UOP Year Units 2009 2010

110,000 140,000

Acc. Depr. $3,960 7,920

Beg. BV $22,800.00 13,680.00 8,208.00 4,924.80 3,000.00

Annual Depreciation Rate: Depr End. BV $9,120.00 $13,680.00 5,472.00 8,208.00 3,283.20 4,924.80 1,924.80 3,000.00 0.00 3,000.00

0.4 Acc. Depr. $ 9,120.00 14,592.00 17,875.20 19,800.00 19,800.00

Beg. BV $22,800 19,500

Per-unit depreciation rate: Depr End. BV $3,300 $19,500 4,200 15,300

$0.03 Acc. Depr. $3,300 7,500

2011 2012 2013

(c) (d) (e) (f) 17.

150,000 141,800 118,200

15,300 10,800 6,546

4,500 4,254 3,546

10,800 6,546 3,000

12,000 16,254 19,800

Double-Declining Balance (see previous calculations) Ending book value will be equal to salvage value ($3,000) Accumulated Depreciation will be equal to depreciable amount ($19,800) $0; the full depreciable cost would have been taken by the end of year 4. $3,546

Calculations: Cost $6,500

Salvage Value $500

Depreciable Amount $6,000

Useful Life (years) 6 Annual Depreciation: End. BV $5,500 4,500

$1,000 Acc. Depr. $1,000 2,000 1/3 Acc. Depr. $2,167 3,611

SL Year 2009 2010

Beg. BV $6,500 5,500

Depr $1,000 1,000

Year 2009 2010

Beg. BV $6,500 4,333

Annual Depreciation Rate: Depr End. BV $2,167 $4,333 $1,444 2,889

DDB

(a)

(a)

(1) Depreciation Expense - Equipment Accumulated Depreciation - Equipment (same entry for both years)

1,000

(2) Depreciation Expense - Equipment Accumulated Depreciation - Equipment

2,167

Depreciation Expense - Equipment Accumulated Depreciation - Equipment

1,444

(b) UOP Year Units 2009 2,500 2010 1,900

Beg. BV $6,500 5,250

1,000

2,167

1,444

Per-unit depreciation rate: Depr End. BV $1,250 $5,250 950 4,300

Depreciation Expense - Equipment Accumulated Depreciation - Equipment

Useful Life (units) 12,000

$0.50 Acc. Depr. $1,250 2,200

1,250 1,250

Depreciation Expense - Equipment Accumulated Depreciation - Equipment

950 950

18.18.

Cost $6,500.00

Salvage Value $500.00

Depreciable Amount $6,000.00

Useful Life (units) 12,000

Calculations: 10/1 = ¼ of year in year of acquisition (a) (1) SL Annual Depreciation: Year Beg. BV Depr End. BV 2009 $6,500.00 $ 250.00 $6,250.00 2010 6,250.00 1,000.00 5,250.00 2011 5,250.00 1,000.00 4,250.00

$1,000.00 Acc. Depr. $ 250.00 1,250.00 2,250.00

(a) (2) DDB Year 2009 2010 2011

1/3 Acc. Depr. $ 541.75 2,527.83 3,851.89

Beg. BV $6,500.00 5,958.25 3,972.17

Annual Depreciation Rate: Depr End. BV $ 541.75 $5,958.25 1,986.08 3,972.17 1,324.06 2,648.11

(b) Equipment Cash

6,500 6,500

Depreciation Expense Accumulated Depreciation - Equipment 19.

Useful Life (years) 6

250 250

Calculations: Cost $14,500

Salvage Value $500

Depreciable Amount $14,000

Useful Life (years) 5

Depr $2,800 2,800 1,400

Annual Depreciation: End. BV $11,700 8,900 7,500

SL Year 2007 2008 (½ year) 2009

Beg. BV $14,500 11,700 8,900

(a) Book Value on December 31, 2008 = $8,900

$2,800.00 Acc. Depr. $2,800 5,600 7,000

(b) Depreciation Expense Accumulated Depreciation – Computer

1,400

Cash Accumulated Depreciation – Computer Loss on Sale Computer

7,250 7,000 250

1,400

14,500

20.

Cost $8,000

Salvage Value $800

Depreciable Amount $7,200

Useful Life (years) 8

Beg. BV $8,000 7,100 6,200 5,300

Depr $900 900 900 675

Annual Depreciation: End. BV $7,100 6,200 5,300 4,625

SL Year 2006 2007 2008 9 ( /12 year) 2009

(a) Depreciation Expense - Machines Accumulated Depreciation - Machines

675 675

Book value = $4625 ÷ 10 = $462.50 per washer (b) Gain (Loss) = Cash Received – Book Value Gain (Loss) = $1,630.00 – $4,625.00 Loss = $2,995.00 Cash Accumulated Depreciation - Machines Loss on Sale of Machines Machines

1,630 3,375 2,995 8,000

(c) Gain (Loss) = Cash Received – Book Value Gain (Loss) = $0 – $4,625.00 Loss = $4,625.00 Accumulated Depreciation - machines Loss on Disposal of Machines Machines

3,375 4,625 8,000

$900.00 Acc. Depr. $ 900 1,800 2,700 3,375

21.

(a) Land Natural Resource Cash

600,000 4,650,000 5,250,000

(b) The average cost per acre would be ($4,650,000 ÷ 1,500) or $3,100. Such a cost might not be appropriate if there were significantly different density of trees on the acreage or if there were different types or sizes of trees with different selling price values on different sections of the acreage. (c) Cost of Goods Sold Natural Resource

310,000 310,000

(d) Pappas should not change the historical cost of the land because increases in the valuation of long-term asset are not considered in the preparation of U.S. financial statements. The conservatism principle does not allow the write-up of asset value.

However, if International Financial Reporting Standards (IFRS) are being used for reporting; the write-up of long-term assets is allowed if the fair value to the asset can be reliably measured. (e) Land cost per acre = $600,000 ÷ 1,500 = $400 Cash ($3,300 x 300) Land ($400 x 300) Gain on Sale of Land 22.

(a) Patent Cash

990,000 120,000 870,000 1,871,800 1,871,800

(b) The salvage value will be zero after seven years. As with most intangible assets, after the right to use the patent expires, the patent has no value. (c) $1,871,800 ÷ 7 = $267,400 per year 2009 $267,400 x 9/12 = $200,550 All other full years $267,400 (d) 2009 Amortization Expense Patent

200,550 200,550

23.

(a) Depreciation Expense in 2007: ($144,000 - $18,000) ÷ 6 = $21,000 x 7/12 = $12,250 (b) (1) Equipment cleaning is treated as an expense when incurred in 2008 and 2009.

(2) Lubricating should be expensed when incurred.

(3) Engine replacement should be capitalized. (c) Original cost of equipment $144,000 Depreciation taken in 2007 (7 months) $12,250 Depreciation taken in 2008 and 2009 42,000 (54,250) Depreciation taken in 2010 before engine replacement ($21,000 x 5/12) (8,750) 2010 BV before engine replacement $ 81,000 Capitalized engine replacement 7,000 “New” cost $ 88,000 Salvage value (no change) (18,000) New depreciable cost $70,000 New remaining life (3 remaining + 2 additional) ÷5 Annual depreciation for next three years $ 14,000 Depreciation in 2010: January through May $8,750 May through December ($14,000 x 7/12) 8,167

$16,917

Depreciation in 2011

$14,000

24. (a) Average Age = Accumulated Depreciation ÷ Depreciation Expense Average Age = $1,058,700 ÷ $250,000 Average Age = 4.2 years (b) Average Useful Life = Average Investment ÷ Depreciation Expense Ending Balance = Beginning Balance + Acquisitions $3,670,000 = Beginning Balance + $978,000 Beginning Balance = $3,670,000 – $978,000 Beginning Balance = $2,692,000 Average Investment = (Beginning + Ending) ÷ 2 Average Investment = ($2,692,000 + $3,670,000) ÷ 2 Average Investment = $6,362,000 ÷ 2 Average Investment = $3,181,000 Average Useful Life = $3,181,000 ÷ $250,000 Average Useful Life = 12.7 years

(c) If the acquisitions were made in December, the average investment amount is misleading because for most of the year, the investment would be the beginning balance of $2,692,000.Given that information, the average investment should be recalculated, which would change the calculation of average useful life.

Average Investment = ($2,692,000 × 11/12) + ($3,670,000 × 1/12) Average Investment = $2,467,667 + $305,833 Average Investment = $2,773,500 Average Useful Life = $2,773,500 ÷ $250,000 Average Useful Life = 11.1 years

PROBLEMS 25.

(a) Land Warehouse Cash

Land Warehouse

650,000 1,950,000 2,600,000 Fair Market Value

Proportion of Fair Market Value

Total Cost

$ 700,000 2,100,000 $2,800,000

0.25 0.75

$2,600,000 $2,600,000

$ 650,000 1,950,000 $2,600,000

1,000,000

Equipment Cash

1,000,000

Repair Expense Cash

2,700 2,700

Office Furniture & Fixtures Cash

400,000

Trucks Cash

51,600

Trucks Cost Delivery Insurance Alarm

Proportion of Total Cost

400,000

51,600 Expenditure $12,000 900 300 600

Quantity 4 1 1 4

Extended $48,000 900 300 2,400 $51,600

(b) Depreciation Expense - Warehouse Accumulated Depreciation – Warehouse

87,500

Depreciation Expense - Equipment Accumulated Depreciation - Equipment

188,000

Depreciation Expense – F&F Accumulated Depreciation – F&F

27,750

Depreciation Expense - Trucks Accumulated Depreciation - Trucks

5,250

Asset Warehouse Equipment Furniture & Fixtures Trucks

26.

Cost Salvage Value $1,950,000 $200,000 1,000,000 60,000 400,000 51,600

Depreciable Amount $1,750,000 940,000

30,000 9,600

370,000 42,000

87,500

188,000

27,750

5,250

Useful Life(yrs) 20 5

Annual Depreciation $ 87,500 188,000

10 4

Portion of 2009 Owned 12/12 12/12

37,000 10,500

(a) Building Cash Note Payable

650,000

Equipment Cash

80,000

9/12 6/12

2009 Depr Expense $ 87,500 188,000 27,750 5,250

65,000 585,000

80,000

(b) Cost $650,000

Salvage Value $150,000

SL

Depreciable Amount $500,000

Useful Life (years) 25

Year 2009 2010

Beg. BV $650,000 630,000

Annual Depreciation: Depr End. BV $20,000 $630,000 20,000 610,000

Year 2009 2010

Beg. BV $650,000 598,000

Annual Depreciation Rate: Depr End. BV $52,000 $598,000 47,840 550,160

DDB

(c) (1) 2009 and 2010; same entry: Depreciation Expense - Building 20,000 Accumulated Depreciation - Building

20,000

$20,000 Acc. Depr. $20,000 40,000 0.08 Acc. Depr. $52,000 99,840

(2) DDB 2009: Depreciation Expense - Building 52,000 Accumulated Depreciation – Building

52,000

DDB 2010: Depreciation Expense - Building 47,840 Accumulated Depreciation – Building

47,840

(d) Cost $80,000

Salvage Value $8,000

Depreciable Amount $72,000

Year 2009 2010 2011 2012

Beg. BV $80,000 62,000 44,000 26,000

Depr $18,000 18,000 18,000 18,000

Annual Depreciation: End. BV $54,000 44,000 26,000 8,000

$18,000 Acc. Depr. $18,000 36,000 54,000 72,000 0.5

Beg. BV $80,000 40,000 20,000 10,000

Annual Depreciation Rate Depr End. BV $40,000 $40,000 20,000 20,000 10,000 10,000 2,000* 8,000

SL

DDB Year 2009 2010 2011 2012

Useful Life (years) 4

Acc. Depr. $40,000 60,000 70,000 72,000

*Can only take $2,000 in this year because to take $5,000 would depreciate the equipment below the salvage value.

(e) It would not be unethical to use the SL method. Both SL and DDB are acceptable depreciation methods. The organization needs to choose one method to use for a particular asset and continue the use of that method throughout the asset's life. (f) Positive: Used equipment is less expensive; thus, depreciation is a lower amount.

Reduced expenses are good for new businesses that do not have large revenues from which to deduct expenses.

Negative: Used equipment has a shorter life and may require more maintenance.

27.

(a) Cost

Salvage Value

Depreciable Amount

$2,600,000

$700,000

$1,900,000

5

Year

Beg. BV

Depr

Annual Depreciation: End. BV

$380,000 Acc. Depr.

2009 2010 2011 2012 2013

$2,600,000 2,220,000 1,840,000 1,460,000 1,080,000

$380,000 380,000 380,000 380,000 380,000

$2,220,0000 1,840,000 1,460,000 1,080,000 700,000

$ 380,000 760,000 1,140,000 1,520,000 1,900,000

Year

Beg. BV

Depr

Annual Depreciation Rate: End. BV

Acc. Depr.

2009 2010 2011 2012 2013

$2,600,000 1,560,000 936,000 700,000 700,000

$1,040,000 624,000 236,000*

SL

DDB

Useful Life (years) Useful Life (miles)

$1,560,000 936,000 700,000 700,000 700,000

500,000

0.4

$1,040,000 1,664,000 1,900,000 1,900,000 1,900,000

*Can only take $2,000 in this year because to take $374,400 would depreciate the equipment below the salvage value.

UOP Miles

Year

Beg. BV

Depr

Per-mile depreciation rate: End. BV

100,000 120,000 130,000 90,000 60,000

2009 2010 2011 2012 2013

$2,600,000 2,220,000 1,764,000 1,270,000 928,000

$380,000 456,000 494,000 342,000 228,000

$2,220,000 1,764,000 1,270,000 928,000 700,000

$3.80 Acc. Depr.

$ 380,000 836,000 1,330,000 1,672,000 1,900,000

(b) Units of production is probably the best because it depreciates the asset only to the extent that it is used. (c) The bank would probably prefer CALAir to use the straight-line method because the effect on net income is consistent. Also, other methods may cause a smaller net income in early years while the bank loan is still outstanding. (d) The depreciation method should have limited effect on CALAir’s ability to repay the bank because depreciation is not a cash expense. However, the method chosen may affect the amount of taxes to be paid by the business, which would affect cash flows.

The only other way that a depreciation method could affect cash flows (ability to repay the loan) is if large depreciation amounts (i.e., DDB Method) caused lower net income, which then led to a loss of confidence in the company and lower future revenues. This effect is not likely because investors are usually more savvy that that.

28.

Calculations Cost

Salvage Value

Depreciable Amount

Useful Life (years)

$15,500.00

$2,000.00

$13,500.00

6 $2,250.00 Acc, Depr.

$2,250.00 4,500.00 6,750.00 7,312.50

SL Year

Beg. BV

Depr

Annual Depreciation: End. BV

2009 2010 2011 3 ( /12 year) 2012

$15,500.00 13,250.00 11,000.00 8,750.00

$2,250.00 2,250.00 2,250.00 562.50

$13,250.00 11,000.00 8,750.00 8,187.50

(a) Depreciation Expense - Machines Accumulated Depreciation - Machines

562.50 562.50

(b) $8,187.50 in total or $1,637.50 per machine

29.

(c) Cash Accumulated Depreciation - Machines Loss on Sale of Machines Machines

8,000.00 7,312.50 187.50

(d) Cash Accumulated Depreciation - Machines Machines Gain on Sale of Machines

9,300.00 7,312.50

(a)

1/4 Patent Cash

15,500.00

15,500.00 1,112.50 1,500,000 1,500,000

2/9 Cash Patent Gain on Sale of Patent

800,000

6/30 Amortization Expense Patent Loss due to Obsolescence Patent

50,000

753,000 47,000

50,000 557,000 557,000

12/31 Amortization Expense Patent

300,000

12/31 R&D Expense Cash

876,800

300,000 876,800

Cost

Salvage Value

Amortizable Amount

Shorter of Useful and Legal Life

$1,500,000

$0

$1,500,000

5

Amortization Year

Beginning Balance

2009

$1,500,000

Annual Amortization: Amortization

$300,000

(b) 12/31 R&D Expense Cash

876,800

(c) 12/31 Research Expense Cash

540,700

12/31 Development Cost Cash

336,100

$300,000.00 Ending Balance

$1,200,000

876,800

540,700

336,100

(d) If an investor were only concerned about short-term profitability, the accounting treatment in part (d) would be more preferable because expenses for the year would be $336,100 less than they would be if U.S. GAAP were used. Thus, income before income taxes would be $336,100 higher. However, if no viable asset were produced from the development expenses, that asset would simply have to be written off in a future period—creating the same decline in income that would have occurred under U.S. GAAP. 30.

(a)

Kosciusko Corporation Partial Balance Sheet December 31, 2009

Plant, Property and Equipment Land Office Building Less Accumulated Depreciation

$ 748,000 (230,000)

518,000

Production Equipment Less Accumulated Depreciation

$1,072,800 (112,000)

960,800

Office Furniture Less Accumulated Depreciation

$ 131,500 (61,000)

70,500

Delivery Trucks Less Accumulated Depreciation Total PPE

$ 320,000 (125,000)

(b) Land is not a depreciable asset.

$ 350,000

195,000 $2,094,300

(c) Average Useful Life = Average Investment ÷ Depreciation Expense Average Investment

Depreciation Expense

$ 748,000 1,072,800 131,500 320,000

$34,000 89,400 26,300 40,000

Office Building Production Equipment Office Furniture Delivery Trucks

Average Useful Life

22 years 12 years 5 years 8 years

Average Age = Accumulated Depreciation ÷ Depreciation Expense

Office Building Production Equipment Office Furniture Delivery Trucks

Accumulated Depreciation

Depreciation Expense

Average Age

$230,000 112,000 61,000 125,000

$34,000 89,400 26,300 40,000

6.8 years 1.3 years 2.3years 3.1 years

(d) Capital Spending to Depr. Exp. Ratio = Capital Spending ÷ Depreciation Expense Capital Spending

Depreciation Expense

Cap Spending to Depr Exp

$60,000 5,000

$26,300 40,000

2.3:1 .125 or 1:8

Office Furniture Delivery Trucks

The rule of thumb is that the ratio should be about 1:1.2 (or .833). The lower ratio for delivery trucks suggests that the company is cutting back on expenditures. For office furniture, however, the company is spending a lot, which might indicate that the company is remodeling its offices. (e) Users may want to know about impairments to the assets, particularly the production equipment. Equipment typically has a short life as innovations make older equipment obsolete. The ratio calculations indicate that the production equipment has a life of 12 years which, depending on the type of business in which this company operates, may be fairly long.

31.

(a) Depreciation Expense Accumulated Depreciation – Truck

4,375

Cash Accumulated Depreciation – Truck Loss on Sale of Delivery Truck Delivery Truck

9,000 23,125 2,875

4,375

35,000

Delivery Truck Cost

Salvage Value

Depreciable Amount

Useful Life (years)

$35,000

$5,000

$30,000

4

Year

Beg. BV

Depr

Annual Depreciation: End. BV

(6/12 year) 2006 2007 2008 7 ( /12 year) 2009

$35,000 31,250 23,750 16,250

$3,750 7,500 7,500 4,375

$31,250 23,750 16,250 11,875

SL

(b) Land Building Cash Notes Payable

$ 3,750 11,250 18,750 23,125

180,000 220,000 100,000 300,000 FMV

Land Building

$7,500 Acc. Depr.

Proportion of FMV

Total Cost

0.45 0.55

$400,000 400,000

$247,500 302,500 $550,000

(c) Depreciation Expense – Building Accumulated Depreciation – Building

Proportion of Cost

$180,000 220,000 $400,000

17,000 17,000

Building Cost

Salvage Value

Depreciable Amount

Useful Life (years)

$220,000

$50,000

$170,000

10

SL Year

Beg. BV

Depr

Annual Depreciation: End. BV

$17,000 Acc. Depr.

2009

$220,000

$17,000

$203,000

$17,000

Depreciation Expense Accumulated Depreciation – Equipment

3,888 3,888

Office Equipment Cost

Salvage Value

$45,000

$4,000

Depreciable Useful Life (years) Amount

$41,000

5

DDB

Annual Depreciation Rate: 0.4 End. BV Acc. Depr.

Year

Beg. BV

Depr

2006 2007 2008 2009

$45,000 27,000 16,200 9,720

$18,000 10,800 6,480 3,888

$27,000 16,200 9,720 5,832

Depreciation Expense Accumulated Depreciation – Machinery

$18,000 28,800 35,280 39,168

9,200 9,200

Factory Machinery Cost

Salvage Value

Depreciable Amount

Useful Life (years)

$100,000

$8,000

$92,000

10

SL Year

Beg. BV

Depr

Annual Depreciation: End. BV

$9,200 Acc. Depr.

2005 2006 2007 2008 2009

$100,000 90,800 81,600 72,400 63,200

$9,200 9,200 9,200 9,200 9,200

$90,800 81,600 72,400 63,200 54,000

$ 9,200 18,400 27,600 36,800 46,000

Amortization Expense Patent ($7,000 ÷ 7 years) (d)

1,000 1,000

Withers Industries Partial Balance Sheet December 31, 2009 Plant, Property and Equipment Land Building Less Accumulated Depreciation

$220,000 (17,000)

203,000

Office Equipment Less Accumulated Depreciation

$ 45,000 (39,168)

5,832

Factory Machinery Less Accumulated Depreciation Total PPE

$100,000 (46,000)

Intangible Assets Patent

$180,000

54,000 $442,832

$

6,000

(e) These transactions made the following effects on the income statement: Depreciation Expense of $34,463 was taken.

Amortization Expense of $1,000 was taken.

A loss on sale of $2,875 was taken.

In all, $21,338 expenses (which reduced net income) ended up on the income statement as a result of these transactions.

(f) Average Useful Life = Average Investment ÷ Depreciation Expense Building Office Equipment Factory Machinery

Average Investment $211,500 45,000 100,000

Depr. Expense $17,000 3,888 9,200

Average Useful Life 12.4 years 11.6 years 10.9 years

Average Age = Accumulated Depreciation ÷ Depreciation Expense

Building Office Equipment Factory Machinery

Accumulated Depreciation $17,000 39,168 46,000

Depr. Expense $17,000 3,888 9,200

Average Age 1.0 years 10.1 years 5.0 years

CASES 32.

(a) Cost

Salvage Value

Depreciable Amount

$15,000

$1,000

$14,000

5

Year

Beg. BV

Depr

Annual Depreciation: End. BV

2009 2010

$15,000 12,200

$2,800 2,800

$12,200 9,400

Year

Beg. BV

Depr

Annual Depreciation Rate: End. BV

2009 2010

$15,000 9,000

$6,000 3,600

SL

DDB

Useful Life (years) Useful Life (units)

$9,000 5,400

3,500 $2,800 Acc. Depr.

$2,800 5,600 0.4 Acc. Depr.

$6,000 9,600

(b) Cost

Salvage Value

Depreciable Amount

$15,000

$1,000

$14,000

UOP Units Year

Beg. BV

Depr

Per-unit depreciation rate: End. BV

Acc. Depr.

550 670

$15,000 12,800

$2,200 2,680

$12,800 10,120

$2,200 4,880

2009 2010

Useful Life (years) Useful Life (units)

5

3,500 $4

(c) Each student will have a different answer and a different justification. Straight-line may be considered to provide a better matching of expenses to revenues because it provides a constant amount of depreciation expense each year of an asset's life. For some rapidly deteriorating assets, DDB may better match expenses and revenues.

However, for items that deteriorate with specific usage, units of production may provide better matching. (d) Units-of-production will provide the highest net income in both years 1 and 2, because that method will show the lowest amount of depreciation expense on the income statement. (e) DDB Method gives the highest expense and, therefore, the lowest net income, which will minimize tax liability. (f) A company may want to “smooth” net income (make it as consistent as possible from year to year) on the financial statements. Therefore, a company often chooses SL for financial statement presentation. A company may want lower taxes, so it might use the DDB method to have higher depreciation expenses in early years and lower taxes in those years. If a company continues to add assets, the DDB method will continue to give high depreciation expenses each year for tax purposes. Because companies want both “smooth” earnings and low taxes, they are probably allowed to do both so that there is no incentive to manipulate either.

It is ethical to use different methods for tax purposes and financial statement purposes. Eventually the same amount of depreciation will be taken regardless of the method chosen if the asset is kept for the entire life of the asset. “Tax avoidance” is a term that means operating within the tax laws (i.e., it is legal) to minimize tax debt. It is in the best interest of a company to minimize its tax debt, so companies are likely to take advantage of all legal ways to make that minimization possible.

33.

(a) The air compressor cannot be depreciated any longer because it already has a zero book value. Assets cannot be depreciated below their cost. (b) Yes, it is acceptable to keep the asset on the books even if it is fully depreciated, especially if the asset is still in good working condition and is currently being used by the business.

(c) The matching principle was violated because the cost of the air compressor was spread over four years ($600 per year), but it will continue to be used for a few more years. Therefore, in the first four years, too much expense was taken related to the use of the air compressor, and in future years, too little depreciation (none) will be expensed. Thus, income for the first four years was actually understated and income for however long the compressor continues to be used is overstated.

The violation was not intentional. Depreciation computations are estimates and are made on the best information available at the time. However, if a company intentionally misrepresents salvage value (usually too high) or useful life (usually too long), financial statement users can be very misled. For example, consider the case of Waste Management Inc. which assigned a $25,000 salvage value to each garbage truck but the company never sold used garbage trucks; WM also used a depreciation period that was both longer than the actual depreciable life and longer than the normal depreciation period in the garbage industry. Net income for every year from 1992 to 1997 was overstated by more than $100 million. In early 1998, WM issued restated financial statements for 1991-1997 that were adjusted by $1.32 billion. (d) When an asset is acquired, two very important estimates are made: (1) salvage value and (2) useful life. If these estimates are inaccurate, depreciation calculations will be too high or too low. When depreciation taken is too low or too high, the matching principle has been violated because the cost of the asset is not properly matched with the revenues that asset helped to generate.

The salvage value is the value that will not be depreciated; it is the book value that will remain when the assets useful life is over. This estimate represents the amount that you believe you will be able to sell the asset for after you are done using it. If it will be worthless, the salvage value should be zero. Some suggestions for estimating this number are (1) using your past experience with similar items or (2) finding out what used items are selling for. If the estimate is too high (low), then the depreciable amount will be too low (high), resulting in depreciation expense that is too low (high).

The useful life is the amount of time in years the asset will be used or the number of units or times the asset will be used. This estimates the length of time you will use the asset. Some suggestions for estimating this number are (1) your experience with similar items or (2) the manufacturer’s estimation of life expectancy. If the estimate is too high (low), then the depreciation taken in one year is too low (high) and depreciation will continue too long (not long enough).

34.

(a) Answers will vary. (b) Intangible assets were reduced (credited).

Operating expenses were increased (debited).

Net income and Retained Earnings were reduced.

(c) The goodwill was produced when company A bought company B and paid more than the fair market value for the assets. If an impairment has occurred, the carrying value of B’s net assets are now greater than the fair market value. This overstatement could be because of a decline in fair market value caused by obsolete inventory or technology or because products and services that are no longer desirable. A positive indicator might be that the managers have decided to "clean up" the balance sheet because they recognize that the goodwill being carried does not truly reflect organizational image or value. For instance, assume that Company A bought Company B which had lots of knowledge workers at a price in excess of FMV. Corporate culture at A was such that the B employees did not fit in well and many employees began leaving—deteriorating that which was really being paid for when the goodwill was recorded. Writing off some of that goodwill might reflect the "decline in organizational value" due to the exodus of employees.

35.

(a) (The company includes amortization with depreciation.)

Average Age = Accumulated Depreciation ÷ Depreciation Expense Average Age = $5,901,000,000 ÷ $1,101,000,000 Average Age = 5.36 years Average Investment = (Beginning + Ending) ÷ 2 Average Investment = ($26,639,000,000 + $26,457,000,000) ÷ 2 Average Investment = $53,096,000,000 ÷ 2 Average Investment = $26,548,000,000 Average Useful Life = Average Investment ÷ Depreciation Expense Average Useful Life = $25,548,000,000 ÷ $1,101,000,000 Average Useful Life = 24.11 years (b) Capital Spending Ratio = Capital Spending ÷ Depr Expense Capital Spending Ratio = $3,312,000,000 ÷ $1,101,000,000 Capital Spending Ratio = 3.01:1 The ratio is much larger than the rule of thumb (1:1.2) indicating that Carnival is not backing off capital spending. Carnival does not break down the capital spending or depreciation into types of PPE, so it is difficult to determine what the spending is on.

However, there are separate discussions of ships that are under construction, the portion of interest that was capitalized and included in the capital spending number ($44 million), and that ship improvements are also included. (c) Carnival does not discuss the average age of its assets. (d) Carnival uses the straight-line method of depreciation. Ships are depreciated over 30 years, and other PPE assets are depreciated over a range of years.

36.

Answers will vary.

SUPPLEMENTAL PROBLEMS 37.

(a) 1/2 Computer Cash

55,000 55,000

1/2 Insurance Expense (or Prepaid Insurance) Cash 3/30 Delivery Van Cash

900 900 27,800 27,800

3/30 Automobile Expense Cash

340 340

8/8 Land Cash

87,200 87,200

8/8 Property Tax Expense Cash

950 950

(b)12/31 Depreciation Expense Acc. Depreciation – Computer Acc. Depreciation – Van

9,300 5,400 3,900

COMPUTER Cost

Salvage Value

Depreciable Amount

Useful Life (years)

$55,000

$1,000

$54,000

10

SL Year

Beg. BV

Depr

Annual Depreciation: $5,400.00 End. BV Acc. Depr.

2009

$55,000

$5,400

$49,600

$5,400

DELIVERY VAN Cost

Salvage Value

Depreciable Amount

Useful Life (years)

$27,800

$1,800

$26,000

5

SL Year

2009 (9/12yr.)

Beg. BV

$27,800

Depr

$3,900

Annual Depreciation: $5,200 End. BV Acc. Depr.

$23,900

$3,900

38.

(a) Cost

$52,000

Salvage Value

Depreciable Amount

Useful Life (years)

Useful Life (miles)

$7,000

$45,000

4

144,000

SL

Annual Depreciation: $11,250 End. BV Acc. Depr.

Year

Beg. BV

Depr

(9/12 year) 2009 2010 2011 2012 3 ( /12 year) 2013

$52,000.00 43,562.50 32,312.50 21,062.50 9,812.50

$8,437.50 11,250.00 11,250.00 11,250.00 2,812.50

Year

Beg. BV

Depr

(9/12 year) 2009 2010 2011 2012

$52,000.00 32,500.00 16,250.00 8,125.00

DDB

$43,562.50 32,312.50 21,062.50 9,812.50 7,000.00

$ 8,437.50 19,687.50 30,937.50 42,187.50 45,000.00

Annual Depreciation Rate: 0.5 End. BV Acc. Depr.

$19,500.00 16,250.00 8,125.00 1,125.00*

$32,500.00 16,250.00 8,125.00 7,000.00

$19,500.00 35,750.00 43,875.00 45,000.00

*Can only take $1,125 in this year because to take $4,062.50 would depreciate the equipment below the salvage value.

UOP Year

Units

Beg. BV

Depr

Per-unit depreciation rate: $0.3125 End. BV Acc. Depr.

2009 2010 2011 2012 2013

30,000 32,000 36,000 40,000 6,000

$52,000.00 42,625.00 32,625.00 21,375.00 8,875.00

$ 9,375.00 10,000.00 11,250.00 12,500.00 1,875.00

$42,625.00 32,625.00 21,375.00 8,875.00 7,000.00

$ 9,375.00 19,375.00 30,625.00 43,125.00 45,000.00

(b) Depreciation taken in 2011 would be $8,125 x 10/12 or $$6,771. Thus total depreciation to date of disposal is $19,500 + $16,250 + $6,771 = $42,521. The following entry needs to be made prior to disposal (regardless of which circumstance): Depreciation Expense Accumulated Depreciation – Limo

6,771

(1) Cash Accumulated Depreciation – Limo Gain on Sale of Limo Limo

15,000 42,521

(2) Cash Accumulated Depreciation – Limo Limo

9,479

6,771

5,521 52,000

42,521 52,000

(3) Cash Accumulated Depreciation – Limo Loss on Sale of Limo Limo

9,000 42,521 479

(4) Accumulated Depreciation – Limo Loss on Disposal of Limo Limo Cash

42,521 9,629

52,000

52,000 150

CHAPTER 7 SOLUTIONS TO END OF CHAPTER MATERIAL

QUESTIONS 1.

(a) Liabilities are amounts owed to other entities or individuals. (b) Current liabilities are amounts that must be paid or converted into other current liabilities within one year or an operating cycle, whichever is longer. Examples of current liabilities include accounts payable, wages payable, interest payable, and dividends payable. (c) Long-term liabilities are liabilities other than those classified as current liabilities; long-term liabilities are normally due in more than a year or an operating cycle (whichever is longer). Examples of long-term liabilities include long-term notes payable, mortgages payable, and bonds payable.

2.

An account payable is an amount owed to suppliers; such accounts are usually “open” or have no documentation other than possibly signature support. Accounts payable are generally short-term and typically carry no interest if they are paid within the supplier’s normal credit period.

3.

In contrast, a note payable usually is supported by a legally binding document and bear interest. Notes payable can be either short- or long-term in nature.

Accrued liabilities are liabilities that originate from an expense that has been incurred but not yet paid. Accrued liabilities include accrued wages, accrued interest, accrued income taxes, and accrued warranties.

4.

Answers will vary depending on companies chosen.

5.

Common deductions from an employee’s paycheck include federal and state income taxes, state income taxes, FICA taxes, health insurance premiums, charitable contributions, and union dues. The first three are considered involuntary deductions, and they are remitted to the government appropriate government agency. The remaining deductions are voluntary, and the funds remitted to a variety of agencies. For example, health insurance premiums are sent to the company that provides health insurance.

6.

Contingent liabilities are potential liabilities that may arise in the future because of a particular circumstance or occurrence. A journal entry must be recorded when a loss contingency when meets (a) it is probable that a loss will result from the contingency and (b) the amount of the potential loss can be reasonably estimated.

An attorney will commonly tell clients that journalizing the financial implications of a lawsuit is not wise because the journal entry could be taken to indicate an admission of guilt and a willingness to settle for a particular amount.

SOLUTIONS MANUAL • CHAPTER 7  146

7.

A bond issue is a long-term loan made between parties that is documented by a legal document known as a bond certificate. The terms of the loan are described in the bond indenture.

An advantage of having a callable bond feature is that the issuing company has the option of calling in or retiring the bonds early. This feature allows the issuing company is able to eliminate the debt in the future without market restrictions.

8.

Advantages of Leasing ▪ Leasing improves cash flow.

▪ Leases are easier to finance than purchase.

▪ Leasing makes it easier to keep pace with new technology.

▪ Leasing allows you to afford more items than you might be able to purchase in cash.

Advantages of Purchasing ▪ Purchasing is generally less expensive than leasing.

▪ Owner has the asset on the balance sheet.

▪ Any residual value of the asset belongs to the owner.

9.

10.

A capital lease is one that is non-cancelable and meets at least one of the following criteria: 1. Legal title of the leased asset is transferred to the lessee at the end of the lease term.

2. A “bargain purchase option” that allows the lessee to buy the asset for significantly less than fair market value is included in the lease agreement.

3. The lease term is 75 percent or more of the economic life of the leased asset.

4. The present value of the lease payments equals 90 percent or more of the market value of the leased asset or, put more simply, the total lease payments approximate the purchase cost.

Operating leases are not reported in the company’s balance sheet; rent expense is recorded as the lease payments are made. When a company engages in a capital lease, both the leased asset and long-term lease liability are reported in the lessee’s balance sheet.

A defined benefit plan is one in which employees are promised or guaranteed a monthly pension benefit or payment. A defined contribution plan is one in which employers are obligated to make specified contributions to the plan while the employees are working; the employees’ benefits are retirement depend on how well the pension fund was managed.

Student answers may vary depending; however, a defined benefit plan is usually preferable because no matter how well the fund is managed, the benefit is guaranteed. In a long-term employment situation, a defined contribution plan can often be better if the fund is managed well.

11.

Information needs of decision makers concerning current and long-term liabilities include completeness, unusual circumstances, and valuation methods of current liabilities. In

SOLUTIONS MANUAL • CHAPTER 7  147

addition, decision makers need to assess the company’s liquidity to determine if current obligations will be met and solvency to assess whether long-term obligations can be met.

12.

13.

The current ratio is current assets divided by current liabilities. This ratio indicates the number of dollars of current assets there are for every dollar of current liabilities, or how many times current liabilities can be paid out of current assets. Users usually want this ratio to be greater than 1. If it is less, it is an indication that the company is not liquid or cannot pay its near-term debts.

Working capital is calculated as current assets minus current liabilities. If positive, working capital indicates the amount of current assets that will be left when all current liabilities are paid, which is an indication of the company’s ability to meet near-term debts as well as what funds will be available for unforeseen needs. If negative, working capital indicates a liquidity problem, in that the company will have difficulty meeting its near-term debts.

When a bond is sold at more than face value, it is sold at a premium. The journal entry to sell a $1,000, 10% bond at a premium is shown below; fictional numbers are used for illustration purposes: Cash

1,100 Bonds Payable Premium on Bond

1,000 100

During the bond’s life, interest equal to the face value times the stated rate is paid periodically. When a premium is received, it is amortized (written down to zero) as interest is paid. The journal entry to accrue annual interest is: Interest Expense 90 Premium on Bond 10 Interest Payable 100 The premium amortization reduces the amount of interest expense accrued although the amortization does not affect the amount of interest paid.

The accounting for a bond discount is similar, except that a discount is a contra-liability.

As the discount is amortized, interest expense accrued is increased although the amount of interest payable is not affected.

SOLUTIONS MANUAL • CHAPTER 7  148

EXERCISES 14.

(a)

F Current liabilities must be paid within one year or an operating cycle whichever is longer. (b) T (c) F A deferred liability is created when a customer pays for a service in advance and the product or service will not be provided until sometime in the future. (d) T (e) F For a contingent liability to be recorded, the loss must be probable and the amount reasonably estimated. (f) F A journal entry is required at pay-off because the liability will be eliminated and cash will decrease. (g) T (h) T (i) T (j) F Decision makers are concerned about operating leases because payments still must be paid periodically. (k) F Long-term debt to total assets and to total equity are measure of financial leverage. (l) F Defined contribution plans define the amount to be paid into the plan. (m) T

15.

Payment Schedule

01/01/09 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18 12/31/19

Balance $50,000 $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0

Notes Payable Current Long-term $5,000 $45,000 $5,000 $40,000 $5,000 $35,000 $5,000 $30,000 $5,000 $25,000 $5,000 $20,000 $5,000 $15,000 $5,000 $10,000 $5,000 $5,000 $5,000 $0 $0 $0

Interest Expense $0 $5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500

(a) On December 31, the first $5,000 payment will be made, so the balance due will be $45,000: $5,000 should be classified as a current liability and the rest as a long-term liability. Interest expense of $5,000 will also be reported on the income statement. (b) On December 31 in 2011, $40,000 remains unpaid, $5,000 of which is current and $35,000 is long-term. (c) When assessing the liquidity of Hamilton’s Bakery, the amount of current assets will be too low and liquidity will seem higher.

SOLUTIONS MANUAL • CHAPTER 7  149

16.

Weist Co. Partial Balance Sheet December 31 Current Liabilities Accounts Payable Accrued Expenses Federal Income Tax Withholdings Payable Income Taxes Payable Short-Term Notes Payable Salaries Payable Vacation Payable Total Current Liabilities Long-term Liabilities Long-Term Notes Payable Bonds Payable Total Long-term Liabilities Total Liabilities

17.

$586,000 178,000 42,000 132,000 88,000 195,000 208,000 $1,429,000

$ 70,000 800,000 870,000 $2,299,000

FreeWheelers: Your method of accounting for security deposits and repairs violates generally accepted accounting principles, which will create errors in your financial statements. Below is a discussion about the appropriate accounting treatment for (1) accepting deposits, (2) refunding deposits, and (3) repairs.

When a deposit is taken, you debit cash and credit miscellaneous revenue. Deposits are not revenues because you haven’t earned that money; therefore, this accounting treatment overstates revenues. Deposits are liabilities because you potentially owe all or part of the funds back to the customer. Instead the journal entry should be a debit to cash and a credit to “deposits payable”, a current liability.

When a bike is returned with damage, you debit repairs expense and credit cash (or other appropriate account). An expense is a cost of doing business, but repairs that are paid by customers (from their deposits) are not an expense to FreeWheelers. Therefore, this accounting treatment overstates expense. Instead of debiting repairs expense, you should debit the “deposits payable” account. If damage is in excess of the security deposit, a receivable account should be established representing the amount of money the customer owes you for repairs.

Finally, you must refund none, all, or part of the deposit. Currently, you debit miscellaneous expense and credit cash; however, refunding a deposit is not an expense to FreeWheelers. The refund is payment of a liability; therefore, this accounting treatment is overstating liabilities.

• The entry to refund all of the deposit (i.e., no repairs), debit deposits payable and credit cash.

SOLUTIONS MANUAL • CHAPTER 7  150

•

•

If all of the deposit is retained to cover repairs, debit deposits payable and credit (reduce) accounts receivable—repairs. If the deposit is not enough to pay the repairs, the balance remaining in accounts receivable—repairs represents the amount still due from the customer.

If a portion is refunded, debit deposits payable for the entire deposit amount, credit accounts receivable—repairs for the amount of repairs, and credit cash for the amount refunded. The balance in accounts receivable—repairs will be zero.

Only the monthly rental or unpaid repairs should be classified as revenues and expenses, respectively. Deposits and repairs covered by the deposits should not appear on the income statement.

18.

(a)

Alpha Company (1) Maturity date: July 1, 2009 (2) Interest = Principal × Rate × Time Interest = $3,600 × 10% × 6/12 = $180 Maturity value = Principal + Interest = $3,600 + $180 = $3,780 (3)

No interest will be accrued on December 31, 2009, because this note will be paid in full before December 31, 2009.

(4)

No interest will be accrued on December 31, 2010, because this note will be paid in full before December 31, 2010.

Beta Co. (1) Maturity date: March 31, 2010 (2)

Interest = Principal × Rate × Time Interest = $12,000 × 12% × 12/12 = $1,440 Maturity value = Principal + Interest= $12,000 + $1,440 = $13,440

(3)

On December 31, 2009, eight months of interest should be accrued: Interest = Principal × Rate × Time Interest = $12,000 × 12% × 9/12 = $1,080

(4)

No interest will be accrued on December 31, 2010, because this note will be paid in full before December 31, 2010.

SOLUTIONS MANUAL • CHAPTER 7  151

Gamma Industries (1) Maturity date: August 1, 2011 (2)

Interest = Principal × Rate × Time Interest = $3,000 × 9% × 24/12 = $540 Maturity value = Principal + Interest = $3,000 + $540 = $3,540

(3) On December 31, 2009, five months of interest should be accrued: Interest = Principal × Rate × Time Interest = $3,000 × 9% × 5/12 = $112.50 (4) On December 31, 2010, seventeen months has past, and five months of interest have already been accrued. Therefore, an additional 12 months of interest should be accrued: Interest = Principal × Rate × Time Interest = $3,000 × 9% × 12/12 = $270 Sigma, Inc. (1) Maturity date: February 28, 2010 (2)

Interest = Principal × Rate × Time Interest = $2,000 × 7% × 90/360 = $35 Maturity value = Principal + Interest = $2,000 + $35 = $2,035

(3)

On December 31, 2009, 31 days of interest should be accrued: Interest = Principal × Rate × Time Interest = $2,000 × 7% × 31/360 = $12.06

(4)

(b)

No interest will be accrued on December 31, 2010, because this note will be paid in full before December 31, 2010.

2009 Balance Sheets Alpha, Inc.: This note will not appear on the 2009 balance sheet because it will be paid off before the balance sheet is prepared.

Beta Co.: This note will be a current liability on the 2009 balance sheet because it will be due in 2010.

Gamma Industries: This note will be listed as a long-term liability on the 2009 balance sheet because it will be due in 2011

SOLUTIONS MANUAL • CHAPTER 7  152

Sigma Inc.: This note will be listed as a current liability on the 2009 balance sheet because it will be due in 2010.

19.19.

Purchase Amount Down-payment Amount to Borrow Years to finance Interest rate: (1) 4.5% (2) 5.0% (3) 6.0% 20.

21.

(a)

(a) $ 29,000 $ 2,500 $ 26,500 5 years (60 months) Monthly Payments $494 500 512

Salary Expense FICA Payable Federal Income Tax Payable State Income Tax Payable Health Insurance Payable Salaries Payable

(b) $29,000 $ 5,000 $24,000 5 years (60 months) Monthly Payments $447 453 464 16,400 827 2,910 416 485 11,762

(b)

The company must pay federal and state unemployment tax in most states and match FICA.

(c)

Student’s answers will vary, but should include the following information.

Regardless of whether an employer withholds taxes or not, the taxes must be paid.

If the employer withholds the amount, the employer must remit the taxes. If no taxes are withheld, the independent contractors must remit the taxes themselves.

Many times, independent contractors are not disciplined enough to put aside the tax amount, and when it becomes due, the funds are not available. Employees who pay as they go usually do not have that problem.

(a) If product warranties are not recorded, expenses and liabilities will be understated.

This situation will lead to inaccurate balance sheets and income statements for the cycle(s).

Orackle would be violating the matching principle because the expenses for repairing vacuum cleaners may be recorded in the fiscal year following the year of sale when the revenue was recorded. (b)

If Orackle were experiencing an immaterial rate or amount of warranty, it may be proper for the company not to accrue the warranty liability and expense. However, without knowing the selling price of the vacuum cleaners, the $500 amount cannot be determined to be material or immaterial.

SOLUTIONS MANUAL • CHAPTER 7  153

22.

23.

(c)

General Motor Corporation has material warranty expenditures each year so the assumption for Orackle from part (b) is not valid.

(a)

Management Cruisin’ should consider ask itself two questions. First, is it probable that Cruisin’ will lose the lawsuit and have to pay some amount? Second, can Cruisin’ estimate that amount? Although there is a specific claim of $2.4 million, that amount may or may not be a reasonable estimate. However, assuming that $2.4 million is a reasonable estimate, Cruisin’ must consider whether it has lost similar lawsuits in the past to determine the probability of losing this lawsuit.

(b)

(1)

Cruisin’ would record and expense and a liability in its accounting records if the payment related to this lawsuit is both probable and estimable.

(2)

Cruisin’ would disclose the lawsuit in the footnotes to its financial statements in three situations: (1) if it records an entry [see part (b)(1)], (2) if the chances of a loss are probable but an amount is not estimable, and (3) if the chances of a loss are reasonable probable, whether or not the amount can be estimated.

(3)

Cruisin’ would ignore the lawsuit for accounting and financial reporting purposes if the chance of a loss is remote.

Answers will vary according to students.

Example Mattel Inc. (MAT) Note 10 Commitments and Contingencies Litigation With regard to the claims against Mattel described below, Mattel intends to defend itself vigorously. Management cannot reasonably determine the scope or the amount of possible liabilities that could result from an unfavorable settlement or resolution of these claims, and except as noted below, no reserves for these claims have been established as of December 31, 2007. However, it is possible that an unfavorable resolution of the claims could have a material adverse effect on Mattel’s financial condition and results of operations, and there can be no assurance that Mattel will be able to achieve a favorable settlement or resolution of these claims.

Litigation Related to Product Recalls and Withdrawals Product Liability Litigation in the United States [10-K page 99-101] Source: Mattel Inc., 10-K, February 26, 2008

SOLUTIONS MANUAL • CHAPTER 7  154

24.

(a) 8 (b) 6 (c) 3 (d) 1 (e) 9 (f) 7 (g) 10 (h) 4 (i) 5 (j) 2

25.

(a)

Interest = Principal × Rate × Time Interest = $1,000 × 8% × 6/12 = $40

(b)

1,000 × 98% = $980 Interest payable is not affected by the amount of a bond discount or premium.

Annual interest is always the face value times the stated rate. Amortizing bond premium or discount will have a decreasing or increasing effect on interest expense.

(c)

The market rate of interest is higher than 8%; therefore, investors are not willing to buy these bonds without an incentive. The incentive is a discount on the selling price. The investors will pay $980, but will receive 8% interest as if they had invested $1,000, and will receive $1,000 when the bond matures.

(d)

$1,000 The principal amount is not affected by the selling price of the bond. The principal is the face value of the bond and is established by the bond agreement.

26.

Net cost of buying: Net cost of lease:

$12,183.01 $13,479.87

The greatest benefit of buying a car is that you may actually own it one day. Other benefits include lower insurance limits on your policy as compared to when you lease. In addition, owning allows you to use the vehicle as much as you want. The greatest disadvantage of owning a car is higher car payments ($379 per month). Dealers usually require a down payment when opting to buy than lease. Therefore, buying the car will require a large initial investment ($2,000).

SOLUTIONS MANUAL • CHAPTER 7  155

The greatest benefit of leasing a car is the lower out-of-pocket costs when acquiring and maintaining the car. No down payment is required and monthly car payments are lower ($287 per month). Leasing allows the acquisition of having a new car every few years rather than “being stuck” with one particular car. For business owners, leasing a car may offer tax advantages if the vehicle is used for business purposes. The major disadvantage of leasing is that you always have to pay monthly payments. Mileage restrictions are another disadvantage of leasing as most leases have a set amount of miles you can drive and if you go over the allotted miles, you pay extra. Finally, insurers usually charge higher coverage costs for leased vehicles.

27.

Liabilities (both long-term and short-term) are amounts owed to suppliers and others.

Short-term liabilities are usually due and payable within a year or an operating cycle, whichever is longer. Long-term liabilities are all noncurrent liabilities.

Convertible debenture bonds are long-term debt issues that are convertible into shares of common stock of the issuing company. Accrued pension costs are liabilities for pensions that are due to organizational employees. Unearned subscriptions represent subscriptions that must be sent to subscribers or monies that must be repaid to subscribers if subscriptions are cancelled. Mortgages are long-term liabilities that occur when an entity purchases property, plant and equipment and signs a legal document for the purchase.

Convertible debentures and mortgages help finance the profit-oriented activities of an organization. Pension costs are part of the total wage package of the employees who perform necessary organizational duties in support of profit-oriented activities.

Subscriptions, when earned, are part of the profit-activities of the organization.

28.

29.

(a)

Proof: 2009: $700,000 x 1.08 = $756,000 + $36,500 contribution at 12/31/09 = $792,500 2010: $792,500 x 1.08 = $855,900 + $36,500 contribution at 12/31/10 = $892,400 2011: $892,400 x 1.08 = $963,792 + $36,500 contribution at 12/31/11 = $1,000,292

(b)

Proof: 2009: $700,000 x 1.02 = $714,000 + $36,500 contribution at 12/31/09 = $750,500 2010: $750,500 x 1.03 = $773,015 + $36,500 contribution at 12/31/10 = $809,515 2011: $809,515 x 1.05 = $849,991 + $36,500 contribution at 12/31/11 = $886,491

(a)

2008 Working capital = $253,245 - $110,127 = $143,118 Current ratio = $253,245  $110,127 = 2.3 2009 Working capital = $245,618 - $113,847 = $131,771 Current ratio = $245,618  $113,847 = 2.2

SOLUTIONS MANUAL • CHAPTER 7  156

30.

(b)

Liquidity for the company weakened or decreased from 2008 to 2009. Both working capital and the current ratio decreased from 2008 to 2009 indicating that the firm has fewer dollars of current assets to pay its upcoming current liabilities.

(a)

PV of principal ($5,000,000 × .5537) One principal of $5,000,000 will be paid after 20 periods at an effective interest rate of 3%.

PV of interest ($200,000 × 14.8775) 20 semiannual interest payments of $200,000 will be paid at an effective interest rate of 3% (6%/2).

PV of principal and interest Sold at a premium

$2,768,500

PV of principal ($5,000,000 × .3769) One principal of $5,000,000 will be paid after 20 periods at an effective interest rate of 5%.

PV of interest ($200,000 × 12.4622) 20 semiannual interest payments of $200,000 will be paid at an effective interest rate of 5% (10%/2).

PV of principal and interest Sold at a discount

$1,884,500

(b)

(c)

2,975,500

$5,744,000

2,492,440

$4,376,940

The discount on the bond from part (b) is calculated below: Discount = Face value – sale price Discount = $5,000,000 – $4,376,940 Discount = $623,060 Each time interest is paid (20 times), $31,153 of the discount will be amortized.

PROBLEMS

31.

(a)

(1) Equipment—Rafts Cash Notes Payable

30,000

(2) Interest Expense Interest Payable ($25,000 × 8% × 9/12 = $1,500)

1,500

(3) Notes Payable Interest Payable Interest Expense Cash ($25,000 × 8% ×3/12 = 500)

25,000 1,500 500

5,000 25,000

1,500

27,000

SOLUTIONS MANUAL • CHAPTER 7  157

32.

(b)

In the year the entry is not made, expenses and liabilities will be understated; in the following year, expenses will be understated. The matching principle will be violated because the interest expense is not accrued in the year in which the company had the use of the rafts that had not been paid for.

(a)

Air Conditioners (2,000 × 7% × $150) Air Compressors (1,350 × 9% × $40) Fans (1,700 × 6% × $12) Total estimated cost

(b) 33.

$21,000 4,860 1,224 $27,084

Estimated Warranty Expense Estimated Warranty Liability

27,084

Estimated Warranty Liability Cash

6,800

27,084

6,800

(a)

Employee Addel Blatty Charles Douglas Total

(b)

(c)

Gross Pay $ 800.00 864.00 920.00 1,028.00 $3,612.00

Federal State Income Income Tax Tax $216.00 $66.00 158.00 52.00 248.00 75.00 201.00 84.00 $823.00 $277.00

FICA Tax $61.20 66.10 6.50 78.03 $211.83

Insurance Total DeducPremiums tions $ 0.00 $343.20 62.00 338.10 115.00 444.50 58.00 421.03 $235.00 $1,546.83

Salaries Expense Federal Income Tax Payable State Income Tax Payable FICA Tax Payable Insurance Premiums Payable Salaries payable

Net Pay $456.80 525.90 475.50 606.97 $2,065.17

3,612.00 823.00 277.00 211.83 235.00 2,065.17

(1) 40 hours a week × 50 weeks per year = 2,000 hours (2) 40 hours a week × 2 weeks per year = 80 hours (3) 2,000 hours ÷ 80 hours = 25 hours for 1 hour of vacation (4)

Employee Addel Blatty Charles Douglas Total

Hours Worked 80.00 72.00 80.00 80.00 312.00

Vacation Hours Earned 3.20 2.88 3.20 3.20 12.48

Hourly Wage $10.00 12.00 11.50 12.85

Value of Vacation Earned $32.00 34.56 36.80 41.12 $144.48

SOLUTIONS MANUAL • CHAPTER 7  158

(5) Vacation Pay Expense Vacation Pay Liability 34.

(a)

(b)

(c)

35.

5,760

Unearned Subscription Revenue Subscription Revenue

28,080

Unearned Subscription Revenue Cash

16,400

Interest = Face Value × Interest Rate Interest = $250,000 × 0.095 = $23,750

(b)

(1) (2)

(3)

(d)

144.48

Cash Unearned Subscription Revenue

(a)

(c)

144.48

5,760

28,080

16,400

Cash Bonds Payable

250,000

Cash Discount on Bonds Bonds Payable

242,500 7,500

Cash Bonds Payable Premium on Bonds

255,000

250,000

250,000 250,000 5,000

(1)

The bond was sold at face value. The market rate of interest was equal to the stated rate of interest.

(2)

The bond was sold at a discount. The market rate of interest was greater than the stated rate of interest.

(3)

The bond was sold at premium. The market rate of interest was less than the stated rate of interest.

In each situation, investors will receive $250,000 at the maturity date.

SOLUTIONS MANUAL • CHAPTER 7  159

36.

Option A Purchase Price Down payment Percent Down payment amount Amount to borrow Years to finance

(a) (b) (c)

Interest Rate Monthly Payment Interest Paid (total) Savings on down payment Maturity value of 7% CD during finance Net Interest Mort — CD

Option B

Option C

Option D

$780,000.00

$780,000.00

$780,000.00

$780,000.00

20%

20%

30%

30%

$156,000.00

$156,000.00

$234,000.00

$234,000.00

$624,000.00

$624,000.00

$546,000.00

$546,000.00

15

30

15

30

8%

8%

6.5%

6.5%

$5,963.27

$4,578.69

$4,756.25

$3,451.09

$1,073,388.60

$1,648,328.40

$856,125.00

$1,242,392.40

$78,000.00

$78,000.00

$247,429.26 = $78,000 × FV of $1 at 8% for 15 yrs)

$863,440.92 = $78,000 × FV of $1 at 8% for 30 yrs

$825,959.34

$784,887.48

$856,125.00

$1,242,392.40

The college should choose option B because it results in the least amount of interest.

37.

(a)

Year 1 Working capital = $4,270 - $3,770 = $500 Current ratio = $4,270  $3,770 = 1.1 Year 2 Working capital = $4,664 - $3,828 = $836 Current ratio = $4,664  $3,828 = 1.2

(b) Liquidity has slightly improved. In year one, Iago’s current assets were 1.1% of current liabilities. In year two, Iago’s current assets were 1.2% of current liabilities.

38.

(a)

2008 Long-Term Debt to Equity = $1,090  $1,365 = 0.8 Times Interest Earned = ($99 + $56 + $31)  $99 = 1.9 2009 Long-Term Debt to Equity = $1,490  $1,461 = 1.0 Times Interest Earned = ($149 + $25 + $75)  $149 = 1.7

(b) The LTD to Equity ratio increased and the interest coverage decreased from 2008 to 2009.

SOLUTIONS MANUAL • CHAPTER 7  160

39.

(a)

2008 Long-Term Debt to Equity = $121,792  $37,153 = 3.3 Times Interest Earned = ($9,417 + $4,806 + $8,949)  $8,949 = 2.6 2009 Long-Term Debt to Equity = $161,302  $95,791 = 1.7 Times Interest Earned = ($11,840 + $6,100 + 9,179)  $9,179 = 3.0 The debt to equity ratio decreased from year 1 to year 2, while the times interest earned ratio increased from 2008 to 2009.

(b) Zammillo Corp. apparently issued additional long-term debt and stock between the two years. (c)

Neither ratio is good considering the industry averages. The average resort has twice as much equity as long-term debt, but Zammillo’s long-term debt is more than its equity. Also, the average resort earns its interest 4.5 times, but Zammillo earns its interest less than 3 times.

(d)

The main objective of this disclosure is to inform current stockholders of future plans for expansion and the company’s need for additional financing.

40.

(a)

(1)

Principal Interest

$20,000,000 800,000

Periods 10 10

Eff. Rate 3.50 3.50

Factor 0.7089 8.3166

Present Value $14,178,400 6,653,288 $20,831,688

Principal Interest

$20,000,000 800,000

10 10

5.50 5.50

0.5854 7.5376

$11,708,600 6,030,104 $17,738,704

(2)

(b) (1)

Journal entries for 7% market rate 5/1 Cash Bonds Payable Premium on Bonds Payable 11/1

Interest Expense Premium on Bonds Payable Cash ($831,688  10 = $83,168.80)

20,831,688.00 20,000,000.00 831,688.00 716,831.20 83,168.80

12/31 Interest Expense 205,610.40 Premium on Bonds Payable 27,722.93 Interest Payable ($20,000,000 x 7% x 2/12 = $233,333.33) ($83,168.80 × 2/6 = $27,722.93)

800,000.00

233,333.33

SOLUTIONS MANUAL • CHAPTER 7  161

5/1

(2)

Interest Expense Premium on Bonds Payable Interest Payable Cash ($83,168.80 × 4/6 = $55,445.87)

Journal entries for 11% market rate 5/1 Cash Discount on Bonds Payable Bonds Payable 11/1

511,220.80 55,445.87 233,333.33 800,000.00

17,738,704.00 2,261,296.00 20,000,000.00

Interest Expense 1,026,129.60 Cash Discount on Bonds Payable ($2,261,296.00  10 = $226,129.60)

800,000.00 226,129.60

12/31 Interest Expense 442,043.00 Interest Payable 366,666.67 Discount on Bonds Payable 75,376.33 ($2,261,296.00  5 years ÷ 12 months × 2 months= $75,376.53) 5/1

(c)

Interest Expense 584,086.40 Interest Payable 366,666.67 Cash 800,000.00 Discount on Bonds Payable 150,753.07 ($2,261,296.00  5 years ÷ 12 months × 4 months= $150,753.07)

Carrying value at 12/31/09 at 7% market value Bonds Payable Premium ($831,688.00 - $83,168.80 - $27,722.93)

Carrying value at 12/31/09 at 11% market value Bonds Payable Discount ($2,261,296.00 - $226,129.60 - $75,376.33)

$20,000,000.00 720,796.27 $19,279,203.73

$20,000,000.00 (1,959,790.10) $18,040,209.90

SOLUTIONS MANUAL • CHAPTER 7  162

CASES 41.

42.

An adjusting entry for the estimated warranty expenses on a year’s sales must be recorded; to do otherwise would violate the matching principle. Because the items were sold and the amount of repairs/returns can be estimated, this expense must be recorded.

If the books are not adjusted for this expense, expenses will be understated and, thus, net income will be overstated. Also, if the entry is not made current liabilities will be understated, which will impact liquidity ratios for the current operating cycle. (a) Scenario A should be recorded as a contingent liability because it appears probable that this event will occur and management can make a reasonable estimate of the loss. A liability in the amount of $4,000,000 should be accrued on the books.

Scenario B should be disclosed in the financial statements because it appears that it is probable a loss will be incurred (“the fine reduced” but not eliminated) but the amount is unknown.

Scenario C should neither record nor disclose this situation as there appears to be a remote chance that anything will come of the lawsuit. (b)

43.

Companies probably do have an incentive to downplay contingent liabilities for financial statement purposes. It is very difficult to accurately determine the outcome of a potential lawsuit in any situation. Decision makers who rely on financial statements that might not present contingent liability information are dealing with incomplete information and a lack of full disclosure on the company’s part.

(a) $10,000,000 x 122.25% = $12,225,000 to retire at current market price. The main difference between carrying value and market is the current market rate of interest for similar debt instruments. (b) Bonds Payable 10,000,000 Loss on Retirement of Bonds 2,348,000 Discount on Bonds Payable 123,000 Cash 12,225,000 ($10,000,000 - $9,877,000 = $123,000) (c)

The bonds could have been either callable at a specified price or convertible into stock of the issuing company.

SOLUTIONS MANUAL • CHAPTER 7  163

44.

Charlotte Foods Corporation (a)

45.

(1) Working Capital 2008 = $619,904 - $227,058 = $392,846 2009 = $708,215 - $264,917 = $443,298 (2) Current Ratio 2008 = $619,904  $227,058 = 2.7 (rounded) 2009 = $708,215  $264,917 = 2.7 (rounded) (3) Quick Ratio 2008 = ($157,558 + $14,862 + $218,487)  $227,058 = 1.7 (rounded) 2009 = ($248,599 + $11,360 + $228,369)  $264,917 = 1.8 (rounded)

Slidell, Inc. (1) Working Capital 2008 = $45,167 - $47,093 = $(1,926) 2009 = $47,441 - $(59,552) = $(12,111) (2) Current Ratio 2008 = $45,167  $47,093 = .96 (rounded) 2009 = $47,441  $59,552 = .8 (rounded) (3) Quick Ratio 2008 = ($8,241 + $1,947 + $12,545)  $47,093 = .48 (rounded) 2009 = ($6,699 + $1,399 + $15,445)  $59,552 = .4 (rounded)

(b)

Charlotte Foods is more liquid in both years because the current and quick ratios both indicate a higher ability to pay short-term debts.

(c)

The quick ratio is probably the best indicator of liquidity because the assets used to calculate this ratio can quickly and easily be converted into cash.

(d)

Students will have different answers to this question. However, they may want to address why there were large increases in Charlotte’s 2009 Cash, Accounts Receivable, Accounts Payable, Accrued Advertising, and Federal Income Taxes Payable as well as in Slidell Inc.’s 2009 Accounts Receivable, Line of Credit, and Accounts Payable.

(a)

(1)

2006 Current ratio = Current Assets ÷ Current Liabilities Current ratio = $1,995,000 ÷ $5,415,000 = 0.37 2007 Current ratio = Current Assets ÷ Current Liabilities Current ratio = $1,976,000 ÷ $7,260,000 = 0.27

(2)

2006 Working capital = Current Assets – Current liabilities Working capital = $1,995,000 - $5,415,000 = -$3,420,000

SOLUTIONS MANUAL • CHAPTER 7  164

2007 Working capital = Current Assets – Current Liabilities Working capital = $1,976,000 - $7,260,000 = -$5,284,000 (3)

2006 Debt to total assets = Long-term Debt ÷ Total assets Debt to total assets = $6,927,000 ÷ $30,552,000 = 0.23 2007 Debt to total assets = Long-term Debt ÷ Total assets Debt to total assets = $6,958,000 ÷ $34,181,000 = 0.20

(4)

2006 LTD to Equity = Long-term Debt ÷ Equity LTD to Equity = $6,927,000 ÷ $18,210,000 = 0.38

2007 LTD to Equity = Long-term Debt ÷ Equity LTD to Equity = $6,958,000 ÷ $19,963,000 = 0.35 (5) 2006 Times Interest Earned = (Net Income + Int Exp + Inc Tax Exp + Other Exp) ÷ Interest Expense = ($2,279,000 + $312,000 + $39,000 + $8,000) ÷ $312,000 = 8.46 2007 Times Interest Earned = (Net Income + Int Exp + Inc Tax Exp + Other Exp) ÷ Interest Expense = ($2,408,000 + $367,000 + $16,000 + $1,000) ÷ 367,000 = 7.61 (b)

According to the notes to the financial statements, Carnival has contingent lease obligations. The likelihood that they will have to make payments related to these leases is if highly rated companies fail to perform as agreed. Because of that, Carnival believes that it is not probable that they will have to make payments, and therefore, the liability is not listed in the financial statements.

In addition, Carnival is a defendant of a lawsuit filed in January 2006 in relation to intellectual property right to musical plays and other works. The plaintiffs claim infringement of copyrights to Broadway, off Broadway and other plays. Other claims and lawsuits have been filed or are pending against Carnival. Most of these claims and lawsuits are covered by insurance. However, Carnival does not have a basis on which to estimate the probability or amount of a loss, and does not disclose these contingencies in the financial statements, just the notes.

(c)

Carnival offers both a defined benefit and defined contribution plan.

SOLUTIONS MANUAL • CHAPTER 7  165

46.

(d)

$1,028,000

(e)

Carnival leases office and warehouse space under an operating lease.

(f)

Carnival uses a form of notes that operate as bonds.

Answers will vary depending on what companies are chosen.

SUPPLEMENTAL PROBLEMS

47.

10/2

Cash Notes Payable

10,000

12/31 Interest Expense Interest Payable ($10,000 × 0.09 × 90/360)

225

3/1

48.

(a)

(b)

49.

(a)

Interest Expense Notes Payable Interest Payable Cash ($10,000 × 0.09 × 60/360) Edgers (3,400 × 1% × $40) Push Mowers (2,820 × 4% × $90) Fans (1,900 × 3% × $170) Total estimated cost

10,000

225 150 10,000 225 10,375

$ 1,360 10,152 9,690 $21,202

Estimated Warranty Expense Estimated Warranty Liability

21,202

Estimated Warranty Liability Salaries Payable Parts Inventory

2,200

Salaries Expense FICA Tax Payable Federal Income Tax Payable State Income Tax Payable Insurance Premiums Payable Salaries Payable

30,000

21,202 400 1,800

2,295 7,353 1,138 1,000 18,214

SOLUTIONS MANUAL • CHAPTER 7  166

(b)

Gross salary for 2 weeks = $30,000 Gross salary for 1 week = $15,000 Portion of vacation earned in 1 week = 2 weeks ÷ 50 weeks = 0.04 weeks × 2 weeks = .08 weeks Value of vacation earned = .08 weeks × $15,000 = $1,200

(c)

50.

(a)

(b)

51.

Vacation Pay Expense Vacation Pay Liability

1,200

Salaries Payable Cash

18,214

Cash Unearned Pizza Revenue

4,000

Unearned Pizza Revenue Pizza Revenue

1,200

18,214

4,000 135 135

(c)

The current liability, Unearned Pizza Revenue, should be presented on the balance sheet with a balance of $335.

(a)

Prosperous Bank would be more interested in the financial leverage of the company because it would want to know if Kirsten could pay back the loan and the required amount of interest. Cornell Manufacturing would probably be more interested in the profitability and dividend payments of Kirsten.

(b)

2008 LT debt to equity ratio = $226,279  $604,215 = 0.37 2009 LT debt to equity ratio = $287,837  $675,322 = 0.43 The company became more leveraged between the two years.

(c)

2008 Times interest earned = ($81,584 + $10,203 + $28,578)  $10,203 = 11.8 2009 Times interest earned = ($99,586 + $13,985 + $42,680)  $13,985 = 11.2 The ratio decreased between the two years, indicating that the company is less able to pay interest.

SOLUTIONS MANUAL • CHAPTER 7  167

52. (a)

Periods

Eff. Rate

Factor

20 20

4.50 4.50

0.4146 13.0079

Principal Interest

$4,000,000 220,000

(b)

Cash Bonds Payable Premium on Bonds Payable

9/1/09

Present Value

$1,658,400 2,861,738 $4,520,138

4,520,138.00 4,000,000.00 520,138.00

12/31/09 Interest Expense 129,328.74 Premium on Bonds Payable 17,337.93 Interest Payable 146,666.67 ($4,000,000 x 11% x 4/12 = $146,666.67) ($520,138  10 years= $52,013.80; $52,013.80 × 4/12 = $17,337.93) 3/1/10

Interest Expense 64,664.36 8,668.97 Premium on Bonds Payable Interest Payable ($4,000,000 x 11% x 2/12 = $73,333.33) ($52,013.80 × 2/12 = $8,668.97) Interest Payable Cash

9/1/10

(c)

(d)

73,333.33

220,000.00 220,000.00

Interest Expense 193,993.10 Premium on Bonds Payable 26,006.90 Cash ($4,000,000 x 11% x 6/12 = $220,000.00) ($52,013.80 × 6/12 = $26,015.34)

220,000.00

Bonds Payable Bond Premium ($520,138 - $17,337.93 - $8,668.97 - $26,006.90) Carrying Value

$4,000,000.00 468,124.20 $4,520,306.80

Principal Interest

$1,200,000 66,000

Periods

Eff. Rate

Factor

Present Value

20 20

4.50 4.50

0.4146 13.0079

$497,520.00 858,521.40 $1,356,041.40

When Gary Schorg sells his bonds to another investor, Parisian Globe does not make any entry. This transaction takes place in the secondary market and does not affect the issuing company.

(e)

Principal Interest

$4,000,000 220,000

Periods 20 20

Eff. Rate 7.00 7.00

Factor 0.2584 10.5940

Present Value $1,033,600 2,330,680 $3,364,280

CHAPTER 8 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1.

A corporation is an organization that has an existence apart from its owners and has inherent and distinct powers and drawbacks. A “closely-held” corporation is usually owned by a few people and is not traded on a stock exchange.

Generally, people choose the corporate form of business because of its most valuable attribute: limited liability of shareholders. Closely-held corporations offer 100% of control by a small number of people (oftentimes family members). However, publicly traded corporations can raise more capital by selling stock to a variety of investors.

2.

Articles of incorporation identify the purpose of the organization, type(s) and quantity of stock the organization plans to issue, and principal operating units.

A corporate charter is a contract between the organization and the state in which the organization was created. The charter identifies the rights and obligations of the corporation.

Shareholders will think the corporate charter is more important because it is the document that authorizes the issuance of a maximum number of shares of one or more classes of stock

3.

Advantages of the corporate form of business include limited liability of stockholders, ease of raising capital, ease of transferability of ownership, ability to hire/retain professionals, and unlimited life. Disadvantages of the corporate form of business include double taxation and regulatory requirements.

4.

A corporation pays income taxes on its net income. In addition, when the corporation declares and pays cash dividends, the stockholders must pay taxes on the dividends received as income.

5.

There are similarities between common and preferred stock. Both forms of stock pay dividends, both represented ownership in the corporation, and both entitle the owner to a portion of the company if it goes out of business (after creditors are paid).

There are some important differences. Common stock has voting rights whereas preferred stock usually does not. Common stock usually has lower par and market values than preferred stock. Preferred stockholders get their dividends and their share of liquidation funds before common stockholders. In addition, preferred stock may have cumulative dividends, whereas common stock will not.

SOLUTIONS MANUAL • CHAPTER 8  176

6.

Rights of a common stockholder • One vote per share.

• Preemptive right (right to maintain ownership percentage) • Share proportionately in dividends • Share proportionately in remaining assets of a liquidated corporation after creditors and preferred stockholders get their share.

Rights of a preferred stockholder • Receive dividend before common stockholders • Often entitled to a fixed annual rate • Sometimes dividends are cumulative • Fixed share of remaining assets of a liquidated corporation after debts to creditors have been settled.

Student preferences will be different as to which type of shareholder they prefer.

However, if the shareholder wishes to receive dividends and not bother with voting, the preferred stock is better; this is often the case with older shareholders.

7.

A corporation may decide to buy back its own shares from the market if it feels that the stock is selling for less than its actual value. The corporation may also want to buy back stock to use in providing employees with stock as part of an incentive package; the corporation may have issued all of its authorized stock. Buying back its own stock also has the impact of reducing the amount of dividends that a corporation must pay in the future.

Examples given by students will vary.

8.

When a cash dividend is declared and paid, cash is remitted to stockholders (creating a credit to cash). Because dividends are a distribution of earnings, retained earnings is also decreased (a debit).

In a stock dividend, stockholders receive additional shares of stock instead of cash. A stock dividend does not alter total stockholders’ equity; it just reorganizes the dollar amounts in stockholders’ equity accounts. A portion of retained earnings (generally equal to the stock’s market value on the declaration date) is moved from retained earnings to the common stock and APIC accounts (a debit to retained earnings and credits to common stock and APIC).

9.

A stock split increases the number of shares in the hands of stockholders and proportionately reduces the par value of the stock. A stock split does not affect total stockholders’ equity except to reduce the par value of the stock and increase the number of shares. Split shares often stimulates trading of shares that were too expensive to trade before the split, which may increase the value of a shareholders investment. (Reverse splits have the opposite effects.)

SOLUTIONS MANUAL • CHAPTER 8  177

10.

Retained earnings and cash are not the same account; therefore, the balances would be different. Retained earnings represents the cumulative income earned during the life of the corporation less any dividends declared; this amount does not have any relationship to the balance in the cash account.

11.

A prior period adjustment is made to correct an error that occurred in one fiscal year, but was found in a subsequent year. Because the year in which the error occurred has already been closed, the adjustment often affects the retained earnings account. For example if the error resulted in understating an expense, the correction would reduce retained earnings. These adjustments are made on the statement of stockholders’ equity.

12.

Return on equity is computed as [(Net income – preferred stock dividends)  average common stockholders’ equity]. This ratio is a measure of the firm’s profitability for the cycle.

EXERCISES

13.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)

14.

T T T F That class is automatically considered common stock.

F If common shares outstanding are less than common shares issued, the company has treasury stock.

F Authorized stock is the number of shares that can be sold.

F Companies can pay any amount for dividends as they have sufficient retained earnings and cash (or authorized but unissued stock).

T F Book value per share is computed by dividing common stockholders’ equity by the number of common shares outstanding.

T F Dividend yield is calculated for annual dividend divided by current market price of stock.

F Reverse stock splits cause the number of outstanding shares to decrease and the par value per share to increase.

(a) 3 (b) 6 (c) 1 (d) 4 (e) 7 (f) 9 (g) 10 (h) 11 (i) 5 (j) 8 (k) 2

SOLUTIONS MANUAL • CHAPTER 8  178

15.

Stephanie and Jason: There are many benefits to incorporating. Probably the biggest advantage is the limited liability of the owners. Put simply, should the corporation owe more than it has (e.g., in the event of bankruptcy or loss of a large lawsuit), the owners only stand to lose what they have invested; claimants cannot seek damages from the personal assets of the owners. In its current form, you are both personally liable for the debts of Videos Unlimited.

If Videos Unlimited continues to grow, the stock may eventually be traded on a stock exchange. Should you ever need to raise additional capital, you can sell shares of the stock (if the company’s credit is good). Also, if one owner wants out of the endeavor, his/her shares of stock can be transferred to another interested party.

However, there are several disadvantages of the corporate form of business. Perhaps the worst is double taxation. That is, corporate earnings are taxed as a separate entity (instead of being included with your personal income as you are doing now). When the earnings of the corporation are transferred to owners, the funds are taxed again on the individuals personal taxes. Also, corporations exist in a very regulated environment with rules issued by the state and national government (and the SEC if traded on an exchange). If Video Unlimited continues to grow and new owners are added, the profits will be distributed among more members.

16.

(a) (1) Cash (1,350,000 shares × $18 MV) Common Stock (1,350,000 shares × $0.50 PV) APIC-CS (1,350,000 shares × $17.50 MV–PV)

24,300,000

(2) Cash (1,350,000 shares × $18 MV) Common Stock (1,350,000 shares × $3.00 PV) APIC-CS (1,350,000 shares × $15 MV–PV)

24,300,000

(3) Cash (1,350,000 shares × $18 MV) Common Stock (1,350,000 shares × $18 MV)

24,300,000

675,000 23,625,000

4,050,000 20,250,000

24,300,000

(b) A company does not “profit” from the sale of its stock. When a company receives money from its investors the money is contributed equity and not revenue. If the selling price is not revenue, it cannot appear on the income statement, and therefore, cannot affect profit.

17.

(a) Issued refers to the number of shares that have ever been sold. An issued share must have been sold to a shareholder at some time since it was authorized, but there is no requirement that it is still owned by a shareholder. If that share is still issued by a shareholder, it is issued and outstanding. Therefore, a share of stock that was sold to a shareholder and then repurchased later by the issuing company is still issued, but not outstanding; instead that share is held as treasury stock.

SOLUTIONS MANUAL • CHAPTER 8  179

(b) (1) 3,790,000 (2) 70,000 (3) 1,260,000 (c) Authorized = 5,000,000 Issued = 3,800,000 Outstanding = 3,800,000 Treasury = 0 18.

(a) Dividend per share = $30,000  50,000 shares = $0.60 Dividends expected to receive = $0.60 × 5,000 share = $3,000 (or 5,000  50,000 = 10% ownership; $30,000 × 0.10 = $3,000) (b) The preemptive right gives a common stockholder the right to purchase a proportionate share of all new issues so that he/she can maintain a stated ownership percentage. Therefore, I will have the right to purchase 10% of 14,000 shares or 1,400 shares. (c) Total value of investment = $71 × 5,000 shares = $355,000 Book value per share = $3,200,000 ÷ 50,000 = $64 The book value of the investment is not equal to the amount that I paid for the stock.

The value of stock changes with time but the percentage of ownership will always remain the same, assuming all things constant. Because of constant market changes the book value of my investment is not equal to the market value of my investment.

19.

(a) Common Stock = 550,000 shares issued × $6 par value = $3,300,000 (b) Outstanding Shares = 550,000 issued – 40,000 in treasury = 510,000 shares (c)

Authorized Issued Outstanding Original 1,000,000 550,000 510,000 Option (a) × 2 × 2 × 2 2,000,000 1,100,000 1,020,000

Treasury 40,000 × 2 80,000

Option (b) Dividend shares = 510,000 × 15% = 76,500 Original 1,000,000 550,000 510,000 + 0 + 76,500 + 76,500 1,000,000 626,500 586,000

40,000 + 0 40,000

Original Option (c)

1,000,000  2 500,000

550,000  2 275,000

510,000  2 255,000

40,000  2 20,000

SOLUTIONS MANUAL • CHAPTER 8  180

(d)(1) Reduction in RE from 2:1 split = $0; balance in RE = $3,500,000 (2) Reduction in RE from stock dividend = 76,500 shares × $15 = $1,147,500; new balance in RE = $2,352,500 (3) Reduction in RE from 1:2 split = $0; balance in RE = $3,500,000 (e) (1) Par value per share after 2:1 split = $6 ÷ 2 = $3 Balance in Common Stock account = 1,100,000 × $3 = $3,300,000 (2) Par value per share after stock dividend = $6 Balance in Common Stock account = 626,500 × $3 = $1,879,500 (3) Par value per share after 1:2 = $6 × 2 = $12 Balance in Common Stock account = 550,000 × $6 = $3,300,000 (f) (1) Market value per share would decrease because there would be more shares outstanding representing the same amount of equity in the company.

(2) Same as (f)(1) for a dividend.

(3) Market value per share would increase because there would be fewer shares outstanding representing the same amount of equity in the company.

20.

(a) Treasury shares = Issued shares – outstanding shares Treasury shares = 400,000 – 380,000 = 20,000 shares (b) Dividend shares = 380,000 shares outstanding × 10% = 38,000 (c) (1) Stock Dividends - CS (38,000 shares × $40 MV) 1,520,000 Stock Dividends Distributable - CS (38,000 shares × $10 PV) 380,000 APIC - CS (38,000 shares × $30 MV–PV) 1,140,000 (2) no entry (3) Common Stock Dividends Distributable Common Stock

380,000 380,000

(d) No liability for the undistributed stock will be shown on the balance sheet.

Technically, liabilities are debts to others that will be settled using assets or issuing new liabilities. In this case, the company owes stock. The account Common Stock Dividends Distributable is a stockholders’ equity account.

SOLUTIONS MANUAL • CHAPTER 8  181

21.

(a) Annual preferred dividend = $5 per share × 10,000 shares = $50,000 (b) Year 2005 2006 2007 2008 2009 (c) (1) Year 2005 2006 2007 2008 2009

Dividend $170,000 0 110,000 30,000 200,000 Dividend $170,000 0 110,000 30,000 200,000

Due to PS $50,000 50,000 50,000 50,000 50,000

Paid to PS $50,000 0 50,000 30,000 50,000

Due to PS $ 50,000 50,000 100,000 50,000 70,000

Paid to CS $120,000 0 60,000 0 150,000

Paid to PS $50,000 0 100,000 30,000 70,000

Paid to CS $120,000 0 10,000 0 130,000

(2) In the case of cumulative preferred stock, dividends that are not paid in one year to preferred shareholders are carried forward to the next year. The amount of unpaid dividends at the end of any one year is called dividends in arrears, which is listed in the notes to the financial statements.

(3) Dividends in arrears are not listed as a liability on the balance sheet because there is no obligation to pay these dividends; the only obligation is that they be paid before common shareholders receive any dividends. As long as the dividends in arrears is included in the notes, generally accepted accounting principles has been followed and EAM is not misleading investors.

22.

(a) Effect on RE Issuing common stock No effect Cash dividend Decrease Stock dividend Decrease Stock split No effect Purchasing treasury stock No effect Selling treasury stock No effect Net income Net loss Prior period error that overstated revenues Prior period error that overstated expenses

(b) Timing of Effect

n/a Closing Closing n/a n/a n/a

(c) Effect on Total SE

Increase Decrease

Closing Closing

Increase Decrease No effect No effect Decrease Increase or decrease Increase Decrease

Decrease

Immediate

Decrease

Increase

Immediate

Increase

SOLUTIONS MANUAL • CHAPTER 8  182

23.

(a)

Biyama Corp.

Statement of Shareholders’ Equity For the Year ended December 31, 2009 Additional Preferred Common Paid-In Retained Stock Stock Earnings Capital

Balance at 1/1/09 Issuance of CS Purchase of TS Sale of TS Dividends (CS + PS) Net income Balance at 12/31/09

$650,000

$180,000

$2,628,000

2,000

70,000

$738,400

$182,000

$2,698,200

Total Shareholders’ Equity

$

$4,196,400

0

72,000

200

$650,000

Treasury Stock (at cost)

(6,300)

(6,300)

2,100

2,300

(53,800)

(53,800)

121,650

121,650

$806,250

$(4,200)

$4,332,250

(b) $5 per share × 6,500 shares = $32,500 preferred dividend Dividend to common = $53,800 - $32,500 = $21,300 24. (a) Book Value Per Share

(b) Return on Equity

= Common stockholders’ equity ÷ common shares outstanding

= (Net income – PS Div) ÷ Avg common stockholders’ equity

2005

= $262.3 ÷ 59.7 = $4.39

2006

= $337.8 ÷ 63.9 = $5.29

2007

= $337.4 ÷ 64.0 = $5.27

2008

= $454.1 ÷ 64.1 = $7.08

2009

= $456.1 ÷ 62.9 = $7.25

= ($55.4 - $1.5) ÷ [($228.7 + $262.3) ÷ 2] = $53.9  $245.5 = 22.0% = ($75.9 - $1.5) ÷ [($262.3 + $337.8) ÷ 2] = $74.4  $300.05 = 24.8% = ($88.2 - $1.5) ÷ [($337.8 + $ 337.4) ÷ 2] = $86.7  $337.6 = 25.7% = ($73.9 - $1.5) ÷ [($337.4 + $454.1) ÷ 2] = $72.4  $395.75 = 18.7% = ($55.4 - $1.5) ÷ [($454.1 + $456.1) ÷ 2] = $53.9  $455.1 = 11.8%

SOLUTIONS MANUAL • CHAPTER 8  183

(c) The trend in book value per share is favorable (increasing) but the trend in return on equity has declined sharply since 2007. This ROE decline can be attributed both to income declines and a large increase in common stockholders’ equity. (d) Some of the questions that might be asked include: (1) For what were the funds raised by selling stock used?

(2) When was the last time the company paid dividends to common stockholders?

(3) What rate(s) of dividends has (have) been paid on each share of common stock annually?

(4) What is causing the steep decline in income?

(5) By how much have fuel cost increases affected the company’s net income?

PROBLEMS 25.

(a) Land Common Stock (1,400 x $1 = $1,400) Paid-in Capital - Common Stock

110,000

(b)Land (1,400 x $75 MV) Common Stock (1,400 x $1 PV) APIC-CS (1,400 x $74 MV-PV)

105,500

(c) Cash (1,400 x $80 MV) Common Stock (1,400 x $1 PV) APIC-CS (1,400 x $79 MV-PV)

112,000

Land Cash

1,400 108,600 1,400 103,600 1,400 110,600 110,000 110,000

(d) There is no difference on stockholders’ equity between parts (b) and (c). However there are differences with respect to assets. Under part (b), the land is recorded at $105,500 and cash is unaffected. In part (c), the land is recorded at $110,000 and cash is increased by $2,000 (+$112,000 – $110,000).

26.

(a) A company will buy back its own stock to reduce the number of shares outstanding and, thus, amount of dividends that it is required to pay. Also, a company may purchase its own shares if it believes the stock is selling for less than its actual value or if it needs shares to issue as part of employee compensation. (b) Treasury Stock Cash

1,950,000 1,950,000

($1,950,000 ÷ 65,000 shares = $30 per share)

(c) Cash (2,000 × $35) Treasury Stock (2,000 × $30) APIC-TS (2,000 x $5)

70,000 60,000 10,000

SOLUTIONS MANUAL • CHAPTER 8  184

(d) Cash (3,000 × $27) APIC-TS (3,000 x $3) Treasury Stock (3,000 × $30)

81,000 9,000 90,000

(e) A company cannot own itself; therefore treasury stock is just a reduction in equity, not an asset.

27.

(a) The dividend became a liability on January 11, the date of declaration. (b) 1/11

Dividends Dividends Payable

200,000 200,000

(1,000,000 x $0.20 = $200,000)

2/12

no entry

3/9

Dividends Payable Cash

200,000

12/31 Retained Earnings Dividends

200,000

200,000 200,000

(c) The board of directors authorized the dividend. (d) Organizations must disclose the amount of cash dividends declared and paid out for the last five years. Any significant restrictions on the amount of dividends that can be declared must also be disclosed. Investors would want to know how frequently dividends had been declared and how if dividends in arrears exist.

28.

(a) Biloxi should disclose the fact that dividends in arrears exist in the amount of $240,000 (10,000 shares x $8 per share dividend x 3 years). (b) This disclosure should be made in the footnotes to the financial statements. (c) Dividends in arrears information indicates the amount of dividends that preferred shareholders must receive before common shareholders can be paid anything.

Potential investors in preferred stock may view this information as negative (in that the company is not meeting its obligations to preferred shareholders). Potential common shareholders also view this information as negative because they recognize that $240,000 of dividends must be paid to preferred shareholders before the common shareholders are entitled to any dividends. (d) PS dividend = Dividends in arrears + Current year’s dividends PS dividend = $240,000 + $80,000 = $320,000 CS dividend = Total dividends – PS dividend CS dividend = $500,000 – $320,000 = $180,000 Dividend per common share = $180,000  250,000 = $0.72

SOLUTIONS MANUAL • CHAPTER 8  185

(e) Dividend yield per common share = Annual dividend ÷ Market price Dividend yield per common share = $0.72 ÷ $18 = 4.0% The yield rate is low, but the rate should be compared to other investment opportunities. For example, in 2009, most savings and CD rates were lower than 4%-as were returns on many stock investments.

29.

(a) (1) No effect (2) Decrease (3) No effect (b) Treasury shares = Issued shares – Outstanding shares Treasury shares = 4,600,000 – 4,200,000 = 400,000 Dividends are not distributed to treasury shares because a company does not pay dividends to itself. (c) Dividend shares = Outstanding shares × Dividend percentage Dividend shares = 4,200,000 × 5% = 210,000 shares (d) (1) Dividends (210,000 shares × $18) CS Dividends Distributable (210,000 shares × $5) APIC-CS (210,000 shares × $13)

3,780,000 1,050,000 2,730,000

(2) no entry (3) CS Dividends Distributable Common Stock 30.

(a) 1/10

3/30

6/12

10/3

11/4

1,050,000 1,050,000

Cash (22,000 × $18) Common Stock (22,000 × $3) APIC-CS (22,000 × $15)

396,000

Cash (5,000 × $145) Preferred Stock (5,000 × $100) APIC-PS (5,000 × $45)

725,000

Building (3,000 × $22) Common Stock (3,000 × $3) APIC-CS (3,000 × $19)

66,000

Cash (7,000 × $27) Common Stock (7,000 × $3) APIC-CS (7,000 × $24)

189,000

Dividends (5,000 × $5) Dividends Payable - PS

25,000

66,000 330,000 500,000 225,000 9,000 57,000 21,000 168,000 25,000

SOLUTIONS MANUAL • CHAPTER 8  186

11/21

no entry

12/6

Dividends Payable - PS Cash

25,000

Income Summary Retained Earnings

734,000

Retained Earnings Dividends

25,000

(b) 12/31

(c)

25,000

734,000

25,000

Dozier Manufacturing Partial Balance Sheet December 31, 2009

STOCKHOLDERS’ EQUITY Paid-In Capital Capital Stock $100 par cumulative Preferred Stock - authorized 50,000 shares; issued and outstanding, 5,000 shares $3 par Common Stock- authorized 800,000 shares; issued and outstanding, 32,000 shares Total Capital Stock Additional Paid-in-Capital Preferred Stock Common Stock Total Paid-In Capital Retained Earnings Total Stockholders’ Equity

$ 500,000 96,000 $ 596,000

$225,000 555,000

(d) 1/10 Cash Common Stock

396,000

6/12 Building Common Stock

66,000

10/3 Cash Common Stock

189,000

(e) 6/12 Building Common Stock (3,000 × $3) APIC-CS (f) The full disclosure principle dictates this inclusion.

780,000 $1,376,000 709,000 $2,085,000

396,000

66,000

189,000 71,000 9,000 62,000

SOLUTIONS MANUAL • CHAPTER 8  187

31.

(a)

Ariat Productions, Inc. Partial Balance Sheet December 31. 2008

STOCKHOLDERS’ EQUITY Paid-In Capital Capital Stock 6%, $10 par cumulative Preferred Stock - authorized 5,000,000 shares; 1,200,000 issued and outstanding $0.10 par Common Stock- authorized 7,500,000 shares; 4,925,000 issued; 4,804,200 outstanding Total Capital Stock Additional Paid-in-Capital Common Stock Total Paid-In Capital Retained Earnings ($1,819,360 - $720,000 PS dividend) Paid-In Capital & Retained Earnings Less: Treasury Stock (120,800 shares) Total Stockholders’ Equity

$12,000,000 492,500 $12,492,500 75,845,000 $88,337,500 1,099,360 $89,436,860 (1,932,800) $87,504,060

Ariat Productions, Inc. Partial Balance Sheet December 31. 2009 STOCKHOLDERS’ EQUITY Paid-In Capital Capital Stock 6%, $10 par cumulative Preferred Stock - authorized 5,000,000 shares; 1,200,000 issued and outstanding $0.10 par Common Stock- authorized 7,500,000 shares; 4,983,000 issued; 4,878,700 outstanding Total Capital Stock Additional Paid-in-Capital Common Stock and Treasury Stock ($76,964,400 + $40,000) Total Paid-In Capital Retained Earnings ($1,099,360 + $1,083,700 - $720,000 PS dividend) Paid-In Capital & Retained Earnings Less: Treasury Stock (104,300 shares) Total Stockholders’ Equity (b) 2008 BVPS = CS Equity ÷ CS Outstanding 2008 BVPS = ($87,504,060 – $12,000,000) ÷ 4,804,200 2008 BVPS = $75,504,060 ÷ 4,804,200 2008 BVPS = $15.72 2009 BVPS = ($89,279,460 – $12,000,000) ÷ 4,878,700 2009 BVPS = $77,279,460 ÷ 4,878,700 2009 BVPS = $15.84

$12,000,000 498,300 $12,498,300 77,004,400 $89,502,700 1,463,060 $90,965,760 (1,686,300) $89,279,460

SOLUTIONS MANUAL • CHAPTER 8  188

(c) 2008 ROE = (Net income – PS Div) ÷ Avg. CS Equity 2008 ROE = ($1,819,360 - $720,000)  [($0 + $87,504,060)  2] 2008 ROE = $1,099,360  $43,752,030 2008 ROE = 2.5% 2009 ROE = ($1,083,700 - $720,000)  [($87,504,060 + $77,279,460)  2] 2009 ROE = $363,700  $82,391,760 2009 ROE = 0.4% The ROE is deteriorating. (d) Dividend per share = Dividends ÷ Shares outstanding Dividend per share = $720,000 ÷ 4,878,700 = $0.15 (rounded) Dividend yield = Dividend per share ÷ Market value per share Dividend yield = $0.15 ÷ $20 = 0.0075 (e) Par values are often set at very low amounts because the balance in the stock accounts is considered “legal capital” and must be maintained in the business. Additionally, by setting a very low par value, a company does not have to worry that the initial public offering of its stock might be at a price below par value per share (which is illegal in most states).

CASES 32.

If Dee will encounter cash flow problems after issuing a cash dividend, it would be wise for the company to choose an alternative. A stock split will have no effect on Dee’s financial statements, but it will require a lot of paperwork. Unless the stock is trading at a very high price, the split is unlikely to have any benefit. In fact, the stockholders and potential investors are likely to see it as a poor substitute for dividends. A mid-year cash dividend in the following year might be an option for Dee, whose stockholders might simply view it as a couple of months late, especially if the cash flow issues are over.

However shareholders and potential investors are likely to see the delay as a “first sign” of trouble.

The stock dividend is a good substitute for a cash dividend. Dee has been profitable, so it is likely that the company has sufficient Retained Earnings for a stock dividend to be declared. If investors desire, they can convert the new shares into cash (although that will reduce their equity position in the firm).

33.

(a) Authorized Issued shares Outstanding shares Treasury shares

2006 1,960,000,000 641,000,000 623,000,000 18,000,000

2007 1,960,000,000 643,000,000 624,000,000 19,000,000

SOLUTIONS MANUAL • CHAPTER 8  189

(b) Note 9 – Stockholders’ Equity (pg. 23) Yes. Although 40 million shares have been authorized, no preferred shares have been issued. Thus, there is no financial data related to the preferred shares presented on the balance sheet. (c) 2006 Cash Dividends = $803,000,000 2007 Cash Dividends = $990,000,000 (d) BVPS = Stockholders’ Equity ÷ Weighted Average Common Shares Outstanding* BVPS = $19,963,000,000 ÷ 793,000,000 BVPS = $25.17 *From Note 14, p. F-25 Dividend Yield = Dividend per share ÷ Market Value per share Dividend Yield = $1.375 ÷ $25 Dividend Yield = 5.5% ROE = (Net Income – PS Div) ÷ Avg. CS Equity ROE = $2,408,000,000 ÷ [($19,963,000,000 + $18,210,000,000) ÷ 2] ROE = $2,408,000,000  $19,086,500,000 ROE = 12.6% (e) The BVPS indicates that for every share of Carnival owned, the stockholder owns $25.17 of Carnival’s book value. For that privilege, investors were willing to pay $25, an indication that investors believe that Carnival’s asset values are approximately close to their fair market values. The dividend yield is only $0.055 for every dollar invested, which may be discouraging to investors. However, using the money invested, Carnival is able to generate almost $0.12 for each dollar of equity.

34.

Answers will vary.

35.

(a) Cash Common Stock (100,000 × $1) APIC-CS

200,000

Land Building Common Stock (100,000 × $1) APIC-CS

50,000 175,000

(b) Cash (10,000 × $10) Common Stock (10,000 × $1) APIC-CS (10,000 × $9)

100,000

100,000 100,000

100,000 125,000 10,000 90,000

(c) No entry required. This transaction is between one stockholder and another and has no effect on Spader Inc.’s financial statements.

SOLUTIONS MANUAL • CHAPTER 8  190

36.

(a) Because of the preemptive right of shareholders, any shares that have never been issued must be offered to the shareholders first. (b) Treasury Stock (20,000 × $40) Cash

800,000

(c) Bonus Expense Treasury Stock

800,000

800,000

800,000

There is no effect on the Common Stock account because the 20,000 shares of treasury stock were still considered issued (but not outstanding) upon their acquisition. As such, Common Stock was not reduced when the shares were acquired as treasury stock nor is Common Stock increased when the treasury shares are reissued.

37.

(a) Authorized Issued Outstanding Treasury Par value CS account

Original 1,000,000 475,000 425,000 50,000 $1 $475,000

After 11/1/07 1,000,000 517,500 517,500 50,000 $1 $517,500

After 10/8/08 4,000,000 2,070,000 2,070,000 200,000 $0.25 $517,500

After 11/5/09 4,000,000 2,070,000 2,070,000 200,000 $0.25 $517,500

Dividend shares = 425,000 × 10% = 42,500 (b) 11/1

Dividends (42,500 × $50) CS Dividends Distributable (42,500 × $1) APIC-CS (42,500 × $49)

10.8

No entry for a stock split

11/5

Dividends (2,070,000 × $1) Dividends Payable

2,125,000 42,500 2,082,500

2,070,000 2,070,000

(c) Paying a cash dividend might have created a cash flow problem. (d) If the stock price was trading at a high price, a split would decrease the trading price and perhaps stimulate increased trading. (e) Answers will vary.

38.

(a) In the 2008 notes to the financial statements, McBain Industries should disclose the dividends in arrears of $25,000 for the dividends not paid to preferred shareholders.

Also, a list of all dividends paid in latest five years will be disclosed.

SOLUTIONS MANUAL • CHAPTER 8  191

(b) Preferred Stock Dividend 2008 Preferred Stock Dividend 2009 Common Stock Dividend 2009 (450,000 × $0.50) Total Dividend

$ 25,000 25,000 225,000 $275,000

(c) The $25,000 to preferred stockholders for 2008 would not be necessary. Thus, the total dividend paid in 2009 would have been $250,000 ($25,000 to preferred and $225,000 to common). (d) 8/8 Dividends Dividends Payable

275,000

9/15 Dividends Payable Cash

275,000

275,000

275,000

(e) There will be a discussion about the dividends paid. Also, that amount will reduce year-end Retained Earnings, which will be depicted on the Statement of Stockholders’ Equity. Also, a list of all dividends paid in latest five years will be disclosed.

39.

(a) Common Stockholders Equity = Common Stock + RE – Treasury Stock 2007 CSE = $9,795 + $10,994 – $601 = $20,188 2008 CSE = $9,234 + $12,256 – $605 = $20,885 2009 CSE = $8,970 + $12,739 – $729 = $20,980 (1) BVPS = CS Equity ÷ Shares outstanding 2007 = $20,188 ÷ 2,070 = $9.75 2008 = $20,885 ÷ 2,071 = $10.08 2009 = $20,980 ÷ 2,068 = $10.15 (2) Dividend Yield = Dividend per share ÷ Market Value 2007 = ($484 ÷ 2,070) ÷ $32.20 = 0.73% 2008 = none 2009 = ($457 ÷ 2,068)÷ $27.95 = 0.79% (3) ROE = Net Income ÷ Average CS Equity 2008 = $1,380 ÷ [($20,188 + $20,885) ÷ 2] = $1,380  $20,536.5 = 6.7% 2009 = $1,220 ÷ [($20,885 + $20,980) ÷ 2] = $1,220  $20,932.5 = 5.8% (b) BVPS and Dividend Yield made small increases, but ROE has decreased. The decline in ROE could be reflective of poor economic circumstances and fewer people going out to dinner in restaurants. (c) Depending on the source of the industry information, student answers are likely to vary.

SOLUTIONS MANUAL • CHAPTER 9  200

CHAPTER 9 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1.

(a) Less than 20% ownership: Income Statement: Dividends received from Sanri are recorded as revenues Balance Sheet: Investment in Sanri is recorded as an asset at original cost; at year-end the investment account is adjusted to fair market value with an off-setting adjustment to equity (b) 20-50% ownership Income Statement: Paolo’s portion of Sanri’s income or loss appears on the income statement as an income or loss from unconsolidated affiliates Balance Sheet: The investment in Sanri is recorded as an asset at original cost; dividends received from Sanri reduce the investment account; and Paolo’s portion of Sanri’s income or loss used to adjust the investment account. (c) Greater than 50% ownership Income Statement: The income statements of both companies are consolidated and the effects of intercompany transactions are elminated and any minority interest in Sanri is deducted Balance Sheet: The investment in Sanri is recorded as an asset at original cost; dividends received from Sanri reduce the investment account; Paolo’s portion of Sanri’s income or loss used to adjust the investment account; and the balance sheets of both companies are consolidated and the investment account and effects of intercompany transactions are eliminated and any minority interest in Sanri is recorded

2.

Companies purchase the stock or bonds of other entities to invest for cash requirements for the short-term run. Other companies invest for the long-term in stock or bonds of other entities because the investing corporation wants to establish a working relationship with the other entity.

3.

Income from continuing operations is used by decision makers in developing financial forecasts for the organization. This line item is considered to be the one that might be best used to forecast because there should be no nonrecurring items included in it.

4.

Discontinued operations are shown separately on a corporate income statement as an indication that these items are not part of the firm's continuing operations and should not be considered in financial projections. Typically, two items are included: (1) any net income or net loss from that organization for the portion of the year it was operated, and (2) any realized gain or loss from the sale of the assets of the discontinued organization.

SOLUTIONS MANUAL • CHAPTER 9  201

5.

The most simplistic calculation of earnings per share is computed by dividing net income minus preferred stock dividends by the weighted average shares of common stock outstanding during the cycle. Earnings per share is the portion of net income associated with one share of stock outstanding for the fiscal year. This ratio is one of the most influential as evidenced by the stock market reaction to unexpected negative or positive EPS. Other financial ratios may be computed differently by different users, whereas the EPS calculation is standardized.

6.

Taxable income is the amount of income that is reported to the Internal Revenue Service and on which corporations pay taxes. Income before income taxes is also know as pretax accounting income and is calculated using generally accepted accounting principles.

Because there are differences between the accounting for some items for tax and GAAP purposes, taxable income is not always equal to income before income taxes.

7.

A temporary difference is one that will eventually reverse itself. With respect to income taxes, a temporary difference arises because there are different rules for generally accepted accounting principles and tax law. For example, an asset can be depreciated differently on the income statement and on the tax return. Therefore, in any one year that asset is being depreciated, taxable income and income before income taxes will be different. However, the difference is temporary because, regardless of how the depreciation expense is spread over the life of the asset, total depreciation expense and deductions over the asset’s life will be the same.

Temporary differences create deferred income taxes, which are shown on the balance sheet. The differences will be shown as deferred tax assets if the company taxable income is more than income before income taxes. If the reverse is true, the difference is a deferred tax liability.

8.

A corporation uses a Deferred Income Taxes account when there is a difference between the amount of taxes payable determined on the tax return and the amount of tax expense determined on the income statement. Regardless of whether the deferred tax is an asset or liability, it is usually long-term because there may be several years before the differences are reversed. However, the Deferred Income Tax account is usually a liability account, because companies try to defer the payment of taxes for as long as possible.

9.

Investors rely on corporate income statements to determine if they should make initial investments or invest additional funds in a firm. Creditors rely on corporate income statements to determine an organization's profitability to make decisions concerning whether the organization would be able to pay interest and maturity values on a timely basis. Regulators may use financial statements to assess compliance with regulations or determination of rate bases.

SOLUTIONS MANUAL • CHAPTER 9  202

10.

Trend analysis tracks proportional changes in financial statement items over a number of accounting cycles. Financial statement items in trend analysis are presented as a percentage of a base year. Trend analysis is used to predict future dollar amounts for certain financial statement items.

Common-sized financial statements are used to gain a better understanding of relationships among items in a financial statement for a number of years. These statements are also used as a comparison against industry norms for a company. Items in common-sized financial statements are presented as a percentage of total assets on the balance sheet and net revenue on the income statement. Common-sized statement can be used to determine how financial statement relationships within given categories have changed over time.

Ratio analysis studies the relationships between two (or more) financial statement items.

Cross-sectional ratio analysis compares a company’s financial ratios with those of competitors. Longitudinal ratio analysis focuses on changes in a company’s financial ratios over a period of time.

11.

(a) Liquidity is defined as the ability to pay debts as they come due. The current and quick ratios are examples of liquidity ratios. Liquidity ratios show relationships between current assets from which liabilities are paid and current liabilities. (b) Leverage addresses the relationship between debt and equity sources of capital. Debt to total assets and debt to equity ratios are leverage ratios. (c) Activity ratios measure how well a company is using its assets. Common activity ratios examine turnover or accounts receivable, inventory, and total assets. (d) Profitability ratios measure the company’s ability to use its assets and equity to generate profits. Return on equity and return on assets are common measure of profitability. Also, the gross profit percentage and the profit margin percentage measure how revenues relate to profit. (e) Market strength ratios measure how capital markets perceive the company’s common stock. The price-earnings ratio and market to book value ratio will help investors decide if the purchase of a particular company’s stock is a good investment.

12.

Earnings quality relates to the degree to which reported earnings reflect the firm’s economic income. Several factors that affect earnings quality include different methods of accounting for items (such as depreciation or inventory cost flow), whether income is controllable, continuing, and collectible, management's delaying the recognition of expenses or advancing the recognition of revenues, and the potential for fraud in an organization.

SOLUTIONS MANUAL • CHAPTER 9  203

13.

Earnings management refers to using bending or manipulating GAAP (or outright violating it) in an effort to achieve a desired net income amount. If earnings management presents a more favorable (or less favorable, which is unusual) earnings number, then financial income ceases to accurately reflect economic income and is, therefore, of lower quality.

EXERCISES

14.

(a) F Taxes are based on taxable income shown on the tax return. (b) F A change in accounting principle is not an extraordinary item and should not be reported on the income statement. (c) T (d) F A bargain would be indicated by a lower price-earnings ratio. (e) F Consolidation would not take place until over 50 percent of Company B was earned. (f) F Liquidity ratios evaluate liquidity. (g) T (This answer assumes that common-sized financial statements have been computed for multiple years.) (h) F Stockholders benefit when interest paid is less than the rate of return. (i) T (j) T (k) F Each line item is expressed as a percentage of total assets. (l) F Company P will not show a discount account related to the bond investment. (m) T

15.

(a) Gross Profit Operating Income Income from Continuing Operations Discontinued Operations Extraordinary Loss Net Income (b) Discontinued Operations Extraordinary Loss (c) Extraordinary items, by definition, are material items that are unusual in nature and infrequent in occurrence in the environment that the business operates. These items should be shown separately on the income statement to alert readers that something out of the ordinary happened during the accounting cycle and is not likely to reoccur. (d) Income from continuing operations usually refers to the profit oriented operations of the firm. The items that are presented after continuing operations typically are not expected to have an effect on future years. Therefore, income from continuing operations is the best indicator of future earnings.

SOLUTIONS MANUAL • CHAPTER 9  204

16.

(a) (b) (c) (d) (e) (f) (g)

17.

Income Statement items presented in order: (g) (a) (m) (k) (d) (f) (e)

3 7 4 5 2 1 6 Net Sales Cost of Goods Sold Selling and Administrative Expenses Gain on Sale of Equipment (assumes not from discontinued operations) Income Tax Expense Loss from Discontinued Operations (net of taxes) Earnings per Share

Items that are not presented on the income statement: (b) (c) (h) (i) (j)

Income Taxes Payable: current liability on balance sheet Accounts Receivable: current asset on balance sheet Possible Loss from Lawsuit; disclosed in the footnotes if reasonably estimable Accounts Payable: current liability on balance sheet Dividends (declared by the Board of Directors): reduction to retained earnings on the statement of stockholders’ equity; Dividends Payable would be shown on the current liability section of the balance sheet. (l) Salaries Payable: current liability on the balance sheet (n) Stock dividends declared but not yet distributed: paid-in capital account in the stockholders’ equity section of the balance sheet

18.

(a) 1/1– 3/31 400,000 x 3/12 4/1– 8/31 480,000 x 5/12 9/1– 12/31 600,000 x 4/12 Total weighted-average shares

100,000 200,000 200,000 500,000

(b) $375,000  500,000 = $ 0.75 per share (c) The weighted-average number of shares is used as the denominator in the calculation because that number better represents the actual capital availability from common stock. Using the number of shares outstanding at the end of the year would distort the calculation, because earnings were generated throughout the year using the equity provided by stocks that were not outstanding throughout the year.

SOLUTIONS MANUAL • CHAPTER 9  205

19.

(a) 1 (b) 10 (c) 9 (d) 3 (e) 11 (f) 7 (g) 5 (h) 4 (i) 6 (j) 8 (k) 2

20.

(a)(1) Potential investors would want to know if the company is sound, is profitable, has paid dividends recently, and how strong the market is for that particular company.

(2) In addition to the items in (1), a potential executive would want to know what type of bonus arrangements the company has, level of stock options outstanding, pension arrangements, and contingent liabilities.

(3) Bankers would want to know the level of debt compared to ownership equity and whether the company has been paying its debts and related interest on time.

Bankers would perform ratio analysis to determine liquidity and financial stability.

(4) Suppliers would want to know if the firm is paying its debts on time or if it is behind on payments. Suppliers would be interested in liquidity ratios. (b) Any of the above could use annual reports and filings with the SEC to gather information and Dunn & Bradstreet reports (or others) to compare a company to others in the same industry. Footnotes are an extremely important source of information.

SOLUTIONS MANUAL • CHAPTER 9  206

21.

TREND ANALYSIS BALANCE SHEET ASSETS Cash and Cash Equivalents Marketable Securities Receivables Inventory Deferred Income Taxes Other Current Assets TOTAL CURRENT ASSETS Property, Plant and Equipment Other Assets TOTAL ASSETS

2007 $ 118,044 530,486 53,801 333,153 36,128 68,643 $1,140,255 1,318,291 109,052 $2,567,598

144.0% 118.5% 124.4% 77.9% 108.9% 117.4% 104.4% 120.7% 171.2% 114.2%

$

2006 81,959 447,793 43,240 427,447 33,170 58,469 $1,092,078 1,092,282 63,707 $2,248,067

100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

$ 108,437 43,361 280,910 37,325 72,480 $ 543,113

107.5% 158.3% 108.0% 105.4% 83.6% 106.4%

$ 100,919 27,391 260,219 35,423 86,675 $ 510,267

100% 100% 100% 100% 100% 100%

22,491 213,739 169,942 $ 406,172

74.0% 104.8% 173.8% 122.3%

30,394 203,943 97,806 $ 332,143

100% 100% 100% 100%

SHAREHOLDERS' EQUITY Common Stock Paid-In Capital Retained Earnings

1,033 319,451 2,051,463

1,033 289,732 1,646,290

100% 100% 100%

Accumulated Other Comprehensive Income Treasury Stock TOTAL SHAREHOLDERS' EQUITY

7,118 -760,752 $1,618,313

100.0% 110.3% 124.6% 716.1% 143.3% 115.2%

-994 -530,764 $1,405,297

100% 100% 100%

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY

$2,567,598

114.2%

$2,248,067

100%

LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts Payable Outstanding Checks Accrued Expenses Deferred Lease Credits Income Taxes Payable TOTAL CURRENT LIABILITIES LONG-TERM LIABILITIES Deferred Income Taxes Deferred Lease Credits Other Liabilities TOTAL LONG-TERM LIABILITIES

SOLUTIONS MANUAL • CHAPTER 9  207

TREND ANALYSIS INCOME STATEMENT Net Sales Cost of Goods Sold Gross Profit Stores & Distribution Expense Marketing, General & Admin. Exp. Other Operating Income, Net OPERATING INCOME Interest Income, Net INCOME BEFORE TAXES Provision for Income Taxes NET INCOME OTHER COMPREHENSIVE INCOME Cumulative Foreign Currency Trans. Adj. Unrealized Gains(Losses) on Marketable Other Comprehensive Income (Loss) COMPREHENSIVE INCOME

2007 $3,749,847 -1,238,480 $2,511,367 -1,386,846 -395,758 11,734 $ 740,497 18,828 $ 759,325 -283,628 $ 475,697

113.0% 111.7% 113.7% 116.8% 105.9% 117.5% 112.5% 135.5% 113.0% 113.5% 112.7%

2006 $3,318,158 -1,109,152 $2,209,006 -1,187,071 -373,828 9,983 $ 658,090 13,896 $ 671,986 -249,800 $ 422,186

100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

7,328 784 8,112 $ 483,809

-3166.1% 1912.2% -4197.0% 114.7%

-239 41 -198 $ 421,988

100% 100% 100% 100%

SOLUTIONS MANUAL • CHAPTER 9  208

22.

(a)

COMMON SIZE BALANCE SHEET ASSETS Cash and Cash Equivalents Marketable Securities Receivables Inventory Deferred Income Taxes Other Current Assets TOTAL CURRENT ASSETS Property, Plant and Equipment Other Assets TOTAL ASSETS

2007 $ 118,044 530,486 53,801 333,153 36,128 68,643 $1,140,255 1,318,291 109,052 $2,567,598

4.6% 20.7% 2.1% 13.0% 1.4% 2.7% 44.4% 51.3% 4.3% 100.0%

$ 108,437 43,361 280,910 37,325 72,480 $ 543,113

4.2% 1.7% 10.9% 1.5% 2.8% 21.2%

22,491 213,739 169,942 $ 406,172

0.9% 8.3% 6.6% 15.8%

SHAREHOLDERS' EQUITY Common Stock Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income Treasury Stock TOTAL SHAREHOLDERS' EQUITY

1,033 319,451 2,051,463 7,118 -760,752 $1,618,313

0.0% 12.4% 79.9% 0.3% -29.6% 63.0%

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY

$2,567,598

100%

LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts Payable Outstanding Checks Accrued Expenses Deferred Lease Credits Income Taxes Payable TOTAL CURRENT LIABILITIES LONG-TERM LIABILITIES Deferred Income Taxes Deferred Lease Credits Other Liabilities TOTAL LONG-TERM LIABILITIES

SOLUTIONS MANUAL • CHAPTER 9  209

22 (b) COMMON SIZE INCOME STATEMENT Net Sales Cost of Goods Sold Gross Profit Stores & Distribution Expense Marketing, General & Admin. Exp. Other Operating Income, Net OPERATING INCOME Interest Income, Net INCOME BEFORE TAXES Provision for Income Taxes NET INCOME OTHER COMPREHENSIVE INCOME Cumulative Foreign Currency Trans. Adj. Unrealized Gains(Losses) on Marketable Other Comprehensive Income (Loss) COMPREHENSIVE INCOME

$3,749,847 -1,238,480 $2,511,367 -1,386,846 -395,758 11,734 $ 740,497 18,828 $ 759,325 -283,628 $ 475,697

100.0% 33.0% 67.0% 37.0% 10.6% 0.3% 19.7% 0.5% 20.2% 7.6% 12.7%

7,328 784 8,112 $ 483,809

0.2% 0.0% 0.2% 12.9%

23.(a) (1) Current ratio = Current Assets/Current Liabilities Current ratio = $1,140,255 ÷ $543,113 = 2.10 (2) Quick ratio = Quick Assets/Current Liabilities Quick ratio = [$118,044 + $530,486 + $53,801] ÷ $543,113 = 1.29 (3) Debt to Total Assets = Total Liabilities Total Assets Debt to Total Assets = [$406,172 + $543,113] ÷ $2,567,598 = 36.97% (4) Long-term Debt to Equity = Total Long-term Debt  Total Equity Long-term Debt to Equity = $406,172 ÷ $1,618,313 = 25.10% (5) Accounts Receivable Turnover = Net Sales  Avg. Accts. Receivables (Net) Accounts Receivable Turnover = $3,749,847 ÷ [($53,801 + $43,240)  2] Accounts Receivable Turnover = $3,749,847 ÷ $48,520.50 = 77.28 (6) Inventory Turnover = Cost of Goods Sold  Avg. Inventory Inventory Turnover = $1,238,480 ÷ [($333,153 + $427,447)  2] Inventory Turnover = $1,238,480 ÷ $380,300 = 3.26 (7) Gross Profit Percentage = Gross Profit  Sales Gross Profit Percentage = $2,511,367 ÷ $3,749,847 = 66.97% (8) Return on Equity = Net Income  Avg. Shareholders’ Equity Return on Equity = $475,697 ÷ [($1,618,313 + $1,405,297)  2] Return on Equity = $475,697 ÷ $1,511,805 = 31.47%

SOLUTIONS MANUAL • CHAPTER 9  210

(b) Some of Abercrombie & Fitch’s significant accounting policies are as following: o Revenue recognition o Contingencies o Inventories o Foreign Currency Translations o Credit Card Receivables o Income Taxes (c) Some of Abercrombie & Fitch’s business risk factors include the following: o Changes in consumer spending patterns and consumer preferences o Effects on consumer purchases due to a general economic downturn o Ability to develop innovative, high-quality new merchandise in response to changing fashion trends o Currency and exchange risks and changes in existing or potential duties, tarrifs or quotas 24.

Charlie: Earnings quality is defined as the degree of correlation between a firm’s economic income and its reported earnings determined by GAAP. Several factors that affect earnings quality include: (1) different methods of accounting for depreciation, (2) different methods of accounting for cost of goods sold, (3) different methods of accounting for bad debts, and (4) management delaying recognizing expenses.

For example, if a firm chooses to straight-line depreciate a fixed asset that cost $50,000 and had a salvage value of $2,000 and an estimated useful life of 5 years, deprecation expense each year would be $9,600. If that same firm chose to use double-declining balance method of computing depreciation, the amount for the first year would be $20,000. Both of these methods are generally acceptable for accounting for depreciation.

These two different amounts of depreciation would cause net income to be different amounts in the same year. The method chosen to depreciate assets must be used consistently so as not to cause further distortion to net income.

To properly evaluate a firm’s quality of earnings, you should be familiar with that particular firm and the industry in which it operates. You should also look at footnote disclosures to assess the items mentioned there. Examining competitor’s financial statements might also provide some insight into the quality of earnings in that industry.

SOLUTIONS MANUAL • CHAPTER 9  211

PROBLEMS 25.

(a) (1) Investment in Walker Cash

300,000

Cash Dividend Revenue

5,000

(2) Investment in Walker Cash

300,000

300,000

5,000

300,000

Cash Investment in Walker

5,000

Investment in Walker Income from Walker

40,000

(3) Investment in Walker Cash

5,000

40,000 300,000 300,000

Cash Investment in Walker

5,000

Investment in Walker Income from Walker

80,000

5,000 80,000

(b) (1) Adler will adjust its Investment in Walker account to fair market value by debiting (crediting) the investment account for an increase (decrease) and crediting (debiting) an unrealized gain (loss) stockholders’ equity account.

(2) No other entries will be made.

(3) Adler will consolidate its financial statements with Walker’s financial statements, which involves eliminating intercompany transactions and the Investment in Walker account as well as deducting minority interests in Walker on the income statement and recording a Minority Interest account on the balance sheet. (c) Investment in Bonds Cash Cash Investment in Bonds ($100 discount 20 periods) Bond Interest Revenue ($5,000 × 10% × 6/12)

4,900 4,900 250 5 255

SOLUTIONS MANUAL • CHAPTER 9  212

26.

Kagawa Company Income Statement For the year ended December 31, 2009 Net Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Continuing Operations (before taxes) Income Taxes Current Deferred Income from Continuing Operations Discontinued Operations: Operating Income (net of tax) Gain on Sale of Assets (net of tax) Income Before Extraordinary Items Flood Loss (net of tax) Net Income

$660,000 (370,000) $290,000 (134,000) $ 156,000 $40,000 22,400

$ 38,400 33,000

Earnings Per Share: Income from Continuing Operations Income from Discontinued Operations Income Before Extraordinary Items Extraordinary Loss Net Income 27.

(a) 252,000 x 1/12 300,000 x 8/12 360,000 x 2/12 348,000 x 1/12 Total WA shares

(62,400) $ 93,600

71,400 $165,000 (100,200) $ 64,800 $0.62 0.48 $1.10 (0.67) $0.43

21,000 200,000 60,000 29,000 310,000

(b) Earnings Per Share Income from Continuing Operations Discontinued Operations Income Before Extraordinary Item Extraordinary Item Net Income

$1.81 (0.02) $1.79 (0.23) $1.56

SOLUTIONS MANUAL • CHAPTER 9  213

28.

(a) It is not unethical to use different accounting methods for financial and tax purposes.

The tax laws allow the use of different methods for these two purposes, recognizing that temporary differences will reverse over time and, thus, causing all tax amounts to be paid. (b) Income tax expense = $880,000 x 40% = $352,000 Income tax payable = $760,000 x 40% = $304,000 Income tax expense = $950,000 x 40% = $380,000 Income tax payable = $820,000 x 40% = $328,000 Income tax expense = $740,000 x 40% = $296,000 Income tax payable = $980,000 x 40% = $392,000

29.

(c) Income Tax Expense Deferred Income Taxes Income Tax Payable

352,000

Income Tax Expense Deferred Income Taxes Income Tax Payable

380,000

Income Tax Expense Deferred Income Taxes Income Tax Payable

296,000 96,000

48,000 304,000 52,000 328,000

392,000

(a)

Sales

Operating Income EPS BV per share

Year 1 $254,882 100% $6,546 100% $0.52 100% $1.22 100%

Year 2 $298,468 117.1% $9,023 137.8% $0.54 103.8% $1.78 145.9%

Year 3 $392,549 154.0% $9,842 150.4% $0.61 117.3% $2.97 243.4%

Year 4 $348,351 136.7% $7,343 112.2% $0.56 107.7% $2.77 227.0%

Year 5 $387,430 152.0% $10,666 162.9% $0.62 119.2% $3.87 317.2%

(b) Trend analysis is used by decision-makers to track changes in financial statement items over a period of years to predict future dollar amounts for financial statement items. Trend analysis helps identify trends from year to year, but does not examine relationships within a year, which could help explain trends. Also economic conditions have a major effect on trends and, should such conditions differ dramatically from a prior year, reliance on trends would be foolhardy.

SOLUTIONS MANUAL • CHAPTER 9  214

30.

(a) Income Statement

Sales* Cost of Goods Sold Gross Profit Operating Expenses Operating Income Other Revenue (Expense) Income before Income Tax Income Tax Expense Net Income

Balance Sheet

2006 $641,900 (304,500) $337,400 (154,200) $183,200 13,400 $196,600 (78,600) $118,000

100.0% 47.4% 52.6% 24.0% 28.5% 2.1% 30.6% 12.2% 18.4%

2006

2007 $652,000 (323,700) $328,300 (155,800) $172,500 (6,400) $166,100 (66,400) $99,700

100.0% 49.6% 50.4% 23.9% 26.5% 1.0% 25.5% 10.2% 15.3%

2007

2008 $654,500 100.0% (339,200) 51.8% $315,300 48.2% (161,900) 24.7% $153,400 23.4% (1,200) 0.2% $152,200 23.3% (60,900) 9.3% $91,300 13.9% 2008

Assets Cash Accounts Receivable (net) Inventory Prepaid Expenses Total Current Assets Property & Equipment (net) Other Assets Total Assets

$ 22,000 72,500 109,800 2,500 $206,800 212,000 3,200 $422,000

5.2% 17.2% 26.0% 0.6% 49.0% 50.2% 0.8% 100.0%

$ 9,100 103,300 102,000 1,400 $215,800 201,500 2,600 $419,900

2.2% 24.6% 24.3% 0.3% 51.4% 48.0% 0.6% 100.0%

$ 3,700 116,900 89,000 1,700 $211,300 189,400 1,500 $402,200

0.9% 29.1% 22.1% 0.4% 52.5% 47.1% 0.4% 100.0%

Liabilities Accounts Payable Notes Payable Accrued Liabilities Total Current Liabilities Bonds Payable Total Liabilities

$ 51,900 25,000 41,100 $118,000 100,000 $218,000

12.3% 5.9% 9.7% 28.0% 23.7% 51.7%

$ 57,200 15,000 35,800 $108,000 80,000 $188,000

13.6% 3.6% 8.5% 25.7% 19.1% 44.8%

$ 64,900 12,000 7,400 $ 84,300 80,000 $164,300

16.1% 3.0% 1.8% 21.0% 19.9% 40.9%

Stockholders' Equity Common Stock Additional Paid–in Capital Retained Earnings Total Stockholders' Equity Total Liabilities & Equity

$ 50,000 130,000 24,000 $204,000 $422,000

11.8% 30.8% 5.7% 48.3% 100.0%

$ 50,000 130,000 51,900 $231,900 $419,900

11.9% 31.0% 12.4% 55.2% 100.0%

$ 50,000 130,000 57,900 $237,900 $402,200

12.4% 32.3% 14.4% 59.1% 100.0%

(b) • • • • •

Cost of goods sold increased (unfavorable) creating a decrease in income.

Cash has decreased (unfavorable) while accounting receivable has increased Accounts payable has increased (unfavorable).

Liabilities are decreasing (favorable).

Retained earnings is increasing (favorable).

SOLUTIONS MANUAL • CHAPTER 9  215

31.

(a) Liquidity Ratios Current Ratio = Current Assets ÷ Current Liabilities 2007: $206,800  $118,000 = 1.8 2008: $215,800  $108,000 = 2.0 2009: $211,300  $84,300 = 2.5 Quick Ratio = (Cash + A/R + ST Inv) ÷ Current Liabilities 2007: ($22,000 + $72,500)  $118,000 = $94,500  $118,000 = 0.8 2008: ($91,000 + $103,300)  $108,000 = $194,300  $108,000 = 1.8 2009: ($3,700 + $116,900)  $84,300 = $120,600  $84,300 = 1.4 Leverage Ratios Debt to Asset = Liabilities ÷ Assets 2007: $218,000 ÷ $422,000 = 0.5 2008: $188,000 ÷ $419,900 = 0.4 2009: $164,300 ÷ $402,200 = 0.4 LT Debt to Equity = LT Debt ÷ Equity 2007: $100,000  $204,000 = 0.5 2008: $80,000  $231,900 = 0.3 2009: $80,000  $237,900 = 0.3 Times Interest Earned = (NI + Int Exp + Inc Tax Exp) ÷ Int Exp 2007: ($118,000 + $8,900 + $78,600)  $8,900 = $205,500  $8,900 = 23.1 2008: ($99,700 + $7,400 + $66,400)  $7,400 = $173,500  $7,400 = 23.4 2009: ($91,300 + $7,100 + $60,900)  $7,100 = $159,300  $7,100 = 22.4 (1) The company’s liquidity improved between the two years as the steadily increasing ratios indicate.

(2) The company became less leveraged as indicated by the decreasing amount of debt outstanding during the time span. (b) Activity Ratios A/R Turnover = Net Credit Sales ÷ Average A/R 2007: $641,900  $72,500* = 8.9 times 2008: $652,000  [($72,500 + $103,300)  2] = $652,000  $87,900 = 7.4 times 2009: $654,500  [($103,300 + $116,900)  2] = $654,500  $110,100 = 5.9 times Age of Receivables = 360 ÷ A/R Turnover 2007: 360  8.9 = 40.4 days 2008: 360  7.4 = 48.6 days 2009: 360  5.9 = 61.0 days

SOLUTIONS MANUAL • CHAPTER 9  216

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory 2007: $304,500  $109,800* = 2.7 times 2008: $323,700  [($109,800 + $102,000)  2] = $323,700  $105,900 = 3.1 times 2009: $339,200  [($102,000 + $89,000)  2] = $339,200  $95,500 = 3.6 times Age of Inventory = 360 ÷ Inventory Turnover 2007: 360  2.7 = 133.3 days 2008: 360  3.1 = 116.1 days 2009: 360  3.6 = 100.0 days Total Asset Turnover = Net Sales ÷ Average Total Assets 2007: $641,900  ($425,000 + $422,000) = $641,900  $423,500 = 1.5 times 2008: $652,000  [($422,000 + $419,900)  2] = $652,000  $420,950 = 1.5 times 2009: $654,500  [($419,900 + $402,200)  2] = $654,500  $411,050 = 1.6 times *An average cannot be calculated for these amounts because no beginning balance is available.

(1) A/R turnover continually decreased over the three years, which caused the age of A/R each year. The inventory turnover improved over the three years, but that could be caused simply by the fact that total inventory is declining. Total asset turnover improved but only very slightly.

(2) If the company’s normal credit terms are 30 days, the company is doing a very poor job of collecting its A/R. Turning over inventory every 100 days is probably not very good for a clothing store since there are four (not three) seasons in the year and fashion tends to change with each season (especially in an extreme northern state). (c) Profitability Ratios Profit Margin Percentage = Net Income ÷ Net Sales 2007: $118,000  $641,900 = 18.4% 2008: $99,700  $652,000 = 15.3% 2009: $91,300  $654,500 = 13.9% Gross Profit Percentage = Gross Profit ÷ Net Sales 2007: $337,400  $641,900 = 52.6% 2008: $328,300  $652,000 = 50.4% 2009: $315,300  $654,500 = 48.2% Return on Assets = (Net Income + Interest Expense) ÷ Average Assets 2007: ($118,000 + $8,900)  [($425,000 + $422,000)  2] $126,900  $423,500 = 30.0% 2008: ($99,700 + $7,400)  [($419,900 + $422,000)]  2) $107,100  $420,950 = 25.4%

SOLUTIONS MANUAL • CHAPTER 9  217

2009: ($91,300 + $7,100)  [($402,200 + $419,900)  2)] $98,400  $411,050 = 23.9% Return on Equity = Net Income ÷Average Equity 2007: $118,000  [($186,000 + $204,000)  2)] = $118,000  $195,000 = 60.5% 2008: $99,700  [($231,900 + $204,000)  2)] = $99,700  $217,950 = 45.7% 2009: $91,300  [($237,900 + $231,900)  2)] = $91,300  $234,900 = 38.9% Market Strength Ratios Price Earnings Ratio = Market Price ÷ Earnings per Share 2006: $8.50  ($118,000  50,000 shares) = 3.6 2007: $7.75  (99,700  50,000 shares) = 3.9 2008: $6.50  ($91,300  50,000 shares) = 3.6 Market Price to Book Value = Market Price ÷ Book Value per Share 2006: $8.50  ($204,000  50,000 shares) = $8.50  $4.08 = 2.1 2007: $7.75  ($231,900  50,000 shares) = $7.75  $4.638 = 1.7 2008: $6.50  ($237,900  50,000 shares) = $6.50  $4.758 = 1.4 (1) The profitability ratios indicate that the company became less profitable over this 3-year time span, with both declining profit margin and gross profit percentages.

Even with a shrinking asset base, the return on assets declined.

(2) The P/E ratio increased from 2007 to 2008, but then declined in 2009. The market price to book value ratio steadily decreased from 2007 through 2008. All of the ratios indicate that this company is not a good investment.

32.

(a) Market Price to Book Value = Market Price ÷ BV per Share 2005: $44.26  $35.00 = 1.3 2006: $48.95  $36.52 = 1.3 2007: $44.12  $25.62 = 1.7 2008: $61.05  $28.66 = 2.1 2009: $62.78  $31.28 = 2.0 (b) The company suffered a loss during 2007. This loss may have been felt throughout the truck leasing industry if there were fewer moves or a competitor may have offered incentives that temporarily lured Rent ‘N Drive’s customers away. There also may have been high gas prices during that time. (c) Student answers will vary.

SOLUTIONS MANUAL • CHAPTER 9  218

33.

(a) Cosgrove Company appears to be the healthiest and strongest company given the information in the problem. The ratios for Cosgrove are better in all cases than the industry norms. Alonso has long receivables and inventory turnovers, which probably explains why its liquidity ratios are so far below industry average. Buckley is hovering right around the industry norm except for the PE ratio and market to book ratio, indicating a less favorable perception by the market. (b) Cosgrove’s stock would be most attractive to investors because of its higher than industry norms P/E and Market Price to book value ratios. (c) Student answers will vary but some items that they might list include: (1) Has there been a change in management recently?

(2) Has the company paid dividends in the past several years?

(3) Has the company changed its accounting policies and/or procedures recently?

(4) Are there any contingencies that could affect the company in future years?

(5) What is the economic outlook for this industry?

34.

(a) Book Value per Share = Common Stock Equity ÷ Outstanding Common Shares Company A: ($3,000,000 - $750,000) ÷ 300,000 = $2,250,000  300,000 = $7.50 Company B: ($2,250,000 - $1,200,000) ÷ 600,000 = $1,050,000  600,000 = $1.75 Company C: ($6,000,000 - $4,500,000) ÷ 375,000 = $1,500,000  375,000 = $4.00 Market Price to Book Value = Market Price ÷ Book Value per Share Company A: $25.13 ÷ $7.50 = 335% Company B: $21.07 ÷ $1.75 = 1,204% Company C: $32.16 ÷ $4.00 = 804% (b) Market price is an indication of how much investors are willing to pay for each dollar of a firm’s net assets, but it is also an indication of whether investors believe that the company will be profitable in the future. Book value per share does not have any “future prospects” built in; it is just a measure related to historical cost of assets minus liabilities.

35.

(a) A major factor in the differences in the P/E ratios more than likely is the industries in which each company operates. Since each company operates in a different industry, the demand for products/services will vary from industry to industry. The economy will also impact ratio analysis; in times of economic boom, ratios should be stronger while in unfavorable economic times, ratios will probably suffer. (b) GM’s and Ford’s P/E ratios could have been zero because there was little interest at that time in purchasing the stock of American car manufacturers. In the early 1990s, GM’s stock price was generally in the $40-$60 per share range; it climbed to $90+ in 1999. By 2008, the price was in a nosedive. On June 2, 2009, the NYSE suspended trading in GM stock.

SOLUTIONS MANUAL • CHAPTER 9  219

(c) The P/E ratio indicates the amount investors are willing to pay for each dollar of the firm’s earnings. The market price to book value ratio indicates the amount investors are willing to pay for each dollar of the firm’s assets. The P/E ratio is probably more relevant to investors, because it directly relates to the earnings of the particular firm.

Indirectly, the market to book ratio measures of how profitable a company can be given its assets.

36.

(a) (1) Ratio increases (2) Ratio decreases (3) Ratio decreases (4) Ratio increases (b) (1) Recording sales twice will increase sales while expenses (cost of goods sold) stay the same. The numerator of the gross profit percentage increases; therefore, the gross profit percentage increases.

(2) Overstating ending inventory decreases cost of goods sold on the income statement and increases inventory on the balance sheet. Inventory is not used in the calculation of the quick ratio; therefore, there is no change.

(3) Liabilities, long-term or short-term, are not used in calculating the return on assets ratio, so there is no effect.

(4) An understatement of the estimated useful life increases annual depreciation, which increases expenses and decreases net income (during the estimated useful life). Net income is in the numerator of the return on equity ratio. A lower net income flows through to equity. Therefore, both the numerator and denominator of the return on equity ratio decrease by equal amounts, resulting in an overall increase.

(5) Failure to record interest revenue causes an understatement of revenues and assets.

Lower revenues result in lower net income, which results in a lower earnings per share. EPS is the denominator of the PE ratio. If the denominator decreases, the ratio increases.

(6) Failing to record the declaration of a cash dividend understates both dividends and liabilities. The profit margin percentage does not use either in its calculations; therefore, there is no effect on the profit margin percentage.

(7) Recording a purchase of an LT asset as a current asset overstates the current assets, which is the numerator of the current ratio. Thus, the current ratio would be overstated.

SOLUTIONS MANUAL • CHAPTER 9  220

37.

(a) Earnings quality is defined as the degree of correlation between a firm’s economic income and its reported earnings determined by GAAP. (b) Earnings quality is important because different accounting methods can be used to calculate certain financial statement items and, therefore, can raise or lower income and affect various ratios. Additionally, financial data can be manipulated by management will can affect earnings quality. (c) Several factors that impact earnings quality include: (1) different methods of accounting for depreciation, (2) different methods of accounting for cost of goods sold, (3) different methods of accounting for bad debts, and (4) management delaying recognizing expenses or advancing recognizing revenues.

If a firm chooses to use LIFO for valuing its inventory and shows an ending inventory of $50,000, the value for that same firm’s ending inventory using FIFO might be higher or lower, given depending on whether prices for inventory are increasing or decreasing over the period. Both methods are acceptable to use for valuing inventory, but, each method would impact cost of goods sold in a different manner, and, ultimately, net income. The method chosen to value inventory must be used consistently so as not to cause further distortion to net income. Accelerated depreciation methods will cause lower net income early in the life of an asset and higher net income later in the life of an asset than if straight-line depreciation had been used. Thus it is important to read the footnotes to determine what accounting methods are being used; comparisons (such as ratio analysis) between companies using different accounting methods must be “taken with a grain of salt.”

SOLUTIONS MANUAL • CHAPTER 9  221

CASES 38.

(a)

TREND ANALYSIS INCOME STATEMENT (in millions except per share data)

2007

2006

2005

2004

Revenues Passenger tickets

$9,792

133.10%

$8,903

121.01%

$8,399

114.16%

$7,357

100.00%

Onboard and other Other

2,846 395

137.49% 131.67%

2,514 422

121.45% 140.67%

2,338 357

112.95% 119.00%

2,070 300

100.00% 100.00%

Total

13,033

133.99%

11,839

121.71%

11,094

114.05%

9,727

100.00%

Costs and Expenses Operating Cruise Commissions, transportation and other

-1,941

123.47%

-1,749

111.26%

-1,645

104.64%

-1,572

100.00%

Onboard and other

-495

137.88%

-453

126.18%

-412

114.76%

-359

100.00%

Payroll and related

-1,336

129.33%

-1,158

112.10%

-1,122

108.62%

-1,033

100.00%

Fuel

-1,096

155.02%

-935

132.25%

-707

100.00%

Food

-747

135.82%

-644

117.09%

-613

111.45%

-550

100.00%

Other ship operating Other

-1,717 -296

97.39% 140.95%

-1,538 -314

87.24% 149.52%

-1,465 -254

83.10% 120.95%

-1,763 -210

100.00% 100.00%

Total

-7,628

139.78%

-6,791

124.45%

-6,218

113.95%

-5,457

100.00%

Selling and administrative Depreciation and amortization

-1,579 -1,101 10,308

122.88% 135.59%

-1,447 -988

112.61% 121.67%

-1,335 -902

103.89% 111.08%

-1,285 -812

100.00% 100.00%

136.46%

-9,226

122.13%

-8,455

111.93%

-7,554

100.00%

2,725

125.40%

2,613

120.25%

2,639

121.45%

2,173

100.00%

OPERATING INCOME Non-operating (Expense) Income Interest income

67

394.12%

25

147.06%

29

170.59%

17

100.00%

Interest expense Other expense, net

-367 -1

129.23% 20.00%

-312 -8

109.86% 160.00%

-330 -13

116.20% 260.00%

-284 -5

100.00% 100.00%

-301

110.66%

-295

108.46%

-314

115.44%

-272

100.00%

Income Before Income Taxes Income Tax Expense, Net

2,424 -16

127.51% 34.04%

2,318 -39

121.94% 82.98%

2,325 -72

122.30% 153.19%

1,901 -47

100.00% 100.00%

NET INCOME

$2,408

129.88%

$2,279

122.92%

$2,253

121.52%

$1,854

100.00%

SOLUTIONS MANUAL • CHAPTER 9  222

TREND ANALYSIS BALANCE SHEET (in millions except per share data)

2007

2006

2005

2004

ASSETS Current Assets Cash and cash equivalents

943

146.66%

1163

180.87%

1,178

183.20%

643

100.00%

Trade and other receivables, net

436

106.60%

280

68.46%

408

99.76%

409

100.00%

Inventories Prepaid expenses and other

331 266

137.92% 61.01%

263 289

109.58% 66.28%

250 379

104.17% 86.93%

240 436

100.00% 100.00%

Total current assets

1,976

114.35%

1,995

115.45%

2,215

128.18%

1,728

100.00%

Property and Equipment, Net

26,639

127.93%

23,458

112.65%

21,312

102.35%

20,823

100.00%

Goodwill

3,610

108.70%

3,313

99.76%

3,206

96.54%

3,321

100.00%

Trademarks Other Assets

1,393 563

106.66% 122.93%

1,321 465

101.15% 101.53%

1,282 417

98.16% 91.05%

1,306 458

100.00% 100.00%

TOTAL ASSETS

34,181

123.68%

30,552

110.55%

28,432

102.88%

27,636

100.00%

115

30.18%

438

114.96%

300

78.74%

381

100.00%

Current portion of long-term debt

1,028

150.95%

1,054

154.77%

1,042

153.01%

681

100.00%

Convertible debt subject to current put options

1,396

232.67%

0

0.00%

283

47.17%

600

100.00%

561

88.91%

438

69.41%

690

109.35%

631

100.00%

Accrued liabilities and other Customer deposits

1,353 2,807

155.88% 149.87%

1,149 2,336

132.37% 124.72%

832 2,045

95.85% 109.18%

868 1,873

100.00% 100.00%

Total current liabilities

7,260

144.22%

5,415

107.57%

5,192

103.14%

5,034

100.00%

Long-Term Debt Other Long-Term Liabilities and Deferred

6,313 645

100.35% 117.06%

6,355 572

101.02% 103.81%

5,727 541

91.03% 98.19%

6,291 551

100.00% 100.00%

Total Liabilities

14,218

119.72%

12,342

103.92%

11,460

96.50%

11,876

100.00%

LIABILITIES AND SHAREHOLDERS EQUITY Current Liabilities Short-term borrowings

Accounts payable

Shareholders Equity Common stock of Carnival Corporation;

6

100.00%

6

100.00%

6

100.00%

6

100.00%

354

100.28%

354

100.28%

353

100.00%

353

100.00%

Additional paid-in capital

7,599

103.94%

7,479

102.30%

7,381

100.96%

7,311

100.00%

Retained earnings

12,921

149.84%

11,600

134.52%

10,233

118.67%

8,623

100.00%

Accumulated other comprehensive income

1,296

239.56%

661

122.18%

156

28.84%

541

100.00%

Unearned stock compensation Treasury stock

(2,213)

0.00% 209.17%

(1,890)

0.00% 178.64%

-13 -1,144

81.25% 108.13%

-16 -1,058

100.00% 100.00%

Total shareholders equity

19,963

126.67%

18,210

115.55%

16,972

107.69%

15,760

100.00%

Total Liabilities and Shareholders' Equity

34,181

123.68%

30,552

110.55%

28,432

102.88%

27,636

100.00%

Ordinary shares of Carnival plc

(b) Student answers will vary.

SOLUTIONS MANUAL • CHAPTER 9  223

40.

(a) Balance Sheet

COMMON SIZE BALANCE SHEET 2007

2006

ASSETS Current Assets Cash and cash equivalents

943

2.76%

1163

3.81%

Trade and other receivables, net

436

1.28%

280

0.92%

Inventories Prepaid expenses and other

331 266

0.97% 0.78%

263 289

0.86% 0.95%

Total current assets

1,976

5.78%

1,995

6.53%

Property and Equipment, Net

26,639

77.94%

23,458

76.78%

Goodwill

3,610

10.56%

3,313

10.84%

Trademarks Other Assets

1,393 563

4.08% 1.65%

1,321 465

4.32% 1.52%

TOTAL ASSETS

34,181

100.00%

30,552

100.00%

LIABILITIES AND SHAREHOLDERS EQUITY Current Liabilities Short-term borrowings

115

0.34%

438

1.43%

Current portion of long-term debt

1,028

3.01%

1,054

3.45%

Convertible debt subject to current put

1,396

4.08%

0

0.00%

561

1.64%

438

1.43%

Accrued liabilities and other Customer deposits

1,353 2,807

3.96% 8.21%

1,149 2,336

3.76% 7.65%

Total current liabilities

7,260

21.24%

5,415

17.72%

Long-Term Debt Other Long-Term Liabilities and Deferred Total Liabilities

6,313 645 14,218

18.47% 1.89% 41.60%

6,355 572 12,342

20.80% 1.87% 40.40%

6

0.02%

6

0.02%

354

1.04%

354

1.16%

Additional paid-in capital

7,599

22.23%

7,479

24.48%

Retained earnings

12,921

37.80%

11,600

37.97%

Accumulated other comprehensive income Treasury stock

1,296 (2,213)

3.79% -6.47%

661 (1,890)

2.16% -6.19%

Total shareholders equity

19,963

58.40%

18,210

59.60%

options Accounts payable

Shareholders Equity Common stock of Carnival Corporation; Ordinary shares of Carnival plc

Total Liabilities and Shareholders' Equity

34,181

100.00%

30,552

100.00%

SOLUTIONS MANUAL • CHAPTER 9  224

Income Statement

COMMON SIZE INCOME STATEMENT (in millions except per share data) Revenues Passenger tickets Onboard and other Other Total Costs and Expenses Operating Cruise Commissions, transportation and other Onboard and other Payroll and related Fuel Food Other ship operating Other Total Selling and administrative Depreciation and amortization

OPERATING INCOME Non-operating (Expense) Income Interest income Interest expense Other expense, net Income Before Income Taxes Income Tax Expense, Net NET INCOME

2007

2006

$9,792 2,846 395 13,033

75.13% 21.84% 3.03% 100.00%

$8,903 2,514 422 11,839

75.20% 21.23% 3.56% 100.00%

-1,941 -495 -1,336 -1,096 -747 -1,717 -296 -7,628 -1,579 -1,101 10,308 2,725

-14.89% -3.80% -10.25% -8.41% -5.73% -13.17% -2.27% -58.53% -12.12% -8.45%

-1,749 -453 -1,158 -935 -644 -1,538 -314 -6,791 -1,447 -988

-14.77% -3.83% -9.78% -7.90% -5.44% -12.99% -2.65% -57.36% -12.22% -8.35%

-79.09% 20.91%

-9,226 2,613

-77.93% 22.07%

67 -367 -1 -301 2,424 -16 $2,408

0.51% -2.82% -0.01% -2.31% 18.60% -0.12% 18.48%

25 -312 -8 -295 2,318 -39 $2,279

0.21% -2.64% -0.07% -2.49% 19.58% -0.33% 19.25%

(b) Current liabilities, especially short-term borrowings, increased. But there were no really significant changes. (c) There were no significant changes.

40.

Student answers will vary depending on the companies chosen.

SOLUTIONS MANUAL • CHAPTER 9  225

41.

Effects of errors Before errors are corrected

Sales CGS Gross Profit Op Exp Op Inc Other Rev(Exp) Pretax Income Income Taxes Net Income

$ 2,176,200 (1,212,900) $ 963,300 (333,900) $ 629,400 30,600 $ 660,000 (264,000) $ 396,000

Avg Assets Int Expense Avg Equity

$2,461,500 102,000 1,140,000

Error correction

+$63,900 +$9,600

–½($63,900) –½($9,600 x .6) –½($63,900 x .6)

After errors are corrected

$ 2,176,200 (1,276,800) $ 899,400 (343,500) $ 555,900 30,600 $ 586,500 (234,600) $ 351,900 $2,429,550 102,000 1,117,950

(a) Profit margin percentage = net income ÷ net sales = $396,000  $2,176,200 = 18.2% Gross profit percentage = gross profit ÷ net sales = $963,300  $2,176,200 = 44.3% Return on assets = (net income + interest expense) ÷ average assets = ($396,000 + $102,000)  $2,461,500 = 20.2% Return on equity = net income ÷ average equity = $396,000  $1,140,000 = 34.7% (b) Profit margin percentage = net income ÷ net sales = $351,900  $2,176,200 = 16.2% Gross profit percentage = gross profit ÷ net sales = $899,400  $2,176,200 = 41.3% Return on assets = (net income + interest expense) ÷ average assets = ($351,900 + $102,000)  $2,429,550 = 18.7% Return on equity = net income ÷ average equity = $351,900  $1,117,950 = 29.8% (c) The errors caused all of the ratios to be overstated by between 2 and 5 percent.

Whether these effects are material is a judgment call. (d) Students answers will vary. WorldCom and Enron are good examples of intentional manipulations.

SOLUTIONS MANUAL • CHAPTER 9  226

SUPPLEMENTAL PROBLEMS 42.

(a)(1) Investment in LQTM Cash

300,000

Cash Dividend Revenue

4,800

(2) Investment in LQTM Cash

300,000

Cash Investment in LQTM (3) Investment in LQTM Cash

300,000

4,800

300,000 4,800 4,800 300,000 300,000

Cash Investment in LQTM

4,800

Equity in Net Loss of LQTM Investment in LQTM

8,100

4,800 8,100

(b) (1) NoQWERTY will adjust its Investment in LQTM account up (down) to fair market value by debiting (crediting) the investment account and crediting (debiting) an unrealized gain (loss) stockholders’ equity account.

(2) No other entries will be made.

(3) NoQWERTY will consolidate its financial statements with LQTM’s financial statements, which involves eliminating intercompany transactions and the Investment in LQTM account as well as deducting minority interests in LQTM on the income statement and recording a Minority Interest account on the balance sheet. (c) Investment in Bonds (150/300 × $132,000) Cash Cash ($150,000 ×0.05 × 6/12) Bond Interest Revenue Investment in Bonds ($10,000 premium  20 interest periods)

160,000 160,000 3,750 3,250 500

(d) When an investor owns over 50% but less than 100% of the investee’s voting shares, minority interest is recognized upon consolidation. If the investor owned 100% of the investee, no minority interest would be shown on the consolidated financial statements.

SOLUTIONS MANUAL • CHAPTER 9  227

43.

Allaboutme Corporation Income Statement For the year ended, December, 31, 2009 Net Sales Cost of Goods Sold Gross Profit Operating Expenses: General Selling Administrative Operating Income Other Gains/Revenues Gain on Sale of Machinery Income from Continuing Operations before taxes Income Tax Expense Income from Continuing Operations Discontinued Operations: Operating Income (net of tax) Loss on Disposal (net of tax) Income Before Extraordinary Items Fire Loss (net of tax) Net Income

Earnings Per Share: Income from Continuing Operations Income from Discontinued Operations Income Before Extraordinary Item Extraordinary Loss Net Income 44.

$1,040,000 (720,000) $ 320,000 $36,000 46,000 38,000

(120,000) $ 200,000 44,000 $ 244,000 (97,600) $ 146,400

$12,000 (24,000)

(12,000) $ 134,400 (30,000) $ 104,400

$1.46 (.12) $1.34 (.30) $1.04

(a) A temporary difference occurs when an organization uses one generally acceptable accounting principle for tax purposes and another generally acceptable accounting principle for financial purposes. The temporary difference is $20,000 caused by the difference in depreciation expense. (b) Income before depreciation Depreciation expense Income before taxes Income taxes Net income Income Tax Expense Deferred Income Tax Income Tax Payable

GAAP $200,000 (40,000) $160,000 (64,000) $ 96,000

Tax $200,000 (60,000) $140,000 (56,000) $ 84,000 64,000 8,000 56,000

SOLUTIONS MANUAL • CHAPTER 9  228

(c) Income Tax Payable Cash

56,000 56,000

(d) $20,000 difference x 40% rate = $8,000 (e) The amount will be paid when the temporary difference reverses itself over the year(s). The advantage is a delay in paying the $8,000 of taxes, which can determined by looking at the time value of those funds; thus, the "value" of the advantage can be calculated after specifying a rate of interest and the length of the payment delay.

45.

(a) Total Revenues

2006 2007 2008 2009

$361.9 364.0 418.7 455.1

100% 101% 116% 126%

Dividends Per Share

$0.252 0.252 0.273 0.360

100% 100% 108% 143%

Total Assets

$143.9 137.8 159.3 167.7

100% 96% 111% 117%

(b) Total revenues: 1% + 16% + 10% = 27% 27%  3 = 9% 9% + 126% = 135% 135% x $361.9 = $488.6 Dividends: 8% + 43% = 51% 51%  3 = 17% 17% + 143% = 160% 160% x $0.360 = $0.40 Total assets: (4%) + 11% + 17% = 23% 23%  3 = 7.7% 7.7% + 117% = 124.7% 124.7% x $143.9 = $179.4 Revenues would probably be the amount to have the most confidence in because these have increased steadily over the four-year time span. (c)

Revenues Dividends Assets

Predicted $488.6 $0.40 $179.4

Actual $448.3 $0.39 $181.1

Prediction error $40.3 $0.01 $(1.7)

The trend computations were not precise but were fairly close.

Error rate 9.0% .03% (.01)%

SOLUTIONS MANUAL • CHAPTER 9  229

46.

(a) Common-sized financial statements are used to give decision-makers a better understanding of relationships among items on the financial statements. These statements allow decision-makers to see the percentage change in accounts from year to year. (b)

Narragansett & Warren Balance Sheets December 31, 2008 and 2009 2008

2009

ASSETS Cash Accounts Receivable (net) Inventory Prepaid Expenses Total Current Assets Equipment (net) Total Assets

$ 18,400 16,600 25,000 1,600 $ 61,600 62,400 $124,000

14.8% 13.4% 20.2% 1.3% 49.7% 50.3% 100.0%

$ 37,400 28,800 29,400 600 $ 96,200 55,600 $151,800

24.6% 19.0% 19.4% 0.4% 63.4% 36.6% 100.0%

Liabilities Accounts Payable Accrued Liabilities Total Current Liabilities Long-Term Bank Loan Total Liabilities

$ 14,200 6,600 $ 20,800 20,000 $ 40,800

11.5% 5.3% 16.8% 16.1% 32.9%

$

5,400 7,200 $ 12,600 20,000 $ 32,600

3.6% 4.7% 8.3% 13.2% 21.5%

Stockholders' Equity Common Stock Additional Paid-in Capital Retained Earnings Total Stockholders' Equity Total Liabilities & Equity

$ 24,000 48,000 11,200 $ 83.200 $124,000

19.4% 38.7% 9.0% 67.1% 100.0%

$ 24,000 48,000 47,200 $119,200 $151,800

15.8% 31.6% 31.1% 78.5% 100.0%

(c) The percentage of liabilities decreased during the year, while current assets increased.

These changes would impact the liquidity ratios. Given that there was a significant increase in Retained Earnings, it is possible that the increase in income was used to pay off debts and increase the cash account. The increase in Accounts Receivable indicates an increase in sales.

47.

(a) Liquidity Ratios Current = Current Assets ÷ Current Liabilities 2007: $1,149,047 ÷ $474,232 = 2.4 2008: $891,110 ÷ $500,344 = 1.8 Quick = Quick Assets ÷ Current Liabilities 2007: $281,657 ÷ $474,232 = 0.6 2008: $37,131 ÷ $500,344 = 0.7

SOLUTIONS MANUAL • CHAPTER 9  230

Leverage Ratios Debt to Total Assets = Total Liabilities ÷ Total Assets 2007: $590,823 ÷ $1,720,526 = 34.3% 2008: $805,329 ÷ $1,443,815 = 55.8% Long-term Debt to Equity = LT Debt ÷ Shareholders’ Equity 2007: $116,591 ÷ $1,129,703 = 10.3% 2008: $304,985 ÷ $638,486 = 47.8% Times Interest Earned = (NI + Interest Expense + Income Tax Expense) ÷ Int. Exp. 2007: ($124,045 + $581 + $57,872) ÷ $581 = $182,498  $581 = 314 times 2008: ($158,461 + $2,513 + $88,023) ÷ $2,513 = $248,997  $2,513 = 99.1 times Activity Ratios Accounts Receivable Turnover = Sales ÷ Average Accounts Receivable 2007: $4,743,048 ÷ $0 = 0 2008: $4,656,302 ÷ $0 = 0 Age of Receivables = 365 ÷ Accounts Receivable Turnover 2007: n/a 2008: n/a Inventory Turnover = Cost of Goods Sold ÷ Average Inventories 2007: $2,851,616 ÷ [($836,092 + $758,185) ÷ 2] = $2,851,616  $797,138.5 = 3.6 times 2008: $2,815,959 ÷ [($758,185 + $747,942) ÷ 2] = $2,815,959  $753,063.5 = 3.7 times Age of Inventory = 360 ÷ Inventory Turnover 2007: 360 ÷ 3.6 = 100.0 days 2008: 360 ÷ 3.7 = 97.3 days Total Asset Turnover = Sales ÷ Average Total Assets 2007: $4,743,048 ÷ [($1,720,526 + $1,625,497) ÷ 2] = $4,743,048  $1,673,011.5 = 2.8 times 2008: $4,656,302 ÷ [($1,443,815 + $1,720,526) ÷ 2] = $4,656,302  $1,582,170.5 = 2.9 times Profitability Ratios Profit Margin Ratio = Net Income ÷ Net Sales 2007: $124,045 ÷ $4,743,048 = 2.6% 2008: $158,461 ÷ $4,656,302 = 3.4% Gross Profit Percentage = Gross Profit ÷ Net Sales 2007: $1,891,432 ÷ $4,743,048 = 39.9% 2008: $1,840,343 ÷ $4,656,302 = 39.5%

SOLUTIONS MANUAL • CHAPTER 9  231

Return on Assets = (Net Income + Interest Expense) ÷ Average Assets 2007: ($124,045 + $581) ÷ [($1,720,526 + $1,625,497) ÷ 2] = $124,626  $1,673,011.5 = 7.4% 2008: ($158,461 + $2,513) ÷ [($1,443,815 + $1,720,526) ÷ 2] = $160,974  $1,582,170.5 =10.2% Return of Equity = Net Income ÷ Average Equity 2007: $124,045 ÷ [($1,078,724 + $1,129,703+) ÷ 2] = $124,045  $1,104,213.5 = 11.2% 2008: $158,461 ÷ [($638,486 + $1,129,703) ÷ 2] = $158,461  $884,094.5 = 17.9%

SOLUTIONS MANUAL • CHAPTER 10  1

CHAPTER 10 SOLUTIONS TO END OF CHAPTER MATERIAL

QUESTIONS 1.

The principal use of a statement of cash flows by decision makers is to predict an organization's ability to generate positive cash flows (especially from operating activities) in the future.

2.

The statement of cash flows is necessary to business managers because companies are concerned with both generating revenues and properly managing the firm’s cash resources. The income statement is prepared using accrual accounting, which does not provide cash information.

3. Operating activities are those activities related to the production and delivery of goods and services by a business. Examples include paying of suppliers for merchandise and selling inventory to customers.

Investing activities are those activities related to the purchase and sale of long-term assets. Investing activities include the purchase of equipment and lending/investing money to earn interest/return.

Financing activities are those activities related to obtaining cash from lenders and investors, and repaying these sums. Financing activities include borrowing money from lenders (notes payable, bonds payable) and raising capital from investors (selling stock).

Repayment of debt principal and payment of dividends are also financing activities.

4.

Most current asset and current liability accounts are generated by the day-to-day operations of a business: accounts receivable from the sale of goods to customers; accounts payable for the purchase of inventory to sell; prepaids for short-term payments in advance of expenses, etc. Changes in these accounts must be added to, or subtracted from, net income when computing net cash flow from operating activities because net income is not a cash-based amount.

5.

The starting point in a cash flow statement prepared using the indirect method is net income. Net income is used because, although net income is calculated on an accrual basis, the majority of the items included in that figure are cash-based. Adjustments are made to net income to account for noncash revenues, expenses, gains, and losses.

6.

Preparing the SCF on an indirect basis requires converting accrual net income to a “cash only” number. Any noncash increases (decreases) to NI must be subtracted from (added to) NI to arrive at a “cash only” number. A common non-cash item is depreciation expense which merely “spreads” PP&E cost to periods of use. However, no cash is spent for depreciation. Thus, depreciation expense is added back to net income as the first step to determining cash flows from operating activities. (Note: the cash spent to acquire the PP&E assets appears on the SCF in the investing section.)

SOLUTIONS MANUAL • CHAPTER 10  2

7.

Under the indirect method of preparing the SCF, gains and losses affect net income because under the accrual method of accounting gains and losses are realized on transactions involving the sale of PP&E even though those gains and losses are not specifically cash amounts. The actual cash flows from the sale of PP&E items are shown in the investing section of the SCF.

8.

Users might prefer the direct method because it discloses the specific types of operating cash flows. Users are more likely to understand the detailed terminology of “cash received” and “cash paid” that appears on the operating section of the SCF prepared on a direct basis. However, the indirect method is more commonly used because it: (1) begins with an already existing financial statement figure (net income) so that relationships among the financial statements are depicted; (2) adjusts accrual to cash basis income; and (3) the indirect method would have to be shown in the footnotes to the financial statement if the direct method is used (resulting in “double work.”)

9.

The SCF prepared on the direct method does not show cost of goods sold at all because it is not a cash flow item. From a direct perspective, the cash flow related to inventory is the amount paid for accounts payable.

The SCF prepared on the indirect method also does not show cost of goods sold specifically because that figure is already included in the beginning line of net income (CGS was an expense in computing NI). However, because CGS is not cash-based, two adjustments need to be made to change that accrual based amount to a cash based amount. These two adjustments reflect increases or decreases in both the inventory and accounts payable accounts.

10.

Significant non-cash investing and financing activities are typically included in a schedule that follows the SCF. Although these types of transactions do not involve cash, they must be disclosed by a firm.

Examples of noncash transactions that would be reported also are: ▪ Acquiring an asset by entering into a capital lease.

▪ Converting debt into common stock or other equity securities.

▪ Exchanging noncash assets or liabilities for other noncash assets or liabilities.

11.

Investors can gain understanding of how a company gets and uses its cash. In the longrun, an investor is looking to see that a company is generating the majority of its cash from operating activities as opposed to financing or investing activities.

SOLUTIONS MANUAL • CHAPTER 10  3

12.

The current ratio is calculated by dividing current assets by current liabilities. The result indicates the number of times a company can pay its current liabilities using its current assets. However, many current assets are not cash now (e.g., accounts receivable and inventory) and some will never be cash (e.g., supplies and prepaid insurance). Noncash items cannot be used to pay a liability until they are converted into cash at some point in the future. Thus, some investors think it is better to look at the relationship of cash flows to current liabilities as an indication of whether a company will be able to meet its shortterm (liquidity) and long-term obligations (solvency).

13.

Cash flow per share is computed as (net cash flow from operating activities - preferred stock dividends) divided by the weighted average shares of common stock outstanding.

The inclusion of cash flow per share is not desirable in annual reports it does not indicate the company’s performance—which is best measured by accrual accounting. Also, decision makers really want information about a business’s future rather than historical cash flows and earnings.

14.

The larger amount would depend on the company, the company's industry, and the types of transactions (especially debt and equity financing) in which the company engaged during the year.

15.

In general, free cash flow from operating activities is equal to cash flow from operating activities with adjustments for mandatory payments of principal, payments for capital spending (purchasing new assets), and sometimes dividends. Investors are interested in this amount because it is believed to be a better indicator of funds available for paying current liabilities.

EXERCISES 16.

(a) T (b) T (But this situation cannot exist for the long-run.) (c) T (d) F Companies should generate the majority of their cash from operating activities. (e) F Only cash flows from operating activities are reported differently under the indirect and direct methods of preparing a statement of cash flows. (f) F Acquisitions and sales of PP&E are investing activities. (g) F FCF indicates a company’s ability to maintain its current level of productive capacity, but not to grow or increase that level. (h) F The indirect method of preparing SCF requires adjustments to be made to net income to determine the net cash flow from operating activities. (i) T (j) T (k) F Free cash flow is reported in total. (l) F This calculation provides the dividends declared. Determination of dividends paid requires a review of the current liability accounts.

SOLUTIONS MANUAL • CHAPTER 10  4

17.

(a) (b) (c) (d) (e) (f)3 (g) 5 (h) 2 (i) 4 (j) 2 (k) 3 (l) 5

1 2 4 6 4

18.

(a) The company uses the indirect method, which begins with net income and makes adjustments for noncash items. The direct method shows specific cash inflows and outflows in the operating activities section. (b) Cash flow from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Gain on sale of land Changes in current assets and liabilities: Increase in accounts receivable Decrease in inventories Decrease in prepaid expenses Decrease in short-term notes payable Decrease in accrued liabilities Net cash provided by operating activities Cash flows from investing activities Sale of land Purchase of property, plant, & equipment Net cash used by investing activities Cash flows from financing activities Sale of common stock Dividend payments Net cash provided by financing activities Net increase in cash Cash balance, 12/31/07 Cash balance, 12/31/08 (1) Ending cash = Beginning cash ± Net change in cash $22,664 = Beginning cash + $8,230 Beginning cash = $14,434

$ 2,866 2,176 5 (230) (1,726) 700 1,334 (800) (2,008) $ 2,312 2 $13,052 4 (15,278) (2,226) $12,658 (4,514) 3 8,144 $ 8,230 14,434 1 $22,664

SOLUTIONS MANUAL • CHAPTER 10  5

(2) Net change in cash = ± Operating ± Investing ± Financing $8,230 = Operating – $2,226 + $8,144 Operating = $2,312 (3) Financing = Inflows (stock sale) – Outflows (dividends paid) $8,144 = $12,658 – Dividends paid Dividends paid = $4,514 (4) Investing = Inflows (land sale) – Outflows (purchase PP&E) –$2,226 = Land Sale – $15,278 Land Sale = $13,052 (5) Operating = Net income – Depreciation ± Adjustments $2,312 = $2,866 – Depreciation – $230 – $1,726 + $700 + $1,334 – $ 800 – $2,008 $2,312 = Depreciation + $136 Depreciation = $2,176 (c) The largest source of cash during the year was the sale of land. (d) Too much of the net cash inflow came from financing activities and not enough from operating activities. In one year, that is not necessarily an issue, but long-term the reverse should be true.

19.

(a) Accumulated depreciation on equipment sold: BV = Cost – Acc. Depreciation $24,000 = $60,000 – Acc. Depreciation Acc. Depreciation = $36,000 Accumulated Depreciation: Beginning balance + Depreciation expense – Depreciation on sold equipment = Ending balance $75,000 + X - $36,000 = $54,000 $39,000 + X = $54,000 X = $15,000 depreciation expense for 2009 (b) The depreciation expense of $15,000 would be added back to net income under operating activities. The gain on the sale of the equipment ($49,500 cash received – $24,000 book value = $25,500) would be subtracted from net income under operating activities section. The $49,500 cash proceeds from the sale of the equipment would be shown as a cash inflow in the investing activities. The $120,000 purchase of the equipment would be shown as a cash outflow under investing activities. (This latter item assumes that the equipment was purchased for cash rather than being financed.)

SOLUTIONS MANUAL • CHAPTER 10  6

20.

(a) Salaries payable at the end of the year represents an accrual of year-end salary expenses that won’t be paid until early in the next fiscal year. (b) Salaries Payable: Beginning balance + Salaries expense – Salaries paid = Ending balance $5,340 + $119,835 – X = $4,479 $125,175 – X = $4,479 X = $120,696 (c) Salaries Expense Salaries paid Additional amount paid over expensed

$119,835 120,696 $ 861

The amount of salaries expense has already been deducted in determination of net income, which is the starting point for the operating section of the SCF shown on the indirect method. Thus, because Salaries Payable (a current liability) decreased by $861 during the year, that amount must be deducted as an adjustment to net income. (d) Using the direct method, there would be one line item for Salaries paid which would be an outflow of $120,696.

21.

(a) $0.20 x 649,475 shares = $129,895 (b) Dividends Payable: Beginning balance + Dividends declared – Dividends paid = Ending balance $7,320 + $129,895 – X = $12,492 $137,215 – X = $12,492 X = $124,723 Dividends paid appears as a cash outflow in the financing activities section of the SCF. (c) No, a stock dividend (because it will never be paid from current assets) will not affect the current liability account Dividends Payable.

22.

Sales Cost of goods sold Depreciation expense Rent expense Wages expense Loss on sale of machine Tax expense Net income

$624,000) (235,000) (43,600) (32,000) (165,240) (21,000) (50,864) $ 76,296

SOLUTIONS MANUAL • CHAPTER 10  7

Operating Activities: Net income Adjustments for noncash items: Depreciation expense Loss on sale of machine Decrease in accounts receivable Increase in inventory Increase in prepaid rent Increase in accounts payable Increase in wages payable Decrease in income taxes payable Net cash flow from operating activities 23.

$76,296 $43,600 21,000 2,300 (150) (550) 1,255 1,820 (10,100)

59,175 $135,471

Inventory: Beginning balance + Purchases – Cost of goods sold = Ending balance $2,300 + X – $235,000 = $2,450 X –$232,700 = $2,450 X = $235,150 Accounts Payable: Beginning balance + Purchases – Payments = Ending balance $12,040 + $235,150 – X = $13,295 $247,190 – X = $13,295 X = $233,895 Operating Activities: Collections from customers Payments for inventory purchases Payment of rent ($32,000 + $550) Payment of wages ($165,240 – $1,820) Payment of taxes Net cash flow from operating activities

24.

$626,300 (233,895) (32,550) (163,420) (60,964) $135,471

(a) Net income is derived by subtracting all expenses and losses from revenues generated that particular cycle. Cash flow from operating activities considers only those items related to a business’s principal profit oriented activities. Some expenses and all losses will not cause a decrease in cash. (b) Investing activities primarily involve using cash to acquire long-term investments or PP&E, both outflows. Only when those assets are sold is an inflow created. If a company routinely sold more assets than it acquired, the asset base would dwindle to zero. Hence, more investing outflows than inflows generally occur. (c) Financing activities were the largest source of funds for this company. Generally, companies do not want to be in such a situation because that means it is either borrowing additional funds or issuing additional shares of stock. Long-term, larger financing activities indicate that a company is not able to sustain its operating (revenue-generating) activities without additional funds.

SOLUTIONS MANUAL • CHAPTER 10  8

25.

(a) The larger the noncash items on the income statement, the larger the gap between net income and cash flow from operations. Kaleidoscope could incur a large net loss while showing positive cash flows in a particular accounting cycle for several reasons. For example, (1) Kaleidoscope could have recorded a significant amount of expenses that were not paid in cash during the year; (2) a large loss could have been recorded because of a sale of PP&E for which some cash was received but not equal to or greater than book value; (3) a large loss due to a natural disaster could have been incurred that resulted in the loss of assets. (b) The loss is probably more important to current and future investors because investors are most concerned about the going concern and future profitability of a business rather than cash flows.

26.

(a) Current Ratio = Current Assets ÷ Current Liabilities Current Ratio = $359,200 ÷$184,200 = 1.95 times Operating Cash Flow Ratio = Cash Inflow from Operating Activities ÷ Current Liabilities Operating Cash Flow Ratio = $700,000 ÷ $184,200 = 3.8 times The operating cash flow ratio is much higher, indicating that last year the company was able to generate 3.8 times more cash than the year-end balance of current liabilities. Many people believe that this ratio is a better measure of liquidity than the current ratio; however, users should be careful to remember the following: (1) cash inflow is a historical number and current liabilities is a number that must be paid in the future and (2) cash inflow is a number that represents a year’s worth of cash, while current liabilities are only the liabilities due in the next year that have been accrued so far (more are sure to come). (b) Times Interest Earned = (Net Income + Interest Expense + Income Tax Expense) ÷ Interest Expense Times Interest Earned = ($468,000 + $114,000 + $256,000) ÷ $114,000 = $838,000  $114,000 = 7.35 times Cash Interest Coverage Ratio = (Cash Inflow from Operating Activities + Interest Expense + Income Tax Expense) ÷ Interest Expense Cash Interest Coverage Ratio = ($700,000 + $114,000 + $256,000) ÷ $114,000 = $1,070,000  $114,000 = 9.39 times The cash interest coverage ratio is larger, indicating that the company had enough cash inflows from operating activities to pay interest expense 9.39 times. The times interest earned ratio is not as large and indicates the company “earned” enough to pay interest 7.35 times.

SOLUTIONS MANUAL • CHAPTER 10  9

(c) Free Cash Flow = Cash Inflow from Operating Activities – Equipment Purchases Free Cash Flow = $700,000 – $580,000 = $120,000 FCF is much less than net income. However, net income was not sufficient to cover the cash purchases of equipment but there was sufficient cash flow to buy the equipment and have a positive remainder in cash.

27.

(a) Earnings per share = (Net Income – PS Dividends) ÷ Weighted Average Number of Common Shares Outstanding.

2007: ($88,935,000 – $0)  165,765,000 = $0.54 2008: ($121,392,500 – $0)  168,202,500 = $0.72 2009: ($184,085,000 – $1,930,000)  172,522,500 = $182,155,000  172,522,500 = $1.06 Cash flow per share = (Cash Inflow from Operating Activities – PS Dividends) ÷ Weighted Average Number of Common Shares Outstanding 2007: ($106,782,500 – $0)  165,765,000 = $0.64 2008: ($90,490,000 – $0)  168,202,500 = $0.54 2009: ($108,142,500 – $1,930,000)  172,522,500 = $106,212,500  172,522,500 = $0.62 (b) EPS as a percentage of CFPS = EPS ÷ CFPS 2007: $0.54  $0.64 = 84% 2008: $0.72  $0.54 = 133% 2009: $1.06  $0.62 = 171% (c) For cash flow from operating activities to be less than net income, revenues had to be larger than cash received or expenses had to be less than cash paid. For example, it is possible that Saffron City did not collect many of its Accounts Receivable during the year or that it paid suppliers off in full rather than carrying a balance into the next year. A potential investor would want to understand what caused this situation so as to better predict future cash flows and possible areas of concern in those flows.

SOLUTIONS MANUAL • CHAPTER 10  10

PROBLEMS 28.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) (q) (r) (s) (t) (u) (v) (w) (x) (y) (z)

Repurchase of common stock Principal payment on long-term notes payable Cash paid for taxes Interest received Refund of income taxes Purchase of property and equipment Cash paid to employees Increase in accounts payable Proceeds from issuing long-term note payable Principal payments under capital lease obligations Increase in accounts receivable Proceeds from issuing common stock Depreciation expense Payment of dividends on preferred stock Principal payments on mortgages Gain on sale of equipment Decrease in prepaid insurance Decrease in wages payable Cash paid to suppliers for inventory Loans to corporate officers Issuance of treasury stock for cash Cash received from customers Declaration of a stock dividend Issuance of common stock for land Proceeds from the sale of property, plant, and equipment Declaration of a 2-for-1 stock split

6 6 9* 9* 1 4 9* 7 5 6 8 5 7 6 6 8 7 8 9* 4 5 9* 9 9 3 9

* These items are part of operating activities, but under the indirect method of preparing the SFC, they are not listed individually because they have been included in net income.

29.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n)

Repurchase of common stock Principal payment on long-term notes payable Cash paid for taxes Interest received Refund of income taxes Purchase of property and equipment Cash paid to employees Increase in accounts payable Proceeds from issuing long-term note payable Principal payments under capital lease obligations Increase in accounts receivable Proceeds from issuing common stock Depreciation expense Payment of dividends on preferred stock

6 6 2 1 1 4 2 7 5 6 7 5 7 6

SOLUTIONS MANUAL • CHAPTER 10  11

(o) (p) (q) (r) (s) (t) (u) (v) (w) (x) (y) (z) 30.

Principal payments on mortgages Gain on sale of equipment Decrease in prepaid insurance Decrease in wages payable Cash paid to suppliers for inventory Loans to corporate officers Issuance of treasury stock for cash Cash received from customers Declaration of a stock dividend Issuance of common stock for land Proceeds from the sale of property, plant, and equipment Declaration of a 2-for-1 stock split

6 7 7 7 2 4 5 1 7 7 3 7

The Nine Muses, Inc. Statement of Cash Flows For the Year Ended, December 31, 2009 (in thousands) Operating Activities: Net income Depreciation expense Gain on disposal of long-term assets Increase in miscellaneous current assets Increase in accounts payable Increase in accrued salaries Increase in inventories Increase in income taxes payable Net cash inflow from operating activities

$ 22,214 8,275 (415) (2,396) 6,590 4,072 (7,320) 5,608

Investing Activities: Purchase of PPE Purchase of long-term investments Proceeds from sale of PPE Proceeds from sale of long-term investment Net cash outflow from investing activities

$(31,083) (29,939) 2,468 14,077

Financing Activities: Issue common stock Reductions of long-term debt Issue long-term notes Net cash flow from financing activities Net cash flow Cash & cash equivalents, 1/1 Cash & cash equivalents, 12/31

$36,628

(44,477)

$10,000 (572) 126 9,554 $ 1,705 21,750 $23,455

SOLUTIONS MANUAL • CHAPTER 10  12

31.

(a) Sales on Account + Change in A/R = Cash collected $3,756,000 – Increase in A/R of $2,396 = $3,753,604 (b) Cost of Goods Sold + Change in Inventory = Purchases $1,810,000 + Increase in Inventory of $7,320 = $1,817,320 Purchases + Change in A/P = Payments on Account $1,817,320 – Increase in A/P of $6,570 = $1,810,730 (c) Tax Expense + Change in Tax Payable = Tax Paid $434,000 – Increase in Taxes Payable of $5,608 = $428,392 (d) Salary Expense + Change in Salary Payable = Salary Paid $695,000 – $4,072 = $690,928

32.

(a)

Wickenia Corporation Partial Statement of Cash Flows (Indirect) For the year ended December 31, 2009 Operating Activities: Net Income Depreciation expense Gain on sale of land Increase in accounts receivable Increase in inventory Decrease in prepaid expenses Increase in accounts payable Increase in accrued liabilities Net cash flow from operating activities

(b)

$8,400 950 (2,750) (2,650) (2,300) 1,350 1,350 650 $ 5,000

Wickenia Corporation Partial Statement of Cash Flows (Direct) For the year ended December 31, 2009 Operating Activities: Receipts from customers1 Payment to suppliers2 Payments for expensex3 Payment of income taxes Net cash flow from operating activities 1

2

Sales – Increase in A/R = Cash collected $38,800 – $2,650 = $36,150

Cost of Goods Sold + Increase in Inventory = Purchases $22,200 + $2,300 = $24,500

$36,150 (23,150) (2,400) (5,600) $ 5,000

SOLUTIONS MANUAL • CHAPTER 10  13

Purchases – Increase in A/P = Cash paid $24,500 – $1,350 = $23,150 3

Because the selling and general administrative expenses amount on the income statement is not separated into the part paid in cash and the prepaid part, these accounts must be examined together.

Selling and Administrative Expenses – Decrease in Prepaid Expenses – Increase in Accrued Liabilities Cash paid for selling and administrative expenses

$4,400 (1,350) (650) $2,400

(c) Liabilities are increasing whereas collections of Accounts Receivable seem to be lagging. Inventory increases could be caused by a downturn in sales. Also, the company may be slow in paying its Accounts Payable. The financial health of Wickenia Corporation appears to be deteriorating.

33.

(a) An increase in Accounts Receivable decreases cash flow from operating activities because sales that are made are not being collected. (b) No. Accounts receivable is the portion of sales that have not yet been realized in cash.

If sale are increasing, then one can expect a proportional increase in accounts receivable. If the increase in A/R is a greater increase than sales, there is probably a collections problem related to outstanding customer accounts.

34.

(a) Suppliers are interested in payments for inventory. In the three years listed, the following occurred:

2007 2008 2009

Change in Inventory Decrease $231.1 Increased $49.4 Decreased $84.4

Change in Accts Payable Increased $211.4 Increased $73.3 Decreased $19.2

Relationship of Change in A/P to Change in Inventory $211.4 ÷ $(231.1) = $0.914:($1) $73.3 ÷ $49.4 = $1.484:$1 $(19.2) ÷ $84.4 = ($0.227):($1)

Inventory is declining at a rate faster than A/P is increasing. Increases in inventory tend to indicate that a company is paying suppliers more aggressively. However, when inventory decreases, a slower decrease in accounts payable is of concern.

Additionally, the operating losses and the negative cash flow from operations in 2008 would be worrisome. (b) Current and potential investors will be concerned by the net losses for 2007 and 2008 as well as the negative cash flow in 2008. Another problem is that almost the exact same amounts have been made for principal payments on short-term debt as have been borrowed. It might be of concern that as losses arise, dividends have been increasing. There has also been a substantial decline in the sale of stock in 2008.

SOLUTIONS MANUAL • CHAPTER 10  14

(c) An employee will see that there is definitely a problem. Employees would want to find out whether Circuit City is saving cash by laying off employees and what PP&E is being sold (locations, etc.). There is a question about why so much money is being spent on buying PP&E when the income statement is not suggestive of a positive economic trend. (d) Circuit City filed for a petition for bankruptcy and its stock was closed for trading.

All Circuit City stores closed in 2009. Although those circumstances could not have been specifically predicted from the SCF, that statement did provide a strong indication of what was to come.

35.

(a) Cash Interest Coverage Ratio = (Cash Inflow from Operating Activities + Interest Expense + Income Tax Expense) ÷ Interest Expense No income tax expense information is provided.

2006: ($364.9 + $3,143)  $3,143 = $3,507.9  $3,143 = 1.1 2007: ($316.3 + $1,519)  $1,519 = $1,835.3  $1,519 = 1.2 2008: [$(45.6) + $1,180]  $1,180 = $1,134.4  $1,180 = .96 (b) Capital Expenditure Ratio = Cash Flow from Operating Activities ÷ Capital Expenditures 2006: $364.9 ÷ $254.5 = 1.4 2007: $316.3 ÷ $285.7 = 1.1 2008: $(45.6) ÷ $325.4 = (0.14) (c) Cash Flow Per Share = Cash Flow from Operating Activities ÷ Weighted Average CS Outstanding 2006: $364.900,000 ÷ 165,134,000 = $2.21 2007: $316,300,000 ÷ 170,448,000 = $1.86 2008: $(45,600,000) ÷ 177,456,000 = $(0.26) (d) Earnings Per Share = Net Income ÷ Weighted Average CS Outstanding 2006: $145,100,000 ÷ 165,134,000 = $0.88 2007: $ (8,400,000) ÷ 170,448,000 = $(0.05) 2008: $(321,400,000) ÷ 177,456,000 = $(1.81) (e) The trend in all of the ratios is downward. Both earnings per share and cash flow per share are decreasing. This indicates serious financial hardships for Circuit City. The huge drop in earnings could be attributed to incompetence of the management and sales staff, economic recession, poor quality goods, inferior service, or (highly likely) competition from other companies within the same industry. The number of shares outstanding (denominator of EPS and CFPS) is increasing, which should cause the overall ratio to decrease. In both cases of EPS and cash flow per share, it is declining anyway, which means that the numerator (net income) is decreasing at a faster rate.

SOLUTIONS MANUAL • CHAPTER 10  15

(f) Free Cash Flow = Cash Flow from Operating Activities – Capital Expenditures 2006: $364,900,000 – $254,500,000 = $110,400,000 2007: $316,300,000 – $285,700,000 = $30,600,000 2008: $(45,600,000) – $325,400,000 = $(371,000,000)

CASES 36.

(a) Carnival uses the indirect method to prepare the SCF. (b) Operating: Net income (or collections of sales from customers) Investing: Sale of short-term investments Financing: Issuance of long-term debt (c) Operating: Payments for expenses, supplies, and inventory (netted from sales; not shown directly on the SCF) Investing: Purchases of PP&E, purchases of stock in other companies Financing: Principal repayments of long-term debt, dividend payment, principal repayments of short-term debt, treasury stock acquisition (d) Net income increased slightly (from $2,253 M to $2,408 M) over the three years.

Cash flows from operating activities (from 3,410 M to $4,069 M) are increasing at a higher rate than net income. In every year, cash flow from operations is higher than net income. The ratio of net income to cash flows indicates that for every dollar of cash flow from operation, Carnival earns about 59 to 66 cents, which is fairly consistent. The company’s ratio of NI to CF decreased by 7 cents (66 cents – 59 cents) over the three-year period.

Net Income CF from Op. Act. Ratio of NI to CF (e) Net Income CF from Op. Act. WA # of shares EPS Trend CFPS Trend

2005 $2,253,000,000 3,410,000,000 $0.66

2006 $2,279,000,000 3,633,000,000 $0.63

2007 $2,408,000,000 4,069,000,000 $0.59

2005 $2,253,000,000 3,410,000,000  847,000,000 $2.80

2006 $2,279,000,000 3,633,000,000  794,000,000 $2.85 + 2% $4.56 + 13.4%

2007 $2,408,000,000 4,069,000,000  787,000,000 $3.04 + 6.7% $5.17 +13.4%

$4.02

Earnings per share and cash flow per share have each shown a constant upward trend at an increasing rate. (f) The ratios per share add a different dimension that is relevant to investors. However, creditors and employees are probably more interest in raw numbers.

SOLUTIONS MANUAL • CHAPTER 10  16

(g) Investors will be impressed by the increase in earnings, customer deposits and receivables. Investors will also compare the company to the industry average and determine how well the company is performing in comparison to its peers. Overall, the investors should be happy because the company is producing positive results and is increasing its investments.

Suppliers will notice that the balance in accounts payable is getting larger in larger proportions than inventories. However, net income is increasing and cash flow from operations are increasing as well, therefore suppliers should be content with the company’s ability to continue to generate cash for operations.

Employees should be pleased that the company is able to maintain consistent results for operating cash flows. Employees should also be impressed with the increase in investments by the company. Steady earnings also give employees security about their jobs. (h) In its most recent year, Carnival raised $2,654,000,000 by issuing new long-term debt. However, both its investing and financing activities result in negative cash flows, which indicates that the company does not depend on investing and financing activities to meet its cash flow demand. Instead, repayments to debt-holders and dividends to stockholders are being made consistently. (i) Absolutely. Tourism is very dependent on a vibrant economy and an economic recession would hurt the company’s cash flows significantly. (j) Operating Cash Flow Ratio = Cash Inflow from Operating Activities ÷ Current Liabilities 2006: $3,633 ÷ $5,415 = 0.7 2007: $4,069 ÷ $7,260 = 0.6 Cash Interest Coverage Ratio = (Cash Inflow from Operating Activities + Interest Expense + Income Tax Expense) ÷ Interest Expense 2005: ($3,410 + $330 + $72) ÷ $330 = $3,812  $330 = $11.55 2006: ($3,633 + $312 + $39) ÷ $312 = $3,984  $312 = $12.77 2007: ($4,069 + $367 + $16) ÷ $367 = $4,452  $367 = $12.13 Capital Expenditure Ratio = Cash Flow from Operating Activities ÷ Capital Expenditures 2005: $3,410 ÷ $1,977 = 1.72 2006: $3,633 ÷ $2,480 = 1.46 2007: $4,069 ÷ $3,312 = 1.23 (k) Free Cash Flow = Cash Flow from Operating Activities – Capital Expenditures 2005: $3,410 – $1,977 = $1,433 M 2006: $3,633 – $2,480 = $1,153 M 2007: $4,069 – $3,312 = $757 M

SOLUTIONS MANUAL • CHAPTER 10  17

A significant portion of the money generated by Carnival is used to purchase PP&E. 37.

Answers will vary depending on companies chosen

SUPPLEMENTAL PROBLEMS 38.

39.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) (q) (r)

Accounts receivable, increase Accounts payable, decrease Accrued expenses, decrease Capital expenditures Deferred income taxes (long-term), increase Depreciation and amortization expense Dividends paid Purchase common stock in subsidiary Income taxes payable, decrease Issuance of common stock Issuance of long-term debt Issuance of short-term debt Repayment of long-term debt Merchandise inventories, decrease Other current assets, increase Cash proceeds from disposals of P&E Sale of treasury stock Loss on sale of property and equipment

O; neg. non-cash adj.

O; neg. non-cash adj.

O; pos. non-cash adj.

I; outflow O; pos. non-cash adj.

O; pos. non-cash adj.

F; outflow I; outflow O; pos. non-cash adj.

F; inflow F; inflow F; inflow F; outflow O; pos. non-cash adj.

O; neg. non-cash adj.

I; inflow F; inflow O; pos. non-cash adj.

Caliope, Inc. Statement of Cash Flows For the Year ended December 31, 2009 Operating Activities: Net Income Depreciation expense Loss on sale of land Decrease in accounts receivable Decrease in inventory Increase in prepaid expenses Decrease in accounts payable Increase in accrued liabilities.

Net cash inflow from operating activities

$40,200 11,400 5,000 8,500 3,400 (5,400) (3,800) 400

Investing Activities: Proceeds from sale of land Net cash inflow from investing activities

$ 5,200

$59,700

5,200

SOLUTIONS MANUAL • CHAPTER 10  18

Financing Activities: Issuance of common stock Payment of dividends Net cash outflow from financing activities

$ 4,800 (15,000) (10,200)

Net increase in cash flow Cash & cash equivalents, 1/1 Cash & cash equivalents, 12/31 40.

$54,700 24,200 $78,900

Direct method Caliope, Inc. Statement of Cash Flows For the year ended December 31. 2009 Operating Activities: $194,300 Receipts from customers (74,000) Payment to suppliers (34,600) Payments for expenses (26,000) Payment of income taxes Net cash flows from operating activities Investing Activities: $ 5,200 Proceeds from sale of land Net cash inflow from investing activities Financing Activities: $ 4,800 Issuance of common stock (15,000) Payments of dividends Net cash outflow from financing activities Net increase in cash flow Cash and cash equivalents, 1/1 Cash and cash equivalents, 12/31

$59,700

5,200

(10,200) $54,700 24,200 $78,900

CHAPTER 11 Solutions to End of Chapter Material

Questions 1.

(a) Financial accounting refers to the accounting information (that result in the balance sheet, income statement, and statement of cash flows) that is developed primarily for external users (such as investors and creditors). This information is generally historical, monetary, required, aggregated, verifiable, and presented in conformity with generally accepted accounting principles. Managerial accounting refers to the accounting information that is developed primarily for internal users. This information is not required and is commonly based on current or expected future amounts, related to individual parts of the organization, presented in a manner that is most informative to its users, and likely to be more timely and less verifiable than financial accounting. (b) Product costs are those costs that are directly related to inventory items that generate organizational revenues. In a retail company, product costs include purchase prices of inventory plus any other normal and reasonable charges to get that inventory into place, position, and ready for sale. In a manufacturing company, product costs include the material, labor, and overhead costs of making the products that are to be sold to others. Period costs are those costs that are related to the selling and administrative activities of an organization. These costs are more closely associated with a specific time period or the passage of time than they are with the generation of revenues. (c) Direct costs are those costs that are clearly and conveniently traceable to and are a monetarily important part of a designated cost object. Indirect costs are those costs that either cannot be directly traceable to a designated cost object or are not directly traced to a designated cost object because it is not convenient (generally in terms of monetary significance) to do so. Indirect costs must be allocated (assigned) to products using a reasonable measure of activity. (d) Variable costs are those costs that, within the relevant range of activity, change in total in direct proportion to changes in some designated measure of activity. These costs are constant per unit of activity. Fixed costs are those costs that, within the relevant range of activity, do not change in total in response to changes in some designated measure of activity. On a per-unit basis, these costs vary inversely with changes in activity. Mixed costs have variable and fixed components. One portion of the cost is constant (fixed) regardless of the number of units produced. The remaining portion represents the total variable cost, which will increase in direct proportion to increases in production.

SOLUTIONS MANUAL • CHAPTER 11  228

(e) Job order costing is a costing system that is used by most service companies and by manufacturers that are producing goods in relatively small quantities and in response to specific customer demands. Direct material and direct labor costs can be easily traced to the resulting products in a job order system. Process costing is a costing system that is used by manufacturers that are producing mass quantities of homogeneous goods. Costs cannot be easily traced to individual products in a process costing system and, thus, equivalent units of production are employed to do so. (f) Actual costing refers to an inventory valuation method in which the actual costs of material, labor and overhead are used to compute product or service cost. Normal costing refers to an inventory valuation method in which product or service cost is calculated using the actual cost of material, the actual cost of labor, and overhead applied at an estimated standard rate. Standard costing uses a standard cost for material, a standard cost for labor, and a standard rate for applied overhead to calculate cost.

2.

Job order costing is accomplished by assigning a job ticket to each job and accumulating costs specific to each job by writing it on the job ticket. This system is convenient when there is a relatively small number of jobs, when jobs are distinguishable, and when jobs are made to customer satisfaction. Examples given by students will differ.

Process costing accumulates costs for batches of identical products. Companies that produce large quantities of homogenous products like breakfast cereal, could not assign costs to each individual box of cereal. The products are made in huge batches and then separated into sellable units. Therefore, these products are assigned a cost using process costing. Examples given by students will differ.

3.

Process costing is accomplished by accumulating costs for “batches” of product. Often, the production process is ongoing; that is, there is product at every stage of product at all times. In that case, it would be difficult attach a specific cost to a specific batch.

Therefore, costs are often accumulated for one big batch. To identify how much one batch of a defined size costs, production would have to be taken to completion without starting a new batch, which wastes valuable time.

For that reason, process costing often involves equivalent units of production (EUP), a calculation that converts partially completed units to a fewer number of fully completed units. EUP equals the sum of (1) the number of products that were started and finished during the period, (2) the number of units started times the progress toward completion expressed as a percentage, and (3) the number of units started in a previous period that were completed times the remaining progress toward completion expressed as a percentage. [Note: The percentage from (2) + the percentage from (3) = 1.]

SOLUTIONS MANUAL • CHAPTER 11  229

4.

A predetermined overhead rate is an estimated per-unit charge for overhead. The rate is used in both normal and standard costing. It is calculated by computing expected overhead at an expected level of activity and then dividing that expected overhead amount by that level of activity. Predetermined overhead rates are used so that timely determinations of product/service cost can be made without having to wait for all actual overhead costs of a period to be determined. Additionally, predetermined overhead rates allow overhead costs that vary on a monthly basis to be "smoothed" over an annual period, providing the same "average" overhead cost per unit of product in each period.

5.

Under- and overapplied overhead refer to a difference between the actual overhead incurred during a period and the overhead that has been assigned (applied) to products or services during a period using a predetermined overhead application rate. Overhead is underapplied (overapplied) if the amount of actual overhead is greater than (less than) the amount of applied overhead. Under- or overapplied overhead exists at the end of a period for two reasons: (1) the expected activity level chosen to calculate the predetermined overhead rate does not match the actual activity level of the period, and (2) expected overhead costs used to calculate the predetermined overhead rate do not match the actual overhead costs incurred during the period.

At the end of the period, if the amount is insignificant, the under- or overapplied amount is closed to Cost of Goods Sold on the income statement. Underapplied overhead will cause CGS to increase; overapplied overhead will cause CGS to decrease. (Note: If the amount is significant, it is proportionately allocated among the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts using the ending balances of these accounts. This situation is not discussed in the chapter.)

6.

Financial statements, prepared by financial accountants for use by creditors and investors, are sometimes intentionally misstated to enhance confidence in the viability or economic position of the company. At first thought, it seems that misstating managerial accounting, which is an internal process, would not benefit anyone because the primary purpose is to provide information only to internal users. However, managers are often evaluated on the data provided by managerial accounting. Therefore, costs that reflect badly on a manager may be concealed. For example, completed products are examined for a certain quality level and “bad” products must be reworked or disposed of. If a manager is evaluated by the percentage of reworks, s/he may try to conceal how high that rework percentage is.

7.

To be accounted for as a direct material, the cost must be significant and easily traceable to the job. A shirt, for example, is made of fabric, thread, and buttons. If the cost of the buttons were insignificant to the total cost of the shirt, it would be inconvenient and cost ineffective to account for each button used. It would be more likely that a large container of buttons would be available to production and the cost of all the buttons would be added to overhead. However, if the buttons were extremely expensive (as potentially on high-end, couture fashions), the cost of those buttons would be accounted for as a direct material.

SOLUTIONS MANUAL • CHAPTER 11  230

8.

Student answers will vary but examples for each company follow. (a) Toyota Product/ Service Direct Material Direct Labor Variable Overhead

Corolla

Fixed Overhead

Production line manager’s salary

Windshield Windshield installer Electricity

(b) Dell Computers Desktop computer Processor chip Chip installer Solder

Insurance on production facilities

(c) KPMG Audit (probably none) Staff associate Worksheets

Software license for Microsoft Office

(d) Applebee’s Restaurant Chicken fingers Chicken

(e) Kellogg Company Cereal

Cook

Machine operator Electricity

Grease for deep frying Salary of kitchen supervisor

Corn

Production line manager’s salary

(f) H&R Block Tax return (personal) (probably none) Tax preparer Paper

Rent on store

9.

The term cost of goods manufactured refers to the total cost of the products that were completed in a specific period of time. CGM includes the costs of beginning Work in Process Inventory (those items started in a previous period but not completed until the current period), direct material used, direct labor incurred, and actual or applied overhead; the cost of ending Work in Process Inventory (those items started in the current period but not completed) is then subtracted to get CGM.

10.

The Cost of Services Rendered (CSR) account is a service company’s equivalent to Cost of Goods Sold (CGS) on the income statement of manufacturing or retail companies. The calculation of the CSR differs from that of CGS because service companies typically do not have a Work in Process or Finished Goods Inventory account. Thus, CSR is the cost of direct material (or, more likely, supplies) used during the period, direct labor incurred, and actual or applied overhead.

Exercises 11.

(a) (b)

(c) (d) (e) (f) (g) (h)

F A mixed cost is part fixed and part variable..

F Many period costs are expensed as incurred, but some will provide future benefits and are capitalized when incurred and expensed as the benefit provided is used.

T T T T F Controllable costs are sometimes variable but may be fixed.

T

SOLUTIONS MANUAL • CHAPTER 11  231

(i)

F Application of overhead is based on estimates of (a) overhead costs, (b) which driver to use, and (c) units of the driver. Because there are so many estimates, there will almost always be over- or under-applied overhead. If the under- or overapplied overhead is insignificant, the reason was probably an error in estimation. (j) T (k) T (l) F Service companies tend to have little direct material cost. (m) F In the preparation of a flexible budget, mixed costs are divided into their fixed and variable components so that predetermined rates are only computed for those two components.

12.

(a) Financial accountant (b) Managerial accountant (c) Financial or managerial accountant (depends on what the reports are related) (d) Managerial accountant (e) Financial accountant (f) Financial accountant (g) Managerial accountant (h) Financial accountant (i) Managerial accountant (j) Financial or managerial accountant (financial accountants may perform this function because depreciation is related to external financial statement preparation; managerial accountants may perform this function if the equipment were used in the manufacturing process and depreciation was part of the calculation of the predetermined overhead rate) (k) Financial or managerial accountant (financial accountants may perform this function because depreciation is related to external financial statement preparation; managerial accountants may perform this function because it is a continuation of the cost of goods manufactured schedule). (l) Managerial accountant

SOLUTIONS MANUAL • CHAPTER 11  232

13.13.

Item

Wood Brass ornamentation Engraving materials Adhesive for trophy production Salary of sales staff Wages of machine operators Wages of factory custodial staff Production manager's salary Rent and insurance on factory building Rent on headquarters building Engraving machine Electricity in factory building Depreciation of office equipment Maintenance on engraving machines

(1) (2) (3) (4) 14.

Product or Period

Direct or Indirect

Variable, Fixed or Mixed

Controllable or Noncont. from view of Production (Manager)

Product Product Product Product Period Product Product Product Product (1) Period Product Both (1) Period

Direct Direct Indirect Indirect n/a (2) Direct Indirect Indirect

Variable Variable Mixed Variable Fixed (4) Variable Variable Fixed

Controllable Controllable Controllable Controllable Controllable Controllable Controllable Noncontrollable

Indirect n/a Indirect Indirect n/a

Fixed Fixed Fixed (3) Mixed Fixed (3)

Noncontrollable Noncontrollable Noncontrollable (3) Noncontrollable Noncontrollable

Product

Indirect

Variable

Controllable

This assumes that the factory building does not share space with the sales staff.

Period costs are not classified as direct or indirect because they are not part of production.

The cost of machinery is not controllable after it is acquired. The depreciation on the machine is fixed if a depreciation method other than units-of-production is used.

Typically salaries are fixed and wages are variable.

(a) Variable: timer mechanisms, resin bases, direct labor Fixed: machine depreciation, supervisor salaries Mixed: utilities (b) Timer = $40,750  25,000 timers = $1.63 (c)

Timer mechanisms Resin base Direct labor Depreciation Supervisor salaries Utilities Total

Cost of 25,000 units $11,250 8,750 9,000 3,750 6,000 2,000 $40,750

Cost of 1 unit $ 0.45 0.35 0.36 3,750 6,000 ?

Cost of 30,000 units $ 13,500 10,500 10,800 3,750 6,000 ? $ 44,550 plus utilities

The utilities cannot be determined because there is no basis for dividing it into its fixed and variable portions.

SOLUTIONS MANUAL • CHAPTER 11  233

15.

(a) High Low

# of copies 20,050 12,500 7,550

Rental fee $801.25 612.50 $188.75

$188.75 ÷ 7,550 = $0.025 per copy VC (activity) + FC = Total cost $0.025(20,050) + FC = $801.25 (can use either high or low activity level) $501.25 + FC = $801.25 FC = $300 Cost formula = $0.025 per copy + $300 (b) Estimated total rental fee TC = $300 + (activity × $0.025) TC = $300 + (15,970 × $0.025) TC = $300 + $399.25 TC = $699.25 16.

(a)

Rolls-Royce manufacturer Brick manufacturer Interior decorator Assisted-living facility Manufacturer of cleaning products Producer of TV drama

Costing: Process or Job Order Job order Process Job order Job order Process Job order

(b) Companies that use process costing have work in process at every stage of completion. All costs are accumulated for a batch, often defined by a period of time or a large quantity of finished product. Batch costs are divided by the number of whole units completed to get a cost per unit. If there units in partial stages of completion, EUP is used to determine the equivalent number of whole units produced. (c) Cost plus a reasonable markup is probably the primary determinant of the selling prices of automobiles, custom furniture, and interior decoration. Demand and reputation for the product will play a role in the markup amount. Market competition will primarily influence the selling price of cleaning products. Ambiance, reputation, and level of care drive the selling price of an assisted-living facility as much, if not more, than cost. Popularity, time slot, appeal of stars, and other factors drive the selling price of a television show.

SOLUTIONS MANUAL • CHAPTER 11  234

17.

(a) Predetermined Overhead Rate = Estimated Overhead ÷ Estimated MHs Predetermined Overhead Rate = $761,250 ÷ 175,000 = $4.35 per MH (b) Applied Overhead = Actual MHs × Predetermined Overhead Rate Applied Overhead = 182,000 × $4.35 = $791,700 (c) Actual overhead Applied overhead Overapplied overhead

$782,630 791,700 $ 9,070

(d) The overapplied overhead will be closed to Cost of Goods Sold, causing that account to decrease and net income to increase.

18.

(a) Variable Costs: Indirect labor Indirect material Variable portion of electricity Total Variable Cost Variable cost per MH Fixed Costs: Rent Insurance Salaries Depreciation Fixed portion of electricity Total Fixed Cost

Variable cost per MH $3.92 2.60

Number of machine hours (MHs) 120,000 130,000 150,000 $470,400 $509,600 $ 588,000 312,000 338,000 390,000

0.42

50,400 $832,800

54,600 $902,200

63,000 $1,041,000

$6.94 Fixed cost

$6.94

$6.94

$6.94

$14,500 1,680 8,260 4,150

$14,500 1,680 8,260 4,150

$14,500 1,680 8,260 4,150

680 $29,270

680 $29,270

680 $29,270

680 $29,270

$0.24

$0.23

$0.20

Fixed Cost per MH

$

14,500 1,680 8,260 4,150

(b) The variable predetermined rate would not vary according to levels. It would be $6.94 per MH. The fixed predetermined rate would vary by level because fixed cost per unit varies inversely with changes in activity.

Indirect labor = $529,200 ÷ 135,000 = $3.92 Indirect materials = $351,000 ÷135,000 = $2.60

SOLUTIONS MANUAL • CHAPTER 11  235

19.

(a) Day workers: 0.7 × 18,000 = 12,600 hours Evening workers: 0.3 × 18,000 = 5,400 hours Day workers: (12,600 × $12) + (1,000 × $18) = $151,200 + $18,000 = $169,200 Evening workers: 5,400 × ($12 x 1.2) = 5,400 × $14.40 = $77,760 Total pay = $169,200 + $77,760 = $246,960 (b) Direct labor cost = Total Hours × Base Rate Direct labor cost = 18,000 × $12 = $216,000 (c) Total indirect labor cost = $246,960 – $216,000 = $30,960 Shift Premium = Evening Hours × (Shift Pay – Base Rate) Shift Premium = 5,400 × ($14.40 – $12.00) = 5,400 × $2.40 = $12,960 Overtime Premium = Overtime Hours × (OT Pay – Base Rate) Overtime Premium = 1,000 × ($18 – $12) = $6,000

21.

20.

Cost Category Classification From To

(a) Machine oil (b) Unfinished wood, nails, and stain (c) Used stain to varnish a desk (d) Oiled the woodworking machinery (e) Paid insurance on the factory and equipment (f) Paid person who oils and maintains machinery (g) Used machinery to cut wood for a desk (h) Used cut wood and nails to assemble a desk (i) Paid a woodworker to build a desk (j) Applied overhead based on DLHs (k) Completed a desk, which is ready to be sold (l) Sold a desk

IM DM: IM DM IM FOH VOH FOH DM; IM DL OH

(a)

RM RM RM RM FOH VOH FOH RM WIP WIP WIP FG

WIP VOH

WIP; VOH

FG CGS

Spanglish Industries Cost of Good Manufactured Schedule For the month ended June 30, 2009 Beginning Inventory—Work in process (2) Manufacturing Costs for the period: Raw Material (direct & indirect) Beginning Balance Purchases (5) Raw Material available (4) Ending Balance Total Raw Material used Indirect Materials Direct Material Used (3)

$ 600,000

$180,000 525,000 $705,000 210,000 $495,000 (60,000) $435,000

SOLUTIONS MANUAL • CHAPTER 11  236

Direct Labor Used Variable Overhead Applied Fixed Overhead Applied Total Manufacturing Costs Total Costs in Work In Process Less: Ending Balance—Work In Process (1) Cost of Goods Manufactured

465,000 142,500 217,500 1,260,000 $1,860,000 (757,500) $1,102,500

(1) CGM = Total Costs in WIP – End WIP $1,102,500 = $1,860,000 – End WIP End WIP = $757,500 (2) Total Costs in WIP = Beg WIP + Total Mfg Costs $1,860,000 = Beg WIP + $1,260,000 Beg WIP = $600,000 (3) Total Mfg Costs = DM Used + DL Used + (Variable & Fixed OH Applied) $1,260,000 = DM Used + $465,000 + $142,500 + $217,500 DM Used = $435,000 (4) Raw Material Used = Raw Material Available – Ending Raw Material $495,000 = Raw Material Available – $210,000 Raw Material Available = $705,000 (5) Raw Material Available = Beg Raw Material + Purchases $705,000 = $180,000 + Purchases Purchases = $525,000 (b) Cost per unit = CGM ÷ Units produced Cost per unit = $1,102,500 ÷ 150,000 = $7.35 (c)

Units Cost Beg. FG 100,500 June 150,000 Available 250,500 Sold (147,000) CGS (d) End. FG 103,500

$ 728,625 ($7.25 per unit) 1,102,500 $1,831,125 (1,070,400) $ 760,725

($341,775) + (100,500 × $7.25)

SOLUTIONS MANUAL • CHAPTER 11  237

22.

Urdue Clinici Cost of Services Rendered Schedule For the month ended October 31, 2009 Service Costs for the period: Medical Supplies Beginning Balance Purchases Raw Material Available Ending Balance Total Supplies Used Direct Labor Used Doctors Nurses Total Direct Labor Overhead Applied Electricity ($2,400 × 75%) Rent ($5,700 × 75%) Depreciation on medical equipment Office salaries ($3,900 × 35%) Total Overhead Cost of Services Rendered

$

450 17,400 $ 17,850 4,350 $ 13,500 $108,000 24,900 132,900 $

1,800 4,275 7,200 1,365 14,640 $161,040

PROBLEMS 23.

(a) Variable Costs Fixed Costs Total Costs Cost per call

Cost $ 35 1,360

12 Calls $ 420 1,360 $1,780 $148.33

18 Calls $ 630 1,360 $1,990 $110.56

24 Calls $ 840 1,360 $2,200 $91.67

(b) The cost per service call decreases because as the number of calls goes up, the portion of fixed cost attributable to an individual call goes down. (c) $95X = $1,360 + $35X $60X = $1,360 X = 22.67 X = 23 (rounded) No Contract = 23 calls × $95 = $2,185 Contract = 23 calls × $35 = $805 + $1,360 = $2,165

SOLUTIONS MANUAL • CHAPTER 11  238

(d) If Green Wings expects to only have 15 service calls, then the service contract would appear to be a bad idea until material and labor costs are considered. If the company’s equipment is fairly old, it is very possible that the material and labor costs could significantly exceed the cost of the service contract. If material and labor costs exceed $460, the company has saved money by having the service contract.

Contract [(15 calls × $35) + $1,360] = ($525 + $1,360) $1,885 No Contract (15 calls × $95) 1,425 Amount that material and labor total needs to exceed $ 460 24.

(a) Student answers will vary; examples given below • Salary of concierge: Number of guests, number of occupied rooms, number of people who ask for the concierge’s help • City property taxes: Number of guests, square footage, asset value • Wages for housekeeping staff: Number of guests, number of rooms occupied, square footage • Electricity: Number of rooms, number of guests, square footage • Wages for table cleaners (bus staff): Number of meals served, number of tables turned, number of hours worked • Internet provider cost: Number of guests, number of internet access ports, number of internet accesses • Unemployment taxes: Number of employees, employee turnover, hourly wage • Water bill for spa: Number of guests, number of occupied rooms, square footage • Cleaning supplies: Number of rooms cleaned, square footage cleaned, number of cleaning employees, number of cleaning hours • Liability insurance for fitness facility: Average number of cases reported, average number of risk factors, average number of guests • Liquor license fee: Number of drinks served, number of guests, number of visitors to the bar • Laundry services: Number of bundles of laundry, number of laundry employees, hours worked by laundry employees, number of guests • Food costs: Number of meals served, number of guests, number of tables • Insurance policy: Asset value, number of guests, square footage (b) The hotel is probably charging customers to offset the $8,400 fixed base fee or to dissuade extensive usage of the phone (e.g., there may be a limited number of outgoing lines). The $1 charge was probably derived by estimating that 8,400 calls are placed by guests in a month. The increase to $2 was most likely the result of the fact that calls placed by guests have declined, probably due to the increased use by guests of personal cell phones.

SOLUTIONS MANUAL • CHAPTER 11  239

25.

(a) Predetermined Overhead Rate—DLHs = Estimated Total Overhead ÷ Estimated Total DLHs OH rate = ($603,000 + $66,600) ÷ (4,500 + 30,000) DLHs OH rate = $669,600 ÷ 34,500 DLHs = $19.41 per DLH Applied to one unit of Product N—DLHs = Predetermined Overhead Rate × DLHs per unit of N Applied OH to one unit of Product N = $19.41 per DLH × (.15 + 1.20) DLHs Applied OH to one unit of Product N = $19.41 × 1.35 = $26.20 (b) Predetermined Overhead Rate—MHs = Estimated Total Overhead ÷ Estimated Total MHs OH rate = ($603,000 + $66,600) ÷ (45,000 + 9,000) MHs OH rate = $669,600 ÷ 54,000 MHs = $12.40 per MH Applied to one unit of Product N—MHs = Predetermined Overhead Rate × MHs per unit of N Applied OH to one unit of Product N = $12.40 per MH × (8.0 + 0.3) MHs Applied OH to one unit of Product N = $12.40 × 8.3 = $102.92 (c) Predetermined Overhead Rate—Production (MHs) = Estimated Overhead ÷ Estimated MHs = $603,000 ÷ 45,000 MHs = $13.40 per MH Predetermined Overhead Rate—Assembly (DLHs) = Estimated Overhead ÷ Estimated DLHs = $66,600 ÷ 30,000 DLHs = $2.22 per DLH Applied to one unit of Product N—MHs & DLHs = Predetermined Overhead Rate × MHs per unit of N Applied OH to one unit of Product N = ($13.40 per MH × 8 MH) + ($2.22 per DLH × 1.2 DLHs) Applied OH to one unit of Product N = $107.20 + $2.66 = $109.86 (d) Because Product N uses so few direct labor hours, using that base to apply overhead will result in an extremely low amount of overhead applied. Using MHs in part b gives a better overhead application amount because the majority of the work performed on Product N is done in the form of machine hours. Part c allows the use of the best base in each department, thus resulting in the most appropriate allocation of overhead to Product N, given the quantity of each type of work performed in each department.

SOLUTIONS MANUAL • CHAPTER 11  240

26.

(a) Raw Material Inventory Accounts Payable

84,000

(b) Work in Process Inventory Raw Material Inventory

44,000

(c) Work in Process Inventory Overhead Control Wages Payable

40,000 12,000

(d) Overhead Control Accumulated Depreciation

4,400

(e) Overhead Control Prepaid Insurance

2,000

(f) Overhead Control Utilities Payable

1,700

(g) Overhead Control Cash

500

84,000

44,000

52,000

4,400

2,000

1,700

500

(h) Work in Process Inventory Overhead Control (3,400 DLHs × $5)

17,000

(i) Finished Goods Inventory Work in Process Inventory

107,200

(j) Accounts Receivable Sales

178,000

Cost of Goods Sold Finished Goods Inventory

17,000 107,200

178,000 100,000 100,000

SOLUTIONS MANUAL • CHAPTER 11  241

27.

(a) Work in Process - beginning Raw Material Inventory Beginning Balance Purchases Available to use Ending Balance Raw material used Direct labor Overhead applied* Total cost used in production Total costs to account for Work in Process - ending Cost of Goods Manufactured

$

85,200

$ 18,000 260,000 $278,000 (20,800) $257,200 342,000 450,000 1,049,200 $1,134,400 (50,800) $1,083,600

*Direct Labor Costs = Direct Labor Hours × Labor Rate $342,000 = Direct Labor Hours × $9.50 Direct Labor Hours = $342,000 ÷ $9.50 = 36,000 DLHs Overhead Applied = Predetermined Overhead Rate × DLHs Overhead Applied = $12.50 × 36,000 DLHs Overhead Applied = $450,000 (b) Finished Goods - beginning Cost of Goods Manufactured Total cost of goods available for sale Finished Goods - ending Cost of Goods Sold

$

43,200 1,083,600 $1,126,800 (14,700) $1,112,100

SOLUTIONS MANUAL • CHAPTER 11  242

28.

Schatzie Cost of Services Rendered Schedule For the Month Ended July 31, 2009 Service Costs for the period: Veterinary Supplies Beginning Balance Purchases Supplies available Ending Balance Total supplies used Direct Labor Used Veterinary Staff Veterinary Assistants Total Direct Labor Overhead Applied Utilities ($1,800 × 80%) Rent ($3,600 × 60%) Depreciation on equipment Total Overhead Cost of Services Rendered

$

720 9,600 $10,320 (1,150) $ 9,170 $32,000 12,000 44,000 $ 1,440 2,160 8,600 12,200 $65,370

(a) $12,200 (b) $65,370 (c) Treatment Fees Cost of Services Rendered Gross Profit Other Expenses: Depreciation on office equipment Receptionist’s salary Utilities ($1,800 × 20%) Rent ($3,600 × 40%) Net Income

$88,000 (65,370) $22,630 (3,000) (2,500) (360) (1,440) $15,330

SOLUTIONS MANUAL • CHAPTER 11  243

CASES 29.

Type of Cost Classified ad Coveralls Day-timer Mileage Toll charges Cell phone(1) Paint cost(2) Mineral spirits(3) Brushes(4) Helper Insurance

Variable

Fixed X X X

X X

Direct

Indirect X X X

X X X

X X X X

X X X X X

X

X

Period X

Product X X X X 40% X X X X X

(1) Because the remainder of the cell phone charges are for personal use, that percentage should not be considered a period cost of Abuzi's business.

(2) Although the paint cost was given as a single amount, the more houses Abuzi paints, the more paint he will need. Thus, the paint is a variable cost.

(3) Although the mineral spirits cost was given as a single amount, the more paint that is used, the more mineral spirits will be needed to clean brushes. Additionally, the cost is indirect because mineral spirits can be used multiple times and, thus, the cost is not direct to a particular job.

(4) Although the brush cost is given as a single amount, the more houses Abuzi paints, the more brushes he will need. Additionally, the brushes (after being cleaned) may be used for multiple jobs and, thus, the cost is not direct to a particular job.

30.

(a) As manager of special events, the cost objects with which I would be concerned are the ones that are charged against the profitability of special events. The primary source of revenue for special events is the fee to organizations or groups to hold meetings and conferences. The costs of special events, which reduce my revenue, are either controllable or noncontrollable. Controllable costs include the cost of food or other items provided by the hotel for a special event. Because I am responsible arranging for these items, I can make sure those costs are covered in price charged to the customer. Costs outside of my control are those that the hotel charges against my profitability at a rate controlled by someone outside of the special events department (e.g., electricity). (b) As my performance is evaluated on the basis of the profitability of special events, the costs charged to special events by other departments have the potential to reflect poorly on my performance. These costs are beyond my control, and therefore, I do not believe that they should be considered when evaluating the quality of work I

SOLUTIONS MANUAL • CHAPTER 11  244

provide and the profits that special events generate. It is not my intention to have these charges eliminated because it is also not fair to other departments to be charged for costs that benefit special events…nor is it fair to evaluate them on fees over which they have no control.

At the very least, I should be given the opportunity to negotiate these fees with other departments. For example, the manager of guest facilities is now charging me for conference guests that use the parking garage. If this continues, the accommodations manager should also be charged for guest parking, which will result in all parking fees being assigned to other departments (and not as a cost to guest services). Should the hotel management decide that this is a good plan, the parking should be charged in a systematic manner, for example, issuing colored hang tags for vehicles depending on the originating department. Then, I would be in control of the tags issued by special events, so I could build the cost of parking into the price of event.

Other costs charged to special events each have similar lines of logic. If I am in control of these costs, it is much more reasonable for me to be evaluated on them.

31.

Overhead is applied on the basis of estimates: estimates of overhead costs for the coming year, estimates of the number of units of the overhead cost driver that will be used in the coming year, and a best guess about what the cost driver should be. Because there are so many estimates, it is a fact that indirect costs charged to a job via overhead is less accurate than costs accounted for directly. Therefore, costs that go into overhead should be only those costs that truly are not attributable to one job (e.g., electricity, depreciation, maintenance) or costs that are so immaterial that to account for them would be too costly.

As a result of the inaccurate nature of overhead application, the true cost of jobs is often not known. If the cost of a job is not known, it is impossible to evaluate whether that job is generating a profit. Currently, virtually all of the costs of MLS are spread evenly among the jobs, so the income statement presents all profits minus all costs to obtain gross profit. If a more precise cost could be assigned to each job, it may be revealed that some jobs are less profitable than others and perhaps some jobs are actually losing money.

The only way to obtain this information is to systematically account for as many direct costs as possible. Direct materials are those used for a specific job. If materials are ordered for or used by a specific customer’s job, the cost of those materials should be attached to that job. The cost of the time spent by workers on a specific customer’s job should be attached to that job. The overhead category should reflect the cost of materials that benefit all jobs (e.g., machinery oil used during maintenance) and the cost of labor that benefits all jobs (e.g., the maintenance personnel who service the machinery).

SOLUTIONS MANUAL • CHAPTER 11  245

32.

(a) Gross Profit = Sales – Cost of Goods Sold ($110,000 × 30%) = $110,000 – Cost of Goods Sold Cost of Goods Sold = $77,000 CGS = Beginning FG + CGM – Ending FG $77,000 = $3,600 + CGM - $2,900 $77,000 = $700 + CGM CGM = $76,300 Predetermined OH Rate = Estimated OH ÷ Estimated DLHs Predetermined OH Rate = $176,400 ÷ 18,000 DLHs = $9.80 per DLH Wages Payable = DLHs × Rate $8,750 = DLHs × $7 DLHs = 1,250 DLHs Overhead applied = Predetermined overhead rate × DLHs used Overhead applied = $9.80 per DLH × 1,250 DLHs Overhead applied = $12,250 Beginning WIP Inventory Direct materials used Direct labor Applied OH Total costs to account for Cost of goods manufactured Ending WIP Inventory

$ 27,000 $64,000 8,750 12,250

85,000 $112,000 (76,300) $ 35,700

(b)The insurance company would probably want to see copies of the receiving reports for the materials purchased, time cards of the direct labor workers, and accounting records to support the beginning of the month account balances. Additionally, the insurance company would probably want to see several previous financial statements to support the 30% gross margin and overhead application rate.

33.

Students answer will vary depending on companies chosen.

SOLUTIONS MANUAL • CHAPTER 11  246

SUPPLEMENTAL PROBLEMS 34.

(a) Predetermined Overhead Rate—DLHs = Estimated Total Overhead ÷ Estimated total DLHs OH rate = $4,800,000 ÷ 192,000 DLHs = $25 per DLH DLHs used per unit Predetermined Overhead Rate (per DLH) Overhead Applied per unit Units Produced Overhead Applied

Product X 2.0 × $25 $50 × 6,000 $300,000

Product Y 3.2 × $25 $80 × 9,000 $720,000

(b) Est. Overhead for October = Annual Estimate ÷ 12 months Est. Overhead for October = $4,800,000 ÷ 12 Est. Overhead for October = $400,000 Under (Over) Applied OH = Estimated OH – Applied OH Under (Over) Applied OH = $400,000 – ($300,000 + $720,000) Under (Over) Applied OH = $400,000 – $1,020,000 Overapplied OH = $620,000 (c) Predetermined Overhead Rate—MHs = Estimated Total Overhead ÷ Estimated total MHs OH rate = $4,800,000 ÷ 960,000 MHs = $5 per MH MHs used per unit Predetermined Overhead Rate (per MH) Overhead Applied per unit Units Produced Overhead Applied

Product X 23.0 × $5 $115 × 6,000 $690,000

Product Y 6.0 × $5 $30 × 9,000 $270,000

(d) Under (Over) Applied OH = Estimated OH – Applied OH Under (Over) Applied OH = $400,000 – ($690,000 + $270,000) Under (Over) Applied OH = $400,000 – $960,000 Overapplied OH = $560,000 (e) Because the choice of driver significantly influences the amount of overhead applied to each product. Product X uses more machine hours and Product Y uses more direct labor hours. The more costs overhead costs applied to a product the lower the gross margin on that product.

SOLUTIONS MANUAL • CHAPTER 11  247

(f) The driver chosen on which to apply overhead is a significant factor in the amount of overhead applied to each job. The driver should, if possible, represent the most accurate cause of the costs in the overhead account. That way, when the overhead is applied, it is applied fairly. For example, if machinery take up the bulk of the floor space (i.e., leads to rent, depreciation, maintenance, etc.), machine hours would be a more accurate driver than direct labor hours. If work space for laborers is more prevalent, direct labor hours would be a good driver.

However, in the case of Intronin, the two products manufactured are very different with respect how they are manufactured; product X (Y) uses more machine hours (direct labor hours). In this case, it might be more beneficial for Intronin to collect two pools of overhead, one driven by machine hours and one by direct labor hours.

Otherwise, you will never know how profitable each product is because the indirect costs associated with each are arbitrary.

35.

(a) Raw Material Inventory Accounts Payable

205,700 205,700

Work in Process Inventory Raw Material Inventory

190,000

Work in Process Inventory Wages Payable

98,240

Overhead Control Accumulated Depreciation

9,500

Overhead Control Wages Payable

38,565

Overhead Control Prepaid Insurance

4,000

Overhead Control Cash

3,500

Overhead Control Cash

6,250

Work in Process Inventory Overhead Control (11,000 DLHs × $4.50)

49,500

Finished Goods Inventory Work in Process Inventory

328,655

190,000

98,240

9,500

38,565

4,000

3,500

6,250

49,500 328,655

SOLUTIONS MANUAL • CHAPTER 11  248

Accounts Receivable Sales

572,320

Cost of Goods Sold Finished Goods Inventory

306,140

572,320

306,140

(b) Raw Material 5,000 190,000 205,700

Finished Goods 12,500 306,140 328,655

20,700

35,015

Overhead 9,500 38,565 4,000 3,500 6,250

49,500

12,315

Work in Process 65,080 328,655 190,000 98,240 49,500

74,165

Cost of Goods Sold 306,140 306,140 (c)

Nassor, Inc. Schedule of Cost of Goods Manufactured For the Month ended May 31, 2009

Work in Process - beginning Raw Materials Inventory Beginning Balance Purchases Available to use Ending Balance Raw materials used Direct labor Overhead applied Total cost used in production Total costs to account for Work in Process – ending Cost of Goods Manufactured

$ 65,080 $

5,000 205,700 $210,700 (20,700) $190,000 98,240 49,500 337,740 $402,820 (74,165) $328,655

SOLUTIONS MANUAL • CHAPTER 11  249

(d) Overhead is underapplied by $12,315. Closing it (a credit to overhead) would increase Cost of Goods Sold (a debit). (e)

Nassor, Inc. Schedule of Cost of Goods Sold For the month ended May 31, 2009

Finished Goods—Beginning Add: Cost of Goods Manufactured Cost of Goods Available for Sale Less: Finished Goods–Ending Cost of Goods Sold

$ 12,500 328,655 $341,155 (35,015) $306,140

CHAPTER 12 Solutions to End of Chapter Material

Questions 1.

The break-even point is that level of sales at which no profits are generated and no losses are incurred. Total sales (dollars collected from customers) are equal to total costs (dollars associated with production and sales of the product sold to customers) at the break-even point.

The BEP is the starting point for CVP analysis because a company must break even before it can begin to earn profits. Calculating the BEP also provides a picture of how costs will (variable) or will not (fixed) react in response to changes in sales volume.

2.

A relevant range is a quantity of units that can be produced while keeping fixed costs fixed in total and variable costs constant per unit. The assumption is necessary for BEP and CVP analysis because operations outside the relevant range begin to change costs in ways that are possibly unknown. Typically, if operations fall below the relevant range, the company will not be able to buy raw material in the same quantity as is currently being purchased, which could cause variable cost per unit to increase; space and equipment may no longer be able to be supported and, thus, will need to be disposed of which will cause a decrease in fixed costs. The opposite effects are often true if the company begins operating above the current relevant range.

For example, a restaurant has a certain amount of floor space devoted to the dinning room. Because of that, a certain number of tables and chairs are available and a certain number of cooks are needed to prepare meals for those tables in a timely manner. These "certains" define the restaurant's relevant range. If the restaurant wants to expand its dining area to add more tables, cost such as linen service, electricity, and salaries of the cooks if more must be hired are likely to change.

3.

The assumptions underlying break-even analysis are not very realistic for the following reasons: • Most companies do not sell a single product or cannot predict with great accuracy the sales mix of the group of products being sold.

• Most companies have varying selling prices depending on the type of customer doing the purchasing and the volume of goods being purchased (either at a single point in time or for a period of time).

• Most companies cannot accurately separate mixed costs into their fixed and variable elements.

• Most companies' variable and fixed costs are not constant, respectively, per unit and in total for an annual period of time.

• Most companies do not have equal production and sales levels.

• Most companies face frequently changing business conditions throughout an annual period.

SOLUTIONS MANUAL • CHAPTER 12  257

4.

The assumption that all units produced are sold ignores the fact that a company may incur costs for producing items that it might not sell until later or that it might not sell at all due obsolescence, defects, or lack of demand. BEP and CVP analysis are calculated on a perunit basis and do not have the capability of adding in additional costs of products that are not sold.

5.

The contribution margin is the difference between selling price (on either a per unit or total basis) and variable costs (on either a per unit or total basis). CM fluctuates in direct proportion to sales volume because both the selling price and the variable cost per unit are assumed to be constant for each unit sold; thus, the CM is also constant per unit.

6.

The contribution margin ratio is calculated as (revenues minus variable costs) divided by revenues. The ratio can be calculated using either per-unit or total numbers; the answer will be the same with either calculation. The ratio provides information about the portion (percentage) of each sales dollars that is used to cover fixed costs and then “contributes to” (accumulates as) profit after fixed costs are covered. The remaining percentage (100% – CM ratio) is the portion (percentage) of each sales dollar that is used to cover variable costs.

7.

The constant sales mix assumption is necessary in a multiproduct firm so that a weighted average contribution margin to be computed for the "basket" of goods sold by the company. Without such a weighted average, it would be impossible to estimate the impact of each product's contribution margin on the coverage of fixed costs and the generation of profits.

The sales mix assumption is not very realistic because most businesses cannot accurately predict the quantities in which specific products will be sold in relationship to other products.

8.

The break-even graph provides three lines, one for revenues, total costs, and fixed costs.

At any level of production (x-axis), a comparison can be made between the total revenues and total costs. The point at which the lines cross is the break-even point and before and after that point, respectively, losses and profits are depicted.

The profit-volume graph has one line depicting revenues. At any level of production (xaxis), the total revenues are determined by the line. The line crosses the x-axis at the break-even point in units. Before and after that point, respectively, the company incurs the loss or profit amount that can be read on the y-axis.

Student answers will vary about which provides better information. However, using the break-even point graph allows one to determine fixed costs, total costs, variable costs, and revenues in addition to the point at which the company breaks even. The profitvolume graph only gives profit (or loss), but not the numbers the underlying components.

SOLUTIONS MANUAL • CHAPTER 12  258

9.

The margin of safety allows managers to assess how closely the company is operating to the break-even point. This information is important because the closer operations are to BEP, the more important it is not to lose any sales so that losses will not be incurred. The degree of operating leverage shows the impact a percentage increase in sales will have on company profitability. The closer the company is to the BEP, the more dramatic (percentage-wise) a profitability impact a sales percentage increase is; the further a company is from BEP, the less dramatic (percentage-wise) profitability impact will occur but the dollar impact can be substantially greater.

The concept of margin of safety and degree of operating leverage are related to one another because they have a common use in the analysis of the relationship between current operations and BEP. The results of both concepts help managers to determine how close the current level of operations are to the BEP.

10.10.

Benefits

•

Drawbacks

•

Margin of Safety Gives management as sense of how much they can decline in sales before profits are in danger Assumes operations are within a relevant range which may not be the case when sales are declining

•

• •

Degree of Operating Leverage Measures the effect on profit with a change in sales

Assumes operation within a relevant range Measures change as a percentage that can be misleading

Exercises 11.

(a) F At the break-even point, total revenues equal total (variable and fixed) costs. (b) T (c) T (d) F The BEP is computed for the “basket” of goods being sold, not each type of good individually. (e) T (f) T (g) T (h) F Each dollar of contribution margin contributes to pretax profit, not net income. (i) T (because production and sales are considered to be equal under break-even assumptions) (j) F The further away from BEP, the lower the degree of operating leverage. (k) F When variable cost per unit decreases, contribution margin per unit will increase.

SOLUTIONS MANUAL • CHAPTER 12  259

12.

(a) R(X) – VC(X) – FC = $0 R(10,000) – $8(10,000) – $165,000 = $0 R(10,000) ) – $80,000 – $165,000 = $0 R(10,000) ) – $245,000 = $0 R(10,000) = $245,000 R = $24.50 (b) $40(20,000) – VC(20,000) – $360,000 = $0 $800,000 – VC(20,000) – $360,000 = $0 $440,000 – VC(20,000) = $0 VC(20,000) = $440,000 VC = $22 (c) $8(X) – $3.50(X) – $59,994 = $0 $4.50(X) = $59,994 X = 13,332 (d) $59(42,700) – $40(42,700) – FC = $0 $2,519,300 - $1,708,000 – FC = $0 $811,300 – FC = $0 FC = $811,300 (e) $35(X) - $22(X) - $30,745 = $0 $13(X) = $30,745 X = 2,365

13.

(a) Contribution margin per unit = Revenue per unit – Variable cost per unit Contribution margin ratio = [(Revenue per unit – Variable cost per unit) ÷ Revenue per unit Company A CM = $75.00 - $38.25 = $36.75 CM % = $36.75 ÷ $75.00 = 49% Company B CM = $60.00 - $40.00 = $20.00 CM % = $20.00 ÷ $60.00 = 33 1/3% Company C CM = $12.50 - $9.50 = $3.00 CM % = $3.00 ÷ $12.50 = 24% Company D CM = $41.25 - $15.51 = $25.74 CM % = $25.74 ÷ $41.25 = 62.4%

SOLUTIONS MANUAL • CHAPTER 12  260

(b) Break even point in units = FC  CM Company A X = $678,037.50  $36.75 X = 18,450 units (or $1,383,750) Company B X = $720,000  $20 X = 36,000 units (or $2,160,000) Company C X = $240,000  $3 X = 80,000 units (or $1,000,000) Company D X = $84,993.48  $25.74 X = 3,302 units (or $136,207.50) (c) Total Revenues – Total Costs = Profit R(X) – VC(X) – FC = P CM(X) – FC = P X = (P + FC)  CM Company A $36.75(X) – $678,037.50 = $155,452.50 X = $833,490  $36.75 X = 22,680 units Company B $20(X) – $720,000 = $196,000 X = $916,000  $20 X = 45,800 units Company C $3(X) – $240,000 = $46,860 X = $286,860  $3 X = 95,620 units Company D $25.74(X) – $84,993.48 = $90,038.52 X = $175,032  $25.74 X = 6,800 units

SOLUTIONS MANUAL • CHAPTER 12  261

14.

Pretax Profit × (1 – Tax Rate) = After-tax profit Pretax Profit = After-tax Profit  (1 – Tax Rate) (a) Pretax Profit = $1,300,000  (1 – .35) Pretax Profit = $1,300,000  .65 Pretax Profit = $2,000,000 (b) $5,000,000 × (1 – TR) = $3,200,000 $5,000,000 – $5,000,000TR = $3,200,000 1 – TR = .64 TR = .36 (c) $1,900,000 × (1 – .29) = After-tax profit $1,900,000 × .71 = After-tax profit After-tax profit = $1,349,000

15.

(a) BEP$ = FC ÷ CM Ratio BEP$ = $2,385,360 ÷ .45 = $5,300,800 (b) VC Ratio = 1 – CM Ratio VC Ratio = 1 – .45 = .55 VC ÷ R = VC Ratio VC ÷ $320 = .55 VC = $176 (c) BEPu = BEP$ ÷ R BEPu = $5,300,800 ÷ $320 BEPu = 16,565 R(X) – VC(X) – FC = 0 $320(X) – $176(X) – $2,385,360 = 0 $144(X) = $2,385,360 X = 16,565

16.

(a) $45(225,000) – $24(225,000) – $1,672,500 = Profit $10,125,000 – $5,400,000 – $1,672,500 = Profit Profit = $3,052,500 (b) R(140,000) – $130(140,000) – $4,040,000 = $2,260,000 R(140,000) – $18,200,000 – $4,040,000 = $2,260,000 R(140,000) = $24,500,000 R = $175

SOLUTIONS MANUAL • CHAPTER 12  262

(c) $44(85,400) – $1,907,600 = Profit $3,757,600 – $1,907,600 = Profit Profit = $1,850,000 (d) $135(X) – $105(X) – $36,000,000 = $27,000,000 $30(X) = $63,000,000 X = 2,100,000 units (e) Pretax profit × (1 – .35) = $3,325,000 Pretax profit = $5,115,384.62 $18.50(X) – $9,000,000 = $5,115,384.62 $18.50(X) = $14,115,384.62 X = 762,994 (rounded) 17.

(a) CM(X) – FC = Pretax Profit (Loss) ($320 × .45)(30,000) – $2,385,360 = Pretax Profit (Loss) $144(30,000) – $2,385,360 = Pretax Profit (Loss) $4,320,000 – $2,385,360 = Pretax Profit (Loss) Pretax Profit = $1,934,640 After Tax Profit = Pretax Profit × (1 – TR) After Tax Profit = $1,934,640 × (1 – .35) After Tax Profit = $1,257,516 (b) Increase in units = 30,000 × 20% = 6,000 Increase in contribution margin [$144 × (30,000 × 20%)] Increase in FC (advertising) Change in pretax profit Previous pretax profit New pretax profit Less taxes New after tax profit

$ 864,000 (150,000) $ 714,000 1,934,640 $2,648,640 (927,024) $1,721,616

Yes, the company should make the change in advertising.

PROOF: CM(X) – FC = Pretax Profit (Loss) $144(30,000 × 120%) – ($2,385,360 + $150,000) = Pretax Profit $144(36,000) – $2,535,360 = Pretax Profit $5,184,000 – $2,535,360 = Pretax Profit (Loss) Pretax Profit = $2,648,640

SOLUTIONS MANUAL • CHAPTER 12  263

(c) Decrease in contribution margin on current sales [$3 × 30,000] Increase in CM from additional sales [($144 – $3) × (30,000 × 5%)] Increase in FC (advertising) Change in pretax profit Previous pretax profit New pretax profit Less taxes New after tax profit

$

(90,000) 211,500 (45,000) $ 76,500 1,934,640 $2,011,140 (703,899) $1,307,241

Yes, the company should make the change in material quality.

PROOF: CM(X) – FC = Pretax Profit (Loss) ($144 – $3)(30,000 × 105%) – ($2,385,360 + $45,000) = Pretax Profit $141(31,500) – $2,430,360 = Pretax Profit $4,441,500 – $2,430,360 = Pretax Profit (Loss) Pretax Profit = $2,011,140 18.

Number in Basket Revenue per unit Contribution Margin

Potholder Unit Basket 2 $1.00 $2.00 $0.50 $1.00

Unit $2.50 $1.50

(a) BEPu = Fixed Costs ÷ CM BEPu = $8,800 ÷ $5.50 BEPu = 1,600 baskets Revenue = 1,600 × $9.50 = $15,200 Potholders = 1,600 baskets × 2 = 3,200 Towels = 1,600 baskets × 3 = 4,800 (b) Pretax profit × (1 – .25) = After-tax profit Pretax profit × .75 = $40,500 Pretax profit = $54,000 Annual FC = $8,800 × 12 = $105,600 R(X) – VC(X) – FC = Pretax profit CM(X) – $105,600 = $54,000 $5.50(X) = $159,600 X = 29,019 baskets (rounded up) Revenue = $9.50 × 29,019 = $275,680.50

Towels Basket 3 $7.50 $4.50

Basket Total % 5 $9.50 $5.50

SOLUTIONS MANUAL • CHAPTER 12  264

(c) Number in Basket Revenue per unit Contribution Margin

Potholder Unit Basket 2 $1.00 $2.00 $0.50 $1.00

Towels Basket 4 $2.50 $10.00 $1.50 $6.00 Unit

Basket Total % 6 $12.00 $7.00

CM(X) – FC = Pretax Profit (Loss) $7.00(29,019 baskets) – $105,600 = Pretax Profit (Loss) $203,133.00 – $105,600 = Pretax Profit (Loss) Pretax Profit = $97,533.00 The amount is not the same as desired because the "basket" sales mix changed and added one additional unit, providing a significant increase in contribution margin per basket. Thus, sales of the same number of "baskets" generated more profit than desired. (d) Number in Basket Revenue per unit Contribution Margin

Potholder Unit Basket 3 $1.00 $3.00 $0.50 $1.50

Towels Basket 2 $2.50 $5.00 $1.50 $3.00 Unit

Basket Total % 5 $8.00 $4.50

CM(X) – FC = Pretax Profit (Loss) $4.50(29,019 baskets) – $105,600 = Pretax Profit (Loss) $130,585.50 – $105,600 = Pretax Profit (Loss) Pretax Profit = $24,985.50 The amount is not the same as desired because the "basket" sales mix changed and shifted toward the units with the lower contribution margin. Thus, sales of the same number of "baskets" generated less profit than desired.

19.

(a) The numbers are volume of units produced and sold. (b) (A) Total revenues (B) Total cost (C) Fixed cost (c) Point (D) is created by the intersection of total revenues (A) and total cost (B); that is, total revenues equal total cost. Therefore, (D) is the break-even point; if extended to the x-axis, it is BEPu and, if extended to the y-axis, it is BEP$. (d) Student answers will vary slightly from those given as both these answers and student answers are estimates.

(1) $5,250,000

SOLUTIONS MANUAL • CHAPTER 12  265

(2) Variable cost per unit is the slope of line (b) Slope = (y1 – y2) ÷ (x1 – x2) <- Select any two points For example: When x = 0, y = $5,250,000 and When x = 106,000, y = $10,000,000

VC = ($10,000,000 – $5,250,000) ÷ (106,000 – 0) units VC = $4,750,000 ÷ 106,000 units VC = $44.81 per unit (3) Revenue per unit is the slope of line (a) Slope = (y1 – y2) ÷ (x1 – x2) <- Select any two points For example: When x = 0, y = 0 and When x = 106,000, y = $10,000,000

VC = ($10,000,000 – $0) ÷ (106,000 – 0) units VC = $94.34 per unit (4) 106,000 (5) $10,000,000 (6) Profit = Revenues – total costs Profit when X =150,000 = $14,000,000 – $11,750,000 Profit when X =150,000 = $2,250,000 (7) $7,250,000 (8) Total cost = VC + FC VC = Total Cost – FC VC when X =100,000 = $9,250,000 – $5,250,000 VC when X =100,000 = $4,000,000 20.

Actual (185,000 units) CMu = Ru – VCu = $13.00 – $5.50 = $7.50 Total CM = Salesu × CMu = 185,000 × $7.50 = $1,387,500 Total Revenue = Salesu × Ru = 185,000 × $13.00 = $2,405,000 Total VC = Salesu × VCu = 185,000 × $5.50 = $1,017,500 Pretax Profit = TCM – TFC = $1,387,500 – $1,260,000 = $127,500 Breakeven BEPu = FC ÷ CMu = $1,260,000 ÷ $7.50 = 168,000 BEP$ = BEPu × Ru = 168,000 × $13.00 = $2,184,000 (a) MSu = Actual units – BEu = 185,000 – 168,000 = 17,000 units MS$ = Revenue – BEP$ = $2,405,000 – $2,184,000 = $221,000 (b) DOL = TCM ÷ Pretax Profit = $1,387,500 ÷ $127,500 = 11 (rounded) (c) % increase in profit = DOL × % increase in sales % increase in profit = 11 × .20 = 2.2 times or 220%

SOLUTIONS MANUAL • CHAPTER 12  266

Revenues Variable Cost Fixed Cost Pretax Profit

Per unit $13.00 $5.50 $1,260,000

Current 185,000 units $2,405,000 (1,017,500) (1,260,000) $ 127,500

Increase 20% 222,000 units $2,886,000 (1,221,000) (1,260,000) $ 405,000

Increase in profit = $405,000 – $127,500 = $277,500 % increase in profit = $277,500 ÷ $127,500 = 2.2 times (rounded) (d) Per unit $13.00 5.50

Revenues Variable Cost Contribution Margin Fixed Cost Pretax Profit

Increase 8% 199,800 units $2,597,400 (1,098,900) $ 1,498,500 (1,325,000) $ 173,500

DOL = TCM ÷ Pretax Profit = $1,498,500 ÷ $173,500 = 8.6 (rounded)

PROBLEMS 21.

(a) CMu = Ru – VCu = $300 – $170 = $130 BEPu = FC ÷ CMu = $93,600 ÷ $130 = 720 hours (b) BEP$ = 720 hours × $300 per hour = $216,000 (c) 720 hours ÷ 28 hours per engagement = 26 engagements (rounded) (d) After tax profit = Pretax Profit × (1 – TR) $7,800 = Pretax Profit × .75 Pretax Profit = $10,400 CMu(X) – FC = Pretax Profit $130(X) – $93,600 = $10,400 X = 800 hours (e) Variable cost per consulting hour is made up primarily of the salary paid to the consultant and costs associated with seeing the customer. Variable costs may include supplies used, but that is typically an immaterial amount. The best way to reduce the cost of one unit of service is to reduce salaries paid to the service provider (which may not be appropriate if the company wishes to hire the most qualified employees).

To reduce the cost of a service engagement, reduce travel expenses or meals and entertainment associated with meeting the client.

SOLUTIONS MANUAL • CHAPTER 12  267

Fixed cost includes items such as rent, insurance, depreciation. To reduce rent, Barkley, Inc. could move to a smaller workspace (could be possible if employees were more prone to telecommuting). Higher deductibles or less coverage could lower insurance. Depreciation could be changed by choosing an alternative method—but, in the end, all equipment cost will be depreciated (either now or later). (f) Variable costs per engagement will be reduced because travel costs will be cut.

Depreciation expense, a part of fixed cost, will increase significantly because the technology needed is expensive. This decision may not save the company money.

Also, clients may not be as receptive to or able to teleconference, resulting in a reduction in sales.

22.

(a) CMu = Ru – VCu = $1.50 – $0.45 = $1.05 BEPu = FC ÷ CMu = $1,260 ÷ $1.05 = 1,200 units BEP$ = BEPu × Ru = 1,200 × $1.50 = $1,800 (b) Pretax Profit = CM(X) – FC $1,200 = $1.05(X) – $1,260 $1.05(X) = $2,460 X = 2,343 units (c) Pretax Profit = CM(X) – FC $24,360 = $1.05(X) – ($1,260 × 5) $24,360 = $1.05(X) – $6,300 $1.05(X) = $30,660 X = 29,200 units in 5 months 29,200 × 75% = 21,900 in the three busy months 21,900 ÷ 3 = 7,300 each month if sold evenly (d) Pretax Profit = After tax profit ÷ (1 – TR) Pretax Profit = $24,360 ÷ .8 = $30,450 Pretax Profit = CM(X) – FC $30,450 = $1.05(X) – ($1,260 × 5) $30,450 = $1.05(X) – $6,300 $1.05(X) = $36,750 X = 35,000 units in 5 months 35,000 × 75% = 26,250 (rounded) in the three busy months or 8,750 per month (e) One of the variable costs in a snow cone stand is ice. Due to the heat in Florida, ice will melt as the day progresses and on hotter days, making the variable cost per unit different under different circumstances.

SOLUTIONS MANUAL • CHAPTER 12  268

To plan for the melting ice before it is sold, S’No’Kones will have to freeze extra ice, so the assumption that all product is used will not necessarily be true.

The weather conditions in the area of business might cause assumptions to be inaccurate. Bad weather like hurricanes can have a heavy effect on business. For example, a hurricane may force people to evacuate from the region and there will not be any customers available for the business—and the hurricane season begins in the summer during the most popular snow cone time.

23.

(a) CMu = $11.50 – ($3.70 + $3.20) = $11.50 – $6.90 = $4.60 CM Ratio = $4.60 ÷ $11.50 = 40% (b) BEPu = FC ÷ CMu = ($37,300 + $15,186) ÷ $4.60 = $52,486  $4.60 = 11,410 lbs.

BEP$ = BEPu × Ru = 11,410 × $11.50 = $131,215 (c) CMu(X) – FC = Pretax profit $4.60X – $52,486 = $39,974 $4.60X = $92,460 X = 20,100 pounds of ribs Total Revenue = Salesu × Ru = 20,100 lbs × $11.50 = $231,150 (d) Pretax profits = After tax profits ÷ (1 – .3) Pretax profits = $24,500 ÷ .7 Pretax profits = $35,000 CMu(X) – FC = Pretax profit $4.60X – $52,486 = $35,000 $4.60 = $87,486 X = 19,019 pounds of ribs (rounded up) Total Revenue = Salesu × Ru = 19,019 lbs × $11.50 = $218,718.50 (e) CMu(X) – FC = Current pretax profit $4.60(39,750) – $52,486 = Current pretax profit $182,850 – $52,486 = Current pretax profit Current pretax profit = $130,364 Desired after tax profit = $120,000 ÷ .7 = $171,429 Necessary pretax profit from new sales = $171,429 – $130,364 = $41,065

SOLUTIONS MANUAL • CHAPTER 12  269

R(X) – VC(X) = $41,065 [All FC are covered by existing sales.]

R(15,000) – $6.90(15,000) = $41,065 R(15,000) = $41,065 + $103,500 R(15,000) = $144,565 R = $9.64 per pound Regular sales (39,750 × $11.50) New sales (15,000 × $9.64) Total sales Variable costs (54,750 × $6.90) Fixed costs Pretax profits Taxes (30%) Net income (off due to rounding)

$ 457,125 144,600 $601,725 $377,775 52,486

(430,261) $171,464 (51,439) $120,028

(f) Yes, this is a good change.

Decrease in current sales [5,000 lbs × $4.60 CM] Increase in CM [(39,750–5,000) × $3] Addition to pretax profit

$ (23,000) 104,250 $ 81,250

(g) CMu(BEPu) – FC = $0 ($4.60 + $3)(BEPu) – ($52,486 + $12,000) = $0 $7.60(BEPu) – $64,486 = $0 BEPu = 8,485 pounds of ribs BEP$ = 8,485 × $11.50 = $97,577.50 24.

(a) CMu = Ru – VCu = $120 – $52.20 = $67.80 CM Ratio = CMu ÷ Ru = $67.80 ÷ $120 = 56.5% (b) BEPu = FC ÷ CMu = $1,830,600 ÷ $67.80 = 27,000 units (c) BEP$ = $1,830,600 ÷ .565 = $3,240,000 (d) MSu = Salesu – BEPu = 35,000 – 27,000 = 8,000 MS$ = MSu × Ru = 8,000 × $120 = $960,000 MS% = MSu ÷ Salesu = 8,000 ÷ 35,000 = 22.9% (e) Total CM = CMu × Salesu = $67.80 × 35,000 = $2,373,000 Pretax profit = TCM – FC = $2,373,000 – $1,830,600 = $542,400 DOL = TCM ÷ Pre-tax profit = $2,373,000 ÷ $542,400 = 4.375 % Increase in profit = 4.375 × 20% = 87.5% increase

SOLUTIONS MANUAL • CHAPTER 12  270

(f) Add’l units to cover FC = Increase in FC ÷ CMu Add’l units to cover FC = $94,920 ÷ $67.80 = 1,400 New BEPu = Original BEPu + Additional BEPu New BEPu = 27,000 + 1,400 = 28,400 units (g) Pretax profit = After tax profit ÷ (1 – .25) Pretax profit = $339,000 ÷ .75 = $452,000 CMu(X) – FC – Pretax profit $67.80(X) – $1,830,600 = $452,000 $67.80(X) = $2,282,600 X = 33,667 units (h) Ru(X) – VC(X) – FC = pretax profit Ru(15,000) – Ru(.1)(15,000) – [($52.20 + $4.50)(15,000)]– $9,000 = $11,250 Ru(.9)(15,000) – $56.70(15,000) = $20,250 Ru(13,500) – $850,500 = $20,250 Ru(13,500) = $870,750 Ru = $64.50 Income Statement Sales [15,000 x $64.50] Commission Cost [($64.50×10%)×15,000] Variable Cost [15,000 x $56.70] Contribution margin Fixed costs related to this sale Profit from this sale

$967,500 (96,750) (850,500) $ 20,250 (9,000) $ 11,250

25.

Number in Basket Selling price Variable Cost Contribution Margin

Phone Answering Unit Basket 3 $ 3,600 $10,800 2,160 6,480 $ 1,440 $ 4,320

(a) CMu(BEPu) – FC = $0 $6,700(BEPu) – $2,345,000 = $0 BEPu = 350 baskets Phone: 350 × 3 = 1,050 clients Billing: 350 × 2 = 700 clients

Billing Basket 2 $5,000 $10,000 3,810 7,620 $1,190 $ 2,380

Basket

Unit

Total

%

5 $20,800 14,100 $ 6,700

100.0% 67.8% 32.2%

SOLUTIONS MANUAL • CHAPTER 12  271

(b) Pretax profit = After tax profit ÷ (1 – TR) Pretax profit = $217,750 ÷ .65 = $335,000 CMB(X) – FC = $0 $6,700X – $2,345,000 = $335,000 $6,700X = $2,680,000 X = 400 baskets Phone: 400 × 3 = 1,200 clients Billing: 400 × 2 = 800 clients (c) CMu(X) – FC = Pretax profit ($1,440 × 2,460) + ($1,190 × 1,640) – $2,345,000 = Pretax profit $3,542,400 + $1,951,600 – $2,345,000 = Pretax profit Pretax profit = $3,149,000 Number in Basket Selling price Variable Cost Contribution Margin

Phone

Billing

$3,200 2,160 $1,040

$4,400 3,810 $ 590

CMu(X) – FC = Pretax profit ($1,040 × 2,460) + ($590 × 1,640) – FC = $3,149,000 $2,558,400 + $967,600 – FC = $3,149,000 $3,526,000 – FC = $3,149,000 FC = $377,000 (d) Number in Basket Selling price Variable Cost Contribution Margin

Phone Answering Unit Basket 3 $3,600 $10,800 2,160 6,480 $1,440 $ 4,320

Billing Basket 1 $6,350 $6,350 3,810 3,810 $2,540 $2,540

Unit

Basket Total % 4 $17,150 100.0% 10,290 60.0% $ 6,860 40.0%

CMu(BEPu) – FC = $0 $6,860(BEPu) – $2,345,000 = $0 BEPu = 342 baskets Phone: 342 × 3 = 1,026 clients Billing: 342 × 1 = 342 clients (e) As Salida gains and loses clients, the assumption of a constant mix is not likely to hold. In addition, the variable cost per unit and fixed costs are not likely to remain constant over the three-year period.

SOLUTIONS MANUAL • CHAPTER 12  272

(a)

Philadelphia Phenoms: Break-even Graph $30,000 $28,000 $26,000 $24,000 $22,000 $20,000 $18,000

Dollars

26.

$16,000 $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 0

50

100

150

200

Number of Members TC

TFC

TR

SOLUTIONS MANUAL • CHAPTER 12  273

(b)

Philadelphia Phenoms: Profit-Volume Graph

$6,000

$4,000

Profit (Loss) Dollars

$2,000

$0 0

50

100

150

200

(c) Student answers will vary.

Benefit of (1): more information ($2,000) Benefit of (2): more simple, easier for those unfamiliar with the graphs to understand.

($4,000)

($6,000) Members

(c) While student answers will vary by personal preference, the graph in (a) shows fixed costs, variable costs, and revenues, which may convey the information to nonaccounting members better than the graph in (b).

SOLUTIONS MANUAL • CHAPTER 12  274

CASES 27.

(a) VCu = $10 + $18 + $5 + $12 = $45 Profit = Ru(X) – VCu (X) – FC Profit = $80(50,000) – $45(50,000) – $1,250,000 Profit = $35(50,000) – $1,250,000 Profit = $1,750,000 – $1,250,000 = $500,000 (b) Sales volume = 50,000 × .9 = 45,000 VCu = $45 × 1.15 = $51.75 Profit = R(X) – VC(X) – FC Profit = $80(45,000) – [$51.75 × 45,000] – $1,250,000 Profit = $3,600,000 – $2,328,750 – $1,250,000 Profit = $21,250 (c) Sales volume = 50,000 × 1.15 = 57,500 VCu = $45 × 0.80 = $36 Profit = R(X) – VC(X) – FC Profit = $80(57,500) – [$36 × 57,500] – $1,250,000 Profit = $4,600,000 – $2,070,000 – $1,250,000 Profit = $1,280,000 (d) TO: Whitney Management FROM: Accounting Department SUBJECT: Cost Improvements The best method that management can apply to cut down on the company’s costs for producing embossed cookbooks would be to improve the company’s cost efficiency.

Management has to analyze each stage of the production process and determine whether each stage adds value to final product. Management should try to identify under performing production stages and unnecessary production costs in order to reduce the total variable cost and fixed cost for producing embossed cookbooks.

28.

Student answers will vary depending on product selected.

SOLUTIONS MANUAL • CHAPTER 12  275

SUPPLEMENTAL PROBLEMS 29.

Cost Depreciation Labor Food Utilities Other

Variable (per unit)

Fixed $18,000 35,000

$2.00 3.00 0.25 0.50 $5.75

Capacity Occupancy rate Animals per day Days per Year Animals per year

15,000 22,000 $90,000

50 × 80% 40 × 360 14,400

(a) Ru(X) – VCu(X) – FC = $0 Ru(14,400) – $5.75(14,400) – $90,000 = $0 Ru(14,400) – $82,800 = $90,000 Ru(14,400) = $172,800 Ru = $12 minimum charge to break even (b) Pretax profit = After tax profit ÷ (1 – TR) Pretax profit = $38,400  (1 – .25) = $51,200 Ru(X) – VCu(X) – FC = Pretax profit Ru(14,400) – $5.75(14,400) – $90,000 = $51,200 Ru(14,400) – $82,800 = $141,200 Ru(14,400) = $224,000 Ru = $16 (c) Cats Unit Number in Basket Selling price Variable Cost Cont. Margin

$15.00 5.75 $ 9.25

Dogs Basket 1 $15.00 5.75 $ 9.25

Unit $RD 5.75 RD–$5.75

Pretax profit = $42,000  .75 = $56,000 CMB(X) – FC = Pretax profit (9RD – $42.50)(14,400 ÷ 10) – $90,000 = $56,000 (9RD – $42.50)(1,440) – $90,000 = $56,000 9RD(1,440) – $42.50(1,440) = $146,000 RD(12,960) – $61,200 = $146,000 RD(12,960) = $207,200 RD = $16

Basket 9 9×RD $51.75 9RD–$51.75

Basket Total 10 9RD+$15.00 $57.50 9RD–$42.50

SOLUTIONS MANUAL • CHAPTER 12  276

Total selling price per “basket” = $15 + 9($16) = $15 + $144 = $159 Total VC per “basket” = $5.75 × 10 = $57.50 Total CM per “basket” = $159.00 – $57.50 = $101.50 Contribution margin (1,440 x $101.50) Fixed costs Pretax profit Tax (25%) Net income (off due to rounding)

$146,160 (90,000) $ 56,160 (14,040) $ 42,120

(d) Total animals = 30 animals per day × 360 days = 10,800 CMB(X) – FC = Pretax profit (9RD – $42.50)(10,800 ÷ 10) – ($90,000 + $12,000) = $56,000 9RD(1,080) – $42.50(1,080) – $102,000 = $56,000 (9RD – $42.50)(1,080) – $102,000 = $56,000 RD(9,720) – $45,900 = $158,000 RD(9,720) = $203,900 RD = $21 (e) R(X) – VC(X) – FC = Pretax profit $40(X) – $8(X) – $3,680 = $8,000 $32(X) = $11,680 X = 365 dogs 30.

(a) Ties $18.50 12.80 $ 5.70 30.8%

Selling price Variable Cost Cont. Margin % of Price

Blouses $43.00 23.85 $19.15 44.5%

Shirts $40.00 33.65 $ 6.35 15.9%

The blouses are the most profitable (44.5%); men's shirts are the least (15.9%). This situation is reasonable because women's clothing is generally priced at a higher markup than men's. (b) # in Basket Selling price Variable Cost Cont. Margin

Ties Unit $18.50 12.80 $ 5.70

Basket 2 $37.00 25.60 $11.40

Blouses Basket 3 $43.00 $129.00 23.85 71.55 $19.15 $ 57.45

Unit

Shirts Total $40.00 33.65 $ 6.35

Unit 1 $40.00 33.65 $ 6.35

Total Basket 6 $206.00 130.80 $ 75.20

SOLUTIONS MANUAL • CHAPTER 12  277

Fixed Costs = $920,000 + $150,000 + $174,100 = $1,244,100 CMB(BEPu) – FC = $0 $75.20(BEPu) – $1,244,100 = $0 $75.20(BEPu) = $1,244,100 BEPu = 16,544 baskets BEP$ = BEPu × RB = 16,544 × $206 = $3,408,064 (c) Ties: 16,544 baskets × 2 = 33,088 Blouses: 16,544 baskets × 3 = 49,632 Shirts: 16,544 baskets × 1 = 16,544 (d) CMB(X) – FC = Pretax profits $75.20(X) – $1,244,100 = $1,010,360 $75.20(X) = $2,254,460 BEPu = 29,980 baskets Ties: 29,980 baskets × 2 = 59,960 Blouses: 29,980 baskets × 3 = 89,940 Shirts: 29,980 baskets × 1 = 29,980 Revenue = # baskets × RB = 29,980 × $206 = $6,175,880 (e) Pretax profit = After tax profit ÷ (1 – TR) Pretax profit = $806,000 ÷ (1 – .35) = $1,240,000 CM Ratio = CM ÷ R = $75.20 ÷ $206.00 = 36.5% (rounded) (FC + Pretax profit) ÷ CM Ratio = Revenue ($1,244,100 + $1,240,000) ÷ 36.5% = Revenue $2,484,100 ÷ 36.5% = Revenues Revenues = $6,805,754 (f) MS$ = Revenue – BEP$ = $6,175,880 – $3,408,064 = $2,767,816 MS% = (29,980 – 16,544) ÷ 29,980 = 13,436  29,980 = 44.8%

SOLUTIONS MANUAL • CHAPTER 12  278

31. (a) Koontz Ltd.: Break-even Graph

Dollars

$900,000 $750,000 $600,000 $450,000 $300,000 $150,000 $0 0

15000

30000

45000

Sales in Units TC

TFC

TR

(b) Koontz Ltd.: Profit-Volume Graph $450,000

$300,000

$150,000

$0 0

1 5000

3000 0

($150,000) Sa les in Units

4 5000

6000 0

60000

SOLUTIONS MANUAL • CHAPTER 12  279

(c) Two graphs have been prepared for Koontz Ltd. to analyze the revenues, costs, and profit associated with production and selling your product. These graphs are based on the assumptions and amount in the 2009 income statement.

The first graph, the break-even graph, depicts three lines. The TR line represents total revenues at any level of sales from 0 units to 60,000 units. The TC line represents total costs at any level of sales within the same range. The TFC lines, which is horizontal represents fixed costs, which are constant across any sales level. The intersection point of the TR and TC lines represents the sales in units at which revenues and costs are equal and Koontz will break even. To the left of that point, a loss will be incurred, and to the right profits are realized. The profit or loss amount is depicted by the distance between the two lines.

The second graph, the profit-volume graph, depicts only one line that extends below the x-axis. The line represents revenues, and at any sales level (x-axis), the y-axis gives the amount of profit or loss. When the line crosses the x-axis, both profit and loss are equal to zero, indicating the sales level at which Koontz will break even. To the left of that point, a loss is incurred, and to the right, a profit is realized.

CHAPTER 13 Solutions to End of Chapter Material

QUESTIONS 1.

A budget is an organization’s formalized financial plan for operations for a specified future period. The plan helps the organization coordinate the activities needed to achieve the plan’s desired results. The budget reflects management’s forecast of the financial effects of an organization’s plans for one or more future time periods.

Budgeting is equally important for small and large businesses. However, good budgeting can mean the difference between staying in business and going bankrupt for a small business. In large organizations, budgeting is important to allocate resources to many available projects and operating activities.

2.

Management is often able to effectively prepare a budget that fits with the company’s goals and objectives. Thus, top level management may prepare the budget with little or no input from subordinates…leaving those employees to perform activities according to the budget limitations imposed by management.

The benefit of including lower-level employees in budget preparation is that management is made aware of lower-level employees’ concerns regarding the budget and related activities. Without input from lower-level employees, management may not be aware of specific problems or considerations that could affect goal achievement or employee performance.

3.

In preparing budgets, managers forecast a number of items, such as volume of goods or services that will be sold and selling prices of those items. Using these estimates, plans are developed to determine needed organizational resources, including employees, raw materials and supplies, cash, space, and anything else necessary to the future operations.

The master budget is a comprehensive plan for an upcoming financial period, usually a year. The master budget is directly affected by forecasted information because various interrelated activities link together in the budget’s preparation.

4.

The production and purchases budgets are similar because they both require management to determine the quantity of raw materials or units are needed in a particular period.

Management also needs to establish beginning and ending inventory policies on quantities of units or materials.

Manufacturing organizations use both a production and purchases budget. Wholesale and retail companies use a purchases budget for both inventory and supplies. A service company would typically prepare a purchases budget for supplies.

SOLUTIONS MANUAL • CHAPTER 13 1

SOLUTIONS MANUAL • CHAPTER 13  2

5.

Monthly ending inventory is necessary to meet product demand in the event that forecasts are not exact. In an ideal world, sales and production would be precise but, in reality, sales and production fluctuate from estimates so there is always an inventory reserve.

Additionally, the economic climate may indicate a need to maintain a level of inventory of essential raw materials or supplies that may become scarce in a future period.

6.

Desired ending inventory is added to the production budget because these units are supposed to be on hand at the end of the period. However, because there is some level of beginning inventory, these units are subtracted because they are already available and do not need to be manufactured or purchased in the current period.

For a manufacturing company, beginning and ending inventory amounts on production budget are expressed in whole finished units, while these amounts are expressed in units of components on a purchases budget.

7.

Production overhead and selling and administrative costs need to be separated into their variable and fixed components because variable costs will change with the level of activity (either production or sales, respectively), while fixed costs will not. Additionally, production costs become a part of inventory cost and are capitalized until the units are completed and sold, whereas selling and administrative costs are period costs and (unless they benefit a future period) are expensed as incurred.

8.

Answers will vary according to student. Students will probably indicate that there is a significant difference in the size of their “minimum balances” compared with those of an organization. Organizations typically must go to the bank to obtain short-term loans to cover cash shortages; students may be able to simply ask parents to put some more funds in the checking account. The difference is that organizations are self-sufficient and students are usually dependent on someone to help support them through their educational process.

9.

The master budget concludes with a presentation of pro forma financial statements because these are projected financial statements that management expects in the future.

Pro forma statement amounts will differ from the actual financial statements amounts because pro forma statements are based on estimates which will not be in complete agreement with actual occurrences.

10.

Rolling budgets are continuous in nature because the budget is determined on an ongoing basis. As one month (or quarter) passes, another month (or quarter) is added to the budget. A rolling budget allows a company to adjust its expectations in response to changes in the business environment. Rolling budgets enable companies to have current time events in their budget.

Rolling budgets will create more work for the managers because of the continuous need for determining how the changes in the business environment will affect the budget.

SOLUTIONS MANUAL • CHAPTER 13  3

11.

Companies use standard costs to allow for unvarying amounts in a budget period or to have a norm against which to assess actual performance. Standard costs are developed from historical information and are adapted for changed conditions as well as internal and external benchmarks.

12.

A material price variance (MPV) indicates the difference in total cost between the actual and expected price per unit of input. MPVs are typically calculated on the basis of the actual quantity purchased. A material quantity variance (MQV) is the total cost difference caused by using more or less of an input than that which was expected. The MPV and MQV can occur without one another.

Some causes of a MPV or MQV are: • Change in price paid for materials caused by: o A change in the quantity of materials purchased o A change in quantity purchased leading to a change in purchase discount o A new supplier contract • Unreasonable material price or quantity standard • Error in the accounting records for the actual price of materials or quantity of materials used • Normal fluctuation in material usage • Change in production processes, causing a change in the quantity of materials used • Theft of raw materials

13.

There is no way to make such a determination until additional investigation. If the purchasing agent bought the proper quantity and quality of food items, then I would be pleased with the reduced cost to purchase. However, if the purchasing agent bought too much food to obtain a quantity discount and then the food spoiled, or if the food was the wrong type (causing a problem for the chef who could not fill customers’ orders), or if the food purchased was of low quality (causing a problem with the chef’s food preparation), then I would not be pleased with the purchasing agent.

14.

(a) Labor Rate Variance (F or U would depend on whether the actual was below or above the standard) • Change in average wage rate paid to employees caused by: o A new union contract o A change in average experience or training of workers o A change in the government-mandated minimum wage • Unreasonable labor price standard • Error in the accounting records for the actual price of direct labor (b) Labor Efficiency Variance (F or U would depend on whether the actual was below or above the standard) • Normal fluctuation in labor hours • Change in average labor time caused by: o A change in equipment, technology, or other aspect of production processes o Intentional work slowdown

SOLUTIONS MANUAL • CHAPTER 13  4

• • • • 15.

o A change in average worker experience or training caused by: ▪ Improved performance from effective training programs ▪ Change in employee turnover Intentional or unintentional over- or underreporting of labor hours Unanticipated overtime hours Unreasonable labor hours standard Error in the accounting records for the quantity of labor hours

Management by exception is a technique that allows managers to determine whether immediate action is required or not depending on the event’s level of acceptability. If the event is out of the range of acceptability, management should take immediate action to further investigate the event.

This process is useful because it allows managers to use their time wisely and not to waste time on unimportant issues.

EXERCISES 16.

(a)

F The purchases budget is used to determine how much raw material is needed to manufacture the units that will be sold in a period. (b) F The company may still need to pay for some items previously purchased. (c) T (d) F Efficiency of use would be related to the material quantity variance; it is possible that a favorable price variable offset an unfavorable quantity variance (if the quantity purchased and used are equal). (e) F A flexible budget relates to different levels of volume. (f) F The formula given provides the labor rate variance; the labor efficiency variance is (AQ × SR) – (SQ × SR). (g) F The direct labor budget should include only the cost of direct labor workers; indirect labor workers’ wages and salaries should be included in the overhead budget. (h) T (i) F The order in which budgets are prepared begins with sales information and then reflects the implications of those sales figures throughout the organization. (j) F The number of budgets produced is dependent on the units produced and sold as well as the number of different raw materials required. These individual budgets may be combined to create a single comprehensive budget. (k) F Although there may be a correlation between material price variance and material quantity variance, such a correlation is not automatic. (l) F Beginning inventory units are subtracted and ending inventory units are added to the number of units to be produced. (m) T (n) F The cash payments budget would never include an estimate of what the company would not pay.

SOLUTIONS MANUAL • CHAPTER 13  5

17.17.

18.

Sales in units Unit sales price Total sales

January 70,000 × $7.50 $525,000

February 70,000 × $7.50 $525,000

March 110,000 × $7.50 $825,000

Quarter 250,000 × $7.50 $1,875,000

Sales in units Unit sales price Total sales

April 120,000 × $7.50 $900,000

May 70,000 × $7.50 $525,000

June 110,000 × $7.50 $825,000

Quarter 300,000 × $7.50 $2,250,000

Sales in units Unit sales price Total sales

July 120,000 × $7.60 $912,000

August 80,000 × $7.60 $608,000

September 50,000 × $7.60 $380,000

Quarter 250,000 × $7.60 $1,900,000

Sales in units Unit sales price Total sales

October 70,000 × $7.60 $532,000

November 50,000 × $7.60 $380,000

December 80,000 × $7.60 $608,000

Quarter Year 200,000 1,000,000 × $7.60 $1,520,000 $7,545,000

(a) (1) 45,750 – 6,750 = 39,000 units (2) 41,850 – 36,000 = 5,850 units (3) 126,300 – 120,000 = 6,300 units (also EI from June) (4) 6,750 units (EI from May) (5) 5,625 units (BI from April) (6) 41,850 – 5,625 = 36,225 units (7) 45,750 – 5,850 = 39,900 units (8) 51,300 – 6,750 = 44,550 units (9) 126,300 – 5,625 = 120,675 units (b) EI = 15% of sales of the following month (5,850 ÷ 39,000 or 6,750 ÷ 45,000) EI in March: 15% × 36,000 units = 5,400 units No, the EI in March was not in conformity because it was 5,625 units (i.e., BI shown for April). (c) 6,300 = 15%X X = 42,000 units

SOLUTIONS MANUAL • CHAPTER 13  6

19.

Purchases Budget for Wax April Production 36,225 in units Ounces per × 8 unit Total ounces 289,800 needed Desired EI 31,920 (10%) BI (28,980) Total ounces to purchase Cost per ounce Total cost

June

Quarter

July

39,900

44,550

120,675

41,775

×

×

×

×

8

8

8

319,200

356,400

965,400

35,640

33,420

33,420

(31,920)

(35,640)

292,740

322,920

354,180

969,840

× $0.15

× $0.15

× $0.15

× $0.15

$43,911

$48,438

$53,127

$145,476

Purchases Budget for Dye April Production 36,225.00 in units Ounces per × 1 unit Total ounces 36,225.00 needed Desired EI 5,985.00 (15%) BI (5,433.75) Total ounces to purchase 36,777 (rounded up) Cost per × $0.02 ounce Total cost $735.54 Total cost of purchases

May

$44,646.54

8

334,200

(28,980)

May

June

Quarter

July

39,900.00

44,550.00

120,675.00

41,775.00

×

×

1

1

×

1

39,900.00

44,550.00

120,675.00

6,682.50

6,266.25

6,266.25

(5,985.00)

(6,682.50)

(5,433.75)

40,598

44,134

121,509

× $0.02

× $0.02

× $0.02

$811.96

$882.68

$2,430.18

$49,249.96

$54,009.68

$147,906.18

×

1

41,775.00

SOLUTIONS MANUAL • CHAPTER 13  7

20.

April Production in units DL hours needed per unit Total DL hours needed (rounded up) DL wage rate per hour Total DL cost (cash)

May

June

Quarter

36,225

39,900

44,550

120,675

×0.05

×0.05

×0.05

× 0.05

1,812

1,995

2,228

6,035

× $9.50

× $9.50

× $9.50

× $9.50

$17,214.00

$18,952.50

$21,166.00

$57,332.50

21.

Sales + EI (10%) - BI Production

April 25,000 2,000 (2,400) 24,600

May 20,000 3,800 (2,000) 21,800

June 38,000 3,500 (3,800) 37,700

May 21,800 × 5 109,000 28,275 (16,350) 120,925 × $0.20 $24,185

June 37,700 × 5 188,500 26,625 (28,275) 186,850 × $0.20 $37,370

July 35,000 4,000 (3,500) 35,500

Purchases - Metal Production Ounces Needed EI (15%) - BI To purchase Cost Cost for metal

April 24,600 × 5 123,000 16,350 (18,500) 120,850 × $0.20 $24,170

July 35,500 × 5 177,500

Purchases - Felt Production Pieces Needed + EI (15%) - BI To purchase ÷ 10 Cost per 10 Cost for felt

April 24,600 × 2 49,200 6,540 (7,250) 48,490 4,849 × $0.03 $145.47

May 21,800 × 2 43,600 11,310 (6,540) 48,370 4,837 × $0.03 $145.11

June 37,700 × 2 75,400 10,650 (11,310) 74,740 7,474 × $0.03 $224.22

July 35,500 × 2 71,000

SOLUTIONS MANUAL • CHAPTER 13  8

Total Purchases Cost Metal Felt Total 22.

April $24,170.00 145.47 $24,315.47

May $24,185.00 145.11 $24,330.11

June $37,370.00 224.22 $37,594.22

Credit sales for February: $525,000 × 0.85 = $446,250 Credit sales for March: $825,000 × 0.85 = $701,250 Sales in April: $900,000; credit sales = $765,000 Sales in May: $525,000; credit sales = $446,250 Sales in June: $825,000; credit sales = $701,250 April Collections from Feb. ($446,250 × 10%) Collections from Mar. ($701,250 × 30%) ($701,250 × 10%) Collections from Apr. Cash (15%) ($765,000 × 60%) ($765,000 × 30%) ($765,000 × 10%) Collections from May Cash (15%) ($446,250 × 60%) ($446,250 × 30%) Collections from June Cash (15%) ($701,250 × 60%) Total cash collected

May

June

$ 44,625

$

210,375

135,000 459,000 $ 76,500

135,000 459,000 229,500 76,500

133,875

78,750 267,750 133,875

123,750 420,750 $754,875

123,750 420,750 $2,250,000

229,500

78,750 267,750

$646,125

44,625

210,375 70,125

$ 70,125

$849,000

Quarter

SOLUTIONS MANUAL • CHAPTER 13  9

23.

January Collections from Nov. ($680,000 × 5%) Collections from Dec. ($925,000 × 15%) ($925,000 ×5%) Collections from Jan. ($864,000 × 80%) ($864,000 × 15%) ($864,000 × 5%) Collections from Feb. ($732,000 × 80%) ($732,000 × 15%) Collections from Mar. ($788,000 × 80%) Total 24.

February

March

$ 34,000

Quarter

$

138,750

138,750 46,250

$ 46,250

691,200 $ 43,200

691,200 129,600 43,200

109,800

585,600 109,800

630,400 $783,400

630,400 $2,408,800

129,600

585,600

$863,950

$761,450

(a) Balance related to April sales = $234,600 – $170,400 = $64,200 0.1X = $64,200 X= $642,000 (total April credit sales) $642,000 = 0.75X X = $856,000 total April sales (b) 0.3X = $170,400 X = $568,000 (total May credit sales) (c) June Collections from April (remaining amount) Collections from May ($568,000 × 0.20) Collections from June Cash ($864,500 × 25%) Credit Sales ($648,375 × 70%) Total collections for June

34,000

$ 64,200.00 113,600.00 216,125.00 453,862.50 $847,787.50

SOLUTIONS MANUAL • CHAPTER 13  10

25.

(a) $25,500 ÷ 10,625 = $2.40 per pound (b) 300 tables × 35 lbs. per table = 10,500 lbs (c)

AP × AQ SP × AQ SP × SQ $2.40 × 10,625 $2.60 × 10,625 $2.60 × 10,500 $25,500 $27,625 $27,300 $2,125 F $325 U Material Price Variance Material Quantity Variance $1,800 F Total Material Variance

(d)

AP × AQ SP × AQ $2.40 × 12,500 $2.60 × 12,500 $30,000 $32,500 $2,500 F Material Price Variance The MQV is the same as calculated in part (c) or $325 U

(e) The person in charge of purchasing materials would normally be responsible for material price variance and the supervisor for production operations would normally be responsible for material quantity variance. If the material purchased in June were of lower-than-normal quality, responsibility for the unfavorable material quantity variance should be shifted to the person in charge of purchasing materials.

26.

Company A

MPV = (AP × AQ) – (SP ×AQ) MPV = $280,000 – ($12 × 24,050) MPV = $280,000 - $288,600 MPV = $8,600 F MQV = (SP × AQ) – (SP × SQ) ($480) = ($12 × 24,050) – ($12 × SQ) $12 × SQ = $288,600 + $480 SQ = $289,080 ÷ $12 SQ = 24,090 lbs.

Units produced = Standard quantity allowed ÷ Standard quantity per unit Units produced = 24,090 lbs ÷ 6 lbs. = 4,015 units Company B

MPV = Actual material cost – (SP × AQ) ($3,700) = Actual material cost – ($24 × 15,100) ($3,700) = Actual cost - $362,400 Actual cost = $358,700

SOLUTIONS MANUAL • CHAPTER 13  11

MQV = (SP × AQ) – (SP × SQ) $2,400 = ($24 × 15,100) – ($24 × SQ) $2,400 = $362,400 – ($24 × SQ) $24 × SQ = $362,400 – $2,400 SQ = $360,000 ÷ $24 SQ = 15,000 lbs.

Company C

Standard quantity per unit = 3,600 gal. × 8 pts = 28,800 pts.

28,800 ÷ 14,400 units = 2 pts. per unit MQV = (SP × AQ) – (SP × SQ) ($450) = ($18 × AQ) – ($18 × 3,600) ($450) = ($18 ×AQ) – $64,800 $18 × AQ = $64,350 AQ = 3,575 gals.

MPV = (AP × AQ) – (SP × AQ) MPV = $60,000 – ($18 × 3,575) MPV = $60,000 – $64,350 MPV = $4,350 F Company D

Standard quantity per unit 82,400 ÷ 8 pts = 10,300 units MQV = (SP × AQ) – (SP × SQ) MQV = SP (AQ – SQ) $3,009 = SP (83,420 – 82,400) 1,020 SP = $3,009 SP = $3,009 ÷ 1,020 SP = $2.95 MPV = (AP × AQ) – (SP × AQ) MPV = $250,000 – ($2.95 × 83,420) MPV = $250,000 – $246,089 MPV = $3,911 U 27.

(a)

AP × AQ $60,250

SP × AQ $180 × 325 $58,500

$1,750 U Labor Rate Variance

SP × SQ $180 × 350 $63,000

$4,500 F Labor Efficiency Variance $2,750 F Total Labor Variance

SOLUTIONS MANUAL • CHAPTER 13  12

(b) The partners at Imello & Havers, CPAs might be concerned if all of the audit procedures were performed during the audit. The partners might also be concerned that audit hours are being overbudgeted, which might cause the firm to lose audit engagements if the firm is bidding on audits based on too many budgeted hours.

28.

(a) Standard hours = 3,000 units × 6 hr per unit = 18,000 hours (b) Actual Labor Cost LRV = (AP × AQ) – (SP × AQ) $3,330 = (AP × 16,650) – ($14 × 16,650) $3,330 = (AP × 16,650) – $233,100 $236,430 = 16,650 AP AP = $14.20 (c) LEV = (SP × AQ) – (SP × SQ) LEV = ($14 × 16,650) – ($14 × 18,000) LEV = $233,100 – $252,000 = $18,900 F (f) LRV = (AP × AQ) – (SP × AQ) $1,857 = $44,499 – (SP × 6,180) SP = ($44,499 – $1,857) SP = $42,642 ÷ 6,180 SP = $6.90 (e) LEV = (SP × AQ) – (SP × SQ) ($828) = ($6.90 × 6,180) – ($6.90 × SQ) ($828) = $42,642 – ($6.90 × SQ) SQ = $43,470 ÷ $6.90 SQ = 6,300 hours (d) Standard hours per unit = 6,300 hours ÷ 1,500 units = 4.2 hours per unit (g) Units produced = 22,050 hours ÷ 10.5 hours per unit = 2,100 units (h) LRV = (AP × AQ) – (SP × AQ) ($3,285) = $260,715 – ($12 × AQ) ($12 × AQ) = $264,000 AQ = $264,000 ÷ 12 AQ = 22,000 hours (i) LEV = (SP × AQ) – (SP × SQ) LEV = ($12 × 22,000) – ($12 × 22,050) LEV = $264,000 – $264,600 LEV = $600 F (j) Standard hours allowed = 4,800 × 5.1 = 24,480 hours

SOLUTIONS MANUAL • CHAPTER 13  13

(k) LEV = (SP × AQ) – (SP × SQ) ($840) = ($10.50 × AQ) – ($10.50 × 24,480) ($840) = ($10.50 × AQ) – $257,040 ($10.50 × AQ) = $256,200 AQ = $256,200 ÷ 10.50 AQ = 24,400 hours (l) LRV = (AP × AQ) – (SP × AQ) LRV = $257,420 – ($10.50 × 24,400) LRV = $257,420 - $256,200 LRV = $1,220 U

PROBLEMS 29.29.

Sales in units Desired E.I (25%) Total needed BI units Production in units 30.

July 30,000 15,000 45,000 (7,400) 37,600

August 60,000 12,000 72,000 (15,000) 57,000

Sept.

48,000 9,000 57,000 (12,000) 45,000

Quarter 138,000 9,000 147,000 (7,400) 139,600

(a) Production Budget Sales in units Desired E.I (20%) Total needed BI units Production in units

January 8,000 1,520 9,520 (1,680) 7,840

(b) Purchases Budget for Material X January Production in units 7,840 Gal. per unit × 2.5 Total gals needed 19,600 Desired E.I (30%) 6,240 B.I (5,800) Total gals to 20,040 purchase Cost per gal × $5.90 Total cost of $118,236 material X

February 7,600 2,240 9,840 (1,520) 8,320

March 11,200 1,160 12,360 (2,240) 10,120

April 5,800 1,220 7,020 (1,160) 5,860

February 8,320 × 2.5 20,800 7,590 (6,240) 22,150

March 10,120 × 2.5 25,300 4,395 (7,590) 22,105

April 5,860 × 2.5 14,650

× $5.90 $130,685

× $5.90 $130,419.50

SOLUTIONS MANUAL • CHAPTER 13  14

Purchases Budget for Material Y January Production in units 7,840 Pounds per unit × 3 Total pounds 23,520 needed Desired E.I (30%) 7,488 B.I (7,200) 23,808 Total pounds to purchase Cost per pound × $3.75 $89,280 Total cost of material Y 31.

February 8,320 × 3 24,960

March 10,120 × 3 30,360

9,108 (7,488) 26,580

5,274 (9,108) 26,526

× $3.75 $99,675

× $3.75 $99,472.50

(a) Sales budget for 2010 Sales in units Unit sales price Total sales

Mixers 60,000 × $50 $3,000,000

Bread-makers 40,000 × $120 $4,800,000

(b) Production Budget for 2010 Sales in units Desired E.I Total needed BI units Production in units

Mixers 60,000 2,000 62,000 (3,000) 59,000

Bread-makers 40,000 2,800 42,800 (6,000) 36,800

(c) Purchases Budget for Plastic Housing for 2010 Mixers Bread-makers Production in units 59,000 36,800 Plastic housing per unit × 1 × 1 Total plastic needed 59,000 36,800 Desired E.I 700 800 BI (500) (620) Total plastic to purchase 59,200 36,980 Cost per unit × $8 × $24 Total cost of plastic $473,600 $887,520

April 5,860 × 3 17,580

SOLUTIONS MANUAL • CHAPTER 13  15

Purchases Budget for Motors for 2010 Mixers Production in units 59,000 Motors per unit × 1 Total motors needed 59,000 Desired EI 2,400 BI ( 1,100) Totals motors to purchase 60,300 Cost per unit × $15 Total cost of motors $904,500 Purchases Budget for Beaters for 2010 Mixers Production in units 59,000 Beaters per unit × 2 Total beaters needed 118,000 Desired EI BI Total beaters to purchase Cost per unit Total cost of beaters

Bread-makers 36,800 × 1 36,800 1,200 (1,380) 36,620 × $17.80 $651,836

Bread-makers 36,800 × 4 147,200

(d) Direct Labor Budget for Class A labor Mixer Production in units 59,000 DL hours needed per unit × 1.3 Total DL hours needed 76,700 DL wage rate per hour × $10 Total Class A DL cost $767,000

Bread-makers 36,800 × 1.6 58,880 × $10 $588,800

Direct Labor Budget for Class B labor Mixer Production in units 59,000 DL hours needed per unit × 1.5 Total DL hours needed 88,500 DL wage rate per hour × $12 Total Class B DL cost $1,062,000

Bread-makers 36,800 × 2.2 80,960 × $12 $971,520

Total

265,200 4,000 (5,000) 264,200 × $2.20 $581,240

(e) In addition to the direct costs of production, overhead costs need to be included in the budgeting process. The following items can be part of the manufacturing overhead costs: • Supplies • Indirect labor • Maintenance • Miscellaneous

SOLUTIONS MANUAL • CHAPTER 13  16

• Depreciation • Property taxes • Insurance • Plant supervision • Fringe benefits (f) The in-house manufacturing of plastic housings would create the following types of costs: • Property, plant and equipment • Direct labor • Training costs • Direct material needed for production • Increase in electricity • Increase in depreciation on new PP&E • Increase in insurance on new PP&E • Possible increase in property taxes on new PP&E and possible new space needed The in-house manufacturing of plastic housings would eliminate or reduce the following types of costs: • Purchase cost of product • Possible reduction of some purchasing agent costs • Reduction of some transportation-in costs 32.

(a) Schedule of Cash Collections January Collection from Nov. ($336,000 × 40%) ($336,000 × 10%) Collection from Dec. ($728,000 × 50%) ($728,000 × 40%) ($728,000 × 10%) Collection from Jan. Cash sales ($378,000 × 30%) ($264,600 × 50%) ($264,600 × 40%) ($264,600 × 10%) Collection from Feb. Cash sales ($550,000 × 30%) ($385,000 × 50%) ($385,000 × 40%) Collection from Mar. Cash ($440,000 × 30%) ($308,000 × 50%) Total cash collections

February

March

$134,400

$ 134,400 33,600

$ 33,600 364,000 $ 72,800

364,000 291,200 72,800

26,460

113,400 132,300 105,840 26,460

154,000

165,000 192,500 154,000

132,000 154,000 $539,260

132,000 154,000 $2,071,500

291,200

113,400 132,300 105,840

165,000 192,500

$744,100

$788,140

Quarter

SOLUTIONS MANUAL • CHAPTER 13  17

(b) Expected A/R balance at 3/31/10 = (0.10 × $385,000) + (0.50 × $308,000) Expected A/R balance = $38,500 + $154,000 = $192,500 (c) The company’s customers could be experiencing cash flow problems due to economic difficulties. As such, payments could be significantly slower than expected and the company’s bad debts (previously at almost zero) could be sharply increasing.

33.

(a) $512,100 – $432,000 = $80,100 remaining of November billings $80,100 = 0.15 of total November sales November sales = $80,100 ÷ 0.15 = $534,000 (b) $432,000 = remaining December billings $432,000 = 0.60 of total December sales December sales = $432,000 ÷ 0.60 = $720,000 Estimated uncollectible accounts for December = $720,000 × 0.01 = $7,200 (c) From November sales ($534,000 × 0.14) From December sales ($720,000 × 0.45) From January sales ($630,000 × 0.40) Total collections

$ 74,760 324,000 252,000 $650,760

(d) A company can decrease its amount of uncollectible accounts by having more stringent credit policies. A company can also request purchase orders include a partial down payment. A company can insist that any outstanding account be up-to-date relative to payments before another transaction is processed with a customer. The company may have fewer sales because of introducing new credit policies.

34.

Cash collections: From December sales ($600,000 × 0.80 × 0.18) From January sales Cash ($800,000 × 0.20) Credit ($640,000 × 0.80; × 0.18) From February sales Cash ($700,000 × 0.20) Credit ($560,000 × 0.80) Total collections CGS: December CGS ($600,000 × 0.70) = $420,000 January CGS ($800,000 × 0.70) = $560,000 February CGS ($700,000 × 0.70) = $490,000 March CGS ($750,000 × 0.70) = $525,000

January $ 86,400

February

160,000 512,000

$115,200

$758,400

140,000 448,000 $703,200

SOLUTIONS MANUAL • CHAPTER 13  18

Purchases: CGS Desired EI (25%) BI Purchases

December $420,000 140,000 (105,000) $455,000

January $560,000 122,500 (140,000) $542,500

Cash payments for merchandise: For December purchases ($455,000 × 0.40) For January purchases ($542,500 × 0.60; × 0.40) For February purchases ($498,750 × 0.60) Total payments for purchases

Beginning cash balance Cash collections Cash paid for purchases Salary expense Utility expense Rent expense Balance Borrowed Balance 35.

January $ 7,125 758,400 (507,500) (133,000) (78,500) (50,000) $ (3,475) 11,000 $ 7,525

February $490,000 131,250 (122,500) $498,750 January $182,000 325,500 $507,500

March $525,000

February $217,000 299,250 $516,250

February $ 7,525 703,200 (516,250) (133,000) (78,500) (50,000) $ (67,025) 75,000 $ 7,975

(a) Income Statement for the year ended December 31, 2010 Sales (161,000 × $14.25) $2,294,250 Cost of goods sold DM (161,000 × $4.28) $(689,080) DL (161,000 × $2.25) (362,250) OH ($362,250 × 0.40) (144,900) (1,196,230) Gross Profit $1,098,020 Expenses Variable selling $ (91,770) Fixed selling (36,000) Admin. ($150,000 × 1.20) (180,000) (307,770) Income before taxes $ 790,250 Income taxes (40%) (316,100) Net Income $ 474,150 Material cost = $560,000 ÷ 140,000 = $4; new = $4 × 1.07 = $4.28 Labor cost = $350,000 ÷ 140,000 = $2.50; new = $2.50 × 0.90 = $2.25 OH cost = $122,500 ÷ $350,000 = 35% + 5% = 40% (or ($0.90 per unit) Variable selling = $120,000 × 0.70 = $84,000; $84,000 ÷ $2,100,000 = 0.04 $2,294,250 × 0.04 = $91,770 Fixed selling = $120,000 × 0.30 = $36,000 Tax rate = $319,000 ÷ $797,500 = 40%

SOLUTIONS MANUAL • CHAPTER 13  19

(b)

Income before taxes = Net Income ÷ (1- Tax Rate) Income before taxes = $636,000 ÷ (1 – 0.40) = $1,060,000 Sales – CGS – Var. Selling Exp. – Fixed Selling Exp. – Fixed Admin. Expenses = Income before Taxes SP(161,000) – ($4.28 + $2.25 + $0.90)(161,000) – 0.04(SP)(161,000) – $36,000 – $180,000 = $1,060,000 161,000(SP) – (7.43)(161,000) – 6,440(SP) – $216,000 = $1,060,000 161,000(SP) – $1,196,230 – 6,440(SP) – $216,000 = $1,060,000 154,560(SP) = $2,472,230 SP = $16 Sales (161,000 × $16) CGS ($7.43 × 161,000) Gross Profit Var. Selling ($2,576,000 × 0.04) Fixed Selling Fixed Administrative Income before Taxes Income Taxes Net Income (off due to rounding)

36.

$2,576,000 (1,196,230) $1,379,770 $103,040 36,000 180,000

(319,040) $1,060,730 (424,292) $ 636,438

(a) Standard cost per foam hand Material cost $1.25 Labor cost ($6 × 1/10) 0.60 Variable overhead ($12 × 5/60 minutes) 1.00 (all cash) Fixed overhead ($360,000 ÷ 450,000) ...............0.80 ($312,000 in cash; rest depr.)

Total cost $3.65 Number of foam hands in beginning finished goods inventory = $1,460 ÷ $3.65 = 400 foam hands (b) Beginning Raw Material Inventory = $750 ÷ $1.25 = 600 sheets of foam (c) Sales Budget Sales in units Unit sales price Total sales

January 8,000 × $12 $96,000

February 10,000 × $12 $120,000

March 15,000 × $12 $180,000

Quarter 33,000 × $12 $396,000

SOLUTIONS MANUAL • CHAPTER 13  20

Production Budget Sales in units Desired E.I. (10%) Total needed B.I. units Production in units

January 8,000 1,000 9,000 (400) 8,600

February 10,000 1,500 11,500 (1,000) 10,500

March 15,000 1,200 16,200 (1,500) 14,700

Quarter 33,000 1,200 34,200 (400) 33,800

April production = 12,000 + 1,100 – 1,200 = 11,900 Purchases Budget Production in units Sheets per hand Total sheets needed Desired E.I (5%) B.I Total sheets to purchase Cost per sheet Total cost of sheets

January 8,600 × 1 8,600 525 (600) 8,525

February 10,500 × 1 10,500 735 (525) 10,710

March 14,700 × 1 14,700 595 (735) 14,560

Quarter 33,800 × 1 33,800 595 (600) 33,795

× $1.25 $10,656.25

× $1.25 $13,387.50

× $1.25 $18,200

× $ 1.25 $42,243.75

January 8,600 × 0.10 860 × $6 $5,160

February 10,500 × 0.10 1,050 × $6 $6,300

March 14,700 × 0.10 1,470 × $6 $8,820

Quarter 33,800 × 0.10 3,380 × $6 $20,280

Direct Labor Production in units DLHs per unit Total DLHs Wage rate per DLH Total DL cost

SOLUTIONS MANUAL • CHAPTER 13  21

Overhead Budget Production in units MHs per unit Rate per MH Total VOH cost Cash FOH cost* Total cash production OH Depreciation Total production OH Applied OH (units × $1.80) Underapplied OH Salaries Rent Utilities Total S&A cost

January 8,600 × 1/12 × $12 $ 8,600 26,000 $34,600

February 10,500 × 1/12 × $12 $10,500 26,000 $36,500

March 14,700 × 1/12 × $12 $14,700 26,000 $40,700

Quarter 33,800 × 1/12 × $12 $ 33,800 78,000 $111,800

4,000 $38,600

4,000 $40,500

4,000 $44,700

12,000 $123,800

$15,480

$18,900

$26,460

$60,840

$14,000 10,000 1,800 $25,800

$14,000 10,000 1,800 $25,800

$14,000 10,000 1,800 $25,800

$62,960 $ 42,000 30,000 5,400 $ 77,400

$62,300

$66,500

$189,200

February $12,000 $ 9,600

March $ 0 $2,400

Quarter $12,000 $12,000

March

Quarter $ 24,300

Total OH & S&A $60,400 cost (cash) *$312,000 ÷ 12 months = $26,000 Capital Budget Purchase of PP&E Cash payments for PP&E

January $0 $0

Schedule of Cash Collections from Sales January Collection from Dec. sales $ 24,300 Collection from Jan. sales Cash ($96,000 × 0.7) 67,200 ($28,800 × 0.25) 7,200 ($28,800 × 0.75) Collection from Feb. sales Cash ($120,000 × 0.7) ($36,000 × 0.25) ($36,000 × 0.75) Collection from Mar. sales Cash ($180,000 × 0.7) ($54,000 × 0.25) Total cash collections $98,700

February

67,200 7,200 21,600

$ 21,600 84,000 9,000

$114,600

$ 27,000

84,000 9,000 27,000

126,000 13,500 $166,500

126,000 13,500 $379,800

SOLUTIONS MANUAL • CHAPTER 13  22

Schedule of Cash Payments for Purchases January February For Dec. purchases $ 4,200.00 For Jan. purchases ($10,656.25×0.6) 6,393.75 ($10,656.25×0.4) $4,262.50 For Feb. purchases ($13,387.50×0.6) 8,032.50 ($13,387.50×0.4) For Mar. purchases ($18,200×0.6) Total cash $10,593.75* $12,295.00 payments

March

Quarter $ 4,200.00 6,393.75 4,262.50

$ 5,355.00

8,032.50 5,355.00

10,920.00 $16,275.00

10,920.00 $39,163.75*

*For purposes of cash budget, round up to next dollar.

Cash Budget Beg. Cash Bal. Cash collections Cash available Cash paid for DL Cash OH&SA Plant Assets Purchases Pay dividend Balance Borrow (repay) Sell (acquire) investments Interest received Interest paid End. Cash Bal.

January $ 10,200 98,700 $108,900

February $ 10,496 114,600 $125,096

March $ 10,461 166,500 $176,961

Quarter $ 10,200 379,800 $390,000

(5,160) (60,400)

(8,820) (66,500) (2,400) (16,275)

$ 32,746

(6,300) (62,300) (9,600) (12,295) (25,000) $ 9,601

$ 82,966

(20,280) (189,200) (12,000) (39,164) (25,000) $104,356

(22,000)

1,000

(72,000)

(93,000)

(250) $ 10,496

110 (250) $10,461

105 (250) $ 10,821

215 (750) $ 10,821*

(10,594)

*Actual cash is $10,821.25 because actual payments for purchases in January were only $10,593.75.

SOLUTIONS MANUAL • CHAPTER 13  23

Bobcat Paws Pro Forma Schedule of Cost of Goods Manufactured For the Quarter Ending March 31,2010 Beginning Work In Process Inventory, 1/1/10 Raw Material Beginning Balance Purchases Ending Balance (595 × $1.25) Raw Material Used Direct Labor (33,800 × $0.60) Overhead Total costs to be accounted for Ending Work In Process, 3/31/10 Cost of Goods Manufactured

$ $

750.00 42,243.75 (743.75) 42,250 20,280 60,840 $123,370 0 $123,370

Bobcat Paws Pro Forma Income Statement For the Quarter Ending March 31, 2010 Sales (Sales Budget) Cost of Goods Sold Finished Goods, 1/1/10 $ 1,460.00 CGM 123,370.00 CGA $124,830.00 Finished Goods, 3/31/10 (1,200 × $3.65) (4,380.00) CGS $120,450.00 Underapplied FOH* 62,960.00 Adjusted CGS Gross Margin Selling and Administrative (OH Budget) Other Revenues and Expenses $ 215 Interest Revenue (Cash Budget) Interest Expense (Cash Budget) (750) Income before Income Taxes Income Tax Expense (assume rate of 40%) Net Income *Expected production for one quarter (450,000 × 3/12) Actual production for first quarter Production not available to absorb FOH FOH rate per unit Underapplied OH

0

$396,000

183,410 $212,590 (77,400)

(535) $134,655 (53,862) $ 80,793

112,500 units 33,800 units 78,700 units × 0.80 $62,960

SOLUTIONS MANUAL • CHAPTER 13  24

Bobcat Paws Pro Forma Balance Sheet March 31, 2010 ASSETS Cash Accounts Receivable ($54,000 × 0.75) Investments (Cash Budget) Inventories Raw Material (595 × $1.25) Finished Goods (1,200 × $3.65) Property, Plant & Equipment Accumulated Depreciation Total Assets

$ 10,821.25 40,500.00 93,000.00 $

743.75 4,380.00

$437,000.00 (102,000.00)

5,123.75 335,000.00 $484,445.00

LIABILITIES & STOCKHOLDERS' EQUITY Accounts Payable ($18,200 × 0.40) 7,280.00 Note Payable 25,000.00 Taxes Payable 53,862.00 Common Stock $230,000.00 Paid-In Capital 20,000.00 Retained Earnings 148,303.00 398,303.00 Total Liabilities & Stockholders' Equity $484,445.00

SOLUTIONS MANUAL • CHAPTER 13  25

Bobcat Paws Pro Forma Statement of Cash Flows For Quarter Ended March 31, 2010 Operating Activities: Net Income + Depreciation Expense – Increase in A/R ($40,500 – $24,300) + Decrease in RM Inventory ($750 – $743.75) – Increase in FG Inventory ($4,380 – $1,460) + Increase in A/P ($7,280 – $4,200) + Increase in Taxes Payable ($53,862 – $0) Net cash inflow from operating activities Investing Activities: Purchase of short-term investments Purchase of PP & E Net cash outflow from investing activities Financing Activities: Paid dividend Net cash outflow from financing activities Net increase in cash flow Beginning cash balance Ending cash balance 37.

$80,793.00 12,000.00 (16,200.00) 6.25 (2,920.00) 3,080.00 53,862.00 $130,621.25 $(93,000) (12,000) (105,000.00) $(25,000) (25,000.00) 621.25 10,200.00 $ 10,821.25

(a) 7,500 = 5,000 x 1.5 (b) MPV = (AP x AQ) - (SP x AQ) = MPV = ($7.50 x 7,560) - ($7.30 x 7,560) = MPV = $56,700 - $55,188 = 1,512 U MQV = (SP x AQ) - (SP x SQ) = MQV = ($7.30 x 7,560) - ($7.30 x 7,500) = MQV = $55,188 - $54,750= 438 U TMV = $1,512 U + $438 U = $1,950 U (c) Higher quality material may be more expensive creating an unfavorable MPV.

SOLUTIONS MANUAL • CHAPTER 13  26

38. (a) 4,320 × 5/60 = 360 hours (b)

AP × AQ $9.10 × 380 $3,458

SP × AQ $9 × 380 $3,420

SP × SQ $9 × 360 $3,240

$38 U Labor Rate Variance

$180 U Labor Efficiency Variance $218 U Total Labor Variance

(c) The actual price for workers might be higher because of a shortage of people during the holiday season; thus, the store might be willing to pay slightly more than standard wage. Also because of the holiday season, the wrappers might be more pressured (from in-a-hurry customers) and make more mistakes, thus having to take more time in the process of rewraps. Also gifts might be larger at this time of year or the new workers are not as good at wrapping and, therefore, take longer.

39.

(a) 46,800 × 5 ounces = 234,000 ounces ÷ 16 = 14,625 pounds (b) SP per pound = $0.50 × 16 = $8.00 AP × AQ SP × AQ SP × SQ $8.30 × 14,250 $8 × 14,250 $8 × 14,625 $118,275 $114,000 $117,000 $4,275 U $3,000 F Material Price Variance Material Usage Variance $1,275 U Total Material Variance (c) 46,800 units × 5/60 = 3,900 hours (d)

AP × AQ SP × AQ SP × SQ $9.25 × 3,840 $9 × 3,840 $9 × 3,900 $35,520 $34,560 $35,100 $960 U $540 F Labor Rate Variance Labor Efficiency Variance $420 U Total Labor Variance

(e) There are various interactions between the material price variance and the material usage and labor efficiency variances. Higher quality material may be more expensive (creating an unfavorable MPV) but would be easier to work with and provide fewer defective items (creating favorable MUV and LEV). Lower quality material may be less expensive (creating a favorable MPV) but create more defects and thus longer labor times (creating unfavorable MUV and LEV).

SOLUTIONS MANUAL • CHAPTER 13  27

(f) There are various interactions between the labor rate variance and the labor efficiency variance. Higher wages (unfavorable LRV) may cause employees to work harder (favorable LEV). Also higher wages may be paid to more skilled employees who perform their tasks more quickly. The opposite situations are also possible.

CASES 40.

Beginning cash balance Cash collections Total cash available Cash payments for Supplies Labor Other Total payments Cash available (short) Borrow (repay) Sell (buy) investments Interest received (paid) Ending cash balance

April $ 385

May $ 338

June $ 346

$

2,750 $3,135

4,210 $4,548

3,720 $4,066

10,680 $11,065

$

890 1,430 970 $ 3,290 $ (155)

$ 660 1,525 920 $3,105 $1,443

$ 880 1,550 895 $3,325 $ 741

$ 2,430 4,505 2,785 $ 9,720 $ 1,345

500 0

(700) (400)

0 (400)

(200) (800)

(7)

3

6

2

$ 338

$ 346

$ 347

(a) $385 + $2,750 = $3,135 (b) $3,290 – ($890 + $970) = $1,430 (c) $3,135 – $3,290 = $(155) (d) $(155) + $500 – $7 = $338 (e) $338 ending balance from April (f) $4,548 – $338 = $4,210 (g) $2,430 – ($890 + $880) = $660 (h) $3,105 – ($660 + $1,525) = $920 (i) $4,548 – $1,443 = $3,105 (j) $1,443 – $700 + $3 – $346 = $400 (k) $346 June beginning balance (l) $4,066 – $346 = $3,720 (m) $3,325 + $741 = $4,066 (n) $880 + $1,550 + $895 = $3,325 (o) $0 (p) $741 – $0 – $400 – $347 = $6 (q) $347 Quarter ending balance (r) $385 (April beginning balance) (s) $11,065 – $385 = $10,680 (t) $1,430 + $1,525 + $1,550 = $4,505

$

Total 385

347

SOLUTIONS MANUAL • CHAPTER 13  28 (u) $970 + $920 + $895 = $2,785 (v) – ($11,065 – 9,720) = $1,345 (w) $500 – $700 = $(200) (x) $(400) + $(400) = $(800) (y) $(7) + $3 + $6 = $2

41.

Memo To: From: Subject:

Upper Level Management Accountant Budgeted Financial Statements

Budgeted financial statements are important because management is able to determine how much income is expected in the period. Management is also able to determine the amount of assets owned and liabilities owed at a specific time as well as the net cash flow from operating activities. These amounts are very important for management to determine if the organization is operating effectively.

Budgeted financial statements are also often requested by external financial statement users. Lenders, potential investors and others have a keen interest in such information.

Budgeted financial statements can also be used for comparative purposes with actual results in the evaluation of the company’s performance over the course of a trading period.

If budgets do not contain pro forma financial statements, there is a possibility that the information provided between/among divisions will be misleading. No individual manager will be able to see the effect that his/her operating entity has on the company as a whole.

42.

(a) Memo To: From: Subject:

Sales Manager Restaurant Manager Sales Projections

The understatement of sales will have a huge effect on the forecasted budget because sales are the basis of the budget. If the sales are understated, the purchases budget, direct labor budget, and overhead budgets will all be misstated. Additionally, there will be cash implications relative to the collection and payments of accounts receivable and accounts payable. The misstatement of these budgets would have ripple effects on the pro forma statement prepared by management. Thus, exceptional care should be taken in the preparation of the expected sales budget so that proper cash, inventory, and facilities plans can be developed.

SOLUTIONS MANUAL • CHAPTER 13  29

(b) Memo To: From: Subject:

CEO Restaurant Manager Employee Bonus System

The participation of upper-level managers in the budgeting process has a huge potential of creating spill-over effects on the company’s current bonus system. Given that the current bonus system rewards upper-level management a year-end bonus of $1,000 for every one-percentage point above the projected budget amounts, managers may be tempted to underestimate their sales projections with the intent of inflating their year-end bonuses.

The potential understatement of revenues and events by upper-level management also hinders the advancement of the organization and creates a slow working environment.

When slack is introduced into the work environment, employees may fail to maximize sales and minimize costs. Future period performance may be affected if no immediate is taken. (c) Material standard costs • Beverage cost per gallon • Beef cost per pound • Poultry cost per pound Direct Labor • Chef cost per hour • Waiters/Waitress cost per hour • Dishwashers cost per hour • Administrative cost per hour (or salary) Standard Quantity • Ounces of beef per serving • Ounces of beverage per serving 43.

Answers will vary according to students.

SOLUTIONS MANUAL • CHAPTER 13  30

SUPPLEMENTAL PROBLEMS 44.

(a)(1) Production Budget

Sales in units Ending Inventory Total needed Beginning Inventory Production in units

Drawers 42,000 4,100 46,100 (3,500) 42,600

Containers 35,000 3,850 38,850 (4,900) 33,950

Drawers 42,600 × 0.5 21,300

Containers 33,950 × 1.3 44,135

Drawers 42,600 × 1 42,600

Containers 33,950 × 3 101,850

Drawers 42,600 × 0.1 4,260 × $9.50 $40,470

Containers 33,950 × 0.2 6,790 × $9.50 $64,505

(a)(2) Purchases Budget - Plastic

Production in units Pounds per unit Total pounds needed Ending Inventory Beginning Inventory Total lbs. to purchase Cost per lb.

Total cost of plastic

Total

65,435 5,300 (3,900) 66,835 × $0.75 $50,126.25

Purchases Budget - Dye

Production in units Ounces per unit Total ounces needed Ending Inventory Beginning Inventory Total ounces to purchase Cost per ounce Total cost of dye (a)(3) Direct Labor Budget

Production in units DL hours needed per unit Total DL hours needed DL wage rate per hour Total DL cost (cash)

Total

144,450 9,800 (12,000) 142,250 × $0.20 $28,450

SOLUTIONS MANUAL • CHAPTER 13  31

(a)(4) Schedule of overhead Drawers 4,260 × $3 $12,780

Total DL hours needed Rate Total production OH

Containers 6,790 × $3 $20,370

(b) Actual OH Applied OH (12,200 × $3) Overapplied OH 45.

$35,400 36,600 $ 1,200

(a)

Sales in units Ending Inventory Total needed Beginning Inventory Production in units

January through June 1,500,000 104,000 1,604,000 (120,000) 1,484,000

July through December 1,680,000 60,000 1,740,000 (104,000) 1,636,000

(b) Purchases Budget (January through June)

Production in units Pounds per unit Total pounds needed Ending Inventory Beginning Inventory Total pounds to purchase Cost per pound Total cost of material

Material A 1,484,000 × 2.5 3,710,000 26,000 (40,000) 3,696,000 × $6 $22,176,000

Material B 1,484,000 × 1.5 2,226,000 18,000 (10,000) 2,234,000 × $11 $24,574,000

Purchases Budget (July through December)

Production in units Pounds per unit Total pounds needed Ending Inventory Beginning Inventory Total pounds to purchase Cost per pound Total cost of material

Material A 1,636,000 × 2.5 4,090,000 15,200 (26,000) 4,079,200 × $6 $24,475,200

Material B 1,636,000 × 1.5 2,454,000 44,000 (18,000) 2,480,000 × $11 $27,280,000

SOLUTIONS MANUAL • CHAPTER 13  32

(c) The company could hold large quantities of Material B because of various factors.

There could be shortage of material B on the market. The company could be anticipating an increase in the price of Material B. Companies often incur large costs for storage and insurance (and possibly breakage or deterioration) to keep large quantities of inventories on hand.

46.

(a) Sales Budget

Sales in units Unit sales price Total sales

January 13,400 × $70 $938,000

February 9,200 × $70 $644,000

March 10,400 × $70 $728,000

Quarter 33,000 × $70 $2,310,000

(b) Cash Collections from Sales

Collection from Dec. sales Collection from Jan. sales ($938,000 × 35%) ($938,000 × 65%) Collection from Feb. sales ($644,000 × 35%) ($644,000 × 65%) Collection from Mar. sales ($728,000 × 35%) Total cash collections

January $162,500

February

March

328,300

328,300 609,700

$609,700

225,400

$490,800

$835,100

Quarter $ 162,500

$418,600

225,400 418,600

254,800 $673,400

254,800 $1,999,300

March 10,400 3,000 13,400 (2,600) 10,800

Quarter 33,000 3,000 36,000 (3,200) 32,800

(c) December sales: $162,500 ÷ 0.65 = $250,000 A/R as of April 1, 2010: $728,000 × 0.65 = $473,200 (d) Production Budget Sales in units Desired EI (25%) Total needed B.I units Production in units

January 13,400 2,300 15,700 (3,200) 12,500

February 9,200 2,600 11,800 (2,300) 9,500

SOLUTIONS MANUAL • CHAPTER 13  33

(e) Purchases Budget – Felt Production in units Yards per unit Total yards needed Desired EI (10%) Beginning Inv. Total yards to purchase (rounded up to nearest 100 yds.)

Cost per yard Total cost

January 12,500 × 0.75 9,375 713 (450) 9,700 9,638 = 62 extra + 713 × $3 $29,100

February 9,500 × 0.75 7,125 810 (775) 7,200 7,160 = 40 extra + 810 × $3 $21,600

March 10,800 × 0.75 8,100 900 (850) 8,200 8,150 = 50 extra + 950 × $3 $24,600

Quarter 32,800 × 0.75 24,600 900 (450) 25,100

× $3 $75,300

April production = 12,000 hats; 12,000 × 0.75 = 9,000 Purchases Budget Leather Production in units Yards per unit Total yards needed Desired EI (10%) Beginning Inv. Total yards to purchase (rounded up to nearest 5 yds.)

Cost per yard Total cost

January February March 12,500 9,500 10,800 × 2/3 × 2/3 × 2/3 8,333 6,333 7,200 633 720 800 (305) (637) (724) 8,665 6,420 7,280 8,661 = 4 6,416 = 4 7,276 = 4 extra + extra + 720 extra + 800 633 × $15 × $15 × $15 $129,975 $96,300 $109,200

Quarter 32,800 × 2/3 21,866 800 (305) 22,365

× $15 $335,475

April production = 12,000 hats; 12,000 × 2/3 = 8,000 Cost for felt Cost for leather Total purchases

$ 29,100 129,975 $159,075

$ 21,600 96,300 $117,900

$ 24,600 109,200 $133,800

$ 75,300 335,475 $410,775

SOLUTIONS MANUAL • CHAPTER 13  34

(f) Schedule of Cash Payments for Purchases January February For Dec. purchases $31,500.00 For Jan. purchases ($159,075 × 30%) 47,722.50 ($159,075 × 70%) $111,352.50 For Feb. purchases ($117,900 × 30%) 35,370.00 ($117,900 × 70%) For Mar. purchases ($133,800 × 30%) Total for purchases $79,222.50 $146,722.50

March

Quarter $ 31,500.00 47,722.50 111,352.50

$ 82,530.00

35,370.00 82,530.00

40,140.00 $122,670.00

40,140.00 $348,615.00

(g) December raw material purchases: $31,500 ÷ 0.70 = $45,000 A/P as of April 1: $133,800 × 0.70 = $93,660 (h) Combined Payment Schedule for Factory Overhead and Non-Factory Costs January February March Quarter 12,500 9,500 10,800 32,800 Production in units OH cost per unit × $2.50 × $2.50 × $2.50 × $2.50 VOH cost $31,250 $23,750 $27,000 $ 82,000 FOH cost (cash) 15,000 15,000 15,000 45,000 Fixed Depr. Cost 3,000 3,000 3,000 9,000 Total production $49,250 $41,750 $45,000 $136,000 OH Total Cash Cost $46,250 $38,750 $42,000 $127,000 Total sales Rate Variable cost Fixed cost (cash) Total nonfactory costs

$938,000 × $0.10 $ 93,800 32,800 $126,600

$644,000 × $0.10 $ 64,400 32,800 $ 97,200

$728,000 × $0.10 $ 72,800 32,800 $105,600

$2,310,000 × $0.10 $ 231,000 98,400 $ 329,400

January 12,500

February 9,500

March 10,800

Quarter 32,800

× $9 $112,500

× $9 $85,500

× $9 $97,200

× $9 $295,200

Direct Labor Cost Production in units DL cost per hat DL cost

SOLUTIONS MANUAL • CHAPTER 13  35

(i) Cash Budget Beg. Cash bal.

Cash Collections Cash available Cash paid for DL Factory Non-Factory Purchases Taxes Bonuses Balance

January 3,500 490,800 $494,300

February $129,727 835,100 $964,827

March $ 596,655 673,400 $1,270,055

(112,500) (46,250) (126,600) (79,223)

(85,500) (38,750) (97,200) (146,722)

$129,727

$596,655

(97,200) (42,000) (105,600) (122,670) (245,000) (435,000) $ 222,585

$

(j) $80,800 ÷ 3,200 = $25.25 Proof: Felt (0.75 × $3.00) Leather (2/3 × $15) DL per hat VOH cost per hat FOH cost per hat Standard cost per hat

$ 2.25 10.00 9.00 2.50 1.50 $25.25

FOH: $18,000 ÷ $1.50 = 12,000 hats per month 47.

(a) TMV (fabric) = Actual Cost – Standard Cost TMV = (AP × AQ) – (SP × SQ) TMV = $140,200 – ($2 × 70,000) TMV = $140,200 – $140,000 TMV = $200 U (b) MPV (fabric) = (AP × AQ) – (SP × AQ) MPV = $140,200 – ($2 × 68,100) MPV = $140,200 – $136,200 MPV = $4,000 U (c) MQV (fabric) = Actual Quantity Used – Standard Quantity Allowed MQV = (SP × AQ) – (SP × SQ) MQV = ($2 × 68,100) – ($2 × 70,000) MQV = $136,200 – $140,000 MQV = $3,800 F

Quarter 3,500 1,999,300 $2,002,800 $

(295,200) (127,000) (329,400) (348,615) (245,000) (435,000) $ 222,585

SOLUTIONS MANUAL • CHAPTER 13  36

(d) TMV (thread) = Actual Cost – Standard Cost TMV = (AP × AQ) – (SP × SQ) TMV = $34,900 – ($0.25 × 175,000) TMV = $34,900 – $43,750 TMV = $8,850 F (e) MPV (thread) = (AP × AQ) – (SP × AQ) MPV = $34,900 – ($0.25 × 140,800) MPV = $34,900 – $35,200 MPV = $300 F (f) MQV = Actual Quantity Used – Standard Quantity Allowed MQV = (SP × AQ) – (SP × SQ) MQV = ($0.25 × 140,800) – ($0.25 × 175,000) MQV = $35,200 – $43,750 MQV = $8,550 F 48.

(a) TLV (cutting) = LRV + LEV TLV = (AP × AQ) – (SP × SQ) TLV = $66,352 – ($9.25 × 7,000) TLV = $66,352 – $64,750 TLV = $1,602 U (b) LRV = (AP × AQ) – (SP × AQ) LRV = $66,352 – ($9.25 × 7,150) LRV = $66,352 – $66,137.50 LRV = $214.50 U (c) LEV = (SP × AQ) – (SP × SQ) LEV = ($9.25 × 7,150) – ($9.25 × 7,000) LEV = $66,137.50 – $64,750 LEV = $1,387.50 U (d) TLV (sewing) = LRV + LEV TLV = (AP × AQ) – (SP × SQ) TLV = $35,020 – ($10.50 × 3,500) TLV = $35,020 – $36,750 TLV = $1,730 F (e) LRV = (AP × AQ) – (SP × AQ) LRV = $35,020 – ($10.50 × 3,400) LRV = $35,020 – $35,700 LRV = $680 F

SOLUTIONS MANUAL • CHAPTER 13  37

(f) LEV = (SP × AQ) – (SP × SQ) LEV = ($10.50 × 3,400) – ($10.50 × 3,500) LEV = $35,700 – $36,750 LEV = $1,050 F 49.

(a) Fiberglass MPV = (AP × AQ) – (SP × AQ) MPV = ($4.65 × 245,000) – ($4.25 × 245,000) MPV = $1,139,250 – $1,041,250 MPV = $98,000 U MQV = (SP × AQ) – (SP × SQ) MQV = ($4.25 × 245,000) – ($4.25 × 240,000) MQV = $1,041,250 – $1,020,000 MQV = $21,250 U TMV = MPV + MQV TMV = $98,000 U + $21,250 U TMV = $119,250 U Paint MPV = (AP × AQ) – (SP × AQ) MPV = ($23.50 × 115) – ($25 × 115) MPV = $2,702.50 – $2,875 MPV = $172.50 F MQV = (SP × AQ) – (SP × SQ) MQV = ($25 × 115) – ($25 × 112.50) MQV = $2,875 – $2,812.50 MQV = $62.50 U TMV = MPV + MQV TMV = $172.50 F + $62.50 U TMV= $110 F Direct Labor LRV = (AP × AQ) – (SP × AQ) LRV = ($16 × 7,250) – ($15 × 7,250) LRV = $116,000 – $108,750 LRV = $7,250 U LEV = (SP × AQ) – (SP × SQ) LEV = ($15 × 7,250) – ($15 × 7,500) LEV = $108,750 – $112,500 LEV = $3,750 F

SOLUTIONS MANUAL • CHAPTER 13  38

TLV = LRV + LEV TLV = $7,250 U + $3,750 F TLV = $3,500 U (b) Examples of reasons for each of the variances in part (a).

Direct Material Variances Price: • Change in price paid for materials caused by: o A change in the quality of materials purchased o A change in quantity purchased, leading to a change in purchase discount o A new supplier contract • Unreasonable materials price standard • Error in the accounting records for the actual price of materials Efficiency: • Normal fluctuation in material usage • Change in production processes, causing a change in the quantity of materials used • Change in proportion of materials spoiled caused by: o A change in quality of materials o A change in equipment, technology, or other aspect of production process o Equipment malfunction o Intentional worker damage • Theft of raw materials • Unreasonable materials quantity standard • Error in the accounting records for the quantity of materials used Direct Labor Variances Price: • A change in average wages paid to employees caused by: o A new union contract o A change in average experience or training of workers o A change in government-mandated minimum wage • Unanticipated overtime hours • Unreasonable labor price standard • Error in the accounting records for the actual price of direct labor • •

▪ ▪

Efficiency: Normal fluctuation in labor hours Change caused by average labor time caused by: o A change in equipment, technology, or other aspect of production processes o Intentional slowdown o A change in average worker experience or training caused by: Improved performance from effective training programs Change in employee turnover

SOLUTIONS MANUAL • CHAPTER 13  39

• • •

Intentional or unintentional over- or underreporting of labor hours Unreasonable labor hours standard Error in the accounting records for the quantity of labor hours

SOLUTIONS MANUAL • CHAPTER 14  39

CHAPTER 14 SOLUTIONS TO END OF CHAPTER MATERIAL

QUESTIONS 1.

Each student will provide different examples for value-added, non-value-added, and business-value-added activities. In the strictest possible definition, a customer would not (given a choice) want to pay for business-value-added activities (e.g., invoice preparation); thus, they are non-value-added. These activities, however, may be necessary at a particular point in time given the management, employees, and/or technology used by an organization to make a product or perform a service for a customer. Over time, some of these activities should be eliminated.

2.

Each student will have a different answer to this question depending on the activity chosen.

3.

A cost driver is a factor that causes a cost to be incurred, indicating a direct cause-effect relationship between the driver and the cost. If the driver is eliminated, the cost will also be eliminated.

Batch cost: the cost of printing one set of payroll checks for employees or of moving a hand truck full of products between locations Product/process cost: the cost of research and development activities on a new product Organizational level cost: the cost of the CEO's salary or of the annual company audit It is important to classify costs as to level of incurrence so that the costs may not be traced to the appropriate products/services that have created the cost or, in the case of organizational level costs, that the costs not be traced at all to products/services.

4.

Activity-based costing differs from traditional costing in that it collects costs on the basis of the underlying nature and extent of the activities that cause the costs to be incurred.

ABC focuses on overhead costs (rather than direct material or direct labor).

5.

The use of ABC does not change the amount of overhead incurred by an organization.

The only way to eliminate overhead costs is to focus on the driver of the individual costs and eliminate or reduce the quantity of the driver. ABC merely changes the allocation of that overhead. A change from traditional overhead allocation to ABC usually means that the costs of standard, high-volume products or services will decline and the costs of specialized, low-volume products/services will increase.

SOLUTIONS MANUAL

6.

• CHAPTER 14  2

The three most common types of responsibility centers are the cost, profit, and investment centers. A cost center has the control of costs as its primary area of responsibility. A profit center needs to generate revenues and control costs so as to produce a "reasonable" profit. An investment center must be able to generate a "reasonable" rate of return (as specified by the organization's top management) through the use of assets, generation of revenues, and control of costs.

Examples will vary by student.

7.

The items over which a center is responsible determine how narrowly or broadly that center's performance can be measured. For example, the manager of a cost center can only be evaluated on how well costs were controlled within the organizational unit. The center generates no revenues and, therefore, cannot be considered “profitable” or “unprofitable.” As a manager’s ability to exercise control over items increases, the types and number of metrics that can be used to assess performance also increase.

It is important to only evaluate performance based on “ability to control” because authority and responsibility should go hand-in-hand. If one has no authority over a particular aspect of a business, one should not be held responsible for the success or failure of that aspect.

8.

The two formulas for return on investment are: (1) income ÷ assets and (2) the Du Pont model of (income ÷ sales) × (sales ÷ assets). The breakdown of the Du Pont model into computations for profit margin and asset turnover allows more information to be gained on what factors created the ROI: what rate of profit was generated on each sales dollar and how many dollars of revenues were generated by each dollar of assets.

9.

A balanced scorecard (BSC) is the basis of a performance measurement system that focuses on a variety of financial and nonfinancial measurements. The BSC is comprised of interrelated categories that all derive from the organization's vision and mission. The scorecard normally contains the following four categories: financial, internal process, learning and growth, and customer. The number of or titles of these categories may vary depending on the organization or the level within the organization at which the scorecard is implemented. The BSC categories reflect the items at which an organization must excel to succeed over the long-run.

10.

Benchmarking refers to comparing a product, process, or service to a similar product, process, or service in another company, generally a company known to be “best in class.”

Benchmarking is not always appropriate. For companies that are highly specialized, adopting the goals set forth by another might be detrimental to the way the company operates. Benchmarking is a lengthy and sometimes costly process; therefore, it is not appropriate to benchmark processes that are of low cost or unimportant to a company’s critical success factors.

SOLUTIONS MANUAL • CHAPTER 14  3

11.

An organization does not necessarily need to focus on industry competitors when determining a benchmark if that organization is attempting to compare a process rather than a product. Process benchmarking allows organizations to assess their abilities at performing certain tasks with the "best of class" regardless of the industry in which those organizations happen to be. For example, companies often benchmark distribution systems against Wal-Mart or equipment maintenance against Disney Theme Parks.

12.

For a company to succeed in the long-run, it must generate profits and cash flow in the short-run. However, to generate those profits, companies need to have good customer relations and loyalty, reliable and standard internal procedures, and competent employees. The balanced scorecard uses all of these elements, even though most are nonfinancial, to evaluate employees.

On the surface, it seems that if a company generates profits in the short-run every year, in the long-run it will be profitable. However, short-run goals often lead to short-sighted decisions. For example, evaluating and giving bonuses based solely on annual profits may create an incentive for managers to inflate profits in each individual year. The managers might choose to eliminate a $10 million dollar advertising campaign, which will decrease expenses and increase profit by $10 million dollars this year. But if the company’s market share begins to slip because the competition is still advertising, in the long-run, profits will be down. Therefore, it is critical to emphasize and evaluate based on both short-term and long-term financial goals to counteract effects of shortsightedness.

13.

An organization's performance measurement and performance reward systems must be aligned so that people recognize the behaviors that will create organizational success and, therefore, to adopt those behaviors so that the people will succeed personally relative to the reward system. A lack of integration between these two systems may cause frustration to the employee or behaviors that are not in the organization's best long-term interests.

All rewards should not be monetary because, like financial measures of performance for the organization, such rewards are short-term in nature. To help the employee focus on the company's short- and long-term goals, the reward system should provide a reasonable current standard of living and provide incentives for the long-term (such as stock ownership).

SOLUTIONS MANUAL

• CHAPTER 14  4

EXERCISES 14.

(a)

F Dividends are distributions of retained earnings, which reflects the long-term accumulation of annual profits. Profits in a single year should not automatically be viewed as an indicator that distributions should be made to stockholders; capital needs for future periods and cash flows should also affect the dividend decision model. (b) T (c) T (d) F The lower the level at which someone exercises managerial duties in an organization, the more specific his or her responsibilities are. For example, consider the range of responsibilities of a receptionist versus the chief financial officer. (e) F If business-value-added activities can be eliminated without detriment to the organization, they should. From the customer’s perspective, BVA activities are non-value-added. (f) T (g) F If overhead is low compared to direct material and labor, the distribution (application) of overhead to products or jobs will be insignificant. (h) T (i) F Cost drivers should be chosen so that overhead is distributed between or among divisions based on the overhead generated by those divisions. (j) F Long-run performance measure may be financial in nature, but should include many nonfinancial measures. (k) F A process map is a visual representation of all steps, not just the steps that can be timed accurately. (l) T (m) T

15.

(a) Dillard’s (1) Value-added: dividing the merchandise by department, employees who help customers find the right size and style (2) Non-value-added: putting all clothes on identical hangers, displaying clothes (3) Business-value-added: checking customer credit history, employing security guards to catch shoplifters (b) H&R Block (1) Value-added: researching a customer’s individual tax issues, attending tax training courses by tax preparers (2) Non-value-added: rechecking calculations, engaging in small talk prior to obtaining tax return information (3) Business-value-added: ordering forms, cleaning the office after-hours

SOLUTIONS MANUAL • CHAPTER 14  5

(c) Saturn (1) Value-added: installing air conditioning, painting body (2) Non-value-added: crash testing, wait time while assembly line is stopped (3) Business-value-added: preparing distribution schedules to retailers, renewing contracts to purchase parts (d) Comet (1) Value-added: dry cleaning garments, hanging clothes (2) Non-value added: testing of chemicals, putting clothes in plastic bags (could be seen as value-added by some customers) (3) Business-valued added: printing receipts for each sale or transaction, stapling receipt on garment bag 16. (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) 17.

Level Organizational Batch Batch Product/process Unit Organizational Batch or Unit Unit Product/process Unit

Batch time (paid per period) number of batches transferred number of set-ups engineering change orders made number of tables manufactured time (per year) number of carts of meals number of rooms delivered number of envelopes stamped number of special meals developed number of holes drilled

(a) Cost of raw materials and labor (overtime); cost of defective, unusable products; cost of machinery repair and maintenance (b) If the Widgets Division were a profit center, in addition to all costs, managers would be responsible for generating a profit (excess revenue over cost) on the sale of widgets. Also, a profit center will likely be responsible for additional costs such as product advertising. (c) In addition to controlling costs and generating a profit, investment centers are responsible for their asset base and using that asset base to generate a rate of return. (d) Yes. When several divisions use raw materials, there is often a separate department (usually a cost center) that buys the raw materials in bulk. When the materials are transferred to another division, the cost is transferred from the purchasing department to the production department. To some extent, the manager of the Widgets Division would have some control related to material costs, but just because other divisions use similar raw materials, does not mean that Widgets cannot be an investment center.

SOLUTIONS MANUAL

• CHAPTER 14  6

(e) Probably not. When the machinery used in production is used by multiple departments, the return on assets can only be evaluated at the overall production level. Therefore, Widgets could not be considered an investment center. However, it is possible that the machinery cost and depreciation could be allocated to each division (probably on hours of machine time used to produce each type of product); if such an allocation is considered reasonable (especially by the division managers), each division could be considered an investment center. (f) Yes. Often, companies use transfer prices that act as “selling prices” to production divisions and “purchase prices” to assembly divisions. No actual funds change hands; the process is merely an internal transfer from one division’s budget to the other. For example, automobile manufacturers have a division that builds engines. The engine (and any other internally built part) is transferred to the department that assembles the car. The assembly line division is the only division capable of generating actual profit from customer sales. A “fair” price is determined for the engine division to “charge” to assembly line division. Therefore, production departments have revenues and can then be classified as profit centers.

18.

(a) Income = Revenues – Expenses = $8,750,000 – $5,975,000 = $2,775,000 ROI = Income ÷ Assets = $2,775,000 ÷ $12,800,000 = 21.7% (b) Profit Margin = Income ÷ Sales = $2,775,000 ÷ $8,750,000 = 31.7% (c) Asset Turnover = Sales ÷ Assets = ÷$8,750,000 ÷ $12,800,000 = 68.4% (d) ROI = PM × AT = 31.7% × 68.4% = 21.7%

19.

Each student will have different answers to this question. Some possibilities include: Financial: Grade in class ÷ Cost for class Hours of study for class ÷ Cost for class Raise received at work because of class – Cost for class Internal Process: Grade in class ÷ Average study hours per week Grade in class ÷ Percentage of homework worked Learning and Growth: Percentage increase in new job skills obtained from class Percentage of information from course used in job (or in other courses) Continuing education credits received ÷ Continuing education credits needed Customer: Level of satisfaction with grade received Level of satisfaction with instruction received

SOLUTIONS MANUAL • CHAPTER 14  7

20.

(a) The owner would probably provide a specific rate of return, percentage increase in membership, and rate of employee turnover. Clarification would be needed as to how each of these items would be calculated and over what period of time. These specifics are needed to compare your progress with the goal. (b) Each student will have different answers to this question, depending on what types of rewards are most important to him/her. Some will concentrate on monetary rewards; others may ask for additional paid vacation time, flex time, guaranteed parking space, paid parking, educational benefits, benefits for spouse/children, etc.

PROBLEMS 21.

22.

Each student will have a different answer, but the following is an example that might be presented.

Group suggestions of food

Open group discussion

Choice of food (pizza)

Ordering the pizza (call and wait time)

Waiting for delivery

Taking order from delivery person

2 min.

4 min.

1 min.

2 min.

25 min.

30 sec.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) (q) (r) (s) (t)

NVA NVA NVA NVA VA NVA NVA NVA (would be BVA) NVA NVA VA VA NVA VA NVA NVA VA VA NVA NVA (can be easily carried without bag)

Paying for order; receiving change; tipping 1.5 min.

Serving the pizza

Eating the pizza

2 min.

15 min.

• CHAPTER 14  8

SOLUTIONS MANUAL

23. (a) Overhead per DLH = Total Overhead ÷ DLHs Overhead per DLH = $2,458,000 ÷ 160,000 = $15.36 per DLH Overhead Cost = Product DLHs × Overhead per DLH X (80,000 DLHs × $15.36) $1,228,800 Y (60,000 DLHs × $15.36) 921,600 Z (20,000 DLHs × $15.36) 307,200 Total applied overhead* $2,457,600 *Off due to rounding

(b) Costs DM & DL OH Total cost # of units Cost per unit Selling price Profit (loss) Profit %

X $ 360,000 1,228,800 $1,588,800 ÷ 160,000 $9.93 $22.00 $12.07 54.86%

Y $ 280,000 921,600 $1,201,600 ÷ 80,000 $15.02 $30.00 $14.98 49.93%

Z $400,000 307,200 $707,200 ÷ 20,000 $35.36 $90.00 $54.64 60.71%

Given this information, it appears that the order of product profitability is Z, X and Y. Thus, emphasis should be placed on selling Z. (c) Overhead & Rates

Material Handling (MH)

Overhead Amount: $1,400,000 Cost Driver:

Pounds of Mat Used

Overhead Type Scheduling Utilities & and Setup Depreciation (SS) (UD)

Indirect Materials (IM)

Total OH

$264,000

$690,000

$104,000

$2,458,000

Number of Setups

Machine Hours Incurred

DL Hours Used

Qnty of Driver:

Product X: Product Y: Product Z: Total Cost Driver Used: Overhead Rates:

1,200,000 600,000 200,000

40 50 20

30,000 40,000 80,000

80,000 60,000 20,000

2,000,000

110

150,000

160,000

$0.70

$2,400

$4.60

$0.65

Per Pound

Per Setup

Per MH

Per DL Hour

SOLUTIONS MANUAL • CHAPTER 14  9

(d) Material Handling (MH) Product X: $ 840,000 420,000 Product Y: 140,000 Product Z: Total: $1,400,000

Overhead Type Scheduling Utilities and and Setup Depreciation (SS) (UD) $ 96,000 $138,000 120,000 184,000 48,000 368,000 $264,000 $690,000

(e) Costs DM & DL OH Total cost # of units Cost per unit Selling price Profit (loss) Profit %

X $ 360,000 1,400,000 $1,760,000 ÷ 160,000 $11.00 $22.00 $11.00 50.00%

Applied Overhead

Y $280,000 264,000 $544,000 ÷ 80,000 $6.80 $30.00 $23.20 77.67%

Indirect Materials (IM) $ 52,000 39,000 13,000 $104,000

Total OH Per Product $1,126,000 763,000 569,000 $2,458,000

Z $ 400,000 690,000 $1,090,000 ÷ 20,000 $54.50 $90.00 $35.50 39.44%

The new information shows that Y is the most profitable product, followed by X. Z now is shown to be the least profitable to sell. The decision difference reflects the more appropriate tracing of costs to products. (f) Alternative Drivers Materials Handling: • Size of material – some material might be larger than other material; that is, size makes delivery costs increase • Number of deliveries – more deliveries increase cost Scheduling and Setup: • Time of setup – some setups might be more complicated that others Utilities and Depreciation: • Square footage occupied – depreciation on facility should be allotted by departmental size and utilities would be higher for larger departments Indirect materials used: • # of different direct materials used – more complicated products may require more indirect material

SOLUTIONS MANUAL

• CHAPTER 14  10

24.24. (a) Salaries – professional staff Printing and postage Job fair events Computer depreciation Supplies Total

Budget $459,000 1,950 13,800 3,600 8,700

Actual $495,000 2,730 20,400 3,600 9,600

Variance $36,000 U 780 U 6,600 U 0 900 U $44,280 U

(b) Based solely on the information provided, the placement director did not do a good job in controlling costs during the year. All variances were unfavorable and between approximately 8%-48% above budgeted amounts. (c) The answer in part (b) would probably change given this additional information. To place the additional 20% of the graduates would have required substantially more work by the placement office, especially since the extra 20% would more than likely have been the students with lower grade point averages (given that the students with high GPAs would be hired most rapidly).

25.

AP × AQ aP × BQ SP × BQ $15 × 380,000 $15 × 300,000 $18 × 300,000 $5,700,000 $4,500,000 $5,400,000 $1,200,000 F $900,000 U Sales Price Variance Sales Volume Variance $300,000 F Total Revenue Variance

26.

(a) Pipe (50,000 × $40) Direct labor (50,000 × $18) OH (50,000 × $8) Total standard cost Pipe Direct labor OH Total standard cost

$2,000,000 900,000 400,000 $3,300,000 $1,813,000 1,086,000 345,000 $3,244,000

Based on this information, the manager did a good job of controlling costs during the month.

SOLUTIONS MANUAL • CHAPTER 14  11

(b) Pipe Direct labor Overhead: Indirect material ($1.20) Indirect labor ($0.60) Depreciation ($3.50) Utilities ($0.90) Maintenance ($0.50) Other ($1.30) Total

Standard Cost $2,000,000 900,000

Actual Cost $1,813,000 1,086,000

Variance $187,000 F 186,000 U

60,000 30,000 175,000 45,000 25,000 65,000 $3,300,000

40,000 25,000 155,000 52,500 17,500 55,000 $3,244,000

20,000 F 5,000 F 20,000 F 7,500 U 7,500 F 10,000 F $ 56,000 F

The manager may have purchased inferior quality pipe at a less-than-standard cost, which caused a favorable material price variance ($.10 per foot) and an unfavorable material usage variance (90,000 feet). If this situation is true, it could explain the unfavorable labor efficiency variance (20,000 DLHs) and, possibly, the need to use additional utilities to rework problems. The manager may have also disregarded the need for certain indirect labor (supervisory) and maintenance activities, so that the $20,000 and $7,500 favorable variances were created for those line items. (c) AP × AQ AP × BQ SP × BQ $80 × 50,000 $80 × 55,000 $85 × 55,000 $4,000,000 $4,400,000 $4,675,000 $400,000 U $275,000 U Sales Price Variance Sales Volume Variance $675,000 U Total Revenue Variance (d) A transfer price is treated as a revenue to a division that produces a part and a cost to the division that uses the part. The price is often set at “market” (or adjusted market) price or what the buying division would have had to pay for the part if it had been purchased from an external (rather than an internal) supplier. Use of a transfer price allows what would have been a cost center to be treated as a profit center, thereby providing additional performance measurements for the manager. Transfer prices are supposed to enhance goal congruence among organizational units, make performance evaluation among units more comparable, and improve managerial motivation.

Transfer prices should also ensure optimal resource allocation and promote operating efficiency.

SOLUTIONS MANUAL

27.

• CHAPTER 14  12

(a) Return on Investment = Net income ÷ Assets Division 1 = $900,000 ÷ $28,700,000 = 3.1% Division 2 = $1,960,000 ÷ $58,876,000 = 3.3% Division 3 = $2,680,000 ÷ $54,518,000 = 4.9% As investment centers, the rank would be 3–2–1. However, Division 3’s costs are substantially higher per dollar of sales than the other divisions: Costs = Sales – Net Income Division 1 = $3,138,000 – $900,000 = $2,238,000 (71.3% of Sales) Division 2 = $7,972,000 – $1,960,000 = $6,012,000 (75.4% of Sales) Division 3 = $16,462,000 – $2,680,000 = $13,782,000 (83.7% of Sales) (This difference could mean that Division 3 has the newest assets and, thus, the highest depreciation charges.) (b) Profit Margin = Net Income ÷ Revenues Division 1 = $900,000 ÷ $3,138,000 = 28.7% Division 2 = $1,960,000 ÷ $7,972,000 = 24.6% Division 3 = $2,680,000 ÷ $16,462,000 = 16.3% Asset Turnover = Revenues ÷ Assets Division 1 = $3,138,000 ÷ $28,700,000 = 10.9% Division 2 = $7,972,000 ÷ $58,876,000 = 13.5% Division 3 = $16,462,000 ÷ $54,518,000 = 30.2% With respect to profit margin, the rank would be 1–2–3. This is another indication that costs are higher for division 2 than for other divisions. (c) Division 1 Assets = $28,700,000 – $4,800,000 = $23,900,000 Asset Turnover $3,138,000 ÷ $23,900,000 = 13.1% Return on Investment = $900,000 ÷ $23,900,000 = 3.8% Given the new information, as investment centers, the rank would be 3–1–2. Division 1’s ROI is the second highest.

SOLUTIONS MANUAL • CHAPTER 14  13

28.

Answers will vary by student; the following are some suggestions. (a) Mission Statement To provide excellent customer service in a pleasant environment; to develop a large customer base; to be profitable; to have knowledgeable employees with respect to the industry and operations. (b) Financial • Sales in dollars or units • Dollars of costs • Total discounts received on purchased movies Internal process • Organization of the store • Promptness of ordering new movies • Hours of training provided to employees Learning and growth • Reviews by employees about manager’s ability to answer questions asked by employees • Ability to handle day-to-day operations without intervention by owner • Development of industry knowledge (e.g., timely acquisition of new releases, ability to suggest movies for the appropriate audience) Customer • Number of repeat customers • Number of customer complaints • Number of customer unresolved complaints (c) Financial • Sales in dollars • Collection of past due fees Internal process • Environment of the store (e.g., cleanliness, temperature) • Time to restock movies Learning and growth • Ability to answer questions asked by customers • Ability to suggest movies for the appropriate audience • Efficiency in locating movies Customer • Number of customer compliments • Number of customer complaints (d) The manager is responsible for managing employees, controlling costs, and other operational duties in which employees are not involved. (e) Pay an annual bonus on profits to encourage increasing revenues and decreasing costs. Adapt the bonus percentage for nonfinancial metrics such as repeat customers, professional development, and ratings by employees. Add a nonfinancial incentive (such as additional vacation time) after several years of increasing profitability or employee retention.

SOLUTIONS MANUAL

• CHAPTER 14  14

CASES 29.

Student answers will vary depending on the organization selected.

30.

Student answers will vary depending on the industry selected and resources used.

31.

(a) Net income is not always the “best” way to evaluate performance because it can be fairly easily manipulated and focuses attention solely on the short-run. (b) Net income should be used, but additional nonfinancial measures (related to critical business success factors) should be incorporated, along with at least one long-run financial measure. (c) Yes. A variety of costs can be reduced to increase net income, but the cost reductions may not be in the company’s best interest (i.e., reduced advertising or machine maintenance expense). (d) The manager of the 35mm Film Division is planning to retire, which in essence makes his horizon short-term. Long-term goals will have little effect on him because he will not be here for the long-term. This manager now has more of an incentive to increase his bonuses without regard to the effect on future profits. To counteract the short-horizon, Icon Film may want to give that manager an incentive that will extend beyond his retirement date for a few years, so that he will have an incentive to work in the best interest of the company.

32.

(a) (1) ROI = Profit Margin × Asset Turnover ROI = [Income ÷ Sales] × [Sales ÷ Assets] (All intersegment amounts have been subtracted from the Cruise segment information.)

Cruise Division 2007: ROI = ($2,694,000 ÷ $12,480,000) × ($12,480,000 ÷ $33,602,000) ROI = .216 × .371 = 8.01% 2006: ROI = ($2,581,000 ÷ $11,306,000) × ($11,306,000 ÷ $29,968,000) ROI = .228 × .377 = 8.60% 2005: ROI = ($2,611,000 ÷ $10,633,000) × ($10,633,000 ÷ $27,782,000) ROI = .246 × .383 = 9.42% Tour Division 2007: ROI = ($31,000 ÷ $553,000) × ($553,000 ÷ $579,000) ROI = .0561 × .955 = 5.36% 2006: ROI = ($32,000 ÷ $533,000) × ($533,000 ÷ $584,000) ROI = .06 × .913 = 5.48% 2005: ROI = ($28,000 ÷ $461,000) × ($461,000 ÷ $567,000) ROI = .0607 × .813 = 4.93%

SOLUTIONS MANUAL • CHAPTER 14  15

(2) The return on investment is decreasing for the cruise division, primarily from a decrease in profit margin. The return on investment is increasing for the tour division, primarily because of an increase in the asset turnover caused by increase in revenues.

(3) Cruises are more profitable as evidenced by the higher profit margin and higher ROI. However, this situation exists because the cruises provide the “captive market” for the tour division (b) The footnote for the “corporate” costs indicates that these costs are not allocated. If Carnival plans to treat cruise and tour as investment centers, the costs at the “corporate” level could be allocated to the divisions on a reasonable basis under activity based costing using several appropriate drivers. However, the corporate costs seem to be related to debt and investments that do not apply to either division.

Therefore, there may be no way to appropriately allocate 100 percent of the costs.

Such costs would, under ABC, be considered “organizational level” costs and would probably not be allocated at all.

33.

(a) Determination of whether the $0.25 bonus is a good reward will have to be made by the individual employees after considering the quantity of effort that must be expended to sell an accessory item---and the selling price of the accessory. If the accessory has a small selling price and is easy to sell, employees may believe that $0.25 is reasonable…but they probably will not have the same opinion if the accessories are high-priced and harder to sell. Though it focuses on short-term goals, that is the point … to boost sales for March. In addition, employees are likely to develop a habit of offering the accessory items if that process is performed repeatedly for one month, which will affect the long-term. Also, customers who like the accessories will continue to purchase them. (b) The $10 bonus for a month is probably too low to be a good incentive. However, monetary rewards are good incentives for short-run performance. If the bonus was for more, or given more often (e.g., daily or weekly), it would be a better motivator. On the other hand, bonuses based on competition often cause new and unwanted problems. Two examples are particularly common: (1) An employee who is not helping a customer might assist another employee who has a demanding customer under regular circumstances; given the competition, the employees may no longer assist people.

(2) If there are other responsibilities of employees who do not generate sales (e.g., emptying trash, restocking shelves, dusting), employees who are competing to be top sales person may not be as willing to complete the other tasks.

SOLUTIONS MANUAL

• CHAPTER 14  16

SUPPLEMENTAL PROBLEMS 34.34. (a) (b)

(g)

Read applicant's resume Straighten desk prior to interview Walks from desk to get cup of coffee Returns to desk and drinks coffee Scans applicant's resume Uses intercom to ask receptionist to send in applicant Stands to greet applicant

(h)

Shakes applicant's hand

(i)

Sits down

(c) (d) (e) (f)

(j) (k) (l)

Picks up resume and scans Interviews applicant Stands to say goodbye to applicant (m) Shakes applicant's hand (n) (o) (p)

Sits down Scans resume Makes notes on interview

(q)

Walks from desk to get cup of coffee Returns to desk and drinks coffee Makes decision about whether to hire applicant

(r) (s)

VA provides information necessary to make decision NVA not necessary NVA not necessary NVA not necessary NVA should remember from reading the first time NVA does not help with hiring

NVA but could be considered BVA because it shows professionalism NVA but could be considered BVA because it shows professionalism NVA but could be considered BVA because he would not want to continue standing during interview NVA should remember from reading the first time VA provides information necessary to make decision NVA but could be considered BVA because it shows professionalism NVA but could be considered BVA because it shows professionalism NVA does not help with hiring NVA should remember from reading the first time VA provides information necessary to make decision and to document decision NVA not necessary NVA not necessary VA

the purpose of the process

SOLUTIONS MANUAL • CHAPTER 14  17

35.

(a) Total Overhead ($160,000 + $380,000 + $136,000) Total purchase orders issued Overhead allocated per purchase order issued

$676,000 ÷ 10,000 $67.60

OH allocated to Product #548 = # of POs × OH per PO OH allocated to Product #548 = 4 × $67.60 = $270.40 (b) Overhead Rates = Overhead ÷ Driver Quantity Finding suppliers = $160,000 ÷ 50,000 = $3.20 per search Issuing POs = $380,000 ÷ 10,000 = $38 per PO Matching documents = $136,000 ÷ 8,000 = $17 per match OH allocated to Product #548 Finding suppliers (25 × $3.20) Issuing POs (4 POs × $38) Matching documents (1 × $17) Total overhead allocated to Product #548

$ 80 152 17 $249

(c) Assuming the drivers are reasonable estimates of what drives the costs from that department, then the $249 is a more accurate representation of the cost of purchasing associated with Product #548.