Financial Accounting, Canadian Edition, 8th edition William Thomas Instructor Manual

INSTRUCTOR’S RESOURCE MANUAL A. S. Merali McMaster University

Financial Accounting Eighth Canadian Edition C. William (Bill) Thomas Baylor University

Wendy M. Tietz Kent State University

Greg Berberich University of Waterloo

Catherine Seguin University of Toronto

Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e

CHAPTER 1 The Financial Statements CHAPTER OVERVIEW The chapter begins with an introduction to National Hardware Ltd., a fictional retail company based in Waterloo, Ontario. The topic of financial statements is presented identifying that many decisions come from analyzing these reports. Following this discussion, the text defines accounting as the language of business and identifies the users of accounting information. The chapter next discusses the differences between Financial and Managerial accounting disciplines and describes the different forms of business: proprietorship, partnership, and corporation.

The chapter then explores financial standards and the multiple sets of Generally Accepted Accounting Principles (GAAP) for Canada. The section references International Financial Reporting Standards (IFRS) for publicly accountable entities (PAEs) and Accounting Standards for Private Enterprises (ASPE) for Canadian privately held companies.

Next the chapter focuses on each of the financial statements: Income Statement, Statement of Retained Earnings, Balance Sheet, and Statement of Cash Flows. The respective elements of each statement are discussed including what each reports and/or measures. The various components of owner’s (shareholders’) equity—revenue, expense, net income, net loss, retained earnings, and dividends—are also defined. The relationship between assets, liabilities, and equity known as the accounting equation is introduced in the discussion of the balance sheet. In addition, the classifications such as current assets and current liabilities are introduced. The operating, investing, and financing activities within the statement of cash flows are introduced and discussed relative to cash receipts and payments. The notes to financial statements are also mentioned in this section. Decision Guidelines help explain how people use the financial statements in decision making.

Next the chapter discusses the qualitative characteristics of the accounting conceptual framework: relevance, faithful representation, comparability, verifiability, timeliness, and understandability and the underlying assumptions of the framework including: the going-concern assumption, the separate-entity assumption, the historical-cost assumption, and the stable-monetary-unit assumption The chapter continues with a section on fraud as it relates to the financial statements and possible reasons for its occurrence. Examples are given, which leads into an introduction to the topic of ethics in accounting and ethical behaviour of accountants, and decision guidelines for making ethical judgments. The chapter concludes with a section on the benefits and risks of tools and technologies used in accounting and business, including spreadsheets, data analytics, artificial intelligence and machine learning, and robotic process automation. At the end of the chapter, a summary problem reviews the income statement, statement of retained earnings, balance sheet, and statement of cash flows, and requires the student to assess the company’s performance and financial position.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e

LEARNING OBJECTIVES After studying Chapter 1, students should be able to: 1. Explain why accounting is the language of business.

2. Describe the purpose and explain the elements of each financial statement.

3. Prepare financial statements and analyze the relationships among them.

4. Explain and apply underlying accounting concepts, assumptions, and principles.

5. Ethically evaluate business decisions.

6. Identify tools and technologies used in accounting and business.

SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Multiple sets of GAAP (generally accepted accounting principles) Relevance, faithful representation, comparability, verifiability, timeliness, understandability characteristics; cost constraint, separate entity assumption, historical-cost assumption, goingconcern assumption, and stable-monetary-unit assumption Financial Statements: Income statement, Statement of Retained Earnings, and Balance Sheet Accounting equation Ethical considerations in accounting and business

RECOMMENDED Types of business organizations Statement of Cash Flows and types of cash flows Tools and technologies used in accounting and business

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e

CHAPTER OUTLINE OBJECTIVE 1: Explain why accounting is the language of business A. Accounting is an information system that measures business activities, processes data into reports, and reports results to decision makers. Exhibit 1-1 illustrates the flow of information in an accounting system. Financial statements report this information to users.

B. Accounting information is used by 1. Managers to set goals, evaluate those goals, and take corrective action.

2. Investors to decide whether to invest in a business or evaluate an investment.

3. Creditors to evaluate a borrower’s ability to make required payments.

4. Government and regulatory bodies such as Canada Revenue Agency (CRA) to ensure organizations pay the correct amount of taxes.

5. Individuals to make investment decisions and/or manage a bank account.

6. Not-for-profit organizations, which use accounting information in virtually the same way as for-profit organizations.

C. Accounting information can be classified into two categories: 1. Financial accounting provides information for managers inside the business and for decision makers outside the organization, such as investor and creditors.

2. Management accounting generates inside information for internal use by management.

D. Forms of business organizations (summarized in Exhibit 1-2): 1. Proprietorship—an unincorporated business with a single owner. The owner has unlimited liability, which means that the owner assumes personal responsibility for the debts of the business.

2. Partnership—an unincorporated business with two or more owners. Each partner has unlimited liability.

3. Corporation—an incorporated business owned by shareholders whose ownership is evidenced by the number of shares held. Shareholders elect the members of the board of directors, which sets policy for the corporation and appoints officers. A shareholder has limited liability. A corporation is distinct from its owners and has many of the rights entitled to a person.

OBJECTIVE 2: Describe the purpose and explain the elements of each financial statement A. Generally accepted accounting principles (or GAAP) are the professional guidelines that govern how accountants record, measure, and report financial information.

1. The Accounting Standards Board in association with Chartered Professional Accountants of Canada (CPAC) establishes GAAP. 2. There are multiple sets of GAAP and each is applicable according to the type of entity or organization. a. Publicly accountable enterprises (PAEs) must apply International Financial Reporting Standards (IFRS), which are standards set by the International Accounting Standards Board (IASB) to enhance the comparability of financial information reported by public enterprises around the world. IFRS was effective January 1, 2011, for Canadian public companies. b. Private enterprises apply the Accounting Standards for Private Enterprises (ASPE). However, private enterprises have the option of using IFRS or ASPE. ..

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c. Other sets of GAAPe are applicable to not-for-profit organizations, pension plans, and government entities.

3. A summary of IFRS-ASPE differences is presented at the end of the chapter.

4. The financial statements provide a company’s financial results for users to make decisions. The income statement for National Hardware Ltd. is presented in Exhibit 14.

B. The financial statements provide answers to four basic questions. The financial statements that would be used to answer these questions are summarized in Exhibit 1-3.

1. How well did the company perform during the year? (The answer is found on the income statement) 2. Why did the company’s retained earnings change during the year? (The answer is found on the statement of retained earnings.)

3. What is the company’s financial position at the end of the year? (The answer is found on the balance sheet.)

4. How much cash did the company generate and spend during the year? (The answer is found on the statement of cash flows.)

C. The income statement (or statement of profit or loss, or statement of earnings, or statement of net earnings) reports the revenues, expenses, and net income or net loss of a company for a specified period of time. (The Consolidated Statements of Income for National Hardware Ltd. is illustrated in Exhibit 1-4.)

1. Companies can choose a fiscal year ending at a different time to the calendar year.

Companies are not obligated to choose December 31 for a year end.

2. National Hardware Ltd. reports operating results for two fiscal years for comparability purposes enabling users to detect any trends.

3. The income statement has two main elements: income and expenses. a. Income includes revenue earned through the sale of goods and services and gains. b. Gains reflect an increase in the economic benefits to a company usually due to a transaction outside of the company’s ordinary business activities. An example is the sale of a long-lived asset that exceeds the carrying amount on a company’s books. c. Expenses consist of costs incurred to purchase goods and services to run a business, and losses. d. Losses are the opposite of gains and reflect a decrease in the economic benefits to a company usually due to a transaction outside of the company’s ordinary business activities. An example is the sale of a long-lived asset that does not exceed the carrying amount on a company’s books.

4. The major expense for National Hardware Ltd. is called Cost of Goods Sold (called cost of producing revenue by National Hardware Ltd.), which represents the cost of the goods National Hardware Ltd. sold to its customers.

5. The income statement reports net income or net loss that is equal to total revenues and gains less total expenses and losses, or the amount of income or loss that is left after total expenses have been deducted from total income.

6. Net income is sometimes known as net earnings or net profit.

D. The statement of retained earnings reports the changes in a company’s retained earnings during a specified period and reflects the accumulated net income of the company since it started business. After accounting for reductions in 2022 and 2021 (these reductions result from transactions covered in upper-level accounting courses), National Hardware Ltd. had an overall surplus both years. (The Consolidated Statements of Retained Earnings for National Hardware Ltd. is illustrated in Exhibit 1-5.)

1. The net income reported on the income statement is added to the opening balance of retained earnings. ..

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e income, the board of directors must decide whether to retain 2. After a company earns net the income for use in the business or to pay dividends. Dividends reduce retained earnings. National Hardware Ltd. declared dividends of $154 million in 2022 and $120.2 million in 2021.

E. The balance sheet (or statement of financial position under IFRS) reports a company’s financial position at a moment in time. (The Consolidated Balance Sheets of National Hardware Ltd. is illustrated in Exhibit 1-6.)

1. The balance sheet is dated as of the last day of the period. The amount of assets reported is the amount of assets National Hardware Ltd. owned as of the last day of the accounting period. The other financial statements cover a period of time.

2. The balance sheet reports three main categories: Assets, Liabilities, and Shareholders’ Equity. The relationship between these categories is known as the accounting equation, where assets always equal the sum of liabilities and owners’ equity: A = L + OE. Exhibit 1-7 illustrates the accounting equation using the 2022 figures from the balance sheet of National Hardware Ltd. Teaching Tip Beginning assets and shareholders’ equity are $120,000 and $30,000, respectively. Liabilities increased $15,000 during the year, and the ending assets are $145,000. What was the ending shareholders’ equity?

Assets = Liabilities + Shareholders’ Equity Beginning of year $120,000 = X + $30,000 X = $90,000 End of year $145,000 = ($90,000 + $15,000) + Y Y = $40,000 3. Assets are economic resources owned by a business that are expected to be of benefit in the future. Assets are divided into two categories: current and non-current (long-term) assets. a. Current assets are those assets that the company expects to convert to cash, sell, or consume during the next 12 months or within the business’s normal operating cycle if longer than a year. i.

The operating cycle is the time span during which (a) cash is used to acquire goods and services, and (b) these goods and services are sold to customers, from whom the business collects cash. ii. Examples of current assets are: Cash.

Receivables—the amount that a company expects to collect from its customers who bought merchandise on credit.

Inventory—the merchandise National Hardware Ltd. sells to its customers.

Prepaid expenses—the amount of advertising, rent, insurance, and/or supplies that National Hardware Ltd. has already paid for but has not yet used. b. Non-current assets (or long-term assets) consist mainly of property, plant, and equipment. These assets are partially used, or depreciated (or amortized). While National Hardware Ltd. does not, some companies report goodwill and intangible assets. Intangible assets are assets with no physical form, such as patents and trademarks. Other non-current assets is a category for assets not reported elsewhere on the balance sheet.

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Teaching Tip Ask students how a business comes up with the funds to acquire additional assets. Lead students to see that a company can borrow (liabilities), or use invested funds (owners’ equity), or hopefully, earn it (also owners’ equity). Later, you can associate the terms “contributed capital” and “retained earnings” with the latter two. Students may say that a company buys assets with cash; however, remind them that this would not change total assets.

4. Liabilities are debts the entity owes as a result of a past event, and which it expects to pay off in the future using some of its assets. Liabilities are also divided into current and noncurrent/long-term categories. a. Current liabilities are debts that are payable within one year or within the entity’s normal operating cycle if longer than a year. i.

Examples of current liabilities are: Accounts payable represents amounts owed for goods and services that have been purchased but not yet paid for. The word payable indicates a liability.

Notes payable—amounts borrowed with a promise to pay back within the year Income taxes payable is the amount owed to the government for income taxes. b. Non-current liabilities (or long-term liabilities) are due in periods beyond the next twelve months.

5. Owners’ Equity is the owners’ remaining interest in the assets of the company after deducting all its liabilities. a. Owners’ equity, or shareholders’ equity in the case of a corporation like National Hardware Ltd., has several components: i.

Share capital refers to the amounts contributed by shareholders in exchange for shares. ii. Retained earnings, which comes from the statement of retained earnings, represents the amount of net income that has been reinvested in the business.

Revenues are amounts earned by delivering goods or services.

Revenues increase net income and, therefore, also increase retained earnings.

Expenses are the costs of operating a business. Expenses decrease net income and, therefore, also decrease retained earnings.

If expenses exceed revenues, the result is a net loss.

Dividends are distributions of assets (usually cash) to the shareholders. The amount of dividends declared is determined after net income is computed. Dividends decrease retained earnings because they represent the amount of the net income that is not reinvested in the business. b. The owners’ equity of proprietorships and of partnerships makes no distinction between what is invested and what is earned. The equity of each owner is accounted for under the single heading, Capital.

F. The statement of cash flows reports the sources and uses of cash from the three major activities of a business--operating, investing, and financing. (The Consolidated Statements of Cash Flows for National Hardware Ltd. is illustrated in Exhibit 1-8.)

The three major activities include: a. Operating Activities relate to the transactions and other events that determine net income/ (loss). i. Cash receipts from a company’s sales of its primary goods and services. ..

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e ii. Cash payments to suppliers and employees for the goods and services they provide to generate sales. b. Investing Activities relate to the purchase and sale of long-term assets that a company uses to conduct is operations. National Hardware Ltd. pays cash to purchase assets and receives cash when assets are sold. c. Financing Activities relate to the way a company acquires the funds used for investing and operating activities. A business can finance its activities by borrowing from a bank or other lender, issuing shares to its owners, and paying dividends.

Teaching Tip Ask students where their money comes from and what they use it for. Categorize their suggestions as operating, investing, or financing activities.

1. Operating—salaries/wages from jobs; rent payments, food, etc.

2. Investing—purchasing or selling investments; buying a house 3. Financing—borrowing or repaying money Or, Set up three unlabelled columns on the board (or screen, etc.). Ask students to call out any kind of activity associated with a business. You can drop each item into the appropriate column and then ask students to come up with names for the columns.

Teaching Tip Ask students which of the three activities is most important and why.

Operating activities are the most important because without them there is no need for the other two. Investing activities are of secondary importance because a company’s current and future operating effectiveness is determined by wise investment decisions.

G. Notes to the financial statements are provided as an integral part of the financial statements and should be read carefully as part of a review of the financial statements.

H. Two parties have critical financial reporting responsibilities: a company’s management and its independent outside (or external) auditor. Company management has the primary financial reporting duties because they are responsible for designing, maintaining, and monitoring the company’s financial reporting process and for preparing the financial statements based on the information generated by this process. The auditor’s responsibility is to gather evidence regarding the financial information reported by management, and then decide whether the information reported in the financial statements complies with the applicable GAAP.

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OBJECTIVE 3: Prepare financial statements and analyze the relationships among them.

A. Exhibit 1-9 summarizes the relationships among the financial statements 1. The income statement is the only financial statement that lists revenues and expenses. a. Net income (or net loss), the difference between revenues and expenses, is reported on the income statement. b. This amount is then used on the statement of retained earnings.

2. The statement of retained earnings reports the following: a. The beginning balance of retained earnings; b. The addition of net income or the subtraction of net loss to that beginning balance; c. The subtraction of dividends; and d. The ending balance of retained earnings. e. The ending balance is used on the balance sheet.

3. The balance sheet is the only financial statement that reports all assets, liabilities, and owners’ equity. The balance sheet must show that the assets equal the sum of liabilities and owners’ equity.

4. The statement of cash flow reports cash flows from three types of business activities— operating, investing, and financing. a. A net cash flow is reported for each activity. b. The ending cash balance is reported. This amount should also be reported on the balance sheet.

Teaching Tip Ask students which of the financial statements is prepared first and why. Income statement to determine profit/(loss) to prepare the next financial statement (statement of retained earnings or statement of changes in owners’ equity).

Ask students which of the financial statements is prepared second and why. Statement of retained earnings (statement of changes in owners’ equity) to determine the ending capital balance to prepare the next financial statement (balance sheet).

B. The Decision Guidelines summarize how people use financial statements in their decisionmaking process.

OBJECTIVE 4: Explain and apply underlying accounting concepts, assumptions and principles.

A. The overall objective of financial reporting is to provide useful information to users to make investing and lending decisions. The characteristics of useful information include: relevance, faithful representation, comparability, verifiability, timeliness and understandability. (Exhibit 1-10 provides an overview of accounting’s conceptual framework.)

1. The relevance characteristic must be considered to ensure the financial statements provide information to the user that is useful. To be relevant, financial information must provide predictive and/or confirmatory value and must be material in nature or magnitude that omitting or misstating it could affect the decisions of an informed user.

2. The faithful representation (or reliability) characteristic states that accounting records should be based on accurate data. The actual cost of assets or services is usually more reliable than market value.

NOTE: Consider the conflict between information that is timely (based on estimates) and reliable that may require additional time to ensure accuracy that may render the statements irrelevant.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e B. There are four accounting assumptions underlying the conceptual framework.

1. The going-concern assumption assumes that the entity will remain in operation for the foreseeable future. The market values of assets may vary from year to year, and for this reason cost is deemed to be preferable to market value for measurement purposes.

2. The separate-entity assumption states that each entity is an economic unit and is kept separate from other entities including the activities of its owners.

Teaching Tip Assume that you own three businesses and maintain one chequebook for all three. How can this situation prevent you from maximizing your profits? (If one or two of the businesses are unprofitable, then you would make more money without them. However, you would have no way of knowing.) The entity concept would require a separate set of records for each business.

3. The historical-cost assumption states that assets should be recorded at actual cost.

Teaching Tip You purchased some land on January 1 of the current year. You had to borrow $100,000 for 2 years at 10% interest at the local bank that appraised the land for $105,000. You will eventually pay $100,000 plus $20,000 for the interest. On December 31 of the current year, you receive an offer for the land for $110,000, but you do not want to sell the land. At what value should the land be reported on the balance sheet? The original cost (excluding interest) of $100,000.

4. The stable-monetary-unit assumption allows accountants to ignore the effect of inflation in the accounting records, thus reporting under the assumption that the value of the currency is stable.

OBJECTIVE 5: Ethically evaluate business decisions.

A. The facts and circumstances surrounding accounting decisions may not always make them clear cut, and yet the decision may determine whether the company shows a profit or a loss in a particular period. Three factors influence business and accounting decisions: economic, legal, and ethical factors.

1. Economic factor states that the decision being made should maximize the economic benefits to the decision maker.

2. Legal factor is based on the proposition that free societies are governed by laws that are written to provide, clarify, and to prevent abuse of the rights of individuals or society.

3. Ethical factor recognizes that while certain actions might be both economically profitable and legal, they may still not be right. Ethical standards are established to enforce a higher level of conduct than that imposed by law. They are shaped by our cultural, socioeconomic, and religious backgrounds, and are needed to guide judgment when making business decisions. CPA Ontario has adopted a code of professional conduct that emphasizes the importance of ethical behaviour of accountants in the decision-making process of investors and creditors.

B. Fraud is the intentional misrepresentation of facts done to persuade another party to act in a way that causes financial damage to that party. Two types are given focus: misappropriation of assets and fraudulent financial reporting. Misappropriation is committed by stealing assets from a company and then covering up the theft by adjusting the accounting records. Fraudulent financial reporting is committed by company managers who make false and misleading entries in the accounting records, usually to present a more favourable financial picture than would be presented if the actual results were disclosed.

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Teaching Tip Use the fraud examples to lead into a discussion on ethics. Ethics play an important role in accounting. Accounting information is used in making decisions that involve huge economic consequences. There always exists a temptation to report information in your favour when you can. We saw the effects of doing so in many of the scandals that were reported prominently in the news in 2002. One well-known company was Enron Corporation, which understated its liabilities and overstated its profit.

C. The Decision Guidelines summarize four questions that help in making ethical business decisions.

OBJECTIVE 6: Identify tools and technologies used in accounting and business A. Technology and tools allow accountants and other professionals to make better decisions through more accurate data, more timely data, and more visual data. Technology is helping to add breadth and depth to the practice of accounting. These tools and technologies come with risks, so it is important to understand what the risks are and how to minimize them before adopting any particular tool or technology. Some examples of technology and tools include: 1. Spreadsheets such as Microsoft Excel, Google Sheets, Apple Numbers, or others.

2. Data Analytics: Accountants can use data analytics to help discover valuable trends or insights within financial data and to help to identify process improvements that can increase efficiency. Accountants can use data analytics to find consumer behaviour trends and trends in the market to help to build models that help companies generate higher profit margins.

3. Artificial Intelligence (AI) and Machine Learning: AI is the science that studies ways to build programs and machines that can solve problems creatively in a human-like manner.

Examples of AI in use today include Apple’s personal assistant, Siri; Amazon’s home hub, Alexa; and the technology used to classify images on Pinterest.

Machine learning is a subset of AI based on the idea that we can provide data to machines and let them learn for themselves without explicitly programming the machines. IBM’s Watson, the computer that beat Ken Jennings at Jeopardy! to end Jennings’s 74 consecutive game winning streak, is an example of a machine learning application. Netflix’s predictive technology based on customer reactions to movies and Google’s Nest, the thermostat that uses behavioural algorithms to learn and anticipate heating and cooling preferences in a home, are two additional examples of machine-learning applications.

4. Robotic Process Automation (RPA): The advantage of bots for accountants is that accounting work becomes much more interesting and engaging. Rather than performing repetitive tasks, accountants are freed to do value-added things like analyzing and interpreting data and trends.

You may have read stories about accountants being replaced by bots, but that is not likely to happen. The technology tools are allowing accountants to employ a higher level of thinking and become more valuable to their organizations.

5. Technology Risks: There are inherent risks with technology. Just as technology can facilitate better decisions, technology used improperly can also lead to catastrophic decisions. The London Olympics incurred significant costs when an employee typed “20,000” into a spreadsheet cell containing the number of seats for four minor heats of synchronized swimming rather than the correct number of “10,000.” Because of this typo, 10,000 tickets for nonexistent seats were sold. The London Olympic Committee then had to upgrade the ticketholders for these nonexistent seats to tickets for major events, causing financial losses for the organization.

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B. The Home Screen of Microsoft Excel for Windows is shown in Exhibit 1-11. In this book, we will be using Microsoft Excel because it is the most widely used program in business for spreadsheets. Google Sheets and Apple Numbers can perform many of the same tasks in similar ways.

C. A summary of IFRS and ASPE differences is presented.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q1 Understanding financial statements 1 1-2 Easy Q2 Understanding financial statements 1 1-2 Easy Q3 Understanding financial statements 2 1-2 Easy Q4 Understanding financial statements 3 1-2 Easy Q5 Understanding financial statements 3 1-2 Easy Q6 Understanding financial statements 3 1-2 Easy Q7 Understanding financial statements 3 1-2 Easy Q8 Understanding financial statements 3 1-2 Easy Q9 Understanding financial statements 3 1-2 Easy Q10 Understanding financial statements 3 1-2 Easy Q11 Understanding financial statements 3 1-2 Easy Q12 Understanding financial statements 3 1-2 Easy Q13 Understanding financial statements 3 1-2 Easy Q14 Understanding financial statements 3 1-2 Easy Q15 Understanding financial statements 3 1-2 Easy S1-1 Distinguish between assets, liabilities, and equity 2 5 Easy S1-2 Apply the accounting equation 2 5 Easy S1-3 Apply the accounting equation 2 5 Easy S1-4 Classify assets, liabilities, and owners’ equity 2 5-10 Easy S1-5 Explain the elements of the income statement 2 5 Easy S1-6 Prepare an income statement 3 5-10 Easy S1-7 Prepare a statement of retained earnings 3 5 Easy S1-8 Prepare a balance sheet 3 10-15 Easy S1-9 Prepare a statement of cash flows 3 10-15 Easy S1-10 Apply accounting assumptions 4 5 Easy S1-11 Make ethical judgments 5 5 Easy S1-12 Classify items on the financial statements 2 10 Easy E1-13 Organize a business 1 10 Medium E1-14 (Critical Thinking) Describe the purpose of the financial statements; use the financial statements to make decisions; make ethical business decisions 2, 3, 5 10 Easy E1-15 Apply accounting assumptions 4 5-10 Medium E1-16 Apply the accounting equation 2 5-15 Medium E1-17 Apply the accounting equation; analyze financial statements 2, 3 10-15 Medium E1-18 Apply the accounting equation; analyze relationships among financial statements 2, 3 1020 Medium E1-19 Apply the accounting equation; analyze relationships among financial statements 2, 3 1015 Medium E1-20 Identify financial statement information 2 10-15 Medium E1-21 Apply the accounting equation; prepare financial statements 2, 3 10-20 Medium E1-22 (Critical Thinking) Prepare a statement of cash flows; identify elements of financial statements; identify activities that affect financial statements 2, 3 15-25 Medium E1-23 Prepare financial statements 3 15-20 Medium E1-24 (Critical Thinking) Prepare and analyze financial statements 3 15-20 Medium E1-25 Explain relationships among financial statements 3 15-20 Medium E1-26 Identify tools and technologies used in accounting and business 6 15-20 Medium E1-27 Identify tools and technologies used in accounting and business 6 10-15 Medium ..

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P1-28A Prepare an income statement; apply underlying accounting concepts and assumptions 2, 3, 4 15-20 Difficult P1-29A (Critical Thinking) Apply the accounting equation; analyze the relationships among financial statements 2, 3 30-40 Medium P1-30A (Critical Thinking) Prepare and analyze a balance sheet; identify on which financial statement to include an account 2, 3 20-25 Medium P1-31A (Critical Thinking) Understand and prepare a balance sheet; apply underlying accounting assumptions 2, 3, 4 20-25 Medium P1-32A Prepare and use the income statement, statement of retained earnings, and balance sheet 2, 3 30-45 Medium P1-33A Prepare and analyze a statement of cash flows 3 20 Medium P1-34A Analyze a company’s financial statements; explain relationships among the financial statements 2, 3 40-50 Medium P1-35A Apply the accounting equation; understand elements of the balance sheet 2 10-15 Medium P1-36B Prepare an income statement; apply underlying accounting concepts and assumptions 2, 3, 4 20 Difficult P1-37B (Critical Thinking) Apply the accounting equation; analyze the relationships among the financial statements, 2, 3 30-45 Medium P1-38B (Critical Thinking) Prepare and analyze a balance sheet; identify on which financial statement to include an account 2, 3 30-40 Medium P1-39B (Critical Thinking) Understand and prepare a balance sheet; apply underlying accounting assumptions 2, 3, 4 20-25 Medium P1-40B Prepare and use the income statement, statement of retained earnings and balance sheet 2, 3 20-25 Medium P1-41B Prepare and analyze a statement of cash flows 2 30-45 Medium P1-42B (Critical Thinking) Analyze a company’s financial statements; explain relationships among the financial statements 2, 3 20 Medium P1-43B Apply the accounting equation; understand elements of the balance sheet 2 4050 Medium Decision Case 1 Evaluate business operations; use financial statements 2 20-30 Medium Decision Case 2 Analyze a company’s financial statement 2 15-20 Medium Decision Case 3 Prepare and analyze financial statements; make business decisions using financial statements 2, 3 30 Medium Ethical Decision 1 Ethical Decision 2 Ethical Decision 3

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ANSWER KEY TO CHAPTER 1 QUIZ 1. D 2. B 3. A 4. C 5. D 6. C 7. A 8. C 9. A 10. C

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Name:_

Date:

Section:

CHAPTER 1 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Which of the following statements is false?

A. Accounting is the information system that measures business activities, processes that information into reports, and communicates the results to decision makers.

B. Financial statements report financial information about a business entity to decision makers.

C. Owners of a corporation are not personally liable for the debts of the corporation.

D. The purpose of financial accounting is to provide information to people inside the entity, such as the owners and managers.

2. Mary owns and operates a fabric shop. Mary needs to borrow money to expand; therefore, she prepared financial statements to present to her banker. Mary recorded the assets of her store at the cost she paid for them 2 years ago rather than when she transferred them to her business this year.

Mary has violated which of the following principles or concepts?

A. Reliability principle B. Separate Entity Assumption C. Going-concern principle D. Stable-monetary-unit concept 3. Which of the following is false?

A. Owners’ Equity – Assets = Liabilities B. Assets = Owners’ Equity + Liabilities C. Owners’ Equity = Assets – Liabilities D. Liabilities = Assets – Owners’ Equity 4. SMT Inc. experienced an increase in total assets of $2,000 during the current year. During the same year, total liabilities decreased $6,000. If dividends for the year were $10,000 and the owners made no additional investment, how much was net income?

A. $14,000 B. $6,000 C. $18,000 D. $2,000 5. Which of the following statements is true?

A. The cash flow statement reports all changes in assets, liabilities, and shareholders’ equity of the business during the period.

B. Revenues and expenses are reported only on the balance sheet.

C. The income statement reports cash flows from three types of business activities—cash receipts, cash payments, and investing.

D. On the statement of retained earnings, any dividends for the period are subtracted from the beginning balance of retained earnings.

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Table 1-1 The following information is taken from the accounting records after current period operations and presented in random order.

Accounts payable $ 9 Service revenue 38 Cash 25 Equipment 110 Common shares 200 Retained earnings (ending balance) ??

Dividends 15 Accounts receivable 4 Land 100 Office supplies 5 Utilities expense 2 Salary expense 18 Cash receipts: Cash payments: Collections from customers 30 Acquisition of land Sale of equipment 15 Dividends To suppliers Issuance of shares to owners 90

50 15 5

6. Total assets are: A. $150.

B. $181.

C. $244.

D. $158.

7. Net income is: A. $18.

B. $13.

C. $120.

D. $38.

8. Cash flow from financing activities is: A. $(85).

B. $(55).

C. $75.

D. $(15).

9. The ending balance in Retained Earnings is: A. $35.

B. $55.

C. $75.

D. $15.

10. On which financial statement can the Beginning balance in retained earnings be found?

A. Balance sheet B. Income statement C. Statement of retained earnings D. Both A and C

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CHAPTER 2 Recording Business Transactions CHAPTER OVERVIEW The chapter begins with an introduction to Apple Inc., a multinational U.S.-based corporation that designs and manufactures consumer electronics. Apple’s income statement is presented to introduce the concept of recording transactions in accounts. The accounting equation is revisited in this chapter explaining that each component of the accounting equation—assets, liabilities, and shareholders’ equity—has its own set of accounts. The most common types of accounts of each are described.

The effects of transactions on the accounting equation are demonstrated through examples of various business transactions. The four financial statements that result from these transactions are presented and linked together. A mid-chapter summary problem includes both the analysis of transactions and the preparation of the income statement, statement of retained earnings, and balance sheet financial statements for a service corporation.

The double-entry system of accounting is introduced. The rules of debits and credits are explained in context to the accounting equation. The process of recording transactions through journalizing is illustrated as a three-step process. The posting to the ledger process is explained and illustrated through the use of T-accounts. Students are provided with a series of entries illustrating the analysis, journalizing, and posting to the ledger through T-accounts.

The chapter then presents the trial balance. Decision Guidelines are presented that assist the student in analyzing and recording transactions. Next, the chapter introduces artificial intelligence (AI), which is the science that studies ways to build programs and machines that can creatively solve problems in a humanlike manner. It then explores machine learning, which is a subset of AI, and how supervised and unsupervised machine learning is used in business and accounting, The chapter concludes with a summary problem that reviews opening accounts, journalizing, posting, preparing a trial balance, and preparing an income statement.

LEARNING OBJECTIVES After studying Chapter 2, your students should be able to: 1. Recognize a business transaction and describe the various types of accounts in which it can be recorded.

2. Determine the impact of business transactions on the accounting equation.

3. Analyze business transactions using T-accounts.

4. Record business transactions in the journal and post them to the ledger.

5. Prepare and use a trial balance.

6. Describe machine learning and its applications in accounting and business.

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Terminology and description of accounts Double-entry accounting Rules of debit and credit Analysis of transactions Journal entries Ledger and posting Trial balance

RECOMMENDED T-account Machine learning and its applications in accounting and business

IF TIME PERMITS Chart of accounts

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CHAPTER OUTLINE OBJECTIVE 1: Recognize a business transaction and describe the various types of accounts in which it can be recorded

A. Account—a basic component of an accounting system that is used to record all of the transactions (increases and decreases) affecting a particular asset, liability, or element of shareholders’ equity. Accounts are grouped based on the accounting equation, A (Assets) = L (Liabilities) + SHE (Shareholders’ Equity).

B. Assets—economic resources that benefit a business now, or will be of benefit to the business in the future. Cash, receivables, inventory, prepaid expenses, land, building, equipment, furniture, and fixtures are examples of assets.

C. Liabilities—debts or other obligations of the business that must be satisfied in the future.

Accounts and notes payable, salary payable, taxes payable, interest payable, and other accrued liabilities are all examples of liabilities.

Teaching Tip As students begin to use many different accounts, remind them that a receivable is always an asset because it represents an amount that will be received in the future and a payable is always a liability because it represents an amount that will be paid in the future. Explain that receivables often are related to customers, while payables often are related to vendors.

D. Shareholders’ Equity—owners’ (investors’) claims on assets owned by the corporation. Share capital, retained earnings, dividends, revenues, expenses, gains and losses are all shareholders’ equity accounts. Another similar term is “owners’ equity.”

E. Revenues—income earned from performing services or selling products. Revenues increase net income and retained earnings and, thus, increase shareholders’ equity.

F. Expenses—costs incurred in operating a business. Expenses decrease net income and retained earnings and decrease shareholders’ equity, which is just the opposite effect of revenues.

G. Gains—another form of income that usually occur outside the course of a company’s ordinary business activities that increase net income and retained earnings.

H. Losses—another form of expense that usually occur outside the course of a company’s ordinary business activities that decrease net income and retained earnings.

OBJECTIVE 2: Determine the impact of business transactions on the accounting equation

A. A business transaction is an event that affects the financial position of a business and can be reliably recorded.

B. Business transactions are analyzed according to their effect on the accounting equation. The accounting equation must balance after each transaction is recorded. A = L + SHE

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C. Exhibit 2-1 illustrates how the following 11 transactions affect the equation: 1. Owners’ investment of cash increases both assets and shareholders’ equity.

2. Purchase of an asset for cash increases assets and decreases assets (no effect on total assets).

3. Purchase of an asset on credit (on account) increases both assets and liabilities.

4. Receipt of cash for service revenue increases both assets and shareholders’ equity.

5. Performance of services on account increases both assets and shareholders’ equity.

6. Cash payment of expenses decreases both assets and shareholders’ equity.

7. Payment on account decreases both assets and liabilities.

8. Personal transactions of the owner do not affect the business, per the separate-entity assumption.

9. Collection of cash on account increases assets and decreases assets.

10. Sale of an asset at a price equal to its cost increases assets and decreases assets.

11. Declaration and payment of cash dividends decreases both assets and shareholders’ equity.

Teaching Tip The purpose of Exhibit 2-1 is to help students identify the accounts involved in each transaction and to determine whether those accounts increase or decrease. It summarizes all transactions in an accounting equation worksheet.

Teaching Tip Help students see the four different ways “on account” is used in transactions: 1. Performed services on account means Accounts Receivable increases.

2. Collected on account means Accounts Receivable decreases.

3. Purchased on account means Accounts Payable increases.

4. Paid on account means Accounts Payable decreases.

D. Exhibit 2-2 illustrates the three financial statements that are prepared from the transactions in the previous exhibit. Arrows link the data that flow from statement to statement.

1. The income statement reports net income or net loss for the period (revenues minus expenses equals net income; if expenses exceed revenues, a net loss is reported).

2. The statement of retained earnings reports the change in retained earnings starting with the beginning balance of retained earnings, adding net income (from the income statement), deducting dividends and obtaining the ending balance of retained earnings.

3. The balance sheet reflects the accounting equation (A = L + SHE) at the end of the period, proving that assets = liabilities + shareholders’ (owners’) equity. Included in the shareholders’ equity section of the balance sheet is ending retained earnings (from the statement of retained earnings).

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Teaching Tip The equations that describee each financial statement can be very helpful to students struggling to understand how one financial statement differs from another.

Income Statement: Revenues – Expenses = Net Income (or Loss) Statement of Retained Earnings: bbRetained Earnings + Net Income – Dividends = ebRetained Earnings (where bb and eb stand for beginning balance and ending balance, respectively) Balance Sheet: Assets = Liabilities + Shareholders’ Equity

OBJECTIVE 3: Analyze business transactions using T-accounts A. Accounting is a double-entry system that reports the dual effects, giving and receiving, of all business transactions. Each transaction affects at least two (and can affect more) accounts.

B. The chart of accounts lists all the accounts and their account numbers (in numerical order).

Accounts are numbered beginning with assets, then liabilities, shareholders’ equity, revenues and finally expenses; accounts in the ledger are always in this same order. Exhibit 2-3 illustrates a chart of accounts.

C. The T-account (as it resembles the capital letter “T”) is an abbreviated form of an account, used to help illustrate the effect of transactions. The vertical line divides the account into left (debit) and right (credit) sides.

Account Name Debit entries (left side)

Credit entries (right side)

D. Every account balance is derived from four components: 1. Beginning balance 2. + Increases 3. – Decreases 4. = Ending Balance For example, if cash at the beginning of the period is $2,000, cash receipts during the period total $26,000, and cash disbursements are $25,000, then ending cash is $3,000. If you know any three of the four components, you can calculate the fourth. You can also see these relationships by recording this information in a T-account for Cash. (You might further illustrate this for your students by drawing three additional T-accounts on the board and review the types of transactions that affect Accounts Receivable, Accounts Payable, and Retained Earnings; relate these accounts to the formula illustrated above.)

E. The type of account determines the side on which increases and decreases are recorded; the rules of debit and credit keep the accounting equation in balance. The accounting equation and the rules of debit and credit are illustrated in Exhibit 2-4. Exhibits 2-5 demonstrates the use of T-accounts. After each transaction is recorded, the accounting equation must remain in balance, as illustrated in Exhibit 2-6.

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Teaching Tip Students must remember that the double-entry system requires that the debit side equals the credit side so that the accounting equation stays in balance. Students may be familiar with the debit and credit terminology used by banks that should not be confused with the rules of debit and credit, which include: Debit = left side of an account Credit = right side of an account 1. Increases in assets are recorded on the left (debit) side of the account. Decreases in assets are recorded on the right (credit) side. This is the left side of the accounting equation or Assets.

2. Rules for liabilities and shareholders’ equity accounts are the opposite of the rules for assets. Increases in liabilities and shareholders’ equity accounts are recorded on the right (credit) side of an account, and decreases are recorded on the left (debit) side. This is the right side of the accounting equation or Liabilities + Shareholders’ Equity.

F. Summaries of the rules of debit and credit are found in Exhibits 2-4 and 2-8. They are derived from the expanded accounting equation found in Exhibit 2-7.

G. The normal balance of an account is the side used to record increases; Exhibit 2-8 lists the normal balances for all types of accounts.

Teaching Tip The following “normal balance T-account” may be helpful to students in applying the rules of debit and credit.

Normal Balances Assets Liabilities Expenses Revenues Dividends Common Shares Retained Earnings H. Often, a shift of a balance amount away from its normal column indicates there has been an accounting error.

Teaching Tip Every transaction involves both a debit and a credit, and the total amount debited in a transaction must always equal the total amount credited. After increases and decreases in an account are recorded, the amount remaining in the account is its balance. All account balances are computed by adding the beginning balance and the increases, and subtracting the decreases. (The balance equals the difference between total debit entries and total credit entries.)

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OBJECTIVE 4: Record business transactions in the journal and post them to the ledger

A. Transactions are recorded first in the journal, a chronological listing of all the entity’s business transactions.

B. The recording process follows three steps: 1. Identify the transaction from the source document, such as a sales invoice or cheque stub. a. Specify each account affected b. Classify each account by type, such as asset or expense 2. For the accounts involved a. Determine which accounts increase and which decrease. (Some transactions may require only increases or only decreases.) b. Apply the rules of debit and credit 3. Record the transaction in the journal, listing the debit first followed by the credit.

The debit side is entered on the left margin, and the credit side is indented to the right.

Verify that total debits equal total credits and provide a brief explanation of the transaction. A journal entry would appear as follows: Account Name XX (debit amount) Account Name XX (credit amount) Brief explanation of the transaction.

Teaching Tip A logical sequence of steps must be followed when recording transactions: analyze (determine the accounts affected and whether the accounts increase or decrease), apply rules of debit and credit, journalize the entry, and include an explanation.

It may be helpful to explain the journal entry process to students in the form of the following set of questions they can ask themselves (and hopefully answer) for each identified transaction: What accounts are involved?

For each account: • What kind of account (asset, liability, owners’ equity (investment, drawing/dividend, revenue, expense)) is it?

• Is that account increasing or decreasing as a result of the transaction?

• Given the type of account and the increase/decrease, is it a debit or a credit?

C. The journal gives more information than a ledger account provides because it shows the complete effect of each transaction, not just one part of it.

D. The journal entry should always include a brief explanation of the transaction.

E. Ledger—a group of accounts. All of the accounts of a business grouped together form a book called the ledger (or general ledger). The correct order of accounts is assets, liabilities, and then shareholders’ equity.

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Teaching Tip Ask students: Why do we use two records, the journal and the ledger? Businesses need both a chronological record of transactions (the journal) and a record of each account’s activity and its balance (the ledger). Both are necessary to ensure that data are reported accurately.

F. Posting—the process of copying (transferring) data from the journal to accounts in the ledger.

1. Debits in the journal are posted as debits to the appropriate accounts; credits in the journal are posted as credits to the appropriate accounts.

2. All transactions must be keyed by date or number to provide a link between the journal and the ledger. (Exhibits 2-9 and 2-10 illustrate the flow of accounting information, from journalizing the original entry to posting it to the accounts in the ledger.)

3. Exhibit 2-11 shows how ledger accounts appear after a series of transactions have been posted and account balances calculated.

OBJECTIVE 5: Prepare and use a trial balance A. The trial balance is a listing, in general ledger order (assets, liabilities, then shareholders’ equity), of the debit or credit balance in each account as illustrated in Exhibit 2-12.

Teaching Tip Make sure that students understand that the trial balance is not one of the four financial statements, but merely a report to aid the accountant in the preparation of the financial statements.

You may also want to point out that the kinds of errors detected by a trial balance are the kinds of errors that humans make frequently but computers make very infrequently.

B. The total debits must equal the total credits. Unequal column totals indicate at least one error.

Some common errors are: 1. Posting incorrectly.

2. Mathematical errors. a. Transposition means digits are written in the wrong order (for example, instead of $567, the number is written as $657). A transposition error is always evenly divisible by 9 ($657 - $567 = $90, which is divisible by 9 = 10). b. A slide means that one or more zeroes are added to, or left off, a number ($1,000 is written as $100). A slide is always evenly divisible by 9.

3. Omitting or entering account balances in the wrong column of the trial balance. Divide an out of account balance by 2 and then look for a transaction involving the exact amount computed.

C. Equal trial balance totals prove only that debits posted to accounts equal credits posted to accounts; it does not prove that the trial balance does not have errors and that it is correct.

Errors in transactions that have equal debits and credits will not be revealed by unequal totals.

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Teaching Tip e Here is one way to look for possible errors on a trial balance. Have students refer to Exhibit 2-12.

Assume that Dividends of $2,100 are erroneously listed in the credit column on the trial balance.

Recalculate the trial balance totals. (Debit column = $59,700. Credit column = $63,900.) To find the mistake, calculate the difference between the column totals and divide that amount by two: $63,900 - $59,700 = $4,200; $4,200/2 = $2,100. Tell students that if they locate that amount on the trial balance, it is probably entered in the wrong column. In this case, it is entered as a credit instead of a debit.

D. Decision Guidelines for analyzing and recording transactions, and reporting are presented.

OBJECTIVE 6: Describe machine learning and its applications in accounting and business A. Machine Learning - Machine learning is a subset of artificial intelligence (AI) based on the idea that we can provide data to machines and let them learn for themselves without explicitly programming them.

Amazon’s recommendations on what you might like to purchase next are an example of a machine learning application. There are two types of machine learning: 1. Supervised learning is the most common type of machine learning, and is also the easiest to understand and implement. Examples include spam filters or advertisement placements on websites.

2. Unsupervised learning is data driven and focuses on identifying clusters of related data, then organizing the clusters in relevant, logical ways. Examples include recommendations in YouTube, Netflix, Amazon, and others.

Companies can also use unsupervised learning to make product improvements and enhancements. Data related to customer comments, customer complaints, social media mentions, product reviews, and other data sources are continually fed into an unsupervised learning algorithm to find clusters or trends in the data so that product improvements can be made.

B. Machine learning in accounting—One example of machine learning in accounting is a machine learning application to identify the general ledger account names for transactions.

The process that a company would use to develop a machine algorithm to classify travel expenses as either meal expense or other travel expense are discussed in the text.

The steps described in the text are highly condensed. In real life, there would be more steps and much more detail, but this brief overview is enough to illustrate the concept of how a machine would learn and develop a useful model for future predictions.

C. The programming languages that are used for machine learning include Python, R, Julia, and Java. Python is the most popular language among machine learning engineers today.

Spotify, Amazon, Netflix, NASA, and Facebook are just some of the organizations that use Python.

D. There are no differences in IFRS and ASPE for the topics covered in this chapter.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q2-1 Analyzing transactions 1 1-2 Easy Q2-2 Analyzing transactions 1 1-2 Easy Q2-3 Analyzing transactions 1 1-2 Easy Q2-4 Analyzing transactions 1 1-2 Easy Q2-5 Analyzing transactions 1 1-2 Easy Q2-6 Analyzing transactions 1 1-2 Easy Q2-7 Analyzing transactions 1 1-2 Easy Q2-8 Analyzing transactions 1 1-2 Easy Q2-9 Analyzing transactions 1 1-2 Easy Q2-10 Analyzing transactions 1 1-2 Easy Q2-11 Analyzing transactions 1 1-2 Easy Q2-12 Analyzing transactions 1 1-2 Easy Q2-13 Analyzing transactions 1 1-2 Easy Q2-14 Analyzing transactions 1 1-2 Easy Q2-15 Analyzing transactions 1 1-2 Easy Q2-16 Analyzing transactions 1 1-2 Easy Q2-17 Analyzing transactions 1 1-2 Easy Q2-18 Analyzing transactions 1 1-2 Easy Q2-19 Analyzing transactions 1 1-2 Easy Q2-20 Analyzing transactions 1 1-2 Easy S2-1 Recognize a business transaction 1 5 Easy S2-2 Analyze the effects of transactions on the accounting equation 2 5 Easy S2-3 Analyze transactions using T-accounts 3 5-10 Easy S2-4 Analyze transactions using T-accounts; determine accounts affected by transactions; assess impact of transactions on accounting equation 1, 2, 3 5 Medium S2-5 Determine accounts affected by transactions; record transactions in the journal 1, 4 5-10 Easy S2-6 Analyze transactions using T-accounts; record transactions in the journal and post them to the ledger 3, 4 10-15 Easy S2-7 Determine the impact of transactions on the accounting equation; analyze transactions using T-accounts; record transactions in the journal and post them 2, 3, 4 10-15 Medium S2-8 Prepare and use a trial balance 5 10 Easy S2-9 Use a trial balance 5 10 Medium S2-10 Prepare a trial balance 5 10 Medium S2-11 Identify business transactions; determine impact of transactions on accounting equation; record transactions in the journal 1, 2, 4 10 Easy S2-12 Record transactions using T-accounts 3 5 Easy E2-13 (Critical Thinking) Analyze transactions using T-accounts; determine accounts affected by transactions; determine the impact of transactions on the accounting equation 1, 2, 3 10-15 Easy E2-14 (Critical Thinking) Create business transactions; determine impact of transactions on the accounting equation 1, 2 5-10 Easy E2-15 Analyze transactions using the accounting equation 2 5 Medium E2-16 Identify business transactions; analyze transactions using the accounting equation 1, 2 15 Medium E2-17 Analyze transactions using the accounting equation and T-accounts; journalize transactions 1, 2, 3, 4 20 Medium ..

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E2-18 Determine accounts affected by transactions; journalize transactions; post to the ledger; e prepare and use a trial balance 1, 4, 5 20-30 Medium E2-19 (Critical Thinking) Journalize transactions 4 10-20 Medium E2-20 Prepare and use a trial balance 5 20-30 Medium E2-21 (Critical Thinking) Record transactions in the journal; correct errors in a trial balance 4, 5 10-15 Medium E2-22 Record transactions in T-accounts; prepare and use a trial balance 3, 5 10-20 Medium E2-23 Analyze transactions using the accounting equation; prepare and use a trial balance 2, 5 25 Difficult E2 24 Analyze transactions using the accounting equation 2 5-15 Medium E2-25 Analyze transactions using T-accounts; record transactions in the journal and post them; prepare a trial balance 3, 4, 5 10-20 Medium E2-26 (Critical Thinking) Analyze transactions using T-accounts 3 20-30 Difficult E2-27 Analyze transactions using T-accounts; prepare and use a trial balance; post transactions 3, 4, 5 30 Difficult E2-28 (Critical Thinking) Analyze transactions using the accounting equation; identify accounts affected by transactions 1, 2 30 Medium E2-29 Describe machine learning and its applications in accounting and business 6 20-40 Medium E2-30 Describe machine learning and its applications in accounting and business 6 20-30 Difficult E2-31 Journalize and post transactions; analyze transactions using the accounting equation and Taccounts; prepare and use a trial balance 1, 2, 3, 4 10-15 Medium P2-32A Use a trial balance 5 15-30 Medium P2-33A Journalize and post transactions; prepare financial statements 2, 4 45-60 Medium P2-34A Analyze transactions with the accounting equation; journalize transactions 1, 2, 4 3040 Easy P2-35A Journalize and post transactions 4 40-50 Difficult P2-36A Journalize and post transactions; prepare and use a trial balance; specify accounts affected by transactions 1, 4, 5 15-20 Medium P2-37A Record transactions in T-accounts; prepare and use a trial balance; specify accounts affected by transactions 1, 3, 5 50-60 Medium P2-38B Use a trial balance 5 15-30 Medium P2-39B Journalize and post transactions; prepare the financial statements 2, 4 45-60 Medium P2-40B Record transactions using the accounting equation and journal entries 1, 2, 4 30-40 Easy P2-41B Journalize and post transactions 4 40-50 Difficult P2-42B Journalize and post transactions; prepare and use a trial balance; specify accounts affected by transactions 1, 4, 5 15-20 Medium P2-43B Record transactions directly in T-accounts; prepare and use a trial balance; specify accounts affected by transactions 1, 3, 5 50-60 Medium Decision Case 1 Record transactions directly in T-accounts, prepare a trial balance, and measure net income or loss; determine which accounts to record transactions in 1, 3, 5 40-50 Difficult Decision Case 2 Correct financial statements; decide whether to expand a business 5 20-30 Medium Ethical Decision 1 Ethical Decision 2 Ethical Decision 3

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce e ANSWER KEY TO CHAPTER 2 QUIZ 1. C 2. B 3. D 4. D 5. A 6. D 7. D 8. B 9. A 10. C

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Name:_

Date:

Section:

CHAPTER 2 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Which of these is (are) an example of an expense account?

A. Service Revenue B. Dividends C. Cost of Goods Sold D. All of the above are expenses 2. Muin Corporation paid $500 on account. The effect of this transaction on Muin’s accounting equation is to: A. decrease liabilities and increase shareholders’ equity.

B. decrease assets and decrease liabilities.

C. have no effect on total assets.

D. decrease assets and decrease shareholders’ equity.

3. Which of these statements is true?

A. Decreases in liabilities and increases in revenues are recorded with a credit.

B. Decreases in assets and increases in shareholders’ equity are recorded with a debit.

C. Increases in both assets and expenses are recorded with a credit.

D. Increases in assets and decreases in liabilities are recorded with a debit.

4. Notes Receivable has a normal beginning balance of $40,200. During the period, new borrowings total $100,000 and payments on loans total $20,600. Determine the correct ending balance in Notes Receivable.

A. $39,200, debit B. $119,600, credit C. $39,200, credit D. $119,600, debit 5. Which of these statements is correct?

A. The account is a basic summary device used in accounting.

B. A business transaction is recorded first in the ledger and then posted to the journal.

C. In the journal entry, all accounts that are increased are listed first and then all accounts that are decreased are listed next.

D. Both A and B are correct.

6. Which of these accounts has a normal credit balance?

A. Salary Expense B. Accounts Payable C. Service Revenue D. Both B and C

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7. The December 31 trial balance reports a credit balance of $5,000 for Service Revenue. During the month, one entry for $1,000 had been posted in error as a debit, instead of as a credit, to Service Revenue. What is the correct balance of Service Revenue at December 31?

A. $4,000 B. $5,000 C. $6,000 D. $7,000 8. The beginning Cash account balance is $ 8,700. During the period, cash payments totalled $44,600. If ending Cash is $1,100, then cash receipts must have been: A. $35,500 B. $37,000 C. $35,900 D. $34,800 9. Use the following selected information to calculate the correct credit column total for a trial balance: Accounts receivable $ 27,200 Accounts payable 15,000 Building 359,600 Cash 55,600 Common shares 120,000 Dividends 4,800 Insurance expense 1,800 Retained earnings 33,800 Salary expense 52,500 Salary payable 3,600 Service revenue 193,200 A. $365,600 B. $304,700 C. $501,500 D. $506,300 10. The journal entry to record the performance of services for $1,200 cash is: A. Service Revenue 1,200 Cash 1,200 B. Accounts Receivable 1,200 Service Revenue 1,200 C. Cash 1,200 Service Revenue 1,200 D. Service Revenue 1,200 Accounts Payable 1,200

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CHAPTER 3 Accrual Accounting and the Financial Statements CHAPTER OVERVIEW The chapter begins with a brief introduction to lululemon athletica and the income statement.

The chapter discusses the distinction between accrual and cash-basis accounting, the revenue and expense recognition principles, the preparation of the three types of adjusting entries: deferrals (prepaid expenses and unearned revenue), depreciation, and accruals (accrued expenses and accrued revenue), the adjusted trial balance, and the preparation of the financial statements.

Ethical issues in accrual accounting and the way in which companies can manipulate income under the accrual basis are also discussed. The different formats for the financial statements— single-step income statement versus multiple step income statement and the classified balance sheet—are presented. A mid-chapter summary problem reviews adjusting entries, the adjusted trial balance, and the financial statements.

The second part of the chapter discusses closing entries and net working capital, the current ratio, the debt ratio, and Decision Guidelines for their use. The chapter ends with using data visualization in the form of charts and graphs to assess a company’s debt-paying ability, and to make communication clearer and more concise. A final summary problem reviews closing entries, the classified balance sheet, the current ratio, and the debt ratio.

LEARNING OBJECTIVES After working with the material presented in Chapter 3, your students should be able to: 1. Explain how accrual accounting differs from cash-basis accounting.

2. Apply the revenue and expense recognition principles.

3. Record adjusting journal entries.

4. Prepare the financial statements.

5. Record closing journal entries.

6. Analyze and evaluate a company’s debt-paying ability.

7. Identify patterns and trends using data visualization.

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Cash basis versus accrual basis Revenue and expense recognition principles Adjusting entries Preparing the financial statements Relationships among the financial statements Closing entries

RECOMMENDED Classification of assets and liabilities Ethical issues

IF TIME PERMITS Net working capital, current ratio, and debt ratio

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CHAPTER OUTLINE OBJECTIVE 1: Explain how accrual accounting differs from cash-basis accounting A. In accrual-basis accounting, an accountant recognizes the impact of a business transaction as it occurs. Both cash transactions (collections from customers and paying salaries) and non-cash transactions (purchase of supplies on account or providing a service on account) are recorded under the accrual basis.

B. In cash-basis accounting, the accountant does not record a transaction until cash is received or paid.

C. GAAP (IFRS and ASPE) require the use of accrual accounting. As a result, transactions are recorded as incurred, not when cash is received or disbursed.

Teaching Tip Stone Company received $500,000 from customers during 20X2. Of that amount, $40,000 was for services rendered in 20X1 but collected in 20X2. Another $20,000 of that amount was received from a customer for services to be provided early in 20X3. Stone had provided $45,000 of services in 20X2 that had not yet been collected. What amount would be reported on the 20X2 income statement using the accrual and cash basis of accounting?

Cash basis: $500,000; Accrual basis: $485,000 ($500,000 − $40,000 − $20,000 + 45,000). This example can also help lead students into the need for adjusting entries.

OBJECTIVE 2: Apply the revenue and expense recognition principles A. Accrual accounting is based on a conceptual framework that includes the following concepts/principles: 1. According to the revenue recognition principle for ASPE, a transaction must satisfy the following conditions before the business can recognize revenue: 1. The ownership (or control) and benefits of the goods have been transferred to the customer, or the services have been provided to the customer.

2. The amount of revenue to be received can be reliably measured.

3. It is probable that the customer will pay for the goods or services when payment becomes due.

2. According to the revenue recognition principle for IFRS, all business transactions involve contracts that exchange goods or services for cash or claims to receive cash. To determine if revenue has been earned from a transaction, the business selling the goods or service must: 1. Identify the contract with the customer, specify its terms, and evaluate the probability the customer will pay the transaction price when it becomes due.

2. Identify the separate performance obligations (the goods or services to be delivered) in the contract.

3. Determine the transaction price.

4. Allocate the transaction price to the separate performance obligations in the contract.

5. Recognize revenue when (or as) the business satisfies each performance obligation.

Exhibit 3-1 shows an application of the ASPE and IFRS revenue recognition criteria.

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3. According to the expense recognition principle a transaction must satisfy the following conditions before the business can recognize expense: 1. There has been a decrease in future economic benefits caused by a decrease in an asset or an increase in a liability.

2. The expense can be reliably measured.

Teaching Tip Stone Company had $1,000 of supplies at the beginning of 20XX. Stone Company purchased $10,000 supplies on account in 20XX and paid $8,000 for those supplies by year end. Stone had $1,500 of supplies left at the end of 20XX. What amount of Supplies Expense should be recorded for 20XX? The amount of supplies used, $9,500 ($1,000 + $10,000 − $1,500), should be treated as supplies expense and deducted from revenue in 20XX. The amount purchased or paid is not considered an expense under the accrual basis.

B. According to the matching principle, expenses should be matched with the revenue that created the expense (for example, Cost of Goods Sold should be matched with Sales). If there is no cause-andeffect relationship, the expenses should be associated with a time period, such as a year.

C. The time-period concept recognizes that there is a requirement for periodic reporting, other than annually, for accounting information to be relevant.

Teaching Tip Often, students are confused about what we mean by “matched.” Assure them that we do not mean that the dollar amounts have to be equal. It has to do with the time period. Remind them that revenues, expenses, and therefore net income, start out at zero every year. Probably the biggest challenge in accounting is to figure out when the revenue is actually earned and what expenses should be matched with the revenue of a particular period. Tell students that these are issues we will be revisiting time after time this semester.

OBJECTIVE 3: Record adjusting journal entries A. Why are adjusting entries needed? Adjusting entries are needed to bring the books up to date for transactions that have taken place but that may not be associated with a single, economic event.

1. Certain revenues and expenses have not been recorded by the end of the period. Adjusting entries ensure that revenues and expenses, and therefore net income, are correct.

2. The revenues and expenses referred to above also have an effect on related asset and liability accounts. Adjusting entries are needed to ensure all balance sheet accounts carry correct balances.

B. There are three main types of adjusting entries. (The information presented in Exhibit 3-2 shows a summary of adjusting entries.)

1. A deferral is an adjustment of an asset or a liability for which the business paid or received cash in advance.

2. Depreciation (amortization under ASPE) records the obsolescence and/or wear-and-tear on capital assets.

3. An accrual, the opposite of a deferral, is an adjustment of an asset or a liability for which the business records an expense or revenue before paying or receiving cash.

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C. Prepaid expenses require adjustment because the cash is paid in one period, but the resource is not completely used until a later period. Examples include prepaid rent, prepaid insurance, and supplies. Exhibit 3-3 diagrams the timing of prepaid-type and accrual-type adjusting entries.

Teaching Tip “An asset is just an expense waiting to happen.” Try putting that statement on the board or screen to start the class period where you talk about prepaid expenses. Come back to it after you are done. See if the students understand what you mean by that statement after you have explained these types of entries.

Teaching Tip An adjusting entry for a prepaid expense always requires a debit to an expense and a credit to an asset.

For example, if ABC pays $4,800 for a one-year insurance policy on November 1, the adjusting entry on December 31 will be: Insurance Expense ($4,800/12 = $400; $400 × 2) Prepaid Insurance

800 800

The remaining asset balance is $4,000 ($4,800 – $800), which reflects the remaining coverage that ABC has in the next year.

D. Unearned revenues arise when a business receives cash in one period but does not earn all of it until a later period.

1. An unearned revenue is a liability because the business owes the customer a good or service.

2. The adjusting entry records the part of the unearned revenue that has been earned.

Teaching Tip All adjusting entries for unearned revenues involve a debit to the liability (because the entity no longer owes the entire service since a portion has already been rendered) and a credit to a revenue. Assume that ABC received $600 on December 1 for services to be rendered in December, January, and February. The adjusting entry at the end of the year would be: Unearned Revenue ($600/3) Service Revenue

200 200

The balance of Unearned Revenue is $400 ($600 – $200). This is the amount of work we have left to do next year.

E. Depreciation expense is the allocation of the cost of a capital asset over its life. (Exhibits 3-4 and 3-5 show how actual companies report adjusting entries, including those for capital assets and depreciation.)

1. When a capital asset is acquired, an asset is recorded. This asset will eventually wear out, or depreciate. Therefore, the asset is expensed as it is used.

2. As the asset depreciates, the asset value declines. Instead of reducing the asset account, another account, Accumulated Depreciation, is used. a. Accumulated Depreciation is a contra asset account; that is, an asset account with a credit balance. b. The carrying value of the asset is determined by deducting the accumulated depreciation from the original cost.

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Teaching Tip Students often confuse Accumulated Depreciation and Depreciation Expense. Depreciation Expense is the amount of depreciation recorded for the current period and belongs on the income statement.

Accumulated Depreciation is the sum of all depreciation expense recorded life-to-date and is deducted from the related asset account on the balance sheet.

Teaching Tip Assume that ABC purchased equipment that cost $6,000 at the beginning of 20X1. The depreciation expense per year is $1,500. The entry to record the depreciation expense for each year is: Depreciation Expense 1,500 Accumulated Depreciation

1,500

At the end of 20X2, the carrying value would be $3,000 ($6,000 − $3,000). Note that carrying value is not an account. It never appears in a journal entry. It is just a subtotal that is derived by taking the cost minus the accumulated depreciation to date.

F. Accrued expenses are expenses that are incurred by the end of the period but have not been billed or paid for until the next period. The adjusting entry records the expense and a liability. The text illustrates accrued salary expense.

Teaching Tip All adjusting entries for accrued expenses involve a debit to an expense (because a resource has been used) and a credit to a liability (because the expense has not yet been paid). For example, assume that ABC’s 5-day weekly payroll was $6,000, and the year ended on a Wednesday. The adjusting entry would be: Salary Expense (($6,000/ 5) × 3) Salary Payable

3,600 3,600

This entry is not necessary during the year because we don’t have to bring everything up to date in order to prepare financial statements. The only time we have to make this entry is when the end of the accounting period falls in between pay dates.

G. Accrued revenues are revenues that have been earned (because the good or service has been provided) but payment is not yet received. The adjusting entry records a revenue and a receivable.

The text illustrates accrued service revenue.

H. Exhibit 3-4 illustrates the adjusting process for Moreau Ltd. Teaching Tip All adjusting entries for accrued revenues involve a debit to a receivable (because cash has not yet been received) and a credit to a revenue (because the revenue has been earned). For example, assume that ABC earns $125 of interest that has not been received. The adjusting entry would be: Interest Receivable Interest Revenue

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I. Accrual accounting provides some ethical challenges that cash accounting can avoid.

1. In accrual accounting, expenditures are not necessarily expensed when paid; therefore, management can exercise some discretion when recording expenses.

2. Net income and liabilities can be misstated by failing to record accrued expenses.

3. During good times, liabilities can be accrued in accounts called “reserves” (debit expenses or losses and credit reserves). These reserves are like grandma’s cookie jar. When you fell off your bike, all your grandma had to do was draw a cookie out of her cookie jar to make you feel better.

When your company stumbles in future periods, managers can debit the reserves and credit revenues and gains to make everyone feel better about the company during the tough times.

4. Accelerated revenue recognition occurs when managers just can’t wait until the earning process is complete before recognizing revenue. Some ways of doing this are recording sales based on anticipated orders from customers, recording a project as completely done when it is still in progress, and recording all of the revenue at the time of the delivery of the product when an obligation to service the product extends into the future.

Teaching Tip A real-world example of this happened in 2002, during the “Summer of the Corporate Scandals.”

Early reports on the scandal at WorldCom indicate that management fraudulently recorded $3.8 billion of expenditures as assets when they should have recorded them as expenses. When cash went out for items that provided a current benefit (rather than a future benefit), WorldCom found a way to debit an asset (and spread the cost out over the life of the asset) rather than recording the cost as expense.

J. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

(Exhibit 3-5 shows the unadjusted trial balance, adjustments, and the adjusted trial balance in worksheet form.)

OBJECTIVE 4: Prepare the financial statements A. The financial statements are prepared using the account balances found on the adjusted trial balance. (Exhibit 3-5 shows the adjusted trial balance used in Exhibits 3-6, 3-7, and 3-8 for the preparation of the financial statements.)

B. The income statement must be prepared first.

1. Net income/ (loss) calculated from the income statement is used in preparing the statement of retained earnings.

2. The balance of retained earnings is used in preparing the balance sheet.

C. The various classifications of accounts on the balance sheet include: 1. Current assets, which are listed first because they are more liquid; that is, current assets can be converted into cash more quickly than other assets. a. Current assets are expected to be converted to cash, sold, or consumed during the nextmonths 12 or within the business’s normal operating cycle, whichever is longer. The operating cycle is the time it takes a business to acquire goods and services, sell these goods or services, and collect from the customers. b. Current assets examples are Cash, Accounts and Notes Receivable, Inventory, and Prepaid Expenses (such as Supplies, Prepaid Insurance, etc.).

2. Long-term assets are assets that are not current. One category of long-term assets is capital assets, often called Property, Plant and Equipment. Land, Buildings, Furniture and Fixtures, and Equipment are examples of capital assets. Long-Term Investments, Intangible Assets, and Other Assets are also long-term assets.

3. Current liabilities are debts that are due to be paid within the next 12 months or within the operating cycle, whichever is longer. Accounts Payable, Notes Payable (due within one year), Salary Payable, Unearned Revenue, Income Tax Payable, and Interest Payable are examples. ..

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4. Long-term liabilities are all liabilities that are not current. An example is Notes Payable (due after one year).

D. A balance sheet that uses these various classifications is called a classified balance sheet.

Classified balance sheets can appear in two different formats. Exhibit 3-9 illustrates a classified balance sheet.

1. The report format shows the assets first, then liabilities beneath the assets, and the shareholders’ equity beneath the liabilities. The account format reports the assets on the left and the liabilities and shareholders’ equity on the right.

E. There are two basic formats for the income statement.

1. A single-step income statement lists all revenues together under one heading and all expenses together under another heading.

Revenues (listed individually) $XX Less: Expenses (listed individually) XX Net income $XX 2. A multi-step income statement contains subtotals to highlight important relationships between revenues and expenses. (Exhibit 3-10) Net sales revenue COGS Gross margin Operating expenses (listed individually) Income from operations Other income (expense) Income before income tax Income tax expense Net income

$XX XX XX important subtotal XX XX important subtotal XX XX important subtotal XX $XX

OBJECTIVE 5: Record closing journal entries A. Closing the books or accounts refers to the end-of-period process of preparing the accounts for the next accounting period.

B. Closing entries perform two functions: 1. Closing entries set the balances of temporary accounts to zero. a. Temporary accounts are revenue, expense, and the dividend accounts. b. These account balances need to have a zero balance to begin the next accounting period.

2. The balances of the temporary accounts are transferred into retained earnings.

3. Permanent accounts are the accounts that will not be closed—assets, liabilities, and shareholders' equity accounts.

C. There are three closing entries (See Exhibit 3-11): 1. Each revenue account is debited and Retained Earnings is credited.

2. Each expense account is credited and Retained Earnings is debited.

3. Dividends is credited and Retained Earnings is debited.

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Teaching Tip Prepare the closing entries for a company reporting the following account balances: Cash $ 400 Rent expense $ 280 Dividends 80 Accounts payable 180 Service revenue 1,000 Retained earnings (beginning) 100 Accounts receivable 50 Utilities expense 320 Common shares 250 Equipment 200 Salary expense 200 Service Revenue 1,000 Retained Earnings 1,000 Net Income = $200 ($1,000 – $800) Retained Earnings 800 Salary Expense 200 Rent Expense 280 Utilities Expense 320

Retained Earnings 80 Dividends 80

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Ending retained earnings = $220 ($100 + $200 – $80)

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OBJECTIVE 6: Analyze and evaluate a company’s debt-paying ability A. Net working capital is a figure that indicates a company’s liquidity or the ease with which a company will be able to use its current assets to pay off its current liabilities.

1. The formula is: Net working capital = Total current assets – Total current liabilities, both of which can be found on the balance sheet.

2. The higher a company’s liquidity or net working capital, the easier it will be able to pay off its current liabilities.

B. The current ratio measures a company’s ability to pay current liabilities with current assets.

1. The formula is: Current ratio = Total current assets Total current liabilities 2. A company prefers to have a high current ratio, which indicates that it should have little difficulty paying current debts as they come due.

3. A current ratio that is too high may mean that a company has too many current assets that are low-earning assets.

Teaching Tip Assume a company has a current ratio of 2, calculated as $200,000 / $100,000. How would the payment of a $2,000 account payable affect the current ratio? The current ratio would increase to 2.02 ($198,000 / $98,000).

C. The debt ratio indicates the proportion of a company’s assets that is financed with debt.

1. The formula is: Debt ratio = Total liabilities Total assets 2. A low debt ratio indicates that the company has a relatively small amount of debt, which results in small interest and principal payments.

D. Ratios are often included in lending agreements. Failure to meet the ratios could violate lending agreements, resulting in the lender being in a position to demand repayment of the debt or extract more favourable terms.

E. Decision Guidelines show how bankers and investors use net working capital, and the current and debt ratios.

OBJECTIVE 7: Identify patterns and trends using data visualization A. Data visualization makes it easier to spot patterns and trends. The textbook uses an example of comparing the current ratio of a fictional company (Fulton Hotels Corporation) to prior years and to other companies in the hospitality industry. When there are a small number of ratios to compare, it is easy to spot the highest current ratio by simply comparing amounts in a spreadsheet and selecting the highest.

B. Using an Excel spreadsheet and its graphing capabilities, a vertical bar chart of current ratios easily shows Fulton Hotels Corporation has the highest current ratio. A bar chart is useful for comparing data across categories.

C. To assess whether Fulton’s liquidity has been improving or declining, a line chart of current ratios over time shows clearly that Fulton Hotels Corporation’s current ratio has been trending up over the past five years, with a slight dip down in 20X4. A line chart is useful for examining data over time. ..

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With four rows and five columns of data, it is difficult to compare the ratios for four companies over five years just by looking at the data. Again, using a line chart to visualize the data helps identify key patterns and trends in the ratios. Fulton’s liquidity is by far the best of the group, both at the end of 20X5 and over the preceding five years.

D. Microsoft Excel was used to create the charts in the text. Google Sheets and Apple Numbers have similar capabilities. Other data visualization tools include Microsoft Power BI, Tableau, and Qlik.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q3-1 Accrual Accounting 2 1-2 Easy Q3-2 Accrual Accounting 2 1-2 Easy Q3-3 Accrual Accounting 1 1-2 Easy Q3-4 Accrual Accounting 2 1-2 Easy Q3-5 Accrual Accounting 3 1-2 Easy Q3-6 Accrual Accounting 3 1-2 Easy Q3-7 Accrual Accounting 3 1-2 Easy Q3-8 Accrual Accounting 3 1-2 Easy Q3-9 Accrual Accounting 3 1-2 Easy Q3-10 Accrual Accounting 2 1-2 Easy Q3-11 Accrual Accounting 3 1-2 Easy Q3-12 Accrual Accounting 5 1-2 Easy Q3-13 Accrual Accounting 5 1-2 Easy Q3-14 Accrual Accounting 5 1-2 Easy Q3-15 Accrual Accounting 6 1-2 Easy S3-1 Apply accrual accounting 1 10 Easy S3-2 Apply accrual accounting 1 10 Easy S3-3 Applying the revenue recognition principles 2 10 Easy S3-4 Record adjusting journal entries 3 10 Easy S3-5 Record depreciation adjustments and prepare financial statements 3, 4 10 Medium S3-6 Apply the revenue and expense recognition principles and prepare financial statements 2, 4 5-10 Easy S3-7 Record adjusting journal entries 3 10 Medium S3-8 Apply the revenue recognition principle and record adjusting journal entries 2, 3 10 Medium S3-9 Report prepaid expenses 3 5-10 Easy S3-10 Apply revenue recognition principles; record adjusting journal entries 2, 3 5-10 Easy S3-11 Prepare the financial statements and closing entries; use the financial statements to evaluate a company’s debt-paying ability and overall performance 4, 5, 6 30-40 Medium E3-12 Apply accrual and cash-basis accounting 1 5-10 Easy E3-13 (Critical Thinking) Apply accrual and cash-basis accounting 1 5-10 Medium E3-14 Apply accrual and cash-basis accounting 1 10 Medium E3-15 Recognize revenue and record expenses under accrual basis of accounting 2 5-10 Easy E3-16 Apply expense recognition principles 2 5-10 Easy E3-17 Apply the revenue and expense recognition principles 2 15-20 Medium E3-18 (Critical Thinking) Record adjusting journal entries and analyze their effects on net income 3 15-20 Medium E3-19 Apply revenue recognition principles 2 10-15 Easy E3-20 Record adjusting entries 3 10-20 Medium E3-21 Record adjusting entries directly in T-accounts 3 10-20 Medium E3-22 Prepare the financial statement 4 20-30 Difficult E3-23 Determine financial statement amounts 4 10-20 Difficult E3-24 Apply revenue and expense recognition principles, and report on the financial statements 2, 4 10 Medium E3-25 Apply the revenue recognition principles 2 10-15 Medium ..

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E3-26 Record closing entries 5 10-20 Medium E3-27 Identify and record adjusting and closing entries; prepare a classified balance sheet and evaluate a company’s debt paying ability 3, 4, 5, 6 30-40 Medium E3-28 Evaluate debt-paying ability 6 20-30 Medium E3-29 Adjust the accounts, prepare the financial statements, close the accounts, and use financial statements to evaluate the business 3, 4, 5, 6 240 Difficult E3-30 Compute financial statement amounts, analyze debt-paying ability 3, 4, 6 20-25 Difficult E3-31 Compute financial statement amounts 3, 4 60 Medium E3-32 Apply accrual accounting, record adjusting entries, and analyze and evaluate a company’s debt-paying ability 1, 3, 6 20-25 Medium E3-33 Prepare financial statements 4 20-25 Medium E3-34 Identify patterns and trend using data visualization 7 20 Medium E3-35 Identify patterns and trends using data visualization 7 20-30 Medium P3-36A Apply accrual accounting and prepare financial statements 1, 4 15-20 Medium P3-37A Apply accrual and cash-basis accounting 1 20-30 Medium P3-38A (Critical Thinking) Explain the difference between accrual and cash accounting 1 15-30 Easy P3-39A Record adjusting journal entries 3 10-20 Medium P3-40A (Critical Thinking) Prepare an adjusted trial balance and the financial statements; evaluate debt-paying ability 3, 4, 6 45-60 Medium P3-41A Record adjusting journal entries and prepare the balance sheet 3, 4 10-20 Medium P3-42A Prepare financial statements and analyze debt-paying ability 4, 6 20-30 Medium P3-43A Record closing entries; prepare a balance sheet and evaluate debt-paying ability 4, 5, 6 25-45 Medium P3-44A Evaluate debt-paying ability 6 20-40 Medium P3-45A Analyze and evaluate liquidity and debt-paying ability 6 20-45 Medium P3-46B Apply accrual accounting and prepare financial statements 3, 4 15-20 Medium P3-47B Apply accrual and cash-basis accounting 1 20-30 Medium P3-48B (Critical Thinking) Explain accrual accounting and expense recognition 1, 2 10-15 Easy P3-49B Record adjusting journal entries 3 10-20 Medium P3-50B (Critical Thinking) Record adjusting entries, prepare financial statements, and evaluate debt-paying ability 3, 4, 6 45-60 Medium P3-51B Record adjusting entries and prepare a balance sheet 3, 4 10-20 Medium P3-52B Prepare financial statements and evaluate debt-paying ability 4, 6 20-30 Medium P3-53B Record closing journal entries; prepare a balance sheet and evaluate debt-paying ability 4, 5, 6 25-45 Medium P3-54B Evaluate debt-paying ability 6 20-40 Medium P3-55B Analyze and evaluate liquidity and debt-paying ability 6 20-45 Medium Decision Case 1 Adjust and correct the accounts, and evaluate debt-paying ability 3, 6 25 Difficult Decision Case 2 Prepare financial statements and make an expansion decision 4 20-30 Medium Decision Case 3 Prepare financial statements and compute a purchase price 4 30-40 Difficult Ethical Decision 1 Ethical Decision 2 Ethical Decision 3

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ANSWER KEY TO CHAPTER 3 QUIZ 1. C 2. D 3. D 4. C 5. D 6. A 7. B 8. D 9. D 10. C

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Name:_

Date:

Section:

CHAPTER 3 TEN-MINUTE QUIZ Circle the letter of the best response.

1. ABC Corporation began operations on January 1, 20XX. During 20XX, ABC collected $100,000 for management services. Of the amount collected, $12,000 was from a contract to provide management services for one year beginning November 1, 20XX. An additional $22,000 of management services had been earned for other clients but not collected by year end. The amount of revenue that should be reported for 20XX under the cash-basis and accrual-basis is: (Cash-Basis; Accrual-Basis) A. $92,000; $80,000 B. $80,000; $100,000 C. $100,000; $112,000 D. $92,000; $102,000 2. Which of the following statements is true?

A. The time-period concept requires companies to prepare financial statements at least quarterly.

B. According to the revenue principle, revenue can be recorded even when a product or service has not been delivered to the customer.

C. Expenses can be deducted from revenue in any time period that they occur.

D. The time-period concept, the revenue principle, and the matching principle all support the practice of preparing adjusting entries.

3. XYZ Company usually purchases office supplies monthly as it needs them and pays for them the following month. Office Supplies would be considered A. an unearned revenue.

B. a prepaid expense.

C. an accrued revenue.

D. an accrued expense.

4. On November 1, 20XX, Marcus Company paid $2,400 for a one-year insurance policy. On December 31, 20XX, the adjusting entry would include A. a debit to Insurance Expense, $1,200.

B. a credit to Insurance Payable, $800.

C. a credit to Prepaid Insurance, $400.

D. a debit to Insurance Expense, $2,400.

5. Which of these could not be a closing entry?

A. Retained Earnings XX Insurance Expense XX B. Retained Earnings XX Dividends XX C. Service Revenue XX Retained Earnings XX D. Retained Earnings XX Service Revenue XX

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6. What type of account is Prepaid Rent (asset, liability, shareholders’ equity, revenue, or expense) and what is its normal balance, respectively?

A. asset, debit B. expense, debit C. liability, credit D. revenue, credit 7. Which of the following transactions is considered unearned revenue?

I. Salaries that employees have earned but not received II. Management fees received in advance III. Newspaper advertising that has been purchased but has not yet appeared in the newspaper A. I only B. II only C. III only D. Both II and III 8. Which of the following types of accounts will appear on the post-closing trial balance?

Assets, Liabilities, Shareholders’ Equity, Revenue, Expenses A. yes, yes, yes, yes, yes B. yes, yes, yes, yes, no C. no, no, no, yes, yes D. yes, yes, yes, no, no 9. Which of the following accounts is considered a current asset?

A. Accumulated Depreciation B. Equipment C. Vehicle D. Prepaid Rent

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10. The balance sheet for AJAX Cleaners Inc. appears below.

AJAX Cleaners Inc. Balance Sheet December 31, 20XX Assets: Cash Accounts receivable Supplies Prepaid insurance Equipment Less: Accumulated depreciation Land Total assets

$400 460 10 60 $400 40

Liabilities: Accounts payable Salary payable Unearned revenue Note payable (due in 5 years) Total liabilities

$300 20 120 400 840

Shareholders’ Equity: Common shares Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity

370 480 850 $1,690

AJAX’s debt ratio for 20XX is A. 0.41 B. 0.99 C. 0.50 D. 0.72

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360 400 $1,690

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CHAPTER 4 Cash and Receivables CHAPTER OVERVIEW This chapter begins with a discussion of the balance sheet of CGI Group Inc. with a focus on its cash and accounts receivable balances. Cash and cash equivalents are illustrated using CGI Group Inc. statements. The bank account is introduced as a control device related to cash. The bank reconciliation is illustrated, and the various “bank” and “book” reconciling items are described in detail, as are the subsequent journal entries. A mid-chapter summary problem allows students to review the preparation of a bank reconciliation and all related journal entries.

The second half of the chapter begins with the different types of receivables and managing the collection of receivables. Decision Guidelines for the major issues relating to the management and accounting of accounts receivable are provided. The allowance method of accounting for bad debts is presented. The aging-of-receivables method to estimate uncollectible account expense (bad debt expense) is illustrated. The procedure for writing off an uncollectible account and recovering it is demonstrated. This part of the chapter concludes with a discussion on computing cash collections from customers.

The chapter continues with an explanation of terms relating to notes receivable. The entries for receipt of the note, interest accrual, and collection of the note are illustrated. The text then discusses how to improve cash flows from sales and receivables using credit and debit cards, and by selling (factoring) accounts receivable. The chapter shows how effects of short-term receivables transactions are reported on the cash flow statement. Next, evaluating a company’s liquidity is discussed using ratios such as the current ratio, the quick or acid-test ratio, and the days’ sales in receivables. Decision Guidelines are illustrated to help the student use this information to make decisions. A summary problem reviews uncollectible accounts.

LEARNING OBJECTIVES After studying Chapter 4, your students should be able to: 1.

Report cash on the balance sheet.

2.

Prepare a bank reconciliation.

3.

Account for accounts receivable.

4.

Evaluate collectibility using the allowance for uncollectible accounts.

5.

Account for notes receivable and interest revenue.

6.

Evaluate liquidity using ratios.

7.

Analyze receivables collectibility using an aging schedule created with an Excel pivot table.

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Cash and cash equivalents Bank reconciliation and related journal entries Accounting for accounts receivable Estimating uncollectibles—aging-of-receivables The allowance method Writing off uncollectible accounts Decision Guidelines for managing and accounting for receivables RECOMMENDED Accounting for notes receivable Evaluating a company’s liquidity (current ratio, acid-test ratio, and days’ sales in receivables)

IF TIME PERMITS Using an Excel pivot table to create an aging schedule to assess collectibility

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CHAPTER OUTLINE OBJECTIVE 1: Report cash on the balance sheet A. “Cash equivalents” reported on the balance sheet include certificates of deposit, treasury bills, commercial paper, and money market funds, which are interest-bearing accounts.

OBJECTIVE 2: Prepare a bank reconciliation A. The bank account is a control device, because banks have practices for safeguarding cash and documents, such as 1. Signature cards: a card that each person authorized to sign on an account must provide 2. Deposit slips: a standard account form that a customer fills in for the amount of the deposit 3. Cheques: tells the bank to pay the designated party a specified amount. There are three parts to a cheque: a. The maker, who signs the cheque b. The payee, to whom the cheque is paid c. The bank on which the cheque is drawn Exhibit 4-1 illustrates a cheque with remittance advice.

B. A bank statement reports the activity in a bank account. Exhibit 4-2 illustrates a bank statement.

C. The bank reconciliation explains the differences between the balance on the bank statement and the balance in the cash general ledger. The bank account balance and the cash balance on the books must be reconciled each period. Exhibit 4-3 illustrates the Nixon Partners Inc.’s ending cash balance per its cash records. Differences are caused by: 1. Items recorded by the company but not yet recorded by the bank: a. Deposits in transit—Because these deposits have been recorded by the company but not yet by the bank, they are added to the bank’s balance. b. Outstanding cheques—Because these cheques have been issued by the company but not yet paid by the bank, they are deducted from the bank’s balance. c. Bank errors—Correct all bank errors on the bank side of the reconciliation.

2. Items recorded by the bank but not yet recorded by the company: a. Bank collections—When the bank has collected money on behalf of the company, the amount collected is added to the book balance. b. Electronic Funds Transfer (EFT)—When the bank has received or paid cash on behalf of the company, the amount is added to or subtracted from the book balance. c. Service charges—Fees charged by the bank for certain services are deducted from the book balance; cheque-printing charges are also deducted. d. Interest income—Interest earned on chequing accounts is added to the book balance. e. Nonsufficient funds (NSF)—Cheques received from customers where there were insufficient funds to honour the cheque are deducted from the book balance. f. The cost of printed cheques—The cost of printed cheques, which is handled like a service charge. g. Book errors—Correct all book errors on the book side of the reconciliation.

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Teaching Tip Students are often confused about NSF cheques. An NSF cheque is a customer cheque that has been received by the business and returned by the bank because the customer’s account balance was not sufficient. (NSF does not refer to cheques that the company itself has written.) Recall that when the customer’s cheque was received, Accounts Receivable was credited. Now, to record the NSF cheque (through an adjusting entry), Accounts Receivable must be debited, to reverse the deposit. It is as though no collection has been received on the account.

3.

The bank reconciliation begins with the ending bank balance and the unadjusted book balance, which is the cash balance from the trial balance. The reconciliation is complete when the adjusted bank balance equals the adjusted book balance.

D. A bank reconciliation is prepared in this format: Balance per bank Add: Deposits in transit

$X X X Less: Outstanding cheques (X)

Balance per books Add: Bank collections/EFT Interest revenue

$X $X X

X X

Less:

Adjusted cash balance

Service charges NSF cheques Adjusted cash balance

$X

$X X

X $X

Note: Errors can either affect the book or bank balance, and may either be added or deducted.

The side that makes the error is adjusted.

Exhibit 4-4 illustrates a bank reconciliation.

E. Journal entries are required for every adjustment to the book’s balance. Merely entering adjustments on a reconciliation does not change account balances.

Teaching Tip Preparing the bank reconciliation itself does not change the Cash balance on the books; it just shows what the ending balance should be. An entry is needed for each reconciling item on the “Book” side of the reconciliation to adjust the Cash balance to the correct amount. Never record adjusting entries for any of the items listed on the “Bank” side of the reconciliation.

F. The amount of cash listed on the balance sheet is the adjusted book balance from the reconciliation.

G. Managers and owners use the bank reconciliation to help maintain control over cash.

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OBJECTIVE 3: Account for accounts receivable A. Receivables are monetary claims against others.

1. Accounts or trade receivables are amounts collectible from customers from the sale of goods and services. Individual customer’s account balances may be found in the Account Receivable Subsidiary Ledger, which balance to a control account in the general ledger.

2. Notes receivable are written promises to pay a creditor a definite sum at a specific future date called the maturity date. a. Notes receivable due within one year or less are current assets. b. Notes receivable due beyond one year are long-term receivables and are reported as non-current.

3. Other receivables is a category that is used to report other receivables such as loans to employees and subsidiaries.

C. Decision Guidelines provide a plan of action for the major issues in managing and accounting for accounts receivable.

OBJECTIVE 4: Evaluate collectibility using the allowance for uncollectible accounts A. Uncollectible-account expense is the cost to the seller of extending credit and arises from the failure to collect from credit customers. This is also called bad debt expense, or doubtful account expense and is reported on the income statement.

B. Net realizable value is accounts receivable less allowance for uncollectible accounts.

C. The allowance method measures bad debt and records collection losses on the basis of estimates by setting up an Allowance for Uncollectible Accounts (or Allowance for Doubtful Accounts or Allowance for Bad Debts).

D. The aging-of-accounts-receivable method (a balance sheet approach) illustrated in Exhibit 4-5 uses an analysis of the age of the receivables to help estimate Bad Debt Expense. Exhibit 4-6 is a summary of the aging-of-receivables method. a. The accounts receivable are classified by their age. b. A percentage is applied to the total in each category. This percentage is determined from past collection experience. c. The sum of the amounts (percentage applied to the total of each category) is the desired balance in Allowance for Uncollectible Accounts. d. The Bad Debt Expense is the difference between the balance before adjustment and the desired ending balance.

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Teaching Tip Following are the steps for executing the aging of receivables approach: 1. Prepare an Aging Schedule: - Break the ending balance in Accounts Receivable into age groups (this is usually done for you) - Multiply ending balance in each age group by the Estimated % Uncollectible for each age group - Add the products together 2. The sum is your desired ending balance in Allowance for Uncollectible Accounts 3. Draw an Allowance for Uncollectible Accounts T-account 4. Put the balance before adjustment in the Allowance for Uncollectible Accounts T-account (note it can be either a debit or credit balance at this time) 5. Put the desired ending balance (see step 2) in Allowance for Uncollectible Accounts into the T-account (this must always be on the credit side) 6. Calculate the amount of the credit entry it would take to get from the balance before adjustment to the desired ending balance. This is your credit to Allowance for Uncollectible Accounts.

7. Debit Bad Debt Expense for the same amount.

Teaching Tip Allen Company has ending accounts receivable of $400,000 and an ending Allowance for Uncollectible Accounts of $2,000 (credit). An aging of the accounts reveals that $280,000 of the receivables are current, $80,000 are 1–30 days past due, and $40,000 are more than 30 days past due. Historically, 1% of the current accounts, 5% of the accounts 1–30 days past due, and 40% of the accounts more than 30 days past due are uncollectible. What is the balance of the allowance for uncollectible accounts, bad debt expense, and the net accounts receivable?

Allowance for uncollectible accounts ($280,000 × 1%) + ($80,000 × 5%) + ($40,000 × 40%) = $22,800* Bad debt expense ($22,800 – $2,000) $20,800 Net accounts receivable ($400,000 – $22,800) $377,200 * Note that the percentage of the receivables is the desired balance in the allowance account.

E. When the credit department determines that a specific account cannot be collected, the account is written off, meaning that the account’s balance will be reduced to zero.

1. The entry to write off the account is: Allowance for Uncollectible Accounts XX Accounts Receivable XX 2. The write-off of an account does not affect net income, but simply reduces the allowance for uncollectible accounts.

Teaching Tip The entry to write off an uncollectible account does not affect net income or net accounts receivable. Net income is reduced when the uncollectible account expense is recorded.

F. Sometimes an already written-off account is recovered, which is called the recovery of an uncollectible account. In this case, the write off is reversed and the cash is recorded.

Exhibit 4-7 contains a summary of transactions for accounts receivable

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G. To improve cash flows from sales and receivables, companies develop strategies to shorten the credit cycle and collect cash more quickly.

1. They might offer sales discounts for early payment (discussed in Chapter 5).

2. They might charge interest on customer accounts that have not been paid after a certain period of time.

3. Credit cards speed up cash collection but at a cost, namely the fee charged by the credit card company.

4. Debit cards are just like cash, without the hassle of carrying it. The merchant is charged a fee for accepting it, like a credit card.

OBJECTIVE 5: Account for notes receivable and interest revenue A. Notes receivable are more formal than accounts receivable. Exhibit 4-8 illustrates a typical promissory note.

B. Accounting for notes receivable is illustrated below.

1. A note receivable can be received for cash, for a sale, or in settlement of an account receivable. The entry is: Note Receivable 1,000 Cash, Sales Revenue, or Accounts Receivable 1,000 2. The entry to accrue interest revenue at the end of the accounting period is: Interest Receivable 30 Interest Revenue 30 3. The entry to record collection of the note and interest on the maturity date is: Cash 1,045 Note Receivable 1,000 Principal amount Interest Receivable 30 Amount accrued at year end Interest Revenue 15 Amount earned this period Teaching Tip The formula for calculating interest is: principal × interest rate × time. Students, though, often compute the accrued interest incorrectly, because they have counted the length of time incorrectly.

Assume $5,000 is loaned out in the form of an 8%, 60-day note receivable on December 1, 20XX. The accrued interest on December 31, 20XX, will be $33.97 ($5,000 × 8% × 31/365). It is very important that the time factor is expressed in annual terms because the interest rate will always be given in annual terms.

C. A company may accept a note receivable from a trade customer whose account receivable is past due.

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OBJECTIVE 6: Evaluate liquidity using ratios A. Liquidity is a measure of how quickly an item can be converted to cash.

B. The current ratio measures the company’s ability to pay current liabilities with current assets.

Current Ratio =

Total current assets Total current liabilities

C. The acid-test (or quick) ratio is a more stringent measure of a company’s ability to pay current liabilities.

1. The acid-test ratio is similar to the current ratio but it excludes inventory and prepaid expenses.

Acid-test ratio

=Cash+Short-term investments+Net receivables Total current liabilities

2. The higher the acid-test ratio, the better the business is able to pay its current liabilities.

D. Days’ Sales in Receivables, also called the Collection Period, tells how long it takes to collect the average level of receivables.

Accounts receivables turnover = Net sales Average net accounts receivable Days’ sales in receivables =

365 days Accounts receivable turnover

1. Average net accounts receivable is calculated by adding the beginning and ending net accounts receivable balances together and dividing by two.

Teaching Tip Compare the current ratio to the acid-test ratio. Inventory and prepaid expenses are included in the numerator of the current ratio but excluded from the numerator of the acid-test ratio. For example, given the following information: Cash $2,000; Equipment $15,000; Short-term investments 4,000; Accumulated amortization 4,000; Accounts receivable 6,000; Accounts payable 14,000; Inventory 17,000; Interest payable 1,000; Supplies 1,000 The current ratio is 2 [($2,000 + $4,000 + $6,000 + $17,000 + $1,000)/($14,000 + $1,000)] The acid-test ratio is 0.8 [($2,000 + $4,000 + $6,000) / ($14,000 + $1,000)] E. Decision Guidelines are provided for using ratios in decision making.

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OBJECTIVE 7: Analyze receivables collectibility using an aging schedule created with an Excel pivot table A. To prepare an aging schedule, a schedule of all outstanding invoice totals needs to be summarized by the number of days past due. A company might categorize its receivables with the following categories: “Under 30 days,” “31–60 days,” “61–90 days,” and “More than 90 days.” “Days” refers to the number of days since the invoice date. Exhibit 4-9 is an Excel worksheet screenshot that shows a partial list of the Pinkettle Company’s outstanding invoices as of the last day of its fiscal year. The full Excel worksheet contains 120 unpaid invoices that are in Pinkettle’s accounts receivable, totalling $652,454.

The managers at Pinkettle can use the pivot table feature in Excel to summarize these invoices by the “Days past due” category as shown in Exhibit 4-10. The managers can then apply the estimated uncollectible percentages to the totals for each of the “Days past due” categories.

Adding the uncollectible totals will provide an estimate of the total amount of uncollectible accounts. This is an example of how a pivot table can be used to summarize data in a table in a useful way.

B. A summary of IFRS and ASPE differences is presented.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q4-1 Bank reconciliation 2 1-2 Easy Q4-2 Bank reconciliation 2 1-2 Easy Q4-3 Accounts receivable 4 1-2 Easy Q4-4 Accounts receivable 3 1-2 Easy Q4-5 Accounts receivable 3 1-2 Easy Q4-6 Accounts receivable 4 1-2 Easy Q4-7 Accounts receivable 4 1-2 Easy Q4-8 Notes receivable 5 1-2 Easy Q4-9 Notes receivable 5 1-2 Easy Q4-10 Notes receivable 5 1-2 Easy Q4-11 Notes receivable 5 1-2 Easy Q4-12 Notes receivable 5 1-2 Easy Q4-13 Notes receivable 5 1-2 Easy Q4-14 Liquidity 7 1-2 Easy Q4-15 Liquidity 7 1-2 Easy Q4-16 Liquidity7 1-2 Easy S4-1 Report cash on the balance sheet 1 5 Easy S4-2 Apply the allowance method 4 10 Easy S4-3 Record a credit card sale 4 5 Medium S4-4 Prepare a bank reconciliation 2 10 Easy S4-5 Record transactions from a bank reconciliation 2 5 Easy S4-6 Use a bank reconciliation to detect fraud 2 10 Medium S4-7 Applying the allowance method to account for uncollectibles 4 5 Medium S4-8 Account for accounts receivable and uncollectible accounts 3, 4 5-10 Medium S4-9 Account for accounts receivable and uncollectible accounts 3, 4 10 Medium S4-10 Account for accounts receivable and uncollectible accounts 3, 4 5-10 Medium S4-11 Account for accounts receivable and uncollectible accounts 3, 4 10 Medium S4-12 Account for a note receivable 5 5-10 Easy S4-13 Account for a note receivable and interest revenue 5 10 Easy S4-14 Account for a note receivable and interest thereon 5 10 Easy S4-15 Report notes receivable and interest revenue 5 5-10 Easy S4-16 Evaluate the acid-test ratio and days’ sales in receivables 6 10 Medium S4-17 Reporting receivables and other accounts in the financial statements and evaluate liquidity 3, 6 15-20 Easy S4-18 Analyze receivables collectability using an aging schedule created with an Excel pivot table 7 10-15 Easy S4-19 Analyze receivables collectability using an aging schedule created with an Excel pivot table 7 15-20 Easy E4-20 (Critical Thinking) Use the bank reconciliation 2 20 Easy E4-21 Classify bank reconciliation items 2 5-10 Easy E4-22 Prepare a bank reconciliation 2 10-20 Easy E4-23 Prepare a bank reconciliation 2 10-20 Easy E4-24 Prepare and use a bank reconciliation 2 10-15 Easy E4-25 Report uncollectible accounts by the allowance method 3, 4 15-20 Medium E4-26 Use the allowance method for uncollectible accounts 3, 4 15 Medium E4-27 Using the allowance method for uncollectible accounts 4 10-15 Medium ..

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E4-28 Use the aging method to estimate uncollectible accounts 4 15-30 Medium E4-29 Measure and account for uncollectibles 4 15-20 Medium E4-30 Record notes receivable and accrue interest revenue 5 10-15 Medium E4-31 Report the effects of note receivable transactions on the balance sheet and income statement 5 15 Easy E4-32 Understand receivables 3, 5 10 Easy E4-33 (Critical Thinking) Using the acid-test ratio and days’ sales in receivables to evaluate a company 6 10-15 Medium E4-34 Analyze a company’s financial statements 6 10-15 Medium E4-35 Determine whether to accept credit cards 4 15-20 Difficult E4-36 Reconstruct receivables and uncollectible-account amounts 3, 4 15-20 Medium P4-37A Prepare the bank reconciliation 2 20-30 Easy P4-38A Prepare a bank reconciliation and the related journal entries 2 20-30 Medium P4-39A Account for accounts receivable, notes receivable, collections, and uncollectibles 3, 4, 5 15-20 Medium P4-40A Account for receivables, collections, and uncollectibles 2, 3, 4 25-35 Medium P4-41A Use the aging approach for uncollectibles and account for notes receivable 4, 5 20-25 Medium P4-42A (Critical Thinking) Account for uncollectibles, and use ratios to evaluate a business 1, 3, 4, 6 20-30 Medium P4-43A Account for notes receivable and accrued interest revenue 5 15-25 Medium P4-44A (Critical Thinking) Use ratio data to evaluate a company’s financial position 4, 6 15-25 Medium P4-45A Account for accounts receivable, uncollectible accounts, and effects on financial information 3, 4, 6 10-15 Medium P4-46B Prepare a bank reconciliation 2 20-30 Easy P4-47B Prepare a bank reconciliation and the related journal entries 2 20-30 Medium P4-48B Account for accounts receivable, notes receivable, collections, and uncollectibles 3, 4, 5 15-20 Medium P4-49B Account for receivables, collections, and uncollectibles 3, 4 25-35 Medium P4-50B Use the aging approach for uncollectibles 4, 5 20-25 Medium P4-51B (Critical Thinking) Account for uncollectibles 1, 3, 4, 6 20-30 Medium P4-52B Account for notes receivable and accrued interest revenue 5 30-40 Medium P4-53B (Critical Thinking) Use ratio data to evaluate a company’s financial position 6 30-40 Medium P4-54B Account for accounts receivable, uncollectible accounts, and effects on financial information 3, 4, 6 10-15 Medium

Decision Case 1 Account for receivables, collections, and uncollectible accounts on receivables 3, 4 20-30 Medium Decision Case 2 Estimate the collectability of accounts receivables and evaluate liquidity 4, 6 15-20 Medium Ethical Decision 1 Ethical Decision 2

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ANSWER KEY TO CHAPTER 4 QUIZ 1. B 2. C 3. D 4. D 5. B 6. A 7. B 8. C 9. C 10. A

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Name:_

Date:

Section:

CHAPTER 4 TEN-MINUTE QUIZ Circle the letter of the best response.

1. When the allowance method is used, the entry to write off a customer’s account A. increases uncollectible-account expense.

B. has no effect on net accounts receivable.

C. decreases net accounts receivable.

D. increases the balance of the allowance for uncollectible accounts.

Table 4-1 Use the following letters to indicate where the items described in questions 2–5 would appear on the July bank reconciliation for Muin Company: A. Add to the bank statement balance.

B. Deduct from the bank statement balance.

C. Add to the book balance.

D. Deduct from the book balance.

E. Does not appear on the bank reconciliation.

2.

Refer to Table 4-1. The bank statement included an EFT credit on July 17 for $500 collected by the bank on Muin’s behalf.

3.

Refer to Table 4-1. Included on the bank statement was a debit memo of $50 for fees that should have been charged to Muin Company by the bank last month.

4.

July.

Refer to Table 4-1. The bank reported $150 of interest charged to the account during

5.

Refer to Table 4-1. A cheque written to one of Muin’s suppliers in June for $300 was not

among the cheques returned by the bank in either the June or the July bank statement.

6. While preparing the bank reconciliation for December, the company bookkeeper discovered that a $6,540 cheque in payment of an account payable had been entered incorrectly in the journal as $6,450. Which of the following statements is true?

A. An adjusting entry must be made to debit Accounts Payable and credit Cash for $90.

B. An adjusting entry must be made to debit Cash and credit Accounts Payable for $90.

C. The bank should be notified and the bank balance corrected by adding $90.

D. No adjusting entry is needed for this reconciling item because it appears on the bank side of the reconciliation.

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7. ABC Company made a $1,000 credit sale to a customer on credit terms of 2/10 n/30. Assume the customer pays in eight days. How much cash will ABC receive?

A. $1,000 B. $ 980 C. $ 900 D. $ 800 8. ABC Co. paid XYZ Co. $2,000 for merchandise with a two-month, 12% note dated October 31.

If ABC pays off the note at maturity, what entry should XYZ make on its books at that time?

A.

Cash 2,040 Notes Receivable 2,040

B.

Notes Payable 2,000 Interest Expense 40 Cash 2,040

C.

Cash 2,040 Notes Receivable 2,000 Interest Revenue 40

D.

Cash 2,240 Notes Receivable 2,000 Interest Revenue 240

(see next page for questions 9 and 10)

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9. Which accounts would be debited and credited in the entry to record accrued interest on a note payable?

Debit A. Interest Expense B. Interest Receivable C. Interest Expense D. Interest Receivable

Credit Interest Receivable Interest Revenue Interest Payable Interest Payable

10. Given the following information, compute the quick ratio.

Salary Payable Inventory Accounts Receivable Supplies

$ 8,000 $100,000 $ 46,000 $ 8,000

Short-term investments Equipment Cash Accounts Payable

A. 1.00 B. 2.43 C. 1.11 D. 2.54

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$ 10,000 $ 96,000 $ 14,000 $ 62,000

Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

CHAPTER 5 Inventory and Cost of Goods Sold CHAPTER OVERVIEW The chapter opens with a discussion of Inventory at Leon’s Furniture Limited. The chapter examines the accounting treatment for merchandise inventory. The perpetual and periodic inventory accounting systems are presented and compared. The perpetual inventory system is then illustrated in the remainder of the chapter. The periodic inventory system is illustrated in Appendix A of this chapter.

Students learn how to determine the quantity and cost of inventories under the perpetual inventory system by using the three inventory costing methods: specific unit cost, first-in, first-out (FIFO), and weighted-average cost. The inventory methods are compared and the effects of FIFO and weightedaverage cost on cost of goods sold, gross profit, and ending inventory are illustrated. A mid-chapter summary problem allows students to practise using FIFO and weighted-average cost using the perpetual inventory system, and to test their understanding of the differences between the methods.

The chapter resumes with a discussion of the accounting principles and concepts that affect inventory—comparability and disclosure. The lower-of-cost-and-net realizable-value rule is explained, and the effect of a write-down on the financial statements is shown.

Next the chapter illustrates how the gross profit percentage and the inventory turnover rate are calculated. Decision Guidelines discuss ratios and decision making. The impact of inventory errors on the financial statements is emphasized and the effects on cost of goods sold, gross margin, and net income in both the period of the error and in the following period are illustrated. The text then discusses ethical issues related to accounting for inventory (“Cooking the Books—Unethical Behaviour with Inventory”). Inventory transactions are traced to the cash flow statement. The chapter examines how to analyze inventory records using the XLOOKUP function in Excel.

XLOOKUP allows users to retrieve information from a reference file and add it to an analysis file to do inventory analysis, among other uses. The chapter concludes with a summary problem covering journal entries, inventory calculations, cost of goods sold and gross margin questions, and two of the ratios covered in the chapter.

Appendix A shows how to account for inventory under the periodic inventory system. A periodic inventory system does not keep a continuous record of inventory, as is the case with the perpetual inventory system; rather, a physical count is performed to determine ending inventory. Cost of goods sold is a computation. A comparison of the journal entries for the perpetual and periodic system is shown.

LEARNING OBJECTIVES After studying Chapter 5, your students should be able to: 1. Show how to account for inventory under the perpetual inventory system.

2. Apply and compare various inventory costing methods.

3. Explain how accounting standards apply to inventory.

4. Compute and evaluate gross profit percentage, inventory turnover, and days’ inventory outstanding.

5. Analyze the effects of inventory errors.

6. Analyze inventory records using the XLOOKUP function in Excel.

A-1. Show how to account for inventory under the periodic inventory system.

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER The cost-of-goods-sold model The perpetual inventory system Inventory costing methods: specific identification, weighted-average, FIFO Accounting principles related to inventory Gross profit percentage and inventory turnover rate RECOMMENDED The periodic inventory system Ethical issues in accounting for inventory Effect of inventory errors

IF TIME PERMITS Using the XLOOKUP function in Excel to analyze inventory records Purchase discounts and purchase returns and allowances

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CHAPTER OUTLINE OBJECTIVE 1: Show how to account for inventory under the perpetual inventory system A. The merchandising company’s balance sheet includes a new current asset, “Inventory” or “Merchandise inventory,” while the company’s income statement includes an expense, “Cost of Goods Sold” or “Cost of Sales.” Exhibit 5-1 contrasts the balance sheet and income statement of a service company versus a merchandiser.

Teaching Tip Cost of Goods Sold may be the first expense account that the students have seen that does not have the word “expense” in its title. You may need to take extra care to ensure they realize that it is an expense.

B. The cost of inventory on hand is the Inventory reported as an asset on the balance sheet, while the cost of inventory that has been sold is the Cost of Goods Sold reported as an expense on the income statement.

C. Exhibit 5-2 illustrates the difference between the sale price of inventory and the cost of inventory when inventory cost is constant.

D. Gross profit or gross margin is the excess of the sales revenue over the cost of goods sold.

Teaching Tip An item in your inventory had a cost of $108. Its sale price is $235. When the above two entries are made to record the sale, what is the difference in the credit to Revenue and the debit to Cost of Goods Sold? It is $127, the amount of gross margin on the sale. Do we need to make an entry to record the $127? No. Gross margin is a subtotal on the income statement, not an account.

E. The cost of inventory is the inventory quantity times the unit cost.

F. Inventory cost includes “all costs incurred to bring the asset to its intended use.” All other costs such as advertising, sales commissions, and so on, are not part of inventory cost but are listed among “operating expenses” on the income statement.

G. Two inventory accounting systems are used to maintain inventory records: 1. the periodic inventory system 2. the perpetual inventory system a. The periodic inventory system, often used by a business that sells a large number of goods at a low unit price, does not keep a continuous record of the inventory on hand.

The business keeps a record of the inventory purchased, counts and prices its inventory periodically—at least once a year—to determine inventory quantities and the total cost of ending inventory, and then calculates the cost of goods sold using the following formula: Beginning inventory + Net purchases − Ending inventory = Cost of goods sold The periodic inventory system is covered in detail in Appendix 5A.

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b. The perpetual inventory system, often used by a business that sells relatively fewer numbers of goods at a higher price per unit, maintains a continuous record for each inventory item. i. Both purchases and sales of inventory items are recorded directly to the Inventory account. ii. The quantity and cost of the inventory on hand can be determined from inventory records, although an actual physical count must still be made at least once a year. iii. Perpetual records give up-to-the-minute data about inventory, enabling managers to make decisions about when and how much to buy. Exhibit 5-3 illustrates the use of an electronic scanner to update the perpetual inventory system in real time. iv. Financial statements can be prepared using information from the perpetual inventory records. v. Two entries are required to record the sale of inventory in a perpetual system: Accounts Receivable (or Cash) XX Sales Revenue XX Cost of Goods Sold XX Inventory XX

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H.

Exhibit 5-4 illustrates the journal entries for a perpetual inventory system.

Teaching Tip Ask your students to tell you about the advantages of each method. If they are having trouble, you might prompt them with the following things to consider: cost to implement, customer service (inventory stock information is available to sales personnel or online), tracking/preventing theft, controlling holding costs. Follow up with questions about how the method makes a difference.

Teaching Tip Many of your students have worked at merchandising businesses—perhaps the Gap, Wal-Mart, or a local grocery store. Let one or two students share their experiences in helping count the physical inventory at the end of the period.

Teaching Tip Typically, a business selects a year end, and therefore counts its ending inventory when the quantity on hand is the lowest, so that counting the inventory will be as simple as possible.

I. Freight-in is the transportation cost paid by the buyer to move goods from the seller to the buyer and is included in the cost of inventory.

J. Purchase discounts and purchase returns and allowances both affect the amount of inventory purchases.

1. Purchase discounts decrease the cost of purchases; these result from making prompt payment on purchased goods and receiving a cash discount from the vendor for the prompt payment.

2. Purchase returns and allowances both also decrease the cost of purchases. a. Purchase returns result from the buyer returning goods to the seller. b. Purchase allowances result from the seller granting the buyer an allowance from the amount owed.

3. The net purchases of the business may be calculated as follows: Net purchases = Purchases + Freight-in – Purchase returns and allowances – Purchase discounts = Net purchases Teaching Tip You may need to be a little bit careful in your presentation of the Net Purchases material. Under the perpetual inventory system, there is no “Purchases” account (nor are there any of the others).

Emphasize that under the perpetual system, the Merchandise Inventory account is always affected irrespective of the nature of the transaction (e.g. freight-in, purchase returns and allowance, and purchase discounts), while under the periodic system, the accounts affected are in accordance to the nature of the transaction.

K. A similar formula provides for the calculation of net sales: Net sales = Sales revenue – Sales returns and allowances – Sales discounts = Net sales Sales returns and allowances and sales discounts both affect the amount of inventory sales. ..

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1. Sales returns and allowances both decrease the cost of sales. Customers usually have a right to return unsatisfactory or damaged merchandise to sellers for refund, credit, or exchange. a. Sales returns result from the buyer returning goods to the seller. b. Sales allowances result from the seller granting the buyer an allowance from the amount owed.

2. U n d e r IFRS, when a company sells merchandise where a right of return exists, it will: a. Increase sales and record the accrued liability Sales Refund Payable for the sales price of the items expected to be returned (sometimes expressed as a percentage of sales expected to be returned); and b. Adjust the inventory and cost of goods sold accounts for the cost of the items expected to be returned in the asset account Estimated Inventory Returns.

When items are returned, Sales Refund Payable is debited for the selling price of the items, and cash or accounts receivable are credited. Inventory is debit for the cost of the items returned and Estimated Inventory Returns is credited.

3. Under ASPE, sales returns are simply recorded as they occur.

4. Sales discounts decrease the cost of sales; these result from the customer making prompt payment on purchased goods and receiving a cash discount from the seller for the prompt payment. If payment is made within the discount period, the customer is entitled to the discount and will pay the amount owed less the discount. If the payment is made after the discount period, the discount is forfeited and the customer must pay the full amount of the invoice.

OBJECTIVE 2: Apply and compare various inventory costing methods A. Any of these three methods are acceptable for valuing inventory and computing cost of goods sold (COGS), according to Canadian GAAP: 1. Specific identification cost 2. Weighted-average cost 3. First-in, first-out (FIFO) cost Teaching Tip Help students understand that if the cost of inventory were fixed throughout the year, we wouldn’t need to use a cost flow assumption. However, costs fluctuate and we need a way to assign costs to the units that are sold during the year and those that are still in inventory at the end of the year.

Exhibit 5-5 uses inventory data to illustrate inventory costing methods.

B. The specific-identification cost method assigns to a specific item its exact, specific cost.

This method is applicable to high-value, low-quantity items such as real estate, cars, appliances, or jewels.

C. The weighted-average-cost method assigns an average cost to both the units remaining on hand and the units sold during the period.

1. When using the perpetual inventory system, the weighted-average-cost per unit is computed by dividing the cost of goods available for sale by the number of units available for sale, and a new average cost per unit is computed every time a purchase is made. ..

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D. FIFO (first-in, first-out) cost assumes that the first goods purchased are the first goods sold and, therefore, the most recent (the latest) prices should be assigned to the units on hand; this leaves the earliest prices to be assigned to cost of goods sold. The amounts for COGS and ending inventory are the same when using FIFO under both the perpetual and periodic inventory methods.

Teaching Tip Stress this point to students: While FIFO seems to be most reasonable in terms of physically handling goods, any of the methods may be used to account for the cost of goods. The physical flow of the goods does not have to be the same as the cost flow of the goods.

E. Exhibit 5-6 summarizes the income effects of the two inventory methods when prices are rising, while Exhibit 5-7 demonstrates the effects of increasing and decreasing costs of inventory on the income statement, balance sheet, and cash flow.

F. Decision Guidelines illustrate managing inventory including the choice of system and method.

OBJECTIVE 3: Explain how accounting standards apply to inventory A. The following accounting principle is relevant to inventory: 1. Comparability implies the use of the same method in valuing inventory period over period. Changes to valuation methods require the change to be accounted for retrospectively and disclosed in the notes.

B. Lower-of-cost-and-net-realizable-value (LCNRV) rule provides additional guidance on the measurement of inventory. It is based on the premise that inventory can become obsolete or damaged or its selling price can decline.

C. Market is often associated with net realizable value, or NRV (estimated price the inventory could be sold for). Write-downs from cost to NRV should be charged to cost of goods sold. In alignment with IFRS, inventory previously written down should be reassessed at each reporting period and if the value has increased, the write-down should be reversed but never to an amount greater than original cost.

D. Exhibit 5-8 illustrates the lower-of-cost-and-net-realizable-value effects on inventory and cost of goods sold.

OBJECTIVE 4: Compute and evaluate gross profit percentage, inventory turnover, and

days’ inventory outstanding A. The gross profit percentage expresses the relationship of an entity’s gross margin (gross profit) to its sales.

1. The gross profit percentage is very important to a merchandising business. A change in the gross profit percentage may be an indication that the business must take corrective action. ..

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2. The formula for calculating the gross profit percentage is: Gross profit percentage = Gross profit Net sales revenue Teaching Tip Zee Corp. reports beginning inventory of $190 and ending inventory of $150. Purchases during the year total $500. Net sales are $800. Calculate Zee’s gross profit percentage. First, calculate cost of goods sold: $190 + $500 − $150 = $540. Next, calculate gross profit: $800 − $540 = $260. Therefore, the gross profit percentage = $260/$800 = 32.5% (or 0.325).

B.

The inventory turnover indicates how rapidly inventory is sold.

1. The formula for calculating inventory turnover is: Inventory turnover = Cost of goods sold Average inventory 2. Average inventory is calculated by dividing beginning and ending inventory by 2.

C. Decision Guidelines are presented on the use of the inventory turnover and the gross profit percentage ratios.

OBJECTIVE 5: Analyze the effects of inventory errors A. Errors in ending inventory affect not only the balance of inventory but also cost of goods sold, gross margin, net income, and owners’ equity. Exhibit 5-9 traces the effects that an inventory error has over three periods.

B. Inventory errors reverse (or counterbalance) in two consecutive periods and have the opposite effect on cost of goods sold, gross margin, and net income.

C. Exhibit 5-10 illustrates the effects of inventory errors on cost of goods sold, gross profit and net income over two periods.

D. As inventory transactions affect cash, their effects are reported on the statement of cash flows as operating activities.

Teaching Tip One reason an auditor spends so much time in the testing and examination of the inventory area is because of the potential for manipulation of both balance sheet and income statement data.

Dollar-for-dollar, an error in ending inventory has the exact same impact on operating income (income before income taxes) for the period.

E. Ethical considerations guide managers in reporting inventory fairly and correctly. Because of an inventory error’s direct impact on net income, it is important that management report the inventory amount with no accidental or intentional modifications. (Refer to “Cooking the Books—Unethical Behaviour with Inventory”).

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OBJECTIVE 6: Analyze inventory records using the XLOOKUP function in Excel A. A manager may want to analyze sales trends by inventory item. Managers may want to decide which sales promotions to run based on past sales results. Managers may want to know which items are still in stock.

B. A common inventory identifier is a SKU, which stands for “stock-keeping unit.” A SKU can contain a mixture of letters and numbers.

A UPC, which stands for “Universal Product Code", is standardized barcode technology commonly used across the United States, Canada, Europe, Australia, and other locations. A UPC code is a 12-digit numeric code that is located under a barcode. Anyone with a barcode scanner can read barcodes.

Serial numbers are another identification system, but typically serial numbers cannot be used as inventory identifiers. A serial number is used to track ownership of one specific unit; serial numbers are often used to track warranty information.

Advantages of SKU over UPC or serial numbers as identifiers are discussed in the text.

C. The Excel XLOOKUP function can be used to extract information from one file and import it into another file. For example, one Excel file may just contain the SKU as part of its fields and the information relating to the SKU may be in another file. This information in the other file may include description, warehouse location, and inventory type. The fields in the second file can be imported into the first file through the common field SKU using the XLOOKUP function in Excel. The XLOOKUP function in Excel be used in a wide variety of situations.

D. A summary of IFRS and ASPE differences is presented.

OBJECTIVE A-1: Show how to account for inventory under the periodic inventory system A. In the periodic inventory system, the business keeps no running record of its merchandise.

Instead, at the end of the period, the business counts inventory on hand and applies unit costs to determine the cost of ending inventory. This ending inventory amount appears on the balance sheet and is used to compute cost of goods sold.

B. In the periodic system: i. Purchases are recorded in the Purchases account (an expense). ii. A physical count of the quantity of inventory is made at the end of the period to determine the quantity and cost of the inventory on hand. iii. At the end of the period a journal entry removes the beginning balance in the Inventory account by crediting Inventory and debiting Cost of Goods Sold. iv. A second journal entry sets up the ending inventory balance based on the physical count. v. The final entry transfers the amount of Purchases to Cost of Goods Sold. vi. No entry to record Cost of Goods Sold and the reduction in Inventory is required when there is a sale. Only one entry is required to record the sale of inventory in a periodic system: Accounts Receivable (or Cash) XX Sales Revenue XX

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C. Exhibit 5A-1 shows the accounting for inventory in both the perpetual and periodic inventory system. Panel A gives the journal entries and Panel B presents the income statement and the (partial) balance sheet.

D. Exhibit 5A-2 contains inventory data that is used to illustrate inventory costing methods for the FIFO and Weighted Average costing methods under the periodic system.

The FIFO (first-in, first-out) inventory costing method is the same for both the periodic and perpetual inventory systems.

When using the periodic inventory system, the weighted-average-cost per unit is based on the average cost of inventory for the entire period. Ending inventory and cost of goods sold are computed by multiplying the number of units by the weighted-averagecost per unit.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q5-1 Understanding accounting for inventory 1, 3 1-2 Easy Q5-2 Understanding accounting for inventory 1, 3 1-2 Easy Q5-3 Understanding accounting for inventory 1, 3 1-2 Easy Q5-4 Understanding accounting for inventory 1, 3 1-2 Easy Q5-5 Understanding accounting for inventory 1, 3 1-2 Easy Q5-6 Understanding accounting for inventory 1, 3 1-2 Easy Q5-7 Understanding accounting for inventory 1, 3 1-2 Easy Q5-8 Understanding accounting for inventory 1, 3 1-2 Easy Q5-9 Understanding accounting for inventory 1, 3 1-2 Easy Q5-10 Understanding accounting for inventory 1, 3 1-2 Easy Q5-11 Understanding accounting for inventory 1, 3 1-2 Easy Q5-12 Understanding accounting for inventory 1, 2 1-2 Easy Q5-13 Understanding accounting for inventory 1, 3 1-2 Easy Q5-14 Understanding accounting for inventory 1, 3 1-2 Easy Q5-15 Understanding accounting for inventory 1, 3 1-2 Easy Q5-16 Understanding accounting for inventory 1, 3 1-2 Easy Q5-17 Understanding accounting for inventory 1, 3 1-2 Easy S5-1 Account for inventory transactions 1 10 Easy S5-2 Account for inventory transactions 1 10-15 Easy S5-3 Account for sales returns 2 15-20 Easy S5-4 Account for sales discounts 2 10-15 Medium S5-5 Account for inventory 1 10-15 Easy S5-6 Understand accounting standards related to inventory 3 5 Medium S5-7 Apply the lower-of-cost-and-net-realizable-value rule to inventory 3 5-10 Easy S5-8 Use ratio data to evaluate operations 4 5-10 Medium S5-9 Assess the effect of an inventory error—one year only 5 5 Medium S5-10 Assess the effect of an inventory error on two years 5 5 Medium S5-11 Analyze inventory records using the XLOOKUP function in Excel 6 10 Easy S5-12 Analyze inventory records using the XLOOKUP function in Excel 6 10 Medium E5-13 Account for sales discounts 2 15-20 Easy E5-14 Analyze inventory transactions—perpetual system 1, 2 15-25 Medium E5-15 (Critical Thinking) Determine inventory amounts by three methods—perpetual system—and compare net income 1, 2 10-15 Easy E5-16 Compute the tax advantage of weighted-average cost over FIFO 2 10 Easy E5-17 Determine inventory values—FIFO versus weighted-average cost, perpetual—and apply accounting standards 1, 2, 3 15 Easy E5-18 Account for sales returns and sales discounts 2 15-20 Easy E5-19 Manage income under the weighted-average-cost method 2 15-20 Easy E5-20 Identify effects of the inventory methods and evaluate operations 1, 2, 3 10-15 Medium E5-21 Apply the lower-of-cost-and-net-realizable-value rule to inventories 3 5-10 Medium E5-22 Account for sales allowances 2 15-20 Medium E5-23 Show how to account for inventory 1 20-30 Medium

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E5-24 (Critical Thinking) Measure and evaluate gross profit and inventory turnover 4 10 Difficult E5-25 Correct an inventory error and measure profitability 4, 5 10-15 Difficult E5-26 Account for sales returns and sales discounts 2 10-15 Medium E5-27 Analyze the effects of an inventory error on multiple years 5 20-25 Medium E5-28 Compute cost of goods sold and gross profit on sales—perpetual system—and evaluate gross profit 1, 2, 4 20-30 Medium E5-29 Record transactions in the perpetual system; report inventory items in the financial statements 1 20 Medium E5-30 Account for inventory 1 10 Medium E5-31 Make inventory policy decisions 2 5-10 Easy E5-32 Assess the impact of a year-end purchase of inventory—perpetual 1, 2 20-30 Medium E5-33 Evaluate a company’s profitability 4 20-30 Easy P5-34A Determine inventory method, cost of goods sold—perpetual system—and apply accounting standards to inventory 1, 2, 3 30 Medium P5-35A Account for inventory in a perpetual system and compute gross profit percentage 1, 2, 4 30 Medium P5-36A (Critical Thinking) Measure cost of goods sold and ending inventory—perpetual system— and determine which method to use 1, 2 20-30 Difficult P5-37A Compute and compare inventory by two methods—perpetual system—and prepare an income statement 1, 2 30 Medium P5-38A Prepare a partial income statement using different inventory costing methods 1, 2 3040 Medium P5-39A (Critical Thinking) Apply the lower-of-cost-and-net-realizable-value rule to inventories—perpetual system 3 15-30 Medium P5-40A Use gross profit percentage and inventory turnover to evaluate two companies 4 20-30 Medium P5-41A Correct inventory errors over a three-year period and analyze net income 4, 5 25 Medium P5-42A Account for sales returns and allowances 2 40 Difficult P5-43A Account for inventory in a perpetual system, prepare an income statement, evaluate a company’s profitability, apply the lower-of-cost-and-net-realizable-value rule 1, 2, 3, 4 40 Difficult P5-44A Compute cost of goods sold, gross profit, ending inventory and evaluate gross profit 1, 2, 4 40 Difficult P5-45B Determine inventory method, cost of goods sold—perpetual system—and apply accounting standards to inventory 1, 2, 3 30 Medium P5-46B Account for inventory in a perpetual system and compute gross profit percentage 1, 2, 4 30 Difficult P5-47B (Critical Thinking) Measure cost of goods sold and ending inventory—perpetual system—and determine which inventory method to use 1, 2 30 Medium P5-48B Compute and compare inventory by two methods—perpetual system—and prepare an income statement 1, 2 30 Medium P5-49B Prepare a partial income statement using different inventory costing methods 1, 2 3040 Medium P5-50B (Critical Thinking) Apply the lower-of-cost-and-net-realizable-value rule to inventories—perpetual system 3 20 Difficult P5-51B Use gross profit percentage and inventory turnover to evaluate two leading companies 4 20-25 Medium P5-52B Correct inventory errors over a three-year period and analyze net income 4, 5 20 Medium P5-53B Account for sales returns and allowances 2 45 Medium P5-54B Account for inventory in a perpetual system, prepare an income statement, evaluate a company’s profitability, apply the lower-of-cost-and-net-realizable-value rule 1, 2, 3, 4 45 Medium P5-55B Compute cost of goods sold, gross profit, ending inventory and evaluate gross profit 1, 2, 4 45 Medium ..

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Decision Case 1 Prepare and compare an income statement under different inventory methods— perpetual system 1, 2 50-60 Difficult Decision Case 2 Assess the impact of the inventory costing method on the financial statements 2, 3 15-25 Medium Ethical Decision 1 Ethical Decision 2 E5A-1 Account for inventory transactions—perpetual and periodic systems A-1 15-20 Medium E5A-2 Measure gross profit—FIFO versus weighted-average cost, falling prices—periodic system 2, A-1 15 Easy E5A-3 Determine amounts for the income statement A-1 15-20 Easy E5A-4 Evaluate profitability and inventory turnover 4, A-1 20-30 Medium E5A-5 Compare ending inventory and cost of goods sold for all three inventory costing methods—periodic system 2, A-1 10-15 Medium E5A-6 Journalize inventory transactions in the periodic system; compute cost of goods sold 2, A-1 25-30 Medium

ANSWER KEY TO CHAPTER 5 QUIZ 1. D 2. B 3. C 4. C 5. B 6. D 7. B 8. D 9. A 10. B

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Name:____________________________

Date:______________

Section:_________

CHAPTER 5 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Buddy Company began the period with 100 units in inventory, costing $5 each. During the period the company purchased 100 units at a cost of $5 each. At the end of the period there were 130 units left on hand. What is the correct amount that should appear on the income statement for the period and on the balance sheet at the end of the period?

IncomeStatement A. Cost of goods sold, $500 B. Inventory, $1,000 C. Cost of goods sold, $650 D. Cost of goods sold, $350

BalanceSheet Inventory, $500 Cost of goods sold, $1,000 Inventory, $350 Inventory, $650

2. XYZ Corp. has $10,000 of goods on hand at November 30. Cost of goods sold averages 50% of sales revenue. Sales for the month of December are budgeted to be $140,000. If ending inventory at the end of December is budgeted to be $20,000, what amount of inventory will XYZ’s managers need to purchase during December to meet this goal?

A. $70,000 B. $80,000 C. $140,000 D. $150,000 Table 5-1 Consider the following data for Ryan Company for the current year (Ryan Company uses the periodic inventory system): #Units Unit Cost Total Beginning inventory 55 $10 $550 Purchase February 4 20 $11 $220 Purchase May 15 20 $12 $240 Purchase October 20 50 $15 $750 Sales during the year, 85 units @ $30 each.

3. Refer to Table 5-1. What is the weighted-average cost per unit?

A. $12.33 B. $12.37 C. $12.14 D. $12.48 4. Refer to Table 5-1. What is the cost of ending inventory, assuming the weighted-average method is used?

A. $708.50 B. $720.00 C. $728.40 D. $732.60

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5. Refer to Table 5-1. What is cost of goods sold, assuming the FIFO method is used?

A. $880 B. $890 C. $900 D. $910 6. Refer to Table 5-1. What is Ryan Company’s gross margin percentage (rounded) for the year, assuming that ending inventory totalled $850?

A. 56% B. 28% C. 36% D. 64% 7. During a period of rising prices, the inventory method that yields the lowest net income and the highest ending inventory value will be: A. weighted average.

B. FIFO. C. specific identity.

D. Can’t be determined based on the information given.

8. BB Company management omitted $65,000 of inventory when they counted their year-end 20X1 ending inventory. As a result of this error, A. 20X2 total assets will be overstated.

B. 20X2 cost of goods sold will be understated.

C. 20X1 shareholders’ equity will be overstated.

D. 20X2 net income will be understated.

9. Which of these statements regarding GAAP/IFRS as applied to inventories is true?

A. The disclosure principle requires that a company disclose the inventory method(s) used.

B. According to the consistency principle, the inventory method can never be changed.

C. The lower-of-cost-and-net realizable value rule states that, in order to be conservative, declines in inventory prices should be recognized in the period in which the goods are actually sold.

D. The materiality principle allows GAAP to be ignored when the result is material in amount.

10. The owner arrived early one morning at her place of business to find that her shop had been burglarized during the prior night. Use the following information that the owner gathered to estimate the amount of inventory that was stolen.

Beginning inventory, January 1 $50,000 Purchases to date, $199,000 Cost of sales to date, $220,000 A. $19,000 B. $29,000 C. $39,000 D. $49,000

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CHAPTER 6 Property, Plant, and Equipment, and Intangible Assets CHAPTER OVERVIEW This chapter opens with a discussion of the long-lived assets of Canadian Tire, a Canadian company that has grown substantially since 1922. The chapter identifies the types of tangible (property, plant, and equipment) and intangible assets, how to determine the cost of tangible assets, and how to distinguish a capital expenditure from an immediate expense.

A detailed discussion of depreciation begins with an explanation of the concept of depreciation, including the items needed to measure depreciation. Three depreciation methods are illustrated and compared: straight-line, units-of-production (UOP), and diminishing balance (DB). The midchapter summary problem allows the student to practise the different depreciation methods.

The chapter covers partial-year depreciation and depreciation revision due to changes in estimated useful life and/or residual value. This is followed by addressing fully depreciated assets and derecognition of assets. The text illustrates the disposal of assets that are junked or sold for a gain or loss. Depreciation for tax versus accounting purposes is discussed briefly. The depreciating of significant components and impairment is addressed. The cost and revaluation models used to measure depreciation are also covered. Decision Guidelines on using property, plant, and equipment and related expenses in decision making is provided.

Intangible assets are defined and illustrated, and amortization of intangible assets is explained.

The accounting for various intangible assets such as patents, copyrights, trademarks, franchises and licenses, goodwill, and research and development costs are discussed. The return on assets (ROA) is covered to illustrate the evaluation of a company’s assets. There is a presentation of transactions affecting the cash flow statement. Decision Guidelines using ROA in decision making are given. Using Excel functions to calculate depreciation expense is shown. A summary of the IFRS/ASPE differences is presented. In conclusion, a final summary problem covers depreciation and the sale of equipment.

LEARNING OBJECTIVES After studying Chapter 6, your students should be able to: 1. Explain how to account for the cost of property, plant, and equipment.

2. Explain how to account for depreciation on property, plant, and equipment.

3. Explain additional topics in accounting for long-lived tangible assets.

4. Explain how to account for intangible assets and goodwill.

5. Analyze a company’s return on assets.

6. Analyze the cash flow impact of long-lived asset transactions.

7. Calculate depreciation expense using Excel functions.

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Types of long-lived assets Capital expenditures versus expenses Depreciation methods Asset sales (derecognition) and gains/losses Intangible assets RECOMMENDED Depreciation for partial years Changing estimates of an asset Impairment of an asset

IF TIME PERMITS Reporting long-lived assets on the cash flow statement Return on assets Depreciation for accounting versus tax purposes Using Excel functions to calculate depreciation

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CHAPTER OUTLINE Teaching Tip It may help to organize the presentation of the material related to long-lived assets according to the life cycle of a long-lived asset. That is, we will study issues related to acquisition (determining the cost), ownership (capital and revenue expenditures during ownership, depreciation), and disposal.

OBJECTIVE 1: Explain how to account for the cost of property, plant, and equipment A. Long-lived assets are assets that are used in the business and not held for sale. These include: 1. Tangible long-lived assets (or property, plant, and equipment), which have physical form such as buildings and equipment.

2. Intangible assets, which carry special rights but do not have physical form such as patents, copyrights, and trademarks. a. The usefulness of tangible assets is derived from their physical form. b. The cost principle directs a business to carry an asset on the balance sheet at its original cost. c. Exhibit 6-1 gives the terminology used for capital assets on the balance sheet and income statement.

B. When tangible long-lived assets are used, the expense is referred to as depreciation expense, while when intangible assets with the exception of goodwill are used, the expense is referred to as amortization.

C. Goodwill, while an intangible asset, is subject to impairment losses rather than amortization or depreciation expense.

D. The cost of any asset is the sum of all of the costs incurred to bring the asset to its location and intended use. The costs for the various categories of property, plant and equipment are as follows: 1. Land costs include purchase price, real estate commission, survey fees, legal fees, back property taxes, costs for grading and clearing the land, and demolishing/removing unwanted buildings.

Teaching Tip The cost of removing an old building in order to construct a new building is included as a part of the cost of the land, not as a part of the cost of the new building.

2. Buildings, Machinery, and Equipment costs include: a. Constructed buildings—architectural fees, building permits, contractor’s charges, material, labour, overhead, and interest incurred during construction. b. Existing buildings—purchase price, brokerage commission, sales and other taxes, and repairs to prepare the building for use. c. Machinery and equipment—purchase price, transportation, insurance while in transit, non-refundable sales and other taxes, purchase commission, installation costs, costs of a trial run, and special equipment platforms.

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3. Land improvements and leasehold improvements a. Land improvements are improvements to land that will eventually deteriorate and costs include fencing, paving, sprinkler systems, lighting, parking lots, and driveways. b. Leasehold improvements are improvements to leased assets. The cost of leasehold improvements should be depreciated over the term of the lease or the life of the asset, whichever is shorter.

4. Businesses often purchase several assets for a single lump-sum amount, which can be referred to as a basket purchase of assets. a. The lump-sum cost must be allocated to the individual assets according to their relative fair values. b. A ratio of an individual asset’s market value to the market value of all of the assets is multiplied by the lump sum purchase price. The result is the asset’s cost.

Teaching Tip Ethics can enter into the decision as to whether an item should be capitalized or expensed. The benefits of capitalizing can be significant because capitalizing an expenditure that should be expensed has the dual effect of increasing assets and decreasing expenses. This can be very tempting to an executive whose job is on the line when financial results do not meet expectations.

Early reports on the WorldCom scandal of 2002 suggest that $3.8 billion of expenditures that should have been expensed were, indeed, capitalized.

Teaching Tip

Determine the cost of the land, land improvements, building, and equipment.

Cash paid to previous owner of land and old building $80,000 Cash paid to construction company 300,000 Assessment to city for road construction 6,000 Real estate commission 1,000 Cost of demolishing old building 7,000 Cost of leveling and grading 4,000 Architects' fee 15,000 Cost of delinquent property tax 3,000 Sprinkler system for lawn 13,000 Lighting system for parking lot 17,000 Paving of parking lot 25,000 Invoice price of machinery* 48,000 Freight on machinery 21,000 Installation and testing of machinery 9,000 Medical bill paid for employee injured installing machinery 1,500 Landscaping (permanent) 16,000 Based on FMV (3 pieces of machinery; FMV: $10,000, $20,000, and $30,000)

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce Expense: medical bill Land $80,000 1,000 6,000 7,000 4,000 3,000 16,000 $117,000

Building $300,000 15,000

Land Improvements $13,000 17,000 25,000 1 piece 2 piece 3 piece

$315,000

$55,000

Machinery 48,000 21,000 9,000 $78,000 $13,000 26,000 39,000 $78,000 10/60 × 78,0000 = $13,000 20/60 × $78,000 = $26,000 30/60 × $78,000 = $39,000

5. Expenditures relating to long-lived assets can be classified as either capital expenditures or an immediate expense. Exhibit 6-2 illustrates the distinction between the two.

1. A capital expenditure is an expenditure that increases the asset’s productivity or to extend its useful life.

2. Costs that merely maintain the asset or restore it to working order are considered immediate expenses.

Teaching Tip When you have an expenditure, you have a credit to cash (or a payable). The question is, “What do you debit?” It depends on the benefit period of that expenditure. If the benefit of the expenditure will be realized in future periods and won’t be used up in the current period, debit an asset. If the benefit of the expenditure is realized exclusively in the current period (that is, it is used up in this period), then debit an expense. If the expenditure provides no additional benefit as it is to replace something that is lost or stolen, then debit a loss (which is like an expense).

OBJECTIVE 2: Explain how to account for depreciation on property, plant, and equipment A. Depreciation is the process of allocating a long-lived asset’s cost to expense over the asset’s useful life due to physical wear and tear and/or obsolescence.

B. Depreciation is not a process of valuation and does not mean setting aside cash to replace assets as they wear out.

C. To calculate depreciation, the following must be known: 1. Cost 2. Estimated useful life is an estimate of the years the asset will be useful to the business, not an estimate of its physical life.

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3. Residual value (also called scrap or salvage value) is the estimated cash value at the end of the asset’s useful life. This amount is not depreciated. The depreciable cost, which is the asset’s cost less the estimated residual value, is the amount that is depreciated.

D. Three main methods are used for computing depreciation—straight-line (SL), units-ofproduction (UOP), and diminishing-balance (DB). Exhibit 6-3 contains data used to illustrate the three methods.

1. The SL formula is: Cost – residual value = SL depreciation per year Useful life, in years a. SL allocates equal amounts of expense to each year of the asset’s life. b. Accumulated depreciation, a contra-asset account, is the portion of the asset’s cost that has already been depreciated (or expensed). c. Exhibit 6-4 shows a straight-line depreciation schedule. d. The entry to record depreciation is: Depreciation Expense Accumulated Depreciation

X X

Teaching Tip Make sure students are aware that carrying value is a subtotal (cost – accumulated depreciation) and not an account. Carrying value does not appear as such in any journal entries (this is especially important for them to know in dealing with disposals).

2. The UOP formula is: Cost – residual value Useful life in units of production

= UOP depreciation per unit of output

a. The UOP method assigns a fixed amount of depreciation to each unit of output or production. b. Depreciation each period will vary based on the units of output. c. Exhibit 6-5 shows a units-of-production depreciation schedule.

3. Diminishing balance (DB) is an accelerated depreciation method. a. Accelerated depreciation methods depreciate higher amounts of the asset’s cost in the early years of the asset’s life, and lower amounts of the asset’s cost are depreciated in the later years of the asset’s life. b. Double diminishing balance DDB depreciation is calculated using the following steps: i.

Step 1: Compute the SL rate.

SL rate = 1 Useful life

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ii.

Step 2: Multiply the SL rate by 2. This is the DDB rate.

DDB rate = SL rate × 2

iii.

Step 3: Multiply the book value (cost – accumulated depreciation) by the DDB rate. This is depreciation expense.

Depreciation expense = Carrying value × DDB rate

c. Exhibit 6-6 shows a double-diminishing-balance depreciation schedule.

Teaching Tip The DDB method does not deduct the residual value from the cost as the other two methods do.

Residual value is only considered near the last year. The cost of the asset is depreciated to its residual value, but never below the residual value. The residual value is not considered under DDB until the last year.

E. Regardless of the method used, the total amount of depreciation recorded will be the same under all three methods.

1. IFRS directs a business to choose a depreciation method that reflects the pattern in which the asset will be used.

2. The type of method chosen may depend upon the type of asset being depreciated. a. SL best fits assets that generate revenue evenly over time. b. UOP best fits assets that wear out due to physical use rather than obsolescence. c. DDB best fits assets that generate greater revenue earlier in their useful lives.

3. Exhibit 6-7 illustrates graphically the pattern of depreciation over time for the three methods.

Teaching Tip On January 2, 20XX, Wang Inc. purchased a machine to be used in the fabrication of a part for one of its key products. The machine cost $85,000, and its estimated useful life was five years or 500,000 units, after which it could be sold for $5,000. Annual production in units for each year is 110,000, 100,000, 175,000, 90,000, and 25,000, respectively. Compute depreciation for each year using SL, UOP, and DDB. Straight-line

Units-of-Production

Year

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1

($85,000 – $5,000) ÷ 5 = $16,000

2 3 4 5 Total

16,000 16,000 16,000 16,000 $80,000

Double-DecliningBalance

($85,000 – $5,000) ÷ $85,000 × 40% = $34,000 500,000 = $0.16/unit 110,000 × $0.16 = $17,600 100,000 × $0.16 = 16,000 ($51,000 × 40%) = 20,400 175,000 × $0.16 = 28,000 ($30,600 × 40%) = 12,240 90,000 × $0.16 = 14,400 ($18,360 × 40%) = 7,344 25,000 × $0.16 = 4,000 ($11,016 − $5,000) = 6,016 Total $80,000 Total $80,000

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OBJECTIVE 3: Explain additional topics in accounting for long-lived tangible assets A. Depreciation for partial years and changes in depreciation assumptions, estimates, and methods may occur from time to time.

B. As companies purchase property, plant, and equipment whenever they need them, partial year depreciation needs to be calculated. To calculate partial year depreciation: 1. Compute depreciation for the full year.

2. Multiply the full year’s depreciation by the fraction of the year that the company held the asset.

Teaching Tip Ask students what happens if the asset is purchased in the middle of the month. It is not a practice to calculate a daily depreciation rate. Many companies do not record depreciation for the month if it is purchased after the 15th of the month and will record the full month’s depreciation if purchased on or before the 15th of the month.

C. Depreciation must be revised any time a change in the useful life or residual value occurs.

To revise depreciation: 1. Determine the asset’s remaining depreciable carrying value.

Remaining depreciable carrying amount = Remaining carrying amount – residual value 2. Then, revise the SL depreciation as follows: New annual Depreciation = Remaining depreciable carrying amount Expense New Estimated Remaining useful life Teaching Tip On January 2, 20X1, ABC Co. purchased a floor maintenance machine costing $2,100. ABC estimated the machine’s useful life at 5 years with a $100 residual value. In 20X3, ABC realized that the machine would only last four years’ total and at that time would have an estimated residual value of $600. Using the straight-line method, compute 202X3 depreciation.

Original depreciation ($2,100 – $100) ÷ 5 = $400/year Carrying value: Cost $2,100 – ($400 × 2 years accumulated depreciation) = $1,300 New depreciation: $1,300 – $600 / (4 – 2) = $350/year

D. A business may continue to use a fully depreciated asset; however, it may not be depreciated below the residual value.

E. A business derecognizes property, plant, and equipment when they are no longer useful or have been sold.

1. Record the depreciation from the beginning of the period to the date of disposal.

2. Calculate the asset’s remaining carrying amount.

3. If an asset is junked before it is fully depreciated, record a loss (other expense) equal to the remaining carrying amount.

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F. The rules for the sale of a property, plant, and equipment are: 1. Record a gain on the sale if the cash received is greater than the remaining carrying amount.

Cash XX Accumulated Depreciation XX Asset (cost) XX Gain on Sale of Asset XX

2. Record a loss on the sale if the cash received is less than the remaining carrying amount.

Cash XX Accumulated Depreciation XX Loss on Sale of Asset XX Asset (cost) XX

Teaching Tip Refer to the Teaching Tip involving ABC Company’s floor maintenance machine. Assume the machine was sold on March 1, 20X4, for $600. Prepare the journal entries to record the depreciation and the sale.

Depreciation Expense ($350 × 2/12) 58 Accumulated Depreciation 58 Cash Accumulated Depreciation Loss on Sale of Equipment Equipment

600 1,208 ($400 + $400 + $350 + $58) 292 2,100

G. T-accounts can be used to analyze the transactions in the property, plant and equipment accounts.

H. The Income Tax Act requires taxpayers to use accelerated and sometimes straight-line depreciation depending on the Class of the asset. A taxpayer may use one method of depreciation for accounting purposes and another method for tax purposes.

I.

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IFRS require that significant components of a property, plant, and equipment item be depreciated separately. Items refer to the components of the asset such as the engine in an aircraft or the interior equipment.

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J. Impairment occurs when the carrying amount of an asset exceeds its recoverable amount, which is determined to be the higher of the asset’s fair value and its present value of estimated future cash flows to be earned. At each reporting date, a company should review its assets for impairment. If there is impairment, the adjusting entry would be: Loss on Impairment XX Accumulated Depreciation

XX

K. Per IFRS, property, plant, and equipment can be measured using one of two models: cost model and revaluation model.

1. The cost model, as explained earlier, measures long-lived assets at cost less accumulated depreciation/impairment.

2. The revaluation model measures long-lived assets at purchase cost but subsequently at fair value less any accumulated depreciation/impairment.

3. Fair value is the price at which an asset can be sold. A professional valuator would do this revaluation regularly.

L. Decision Guidelines are presented showing how to account for property, plant, and equipment and related expenses in decision making.

OBJECTIVE 4: Explain how to account for intangible assets and goodwill A. Intangible assets fall into two categories: 1. Intangible assets with finite lives, in which case amortization is recorded.

2. Intangible assets with indefinite lives, in which case no amortization is recorded but impairment tests are conducted to check for and record any loss in valuation. Goodwill is one example.

B. Examples of intangible assets include: 1. Patents— federal government grants that give an exclusive right to manufacture and/or sell an invention for a period of 20 years.

2. Copyrights— exclusive right to reproduce and/or sell an artistic or literary work, a musical composition, film, other work of art or software program. Copyrights extend 50 years beyond the author’s life.

3. Trademarks and trade names— exclusive right to use a name, symbol, or other product identification. These can have a finite useful life but can also have an indefinite future, in which case it would not be amortized.

4. Franchises and licences— one party grants another party the right to sell a product or service. These have indefinite lives and are, therefore, not amortized.

5. Goodwill— the excess of the cost of an acquired company over the market value of its net assets (assets minus liabilities). Goodwill is not amortized as it has an indefinite life.

Teaching Tip A company acquired a patent at a cost of $10,000. The asset is expected to have an economic life of 10 years. How many years should the patent be amortized? 10 years—its economic life.

How many years should the patent be amortized if its useful life is indefinite? 20 years—its legal life.

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C. All intangible assets are subject to a write-down when their recoverable amount is less than the carrying amount. Per IFRS, companies must check their intangible assets for impairment at each reporting date, while under ASPE, impairment of intangible assets with an indefinite life is tested only when there is an indication of impairment.

D. Research and development costs must be expensed when incurred. Development costs meeting certain criteria must be capitalized and expensed over the life of the product.

OBJECTIVE 5: Analyze a company’s return on assets A. Company performance in terms of assets can be evaluated using the most basic framework return on assets (ROA).

ROA = Net Income + Interest Expense Average Total Assets* * Where average total assets is the beginning total assets plus ending total assets divided by 2

B. ROA measures how much the entity earned for each dollar of assets invested by both shareholders and creditors.

C. Decision Guidelines are presented showing how to use the return on assets in decision making.

OBJECTIVE 6: Analyze the cash flow impact of long-lived asset transactions A. Three main types of long-lived asset transactions appear on the statement of cash flows 1. Acquisitions are investing activities.

The cash paid to acquire capital assets is an outflow.

2. Sales are investing activities.

The cash received from the sale of a capital asset is an inflow.

3. Depreciation and Amortization is included in the operating activities. a. Depreciation/amortization is an expense that reduces net income but has no effect on cash flow. b. When determining cash flow from operating activities, all differences between cash flow and accrual net income are either added to or deducted from net income to determine cash flow. c. Depreciation/amortization is an adjustment that is added to net income.

B. Exhibit 6-8 shows how long-lived asset transactions are reported on the statement of cash flows.

OBJECTIVE 7: Calculate depreciation expense using Excel functions A. Managers can use an Excel function to make quick depreciation calculations. Excel has two functions that calculate depreciation expense. The SLN function calculates straight-line depreciation expense, while the DDB function calculates double-declining-balance depreciation expense.

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To use either of the two Excel depreciation functions, the manager needs the asset’s cost, its estimated useful life, and its estimated residual value.

B. Exhibit 6-9 shows a depreciation schedule using SLN function in Excel and Exhibit 6-10 shows a depreciation schedule using the DDB function in Excel.

C. A summary of IFRS and ASPE differences is presented.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q6-1 Understanding accounting for property, plant, and equipment, and intangibles 2 1-2 Easy Q6-2 Understanding accounting for property, plant, and equipment, and intangibles 2 1-2 Easy Q6-3 Understanding accounting for property, plant, and equipment, and intangibles 2 1-2 Easy Q6-4 Understanding accounting for property, plant, and equipment, and intangibles 2 1-2 Easy Q6-5 Understanding accounting for property, plant, and equipment, and intangibles 6 1-2 Easy Q6-6 Understanding accounting for property, plant, and equipment, and intangibles 2 1-2 Easy Q6-7 Understanding accounting for property, plant, and equipment, and intangibles 2 1-2 Easy Q6-8 Understanding accounting for property, plant, and equipment, and intangibles 3 1-2 Easy Q6-9 Understanding accounting for property, plant, and equipment, and intangibles 1 1-2 Easy Q6-10 Understanding accounting for property, plant, and equipment, and intangibles 1 1-2 Easy Q6-11 Understanding accounting for property, plant, and equipment, and intangibles 7 1-2 Easy Q6-12 Understanding accounting for property, plant, and equipment, and intangibles 5 1-2 Easy Q6-13 Understanding accounting for property, plant, and equipment, and intangibles 5 1-2 Easy Q6-14 Understanding accounting for property, plant, and equipment, and intangibles 5 1-2 Easy S6-1 Measure the cost and carrying amount of a company’s property, plant, and equipment 1 5 Easy S6-2 Measure the cost of property 1 5 Easy S6-3 Measure and record the lump-sum purchase of assets 1 10 Medium S6-4 Measure and account for equipment 1 10-15 Medium S6-5 Compute depreciation by three methods—first year only 2 15 Medium S6-6 Compute depreciation by three methods—final year only 2 10 Medium S6-7 Compute partial-year depreciation 2, 3 15 Medium S6-8 Compute and record depreciation after a change in useful life of the asset 3 10 Medium S6-9 Record a gain or loss on derecognition 3 10 Medium S6-10 Account for intangible assets 4 5-10 Easy S6-11 Analyze a company’s goodwill 4 10-15 Medium S6-12 Account for patents and research cost 4 10-15 Medium S6-13 Report investing activities on the statement of cash flows 6 5 Easy S6-14 Calculate return on assets 5 5 Easy S6-15 Calculate return on assets 5 5 Easy S6-16 Distinguish a capital expense from an immediate expense 1 5 Easy S6-17 Measure and record goodwill 4 5-10 Medium S6-18 Record the effect of asset impairment on financial statements 3, 4 15 Medium S6-19 Calculate operating income using the Excel DDB function 7 10-15 Medium S6-20 Calculate depreciation expense using the SLN and DDB functions in Excel 7 10-15 Medium E6-21 Determine the cost and depreciation of property 1, 2 15 Medium E6-22 Allocate costs to assets acquired in a lump-sum purchase; derecognizing equipment 1, 3 15 Medium E6-23 Distinguish asset expenditures from expenses 1 5-10 Easy E6-24 Measure, depreciate, and report property and plant, determine effect on financial statements 1, 2, 3 20 Medium E6-25 Determine depreciation amounts by three methods 2 15-20 Medium E6-26 Report property, plant, and equipment depreciation and investing cash flow 1, 2, 6 15 Easy E6-27 Calculate return on assets 5 5-10 Easy E6-28 Change a building’s useful life and analyze the effects of a change in its useful life 2, 3 25 Medium E6-29 Record depreciation and the sale of equipment 2, 3 20 Medium E6-30 Measure equipment’s cost, use UOP depreciation, and derecognize a used asset 2, 3 10-15 Medium E6-31 (Critical Thinking) Analyze intangible assets 4 15 Medium

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E6-32 Record intangibles, amortization, and a change in the asset’s useful life 3, 4 10-15 Medium E6-33 Understand goodwill and statement of cash flows 4, 6 15-20 Easy E6-34 Measure and record goodwill 4 5-10 Medium E6-35 Interpret a statement of cash flows 6 10-15 Medium E6-36 Report cash flows for property and equipment 6 10 Medium E6-37 (Critical Thinking) Calculate return on assets 5 10 Easy E6-38 Distinguish capital expenditures from expenses 1 15 Easy E6-39 Understand units-of-production depreciation 1, 2 20 Medium E6-40 Determine the gain or loss on sale of property and equipment 3 25 Difficult E6-41 Determine net income after a change in depreciation method 2 15-20 Difficult E6-42 Determine equipment capitalizing versus expensing; measure the effect of an error 1 15-25 Difficult P6-43A Measure and account for assets; distinguish a capital asset from an expense and record depreciation 1, 2 20-30 Medium P6-44A Record property, plant, and equipment transactions; report on the balance sheet 1, 2 15 Medium P6-45A Record property, plant, and equipment transactions, derecognition 1,2,3 25-35 Medium P6-46A (Critical Thinking) Explain the concept of depreciation 2 10-15 Medium P6-47A Compute depreciation by three methods 1, 2 30-40 Medium P6-48A Analyze property, plant, and equipment transactions from a company’s financial statements 1,2,3,6 20-25 Medium P6-49A Account for intangibles and the related expenses 4 30-40 Medium P6-50A Report property, plant, and equipment transactions on the financial statements 1, 3, 6 30-40 Medium P6-51A (Critical Thinking) Calculate return on assets 5 30 Medium P6-52A Analyze the effect of a plant asset disposal and the cash flow impact of long-lived asset transactions 3, 6 20-30 Medium P6-53A Account for cost and depreciation of property, plant and equipment 1, 2 10-15 Medium P6-54A Measure cost of tangible and intangible assets, derecognize a used asset, and record depreciation 1, 2, 3, 4 20-25 Medium P6-55A Account for the cost of property, plant and equipment, record depreciation and disposal of asset, and distinguish betterments from repairs 1, 2, 3 20-25 Medium P6-56B Measure and account for assets; distinguish a capital asset from expense and record depreciation 1, 2 20-25 Medium P6-57B Record property, plant, and equipment transactions; report on the balance sheet 1, 2 15 Medium P6-58B Record property, plant, and equipment transactions, derecognition 1, 2, 3 25 Medium P6-59B (Critical Thinking) Explain the concept of depreciation 2 15 Medium P6-60B Compute depreciation by three methods 1, 2 30-40 Medium P6-61B Analyze property, plant, and equipment transactions from a company’s financial statements 1, 2, 3, 4, 6 20-25 Medium P6-62B Account for intangibles and the related expenses 4 30-40 Medium P6-63B Report property, plant, and equipment transactions on the financial statements 1, 3, 6 30-40 Medium P6-64B (Critical Thinking) Calculate return on assets 5 40 Medium P6-65B Analyze the effect of a plant asset disposal and the cash flow impact of long-lived asset transactions 3, 6 20-30 Medium P6-66B Account for cost and depreciation of property, plant, and equipment 1, 2 10-15 Medium P6-67B Measure cost of tangible and intangible assets, derecognize a used asset, and record depreciation 1, 2, 3, 4 20-25 Medium P6-68B Account for the cost of property, plant and equipment, record depreciation and disposal of asset, and distinguish betterments from repairs 1, 2, 3 20-25 Medium Decision Case 1 Measure profitability based on different depreciation methods 2 30-45 Difficult Ethical Decision 1 Ethical Decision 2 Comprehensive Case Chapters 4-6, 75 Difficult ..

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ANSWER KEY TO CHAPTER 6 QUIZ 1. C 2. A 3. B 4. B 5. C 6. A 7. C 8. D 9. C 10. A

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Name:______________________

Date:________________

Section:______

CHAPTER 6 TEN-MINUTE QUIZ Circle the letter of the best response.

1. The items below represent expenditures related to the construction of a new office building: Cost of land $200,000; Legal fees relating to land purchase $3,000; Cost of removing old building $1,000; Payment of delinquent property taxes $500; Grading the site $3,000; Payment to contractor $1,000,000; Cost of building permits $4,000; Interest cost incurred during construction $50,000; Cost of paving parking lot $20,000; Cost of fencing $5,000.

The proper balances for the Land account and the Building account should be: Land A. $217,000 B. $213,500 C. $207,500 D. $203,500

Building $1,000,000 $1,050,000 $1,054,000 $1,044,000

2. Which of the following statements is false?

A. Accelerated depreciation methods record more depreciation expense over the life of an asset than either the straight-line method or the units-of-production method.

B. The cost of an asset, its residual value, and its estimated useful life are all used in computing depreciation.

C. The units-of-production method is most appropriate for an asset that wears out due to physical use.

D. Land is never depreciated.

Table 6-1 On January 1, 20X1, Security Services Inc. (SSI) purchased an alarm monitoring system for $90,000. The system is expected to be used for 4 years, after which it can be sold for $10,000.

3. Refer to Table 6-1. What is the book value of the equipment on December 31, 20X2, if SSI uses the straight-line method of depreciation?

A. $40,000 B. $50,000 C. $60,000 D. $70,000 4. Refer to Table 6-1. If SSI uses the double-declining-balance method of depreciation, what is depreciation expense for 20X1?

A. $40,000 B. $45,000 C. $50,000 D. $55,000

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5. Refer to Table 6-1. If SSI sells the equipment for $20,000 at the end of the four years, the journal entry to record the sale will include all of the following except a: A. $20,000 debit to Cash.

B. $10,000 credit to Gain on Sale of Equipment.

C. $20,000 credit to Equipment.

D. $80,000 debit to Accumulated Depreciation.

6. Which of the following statements is false?

A. Straight-line depreciation can be used for financial reporting or for income tax purposes.

B. Straight-line depreciation is the most commonly used method of depreciation in financial reporting.

C. The units-of-production method results in higher depreciation in the years when an asset is more productive and lower depreciation in the years when an asset is less productive.

D. Capital Cost Allowance must be used on the tax return.

7. In the current year, CK Inc. paid $4,000,000 for land and building. The appraised value of each is as follows: Land = $3,000,000 and the Building = $2,000,000. What amount would the company record for the purchase of the land?

A. $3,000,000 B. $2,000,000 C. $2,400,000 D. $4,000,000 8. Which of the following is not accounted for as an intangible asset?

A. Patents B. Goodwill C. Trademark D. Research and development 9. An improvement made to a machine increased its fair market value and its productive capacity by 50% without extending the machine’s useful life. The cost of the improvement should be: A. debited to Repair Expense.

B. debited to Accumulated Depreciation.

C. debited to Machinery.

D. allocated between Machinery and Depreciation Expense.

10. Which of the following statements about the cash flow statement is false?

A. Financing activities are affected by capital asset transactions.

B. Depreciation is not a cash flow.

C. Depreciation is added to net income when calculating cash provided by operations.

D. Investing activities are affected by capital asset transactions.

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CHAPTER 7 Liabilities CHAPTER OVERVIEW The chapter opens with an introduction to Air Canada, identifying that its advanced ticket sales reflects a liability on the company’s balance sheet. The chapter begins with a discussion related to accounting for current liabilities of a known amount, those that must be estimated, and contingent liabilities. Various liability accounts are presented including accounts payable, taxes payable, payroll liabilities, unearned revenues, estimated warranty liabilities, and more. A mid-chapter summary problem covers various liabilities and how they are reported.

Next, students will learn about long-term liabilities, particularly bonds payable, to finance operations. Bond terminology, interest rates, and bond quotations are covered. Present value is related to bonds. Entries are illustrated for issuing bonds, paying interest, and paying bonds at maturity. Accounting for bonds issued at their face value, at a discount and at a premium are discussed and illustrated. First the effective-interest method of debt amortization of the premium or discount is presented, and amortization tables are illustrated. Then the straight-line method of amortization is described. The advantages and disadvantages of financing operations with bonds and shares are covered and earnings per share is introduced. Decision Guidelines related to financing with debt or stock is presented. Evaluating a company’s debt-paying ability is discussed relative to the accounts payable turnover, leverage ratio, and the times-interest-earned ratio.

The chapter then focuses on other long-term liabilities, namely term loans and leases. Both operating and finance leases are discussed. The reporting of various liabilities on the financial statements is illustrated. The chapter then describes how robotic process automation (RPA) can be used in the accounts payable process, and how scenario analysis tools can help companies comply with debt covenants. An end-of-chapter summary problem covers many bonds payable transactions.

LEARNING OBJECTIVES After studying Chapter 7, your students should be able to: 1. Explain and account for current liabilities.

2. Explain the types, features, and pricing of bonds payable.

3. Account for bonds payable.

4. Calculate and account for interest expense on bonds payable.

5. Explain the advantages and disadvantages of financing with debt versus equity.

6. Analyze and evaluate a company’s debt-paying ability.

7. Describe other types of long-term liabilities.

8. Report liabilities on the balance sheet.

9. Describe how robotic process automation (RPA) can help with the accounts payable process.

10. Describe how scenario analysis tools can help companies comply with debt covenants.

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Accounting for current liabilities of known amount Accounting for current liabilities that must be estimated Contingent liabilities Present value of bonds Issuing bonds at face, at a discount, and at a premium Bond interest and maturity Effective interest method of amortization of bond discount or premium Advantages and disadvantages of financing with debt versus equity Term loans and lease liabilities RECOMMENDED Reporting liabilities on the balance sheet Straight-line amortization of bond discount or premium IF TIME PERMITS Post-employment benefits Using robotic process automation (RPA) to help with the accounts payable process Using scenario analysis tools to help companies comply with debt covenants

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CHAPTER OUTLINE

OBJECTIVE 1: Explain and account for current liabilities A. Current liabilities are obligations due within the longer of one year or the company’s normal operating cycle.

B. There are two kinds of current liabilities: 1. Known amounts 2. Estimated amounts C. Current liabilities of a known amount include: 1. Short-term borrowings that are needed to cover temporary shortfalls in cash. A line of credit allows a company to access credit on an as-needed basis up to a maximum amount set by the lender.

2. Accounts payable, which are amounts owed for goods or services purchased on credit or on account.

3. Accrued liabilities (accrued expenses), which result from an expense incurred but not yet paid. Examples include salaries and wages payable, interest payable, and income taxes payable.

4. Short-term notes payable are notes due within one year. a. When the note is issued it can be for cash or to purchase assets and the entry is: Cash XX Note Payable XX b. An adjusting entry must be recorded to accrue interest incurred: Interest Expense XX Interest Payable

XX

c. The following entry is required when the note is paid.

Note Payable XX Interest Expense XX Interest Payable XX Cash XX Teaching Tip Remind students that it is important to keep Interest Payable separate from Note Payable. The accrual entry made at the end of the period will never affect the Note Payable balance. Interest is recorded in a separate account.

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Teaching Tip On December 1, Thomas Company borrowed $10,000 on a 90-day, 12% note. What is the amount of accrued interest on December 31? ($10,000 × 0.12 × 30/365 = $98.63.) What is the entry required on the maturity date?

Note Payable Interest Payable Interest Expense Cash

10,000.00 98.63 197.26 10,295.89

5. Sales tax payable reflects taxes levied on the sale of goods and services that sellers collect from customers and must periodically remit to the government. a. Goods and services tax (GST) is a value-added tax that applies to most goods and services. Only the ultimate consumer pays GST. GST registrants who are not final consumers can deduct GST paid (input tax credit) from GST collected and only remit the difference to the federal government. b. Provincial or regional sales tax (PST) is a retail tax applied to goods and services purchased by individuals or business with rates varying by province or region. c. Harmonized sales tax (HST) combines PST and GST and is a value added tax and is treated the same way as GST. d. The entry to record PST and GST when a company makes a sale is as follows: Accounts Receivable (or Cash) XX Cost of Goods Sold XX Sales Revenue XX Inventory XX GST Payable XX PST Payable XX e. The entry to record HST when a company makes a sale is as follows: Accounts Receivable (or Cash) XX Cost of Goods Sold XX Sales Revenue XX Inventory XX HST Payable XX 6. Payroll liabilities (employee compensation) include salary and wages payable, along with various employee benefits withheld from pay cheques (Canada Pension Plan, Employment Insurance, and federal income taxes), as well as other amounts withheld (such as union dues). a. A salary is employee pay stated on an annual basis. b. A wage is employee pay stated on an hourly basis. c. The company’s share of payroll expenses is an additional payroll liability. d. See Exhibit 7-1 for a journal entry recording various payroll expenses and liabilities.

7. Unearned revenues result from collecting cash before revenue is earned.

8. The current portion of long-term debt is the amount of long-term debt that is payable within one year.

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D. Some current liabilities must be estimated if the amount is not known or the timing is uncertain and it is probable that it will have to be settled.

E. IFRS requires businesses to estimate and record a provision for this obligation, which is a type of contingent liability.

F. Estimated liabilities include warranties, employee pension obligations, and corporate restructuring costs.

G. Warranty agreements are guarantees that companies make concerning defects in their products. Because some warranty agreements last many years, the exact amount of repairs required under the warranty may not be known for many years. a. The matching principle requires that the warranty expense relating to sales in a period be estimated and deducted from the sales revenue. A liability for the estimated repairs must be reported on the balance sheet. The journal entry is: Warranty Expense XX Estimated Warranty Payable XX b. The entry to record the actual repair or replacement of defective merchandise is: Estimated Warranty Payable XX Inventory XX H. A contingent liability is a potential liability that may become an actual liability, depending on the resolution of future events.

1. Accrue the liability if it is likely to occur and the amount can be reasonably estimated.

2. Other less-certain contingent liabilities are disclosed in the notes to the financial statement.

3. Note disclosure is not required if there is only a remote chance the continent liabilities will occur.

Teaching Tip Ask students how they think this situation would be reported: You are president of a large delivery service business. One of your truck drivers was involved in an accident last month, resulting in severe injury to the other driver. Your company has not yet been sued, but you think it is a good possibility that a lawsuit will be filed, and your company lawyer does not think you will be held liable. Should you report this as a contingent liability on the current year-end financial statements?

Students might consider the liability as possible, but it is too remote to report in this example.

When a contingent liability is reported, it is due to something that happened in the past.

OBJECTIVE 2: Explain the types, features, and pricing of bonds payable A. Bonds payable are groups of notes issued to many lenders (bondholders). Underwriters purchase the bonds from the issuing company and resell them to clients.

B. Face value (maturity, principal or par value) is the amount printed on the face of the debt instrument and will be repaid at maturity.

C. The interest rate is the rental fee on money borrowed. It is always stated on the face of the bond certificate. ..

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D. There are different types of bonds including: 1. Term bonds, which mature at a specified time.

2. Serial bonds, which mature in instalments over a period of time.

3. Secured or mortgage bonds, which give the bondholder the right to take specified assets of the issue if the company defaults in paying interest or principle.

4. Unsecured bonds (debentures), which are backed by the good faith of the borrower.

E. Prices of bonds are quoted on the bond market at a percentage of their maturity value.

1. If the price of the bond (market) is less than the face (maturity) value, record a discount on the sale of bonds payable.

2. If the price of the bond is greater than the face value, record a premium.

3. The selling price (the amount an investor is willing to pay for the bond) equals the present value of future receipts. The present value will always be less than the future value because of interest. a. Present value calculations are based on the time value of money. b. The future receipts consist of principal plus interest payments.

Teaching Tip Present value is always less than future value because you should be able to invest the money today and have a greater amount in the future. The difference between PV and FV is the amount of interest.

F. Two interest rates work to set the price of a bond—the stated rate and the market rate.

1. The stated interest rate is the actual interest rate of the bond, which determines the amount of cash interest the borrower pays.

2. The market (effective) interest rate is the return investors demand for lending their money; the market rate changes daily, depending on various market factors.

Teaching Tip The interest payments and maturity value cannot change because they are part of a contract (the bond indenture). The only aspect of the bond that can adjust to changes in interest rates is the selling or issue price of the bond.

3.

4.

5.

6.

If the stated interest rate equals the market rate, the bond will be issued at face value.

If the stated rate exceeds the market rate, the bond will be issued at a premium.

If the stated rate is less than the market rate, the bond will be issued at a discount.

Exhibit 7-2 illustrates how the stated interest rate and the market interest rate interact to determine the price of a bond.

OBJECTIVE 3: Account for bonds payable A. Bonds sold at par on an interest date are recorded with this entry: Cash XX Bonds Payable XX B. At each semi-annual interest payment date, interest expense is recorded. Year-end interest accrual entries are necessary if interest is not paid on that date.

C. Discount on Bonds Payable (when the market price is less than face value) is a contra liability account. It is amortized over the life of the bonds. ..

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1. The entry to record the issuance of bonds at a discount is: Cash Discount on Bonds Payable Bonds Payable

XX XX XX

2. The carrying amount of the bonds on the balance sheet equals Bonds Payable minus the Discount.

Teaching Tip What factors cause a bond to sell at a discount? Initially, the underwriters try to estimate the interest rate the market will be willing to accept. But the bonds are trading long after the contract rate is set. There is lag time between when the interest rate is set and when the bonds are issued.

Many other factors may cause the bond to sell at a discount: the interest rate on other investments available on the market; the rating of the bond; the interest rate on treasury notes and bonds; general economic and political conditions; the supply of investment capital and the demand for those funds; the nature of the business issuing the bonds; specific events that occur in the business’s operations. (Note: these same factors also can have the opposite effect on the price of a bond and cause it to sell at a premium.)

OBJECTIVE 4: Calculate and account for interest expense on bonds payable A. The effective-interest method of debt amortization is used to calculate the amount of interest expense each period.

B. A table that is helpful in determining these periodic entries for a bond issued at a discount is illustrated in Exhibit 7-3. We see that: 1. The semi-annual (cash) interest payment never changes.

2. Interest payment = Maturity value × semi-annual contract rate.

3. The semi-annual interest expense increases each period as the carrying amount increases.

4. Interest expense = Carrying amount × semi-annual market rate.

5. Discount amortized = Interest expense (c) – interest payment (b).

6. The carrying amount increases as the discount is amortized.

7. New carrying amount = Face value – unamortized discount (or, carrying amount + the amount of discount amortized).

Teaching Tip Have students refer to Exhibit 7-3. When should the $3,851 (original discount amount) be recognized as interest expense? When the bonds are issued? At maturity? No, the additional interest belongs to all the periods during which the corporation uses the money. Therefore, the discount should be expensed over the life of the bonds. There are two ways to expense the discount amount—the effective-interest method and the straight-line method.

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C. The entry to record interest expense for a bond issued at a discount is as follows: Interest Expense XX Discount on Bonds Payable XX Cash XX Teaching Tip The credit to Cash each semi-annual interest period is always the same. The amount of interest expense will be greater each period (for a bond sold at a discount) because the carrying value is increasing.

1. The discount represents additional interest expense that the corporation will pay at maturity. Interest Expense each period equals the sum of contract cash interest plus the discount amortized.

D. Exhibit 7-4 illustrates interest expense on bonds payable issued at a discount, while Exhibit 7-5 illustrates amortizing bonds payable issued at a discount.

Teaching Tip The amortization table can be very intimidating to students. One way to help overcome the intimidation factor is to demonstrate how to prepare a table by walking them through it with their calculators. This is a tedious exercise, but it can help to alleviate some of the anxiety about producing a table.

E. There are occasions when bonds are issued other than on interest dates requiring the purchaser to pay for accrued interest.

F. Premium on Bonds Payable (when the market price is greater than face value) is a liability account. It is amortized over the life of the bonds.

1. The entry to record the issuance of bonds at a premium is: Cash XX Premium on Bonds Payable XX Bonds Payable XX 2. The carrying amount of the bonds on the balance sheet equals Bonds Payable plus the premium.

G. A table that is helpful in determining these periodic entries for a bond issued at a premium is illustrated in Exhibit 7-6. We see that: 1. The semi-annual (cash) interest payment never changes.

2. Interest payment = Par value × semi-annual contract rate.

3. The semi-annual interest expense decreases each period as the carrying amount decreases.

4. Interest expense = Carrying amount × semi-annual market rate.

5. Premium amortized = Interest payment (b) – interest expense (c).

6. The carrying amount decreases as the premium is amortized.

7. New carrying amount = Face value + unamortized premium (or, carrying amount – the amount of premium amortized).

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H. The entry to record interest expense for a bond issued at a premium is as follows: Interest Expense XX Premium on Bonds Payable XX Cash XX Teaching Tip The credit to Cash each semi-annual interest period is always the same. The amount of interest expense will be less each period (for a bond sold at a premium) because carrying value is decreasing.

1. The premium represents a reduction in the interest cost for the corporation. Interest Expense each period equals contract cash interest minus the premium amortized.

I.

Exhibit 7-7 illustrates interest expense on bonds payable issued at a premium, while Exhibit 7-8 illustrates amortizing bonds payable issued at a premium.

J. ASPE permits a simpler method of amortizing discounts and premiums than the effectiveinterest method of amortizing a discount or premium, which is the straight-line method.

1. Under the effective-interest method, interest expense is a constant percentage of the bond’s carrying value.

2. The total amount of interest expense recorded over the life of the bonds is the same under either method. The difference is one of timing.

3. Straight-line amortization means that an equal amount of the discount (or premium) is amortized (written off) each semi-annual interest period; this method is useful for quick analysis or estimates, or when the amount of the discount or premium is relatively insignificant.

Teaching Tip Under both methods, the credit to Cash is always the same. Under the effective-interest method, you calculate the debit to Interest Expense (carrying value times the market interest rate) and “plug” the discount or premium amortization amount to make the entry balance. Under the straight-line method, you calculate the amount of discount or premiums amortized each period (discount or premium divided by number of periods) and “plug” the interest expense amount to make the entry balance.

Teaching Tip If you use the “plug” figure terminology (or any similar concept), you should emphasize the importance of making sure that the number that is being “plugged” in makes sense. Also, you need to be very confident in all of the figures when you use a “plug” figure because such a figure is usually dependent on having performed all other computations properly.

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Teaching Tip Space Corporation has outstanding $300,000 of bonds with a carrying value of $282,000. Onehalf of the bonds are called at 102 and retired. What is the gain or loss on the retirement?

(Remind students to compare the cash paid (102 call price × par) and the carrying value (par – discount or par + premium) to determine whether there is a gain or a loss on the retirement.)

Carrying value of bonds Portion being retired Carrying value of bonds being retired Call price of the bonds ($150,000 × 1.02) Loss on retirement

$282,000 × 0.5 $141,000 $153,000 $ 12,000

OBJECTIVE 5: Explain the advantages and disadvantages of financing with debt versus equity A. There are three main ways to finance business activities: 1. Use excess cash not needed for operating activities, which is low-risk and low-cost as it does not require taking on debt or issuing shares.

2. Raise capital from issuing shares creates no new liabilities and requires no interest payments, which increase a company’s credit risk.

3. Borrow money using loan, bonds, or notes does not dilute control of the company as shares are not issued, although there are fees associated with debt arrangements.

B. Earnings per share (EPS) represents the amount of net income (or loss) earned by each of a company’s outstanding common shares.

C. EPS is useful for evaluating the earnings performance of a company and assessing the impact of various financing options on earnings. Exhibit 7-9 shows the EPS advantage of borrowing D. Decision Guidelines are presented regarding financing with debt or with shares.

Teaching Tip Ask students why borrowing might harm a corporation even though it may show improved EPS using debt, as in Exhibit 7-9. They might point out that excess borrowing might cause a cash strain on the company, resulting in a failure to make some interest or principal payments. Also, if the interest rate the company is paying on the debt is greater than the return they can earn on the money, the company may be less profitable than it desires. Often corporations will retire the debt to avoid paying a higher rate than the assets earn.

Teaching Tip Use this chart to help students compare financing a company with shares versus bonds: Shares Shareholders are owners (equity).

Bonds Bondholders are creditors (liability).

Dividends are optional.

Interest is required; it is contractual.

Interest is an expense and is tax-deductible.

Bondholders receive interest periodically and the face amount at maturity

Dividends are not an expense; not tax-deductible.

Shares do not give the shareholder a fixed return; and there is no maturity date ..

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OBJECTIVE 6: Analyze and evaluate a company’s debt-paying ability A. Accounts payable turnover (T/O) measures the number of times a year a company is able to pay its accounts payable. The Days payable outstanding (DPO) expresses the turnover in number of days. Both are calculated as follows: Accounts payable turnover = COGS Average Accounts Payable Days payable outstanding = 365 Accounts payable turnover B. The leverage ratio shows a company’s total assets per dollar of shareholders’ equity and is calculated as follows: Leverage ratio = Total assets Total shareholders’ equity C. The times-interest-earned ratio (interest-coverage ratio) measures a company’s ability to pay interest expense and is calculated as follows: Times-interest-earned ratio = Operating income Interest expense

OBJECTIVE 7: Describe other types of long-term liabilities A. Term loans are a common form of long-term financing that, similar to bonds, allows a company to borrow a fixed amount of money up front and repay over a specified number of years at a stated interest rate. Some of the features for term loans include: 1. Typically arranged with a single lender 2. Secured by certain assets of the borrower. Term loans secured by real property, such as land, are called mortgages.

3. Split between their current and long-term portions 4. The terms of the loan including principal repayments are disclosed in the notes B. Leases are rental agreements between the lessee (renter) and the lessor (property owner), which allows the lessee to use the asset for an agreed period of time for a fee.

1. An operating lease is a lease where the lessor maintains all of the risks and rewards of ownership incidental to the ownership of the asset. The lessee debits Lease Expense for the amount of the lease payment and records neither an asset nor a liability.

2. A financing lease is a lease that transfers all the risks and rewards incidental to the ownership of an asset to the lessee even though legal title of the asset remains with the lessor. The lessee records the asset (as if it were purchased) and the related lease liability. There are several criteria for a finance lease that are referenced in the chapter.

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Teaching Tip Why do lessees want to avoid recording a lease as a finance lease? Assume Oxford Company has assets of $10 and liabilities of $4 (all number in millions). It is considering leasing an asset that costs $2.

Before LeaseRecorded as a Capital Lease As an Operating Lease Assets Liabilities Debt ratio

$10 4 40%

$12 6 50%

$10 4 40%

Recording a lease as a capital lease can affect some ratios adversely.

C. Post-employment benefits are a special type of employee benefits that do not become payable until after a person has completed employment at a company. Examples of these benefits include: 1. Pension benefits 2. Medical and dental insurance 3. Prescription drug benefits OBJECTIVE 8: Report liabilities on the balance sheet A. Exhibit 7-10 illustrates the various liabilities on the balance sheet of Air Canada. The various liabilities are classified as either current or long-term.

B. Working back and forth between the financial statements and the notes to the financial statements is an important part of financial analysis.

OBJECTIVE 9: Describe how robotic process automation (RPA) can help with the accounts payable process A. Robotic process automation (RPA) is a software system that observes a person or user performing a task, recognizes patterns in that user activity, and creates a “bot” to replicate that person’s task processes. A bot (or software robot) is an RPA program that performs repetitive tasks based on rules.

B. The accounts payable bot provides several benefits. One of the main benefits is that fewer errors occur when the invoices are entered into the system because the possibility for human error is removed. Additionally, there is a complete log generated of all completed steps for later review or audit. Also, the employees who were performing the routine, repetitive accounts payable tasks can be assigned to more interesting, value-added activities that require judgment and other strategic thought processes.

C. Many other processes can be automated within an organization, such as customer order processing, customer billing, and employee travel reimbursement.

D. Some processes are better candidates for RPA automation than others. Typically, for a process to be considered an RPA candidate, several conditions and characteristics must be present, as shown in the text.

Conversely, processes that require creativity, social interactions, and human judgment are not suitable targets for RPA. Processes unsuitable for bots include designing an advertising ..

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campaign, deciding upon a one-time capital investment project, or preparing for and conducting an employee’s performance evaluation.

OBJECTIVE 10: Describe how scenario analysis tools can help companies comply with debt covenants A. Lenders often impose debt covenants on borrowers to prevent borrowers from taking actions that increase their risk of defaulting on loans. Debt covenants also benefit borrowers by lowering the cost of borrowing.

If the loan is less risky for the lender, then the lender will charge a lower interest rate on the loan.

B. A debt covenant may require the borrower’s current ratio to be at least 1.0. If the current ratio falls below 1.0, the lender has the right to demand immediate repayment of the loan.

Other common debt covenants include a minimum cash balance, a maximum debt ratio, or a minimum times-interest-earned (TIE) ratio. Debt covenants can also be tied to shortterm loans.

C. The What-If Analysis Scenario Manager tool in Microsoft Excel can be used to calculate projected ratios and balances. What-If Analysis Scenarios allow the user to enter changes and see the impact on the ratios and balances that are included in any debt covenants. Scenarios for different projects can easily be summarized for comparison.

D. A What-If Analysis Scenario Manager Example for The Niswender Corporation's debt covenants on its bank loan is illustrated in the text. The What-If Analysis Scenario Manager can be used to check compliance with debt covenants. The Niswender Corporation has debt covenants on its bank loan. During the 10-year term of the loan, Niswender must comply with these covenants: 1. Current ratio must be 1.50 or higher.

2. Debt ratio must not go above 62.0%.

3. Times-interest-earned (TIE) ratio must be at least 3.00.

Managers in the company are evaluating three separate projects and their effect on the debt covenants.

Exhibit 7-11 illustrates the What-If Analysis Scenario Manager Pop-Up Window.

Exhibit 7-12 illustrates the What-If Analysis Scenario Summary.

Debt covenants must always be evaluated before undertaking new projects.

E. A summary of the differences between IFRS and ASPE is presented.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q7-1 Understanding accounting for liabilities 1 1-2 Easy Q7-2 Understanding accounting for liabilities 1 1-2 Easy Q7-3 Understanding accounting for liabilities 1 1-2 Easy Q7-4 Understanding accounting for liabilities 1 1-2 Easy Q7-5 Understanding accounting for liabilities 1 1-2 Easy Q7-6 Understanding accounting for liabilities 1 1-2 Easy Q7-7 Understanding accounting for liabilities 1 1-2 Easy Q7-8 Understanding accounting for liabilities 3 1-2 Easy Q7-9 Understanding accounting for liabilities 3 1-2 Easy Q7-10 Understanding accounting for liabilities 3 1-2 Easy Q7-11 Understanding accounting for liabilities 3 1-2 Easy Q7-12 Understanding accounting for liabilities 4 1-2 Easy Q7-13 Understanding accounting for liabilities 4 1-2 Easy Q7-14 Understanding accounting for liabilities 4 1-2 Easy Q7-15 Understanding accounting for liabilities 6 1-2 Easy Q7-16 Understanding accounting for liabilities 4 1-2 Easy Q7-17 Understanding accounting for liabilities 3 1-2 Easy Q7-18 Understanding accounting for liabilities 3 1-2 Easy Q7-19 Understanding accounting for liabilities 3 1-2 Easy S7-1 Account for payroll expenses and liabilities; report payroll expenses and liabilities in the financial statements 1, 8 20 Medium S7-2 Account for warranty expense and estimated warranty payable; report warranties in the financial statements 1, 8 10 Easy S7-3 Analyze accounts payable turnover 6 10 Medium S7-4 Price bonds 2, 3 5-10 Medium S7-5 Determine bond prices at face value, a discount, or a premium 2, 3 5-10 Easy S7-6 Journalize basic bond payable transactions 2, 3, 4 5-10 Easy S7-7 Record bond transactions and calculate interest using the effective-interest method; analyze interest on long-term debt 2, 3, 4 20-25 Easy S7-8 Determine bonds payable amounts; amortize bonds by the straight-line method; Record bond transactions and calculate interest using the straight-line method 2, 3, 4 15-20 Easy S7-9 Calculate the leverage ratio, debt ratio, and times-interest earned, and evaluate debt-paying ability 6 10-15 Easy S7-10 Compute and evaluate three ratios 6 10 Medium S7-11 Report liabilities 6 5-10 Easy E7-12 Account for and report warranty expense and the related liability; assess debt-paying ability 1, 6, 8 5-15 Easy E7-13 Record and report current liabilities 1, 8 10-15 Easy E7-14 Account for payroll expenses and liabilities 1, 8 10 Easy E7-15 Record note-payable transactions 1 5-10 Easy E7-16 Analyze current and long-term liabilities; evaluate debt-paying ability 1, 6, 8 20 Medium E7-17 Analyze liabilities and debt-paying ability 1, 6, 8 10-20 Medium E7-18 Evaluate debt-paying ability 6 20-25 Medium E7-19 Account for and report current and long-term liabilities 1, 8 15-20 Easy

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E7-20 Record bond transactions and calculate interest using the straight-line method 2, 3, 4 10-15 Easy E7-21 Measure cash amounts for a bond; amortize the bonds by the straight-line method 2, 3, 4 1015 Medium E7-22 Record bond transactions and calculate interest using the effective-interest method 2, 3, 4 1520 Easy E7-23 Record bond transactions and calculate interest using the effective-interest method 2, 3, 4 1520 Medium E7-24 Create a debt payment and bond amortization schedule 3, 4 15-20 Medium E7-25 Analyze current and long-term liabilities; evaluate debt-paying ability 1, 6, 8 10-20 Medium E7-26 Use ratios to compare companies 6 20-25 Medium E7-27 (Critical Thinking) Assess the impact of transactions on key ratios 1, 6, 8 15 Difficult E7-28 Understand how structuring debt transactions can affect a company 5, 6 20-30 Difficult E7-29 Analyze bond transactions 2, 3, 4 20-30 Difficult E7-30 (Critical Thinking) Explain the advantages and disadvantages of financing with debt versus equity 5 20 Medium E7-31 Classify tasks as bot-ready or manual 9 10 Medium E7-32 Identify processes suitable for RPA 9 5-10 Medium E7-33 Interpret Excel What-If Analysis results related to debt covenants 10 10 Medium E7-34 Create What-If Analysis Scenarios in Microsoft Excel to analyze the impacts of projects on debt covenants 10 10-20 Medium P7-35A Account for and report current liabilities 1, 8 15-20 Easy P7-36A Record liability-related transactions 1 30-40 Easy P7-37A Issue bonds at face value, record accrual and payment of interest, and report bonds payable on the balance sheet 2, 3, 4, 8 20-25 Medium P7-38A Issue bonds at a discount, amortize by the straight-line method, and report bonds payable on the balance sheet 2, 3, 4, 8 30-40 Medium P7-39A Account for bonds payable at a discount and amortize by the straight-line method 2, 3, 4 30-40 Medium P7-40A (Critical Thinking) Explain the advantages and disadvantages of financing with debt versus equity 5 15-30 Medium P7-41A Analyze a company’s long-term debt and report long-term debt on the balance sheet (effective-interest method) 2, 3, 4, 8 30-45 Medium P7-42A Issuing bonds at a discount, amortizing by the effective-interest method, and reporting the bonds payable on the balance sheet 2, 3, 4, 8 40-50 Medium P7-43A Finance operations with debt or with shares 5 20-30 Difficult P7-44A (Critical Thinking) Assess key ratios and the impact of transactions on them 1, 6, 8 20-30 Medium P7-45A Report liabilities on the balance sheet; calculate times-interest-earned ratio 6, 8 20-30 Medium P7-46A Record bond transactions [at par]; report bonds payable on the balance sheet 1, 2 20-25 Medium P7-47B Account for and report current liabilities 1, 8 15-20 Easy P7-48B Record liability-related transactions 1 30-40 Easy P7-49B Record bond transactions (at face value) and report bonds payable on the balance sheet 2, 3, 4, 8 20-25 Medium P7-50B Record bond transactions and calculate interest using straight-line method; report notes payable on the balance sheet 2, 3, 4, 8 30-40 Medium P7-51B Account for bonds payable at a discount and amortize by the straight-line method 2, 3, 4 30-40 Medium P7-52B Analyze a company’s long-term debt and report the long-term debt on the balance sheet (effective-interest method) 2, 3, 4, 8 30-45 Medium P7-53B (Critical Thinking) Finance operations with debt or shares 5 15-30 Medium ..

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P7-54B (Critical Thinking) Assess key ratios and the impact of transactions on them 1, 6, 8 20-30 Difficult P7-55B Report liabilities on the balance sheet; times-interest-earned ratio 6, 8 20-30 Medium P7-56B Record bond transactions [at par]; report bonds payable on the balance sheet 1, 2 20-25 Medium Decision Case 1 Explore an actual bankruptcy; calculate leverage ratio, ROA, debt ratio, and timesinterest-earned ratio 6 15-20 Medium Decision Case 2 Analyze alternative ways of raising $5 million 5 30-40 Difficult Ethical Decision 1 Ethical Decision 2 Ethical Decision 3

ANSWER KEY TO CHAPTER 7 QUIZ 1. D 2. D 3. A 4. A 5. B 6. B 7. A 8. D 9. A 10. C

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Name:_

Date:

Section:

CHAPTER 7 TEN-MINUTE QUIZ Circle the letter of the best response.

1. On October 1, ABC Company borrowed $25,000 on a 10%, 9-month note payable to Bank 1.

The correct entry at maturity, assuming all December 31 year-end entries were made correctly, would include a A. debit to Interest Expense for $833.

B. debit to Interest Expense for $2,500.

C. credit to Cash for $25,000.

D. debit to Interest Expense for $1,250.

2. From the following list of account balances, calculate the correct amount of current liabilities: Accounts receivable $ 5,000 Accounts payable 6,000 Unearned revenues 2,000 Rent expense 1,500 Sales revenue 46,000 Sales tax payable 3,500 Estimated warranty payable 1,000 Note payable, due in 90 days 2,500 Accumulated amortization 1,200 A. $12,000 B. $61,000 C. $13,000 D. $15,000 3. Which type of contingent liability below would most likely be found on the balance sheet?

I. Likely contingent liability that can be estimated II. Likely contingent liability that cannot be estimated III. Unlikely contingent liability A. I only B. I and II C. I, II, and III D. II only 4. If ABC Co. issues their $500,000, 10% bonds payable at a premium, A. the debit to Cash is greater than the credit to Bonds Payable.

B. the maturity value is greater than the present value of the interest and principal payments.

C. the market rate of interest must be greater than the contract rate of interest.

D. both A and C are true.

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5. On January 1, XYZ Co. issued $800,000, 10-year, 9% bonds to yield a 9% return. The bonds pay interest annually on December 31each year. What is the amount of interest expense on December 31 in the first year, assuming the effective-interest method of amortization?

A. $7,200 B. $72,000 C. $8,000 D. $80,000 6. ‘007 Co. issued bonds payable at a discount and uses the effective-interest method of amortization. Which of these statements is true?

A. The carrying amount of the bonds on the balance sheet will decrease each interest period.

B. The interest expense each interest period will be greater than the cash paid for interest.

C. The interest paid will be a constant percentage of the carrying amount.

D. The Discount on Bonds Payable will be added to the liabilities on ‘007 Co.’s financial statements.

7. CGC Corp. has outstanding $600,000 of 5-year, 8% bonds payable with a yield rate of 9% that pays interest semi-annually. Which of the following statements is true: A. The bond was issued at a discount.

B. The bond was issued at a premium.

C. The Present value factor for this bond valuation would be found in the 8% interest column.

D. The Present value factor for this bond valuation would be found in the 9% interest column.

8. Which of the following statements concerning financing operations is false?

A. Issuing shares rather than bonds payable dilutes ownership.

B. Selling shares will decrease earnings per share.

C. Earnings per share will be higher if bonds are issued rather than if shares are issued.

D. Earnings per share will be lower if bonds are issued rather than if shares are issued.

9. KB Corporation sells a product that includes a 2-year warranty. During that time, if the product breaks, it may be returned for replacement. At the beginning of 20XX, Estimated Warranty Payable had a $500 credit balance. During 20XX, 6,000 units were sold; historically, approximately 1% of the units prove to be defective. Each unit costs $50 and sells for $150. If 50 units are actually replaced during 20XX, what is the remaining balance in Estimated Warranty Payable at the end of 20XX? A. $1,000 B. $2,000 C. $3,000 D. Cannot be determined from the information given.

10. When a company reports liabilities on its financial statements: A. the fair market value of long-term debt appears as a part of long-term liabilities on the balance sheet.

B. borrowing and repayment of long-term debt appears as an investing activity on the statement of cash flows.

C. borrowing and repayment of long-term debt appears as a part of financing activities on the statement of cash flows.

D. both operating leases and capital leases are a part of the liabilities section on the balance sheet, and may be either long or short term.

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CHAPTER 8 Shareholders’ Equity CHAPTER OVERVIEW This chapter opens with a discussion of National Hardware Ltd. and the changes to the company’s shareholders’ equity accounts. The chapter then introduces the student to the corporation, explaining the characteristics of a corporation and how it is organized. Shareholders’ rights are discussed and the components of shareholders’ equity are explained. Next, the chapter introduces the different classes of shares, their characteristics, and the entries for issuing shares. Included is a discussion of shares issued for assets other than cash. Students are presented with the ethical considerations concerning accounting for the issuance of shares in “Cooking the Books—Unethical Behaviour with Share Capital.” A mid-chapter summary problem tests students’ understanding of corporations and accounting for share issuances.

The chapter continues with a detailed presentation of accounting for the repurchase of shares.

Retained earnings is explained in greater detail. Dividends (cash and stock) are introduced and the entries for the declaration and payment of dividends are illustrated. Cumulative and noncumulative preferred shares are defined and stock splits are discussed.

The final section in the chapter presents two profitability measures—the return on total assets and the return on common shareholders’ equity. Decision Guidelines help students to make investment decisions. The chapter closes with a discussion of reporting equity transactions and events in the financial statements. A final summary problem allows the student to prepare a classified balance sheet for a corporation and to analyze the shareholders’ equity of a corporation.

LEARNING OBJECTIVES After studying Chapter 8, your students should be able to: 1. Explain the main features of a corporation.

2. Account for the issuance of shares.

3. Explain why a company repurchases shares.

4. Account for retained earnings, dividends, and stock splits.

5. Evaluate a company’s return on equity.

6. Report equity transactions and events in the financial statements.

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Issuing shares Repurchase of shares Cash and stock dividends Stock splits Ethical considerations in accounting for the issuance of shares

RECOMMENDED Characteristics of a corporation Return on assets and return on equity Reporting shareholders’ equity transactions on the balance sheet and notes

IF TIME PERMITS Dividends on cumulative and noncumulative preferred shares

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

CHAPTER OUTLINE OBJECTIVE 1: Explain the main features of a corporation A. The main features of a corporation include the following: 1. Corporations are separate legal entities, which means that the corporation is separate from its owners, who are called shareholders.

2. Corporations are granted articles of incorporation by the federal or provincial government that authorizes the organization of the corporation.

3. The corporation is separate from its owners, who are called shareholders.

4. The corporation has many rights that a person has, such as the right to buy, own, and sell property; the right to sue and be sued; and the right to enter into contracts.

5. Corporations have continuous lives regardless of changes in their ownership.

Ownership is easily transferable through selling, trading, bequeathing or giving shares to another person.

6. Shareholders have limited liability for the corporation debts. (A shareholder can lose no more than his or her investment in the business.)

7. Shareholders own the corporation, but a board of directors, elected by the shareholders, appoints officers to manage the business.

8. Corporations pay income taxes separate from those borne by their shareholders.

9. To protect a corporation’s creditors and the shareholders, both federal and provincial governments monitor corporations ensuring that they disclose information in financial statements for investors and creditors to make informed decisions.

B. The advantages and disadvantages of a corporation are summarized in Exhibit 8-1.

C. Shareholders elect a board of directors who elect a chairperson who is the most powerful person in the organization. The board also appoints the chief executive officer (CEO).

Exhibit 8-2 shows the authority structure in a large corporation.

D. Shareholders have four basic rights which include: 1. The right to sell shares, which may be restricted in certain circumstances.

2. The right to vote—to participate in management by voting on matters. Each share receives one vote.

3. The right to receive dividends—each particular class of a share receives an equal dividend.

4. The right to receive a residual interest upon liquidation, which is a proportionate share of assets remaining upon liquidation of the corporation.

E. Shareholders’ equity has four common and separate components: 1. Share capital reflect amounts contributed by shareholders in exchange for shares in the corporation.

2. Contributed surplus reflects any amounts contributed by shareholders in excess of amounts allocated to share capital.

3. Accumulated other comprehensive income—IFRS requires companies to report Accumulated other comprehensive income, which is an accumulation of past earnings not included in retained earnings.

4. Retained earnings are the accumulated balance of a corporations’ net income/loss since inception less dividends declared.

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

F. Share certificates are issued to shareholders in exchange for their investment.

1. The total number of authorized shares is limited by charter and refer to the maximum number of shares a corporation is allowed to distribute.

2. Issued shares refer to the number of shares sold or transferred to shareholders.

3. Outstanding shares are shares held by shareholders.

G. The two classes of shares are common shares and preferred shares. a. All corporations issue common shares, or ordinary shares per IFRS. These shares are subordinate to all other classes of shares. Common shareholders assume risks when they buy common shares and, therefore, demand increases in share prices, dividends, or both, or they will sell the shares. b. Preferred shares are considered less risky than common because preferred shareholders receive their dividends before the common shareholders and receive assets before the common shareholders in the event of corporate liquidation. i.

Preferred shares pay a fixed dividend similar to interest on debt. ii.

Like common shares, the dividend does not have to be paid unless the board of directors has declared the dividend.

H. Par value shares are shares of stock that have a value assigned to them by the articles of incorporation, which specify the legal details associated with a company’s incorporation. The Canada Business Corporations Act and most provincial incorporating acts require common and preferred shares to be issued without par value.

OBJECTIVE 2: Account for the issuance of shares A. Corporations issue shares to raise capital to finance operations and use an underwriter, such as the brokerage firm Scotia McLeod. The entry to record the issuance of shares is: Cash XX Common Share Capital XX Teaching Tip Is the issuance of shares recorded as a revenue? No, the issuance of shares is recorded as contributed capital since this amount is “contributed” by the investors.

B. Companies sometimes issue shares in return for assets other than cash. The entry to record the issuance of shares for assets would be: Equipment XX Building XX Common Share Capital XX C. Issuance of shares for assets other than cash can pose an ethical challenge. The company issuing the shares may be tempted to record a value that is greater than the asset’s fair market value. It may have the opportunity to do so because it may be difficult to determine the market value of other assets such as land, buildings, equipment, or shares in non-publicly traded companies. GAAP requires the value of shares to be measured at the fair market value of the assets received in exchange for the shares.

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

OBJECTIVE 3: Explain why a company repurchases shares A. Companies may repurchase their own shares for several reasons that include: 1. The company needs the repurchased shares for distribution to employees under share purchase plans and conversions of bonds and preferred shares into common shares 2. The purchase may help to support the share’s current market price by decreasing the supply of shares available to the public; that is, repurchase is anti-dilutive.

3. Management wants to avoid a takeover by an outside party.

B. The repurchase of shares has the opposite effect of issuing shares in that it decreases share capital and total shareholders’ equity.

Teaching Tip Refer students back to the basic accounting equation (A = L + SHE) to analyze the effect of: Issuing shares ➔ Assets increase (cash is received), SHE increases (more shares outstanding) Repurchasing shares ➔ Assets decrease (cash is used), SHE decreases (less shares outstanding)

OBJECTIVE 4: Account for retained earnings, dividends, and stock splits A. Retained Earnings is the account that accumulates all net income minus all net losses and dividends. It is not a fund of cash. The normal balance of retained earnings is a credit. A debit balance reflects a deficit.

B. A dividend is a corporation’s distribution of its earnings to shareholders, which can be in the form of cash dividends or stock dividends.

C. Before a cash dividend can be paid, a company must have: 1. Retained earnings in excess of the desired dividend 2. Enough cash to pay the dividend D. There are three relevant dates for dividends: 1. Date of declaration, which is the date that the board of directors of a corporation declare a dividend. The dividend becomes a liability to the corporation and is recorded as follows: Retained Earnings XX Dividends Payable XX 2. Shareholders who own the shares on the date of record receive the dividend. No entry is recorded.

3. The dividend is paid on the payment date and recorded as follows: Dividends Payable XX Cash XX

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

E. A stock dividend is a proportional distribution by a corporation of its own shares to its own shareholders.

1. The value of a stock dividend is determined by multiplying the number of shares to be issued by the market price of the shares on the date of declaration and the entry is as follows: Retained Earnings XX Stock Dividends Distributable XX 2. On the date of payment, the entry would be: Stock Dividends Distributable XX Common/Preferred Shares XX 3. Stock dividends do not impact total shareholders’ equity as the increase in the Share capital is fully offset by the decrease in Retained earnings.

Teaching Tip Remind students that declaration of cash dividends increases liabilities because a cash dividend requires a transfer of assets. Declaration of a stock dividend does not increase liabilities because stock dividends require a distribution of stock, which is not an asset.

F. The reasons that a corporation might choose to distribute a stock dividend are: 1. To conserve cash 2. To reduce the market price per share Teaching Tip How does an investor’s position change after a stock dividend is declared? If you owned 1,000 (10%) shares of the 10,000 shares before a 20% stock dividend, then after the stock dividend you would own 1,200 (10%) of the 12,000 shares.

G. Dividends on preferred shares are expressed as an annual dollar figure or as a percentage of the share’s stated value.

H. Preferred shareholders receive their dividends before common shareholders.

I.

Dividends on preferred shares may be cumulative, that is, the preferred shareholders must receive all dividends, even the dividends not paid in prior years (dividends in arrears), before the corporation can pay dividends to common shareholders. A corporation is not obligated to pay preferred shareholders dividends in arrears if they hold non-cumulative preferred shares.

J. Dividends in arrears are not a liability until declared by the corporation.

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

Teaching Tip Johnson Corp. has 10,000 shares of $10 cumulative preferred shares and 50,000 common shares issued and outstanding. Johnson has not paid any dividends in the past two years but has declared $320,000 of dividends for the current year. How much will be paid to the preferred and common shareholders?

Dividends in arrears to preferred: $10 × 10,000 × 2 = $200,000 Current dividend to preferred: $10 × 10,000 = $100,000 Remainder to common: $320,000 − $200,000 − $100,000 = $20,000 Total: $300,000 to preferred shareholders, $20,000 to common shareholders How much would be paid to the preferred and common shareholders if the preferred shares were noncumulative?

Current dividend to preferred: $10 × 10,000 = $100,000 Remainder to common: $320,000 − $100,000 = $220,000

K. A stock split is an increase in the number of shares coupled with a proportionate reduction in the value of the shares.

1. Stock splits are recorded with a memorandum entry because no account balances are affected.

2. Stock splits reduce the market price of the shares. A reverse stock split increases the market price of the shares.

L. Exhibit 8-3 summarizes the effects of share-related transaction and events on assets, liabilities, and equity.

OBJECTIVE 5: Evaluate a company’s return on equity A. To compare profitability of companies of different size, investors use standard profitability measures including: 1. Return on assets (ROA) 2. Return on equity (ROE) B. The return on assets (rate of return on total assets) measures a company’s ability to use its assets to earn income. It is the product of two drivers: net income and asset usage.

C. The return on equity (rate of return on common shareholders’ equity) measures a company’s ability to use its invested capital to earn income. The numerator of ROE is net income minus preferred dividends, if any.

D. ROA and ROE can be calculated as follows: ROA Net Income + Interest expense Avg. total assets

ROE Net income − Preferred dividends Avg. common shareholders’ equity

E. To evaluate return, it is necessary to have other information such as: 1. Comparative prior years’ returns 2. Comparative returns for other companies in the same industry 3. Borrowing money to finance assets is called leverage. Leverage used during good economic times produces high returns for shareholders. A higher return on equity than ..

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

return on assets also indicates favourable leverage.

4. The higher the rate of return on common shareholders’ equity, the more successful the company.

F. Decision Guidelines related to investing in stock is presented.

Teaching Tip The financial statements of the XYZ Inc. reported the following information at the end of 20X2 and 20X1: 20X2 20X1 $1.50 Preferred shares 1,000 1,000 (number of shares) Net income $ 20,000 $ 22,500 Interest expense 5,000 6,000 Common shares 50,000 50,000 Retained earnings 45,000 40,000 Total assets 210,000 190,000 XYZ declared and paid dividends of $13,500 and $10,000 to the common shareholders in 20X2 and 20X1, respectively. What is the return on assets? Return on equity? Is the company favourably leveraged?

Return on assets: 12.5% ($20,000 + $5,000) / [($190,000 + $210,000) / 2] Return on equity: 20% [$20,000 − ($1.50 × 1,000) /[($90,000 + $95,000) / 2] XYZ is favourably leveraged, because the return on equity is greater than the return on assets.

OBJECTIVE 6: Report equity transactions and events in the financial statements A. The statement of changes in shareholders’ equity reports the details of all the changes in the shareholders’ equity section of the balance sheet during the period.

(Exhibit 8-4 presents the statement and Exhibit 8-5 presents the shareholders’ equity section of the Balance Sheet).

B. Companies use a variety of terminologies and formats in reporting shareholders’ equity. (See Exhibit 8-6).

C. Some equity information that must be disclosed in the balance sheet, statement of changes in owners’ equity, or the notes include: 1. Number of authorized, issued, and outstanding shares, changes in these amounts for each class of share capital; their par value, if any; dividend rights and preferences; and other restrictions and features.

2. Contributed surplus 3. Accumulated other comprehensive income (IFRS only) 4. Retained earnings D. A summary of IFRS and ASPE differences is presented.

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q8-1 Understand shareholders’ equity 1, 1-2 Easy Q8-2 Understand shareholders’ equity 1, 2 1-2 Easy Q8-3 Understand shareholders’ equity 1, 2 1-2 Easy Q8-4 Understand shareholders’ equity 1, 2 1-2 Easy Q8-5 Understand shareholders’ equity 1, 2 1-2 Easy Q8-6 Understand shareholders’ equity 1, 2 1-2 Easy Q8-7 Understand shareholders’ equity 1, 2 1-2 Easy Q8-8 Understand shareholders’ equity 1, 2 1-2 Easy Q8-9 Understand shareholders’ equity 1, 2 1-2 Easy Q8-10 Understand shareholders’ equity 3 1-2 Easy Q8-11 Understand shareholders’ equity 3 1-2 Easy Q8-12 Understand shareholders’ equity 3 1-2 Easy Q8-13 Understand shareholders’ equity 4 1-2 Easy Q8-14 Understand shareholders’ equity 4 1-2 Easy Q8-15 Understand shareholders’ equity 4 1-2 Easy Q8-16 Understand shareholders’ equity 4 1-2 Easy Q8-17 Understand shareholders’ equity 4 1-2 Easy Q8-18 Understand shareholders’ equity 4 1-2 Easy Q8-19 Understand shareholders’ equity 4 1-2 Easy Q8-20 Understand shareholders’ equity 6 1-2 Easy S8-1 Understand the advantages and disadvantages of a corporation 1 5 Easy S8-2 Summarize the characteristics of authority structure in a corporation 1 5 Easy S8-3 Identify the characteristics of preferred and common shares 1 5-10 Easy S8-4 Assess the rights of shareholders; understand the effect of a share issuance on net income 1, 2, 6 5-10 Easy S8-5 Issue shares and analyze retained earnings 2, 4 10 Easy S8-6 Account for and assess impact of share issuances on the financial statements 2, 6 10 Easy S8-7 Prepare the shareholders’ equity section of a balance sheet 6 5-10 Easy S8-8 Account for and report shareholders’ equity data 4, 6 10 Medium S8-9 (Critical Thinking) Explain how the repurchase of shares could fight off a takeover of a corporation 1, 3 20 Medium S8-10 Account for cash dividends 4 10 Easy S8-11 Divide cash dividends between preferred and common shares 4 5-10 Medium S8-12 Account for and report the impact of stock dividends on the financial statements 4, 6 5-10 Easy S8-13 Divide cash dividends between preferred and common shares 4 10 Easy S8-14 Use the statement of changes in shareholders’ equity 6 5-10 Easy S8-15 Evaluate return on assets and return on equity 5 5-10 Easy S8-16 Account for issuance of shares and dividends; prepare a statement of changes in shareholders’ equity 2, 4, 6 30 Medium E8-17 Evaluate returns on assets and equity 5 5-10 Easy E8-18 Account for the issuance of shares and report shareholders’ equity 2, 6 9-15 Medium E8-19 Assess the impact of share issuances on shareholders’ equity; prepare the shareholders’ equity section of a balance sheet 2, 4 15 Medium E8-20 Measure the share capital of a corporation 2, 4 10 Medium E8-21 Prepare shareholders’ equity section of a balance sheet 2, 4 9-15 Easy ..

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

E8-22 Record share transactions and measure their effects on shareholders’ equity 2, 4, 6 15 Medium E8-23 Record share issuance and dividend transactions; report shareholders’ equity after a sequence of transactions 2, 4, 6 20 Medium E8-24 Analyze a statement of changes in shareholders’ equity 6 10 Easy E8-25 (Critical Thinking) Infer transactions based on changes in a company’s shareholders’ equity 2, 3, 4, 6 20-30 Medium E8-26 Compute dividends on preferred and common shares 4 15 Medium E8-27 Record a stock dividend and report shareholders’ equity 4, 6 15-20 Medium E8-28 Measure the effects of share issuance, dividends, and share split transactions 2, 4 15-20 Medium E8-29 Report shareholders’ equity after a stock split 4, 6 8-15 Medium E8-30 Compute dividends on preferred and common shares; calculate return on equity 4, 5 8-15 Medium E8-31 Evaluate returns on assets and equity 5 8-15 Easy E8-32 Evaluate returns on assets and equity 5 8-15 Medium E8-33 (Critical Thinking) Reconstruct transactions from the financial statements 2, 4 20-25 Difficult E8-34 (Critical Thinking) Explain the changes in shareholders’ equity 2, 4, 6 15 Difficult E8-35 Account for changes in shareholders’ equity 2, 4, 6 25 Difficult

P8-36A (Critical Thinking) Explain the advantages and disadvantages associated with being a corporation 1, 2, 4 20-30 Medium P8-37A Record corporate transactions and prepare the shareholders’ equity section of the balance sheet 2, 4, 6 30-45 Medium P8-38A Assess the impact of shareholders’ equity transactions; prepare the shareholders’ equity section of the balance sheet 2, 4, 6 9-15 Medium P8-39A (Critical Thinking) Explain how to fight off a takeover of a corporation 3 30-40 Medium P8-40A Measure the effects of share issuance and dividend transactions on shareholders’ equity 2, 4, 6 20-30 Difficult P8-41A Analyze the shareholders’ equity and dividends of a corporation 2, 4 15-25 Medium P8-42A Account for share issuance and dividends; report shareholders’ equity on the balance sheet 2, 4, 6 15-20 Medium P8-43A Measure the effects of dividend and share transactions on a company 2, 4 20-30 Medium P8-44A Prepare a corporation’s balance sheet; assess returns on assets and equity 2, 4, 5 40-50 Medium P8-45A (Critical Thinking) Use a statement of changes in shareholders’ equity 6 20-30 Medium P8-46B (Critical Thinking) Explain the features of elements of shareholders equity 1, 2, 4 20-30 Easy P8-47B Record corporate transactions and prepare the shareholders’ equity section of the balance sheet 2, 4, 6 30-45 Medium P8-48B Assess the impact of shareholders’ equity transactions; prepare the shareholders’ equity section of the balance sheet 2, 4, 6 9-15 Medium P8-49B (Critical Thinking) Explain how to fight off a takeover of a corporation 3 15-20 Medium P8-50B Measure the effects of share issuance, net income and dividend transactions on shareholders’ equity 2, 4, 6 20-30 Difficult P8-51B Analyze the shareholders’ equity and dividends of a corporation 2, 4 25-35 Medium P8-52B Account for share issuance and dividends; report shareholders’ equity on the balance sheet 2, 4, 6 15-20 Medium P8-53B Measure the effects of dividend and share transactions on a company 2, 4 20-30 Medium P8-54B Prepare a corporation’s balance sheet; assess returns on assets and equity 2, 4, 5 40-50 Medium P8-55B (Critical Thinking) Use a statement of shareholders’ equity 6 20-30 Medium ..

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Instructor's Resource Manual for Thomas et al., Financial Accounting, 8Ce

Decision Case 1 Account for share transactions; prepare the shareholders’ equity section of the balance sheet; evaluate alternative ways of raising capital 1, 2, 4, 6 30-45 Medium Decision Case 2 Analyze cash dividends and stock dividends 4 15-20 Medium Ethical Decision 1 Ethical Decision 2 Ethical Decision 3 Comprehensive Case, Chapters 7-8

ANSWER KEY TO CHAPTER 8 QUIZ 1. D 2. B 3. C 4. D 5. B 6. C 7. C 8. D 9. D 10. A

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Instructor's Resource Manual for Harrison et al., Financial Accounting, 8ce

Name:_

Date:

Section:

CHAPTER 8 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Which of the following is an advantage of the corporate form of business organization?

A. Limited liability B. Continuous existence C. Separate legal entity D. All of the above.

Table 8-1 On December 31, 20X4, ACME Corp. reported the following in its comparative financial statements: 20X4 20X3 Preferred shares, $20, redemption value $54 per share 2,000 shares authorized and 1,000 shares issued $ 54,000 $ 54,000 Common shares, 20,000 shares authorized and 4,000 (20X4) and 3,000 (20X3) shares issued and outstanding 92,000 86,000 Total contributed capital 146,000 140,000 Retained earnings 140,000 110,000 Total shareholders’ equity $286,000 $250,000 2. Refer to Table 8-1. Assume ACME had not paid any dividends from 20X1-20X3. In 20X4, ACME declared cash dividends of $48,000 to both the preferred and common shareholders. The total dividend received by the common shareholders was (assuming the number of preferred shares did not change): A. $48,000.

B. $28,000.

C. $38,000.

D. $43,000.

3. Refer to Table 8-1. Assume that there are no dividends in arrears. What is the amount of common shareholders’ equity at the end of 20X4?

A. $194,000 B. $146,000 C. $232,000 D. $286,000 4. Refer to Table 8-1. Assume net income for 20X4 is $66,000, and there are no dividends in arrears. What is ACME’s return on common shareholders’ equity for 20X4?

A. 30.8% B. 17.2% C. 24.6% D. 21.5%

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Instructor's Resource Manual for Harrison et al., Financial Accounting, 8ce

5. A company had 1,000 common shares outstanding. The shares had been originally issued for $30 each. The current market price is quoted at $33 per share. However, the company paid $35 per share to repurchase 200 of its shares. The impact of this transaction on total shareholders’ equity is: A. increase by $2,000 B. decrease by $7,000 C. decrease by $7,400 D. increase by $1,400 6. Which of the following transactions decreases shareholders’ equity?

A. A two-for-one stock split B. Payment of a cash dividend C. Declaration of a cash dividend D. A 20% stock dividend 7. The journal entry to record the distribution of a stock dividend would include all of the following except: A. Retained Earnings, debit.

B. Common Shares, credit.

C. Contributed Surplus, credit.

D. the market value of the shares at the date of declaration.

8. Which one of the following statements is true?

A. A stock dividend increases the number of shares issued, but a stock split does not.

B. A stock split reduces the market price of the shares, but a stock dividend does not.

C. A stock split does not decrease the book value of the shares, but a stock dividend does.

D. Both stock splits and stock dividends have no effect on total shareholders’ equity.

9. Which of the following is not an advantage of the corporate form of organization?

A. Continuous life and transferability of ownership B. Limited liability C. Separate legal entity D. None of the above 10. All of the following transactions would be reported on the balance sheet. Which one does not affect cash?

A. Declaration of a cash dividend B. Repurchase of shares above book value C. Issuance of preferred shares D. Payment of a cash dividend

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

CHAPTER 9 The Statement of Cash Flows CHAPTER OVERVIEW The chapter opens with National Hardware, and the cash generated from and used in its operating, investing and financing activities as reported on its statement of cash flows. The chapter discusses the basic concepts and purposes of the statement of cash flows, and defines cash and cash equivalents. Operating, investing, and financing activities are defined. The chapter then identifies the indirect and direct methods of determining cash flows from operations with a brief description of the differences between the methods.

The indirect method is presented identifying the four steps to preparing the statement of cash flows.

Adjustments to net income, including depreciation/amortization, gains and losses, and changes in current assets and current liabilities, are explained. Rules are presented that help students learn how to handle increases and decreases in current assets and current liabilities when calculating net cash flow from operating activities. Calculations are illustrated for investing activities, including acquisitions and sales of tangible and intangible assets and investments, and for financing activities, including issuances and payments of long-term debt, issuances and repurchases of shares, and dividend payments. Non-cash investing and financing activities are discussed. A mid-chapter summary problem provides the opportunity to work a complete example using the indirect method.

This part of the chapter ends with an introduction to the operating cash flows ratio, and how data visualization of a set of this ratio for many companies over time can allow trends, patterns, and comparisons to be more easily seen and understood. Excel’s Quick Analysis button is used to demonstrate data visualization.

In the Appendix 9A, the direct method is presented, along with calculations for cash collections from customers, payments to suppliers for inventory purchases and operating expenses, payments to employees, and payment of interest and taxes as another format for presenting cash flows from operating activities. The chapter identifies that financing and investing activities and the net change in cash are reported the same way for both the direct and indirect methods. A final summary problem illustrates direct-method concepts in a statement of cash flows presentation.

LEARNING OBJECTIVES After studying Chapter 9, your students should be able to: 1. Explain the uses of the statement of cash flows.

2. Explain and classify cash flows from operating, investing, and financing activities.

3. Prepare a statement of cash flows using the indirect method of determining cash flows from operating activities.

4. Describe and apply the Excel Quick Analysis button to visualize data.

A-1. Prepare a statement of cash flows using the direct method of determining cash flows from operating activities.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Operating, investing, and financing activities Indirect method of preparing the statement of cash flows Direct method of preparing the statement of cash flows RECOMMENDED Noncash investing and financing activities

IF TIME PERMITS Free cash flow Applying the Excel Quick Analysis function to analyze data

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

CHAPTER OUTLINE OBJECTIVE 1: Explain the uses of the statement of cash flows A. The statement of cash flows, one of the four required financial statements, shows the changes in cash (including cash equivalents) for a specified period. Exhibit 9-1 illustrates the timing of financial statements.

B. It provides details about a company’s cash receipts and cash disbursements to help managers, investors, and creditors perform the following: 1. predict future cash flows; 2. evaluate management decisions; 3. determine the company’s ability to pay dividends and interest 4. assess the relationship of net income to cash flows 5. compare the operating performance of different companies Teaching Tip While a business must have profitable operations to operate over a long period of time, it must also have cash to operate. More information can be obtained for evaluation of the company by studying the income statement together with the statement of cash flows.

C. Cash includes cash on hand, cash in the bank, and cash equivalents. Cash equivalents are shortterm investments that are readily convertible into cash, such as money market investments and investments in Canadian Government treasury bills.

OBJECTIVE 2: Explain and classify cash flows from operating, investing, and financing activities A. Cash flows on the statement are classified as operating, investing, or financing.

1. Operating activities create revenues, expenses, gains, and losses. a. Operating activities relate to transactions that make up net income. b. Over the life of the business, cash flow from operating activities is the most important activity for a business.

2. Investing activities include the purchase and sale of long-term assets and other investments that do not qualify as cash equivalents. a. Investing activities consist of cash inflows or outflows related to resources used for generating future income and cash flows. b. Only expenditures related to assets that are recognized on the balance sheet qualify as investing activities.

3. Financing activities involve changes in the size and composition of a company’s contributed equity and borrowings. a. Financing activities include the issuance and acquisition of company shares; payment of cash dividends, cash proceeds from loans, bonds, and notes; and the repayment of amounts borrowed. b. Both short-term and long-term borrowings are included in financing activities.

B. IFRS and ASPE offer different guidance on classifying interest and dividends:

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

1. Under IFRS, there is no consensus on the classification of interest paid, and interest and dividends received. A company can freely choose the classification scheme but must be consistent in its use.

2. Under ASPE, interest paid, and interest and dividends received are classified as operating.

C. There are two methods to prepare operating activities on the statement of cash flows: 1. The indirect method adjusts net income from an accrual to a cash basis.

2. The direct method reports all cash receipts and cash payments.

Teaching Tip Remind students that the total net cash flow from operating activities will be the same whether the direct or indirect method is used; just the presentation of data differs.

Teaching Tip Ask students to suggest some reasons why accrual-basis net income is not the same as cash-basis net income. Possible ideas: depreciation/amortization are non-cash expenses that are deducted for accrual-basis net income; at year end, accrued expenses have not yet been paid in cash; likewise, at year end, accrued revenues have not yet been received in cash. There may also be cash payments for expenses that were recorded in previous periods or cash receipts for revenues recorded in previous periods. Students may have additional suggestions.

OBJECTIVE 3: Prepare a statement of cash flows using the indirect method of determining cash flows from operating activities A. The four steps to preparing the statement of cash flows using the indirect method include: 1. Laying out the template (Exhibit 9-2 with a visual picture in Exhibit 9-3).

2. Using the comparative balance sheets (Exhibit 9-4) to determine increases/decreases in cash during the period.

3. Identifying net income, depreciation expense, gains or losses on the sale of long-lived assets from the income statement (Exhibit 9-5) 4. Use the income statement and the balance sheet to prepare the statement of cash flows.

Teaching Tip At this point, direct students to the income statement and balance sheet in Exhibits 9-5 and 9-4.

Talk about the related accounts that will be used together for cash-flow analysis. For example, Sales and Accounts Receivable; Gain on the Sale of Capital Assets, Depreciation, and Net Capital Assets, and so on.

B. Determining cash flows from operating activities begins with net income from the income statement and adjusting it from an accrual to a cash basis by (Exhibit 9-6): 1. Adding back depreciation/amortization expense. These expenses reduce net income but are non-cash items.

2. Adding losses and deducting gains on the sale of long-term assets as they reduce (loss) or increase (gain) net income without affecting cash.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

3. Adding/subtracting for changes in non-cash operating working capital (Exhibit 9-7 summarizes the impacts of changes in non-cash operating working capital): a. Adding decreases in non-cash current assets as decreases indicate that cash has increased. b. Subtracting increases in non-cash current as increases indicate that cash has been paid. c. Adding increases in current liabilities as increases indicate that cash has not been paid. d. Subtracting decreases in liabilities as decreases in current liabilities indicate that cash has been paid.

Teaching Tip Explain why an increase or decrease in a current asset is adjusted differently than an increase or decrease in a current liability. Transactions affecting current assets and current liabilities have the opposite effect on cash and net income, and assets and liabilities are on opposite sides of the accounting equation.

Impact of change in account on the Statement of cash flows Increase Decrease

Assets − +

Liabilities + −

C. The indirect method for presenting the statement of cash flows is illustrated in Exhibit 9-8.

D. Cash flows from investing activities include the purchase and sale of long-term assets and investments that do not qualify as cash equivalents. Purchases result in cash outflows from investing activities, while sales yield cash inflows.

E. Determining cash flows from investing activities includes: 1. Acquisitions and sales of tangible and intangible assets will result in cash payment (outflow), proceeds from the sale (inflow), and gains or losses on sales. a. To identify the carrying amount of the tangible asset sold, the following formula is used: Beginning bal. + Acquisitions - Depreciation - Carrying amount of Net Capital assets sold Assets

=

b. The sale proceeds is the amount to report on the cash-flow statement and is determined as follows: Sale proceeds = Carrying amount sold + Gain or – Loss

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Ending bal.

Net capital Assets

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Teaching Tip Use this information to calculate the amounts to report on the cash-flow statement for investing activities: Beginning capital assets $76,000 Beginning accumulated depreciation $5,200 Depreciation for the year $1,300 Purchases of new assets $4,200 Ending net long-lived assets $72,850 Loss on sale of long-lived assets $150 In the investing activities section on the statement of cash flows: Purchase of assets $(4,200) Sale of long-lived assets 700 [$76,000 – $5,200 = $70,800 beginning net long-lived assets; $70,800 + $4,200 – $1,300 – X = $72,850; X = $850, the carrying value of long-lived assets sold. If the assets were sold at a loss, then cash received from the sale = $700 ($850 – $150)] Teaching Tip Often, jotting down a journal entry helps students to see the cash effect of various transactions. Have your students jot down the journal entry to reflect this transaction: During the year, a company sold, at a gain of $5,000, an investment that had a cost of $30,000. What is the amount that appears on the cash-flow statement? The related journal entry helps identify that amount: Cash 35,000 Gain on Sale of Investment Investment

5,000 30,000

While no journal entries are required to complete the statement of cash flows, they often help students determine the amount of cash inflow (debit to Cash) or cash outflow (credit to Cash) to report.

2. The carrying amount of acquisitions and sales of investments other than cash equivalents can be calculated in the same manner as the acquisition and sales of tangible and intangible assets: Beginning balance Investments

+ Purchases

- Carrying amount of investments sold

= Ending balance Investments

3. The amount of loans/advances made during a period can be calculated as follows: Beginning balance Loans and Notes Receivable

+ New loans – Collections made

= Ending balance Loans and Notes Receivable

F. Determining cash flows from financing activities involves analyzing certain liability and shareholders’ equity accounts.

1. An increase in these liability or shareholders’ equity accounts indicates that shares or debt has been issued. This is reported as a cash inflow (source of cash).

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2. A decrease in these liability or shareholders’ equity accounts indicates that debt or shares have been retired. This is reported as a cash outflow (use of cash).

3. Computation of debt issuances and payments: Beginning balance Long-term Debt

Issuance + of new debt

Repayments – of debt

Ending balance = Long-term Debt

4. Computation of share issuances and retirements: Beginning balance Common Shares

Issuance + of new shares

Repurchase – of shares

Ending balance = Common Shares

5. Computation of dividend payments: Beginning balance + Net income – Cash dividends Retained declared Earnings

= Ending balance Retained Earnings

G. Noncash investing and financing activities include activities such as the acquisition of a subsidiary company in exchange for shares of the acquiring company or the acquisition of capital assets by issuing long-term debt. While these transactions do not involve cash and are, therefore, not included in the statement of cash flows, IFRS and ASPE require note disclosure of non-cash investing and financing activities. Exhibit 9-9 is a sample disclosure of non-cash transactions.

H. Free cash flow measures the amount of cash available from operations after paying property, plant, and equipment, and is calculated as follows: Free cash flow

Net cash flow = provided by operating activities

Cash outflow earmarked –forfor for investments in Capital, equipment, and other longterm assets

1. The company with the greatest free cash flow can respond to new opportunities.

OBJECTIVE 4: Describe and apply the Excel Quick Analysis button to visualize data A. Data visualization is the representation of data in a chart, infographic, or other visual format.

Data visualization allows trends, patterns, and comparisons to be more easily seen and understood.

B. A spreadsheet tool such as Microsoft Excel can also be used for data visualization. Excel has a Quick Analysis button that can be used to create quick visual representations of data. To get to the Quick Analysis button in Excel, select the data to be analyzed. A Quick Analysis icon will appear near the lower right corner of the selected area. Click on that icon to bring up the options. Alternate software tools include Microsoft Power BI, Tableau, and Google Looker, and others.

C. Some examples of data visualization for five companies in the toy and games industry over several years include: ..

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1. Sparklines: Lines (Exhibit 9-10). This option inserts a miniature line chart next to each row of data.

2. Sparklines: Columns (Exhibit 9-11). This option inserts a miniature column chart next to each row of data.

3. Sparklines: Win/Loss (Exhibit 9-12). This option inserts a graphic in one cell that includes a blue dash for each positive number in the row of data and a red dash for each negative number in the row.

4. Formatting: Data Bars (Exhibit 9-13). This option inserts a small data bar in each cell containing data. The data bars vary in size, depending on the value of the cell relative to all other cells.

5. Formatting: Color (Exhibit 9-14). This option applies shades of green and red to the cells containing the data. By default, green is used for the highest third of cell values, and red is used for the lowest third.

6. Formatting: Icon Set (Exhibit 9-15). This option applies green up arrows, yellow side-ways arrows, and red down arrows to the cells containing the data. By default, the green up arrows are used for the highest third of cell values, the yellow sideways arrows are used for the middle third, and red down arrows are used for the lowest third of cell values.

7. Formatting: Greater Than (Exhibit 9-16). This option asks for a cutoff value and a colour choice. In the example here, the cutoff value was specified as 50.0%. Green shading was chosen, so every cell containing a number that is greater than the cutoff value is shown with green shading.

8. Formatting: Top 10% (Exhibit 9-17). This option shades the top 10% of the values with red.

I. Decision Guidelines provide useful information related to how investors and creditors use cash-flow and related information.

J.

A summary of IFRS and ASPE differences is presented.

OBJECTIVE A-1 (Appendix): Prepare a statement of cash flows using the direct method of determining cash flows from operating activities A. IFRS and ASPE encourage companies to prepare the statement of cash flows using the direct method. However, very few companies use this method as the indirect method has gained more prominence.

B. The three steps to preparing the statement of cash flows using the direct method include: 1. Laying out the template (Exhibit 9A-1).

2. Using the comparative balance sheets (Exhibit 9A-6) to determine increases/decreases in cash during the period.

3. Use the available data to prepare the statement of cash flows (Exhibit 9A-3). Some business transactions impact the income statement (Exhibit 9A-5), some the cash-flow statement, and some both.

C. Determining cash flows from operating activities (Exhibit 9A-2 and 9A-4) includes: 1. Cash sales and collections from customers, computed by adjusting sales revenue to the cash basis and is calculated as follows: Beginning balance Accounts Receivable ..

+

Credit Sales 9-8

Ending balance – Collections = Accounts Receivable

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a. An increase in Accounts Receivable means that sales revenue is greater than collections. b. A decrease means that collections are greater than sales.

Teaching Tip Help students understand why cash collections from customers is not the same as Sales Revenue.

There may have been credit sales from last year that were not collected until early this year.

Also, at the end of this year, any credit sales made will not be collected in cash until next year.

What we need to know for the cash-flow statement is just the actual cash collected. (Try to help students understand a similar type of analysis for each type of operating cash flow that is calculated for the direct method approach.)

Teaching Tip This is the basic T-account format. Here is an illustration for Accounts Receivable, but the same type of analysis could be used for any balance sheet account.

Account Name Beginning balance Increases (sales) Decreases (collections) = Ending balance Every account has these four elements. Different transactions create the increases and decreases. This type of analysis is useful when solving for the various cash flows.

2. Cash receipts of interest and dividends. a. Cash receipts of interest is computed by identifying interest revenue less the increase in interest receivable. b. Dividends received are operating activities, while dividends paid are financing activities.

3. Cash payments to suppliers involves two parts: a. Payments for inventory, which calls for adjusting cost of goods sold to the cash basis and is calculated as follows: Beginning Inventory

+

Purchases

–

Ending Inventory

= Cost of Goods Sold

Now, “Purchases” is used in the following formula to find the amount of cash payments: Beginning balance Accounts Payable i. ii.

..

+ Purchases

– Payments for inventory

= Ending balance Accounts Payable

An increase in Inventory means that purchases were greater than the cost of goods sold.

An increase in Accounts Payable means that purchases were greater than the cash payments.

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b. Payments for operating expenses (excluding interest and income tax) adjusts accrual-basis operating expense to the cash basis and is calculated as follows: Beginning balance Prepaid Expenses

+ Payments for prepaid

- Expiration of prepaid = Ending balance expenses Prepaid Expenses

Beginning balance Accrued Liabilities

Year-end + accrued amounts

Payments - for accrued liabilities

Ending balance = Accrued Liabilities

Year-end Accrued Expenses

Expiration + of prepaid expenses

Payments + for operating expenses

Ending balance = Operating Expenses

Total cash paid for operating expenses is the sum of the “Payments” amounts above. ii. An increase in Prepaid Expenses means that payments for prepaids were greater than the expenses recorded. iii. An increase in Accrued Liabilities means that expenses incurred were greater than cash payments. i.

4. Cash payments to employees is determined by analyzing the salary and wages payable account and is calculated as follows: Beginning balance Salary &Wages Payable

Salary & and Wages Expense

Payments - for salaries

Ending balance = Salary &Wages Payable

5. Cash payments for interest and income taxes follows the same pattern as cash payments to employees.

6. Depreciation/Amortization does not affect cash and are not listed on the statement of cash flows (direct method).

7. Gains/losses on sale of property, plant, and equipment are not listed on the statement of cash flows as they do not affect cash.

D. Investing and financing activities are the same under both the direct and indirect methods.

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ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q9-1 Understand the statement of cash flow 1, 2 1-2 Easy Q9-2 Understand the statement of cash flow 1, 2 1-2 Easy Q9-3 Understand the statement of cash flow 1, 2 1-2 Easy Q9-4 Understand the statement of cash flow 1, 2 1-2 Easy Q9-5 Understand the statement of cash flow 1, 2 1-2 Easy Q9-6 Understand the statement of cash flow 1, 2 1-2 Easy Q9-7 Understand the statement of cash flow 1, 2 1-2 Easy Q9-8 Understand the statement of cash flow 1, 2 1-2 Easy Q9-9 Understand the statement of cash flow 1, 2 1-2 Easy Q9-10 Understand the statement of cash flow 3 1-2 Easy Q9-11 Understand the statement of cash flow 3 1-2 Easy Q9-12 Understand the statement of cash flow 3 1-2 Easy Q9-13 Understand the statement of cash flow 3 1-2 Easy Q9-14 Understand the statement of cash flow 3 1-2 Easy Q9-15 Understand the statement of cash flow 3 1-2 Easy Q9-16 Understand the statement of cash flow 3 1-2 Easy Q9-17 Understand the statement of cash flow 3 1-2 Easy Q9-18 Understand the statement of cash flow 3 1-2 Easy Q9-19 Understand the statement of cash flow 3 1-2 Easy Q9-20 Understand the statement of cash flow 3 1-2 Easy S9-1 Understand purposes of the statement of cash flows 1 10 Easy S9-2 Evaluate operating cash flows—indirect method 2 5-10 Easy S9-3 Report cash flows from operating activities— indirect method 3 5-10 Medium S9-4 Identify items for reporting cash flows from operations—indirect method 2 10 Easy S9-5 Prepare a statement of cash flows—indirect method 2, 3 10 Medium S9-6 Prepare a statement of cash flows using the indirect method 2, 3 15 Medium S9-7 (Critical Thinking) Compute investing and financing cash flows 3 20 Easy E9-8 Identify the purposes of the statement of cash flows 1 10-15 Medium E9-9 Identify activities for the statement of cash flows—indirect method 2 10-15 Medium E9-10 Classify transactions for the statement of cash flows—indirect method 2 5-10 Medium E9-11 Compute cash flows operating activities—indirect method 2, 3 10-15 Easy E9-12 Compute cash flows from operating activities—indirect method 3 15-20 Easy E9-13 Prepare the statement of cash flows—indirect method 2, 3 20-30 Easy E9-14 Interpret a statement of cash flows—indirect method 3 5-10 Easy E9-15 Compute investing and financing amounts for the statement of cash flows 3 5-10 Easy E9-16 Use the balance sheet and the statement of cash flows together 3 20 Easy E9-17 (Critical Thinking) Infer information about cash flows using the income statement and balance sheet 2, 3 20-30 Medium E9-18 (Critical Thinking) Interpret information in the statement of cash flows for use in preparing the balance sheet 2, 3 20-30 Medium E9-19 Describe and apply the Excel Quick Analysis button to visualize data 4 10 Easy E9-20 Describe and apply the Excel Quick Analysis button to visualize data 4 10 Easy P9-21A Use cash-flow data to evaluate performance 1, 2 15-30 Medium P9-22A Prepare an income statement, balance sheet, and statement of cash flows—indirect method 2, 3 40 Medium P9-23A Prepare the statement of cash flows— indirect method 2, 3 35-45 Difficult ..

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P9-24A (Critical Thinking) Prepare the statement of cash flows— indirect method 2, 3 35-45 Difficult P9-25A (Critical Thinking) Prepare the statement of cash flows— indirect method 2, 3 30-40 Medium P9-26B Use cash-flow information to evaluate performance 1, 2 15-30 Medium P9-27B Prepare an income statement, balance sheet, and statement of cash flows—indirect method 2, 3 40 Medium P9-28B Prepare the statement of cash flows— indirect method 2, 3 35-45 Difficult P9-29B (Critical Thinking) Prepare the statement of cash flows— indirect method 2, 3 35-45 Difficult P9-30B (Critical Thinking) Prepare the statement of cash flows— indirect method 2, 3 30-40 Medium Decision Case 1 Prepare and using the statement of cash flows to evaluate operations 3 45-60 Difficult Decision Case 2 Use cash-flow data to evaluate an investment 1, 2 15-25 Difficult Ethical Decision 1 Ethical Decision 2

ANSWER KEY TO CHAPTER 9 QUIZ 1. C 2. B 3. C 4. D 5. D 6. B 7. B 8. A 9. A 10. D

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Name:_

Date:

Section:

CHAPTER 9 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Which of the following does not describe one of the purposes of the statement of cash flows?

A. helps to predict future dividend payments.

B. helps to explain the relationship between net income and the change in cash for the year.

C. helps predict the future market value of the company’s shares.

D. helps to evaluate the company’s ability to meet debt payments as they come due.

2. Financing activities includes: A. interest expense paid on bonds payable.

B. cash received from issuing bonds payable.

C. cash paid for purchase of equipment.

D. Both A and B. 3. Investing activities includes: A. interest expense paid on bonds payable.

B. cash received from issuing bonds payable.

C. cash paid for purchase of equipment.

D. Both A and B. 4. If accrued liabilities decrease during the period, then: A. operating expenses were less than cash payments for expenses.

B. the increase should be added to operating expenses to calculate cash payments for operating expenses.

C. cash paid for accrued expenses must have been less than the amount expensed.

D. cash paid for accrued expenses must have been greater than the amount expensed.

5. PS Inc. reports the following information related to its most recent year. What is the correct amount of net cash flow from operating activities using the direct method?

Credit sales Collections from customers Interest received on investments Dividends paid to common shareholders Cost of goods sold Payments to inventory suppliers Depreciation expense Operating expenses Payments for operating expenses Interest and taxes paid

$556,000 450,000 1,000 9,000 331,000 310,000 12,000 68,000 66,000 19,000

A. $ 89,000 B. $ 74,000 C. $138,000 D. $ 56,000

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6. GHI Corp. sold a piece of equipment at a loss of $9,000. The equipment was purchased two years ago at a cost of $68,000 and had accumulated depreciation of $41,000. What is the amount that would be reported as cash flow from the sale of the equipment in the investing activities section?

A. $ 9,000 B. $18,000 C. $27,000 D. $36,000 7. MPS Inc. reported the following data: December 20X2 20X1 Building (net) $890,000 $920,000 Proceeds from sale of building 420,000 Gain on sale of building 20,000 Cost of building purchased during the year 390,000 What amount of depreciation was recorded for the year ended December 31, 20X1?

A. $10,000 B. $20,000 C. $30,000 D. $40,000 8. Which of the following would be reported as a noncash investing and financing activity?

A. Acquisition of Plant Property and Equipment in exchange for bonds B. A stock split C. Distribution of a stock dividend D. Conversion of bonds payable into common shares 9. Use the following information for VI Inc. to calculate net cash flows from operating activities by the indirect method: Net income Depreciation expense Increase in accounts receivable Decrease in inventory Increase in land Decrease in accounts payable Increase in salary payable Loss on sale of investments

$650,000 90,000 9,000 16,000 75,000 12,000 5,000 4,000

A. $744,000 B. $781,000 C. $771,000 D. $706,000 10. When using the indirect method to calculate cash flow from operating activities, which of the following adjustments would be included in the operating activities section?

A. Subtract Loss on the Sale of Investments B. Add a Gain on Disposal of Capital assets C. Add a decrease in Taxes Payable D. Add a decrease in Prepaid Insurance

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ASSIGNMENT GRID (APPENDIX 9A) Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty S9A-1 Prepare a statement of cash flows — direct method 2, A-1 15 Easy S9A-2 Prepare a statement of cash flows — direct method 2, A-1 15 Medium S9A-3 Compute operating cash flows — direct method A-1 15 Easy E9A-4 Identify activities for the statement of cash flows — direct method 2, A-1 10-15 Medium E9A-5 Classify transactions for the statement of cash flows — direct method 2, A-1 5-10 Easy E9A-6 Compute cash flows from operating activities —direct method 2, A-1 10-15 Easy E9A-7 Identify items for the statement of cash flows — direct method 2, A-1 5-10 Medium E9A-8 Prepare the statement of cash flows — direct method 2, A-1 20-30 Medium E9A-9 Compute amounts for the statement of cash flows —direct method A-1 10-15 Medium E9A-10 Compute cash flow amounts A-1 20-30 Easy P9A-11A Prepare the statement of cash flows —direct method 2, A-1 35-45 Easy P9A-12A Prepare an income statement, balance sheet, and statement of cash flows — direct method 2, A-1 40 Easy P9A-13A Prepare the statement of cash flows—direct method 2, A-1 30-40 Easy P9A-14A Prepare the statement of cash flows —direct method 2, A-1 45-60 Easy P9A-15A Prepare the statement of cash flows —direct method 2, A-1 45-60 Easy P9A-16B Prepare the statement of cash flows —direct method 2, A-1 35-45 Easy P9A-17B Prepare an income statement, balance sheet, and statement of cash flows—direct method 2, A-1 40 Medium P9A-18B Prepare the statement of cash flows— direct method 2, A-1 30-40 Difficult P9A-19B Prepare the statement of cash flows— direct method 2, A-1 45-60 Difficult P9A-20B Prepare the statement of cash flows— direct method 2, A-1 45-60 Medium Comprehensive Case for Chapter 9

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CHAPTER 10 Financial Statement Analysis CHAPTER OVERVIEW This chapter opens with an introduction to Empire Company Limited, which owns Sobeys, one of Canada’s leading grocery chains, to illustrate different kinds of financial statement analysis. The chapter is an extensive study of the three elements of financial statement analysis—horizontal, vertical, and ratio analysis. The chapter begins with the big picture—understanding the business and industry of the company. The chapter then provides a detailed explanation and illustration of horizontal analysis, including trend percentages, and vertical analysis including common-size statements. The practice of benchmarking against an industry standard and against a key competitor is explained. A mid-chapter summary problem covers both horizontal and vertical analysis.

The next part of the chapter introduces ratio analysis. The chapter divides ratios into the following five categories according to the type of analysis being performed: 1. Measuring the ability to pay current liabilities 2. Measuring turnover and cash conversion cycle 3. Measuring leverage: overall ability to pay debt 4. Measuring profitability 5. Analyzing stock as an investment The ratios in each category are explained and calculations are illustrated. The text discusses the limitations of ratio analysis and red flags to watch for in financial statement analysis. Decision Guidelines regarding ratios are also included. A summary problem asks students to compute certain ratios and then analyze the results.

LEARNING OBJECTIVES After studying Chapter 10, your students should be able to: 1. Perform an industry and company analysis.

2. Perform a horizontal analysis.

3. Perform a vertical analysis.

4. Prepare common-size financial statements.

5. Use ratios to make business decisions

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER Common-size percentages Using ratios in decision making Ratios measuring the ability to pay current liabilities and collect receivables Ratios measuring the ability to pay long-term debt Ratios measuring profitability RECOMMENDED Trend percentages Ratios analyzing shares as an investment

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CHAPTER OUTLINE OBJECTIVE 1: Perform an industry and company analysis A. Financial statement analysis is the use of financial statements, notes to the financial statements, the auditor’s report (management’s discussion and analysis of financial results— MD&A), and comparative financial data to analyze a company to make informed decisions.

B.

By analyzing various aspects of a company’s financial statements, you will be able to tell how a company’s financial performance compares overall to its recent history and its competitors.

C. What does it mean when a company’s sales increase from $26,588.2 million to $28,268.3 million over two consecutive years? What does it mean if net earnings increase from $612.8 million to $764.2 million over the same two consecutive years? To gain additional insights into these numbers, we need to read industry and company analyses, for example, the annual report or the Management’s Discussion and Analysis (MD&A) in a company’s annual report.

These reports may reveal the impact of external factors such as the impact COVID-19 lockdowns had on the industry and the company, or the company’s growth plans over the next three years and their effect on its core business and brand labels.

D. Once we have an understanding of the big picture, we can dig more deeply into the numbers and compare them to trends or different periods or different competitors.

E.

Exhibit 10-1 is a graphical representation of Empire Company Limited’s sales and net earnings for 2019 to 2021.

OBJECTIVE 2: Perform a horizontal analysis A. Horizontal analysis is the study of percentage changes from year to year.

1. Select data for two periods you wish to compare.

2. Compute the dollar difference between the two periods.

3. Divide this difference by the base period (the earlier period) amount. The result is the percentage change.

Exhibits 10-2 and 10-3 present a comparative income statement and comparative balance sheet, respectively, with horizontal analysis.

Teaching Tip Suppose PepsiCo. Inc. reported the following information (in millions) for the years ended December 31, 20X1, 20X2, and 20X3.

For the Years Ending Dec.31,20X3 Dec.31,20X2 Dec.31,20X1 Sales $20,917 $20,337 $19,067 Net Income 2,142 1,149 1,606 Compute percentage changes for Sales and Net Income from 20X2 to 20X3. % change in Sales = $20,917 −$20,337 $20,337 ..

= $580 = 2.9% increase $20,337 10-3

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% change in Net income = $2,142 − $1,149 $1,149

= $993 = 86.4% increase $1,149

B. Trend percentages, a form of horizontal analysis, show the trend in a particular financial statement item.

1. Begin by selecting a base period, which is always 100%.

2. Divide each period’s data by the base year to calculate a percentage.

3. Percentages are expressed in relationship to the base year, while percentage changes are expressed in relationship to the period immediately before.

Teaching Tip Using the information in the preceding Teaching Tip, calculate the trend percentage for Sales for the years ended December 31, 20X1, 20X2, and 20X3.

For theYears Ending Dec.31,20X3 Dec.31,20X2 Dec.31,20X1 Trend % for Sales = $20,917 = 109.7% $20,337 = 106.7% $19,067 = 100% $19,067 $19,067 $19,067 Sales increased 9.7% from the base period, December 31, 20X1.

OBJECTIVE 3: Perform a vertical analysis A. Vertical analysis shows the relationship of a financial item to a base amount on the financial statement.

B. Each period’s data is analyzed without respect to another period’s data, unlike horizontal analysis, which requires data from two periods.

1. On the income statement, each item is expressed as a percentage of total revenue.

The percentage for total revenue is always 100%. Exhibit 10-4 illustrates vertical analysis using the statement of earnings of Empire Company Limited.

2. On the balance sheet, each item is expressed as a percentage of total assets. The percentage for total assets is always 100%. Exhibit 10-5 illustrates vertical analysis using the balance sheet of Empire Company Limited.

Teaching Tip Using the information in the Teaching Tip above, compute the vertical analysis percentage for net income.

For theYearsEnding Dec.31,20X3 Dec.31,20X2 Dec.31,20X1 Vertical analysis % = $ 2,142 = 10.2% $20,917

$ 1,149 = 5.7% $20,337

$1,606 = 8.4% $19,067

Net income was 8.4% of every sales dollar in 20X1 but only 5.7% of every sales dollar in 20X2.

OBJECTIVE 4: Prepare common-size financial statements A. Common-size financial statements are statements that report only percentages (no dollar amounts).

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B. A change in a percentage from one period to the next may identify the need for corrective action.

C. Benchmarking is the comparison of a company to a standard set by others (e.g., industry averages).

D. Sometimes a direct comparison of companies of different sizes is difficult. Common-size percentages can make a comparison more effective. Exhibit 10-6 illustrates benchmarking against a key competitor by presenting the common-size income statements of Empire Company Limited and Metro Inc. OBJECTIVE 5: Use ratios to make business decisions A. Ratio analysis shows relationships among items on the financial statements. Many companies use ratios to assess the health and strength of a company. Exhibit 10-7 shows a summary of financial data and ratios for Apple Inc. B. Exhibits 10-8 and 10-9 show the consolidated statements of operations and the consolidated balance sheets of Apple Inc. The data are used to illustrate the various ratios.

C. Some ratios measure the firm’s ability to pay current liabilities.

1. Working capital measures the ability to pay current liabilities with current assets. The larger the working capital, the better the ability to pay current debt.

Working capital = Current assets – Current liabilities 2. The current ratio is a ratio of the current assets to the current liabilities. Acceptable current ratios vary from industry to industry.

Current ratio = Current assets Current liabilities Teaching Tip Suppose you were analyzing Company A and Company B, and the two companies reported the following:

Current assets Current liabilities Working capital

Company A $10,000 5,000 $ 5,000

Company B $10,000,000 9,995,000 $ 5,000

Both companies have identical working capital, but which company has a better ability to pay its short-term debt? Company A, because the ratio of the current assets to current liabilities is higher for Company A. Working capital is not a ratio; it does not calculate the relative size of the current assets to current liabilities. The current ratio provides a better understanding of the two companies’ liquidity.

Current ratio:

..

2 ($10,000/$5,000)

1.001 ($10,000,000/$9,995,000)

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Teaching Tip Remind students of the five categories of current assets that are listed in order of their liquidity: Cash, Short-term Investments, Receivables, Inventory, and Prepaid Expenses. Most annual reports show a subtotal for current assets and current liabilities, making the calculation of the current ratio and working capital fairly routine.

3. The quick (acid-test) ratio measures the quick assets—cash, short-term investments, and receivables (net of allowances) relative to current liabilities. This ratio excludes inventory and prepaid expenses, because these current assets are the least liquid current assets.

Quick ratio = (Cash + Short-term investments + Net current receivables) / Current liabilities D. Certain ratios measure turnover and the cash conversion cycle, key factors in a firm’s success.

1. Inventory turnover measures how many times a year the company sells its average level of inventory. A high turnover indicates relative ease of selling inventory.

Inventory turnover = Cost of goods sold Average inventory* *Average inventory is the average of beginning and ending inventory

2. Accounts receivable turnover measures how quickly the firm collects cash from credit customers. The higher the ratio, the more quickly a firm collects its receivables.

Accounts receivable turnover = Net credit sales Average net accounts receivable* *Average net accounts receivable is the average of beginning and ending receivables

3. Days’ sales in receivables reflects the number of days that sales remain as receivables and, therefore, uncollected.

Days’ sales in receivables = Average net accounts receivable (Net sales / 365 days)* *Average daily sales= Net sales/365 days Or Days’ sales in receivables = 365 days Accounts receivable turnover 4. Accounts payable turnover measures how quickly the firm pays off its accounts payable. The higher the ratio, the more quickly a firm collects its receivables.

Accounts payable turnover = Cost of goods sold Average accounts payable* *Average accounts payable is the average of beginning and ending payables.

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5. Days’ payable outstanding reflects the number of days the company takes to pay off its accounts payable.

Days’ payable outstanding = 365 days Accounts payable turnover E. Certain ratios measure leverage, the overall ability of a company to pay its debts.

1. The debt ratio shows the proportion of the company’s assets financed with debt. The higher the debt ratio, the greater the pressure to pay interest and principal.

Debt ratio = Total liabilities Total assets 2. The times-interest-earned (interest coverage) ratio indicates the number of times a company could pay its interest expense out of operating income. The higher the ratio, the greater the ease in paying interest payments.

Times-interest-earned = Income from operations Interest expense F. Certain ratios are used to measure profitability.

1. The gross (profit) margin is the ratio of gross profit (the profit that the entity makes from selling a product before other operating costs are subtracted) to net sales.

Gross profit % = Gross profit Net sales 2. Operating income (profit) percentage is net income from operations as a percentage of net sales.

Operating Income % = Operating income Net sales 3. The return (net profit margin) on sales shows the percentage of each sales dollar earned as net income.

Return on sales (Net profit margin) = Net income Net sales 4. The asset turnover measures the amount of net sales generated for each dollar invested in assets measuring how efficiently management is operating the company.

Asset turnover = Net sales Average total assets 5. The rate of return on total assets (ROA) measures how well a company is using its assets to earn profits. Interest expense is added back to net income, because the ratio is not measuring how a company finances its assets.

Rate of return on total assets = (Net income + Interest expense) Average total assets

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6. Leverage (equity multiplier) ratio measures the impact of debt financing on profitability. Using debt to finance assets can be profitable to the common shareholder; however, greater leverage creates greater risk that the debt and/or interest on the debt cannot be paid.

Leverage ratio = Average total assets Average common shareholders’ equity 7. The rate of return on common shareholders’ equity (ROE) measures how well a company is using capital invested by common shareholders to earn profits. a. If the return on assets is greater than the rate on borrowing, then the return on equity will be greater than the return on assets. A company is said to be trading on the equity.

Rate of return on common = Net income – Preferred dividends shareholders’ equity Average common shareholders’ equity 8. Earnings per common share (EPS) is the most widely quoted ratio; it must appear on the face of the income statement. EPS is the income generated by one common share.

Earnings per share

= Net income – Preferred dividends Average number of common shares outstanding

G. Certain ratios are used to analyze shares as an investment. Investors purchase shares to earn a return on their investment. This return consists of both gains (losses) from selling the shares and dividends.

1. The price/earnings (P/E or Multiple) ratio is the ratio of the market price to the EPS. A sharp increase in the P/E ratio may indicate that the shares should be sold.

Price/earnings ratio = Market price per common share EPS 2. Dividend yield measures the percentage of a stock’s market value returned annually to the shareholders as dividends. Dividend yield can be computed for common and preferred shares.

Dividend yield = Dividend per share Market price per share 3. The book value per common share is the net assets (assets – liabilities) per common share.

Book value has no relationship to the market value; therefore, the usefulness of book value is highly questionable.

Book value per common share outstanding

= Total shareholders’ equity – Preferred equity Weighted-average number of common shares

H. Sharp changes in ratios indicate that something significant has happened, but the manager must analyze the change to determine what has occurred and what corrective action must be taken.

I.

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Ratio analysis is most helpful when calculated over a broad time frame and when used in conjunction with other relevant information that can affect a company, such as legislation, competition, and scandals.

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J. Decision Guidelines summarize all the ratios, their computations, and the information provided by the ratios.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty Q10-1 Understand financial statement analysis 5 1-2 Easy Q10-2 Understand financial statement analysis 5 1-2 Easy Q10-3 Understand financial statement analysis 5 1-2 Easy Q10-4 Understand financial statement analysis 5 1-2 Easy Q10-5 Understand financial statement analysis 2 1-2 Easy Q10-6 Understand financial statement analysis 4 1-2 Easy Q10-7 Understand financial statement analysis 5 1-2 Easy Q10-8 Understand financial statement analysis 5 1-2 Easy Q10-9 Understand financial statement analysis 5 1-2 Easy Q10-10 Understand financial statement analysis 5 1-2 Easy Q10-11 Understand financial statement analysis 5 1-2 Easy S10-1 Perform a horizontal analysis of revenues and net income 2 5-10 Easy S10-2 Perform a trend analysis of sales and net income 2 5-10 Easy S10-3 Perform a vertical analysis to understand a cash shortage 3 10-15 Easy S10-4 Compare common-size income statements of two companies 4 10 Easy S10-5 Evaluate the trend in a company’s current ratio 5 5-10 Easy S10-6 Evaluate a company’s quick (acid-test) ratio 5 5-10 Easy S10-7 Compute and evaluate turnover and the cash conversion cycle 5 10-15 Easy S10-8 Measure ability to pay long-term debt 5 5-10 Easy S10-9 Measure profitability 5 10 Easy S10-10 Computing EPS and the price/earnings ratio 5 5-10 Easy S10-11 Use ratio data to reconstruct an income statement 5 10 Medium S10-12 Use ratio data to reconstruct a balance sheet 5 15-20 Medium E10-13 Compute year-to-year changes in working capital 2 5-15 Easy E10-14 Prepare horizontal analysis of an income statement 2 10-15 Medium E10-15 Compute trend percentages 2 5-10 Easy E10-16 Perform vertical analysis of a balance sheet 3 10-15 Medium E10-17 Prepare a common-size income statement 4 10-15 Medium E10-18 Evaluate the quality of earnings 1 10-15 Medium E10-19 Compute five ratios 5 10-15 Medium E10-20 (Critical Thinking) Analyze the ability to pay current liabilities 5 15-20 Medium E10-21 (Critical Thinking) Analyze profitability 5 10-15 Medium E10-22 Evaluate shares as an investment 5 10-15 Medium E10-23 Use ratio data to reconstruct a company’s balance sheet 5 10-15 Difficult E10-24 Use ratio data to reconstruct a company’s income statement 5 10-15 Difficult E10-25 Use trend percentages, common-size percentages, and ratios to reconstruct financial statements 2, 4, 5 30-40 Medium P10-26A Compute trend percentages, return on sales, asset turnover, and ROA, and compare with industry 1, 2, 5 20-30 Easy P10-27A Prepare common size financial statements and analyze ratios 4, 5 20-30 Medium P10-28A Analyze trends; calculate and interpret ratios 1, 2, 5 20-30 Medium P10-29A Understand the effects of business transactions on selected ratios 5 30-40 Medium P10-30A Use ratios to evaluate a share investment 5 40-50 Medium P10-31A Use ratios to decide between two share investments 5 45-60 Medium P10-32A (Critical Thinking) Analyze a company based on its ratios 5 15-20 Medium ..

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

P10-33A Compute ratios, evaluate turnover, liquidity, and current debt-paying ability 5 10-15 Easy P10-34B Compute trend percentages, return on sales, asset turnover, and ROA, and compare with industry 1, 2, 5 20-30 Medium P10-35B Prepare and evaluate common-size financial statements 3, 4, 5 20-30 Medium P10-36B Analyze trends; calculate and interpret ratios 1, 2, 5 20-30 Medium P10-37B Understand the effects of business transactions on selected ratios 5 30-40 Medium P10-38B Use ratios to evaluate a share investment 5 40-50 Medium P10-39B Use ratios to decide between two share investments 5 45-60 Medium P10-40B (Critical Thinking) Analyze a company based on its ratios 5 15-20 Medium P10-41B Compute ratios; evaluate turnover, liquidity, and current debt-paying ability 5 10-15 Easy Decision Case 1 Assess the effects of transactions on a company 5 30 Medium Decision Case 2 Analyze the effects of an accounting difference on the ratios 5 20-30 Difficult Decision Case 3 Identify action to cut losses and establish profitability 3, 5 20-30 Difficult Ethical Decision 1 Ethical Decision 2

ANSWER KEY TO CHAPTER 10 QUIZ 1. B 2. D 3. C 4. B 5. C 6. D 7. B 8. D 9. D 10. A

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Name:________________________ Date:_________________ Section__________ CHAPTER 10 TEN-MINUTE QUIZ Circle the letter of the best response.

Account Cash Accounts receivable Inventory Capital assets Less: Accumulated amortization Total assets

Assets 20X2 $ 400 1,600 2,750 12,050 (2,300) $14,500

Table 10-1 Balance Sheet As at December 31, 20X2 and 20X1 Liabilities and Shareholders’ Equity 20X1 Account 20X2 20X1 $ 520 Accounts payable $ 1,500 $ 1,800 2,000 Accrued expenses 500 400 payable 3,480 Bonds payable 2,500 5,000 14,800 Common shares 8,250 10,250 (1,300) Retained earnings 1,750 2,050 $19,500

Total liabilities and shareholders’ equity

$14,500

Table 10-1 Income Statement For the Years Ended December 31, 20X2 and 20X1 20X2 20X1 Net sales $24,000 $21,000 Cost of goods sold 18,000 16,000 Gross margin 6,000 5,000 Operating expenses 3,900 3,500 Operating income 2,100 1,500 Interest expense 300 200 Income before income tax 1,800 1,300 Income tax 600 400 Net income $ 1,200 $ 900 1. Refer to Table 10-1. The percentage change in Net Sales is: A. 7.0%.

B. 14.3%.

C. 12.5%.

D. 87.5%.

2. Refer to Table 10-1. The common-size percentage for 20X2 Operating Income is: A. 40%.

B. 175%.

C. 7.1%.

D. 8.75%.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

3. Refer to Table 10-1. The acid-test ratio for 20X2 is: A. 1.33.

B. 2.38.

C. 1.00.

D. 0.44.

4. Refer to Table 10-1. The return on assets for 20X2 is: A. 8.8%.

B. 7.1%.

C. 10.3%.

D. 8.3%.

5. Which of the following is a measure of the ability of a business to pay its short-term debt?

A. times-interest-earned B. inventory turnover C. current ratio D. dividend yield 6. Which of the following statements is true?

A. In trend analysis, each item is expressed as a percentage of the final year.

B. On a common-size income statement, the 100% figure is Net Income.

C. A primary purpose of vertical analysis is to determine trends.

D. It is possible for the dollar amount of an income statement item to increase while its commonsize percentage decreases.

7. Which of the following is (are) used to measure a company’s profitability?

Return on Equity, Earnings Per Share, Dividend Yield A. yes, yes, yes B. yes, yes, no C. no, no, yes D. no, yes, yes 8. Which of the following statements is true?

A. Benchmarking is the practice of comparing a company to an arbitrary standard set by other companies.

B. Companies can be compared to industry averages but this is rarely done.

C. Successful companies generate the greatest percentage of their cash from selling assets.

D. A sudden change in a ratio can indicate a potential problem that should be investigated by the analyst.

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9. JJ Co. reported the following information for 20X1 and 20X2:

Sales Cost of goods sold Inventory turnover

20X1 $100,000 50,000 4

20X2 $120,000 66,000 6

Given these facts, which of the following statements is true?

A. Accounts receivable increased.

B. Average inventory increased.

C. Cost of goods sold decreased.

D. Average inventory decreased.

10. Which of the following is a measure of the ability of a business to pay its long-term debt?

A. times-interest-earned B. inventory turnover C. current ratio D. dividend yield

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

Appendix A Investments and the Time Value of Money APPENDIX OVERVIEW The Appendix begins with an introduction to Loblaw Companies Limited, which holds several different types of investments. The Appendix reviews share investments, discusses share prices and reporting investments on the balance sheet, and explains the various investments (non-strategic, strategic investments: subject to significant influence, and investments in subsidiaries) according to the percentage of ownership held by the investor. Measurement of non-strategic investments must be at fair value with unrealized gains/losses recognized as part of Other Comprehensive Income.

Any investee dividends are treated as investment income. Upon disposition, any amounts reflected in Accumulated Other Comprehensive Income relating to the investment being disposed of must be eliminated from the accounts. The equity method, used when the investor holds 20-50% of the investee’s voting shares, is explained and various transactions are illustrated.

The consolidation method (parent holds more than 50% of the investee corporation’s voting shares) is presented and consolidation accounting is explained. Goodwill and non-controlling interest are described briefly, as is the income of a consolidated entity.

The accounting for long-term investments in bonds is explained and illustrated. Investments in long-term bonds measured at their amortized cost based on the effective interest rate method is discussed. The recognition of a premium or discount based on a comparison of market rates and the bond’s coupon rate, which affects interest expense recognized over the term of the bond, is explained. Decision Guidelines show which accounting method to use for each type of long-term investment. A mid-chapter summary problem reviews cost, equity, and consolidation methods of accounting for investments.

The second part of the Appendix begins with reporting the investing activities related to long-term investments on the statement of cash flows. The Appendix concludes with a discussion on future and present values, and determining the price of a bond. A final summary problem helps the student review the consolidation process.

LEARNING OBJECTIVES After studying Appendix A, your students should be able to: 1. Analyze and report non-strategic investments.

2. Analyze and report strategic investments.

3. Analyze and report long-term investments in bonds.

4. Report investing activities on the statement of cash flows.

5. Explain the impact of the time value of money on certain types of investments.

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Appendix A – 1

Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

SUGGESTED PRIORITY OF APPENDIX TOPICS MUST COVER Accounting for non-strategic investments Accounting for strategic investments Accounting for equity-method investments Consolidation Accounting Consolidation of Foreign Subsidiaries Accounting for long-term investments in bonds

RECOMMENDED Present and future value and determining the price of a bond IF TIME PERMITS Reporting investing activities on the statement of cash flows

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

APPENDIX OUTLINE A. Share investments are shares of a corporation (the investee) that have been purchased by an investor.

B. Reporting investments on the balance sheet is illustrated in Exhibit A-1.

C. Investments may be short term or long term: 1. Short-term share investments, also called temporary investments or marketable securities, are current assets and are listed on the balance sheet. These investments must be liquid and the investor must intend to sell them within one year or use it to pay a current liability.

2. Long-term investments are all other investments, including bonds and shares that the investor expects to hold for more than one year. Refer to Exhibit A-1 for the balance sheet presentation of investments.

D. There are two categories of long-term share investments that are dependent on the percentage of ownership held: 1. Non-strategic investments where the investor owns less than 20% of the voting shares of the investee and have no influence over the affairs of the investee.

2. Strategic investments: a. subject to significant influence where the investor owns between 20% and 50% of the voting shares of the investee and is subject to significant influence. b. include investments in a subsidiary, which is a company controlled by a parent company that owns more than 50% of the voting shares of the subsidiary.

OBJECTIVE 1: Analyze and report non-strategic investments A. Non-strategic investments are accounted for at fair value.

1. The original purchase of a non-strategic investment is recorded at cost, with a debit to Long-Term Investment.

2. Cash dividends received are reported as dividend revenue when received; stock dividends are reported with a memo entry only.

B. At each reporting date, the investment must be measured at fair value with any unrealized gains or losses reflected in Other Comprehensive Income, which is then transferred to Accumulated Other Comprehensive Income, which is a component of Shareholder’s Equity.

The entries to record for a fair value decline are as follows: Other Comprehensive Income (Unrealized Loss) XX Long-Term Investment

XX

Accumulated Other Comprehensive Income XX Other Comprehensive Income (unrealized loss) XX C. When a non-strategic investment is sold, any amounts reflected in Accumulated Other Comprehensive Income must be eliminated and a realized gain or loss is recorded reflecting the difference between the amount received and the carrying amount of the investment. The realized gain or loss is reported as “other” income or loss on the income statement. ..

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Teaching Tip Early in 20X1, Bradley Corp. purchased as a portfolio security (long-term investment) 1,000 shares of ABC for $50 per share. On the December 31, 20X1 balance sheet date, the market value per share had fallen to $47 per share. When the shares are later sold during 20X2 at a price of $51 per share, what entry must Bradley make?

Cash 51,000 Gain on Sale of Portfolio Investments Portfolio Investment

4,000 47,000

OBJECTIVE 2: Analyze and report strategic investments A. Long-term investments between 20% and 50% of the investee’s outstanding shares may significantly influence how the investee operates its business and requires the use of the equity method to account for the investment.

Teaching Tip An investor who owns 20% of a company’s shares can usually elect 20% of the board of directors and influence company decisions. With more than 50% control (majority ownership), the investor can control the company’s affairs.

B. The investment is initially recorded at cost.

C. The investor’s percentage of ownership is applied to record its share of the investee’s net income as shown below: Long-Term Investment XX Investment Revenue XX D. Dividends received by the investor decrease the investment account and are recorded as follows: Cash XX Long-Term Investment XX E. Gain or loss on the sale of an equity-method investment is the difference between the sale proceeds and the carrying amount of the investment.

F. Equity method investment transactions may be summarized in a T-account as follows: Equity-Method Investment Original cost Share of losses Share of income Share of dividends = Ending balance

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Teaching Tip Use a T-account to answer this question. Have students quickly calculate the gain or loss on the sale of this equity-method investment: Day Corp. purchased 5,000 shares (40%) of Night Inc. for $60,000. During the year, Night Inc. paid a total of $30,000 in dividends and reported earnings of $90,000. One-half of the investment is sold for $44,000.

Long-Term Investment 60,000 12,000 36,000 84,000 Given that the selling price of $44,000 is $2,000 more than one-half of the carrying amount of $42,000, Day Corp. will record a $2,000 gain on the sale of the investment.

G. Consolidation accounting is required when the investor or parent has a controlling (greater than 50%) interest in the outstanding shares of the investee or subsidiary company.

H. Consolidation accounting combines financial statements of two or more companies that are controlled by the same owners into one set of consolidated statements. (Exhibit A-2 illustrates the accounting method to be used according to the percentage of ownership) 1. Consolidated financial statements help provide better insight into the total operations of the parent and its subsidiaries. Exhibit A-3 shows a work sheet for a consolidated balance sheet.

2. Both parent and subsidiaries keep their own separate set of books.

3. Parent company uses a work sheet to consolidate the two balance sheets.

4. Investment in Subsidiary accounts are eliminated, as are intercompany receivable accounts.

I. Goodwill and non-controlling (minority) interest are reported on a consolidated balance sheet.

1. Goodwill arises when a parent company’s purchase price of the subsidiary is greater than the fair value of its net assets.

2. Non-controlling interest, arises when a parent company purchases less than 100% of the subsidiary’s shares.

J. The income of the parent company is combined with the income of each subsidiary beginning with sales revenue. All intercompany sales and expenses are eliminated.

OBJECTIVE 3: Analyze and report long-term investments in bonds A. Bonds can be classified as either short term (current asset) or long term, however, short-term investments in bonds are rare. Some of the characteristics of bonds include: 1. Bonds of public companies are traded on the open market like shares.

2. Bonds are usually issued in $1,000 face (par) denominations and typically do not sell at par value.

3. Bonds are sold at a discount when the market price is higher than the coupon (interest) rate on the bond.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

4. Bonds are sold at a premium when the market price is lower than the coupon (interest) rate on the bond.

5. Bond investments are recorded at cost (market price as a percentage of par value of bonds issued).

6. Interest revenue is recorded by the investor at each semi-annual interest payment date.

7. Premiums and discounts are amortized by adjusting the carrying amount of the bond up or down toward its face value.

8. Amortization is calculated using the effective interest method (or the straight-line method under ASPE).

B. IFRS requires bond investments that are held to maturity to be valued at amortized cost, which determines the carrying amount. Designation as held-to-maturity avoids measurement of the investment at fair value. From the date of acquisition to maturity, the investment is measured at amortized cost using the effective interest rate method.

C. The discount or premium is amortized directly to the Investment account; amortizing the discount increases the Investment account, while amortizing the premium reduces the Investment account. With respect to interest income, amortizing the discount increases interest income while amortizing the premium decreases interest income.

Teaching Tip On November 1, 20X1, Hadley Corporation purchased a long-term, $20,000 bond investment at 106. The 8% bonds pay interest on May 1 and November 1 each year and mature in 5 years. Using the straight-line method of amortization, what are the entries required at December 31, 20X1? First record accrued interest receivable for 2 months ($20,000 × 0.04 × 2 / 6 = $267) Interest Receivable 267 Interest Revenue 267 Then record two months of premium amortization ($20,000 × 1.06 = $21,200; $21,200 − $20,000 = $1,200 premium to be amortized over 60 months; $1,200 / 60 = $20 per month; $20 × 2 months = $40) Interest Revenue 40 Long-Term Investment in Bonds 40 Note that the carrying amount on the December 31, 20X1 balance is the bonds’ amortized cost, or $21,160 ($21,200 – $40). Amortizing the premium reduces the carrying amount, while amortizing a discount increases the carrying amount.

D. Decision Guidelines summarize the different accounting methods used for long-term investments of both shares and bonds.

OBJECTIVE 4: Report investing activities on the statement of cash flows A. Along with purchases and sales of long-lived assets, purchases and sales of investments in the shares and bonds of other companies are also reported as investing activities on the cash flow statement.

B. Empire Company Limited’s Consolidated Statement of Cash Flows (Exhibit A-4) illustrates how a successful company manages its investing activities.

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C. While operating activities are the major source of cash for a business, investing activities are usually viewed to be the next most important activity for a company and are listed as the second category on the statement of cash flows.

OBJECTIVE 5: Explain the impact of the time value of money on certain types of investments A. Future value (FV) means the amount of money that a given current investment will be worth at a specified time in the future, assuming a certain interest rate. (Exhibit A-5 illustrates a future value example).

B. The time value of money means that “$1 today is not worth a $1 tomorrow” as money earns interest over time. The difference between an investment today (the present value) and the future value of the investment is the amount of interest revenue earned.

C. Compound interest is the interest earned on principal as well as interest received on interest earned.

D. To calculate the future value of an investment, three inputs are required: 1. Amount of initial payment (receipt) 2. The length of time between investment and future receipt (payment) 3. Interest rate E. Present value (PV) means the value on a given date of a future payment or series of future payments, discounted to present day to reflect the time value of money. The same three inputs to calculate future value are required to calculate present value. (Exhibit A-6 illustrates a present value example and Exhibit A-7 is a present value table).

F. Annuity investments provide multiple receipts of an equal amount at fixed intervals over an investment’s duration. (Exhibit A-8 illustrates a present value of annuity table).

G. The fair value for publicly traded stocks and bonds can be determined through the quoted price from the financial media. The fair value of other types of investments such as notes, non-publicly traded bonds or stocks, contracts, and annuities are valued according to discounted expected cash flows.

H. The present value of a bond or its market price, is the present value of the future principal amount at maturity plus the present value of the future stated interest payments.

1. Principal must be present valued using the factors for a single amount.

2. Interest must be present valued using the factors for an annuity.

I.

A summary of IFRS-ASPE differences is presented.

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

ASSIGNMENT GRID Assignment, Topic(s), Learning Objective(s), Estimated Time in Minutes, Level of Difficulty QA-1 Understanding long-term investments and the time value of money 1 1-2 Easy QA-2 Understanding long-term investments and the time value of money 1 1-2 Easy QA-3 Understanding long-term investments and the time value of money 1 1-2 Easy QA-4 Understanding long-term investments and the time value of money 1 1-2 Easy QA-5 Understanding long-term investments and the time value of money 1 1-2 Easy QA-6 Understanding long-term investments and the time value of money 1 1-2 Easy QA-7 Understanding long-term investments and the time value of money 1 1-2 Easy QA-8 Understanding long-term investments and the time value of money 1 1-2 Easy QA-9 Understanding long-term investments and the time value of money 1 1-2 Easy QA-10 Understanding long-term investments and the time value of money 1 1-2 Easy SA-1 Analyze and report a non-strategic investment 1 10-15 Easy SA-2 Account for the sale of a non-strategic investment 1 5-10 Easy SA-3 Analyze and report a 40% investment in another company 2 10-15 Easy SA-4 Account for the sale of an equity-method investment 2 5 Easy SA-5 Understand consolidated financial statements 2 10 Medium SA-6 Understand goodwill and non-controlling interest 2 10 Easy SA-7 Analyze and report a bond investment 3 10-15 Medium SA-8 Record bond investment transactions 3 10 Easy SA-9 Calculate present value 5 5-10 Easy SA-10 Calculate the present value of an investment 5 5-10 Easy SA-11 Report investing activities on the statement of cash flows 4 5 Medium SA-12 Calculate present value 5 5-10 Easy SA-13 Calculate the present value of an investment 5 5-10 Easy EA-14 Record transactions for a non-strategic investment 1 10-15 Medium EA-15 Analyze and report non-strategic investments 1 15-25 Easy EA-16 Account for transactions under the equity method 2 10-15 Easy EA-17 Analyze gains or losses on equity-method investments 2 10-15 Easy EA-18 Apply the appropriate accounting method for a 25% investment 2 15-20 Medium EA-19 Analyze and report bond investment transactions 3 15-20 Medium EA-20 Calculate the present value of a bond investment 5 5-10 Easy EA-21 Prepare a consolidated balance sheet 2 20-25 Medium EA-22 Prepare and use a statement of cash flows 4 15-20 Easy EA-23 Use a statement of cash flows 4 20-25 Medium EA-24 Calculate the present value of competing investments 5 20-25 Medium EA-25 Explain and analyze accumulated other comprehensive income 1, 6 20 Medium PA-26A Analyze and report various long-term investment transactions on the balance sheet and income statement 1, 2 20-30 Medium PA-27A Analyze and report non-strategic and equity-method investments 1, 2 45-60 Medium PA-28A Analyze consolidated financial statements 2 20-30 Difficult PA-29A Analyze and report a bond investment 3 45-60 Difficult PA-30A Explain the impact of the time value of money on valuation of investments 5 20-25 Medium PA-31A Prepare a consolidated balance sheet 2 20-25 Medium PA-32A Use the statement of cash flows 4 20-25 Medium ..

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PA-33A Analyze consolidated financial statements 2, 2 20-30 Medium PA-34B Analyze and report various long-term investment transactions on the balance sheet and income statement 1, 2 20-30 Medium PA-35B Analyze and report non-strategic and equity-method investments 1, 2 45-60 Medium PA-36B Analyze and report a bond investment 3 45-60 Medium PA-37B Explain the impact of the time value of money on the valuation of investments 5 20 Medium PA-38B Analyze consolidated financial statements 2 20-30 Medium PA-39B Use the statement of cash flows 4 20-25 Medium PA-40B Analyze consolidated financial statements 2 30 Medium Decision Case 1 Make an investment decision 2 15-20 Difficult Decision Case 2 Make an investment sale decision 1, 2, 3 20-30 Difficult Ethical Decision

ANSWER KEY TO APPENDIX B QUIZ 1. C 2. C 3. C 4. D 5. A 6. C 7. D 8. A 9. A 10. B

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Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

Name:_

Date:

Section:

APPENDIX B TEN-MINUTE QUIZ Circle the letter of the best response.

1. At each reporting date, non-strategic investments must: A. be measured at fair value with any realized gains or losses.

B. not be re-measured at fair value.

C. be measured at fair value with any unrealized gains or losses.

D. be measured at book value with any unrealized gains or losses.

2. NB Inc. has a short-term investment in shares of SGC that it had purchased for $42,000. At yearend, the investment has a market value of $40,000. The $2,000 decrease in value of the short-term investment should: A. be added to the value of the asset on the balance sheet.

B. be recorded as a realized loss on the income statement.

C. be recorded as an unrealized loss in other comprehensive income.

D. be added to shareholders’ equity.

3. XY Company purchased 30% of the outstanding shares of Z Corporation for $68,000. During the year, Z pays dividends of $10,000 and reports net income of $100,000. At year-end, the shares have a market value of $92,000. The year-end balance sheet of XY Co. will report Long-Term Investment of: A. $86,000.

B. $90,000.

C. $95,000.

D. $168,000.

4. Which one of these statements related to consolidations is true?

A. When a corporation owns 20% - 50% of another company’s shares, both companies must report consolidated financial statements for the period.

B. Minority Interest results if the parent company does not purchase 90% of the subsidiary company.

C. Both the parent company and the subsidiary company maintain a single set of accounting records.

D. Goodwill results when the parent company pays more to acquire a subsidiary company than the market value of the subsidiary’s net assets.

5. On March 1, 20XX, SL Inc. purchases $150,000 of 10%, 5-year bonds at 100. Interest is paid semi-annually on March 1 and September 1. The company considers these bonds a long-term investment, and uses the straight-line method to amortize any premium or discount. What total amount of Interest Revenue would be recorded by SL on September 1, 20XX? A. $7,500 B. $6,600 C. $8,400 D. $900

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Appendix A – 10

Instructor’s Resource Manual for Thomas et al., Financial Accounting, 8Ce

6. AB Company purchased 50% of the outstanding shares of C Corporation for $80,000. During the year, C pays dividends of $5,000 and reports net income of $45,000. At year-end, the shares have a market value of $90,000. The year-end balance sheet of AB Co. will report Long-Term Investment of: A. $80,000.

B. $90,000.

C. $100,000.

D. $180,000.

7. The amortization of discounts: A. increases the investment account and decreases interest income.

B. decreases the investment account and increases interest income.

C. decreases the investment account and interest income.

D. increases the investment account and interest income.

Table A-1 Included among Glass Corporation’s cash flows for the year are the following: Cash paid to purchase equipment ($98,000) Cash received from sale of land $168,000 Cash received from borrowing on a long-term note $75,000 Cash paid to purchase long-term investment ($55,000) Interest revenue received on long-term investment $11,250 8. Refer to Table A-1. What amount should Glass Corporation report as net cash flows from investing activities on its current year cash flow statement?

A. $15,000 B. $26,250 C. $90,000 D. $101,250 9. Refer to Table A-1. What amount should Glass Corporation report as net cash flows from financing activities on its current year cash flow statement?

A. $75,000 B. $86,250 C. $11,250 D. $70,000 10. Suppose you have $15,000 that you can invest and earn 8% interest over the next 5 years. How much will you have at the end of the five years?

A. $22,000 B. $22,040 C. $22,161 D. $22,200

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Appendix A – 11