Horngrens Financial & Managerial Accounting, The Financial Chapters, 8th edition Tracie Miller Nobl

Horngren's Financial and Managerial Accounting, The Financial Chapters Instructor's Resource Manual Johnny Howard Horngren's Financial & Managerial Accounting (The Financial Chapters) 8th Edition

Miller-Nobles Tracie, University of Kansas Mattison Brenda, University of Kansas

Chapter 1 Accounting and the Business Environment

Chapter 1: Overview The chapter begins with an introduction to accounting and a brief discussion of why accounting is important. The differences between financial and managerial accounting are delineated. The text discusses how accounting information is needed by various users—individuals, businesses, investors, creditors, and taxing authorities. Reasons accounting is important to students not majoring in accounting and career paths available to accounting majors are briefly described, including a comparison of various accounting positions. The role of governing organizations such as the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) as well as the FASB’s relationships with both congressionally created and private accounting groups are explained. Generally Accepted Accounting Principles (GAAP) are introduced. The sole proprietorship, partnership, corporation, and limited liability company (LLC) forms of business are briefly described in the context of the economic entity assumption. In addition, the cost principle, going concern assumption, and monetary unit assumption are explained. The nature of International Financial Reporting Standards (IFRS) and the role of the International Accounting Standards Board (IASB) in their development are explained. The role of ethics in accounting and business is described. The U.S. government’s passing of the Sarbanes-Oxley Act (SOX) and the creation of the Public Company Accounting Oversight Board (PCAOB) are presented. A Data Analytics in Accounting feature highlights the importance of data analytics skills for accountants.

The next section of the chapter introduces the accounting equation: Assets = Liabilities + Equity. Each element of the accounting equation is defined. Nine basic business transactions are analyzed, and their impact on the accounting equation is discussed. The financial statements—income statement, statement of retained earnings, balance sheet, and statement of cash flows—are illustrated. The interrelationship of the financial statements is emphasized.

A Tying It All Together feature poses four questions regarding a company’s asset, liability, revenue, and expense accounts and the proper financial statement reporting for each. Financial statements and return on assets (ROA) are used to evaluate business performance. An additional question asks students to evaluate the impact COVID-19 has had on a corporation’s recent financial statements. A Decisions feature helps students see how financial statements and ROA can be used to make real-world decisions.

The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding feature allows students to record the effects of transactions on the accounting equation, prepare financial statements, and calculate ROA. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 1: Learning Objectives LO 1. Explain why accounting is important and list the users of accounting information LO 2. Describe the organizations and rules that govern accounting LO 3. Describe the accounting equation and define assets, liabilities, and equity LO 4. Use the accounting equation to analyze transactions LO 5. Prepare financial statements LO 6. Use financial statements and return on assets (ROA) to evaluate business performance

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Chapter 1: Teaching Outline with Lecture Notes LO 1. Explain why accounting is important and list the users of accounting information a) Define the term accounting and explain what accountants do b) Exhibit F:1-1: Pathways Vision Model Lecture Notes: The model emphasizes that good decisions have an impact on accounting judgments and economic activity, thus creating a circular flow of cause and effect. Accounting is defined as the information system that measures business activities, processes the information into reports, and communicates the results to decision makers. However, accountants do not simply prepare various types of accounting reports and tax returns. They also review and interpret business information using critical thinking and judgment to partner with clients and managers to help them make better business decisions. c) Differentiate between financial accounting and managerial accounting d) Exhibit F:1-2: Decision Making: Financial Versus Managerial Accounting Lecture Notes: Financial accounting provides historical information—the company reports on events that have already occurred—to external decision makers, including investors and creditors.

Managerial accounting provides more future-oriented information—many companies prepare budgets, forecasts, and projections based on future events—for internal decision makers (company managers and executives). e) Identify the users of accounting information: i.

Individuals

ii.

Businesses

iii.

Investors

iv.

Creditors

v.

Taxing authorities

Lecture Notes: The officers of a company may be (and probably are) stockholders as well. Not all investors are “outside” the company. The financial statements are the primary tools for providing information to outside investors; but officers may also use the statements, along with other financial information, to manage the company on a day-to-day basis. f) Describe career options and certifications available in the accounting profession Lecture Notes: Certified Public Accountants, or CPAs, are licensed professional accountants who serve the general public. Certified Management Accountants, or CMAs, are certified professionals

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who specialize in accounting and financial management knowledge. Not all accountants are licensed, and those who are may not necessarily be members of the AICPA and IMA, the professional associations described in the textbook. There are many other types of accounting-related associations and certifications in the United States and elsewhere around the world, including Certified Internal Auditor (CIA), Certified Government Financial Manager (CGFM), Certified Fraud Examiner (CFE), Certified Financial Manager (CFM), Enrolled Agent (EA), Certified Global Management Accountant (CGMA), Chartered Accountant (CA), Certified Financial Planner (CFP), and many more.

Accountants also need data analytics skills to be successful. An understanding of how technology is used to process financial information is critical in today’s job market. g) Exhibit F:1-3: Comparison of Accounting Positions Suggested In-Class Exercise: E1-17 LO 2. Describe the organizations and rules that govern accounting a) Identify accounting governing organizations, including the Financial Accounting Standards Board (FASB), the Security Exchange Commission (SEC), and the International Accounting Standards Board (IASB) b) Describe Generally Accepted Accounting Principles (GAAP) and introduce the primary objective of financial reporting c) Explain the economic entity assumption i.

Identify the different types of business organizations: ▪

Sole proprietorship

▪

Partnership

▪

Corporation

▪

Limited-liability company (LLC)

ii.

Exhibit F:1-4: Business Organizations

iii.

Describe the distinguishing characteristics and organization of a corporation: ▪

Separate legal entity

▪

Continuous life and transferability of ownership

▪

No mutual agency

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iv.

▪

Limited liability of stockholders

▪

Separation of ownership and management

▪

Corporate taxation

▪

Government regulation

▪

Organization of a corporation

Exhibit F:1-5: Structure of a Corporation

Lecture Notes: Corporate status is not based on the size of the company. Not all large companies are corporations, and not all small companies are sole proprietorships or partnerships. A corporation could have only one stockholder. Why would a one-shareholder business incorporate the business in this case? One reason is limited liability protection. Regardless of the number of stockholders, all corporations follow the same general corporate procedures. d) Explain the cost principle e) Explain the going concern assumption Lecture Note: Point out to students that if it is known that a company should not be considered a going concern, different accounting rules from those covered in this course apply to that company. f) Explain the monetary unit assumption Lecture Note: Point out to students that an implication of the monetary unit assumption is that business activities that cannot be expressed in monetary units are not represented within the financial statements. For example, a company with a well-trained workforce, talented managers, a good reputation with customers, and innovative research and development has important assets that are not represented on the balance sheet. g) Describe International Financial Reporting Standards (IFRS) h) Ethics in accounting and business i.

Sarbanes-Oxley Act (SOX)

ii.

Public Company Accounting Oversight Board (PCAOB)

Lecture Notes: Not all accounting information and financial statements are publicly available; such information is disclosed by public companies only. Company size is not a determinant of public ownership; some large companies are still privately held. All companies, public and private, can follow GAAP. However, this may not be a requirement for private companies. Private companies can use other bases of accounting, such as the cash basis, unless GAAP is required due to an audit.

There is also a difference between record keeping and financial statement preparation. Companies can keep their accounting records on another basis and convert the financial statements to GAAP. .

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For example, small private companies may use the cash basis for record keeping and convert to the accrual basis for financial statement preparation.

The Sarbanes-Oxley Act and the PCAOB relate to public companies. As a rule, public companies are more regulated (in terms of accounting information) than private companies. Some companies are now going private; one reason for doing so may be to reduce the compliance cost associated with these additional regulations.

Although much has been written and discussed about the possibility of convergence of U.S. GAAP and IFRS, complete convergence appears to be increasingly unlikely. The SEC previously announced a policy dedicated to investigating endorsement of IFRS, but political winds now seem to be shifting. Furthermore, standard setting paths of FASB and IASB sometimes converge, as in recent development of unified revenue recognition standards, but sometimes fail to converge, as in recent issuance of very different guidance on leases. For now, U.S. GAAP continues to be different in many respects from IFRS, a condition which seems likely to continue for the foreseeable future, although efforts to increase similarities also continue to meet with some degree of success.

Suggested In-Class Exercise: E1-18 LO 3. Describe the accounting equation and define assets, liabilities, and equity a) The accounting equation: Assets = Liabilities + Equity b) Define assets c) Define liabilities d) Define equity Lecture Notes: The accounting equation must always balance. Demonstrate that the accounting equation always balances, not just at the beginning of the year (or any accounting period). During the year, the change in assets equals the change in liabilities plus the change in equity. At the end of the year, the new values of the accounting equation will balance.

Beginning of Year During the Year End of Year

Assets = Δ Assets = New Assets =

Liabilities + Δ Liabilities + New Liabilities +

Equity. Δ Equity.

New Equity.

Discuss with students that while most textbook examples show companies that are profitable from the very beginning and always have positive equity balances, stockholders’ equity can be negative if liabilities exceed assets, but the accounting equation would still balance. If a company records net losses in the very beginning, Retained Earnings will be negative, and the company will record Accumulated Deficit instead of Retained Earnings. For example, a company could have $100 of assets, $150 of liabilities, and $(50) of equity, and the accounting equation would equal $100 on each side. While this position is usually not desirable, it is not unusual in the business world, especially for new businesses.

Suggested In-Class Exercise: E1-21 .

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LO 4. Use the accounting equation to analyze transactions a) Transaction analysis for Smart Touch Learning i.

Transaction 1—Stockholder contribution

ii.

Transaction 2—Purchase of land for cash

iii.

Transaction 3—Purchase of office supplies on account

iv.

Transaction 4—Earning of service revenue for cash

v.

Transaction 5—Earning of service revenue on account

vi.

Transaction 6—Payment of expenses with cash

vii.

Transaction 7—Payment on account (Accounts Payable)

viii.

Transaction 8—Collection on account (Accounts Receivable)

ix.

Transaction 9—Payment of cash dividend

b) Exhibit F1-6: Analysis of Transactions, Smart Touch Learning Lecture Notes: Every basic transaction always affects at least two accounts. Becoming familiar with each of the nine basic transactions and the two accounts affected by each will promote development of students’ transaction analysis skills. Demonstrate the following transaction analysis process for each transaction: 1. Identify the accounts and the account type.

2. Decide if each account increases or decreases.

3. Determine if the accounting equation is in balance.

When this process is applied correctly, the accounting equation will always balance. Thus, for all transactions that occur during the year: Δ Assets =

During the Year

Δ Liabilities +

Δ Equity

Note that every transaction affects the balance sheet in some way—increasing or decreasing an asset, liability, or equity account—but may or may not affect another financial statement. Remind students that there are two main components of equity: contributed capital and retained earnings. Retained earnings is affected by three types of events: revenues, expenses, and dividends. Thus, there are four ways that equity can change during the year:

Δ Assets =

During the Year

.

+ Contributed Capital + Revenues Δ Liabilities − Expenses − Dividends

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Some students may be confused by how the issuance of stock increases a company’s equity. “If the company sells the stock and receives cash in return, how is the stock account increasing?” Explain that when a company issues stock, it increases the amount of common stock outstanding (or in the hands of stockholders). This results in an increase in Assets (Cash) and an increase in Common Stock (Equity).

Also, it may be helpful to point out that some transactions affect only one side of the accounting equation (left or right), yet the accounting equation still balances. For example, when a company purchases supplies with cash, one asset increases and another asset decreases—with no effect on liabilities and equity. Thus, the accounting equation balances.

Suggested In-Class Exercise: E1-27 LO 5. Prepare financial statements a) Exhibit F:1-7: Financial Statements i.

Exhibit F:1-8: Income Statement

ii.

Exhibit F:1-9: Statement of Retained Earnings

iii.

Exhibit F:1-10: Statement of Stockholders’ Equity

iv.

Exhibit F:1-11: Balance Sheet

Lecture Notes: Each of the financial statements required by GAAP focuses on a different aspect of the company’s financial position or financial activity. All four statements should be completed and analyzed in order to get a complete picture of a company. Emphasize the links between the statements.

The income statement shows the change in equity that results from the operation of the business during the year and is prepared first. The retained earnings statement shows the change in equity from profits earned less dividends paid to the stockholders during the year and is prepared second.

Balance sheets show the financial position of the company at specific points in time and is prepared third. The statement of cash flows explains the change in Cash in relation to everything else that changed during the year and is the final statement to be prepared.

Each financial statement should have a company name, a statement title, and some form of date. The income statement tracks profitability—revenues minus expenses. Remember that “profit” doesn’t necessarily mean “money”; the profit may not have been collected in cash yet. The statement of retained earnings shows the changes in the portion of equity arising from the results of operations (but not the changes in contributed capital) less dividends paid to stockholders. As profits increase, stockholders’ equity will increase; as dividends are paid, profits remaining in the business will decrease. The balance sheet shows the financial position of the company at a specific point in time, such as at the end of the year. The balance sheet will probably change the day after it is prepared. All the other financial statements describe what happened to the company during the year. The

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statement of cash flows describes how the balance of the Cash account changed in relation to changes in other assets, liabilities, and all the components of equity.

Financial position (the balance sheet) is different from profitability (the income statement). A company could be very profitable and do a terrible job of managing its profits or vice versa. Students probably know a person who is like this. Some people have high-income levels and end up with very little net worth because they do not manage their finances effectively. On the other hand, some people have modest income levels and do a very good job of managing their finances.

The statement of cash flows shows how the company is generating and using its cash. Students may have heard the phrase “cash is king.” A company must have cash to pay its outstanding bills. Some recent accounting fraud cases involved companies that reported great profits but no corresponding cash flow—a possible red flag!

Net income and cash flow are separate concepts; neither is always positive. A company could have net income and negative cash flow in one year, and then the company could have a net loss and positive cash flow in another year. Many creditors will focus on cash flow in order to determine whether a company can generate cash in order to pay back any outstanding liabilities.

The stockholders’ equity balance does not represent the balance in the Cash account. Students sometimes think the corporation can simply declare dividends from profits earned at any given time.

However, the income included in stockholders’ equity is based on accrual accounting and may not yet have been collected in cash. In addition, some items that have been paid in cash may not be included in net income until some future period.

Suggested In-Class Exercises: E1-31, E1-32, E1-33 LO 6. Use financial statements and return on assets (ROA) to evaluate business performance a) Review financial statements of Kohl’s Corporation. (see http://www.pearsonhighered.com/Horngren) b) Explain return on assets (ROA) Lecture Notes: Information presented in the financial statements is largely based on historical cost— the cost principle. The balance sheet values of major assets such as land, buildings, and equipment are based on the historical cost of those assets and may not represent their fair market value. For example, land purchased 10 years ago is likely to be worth more than the original cost, but it would still be valued on the balance sheet at original cost. This difference between the fair market value and the balance sheet value is sometimes called “hidden assets.” How are the “true” values of a company’s assets determined? One could have them appraised, but even then, the current fair market value of assets does not represent the value of the company as a whole. Don’t forget about subtracting liabilities! But, of course, even then the resulting value of stockholders’ equity (fair market value of all the assets minus liabilities) does not necessarily represent the true market value of the company as a whole.

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Return on assets measures how well a company uses its assets to generate profits. It is calculated by dividing net income by average total assets. Average total assets is calculated by adding the beginning and ending total assets for the time period and then dividing by two.

Suggested In-Class Exercise: E1-27

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Chapter 1: Handout for Student Notes LO 1. Why is accounting important?

o Decision makers: The users of accounting information

▪ Individuals

▪ Businesses

▪ Investors

▪ Creditors

▪ Taxing authorities

o Accounting matters

LO 2. What are the organizations and rules that govern accounting?

o Governing organizations

o Generally Accepted Accounting Principles (GAAP)

o The economic entity assumption

▪ Distinguishing characteristics and organization of a corporation .

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o The cost principle

o The going concern assumption

o The monetary unit assumption

o International Financial Reporting Standards

o Ethics in accounting and business

LO 3. What is the accounting equation?

o Assets

o Liabilities

o Equity

LO 4. How do you analyze a transaction?

o Transaction analysis for Smart Touch Learning

▪ Transaction 1—Stockholder contribution

▪ Transaction 2—Purchase of land for cash

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▪ Transaction 3—Purchase of office supplies on account

▪ Transaction 4—Earning of service revenue for cash

▪ Transaction 5—Earning of service revenue on account

▪ Transaction 6—Payment of expenses with cash

▪ Transaction 7—Payment on account (Accounts Payable)

▪ Transaction 8—Collection on account (Accounts Receivable)

▪ Transaction 9—Payment of cash dividend

LO 5. How do you prepare financial statements?

o Income statement

o Statement of retained earnings

o Balance sheet

o Statement of cash flows

LO 6. How do you use financial statements to evaluate business performance?

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o Kohl’s Corporation (see http://www.pearsonhighered.com/Horngren)

o Return on assets (ROA)

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Chapter 1: Student Chapter Summary LO 1. Explain why accounting is important and list the users of accounting information Accounting is the language of business. Financial accounting is used by a variety of decision makers outside the company, including individuals, businesses, investors, creditors, and taxing authorities, while managerial accounting is directed to decision makers inside the company. All businesses need accountants. Accountants work in public accounting, private accounting, and governmental accounting jobs. Accountants can be licensed as a Certified Public Accountant (CPA), Certified Global Management Accountant (CGMA), or Certified Management Accountant (CMA), or Certified Financial Planner (CFP). Further, nonaccountant business professionals require accounting knowledge as well, as they regularly utilize accounting information to make business decisions.

LO 2. Describe the organizations and rules that govern accounting The rules that govern accounting are called Generally Accepted Accounting Principles (GAAP).

The Financial Accounting Standards Board (FASB) is responsible for the creation and governance of U.S. GAAP. The Securities and Exchange Commission (SEC) oversees the U.S. financial markets and other standard setters, such as the FASB. A thorough understanding of GAAP is essential to the use and preparation of financial statements. The primary objective of financial reporting is to provide information useful for making investment and credit decisions. Financial statement information must be relevant and have faithful representation to be considered useful. Relevant information is timely and is capable of making a difference in the user’s decision. Information is faithfully representative when it is complete, neutral, and free from material error.

Four accounting principles are introduced. The economic entity assumption requires that the subject of a set of accounting financial statements is a single economic unit separate and distinct from its owners and from other economic units. The cost principle requires that transactions record acquisition of assets and services at their actual cost. The going concern assumption specifies that financial reporting should presume the entity will remain in operation for the foreseeable future. The monetary unit assumption requires that only economic events that can be measured in monetary units are represented in the financial statements.

LO 3. Describe the accounting equation and define assets, liabilities, and equity The fundamental relationship on which all accounting is based is represented by the accounting equation: Assets = Liabilities + Equity. Assets are economic resources with future benefits.

Liabilities are obligations owed to others. Equity represents the residual value of the assets left over after obligations represented by the liabilities are fulfilled.

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LO 4. Use the accounting equation to analyze transactions Transactions are economic events that affect the financial position of the company and can be measured reliably. Basic transactions affect at least two accounts. Transactions are analyzed in three steps: Step 1.

Step 2.

Step 3.

Identify the accounts and the account type (Asset, Liability, or Equity).

Decide whether each account increases or decreases.

Determine whether the accounting equation is in balance.

LO 5. Prepare financial statements Four financial statements are prepared for each accounting period. The income statement reports net income or net loss, calculated as revenues earned minus expenses incurred, for a specific period of time. The statement of retained earnings reports the change in retained earnings from net income (or net loss) minus dividends for a specific period of time. The balance sheet reports the financial position (assets, liabilities, and equity) of the company at a specific point in time.

The statement of cash flows reports the cash receipts and cash payments categorized by operating, investing, and financing activities. The financial statements are prepared in the following order: (1) income statement, (2) statement of retained earnings, (3) balance sheet, and (4) statement of cash flows.

LO 6. Use financial statements and return on assets (ROA) to evaluate business performance The income statement evaluates profitability. The statement of retained earnings shows the amount of earnings kept and reinvested in the company. The balance sheet lists the economic resources owned, the debts and obligations owed, and the residual interest that remains for the stockholders. The statement of cash flows shows the change in cash resulting from operating, investing, and financing activities. Return on assets measures how profitably the company uses its assets.

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Chapter 1: Assignment Grid and Other Materials LO 1 S1-1 S1-2 S1-3 S1-4 S1-5 S1-6 S1-7 S1-8 S1-9 S1-10 S1-11 S1-12 S1-13 S1-14 S1-15 S1-16 E1-17 E1-18 E1-19 E1-20 E1-21 E1-22 E1-23 E1-24 E1-25 E1-26 E1-27 E1-28 E1-29 E1-30 E1-31 E1-32 E1-33 E1-34 E1-35 E1-36 E1-37 E1-38 E1-39

LO 2

LO 3

LO 4

LO 5

LO 6

X X X X X X X X X X X X X X X X X X X X X X X X

X

X X X X X X X X X X X X X X X

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LO 1

LO 2

P 1-40A P 1-41A P 1-42A P 1-43A P 1-44A P 1-45A P 1-46A P 1-47A P 1-48B P 1-49B P 1-50B P 1-51B P 1-52B P 1-53B P 1-54B

LO 3

LO 4

LO 5

X X X

X X X X

X

LO 6 X

X X X X X

X

X X X X X

X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

Other End-of-Chapter Materials: Continuing Problem F:1-1 Tying It All Together Case F:1-1 Decision Case F:1-1 Ethical Issue F:1-1 Fraud Case F:1-1 Financial Statement Case F:1-1

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

1. Which of the following organizations oversees the creation and governance of accounting standards in the United States?

A. American Institute of Certified Public Accountants (AICPA) B. Financial Accounting Standards Board (FASB) C. International Accounting Standards Board (IASB) D. Securities and Exchange Commission (SEC) 2. The ultimate control of the corporation rests with the ______________.

A. President B. Chairperson of the Board of Directors C. Board of Directors D. Stockholders 3. Which accounting principle or assumption states that acquired assets and services should be recorded at the actual amount paid?

A. Economic entity assumption B. Cost principle C. Monetary unit assumption D. Going concern assumption 4. Blue Dog Boutique is famous for fashion collars and other high-end pet supplies. At the end of a recent year, Blue Dog’s total assets added up to $48,000,000, and liabilities were $32,000,000. How much was Blue Dog’s equity?

A. $16,000,000 B. $32,000,000 C. $48,000,000 D. $80,000,000 5. Assume Blue Dog Boutique purchased office supplies on account for $85,000. How would this transaction affect Blue Dog’s accounting equation?

A. Increase assets and liabilities by $85,000 B. Decrease assets and liabilities by $85,000 C. Increase assets and equity by $85,000 D. None of the above 6. Which of the following best describes the role of the Public Company Accounting Oversight Board (PCAOB)?

A. Oversees the creation and governance of accounting standards in the United States B. Oversees U.S. financial markets C. Monitors the work of independent accountants who audit public companies D. Creates International Financial Reporting Standards

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7. Last year, Accounting Service Company (ASC) sold services on account for $150,000 and incurred expenses totaling $96,000. At the end of the year, the balance for Accounts Receivable was $20,000, and the balance for Accounts Payable was $16,000. What was ASC’s net income or net loss for the year?

A. Net income of $54,000 B. Net income of $76,000 C. Net income of $170,000 D. Net income of $246,000 8. The income statement reports the A. Financial position for a specific period.

B. Results of operations for a specific period.

C. Financial position on a specific date.

D. Results of operations on a specific date.

9. Blue Dog Boutique reported net income of $1,800,000 on the 20XX income statement. The company reported beginning total assets of $16,000,000 and ending total assets of $20,000,000 on the 20XX balance sheet. What is Blue Dog’s return on assets for 20XX? A. 9.00% B. 10.00% C. 11.25% D. 25.00% 10. Which of the following is a characteristic of a limited-liability company?

A. Indefinite life B. Separate taxable entity C. Personal liability D. All of the above

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Answer Key to Ten-Minute Quiz: 1. B 2. D 3. B 4. A Assets = Liabilities + Equity $48,000,000 = $32,000,000 + Equity Equity = $48,000,000 − $32,000,000 = $16,000,000 5. A 6. C 7. A Net Income (Loss) = Revenues −Expenses = $150,000 −$96,000 = $54,000 8. B 9. B Return on assets = Net Income / Average total assets = $1,800,000 / [($16,000,000 + $20,000,000) / 2] = $1,800,000 / $18,000,000 = 10.00% 10. A

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Extra Critical Thinking Questions Decision Case F:1-2 Sofia and Luisa Ruiz are sisters and have had a lifelong dream to open a bed and breakfast together named Dos Hermanas. They invested $200,000 of their own money, and the company issued common stock to them. The business then got a $200,000 bank loan for the total of $400,000 needed to get started. The company bought a Spanish mission style home in Santa Fe for $160,000. It was in need of renovations which cost another $100,000. They found most of the furniture at antique shops and flea markets—for a total cost of $40,000. Kitchen equipment cost $20,000, and a computer system cost $4,000.

Prior to the grand opening, the banker requests a report on their activities thus far. The bank statement of Dos Hermanas shows a cash balance of $76,000. Sofia and Luisa believe that the $76,000 represents net income for the period, and they feel pretty good about the results of their business. To better understand how well they are doing, they prepare the following income statement for presentation to the bank:

DOS HERMANAS BED AND BREAKFAST Income Statement Six Months Ended June 30, 20XX Revenues: Common stock Bank loan Total revenues Expenses: Cost of the house Renovation to the house Furniture expense Kitchen equipment expense Computer expense Total expenses Net Income

$ 200,000 200,000 $ 400,000 160,000 100,000 40,000 20,000 4,000 324,000 $ 76,000

Requirements 1. Suppose you are the Ruiz sisters’ banker, and they have given you this income statement. Would you congratulate them on their net income? If so, explain why. If not, how would you advise them to measure the net income of the business? Does the amount of cash in the bank measure net income?

Explain.

2. Prepare the balance sheet for Dos Hermanas based on these data.

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Decision Case F:1-2: Solution

Requirement 1 The banker would not congratulate the Ruiz sisters for their net income because they have not measured net income properly. In fact, they have no net income at all. Net income is revenues minus expenses, and the Sofia and Luisa have neither revenues nor expenses. The amount of cash in the bank does not measure net income, as it is the result of a loan from the bank.

Requirement 2 DOS HERMANAS BED AND BREAKFAST Balance Sheet June 30, 20XX Assets

Liabilities

Cash Computer Kitchen Equipment Furniture Building ($160,000 + $100,000)

$ 76,000 Bank Loan Payable 4,000 20,000 40,000 Stockholders’ Equity 260,000 Common Stock

Total Assets

$ 400,000

.

Total Liabilities and Stockholders’ Equity

$ 200,000

200,000

$ 400,000

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Team Project F:1-1 You are opening Pigeon Run Animal Clinic. Your purpose is to earn a profit, and you organize as a corporation.

Requirements 1. Make a detailed list of 10 factors you must consider to establish the business.

2. Identify 10 or more transactions that your business will undertake to open and operate the kennel.

3. Prepare the Pigeon Run Animal Clinic income statement, statement of retained earnings, and balance sheet at the end of the first month of operations. Use made-up figures and include a complete heading for each financial statement. Date the balance sheet as of January 31, 20XX. 4. Discuss how you will evaluate the success of your business and how you will decide whether to continue its operation.

Team Project F:1-1: Solution (Suggested answers. Student answers may vary.)

Requirement 1 1. How to organize the business—as a proprietorship, a partnership, an LLC, or a corporation (You have decided to organize as a corporation.)

2. Where to locate the business 3. How much of your own time and money to commit to the business 4. How to finance the business—with your own personal money, with equity contributions from others, or through borrowing 5. How many people to employ for the business 6. How to measure the business’s success or failure; how to account for the assets, liabilities, and operations of the business 7. What type of animals to serve (all types, dogs only, dogs and cats, birds, reptiles, and so on) 8. Whether to sell pet foods, toys, and other supplies 9. Whether to offer day play, obedience lessons, or other grooming services 10. How to advertise the business (newspapers, radio, posters, online) Requirement 2 1. Obtain equity financing to start the business 2. Purchase land and building 3. Renovate the building to make it suitable for an animal clinic 4. Purchase veterinary supplies that will be needed to operate the animal clinic 5. Advertising 6. Earn service revenue 7. Pay utility bills 8. Pay employee wages 9. Borrow money 10. Pay dividends

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Team Project F:1-1: Solution (cont’d) Requirement 3 PIGEON RUN ANIMAL CLINIC Income Statement Month Ended January 31, 20XX Revenue: Service Revenue Expenses:* Wages Expense Supplies Expense Advertising Expense Utilities Expense Total Expense Net Income

$ 10,000 $ 2,000 400 300 100 2,800 $ 7,200

*Students may also include depreciation expense on the building.

PIGEON RUN ANIMAL CLINIC Statement of Retained Earnings Month Ended January 31, 20XX Retained Earnings, January 1, 20XX Net income for the month

$

0 7,200 7,200 (2,000) $ 5,200

Dividends Retained Earnings, January 31, 20XX

PIGEON RUN ANIMAL CLINIC Balance Sheet January 31, 20XX Assets

Liabilities

Cash Supplies Building Land

$ 1,500 Accounts Payable 200 25,000 Stockholders’ Equity 9,500 Common Stock Retained Earnings Total Stockholders’ Equity Total Liabilities And Stockholders’ $ 36,200 Equity

Total Assets

.

$ 1,000

30,000 5,200 35,200 $ 36,200

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Team Project F:1-1: Solution (cont’d) Requirement 4 We evaluate the success of the business by considering its: • •

Net income or net loss for the period, as reported on the income statement Financial position at the end of the period, as reported on the balance sheet

A profitable business that should continue is one that shows net income for the period, assets exceeding liabilities, and positive cash flow.

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Team Project F:1-2 You are promoting a music festival in your area. Your purpose is to earn a profit, and you organize Electric Sounds Enterprises as a corporation.

Requirements 1. Make a detailed list of 10 factors you must consider to establish the business.

2. Describe 10 of the items your business must arrange in order to promote and stage the music festival.

3. Prepare your business’s income statement, statement of retained earnings, and balance sheet on June 30, 20XX, immediately after the music festival. Use made-up amounts and include a complete heading for each financial statement. For the income statement and the statement of retained earnings, assume the period is the three months ended June 30, 20XX. 4. Assume that you will continue to promote music festivals if the venture is successful. If it is unsuccessful, you will terminate the business within three months after the music festival. Discuss how you will evaluate the success of your venture and how you will decide whether to continue in business.

Team Project F:1-2: Solution (Suggested answers. Student answers may vary.)

Requirement 1 1. How to organize the business—as a proprietorship, a partnership, an LLC, or a corporation (Assume you have decided to organize as a corporation.)

2. Where to locate the headquarters of the business 3. How much of your own time and money to commit to the business 4. How to finance the business—with your own personal money, with equity contributions from others, or through borrowing 5. How many people to employ for the business 6. How to measure the business’s success or failure; how to account for the assets, liabilities, and operations of the business 7. What type of music to feature; what age group or interest group to appeal to 8. Whether to sell concessions (food, drinks, T-shirts, and so on) yourself or to arrange for outsiders to sell concessions at the music festival 9. How to advertise the business (newspapers, radio, posters, online) 10. Whether to sponsor the music festivals yourself or to arrange for corporate or charitable organizations to sponsor the music festivals Requirement 2 1.

2.

3.

4.

5.

6.

Which band (or bands) to feature at the music festivals How much and when to pay the performers (flat rate or a percentage of gate receipts) Where to stage the music festivals and how to pay for the site rental Need for city or county permits to stage a music festival How to ensure security at the music festival How to get people to come to the music festival––how to advertise the music festivals (newspapers, radio, posters, or other) and how much to pay for advertising

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7. How to offer concessions (buy and sell them yourself or arrange for outside concessionaires). If outsiders, how will they be compensated—keep their own revenues or share them with you?

8. Need for traffic control if the crowd disrupts city traffic 9. Weather considerations if the music festival is staged outdoors 10. Timing of the music festival in relation to other events in the area at the time Team Project F:1-2: Solution (cont’d) Requirement 3 ELECTRIC SOUND ENTERPRISES Income Statement Three Months Ended June 30, 20XX Revenue: Ticket Sales Revenue Concession Revenue Total Revenue Expenses: Band Expense Advertising Expense Concession Expense Rent Expense Security Expense Utilities Expense Permits Expense Total Expenses Net Income

$ 300,000 50,000 350,000 $ 100,000 50,000 20,000 15,000 10,000 3,000 2,000 200,000 $ 150,000

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Team Project F:1-2: Solution (cont’d) ELECTRIC SOUND ENTERPRISES Statement of Retained Earnings Three Months Ended June 30, 20XX Retained Earnings, April 1, 20XX Net income for quarter

$

0 150,000 150,000 (10,000) $ 140,000

Dividends Retained Earnings, June 30, 20XX

ELECTRIC SOUND ENTERPRISES Balance Sheet June 30, 20XX Assets

Liabilities

Cash Accounts Receivable Supplies

$ 136,000 Accounts Payable 8,000 4,000 Stockholders’ Equity Common Stock Retained Earnings Total Stockholders’ Equity Total Liabilities And Stockholders’ $ 148,000 Equity

Total Assets

$

7,000

1,000 140,000 141,000 $ 148,000

Requirement 4 We evaluate the success of the business by considering its: • Net income or net loss for the period, as reported on the income statement • Financial position at the end of the period, as reported on the balance sheet A profitable business that should continue is one that shows net income for the period, assets exceeding liabilities, and positive cash flow.

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Communication Activity F:1-1 Using 25 words or fewer, illustrate the accounting equation and explain each part of the accounting equation.

Communication Activity F:1-1: Solution Assets = Liabilities + Equity simply shows the resources that a business owns (assets) and the claims that others have against those resources (liabilities and equity).

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Chapter 2 Recording Business Transactions

Chapter 2: Overview The chapter introduces the account and then briefly describes specific asset, liability, and stockholders’ equity accounts. The chart of accounts is presented as a way to organize accounts, and a Data Analytics in Accounting feature highlights the chart of accounts as a tool for analyzing a company’s accounting data. The ledger is introduced as a tool for maintaining the accounts. The concept of double-entry accounting and the rules of debit and credit for increasing or decreasing assets, liabilities, and equity are described. The rules of debit and credit are then expanded to include specific types of equity accounts.

The normal balances of accounts are explained. The T-account is illustrated. The accounting equation is tied to the rules of debit and credit.

The flow of accounting data is illustrated from the occurrence of a transaction through recording of the transaction. The process of recording transactions (journalizing) is presented. A series of entries are analyzed, journalized, and posted to T-accounts in the ledger. The four-column account is introduced.

The trial balance is defined and illustrated. Some typical accounting errors revealed by a trial balance are described. How the debt ratio is used to evaluate business performance is discussed.

An Ethics feature helps give real-world perspective on the importance of source documents. The Tying It All Together feature focuses on Universal Logistics Holdings, Inc. A Decisions feature helps students see how the debt ratio can be used to make a real-world decision. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding reviews opening accounts, journalizing, posting, and preparing a trial balance. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

.

Chapter 2: Learning Objectives LO 1. Explain accounts as they relate to the accounting equation and describe common accounts LO 2. Define debits, credits, and normal account balances using double-entry accounting and Taccounts LO 3. Record transactions in a journal and post journal entries to the ledger LO 4. Prepare the unadjusted trial balance LO 5. Describe the accounting cycle LO 6. Use the debt ratio to evaluate business performance

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Chapter 2: Teaching Outline with Lecture Notes LO 1. Explain accounts as they relate to the accounting equation and describe common accounts a) Review the accounting equation i)

Account

b) Assets (Exhibit F:2-1: Asset Accounts) c) Liabilities (Exhibit F:2-2: Liability Accounts) d) Equity (Exhibit F:2-3: Equity Accounts) e) Chart of accounts (Exhibit F:2-4: Chart of Accounts—Smart Touch Learning) i)

Ledger

Lecture Notes: An understanding of Chapter 2 is essential for student success in the remaining financial accounting chapters. Spend adequate time in the beginning with accounting terminology.

Accounting is a “foreign” language to many students, and, as is the case with a real foreign language, you must start with the basics.

Students seem to understand assets and liabilities more easily than they understand equity. An asset can be touched, and a liability can be confirmed by looking at an invoice, but equity is conceptual.

Equity is the residual stockholders’ claims to the business assets—what is left over after liabilities are subtracted from assets. Students may own a car or home that has an outstanding loan or mortgage, so it may be helpful to ask them to think about their personal equity for their car or home.

Suggested In-Class Exercise: E2-11 LO 2. Define debits, credits, and normal account balances using double-entry accounting and T-accounts a) Double-entry system b) The T-account c) The accounting equation and the rules of debit and credit d) Increases and decreases in the accounts e) Expanding the rules of debit and credit f) The normal balance of an account g) Exhibit F:2-5: Rules of Debit and Credit and Normal Balances for Each Account Type h) Determining the balance of a T-account

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Lecture Notes: Define double-entry accounting. Emphasize that every basic accounting transaction affects at least two accounts, with at least one account to be debited and at least one account to be credited. Every journal entry must balance (debits = credits) in order for the accounting system to accurately generate correct and useful information. An incorrect journal entry that is posted to the correct accounts will still produce incorrect information.

When discussing T-accounts, explain how they represent accounts in the general ledger. Emphasize the various account types and the specific accounts within them. In the rules of debit and credit, debit means left side, and credit means right side—nothing more. Point out that students may have heard the terms used in other contexts, such as credit reports and debit cards, but these are different meanings of the words debit and credit. Furthermore, debit does not mean increase, and credit does not mean decrease. Increases and decreases depend on the account type.

An account can have only one balance. Debits and credits within the same account are subtracted to determine the account balance, just like positives and negatives from a mathematical standpoint. The normal balance is the side used to record increases in the account.

Suggested In-Class Exercise: E2-13 LO 3. Record transactions in a journal and post journal entries to the ledger a) Source documents—the origin of the transactions b) Exhibit F:2-6: Flow of Accounting Data c) Journalizing and posting transactions d) Introduce the five steps of journalizing and posting e) Journalize and post with 17 specific Smart Touch Learning examples f) The ledger accounts after posting g) Exhibit F:2-7: Smart Touch Learning’s Accounts After Posting Journal Entries in November and December h) The four-column account: An alternative to the T-account i) Exhibit F:2-8: T-Account Versus Four-Column Account j) Exhibit F:2-9: Posting References Lecture Notes: Define source documents, journalizing, and posting. Walk through the five steps of journalizing and posting transactions. When discussing the posting process, emphasize the need to be very careful when transferring amounts to the ledger. It is common for students to reverse a posting and record a debit as a credit or vice versa. A debit is placed on the left side, and a credit is placed on the right side. Also, relate to them that transposing digits during the posting process is a common mistake. For example, a transaction might be for $630 and recorded in the journal as $630

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but posted to the ledger as $360. If the trial balance doesn’t balance, it is common for students to have reversed a posting or transposed a digit. For this reason, it is important to include dates and/or transaction numbers linking the journal entry to the ledger account to more easily trace those errors.

Suggested In-Class Exercises: E2-16, E2-17 LO 4. Prepare the unadjusted trial balance a) Trial balance b) Exhibit F:2-10: Trial Balance c) Correcting Trial Balance Errors d) Reviewing Financial Statements e) Exhibit F:2-11: Smart Touch Learning’s Financial Statements Lecture Notes: Define a trial balance and explain its importance in the accounting cycle. It may be helpful for students to view the accounting system from both ends. The natural process is to journalize transactions, post entries, and prepare a trial balance. However, once the chapter content is discussed, you can also begin with the trial balance and have students trace back to the ledger and journal to find a specific transaction. They may also get experience doing this when correcting a trial balance that does not balance.

Suggested In-Class Exercise: E2-22 LO 5. Describe the accounting cycle a) Accounting Cycle Steps 1–4 b) Exhibit F:2-13 Lecture Notes: The modern version of the accounting cycle may look different from other versions you may find online or other textbooks. This version begins with the beginning balances from the prior accounting cycle. It’s important to note that for new businesses all balances are starting at $0.

However, as the business operates, some accounts will have balances that carry over from cycle to cycle.

LO 6. Use the debt ratio to evaluate business performance a) Define the debt ratio and explain how it is calculated Lecture Notes: Remind student about the accounting equation: Assets = Liabilities + Equity. This makes it clear that the debt ratio represents the proportion of the total assets that are financed with debt, and therefore “belong” to the creditors of the business. Conversely, 1 − Debt ratio% is the proportion of the assets that belong to the owners (stockholders) of the business.

Suggested In-Class Exercise: E2-28

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Chapter 2: Handout for Student Notes LO 1. What is an account? o Assets

o Liabilities

o Equity

o Chart of accounts

o Ledger

LO 2. What is double-entry accounting? o The T-account

o Increases and decreases in the accounts

o Expanding the rules of debit and credit

o The normal balance of an account

o Determining the balance of a T-account

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LO 3. How do you record transactions? o Source documents—The origin of the transactions

o Journalizing and posting transactions:

▪ Transaction 1—Stockholder contribution

▪ Transaction 2—Purchase of land for cash

▪ Transaction 3—Purchase of office supplies on account

▪ Transaction 4—Earning of service revenue for cash

▪ Transaction 5—Earning of service revenue on account

▪ Transaction 6—Payment of expenses with cash

▪ Transaction 7—Payment on account (Accounts Payable)

▪ Transaction 8—Collection on account (Accounts Receivable)

▪ Transaction 9—Payment of cash dividend

▪ Transaction 10—Prepaid expenses

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▪ Transaction 11—Payment of expense with cash

▪ Transaction 12—Purchase of building with notes payable

▪ Transaction 13—Stockholder contribution

▪ Transaction 14—Accrued liability

▪ Transaction 15—Payment of expense with cash

▪ Transaction 16—Unearned revenue

▪ Transaction 17—Earning of service revenue for cash

o The ledger accounts after posting

o The four-column account: An alternative to the T-account

LO 4. What is the trial balance? o Preparing financial statements from the trial balance

o Correcting trial balance errors

LO 5. What are the first four steps of the accounting cycle?

LO 6. How do you use the debt ratio to evaluate business performance?

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Chapter 2: Student Chapter Summary LO 1. Explain accounts as they relate to the accounting equation and describe common accounts An account is a detailed record of all increases and decreases that have occurred in an individual asset, liability, or equity during a specific period. Common asset accounts include Cash, Accounts Receivable, Notes Receivable, Prepaid Expense, Land, Building, and Furniture.

Common liability accounts include Accounts Payable, Notes Payable, Accrued Liability, and Unearned Revenue. Common equity accounts include Common Stock, Dividends, Revenues, and Expenses. A chart of accounts lists a company’s accounts along with account numbers. A ledger shows the increases and decreases in each account along with their balances.

LO 2. Define debits, credits, and normal account balances using double-entry accounting and Taccounts Double-entry accounting requires transactions to be recorded into at least two accounts. The Taccount is shaped like a capital T, with debits posted to the left side of the vertical line and credits posted to the right side of the vertical line. T-accounts represent ledger accounts. In accounting, debit means left side of the account, and credit means right side of the account.

Assets, Expenses, and Dividends are increased with a debit and decreased with a credit.

Liabilities, Common Stock, and Revenues are increased with a credit and decreased with a debit.

The normal balance of an account is the increase side of that account.

LO 3. Record transactions in a journal and post journal entries to the ledger Source documents provide the evidence and data for transactions. Transactions are recorded in a journal, and then the journal entries are posted (transferred) to the ledger. Transactions are journalized and posted using five steps: Step 1. Identify the accounts and the account type (asset, liability, and equity).

Step 2. Decide whether each account increases or decreases, then apply the rules of debits and credits.

Step 3. Record the transaction in the journal.

Step 4. Post the journal entry to the ledger.

Step 5. Determine whether the accounting equation is in balance.

LO 4. Prepare the unadjusted trial balance The trial balance summarizes the ledger by listing all the accounts with their balances. Assets are listed first, followed by liabilities, and then equity. The trial balance ensures that debits equal credits and is used to prepare the financial statements.

LO 5. Describe the accounting cycle The accounting cycle is the process by which companies produce their financial statements for a specific period of time. This chapter covers the first four steps in the accounting cycle: 1) Start with the beginning account balances, 2) Analyze and record (journalize) transactions in the

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journal, 3) Post journal entries to the accounts in the ledger (T-Accounts), 4) Prepare the unadjusted trial balance.

LO 6. Use the debt ratio to evaluate business performance The debt ratio, calculated as Total liabilities / Total assets, is used to evaluate a business’s ability to pay its debts.

Chapter 2: Assignment Grid and Other Materials LO 1 S2-1 S2-2 S2-3 S2-4 S2-5 S2-6 S2-7 S2-8 S2-9 S2-10 E2-11 E2-12 E2-13 E2-14 E2-15 E2-16 E2-17 E2-18 E2-19 E2-20 E2-21 E2-22 E2-23 E2-24 E2-25 E2-26 E2-27 E2-28 E2-29 P2-30A, P2-36B P2-31A, P2-37B P2-32A, P2-38B P2-33A, P2-39B P2-34A, P2-40B

LO 2

LO 3

LO 4

LO 5

LO 6

X X X X X X X X X X X X X

X

X

X

X

X X X X X X X X X X

X X X X X

.

X X X X X X X X X X X X

X X X X

X X

2-11

P2-35A, P2-41B

X

X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem F:2-1 Practice Set F:2-1 Tying It All Together Case F:2-1 Decision Case F:2-1 Ethical Issue F:2-1 Fraud Case F:2-1 Financial Statement Case F:2-1 Communication Activity F:2-1

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

1. What is the detailed record of all increases and decreases that have occurred in a specific individual asset, liability, or equity during a specific period?

A. Ledger B. Trial balance C. Account D. Journal 2. Which of the following is a collection of all the accounts, the changes in those accounts, and their balances?

A. Balance sheet B. Ledger C. Journal D. Trial balance 3. Which of the following statements is correct?

A. Service Revenue is increased with a debit.

B. Accounts Receivable is decreased with a debit.

C. Unearned Revenue is increased with a credit.

D. Retained Earnings is decreased with a credit.

4. Suppose Akter Corporation has Furniture totaling $316,000, Cash of $36,000, and a $128,000 Note Payable. In addition, the business has Accounts Payable of $104,000 and Accounts Receivable of $86,000. How much is Akter’s stockholders’ equity?

A. $462,000 B. $290,000 C. $242,000 D. $206,000

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5. Cohen Company billed a customer for $7,600 of services provided on account. This transaction appears in T-accounts as follows: Service Revenue Accounts Payable A. 7,600 7,600 B.

Service Revenue 7,600

Accounts Payable 7,600

C.

Service Revenue 7,600

Accounts Receivable 7,600

D.

Service Revenue 7,600

Accounts Receivable 7,600

6. Littleton, Inc., began the year with total assets of $354,000 and liabilities of $224,000. During the year, the business earned revenue of $206,000 and incurred expenses of $96,000. The stockholders received cash dividends of $48,000 and no additional stock has been issued. How much is stockholders’ equity at year-end?

A. $240,000 B. $192,000 C. $158,000 D. $62,000 7. Takagi Printing, Inc., erroneously recorded a purchase of equipment on account by debiting Equipment and crediting Cash. What will be an effect of this error on the trial balance?

A. Liabilities understated B. Cash overstated C. Equipment overstated D. Equipment understated 8. Jerry Lopez is a stockholder of Genesis Corporation. In exchange for additional shares of common stock, Lopez provided Genesis Corporation with $150,000 of computer equipment. The journal entry to record this transaction is as follows: Accounts and Explanations Debit Credit A. Common Stock 150,000 Equipment Expense 150,000 B. Equipment Expense 150,000 Common Stock 150,000 C. Equipment 150,000 Common Stock 150,000 D. Common Stock 150,000 Equipment 150,000

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9. The Bravo Company performed services for a customer, earning $12,000 of service revenue on account. Which journal entry records the collection of the $12,000 cash received when the customer subsequently pays the invoice?

Accounts and Explanations Debit Credit A. Cash 12,000 Accounts Receivable 12,000 B. Cash 12,000 Service Revenue 12,000 C. Accounts Receivable 12,000 Cash 12,000 D. Service Revenue 12,000 Cash 12,000 10. A company has $144,000 in liabilities and $196,000 in equity. What is the debt ratio?

A. 26.5% B. 42.4% C. 73.5% D. 136.1%

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Answer Key to Ten-Minute Quiz: 1. C 2. B 3. C 4. D Assets Accounts Receivable Cash Furniture Total

= $ 86,000 36,000 316,000 $ 438,000

Liabilities

+

Accounts Payable Note Payable

$ 104,000 128,000

Total

$ 232,000

Stockholders’ Equity

Total

?

Assets = Liabilities + Stockholders’ equity; therefore, Stockholders’ equity = Assets −Liabilities Stockholders’ equity = $438,000 − $232,000 = $206,000 5. C 6. B Assets = Liabilities + Stockholders’ equity; therefore, Stockholders’ equity = Assets −Liabilities Stockholders’ equity at the beginning of the year = $354,000 − $224,000 = $130,000 As no common stock has been issued, Stockholder’s equity is made up of the balance in Retained earnings: Retained earnings, beginning of year Net income earned during the year (revenue − expenses) Dividends Retained earnings, end of year

$ 130,000 110,000 240,000 (48,000) $ 192,000

7. A 8. C 9. A 10. B Debt ratio = Total liabilities / Total assets* = $144,000 / $340,000 = 42.4% *Total assets = Liabilities + Equity = $144,000 + 196,000 = $340,000

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Extra Critical Thinking Questions Decision Case F:2-2 Answer the following questions. Consider each question separately.

Requirements 1. Explain the advantages of double-entry bookkeeping instead of recording transactions in terms of the accounting equation to a friend who is opening a used book store.

2. When you deposit money in your bank account, the bank credits your account. Is the bank misusing the word credit in this context? Why does the bank use the term credit instead of debit to refer to your deposit?

Decision Case F:2-2: Solution Requirement 1 The advantage of double-entry bookkeeping is that it provides an arithmetic check on the accounting transactions; the total debits and total credits have to equal, and something is wrong if they don’t.

Double-entry bookkeeping can also handle a higher number of transactions than using the accounting equation.

Requirement 2 The bank uses the term credit your account when you deposit money because it is crediting a liability on its books. It owes you the funds that you just deposited.

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Team Project F:2-1 Contact a local business and arrange with the owner to learn what accounts the business uses.

Requirements 1. Obtain a copy of the business’s chart of accounts.

2. Prepare the company’s financial statements for the most recent month, quarter, or year. (You may omit the statement of cash flows.) You may use either made-up account balances or balances supplied by the owner.

If the business has a large number of accounts within a category, combine related accounts and report a single amount on the financial statements. For example, the company may have several Cash accounts.

Combine all Cash amounts and report a single Cash amount on the balance sheet. You will probably encounter numerous accounts that you have not yet learned about. Deal with them as best you can. Keep in mind that the financial statements report the balances of the accounts listed in the company’s chart of accounts, either by individual account or in summarized categories. Therefore, the financial statements must be consistent with the chart of accounts.

Team Project F:2-1: Solution Requirements 1 and 2 Student answers will vary widely, as the various groups use the charts of accounts of different businesses. The financial statements that the students prepare should be consistent with the business’s chart of accounts.

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Chapter 3 The Adjusting Process

Chapter 3: Overview The chapter introduces the student to the adjusting process so that the amounts for the account balances are reported accurately. Cash basis accounting and accrual basis accounting are illustrated and differentiated. The time period concept, the revenue recognition principle, and the matching principle are explained. Adjusting entries are defined. The four categories of adjusting entries—deferred expenses, deferred revenues, accrued expenses, and accrued revenues—are illustrated and described in detail. The text provides examples of adjusting entries for prepaid rent, office supplies, depreciation of furniture and building, unearned revenue, accrued salaries expense, accrued interest expense, and accrued service revenue. Accumulated depreciation, contra accounts, and book value are explained. A comparison of the timing of deferrals and accruals and a summary of the adjusting process concludes the discussion of adjusting entries.

The last part of the chapter focuses on the adjusted trial balance and the worksheet. Students learn how to prepare an adjusted trial balance. The impact of the adjusting entries on the financial statements is emphasized. The purpose of a worksheet and how a worksheet is used to prepare adjusting entries and the adjusted trial balance is explained. An appendix covers the use of the worksheet to prepare adjusting entries and the adjusted trial balance.

A Tying It All Together feature provides an example of how to report advance payments related to a client contract. An Ethics feature provides students insight into real-world ethical dilemmas in accrual accounting, addressing the issue of when accrued expenses should be recorded. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem reviews the adjusting process, including adjusting entries, the adjusted trial balance, and preparation of a partial worksheet. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 3: Learning Objectives LO 1. Differentiate between cash basis accounting and accrual basis accounting LO 2. Define and apply the time period concept, revenue recognition, and matching principles LO 3. Explain the purpose of and journalize and post adjusting entries for deferrals LO 4. Explain the purpose of and journalize and post adjusting entries for accruals LO 5. Explain the purpose of and prepare an adjusted trial balance LO 6. Identify the impact of adjusting entries on the financial statements LO 7. Describe the accounting cycle LO 8. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance (Appendix 3A)

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Chapter 3: Teaching Outline with Lecture Notes LO 1. Differentiate between cash basis accounting and accrual basis accounting a) Cash basis accounting b) Accrual basis accounting Lecture Notes: To indicate why the accrual method is the more “correct” method, you can provide a simple example of a company with two (or more) transactions, one with cash revenue and one with accrued expense, for example, and ask students to compute net income under the cash basis and accrual basis. Note the differences and ask students which computation provides a more accurate picture of the company’s operations.

LO 2. Define and apply the time period concept, revenue recognition, and matching principles a) The time period concept b) The revenue recognition principle c) The matching principle Lecture Notes: It helps to explain to students that accountants have several accounting principles or concepts that guide them in recording financial information. These principles include the time period concept, the revenue recognition principle, and the matching principle. These three concepts are important for their understanding of adjusting entries. Relating the revenue recognition principle to the payment of rent to a landlord and the five-step process to determine when the landlord may record rent revenue under the lease contract may aid their understanding as many students rent apartments or rooms on campus. Reinforce the interrelationship of revenues and expenses (net income) and why it is important to match expenses incurred against the revenues earned in the same period.

Suggested In-Class Exercise: E3-19 LO 3. Explain the purpose of and journalize and post adjusting entries for deferrals a) Exhibit F:3-1: Unadjusted Trial Balance b) Journalize and post adjusting entries i.

Deferred expenses ▪

Adjusting entry: Increase an expense with a debit and decrease an asset with a credit •

Prepaid rent

•

Office supplies

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•

Depreciation ▪

▪

Explain the following terms: •

Plant assets

•

Depreciation

•

Depreciation expense

•

Residual value

•

Straight-line method

•

Accumulated depreciation

•

Contra account

•

Book value

Exhibit F:3-2: Property, Plant, and Equipment on the Balance Sheet of Smart Touch Learning

Lecture Notes: Just as the adjusting entries for Prepaid Expenses and Office Supplies reduce an asset and increase the related expense, so does the adjusting entry for depreciation. However, because the asset values are considered more significant and therefore more important, the integrity of the original asset acquisition value is maintained in the primary plant asset account, and the reduction of the asset value in the adjusting entry is entered into the related contra asset for accumulated depreciation. Highlight the cost principle when explaining this concept. ii.

Deferred revenues ▪

Adjusting entry: Decrease a liability (Unearned Revenue) with a debit and increase a revenue with a credit

LO 4. Explain the purpose of and journalize and post adjusting entries for accruals i.

Accrued expenses ▪

Adjusting entry: Increase an expense with a debit and increase a liability with a credit

•

Accrued salaries expense

•

Accrued interest expense

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ii.

Accrued revenues ▪

Adjusting entry: Increase an asset (Receivable) with a debit and increase a revenue with a credit

Lecture Notes: Emphasize that adjusting entries are simply a kind of journal entry and must balance: Debits equal credits. Adjusting entries are always dated as of the last day of the accounting period.

Point out that adjusting entries never affect the cash account. This is because cash has already changed hands or will change hands at a later date. Deferral entries are related to cash that has been paid in advance, with the revenue earned or the expense incurred at a later date. Accrual entries are related to revenue that has been earned or expense that has been incurred, with the related cash payment occurring at a later date. Adjusting entries always involve one income statement account and one balance sheet account. It may be helpful to provide several adjusting entry examples and ask students which account affects the balance sheet and which affects the income statement.

Some students have difficulty with adjusting the Unearned Revenue account. Explain that the purpose of the adjusting entry is to record the revenue that was earned during the period by completing work for the client, not the amount related to work to be performed in the future.

However, when adjusted correctly, the ending balance in Unearned Revenue equals the amount related to work to be performed in the future.

Suggested In-Class Exercise: E3-25 LO 5. Explain the purpose of and prepare an adjusted trial balance i.

Exhibit F:3-3: Summary of Deferral and Accrual Adjustments

ii.

Exhibit F:3-4: Journalizing and Posting the Adjusting Entries of Smart Touch Learning

iii.

Adjusted trial balance

iv.

Exhibit F:3-5: Adjusted Trial Balance

Lecture Notes: Explain that the adjusted trial balance is used to ensure that total debits equal total credits after the adjusting entries have been made, although this equality does not necessarily ensure accuracy.

Suggested In-Class Exercise: E3-26 LO 6. Identify the impact of adjusting entries on the financial statements i.

Exhibit F:3-6: Impact of Adjusting Entries on Financial Statements Lecture Notes: Financial statements are created using the adjusted trial balance. Emphasize the impact on the financial statements if adjusting entries are not made. For example, if the adjusting

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entry for a deferred expense is not made to increase an expense and decrease the related asset, then Total Assets is overstated on the balance sheet and Net Income is overstated on the income statement (because Total Expense is understated).

LO 7. Suggested In-Class Exercise: E3-27 Describe the accounting cycle i.

Accounting Cycle steps 1–6

ii.

Exhibit F:3-7 Lecture Notes: In Chapter 2, we introduced the first four steps of the accounting cycle for Smart Touch Learning. Remember, the accounting cycle is the process by which companies produce their financial statements for a specific period of time. It is the steps that companies follow throughout the time period. In this chapter, we discussed the next two steps of the accounting cycle: Step 5: Journalize and post adjusting entries. At the end of the accounting period, companies journalize and post adjusting entries to record revenues to the period in which they are earned and the expenses to the period in which they occur. Step 6: Prepare the adjusted trial balance. An adjusted trial balance is prepared to summarize the account balances as reported in the ledger.

LO 8. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance (Appendix 3A) i.

Worksheet

ii.

First four sections of a worksheet iii.

Exhibit F:3A-1: Partially Completed Worksheet

Lecture Notes: Remind students to be careful when calculating adjusted trial balance totals. Not every adjustment is an addition or subtraction; it depends on the account type. For example, debits are added to debits but are subtracted from credits. Calculations on the worksheet are completed just as they would be in a T-account.

Suggested In-Class Exercise: E3-29

Chapter 3: Handout for Student Notes LO 1. What is the difference between cash basis accounting and accrual basis accounting?

LO 2. What concepts and principles apply to accrual basis accounting?

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o The time period concept

o The revenue recognition principle

o The matching principle

LO 3. What are the adjusting entries for deferrals, and how do we record them?

o Deferred expenses:

▪ Prepaid Rent

▪ Office Supplies

▪ Depreciation

o Deferred revenues

LO 4. What are the adjusting entries for accruals and how do we record them?

o Accrued expenses:

▪ Accrued Salaries Expense

▪ Accrued Interest Expense

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o Accrued revenues

LO 5. What is the purpose of the adjusted trial balance, and how do we prepare it?

LO 6. What is the impact of adjusting entries on the financial statements?

LO 7. What are the next steps in the accounting cycle?

LO 8. How could a worksheet help in preparing adjusting entries and the adjusted trial balance?

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Chapter 3: Student Chapter Summary LO 1. Differentiate between cash basis accounting and accrual basis accounting For cash basis accounting, revenue is recorded only when cash is received, and expenses are recorded only when cash is paid. This method is not permitted by Generally Accepted Accounting Principles (GAAP), although it is often used by small businesses. For accrual basis accounting, revenue is recorded when earned, and expenses are recorded when incurred, which may occur before or after cash is received or paid.

LO 2. Define and apply the time period concept, revenue recognition, and matching principles The time period concept assumes that a business’s activities can be sliced into small time segments and that the financial statements can be prepared for specific periods, such as a month, quarter, or year.

The revenue recognition principle tells accountants when to record revenue and requires companies to follow a five-step process: Step 1.

Identify the contract with the customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations.

Step 2.

Identify the performance obligations in the contract. A performance obligation is a contractual promise with a customer to transfer a distinct good or service.

A contract might have multiple performance obligations.

Step 3.

Determine the transaction price. The transaction price is the amount that the entity expects to be entitled to as a result of transferring goods or services to the customer.

Step 4.

Allocate the transaction price to the performance obligations in the contract. If the transaction has multiple performance obligations, the transaction price needs to be allocated among the different performance obligations.

Step 5.

Recognize revenue when (or as) the entity satisfies each performance obligation. The business recognizes revenue when (or as) it satisfies each performance obligation by transferring a good or service to a customer. A good or service is considered transferred when the customer obtains control of the good or service. The amount of revenue recognized is the amount allocated to the satisfied performance obligation.

The matching principle guides accounting for expenses and ensures that all expenses are recorded when they are incurred during the period. It then matches those expenses against the revenues of the period.

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LO 3. Explain the purpose of and journalize and post adjusting entries for deferrals Adjusting entries are completed at the end of the accounting period and record revenues to the period in which they are earned and expenses to the period in which they are incurred. Adjusting entries also update the asset and liability accounts. The first two types of adjusting entries are for deferred expenses and revenues:

LO 4.

•

Deferred expenses: In the related sequence of events, cash has previously been paid to acquire an asset, such as prepaid rent, office supplies, or a plant asset. The accounting entry to record that transaction increases the asset with a debit and decreases cash with a credit. Later, at the end of the accounting period, the adjusting entry recognizes that the asset has been all or partially used up during the current accounting period by increasing the related expense with a debit and decreasing the asset with a credit. Depreciation is a special case of a deferred expense. Because plant asset values are considered more significant and, therefore, more important, the integrity of the original asset acquisition value is maintained in the primary plant asset account, and the reduction of the asset value in the adjusting entry is entered into the related contra asset for accumulated depreciation.

•

Deferred revenues: In the related sequence of events, cash has previously been received for goods or services to be provided to the customer at some time in the future. The accounting entry to record that transaction increases cash with a debit and increases the liability account Unearned Revenue with a credit. Later, at the end of the accounting period, the adjusting entry recognizes that some or all of the revenues have been earned for goods or services that have since been provided to the customer by decreasing the liability Unearned Revenue with a debit and increasing the corresponding revenue with a credit.

Explain the purpose of and journalize and post adjusting entries for accruals

The second two types of adjusting entries are for accrued expenses and revenues: •

Accrued expenses: In the related sequence of events, the adjusting entry first records that an expense (such as Salaries Expense or Interest Expense) has been incurred but not paid by increasing the expense with a debit and increasing the related liability with a credit. Later, when the cash payment transaction occurs in the following accounting period, the liability is decreased with a debit, and cash is decreased with a credit.

•

Accrued revenues: In the related sequence of events, the adjusting entry first records revenues that have been earned but not collected by increasing an asset, such as Accounts Receivable, with a debit and increasing the related revenue with a credit. Later, when the cash collection transaction occurs in the following period, Cash is increased with a debit, and the asset is decreased with a credit.

LO 5. Explain the purpose of and prepare an adjusted trial balance

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An adjusted trial balance is a list of all the accounts with their adjusted balances. It ensures that total debits equal total credits. Be careful when calculating adjusted trial balance totals. Not every adjustment is an addition or a subtraction; it depends on the account balance. For example, debits are added to debits but subtracted from credits.

LO 6. Identify the impact of adjusting entries on the financial statements If adjusting entries are not recorded, the balance sheet and income statement accounts will either be overstated or understated. Overstating or understating accounts causes the financial statements to be incorrect.

LO 7. Describe the accounting cycle •

Step 1: Start with the beginning account balances

•

Step 2: Analyze and journalize transactions in the journal

•

Step 3: Post journal entries to the accounts in the ledger

•

Step 4: Prepare the unadjusted trial balance

•

Step 5: Journalize and post adjusting entries

•

Step 6: Prepare the adjusted trial balance

LO 8. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance A worksheet is an internal document that helps identify the accounts that need adjustments. In addition, a worksheet helps summarize data for the preparation of the financial statements.

Chapter 3: Assignment Grid and Other Materials LO 1 S3-1 S3-2 S3-3 S3-4 S3-5 S3-6 S3-7 S3-8 S3-9 S3-10 S3-11 S3-12

LO 2

LO 3

LO 4

LO 5

LO 6

LO 7

LO 8

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S3-13 S3-14 S3-15 S3A-16 E3-17 E3-18 E3-19 E3-20 E3-21 E3-22 E3-23 E3-24 E3-25 E3-26 E3-27 E3-28 E3-29

X X X X X X

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P3-30A, P3-35B P3-31A, 36B P3-32A, P3-37B P3-33A P3-34A, P3-38B

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X X X X

X X X

X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

Other End-of-Chapter Materials: Using Excel P3-45 Continuing Problem F:3-1 Practice Set F:3-1 Tying It All Together Case F:3-1 Decision Case F:3-1 Ethical Issue F:3-1 Fraud Case F:3-1 Financial Statement Case F:3-1 Communication Activity F:3-1

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

1. When should a company record earned revenue under accrual accounting?

A. When the customer orders services to be rendered B. When services are rendered C. When cash is received before services are rendered D. When cash is received after services are rendered 2. The matching principle requires that A. expenses are recorded when they are incurred during a period.

B. revenue is recorded only after it has been earned.

C. time is divided into annual periods to measure expenses properly.

D. revenue is recorded after cash is received.

3. The adjustment for accrued revenues A. increases a revenue with a debit and increases an asset with a credit.

B. increases an asset with a debit and increases a revenue with a credit.

C. decreases a revenue with a debit and increases an asset with a credit.

D. decreases a liability with a debit and increases a revenue with a credit.

4. What is the impact on the financial statements if an adjusting entry for deferred expense is not made?

A. Assets understated B. Expenses understated C. Expenses overstated D. Both A and B 5. Go Outdoors Monthly gains a client who prepays $60 for a package of one magazine per month for 12 months. Go Outdoors Monthly collects the $60 in advance and will provide the magazines throughout the next year. Which of the following will be included in the journal entry when Go Outdoors Monthly records receipt of this $60 prepayment?

A. Credit to Subscription Revenue of $60 B. Debit to Subscription Revenue of $60 C. Credit to Unearned Revenue of $60 D. Credit to Cash of $60 6. Refer to question 5 above. Which of the following will be included in the journal entry when Go Outdoors Monthly provides a magazine to the client each month?

A. Credit to Subscription Revenue of $5 B. Debit to Subscription Revenue of $5 C. Credit to Unearned Revenue of $5 D. Credit to Cash of $5

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7. Unearned revenue is always A. a liability.

B. stockholders’ equity.

C. an asset.

D. a revenue.

8. The unadjusted trial balance shows a $4,400 balance for the Office Supplies account. At the end of the period, the office manager determines that the value of supplies on hand is $1,600. What adjusting entry will be made?

Accounts and Explanations Debit Credit A. Supplies Expense 1,600 Supplies Payable 1,600 B. Supplies Expense 2,800 Office Supplies 2,800 C. Supplies Expense 1,600 Office Supplies 1,600 D. Supplies Expense 2,800 Supplies Payable 2,800 9. Assume that the weekly payroll of Happy Hiking, Inc., is $2,000. The end of the year, December 31, falls on Tuesday. Happy Hiking will pay its employees on Friday for the full week. What adjusting entry will Happy Hiking make on Tuesday, December 31? (Use five days as a full workweek.)

Accounts and Explanations Debit Credit A. Salaries Expense 800 Salaries Payable 800 B. Salaries Payable 800 Salaries Expense 800 C. Salaries Expense 1,200 Cash 1,200 D. Salaries Expense 1,200 Salaries Payable 1,200 10. A contra account A. is paired with its related account in the chart of accounts and related financial statement.

B. has a normal balance (debit or credit) that is the same as the normal balance of its related account.

C. increases the balance of its related account when the two accounts are combined.

D. Both A and B.

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Answer Key to Ten-Minute Quiz: 1. B 2. A 3. B 4. B 5. C 6. A 7. A 8. B Office Supplies balance before adjustment − Office supplies used = Office supplies on hand $4,400 − Office supplies used = $1,600 Office supplies used = $2,800 9. A Daily amount = Weekly amount / 5 days = $2,000 per 5-day week / 5 days = $400 per day Amount accrued = Daily amount x 2 days Amount accrued = $400 x 2 days = $800 10. A

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Extra Critical Thinking Questions Decision Case F:3-2 Sandra Nichols has been the owner and operator of Selling.com Advertising since its beginning 10 years ago. The company has prospered. Recently, Nichols mentioned that she would sell the business for the right price.

Assume that you are interested in buying Selling.com Advertising. You obtain the most recent monthly trial balance, which follows. Revenues and expenses vary little from month to month, and January is a typical month. The trial balance shown is a preliminary, or unadjusted, trial balance. The controller informs you that the necessary accrual adjustments should include revenues of $3,800 and expenses of $1,100. Also, if you were to buy Selling.com Advertising, you would hire a manager so you could devote your time to other duties. Assume that this person would require a monthly salary of $5,000.

Selling.com Advertising Trial Balance January 31, 20XX Balance Account Title Cash Accounts Receivable Prepaid Expenses Building Accumulated Depreciation—Building Accounts Payable Salaries Payable Unearned Revenue Common Stock Retained Earnings Dividends Service Revenue Rent Expense Salaries Expense Utilities Expense Depreciation Expense Supplies Expense Total

.

Debit $ 9,700 14,100 2,600 221,300

Credit

$ 68,600 13,000 56,700 30,400 80,000 9,000 12,300 3,400 900

$ 261,000

$ 261,000

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Requirements 1. Assume that the most you would pay for the business is 20 times the monthly net income you could expect to earn from it. Compute this possible price.

2. Nichols states the least she will take for the business is an amount equal to the business’s stockholders’ equity balance on January 31. Compute this amount.

3. Under these conditions, how much should you offer Nichols? Give your reason.

Decision Case F:3-2: Solution Requirement 1 Service Revenue [$12,300 + $3,800 accrual adj.]

Expenses: Salaries Expense [$3,400 + $5,000 new manager] Utilities Expense Other Expenses [accrual adj.]

Total Expenses Expected Monthly Net Income Multiplier Possible price

$ 16,100 $ 8,400 900 1,100 10,400 5,700 × 20 $ 114,000

Requirement 2 SELLING.COM ADVERTISING Statement of Retained Earnings Month Ended January 31, 20XX Retained Earnings, January 1, 20XX Net income for the month Dividends Retained Earnings, January 31, 20XX

$ 80,000 10,700* 90,700 (9,000) $ 81,700

Total stockholders’ equity = Retained earnings, Jan. 31, 20XX + Common stock Total stockholders’ equity = $81,700 + $30,400 = $112,100 * Calculations: Net Income (Loss) = Total Revenues − Total Expenses = [$12,300 + $3,800 adj.] − [$3,400 + $900 + $1,100 adj.] = $16,100 − $5,400 = $10,700

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Requirement 3 Students’ responses will vary. Illustrative answers follow.

Offer Nichols an amount below the $112,100 (Requirement 2) she is willing to take, such as $100,000.

If Nichols is eager to sell the business, she might accept. If not, pay the $112,100, which is still below the $114,000 possible price (Requirement 1). An offer can always be raised, so start below $112,100.

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Team Project F:3-1 Events and Adventures is a nationwide dating service geared toward introducing singles at group social events. It schedules events and outings that its members can sign up for and meet other people in the process. Events and Adventures collects cash up front for a package of events. Suppose your group is opening an Events and Adventures office in your area. You must make some important decisions— where to locate, how to advertise, and so on—and you must also make some accounting decisions. For example, what will be the end of your business’s accounting year? How often will you need financial statements to evaluate operating performance and financial position? Will you use the cash basis or the accrual basis? When will you account for the revenue that the business earns? How will you account for the expenses?

Requirements Write a report (or prepare an oral presentation, as directed by your professor) to address the following considerations: 1. Will the business use the cash basis or the accrual basis of accounting? Give a complete explanation of your reasoning.

2. How often will financial statements be prepared? Why? Discuss how the business will use each financial statement.

3. What kind of revenue will the business earn? When will the business record it as revenue?

4. What kind of expenses will the business incur? When will expenses be recorded?

Team Project F:3-1: Solution Students’ responses will vary. Illustrative answers follow.

Requirement 1 The business will use the accrual basis of accounting because it provides more complete information than the cash basis. Under accrual basis accounting, adjusting entries are completed at the end of the accounting period to record revenues in the period in which they are earned (revenue recognition principle) and expenses in the period in which they are incurred to generate revenue. Adjusting entries also update asset and liability accounts. Adjustments are needed to properly measure net income (loss) on the income statement and assets and liabilities on the balance sheet. An accrual basis income statement gives a better measure of the business’s net income or net loss, and an accrual basis balance sheet gives a more complete indication of the business’s financial position.

Requirement 2 Monthly financial statements will be prepared in order to measure net income (loss), cash flows, and financial position on a timely basis. The business will use the financial statements as follows: • •

Income statement to measure operating performance in terms of net profits and net losses Balance sheet to measure financial position in terms of assets, liabilities, and stockholders’ equity

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•

Statement of cash flows to report cash inflows (positive amounts) and cash outflows (negative amounts) and to report the net increase or decrease in cash during the period, as well as the ending cash balance

Requirement 3 The business will earn service revenue by providing a package of several social events for clients. The business will record revenue when it is earned, as per the revenue recognition principle. Cash collected in advance of providing services will be recorded in a liability account (Unearned Revenue) until services are provided (revenue is earned), at which time revenue will be recorded and the liability will be reduced. In addition, revenue will be accrued (along with a related asset, other than cash) when earned before being collected in cash.

Requirement 4 Examples of expenses the business will incur include salaries expense, events expense, advertising expense, depreciation expense, supplies expense, interest expense, and insurance expense.

The business will record expenses in the same period as the revenues generated by the expenses following the matching principle. Cash paid in advance will be recorded in an asset account (e.g., a prepaid expense account) until used up, at which time an expense will be recorded and the asset will be reduced (or accumulated depreciation, a contra asset account, will be increased, in the case of depreciable assets). In addition, expenses will be recorded (along with a related liability) when incurred before paying cash.

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Chapter 4 Completing the Accounting Cycle

Chapter 4: Overview The chapter begins with a review of the financial statements, emphasizing the relationships among them and the order they must be completed. The classified balance sheet is explained, focusing on the classification of assets and liabilities as current or long term. Assets are listed based on liquidity, starting with the most liquid—Cash. Liabilities are listed in the order in which they must be paid. Stockholders’ equity reflects stockholders’ contributions through common stock and earnings retained in the business. The report format and the account format of the balance sheet are illustrated.

To facilitate discussion of the closing entries, temporary (or nominal) accounts (Revenues, Expenses, Dividends, and Income Summary) and permanent accounts (Assets, Liabilities, and balance sheet Equities) are defined. The closing process is revealed—how closing entries transfer revenues and expenses into the Income Summary account; the transfer of net income/loss from Income Summary into the Retained Earnings account; and the transfer of Dividends into the Retained Earnings account. The post-closing trial balance is illustrated. The accounting cycle is detailed. The current ratio is used to evaluate business performance.

An appendix to the chapter discusses how the worksheet introduced in Chapter 3 aids in preparing the financial statements. The income statement, balance sheet, and net income/loss sections of the worksheet are reviewed and completed. Students follow the preparation of the worksheet from the trial balance through adjustments, to extending account balances to the proper columns, and finally to computing net income or net loss.

A Tying It All Together feature walks students through the process and purpose of closing its books at year-end. An Ethics feature provides real-world perspective on the motivation to record revenue too early.

The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem allows students to prepare the income statement, statement of retained earnings, and the balance sheet, then calculate the current ratio, journalize and post the closing entries, and prepare a post-closing trial balance. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 4: Learning Objectives LO 1. Prepare the financial statements including the classified balance sheet LO 2. Explain the purpose of, journalize, and post-closing entries LO 3. Prepare the post-closing trial balance LO 4. Describe the accounting cycle LO 5. Use the current ratio to evaluate business performance LO 6. Use the worksheet to prepare financial statements (Appendix 4A)

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Chapter 4: Teaching Outline with Lecture Notes LO 1. Prepare the financial statements including the classified balance sheet a) Review the income statement, statement of retained earnings, and balance sheet i.

Exhibit F:4-1: Adjusted Trial Balance

b) Relationships among the financial statements i.

Exhibit F: 4-2: Smart Touch Learning Financial Statements

c) The classified balance sheet i.

Classify assets and liabilities as current or long term

ii.

Stockholders’ equity reflects owner contributions and retained earnings

iii.

Exhibit F:4-3: Classified Balance Sheet

Lecture Notes: When explaining the relationships among financial statements, point out the date differences. The income statement and statement of retained earnings are for a period of time, but the balance sheet is for one day, actually for one moment in time. This is due to the inherent nature of permanent and temporary accounts, discussed later in the chapter. Students may want to report the balance sheet for the period, which is impossible. For example, the Cash balance cannot be computed for an entire period. It is computed for each day, and it changes from day to day. In addition, point out that the retained earnings balance in the balance sheet is for the end of the period, not the beginning.

Suggested In-Class Exercise: E4-17 LO 2. Explain the purpose of, journalize, and post-closing entries a) Explain the closing process and define the following terms: i. Temporary account ii. Permanent account iii. Closing entries iv. Income summary b) Exhibit F:4-5: The Closing Process c) Exhibit F:4-6: Journalizing and Posting Closing Entries

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Lecture Notes: The closing process consists of journalizing and posting the closing entries to set the balances of the revenues, expenses, Income Summary, and Dividends accounts to zero for the next period. Closing entries reflect the action taken “on paper” when the statement of retained earnings is calculated. We must now take the same action in the ledger to move revenue, expense (via Income Summary), and dividend balances to (i.e., close to) Retained Earnings. Revenues, expenses, Income Summary, and Dividends accounts are temporary (or nominal) accounts. This means they all have a zero balance when the closing process is complete. Income Summary is a temporary account used only in the closing process that is used to transfer balances of temporary accounts that affect net income into equity. This series of steps to close the books puts the ending balance of Retained Earnings in the ledger in agreement with the ending balance in the financial statements. Remind students not to forget to post the closing entries in order to update the general ledger accounts. If this is forgotten, the ledger accounts will be incorrect and will not agree with the financial statements.

Suggested In-Class Exercise: E4-22 LO 3. Prepare the post-closing trial balance a) Exhibit F:4-7: Post-Closing Trial Balance Lecture Notes: The only accounts that should remain on a post-closing trial balance are permanent accounts, which are shown on the balance sheet. All temporary non-balance-sheet accounts have been closed and their balances moved into the stockholders’ equity account Retained Earnings.

Suggested In-Class Exercise: S4A-13 LO 4. Describe the accounting cycle a) Exhibit F:4-8: The Accounting Cycle Lecture Notes: During the period, transactions occur and are journalized and then posted to the ledger. A trial balance is created to ensure that total debits equal total credits for the period. At the end of the period, adjustments are made to account balances, an adjusted trial balance is created, financial statements are prepared, the temporary accounts are closed, and a post-closing trial balance is created.

Suggested In-Class Exercise: S4A-14 LO 5. Use the current ratio to evaluate business performance a) Current ratio = Total current assets / Total current liabilities Lecture Notes: Students frequently do not understand the relationship between current assets and current liabilities. Current assets are the company’s resources available for paying current liabilities as they come due. Highlight this point as you walk students through the calculation.

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Suggested In-Class Exercise: S4A-15 LO 6. Use the worksheet to prepare financial statements (Appendix 4A) a) Complete the remaining sections of the worksheet (sections 1–4 are introduced in Chapter 3) i.

Section 5—Income Statement

ii.

Section 6—Balance Sheet

iii.

Section 7—Determine Net Income or Net Loss

b) Exhibit F4A-1: Completed Worksheet Lecture Notes: The worksheet is not a financial statement. It is a summarization tool, or working paper, that facilitates financial statement preparation. It is optional, as financial statements may also be prepared directly from the adjusted trial balance. If the worksheet method is used, it can be prepared manually or with the assistance of a software program.

The textbook uses a 10-column worksheet, with 5 sets of debit/credit columns. This format can vary in practice. The worksheet provides a check figure in that the first three sets of columns should have equal debits and credits. The last two sets of columns, the income statement and balance sheet, will not have equal debits and credits (unless net income is zero). Instead, the difference in these columns should be the same amount, but on opposite sides (debit versus credit), and represents the net income/loss for the period. The net income/loss amount is a balancing amount⎯the amount is entered in the appropriate column for the income statement and balance sheet in order for debits to equal credits.

Students may be confused with the amount of net income/loss being placed in the debit or credit column. Net income or net loss is the balancing amount on the worksheet. It should always be entered on the side that makes the debit and credit columns balance. For example, the net income amount will be placed in the debit column for the income statement, although expense accounts—not revenue accounts—increase with a debit. The reason for the debit entry for net income is that credits (revenues) exceed debits (expenses), and a debit is needed to equalize the columns.

Point out that the Retained Earnings balance shown in the worksheet is the amount of retained earnings from the beginning of the period. The worksheet does not reflect closing entries. Therefore, the Retained Earnings balance on the worksheet will not agree with the Retained Earnings balance that will appear in the balance sheet. Total credits in the Income Statement column may not represent total revenue due to possible sales returns and allowances (to be discussed in Chapter 5). Total debits in the Balance Sheet column may not represent total assets due to accumulated depreciation accounts, which have credit balances but will be reflected in the asset section of the balance sheet.

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Also, students are sometimes confused because Dividends are included on the Balance Sheet column but not on an actual balance sheet. Again, this is because the Retained Earnings balance does not reflect closing entries, so we need to include the debit balance of Dividends (reduction of Retained Earnings) in the Balance Sheet column.

Suggested In-Class Exercise: E4-20

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Chapter 4: Handout for Student Notes LO 1. How do we prepare financial statements?

o Relationships among the financial statements

o Classified balance sheet

▪

Assets

▪

Liabilities

▪

Stockholders’ equity

LO 2. What is the closing process, and how do we close the accounts?

o Closing temporary accounts—Net income for the period

o Closing temporary accounts—Net loss for the period

LO 2. How do we prepare a post-closing trial balance?

LO 3. What is the accounting cycle?

LO 4. How do we use the current ratio to evaluate business performance?

LO 5. How could a worksheet help in preparing financial statements?

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o Section 5—Income statement

o Section 6—Balance sheet

o Section 7—Determine net income or net loss

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Chapter 4: Student Chapter Summary LO 1. Prepare the financial statements including the classified balance sheet Financial statements are prepared from the adjusted trial balance in the following order: 1. Income statement: Reports revenues and expenses and calculates net income or net loss during the period—with net income or loss reflected in statement of retained earnings 2. Statement of retained earnings: Shows how retained earnings changed during the period due to net income or net loss and dividends—with the ending retained earnings balance reflected in the stockholders’ equity section of the balance sheet 3. Balance sheet: Reports assets, liabilities, and stockholders’ equity as of the last day of the period A classified balance sheet classifies each asset and each liability into current and longterm categories. There is no such classification for stockholders’ equity. Stockholders’ equity categories are illustrated in a later chapter (Chapter 13––Stockholders’ Equity).

LO 2. Explain the purpose of, journalize, and post-closing entries The closing process consists of zeroing out all temporary (or nominal) accounts (revenues, expenses, Income Summary, and Dividends) in order to get the accounts ready for the next period. The closing process also updates the Retained Earnings account balance for net income or net loss during the period and any dividends paid to the stockholders. There are four steps in the closing process: 1. Make the revenue accounts equal zero via the Income Summary account.

2. Make the expense accounts equal zero via the Income Summary account.

3. Make the Income Summary account equal zero via the Retained Earnings account.

4. Make the Dividends account equal zero via the Retained Earnings account.

LO 3. Prepare the post-closing trial balance A post-closing trial balance is prepared after the closing entries are recorded and posted to the ledger. It contains only assets, liabilities, Common Stock, and Retained Earnings accounts (permanent accounts). Note that these accounts are the balance sheet accounts.

LO 4. Describe the accounting cycle The accounting cycle is the process by which companies produce their financial statements for a specific period. These are the steps: 1. Start with the beginning account balances.

2. Analyze and journalize transactions as they occur.

3. Post journal entries to the accounts.

4. Compute the unadjusted balance in each account, and prepare the unadjusted trial balance.

5. Enter the unadjusted trial balance on the worksheet and complete the worksheet (optional).

6. Journalize and post adjusting entries.

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7. Prepare the adjusted the trial balance.

8. Prepare the financial statements.

9. Journalize and post the closing entries.

10. Prepare the post-closing trial balance.

LO 5. Use the current ratio to evaluate business performance The current ratio measures a company’s ability to pay its current liabilities with its current assets: Current ratio = Total current assets / Total current liabilities.

LO 6. Use the worksheet to prepare financial statements The columns of a worksheet can be extended to help in preparing the financial statements. The income statement section will include only revenue and expense accounts. The balance sheet section will include asset and liability accounts and all equity accounts except revenues and expenses.

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Chapter 4: Assignment Grid and Other Materials LO 1 S4-1 S4-2 S4-3 S4-4 S4-5 S4-6 S4-7 S4-8 S4-9 S4-10 S4-11 S4-12 S4-13 S4-14 S4A-15 E4-16 E4-17 S4-18 E4-19 E4-20 E4-21 E4-22 E4-23 E4-24 E4-25 P4-26A, P4-31B P4-27A, P4-32B P4-28A, P4-33B P4-29A, P4-34B P4-30A, P4-35B

LO 2

LO 3

LO 4

LO 5

LO 6

X X X X X X X X X X X X X X X X X X

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S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem F:4-1 Practice Set F:4-1 Comprehensive Problem F:4-1 for Chapters F:1–F:4 Comprehensive Problem F:4-2 for Chapters F:1–F:4 Tying It All Together F:4-1 Ethical Issue F:4-1 Financial Statement Case F:4-1 Team Project F:4-1

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

1. What is the last step in the accounting cycle?

A. Prepare the financial statements.

B. Prepare the post-closing trial balance.

C. Journalize closing entries.

D. Prepare the adjusted trial balance.

2. Which columns of the accounting worksheet show unadjusted amounts?

A. Trial Balance B. Adjustments C. Balance Sheet D. Income Statement 3. Which of the following accounts may appear on a post-closing trial balance?

A. Cash, Service Revenue, and Rent Expense B. Cash, Accounts Receivable, and Rent Revenue C. Cash, Accounts Receivable, and Prepaid Rent D. Cash, Accounts Receivable, and Rent Expense 4. Which situation indicates a net income within the Income Statement columns of the worksheet?

A. Total debits exceed total credits.

B. Total debits equal total credits.

C. Total credits exceed total debits.

D. None of the above are correct.

5. Christopher’s Closet sells men’s clothing. At the end of the current year, Christopher’s Closet has Rent Expense of $1,500, and Supplies Expense of $829. What closing entry will Christopher’s Closet make for these expense accounts?

Accounts and Explanations Debit Credit A. Rent Expense 1,500 Supplies Expense 829 Cash 2,329 B. Cash 2,329 Rent Expense 1,500 Supplies Expense 829 C. Rent Expense 1,500 Supplies Expense 829 Income Summary 2,329 D. Income Summary 2,329 Rent Expense 1,500 Supplies Expense 829

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6. Which of the following accounts is closed at the end of the accounting cycle?

A. Cash B. Dividends C. Salary Payable D. Accumulated Depreciation 7. Which of the following statements is true?

A. Cash is a nominal account, and Service Revenue is a temporary account.

B. Equipment is a real account, and Salary Expense is a permanent account.

C. Accounts Receivable is a temporary account, and Dividends is a real account.

D. Prepaid Rent is a permanent account, and Income Summary is a nominal account.

8. Which of the following is an appropriate closing entry?

Accounts and Explanations A. Income Summary Service Revenue B. Salaries Payable Income Summary C. Service Revenue Income Summary D. Salaries Expense Income Summary

Debit XXX

Credit XXX

XXX XXX XXX XXX XXX XXX

9. Which of the following is not a plant asset?

A. Office Supplies B. Land C. Equipment D. All of these are plant assets.

10. Sammy’s Sandwiches has Cash of $400, Accounts Receivable of $1,600, Office Supplies of $800, Supplies Expense of $400, and Service Revenue of $1,800. Sammy’s owes $600 on Accounts Payable, $1,000 on Salaries Payable, and $1,400 on Long-term Notes Payable. What is Sammy’s current ratio (rounded to two decimal places)?

A. 3.13 B. 1.75 C. 1.60 D. 0.93

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Answer Key to Ten-Minute Quiz: 1. B 2. A 3. C 4. C

5. D 6. B 7. D 8. C 9. A 10. B Current ratio = Total current assets / Total current liabilities = $2,800 / $1,600 = 1.75 Total current assets = Cash of $400 + Accounts Receivable of $1,600 + Office Supplies of $800 = $2,800 Total current liabilities = $600 owed on Accounts Payable + $1,000 owed on Salaries Payable = $1,600

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Extra Critical Thinking Questions Decision Case F:4-1 One year ago, Campbell Conwell founded Conwell Consignment Sales Company, and the business has prospered. Conwell comes to you for advice. She wishes to know how much net income the business earned during the past year. The accounting records consist of the Taccounts in the ledger, which were prepared by an accountant who has moved. The accounts at December 31, 20XX, follow:

Conwell indicates that, at year-end, customers owe the business $1,000 accrued service revenue, which the business expects to collect early next year. These revenues have not been recorded.

During the year, the business collected $4,100 service revenue in advance from customers, but the business has earned only $800 of that amount. During the year Conwell Consignment has incurred $2,400 of advertising expense, but the business has not yet paid for it. In addition, the business has used up $2,100 of the office supplies. Conwell determines that depreciation on equipment was $7,000 for the year. At December 31, 20XX, the business owes its employee $1,200 accrued salary.

To get a loan to expand the business, Conwell must show the bank that the business’s stockholders’ equity has grown from its original $40,000 balance. Has it? You and Conwell agree that you will meet again in one week.

Requirements 1. Prepare the financial statement that helps address the first issue concerning Conwell.

2. Can Conwell expect to get the loan? Give your reason(s).

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Decision Case F:4-1: Solution Requirement 1 Ms. Conwell will need to prepare an income statement to answer her question: CONWELL CONSIGNMENT SALES COMPANY Income Statement Year Ended December 31, 20XX Revenues: Service Revenue ($80,700 + $1,000 + $800) Expenses: Salaries Expense ($17,000 + $1,200) Depreciation Expense—Equipment Advertising Expense Supplies Expense Utilities Expense Total Expenses Net Income

$ 82,500 $ 18,200 7,000 2,400 2,100 800 30,500 $ 52,000

Requirement 2 Net income exceeds dividends, so equity grew during the year. Ms. Conwell should be able to get the loan.

Communication Activity F:4-1

In 150 words or fewer, explain the rationale for closing the temporary accounts.

Communication Activity F:4-1: Solution Closing the temporary accounts updates Retained Earnings for the period and zeros out the revenue, expenses, and dividends accounts in preparation for the next period.

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Chapter 5 Merchandising Operations

Chapter 5: Overview The chapter first compares a service business with a merchandising business, discusses the operating cycle for a merchandising company, and then illustrates how a merchandiser’s financial statements differ from a service entity’s financial statements. Next, both the periodic and perpetual inventory systems are defined. Accounting for merchandise inventory in a perpetual inventory system is emphasized in the chapter, and the periodic inventory system is covered in an appendix to the chapter. Journal entries for purchases of merchandise inventory based on purchase invoices are illustrated, including effects of purchase discounts, purchase returns and allowances, and transportation costs, for which the terms FOB destination and FOB shipping point are explained. The calculation of net purchases is detailed. The chapter then illustrates the journal entries for sale transactions using the new revenue recognition rules. This requires that companies report sales based on the amount they expect to receive. The chapter introduces cash and credit sales, cost of goods sold, sales discounts, sales returns and allowances, and outgoing transportation costs. Net sales revenue and gross profit are explained.

The second part of the chapter discusses the creation the financial statements and emphasizes the classifications on the income statement. The multi-step and single-step income statement formats are compared. Discussion of the gross profit percentage and how to use this ratio in decision making completes the chapter. Appendix 5A covers the periodic inventory system.

Appendix 5B discusses how to account for the sale of merchandise inventory using the net method.

An Ethics feature provides a real-world perspective on handling gifts from vendors. A Tying It All Together feature helps students decide whether a business should borrow money to make a payment within the discount period. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. Two Check Your Understanding Problems review journal entries for a perpetual inventory system and preparation of the multi-step income statement, statement of retained earnings, balance sheet in report form, and closing entries. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 5: Learning Objectives LO 1. Describe merchandising operations and the two types of merchandise inventory systems LO 2. Account for the purchase of merchandise inventory using a perpetual inventory system LO 3. Account for the sale of merchandise inventory using a perpetual inventory system LO 4. Adjust and close the accounts of a merchandising business LO 5. Prepare a merchandiser’s financial statements LO 6. Use the gross profit percentage to evaluate business performance LO 7. Account for the purchase and sale of merchandise inventory using a periodic inventory system (Appendix 5A) LO 8. Account for the sale of merchandise inventory using the net method (Appendix 5B)

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Chapter 5: Teaching Outline with Lecture Notes LO 1. Describe merchandising operations and the two types of merchandise inventory systems

a) Review the following terms and give examples of each: i.

Merchandiser

ii.

Merchandise inventory

iii.

Wholesaler

iv.

Retailer

v.

Operating cycle (Exhibit F:5-1: Operating Cycle of a Merchandiser)

vi.

Vendor

vii.

Cost of Goods Sold (COGS)

viii.

Gross profit

ix.

Operating expenses

b) Exhibit F:5-2: Financial Statements of a Service Company and a Merchandising Company c) Merchandise inventory systems: Perpetual and Periodic Inventory Systems i.

Periodic inventory system

ii.

Perpetual inventory system

Lecture Notes: Walk students through the new terminology and the differences between a service firm and a merchandising firm. Introduce COGS and emphasize that it is an expense account. Also emphasize the differences between the financial statements of a service firm and those of a merchandiser.

Theoretically, a perpetual inventory system is always up-to-date. If you need to know the balance of inventory, you simply look in the inventory ledger account. A periodic system is updated periodically. To know the inventory balance, a physical count must be obtained; to determine cost of goods sold, a calculation must be performed.

Suggested In-Class Exercise: S5-1 LO 2. Account for the purchase of merchandise inventory using a perpetual inventory system

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a) Exhibit F:5-3: Purchase Invoice b) Purchase of merchandise inventory c) Purchase returns and allowances d) Purchase discounts e) Transportation costs i.

FOB shipping point

ii.

FOB destination

iii.

Freight in

iv.

Freight out

v.

Exhibit F:5-4: FOB Terms Determine Who Pays the Freight

f) Net cost of inventory purchased Lecture Notes: As mentioned in the previous lecture outlines, the first obstacle for students in accounting can be debits and credits; the second obstacle can be adjusting entries; and the third obstacle can be accounting for inventory. Just when students have the hang of it, new accounts (primarily Merchandise Inventory and Cost of Goods Sold) and transactions are thrown at them!

The purchase of inventory, the sale of inventory, and the payment for inventory are three separate events. A company may purchase and sell inventory before paying for it, which is great cash flow management! A payable would be reported on the balance sheet until the invoice for purchased inventory is paid.

The increases in Sales Revenue and Cost of Goods Sold would be reported on the income statement. The increase in Accounts Receivable and the decrease in Merchandise Inventory would be reported on the balance sheet for the inventory purchased and sold.

Explain purchase returns and allowances as well as purchase discounts. Discuss their respective impact on accounts payable and merchandise inventory.

Explain transportation costs. Emphasize the terms FOB shipping point and FOB destination and discuss who is responsible for paying freight charges. Further, explain the impact of freight charges on cost of inventory purchased. In the calculation of cost of inventory purchased, emphasize that freight in is typically not a service provided by the seller. Delivery is completed by a third party, such as UPS or another freight delivery company. Therefore, when calculating net cost of inventory purchased any early payment discount must be calculated on the purchase less returns and allowances. Then freight in is added.

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Suggested In-Class Exercise: E5-22 LO 3. Account for the sale of merchandise inventory using a perpetual inventory system

a) Cash and credit card sales b) Exhibit F:5-5: Sales Invoice c) Sales on account, no discount d) Sales on account, with discount e) Sales returns and allowances i.

Sales return

ii.

Sales allowance

iii.

Cash collected within discount period

f) Transportation costs—Freight out Lecture Notes: The seller always has two entries for a sale: recording the sales revenue and accounts receivable or cash at the sales price and recording the inventory and cost of goods sold at the cost of inventory purchased. When a buyer requests a refund, the seller also has two transactions to record: 1) to refund the amount of the sale to the customer and 2) to reduce Costs of Goods Sold and place the merchandise back in merchandise inventory. If the product is defective, the merchandise inventory can be adjusted in a separate transaction by following the purchase returns and allowances procedure.

Define sales discounts and emphasize its meaning. Explain how to interpret common payment terms found on invoices, such as 2/10, n30. Many students misunderstand sales discounts and confuse the term with trade discounts. Explain to students that under the new revenue recognition rules, companies will record sales transactions at the net amount or the sale less any sales discounts. Discuss the Sales Discounts Forfeited account which is used when a customer does not pay within the discount period.

Explain freight out and how it is expensed. Emphasize that freight out does not impact the cost of inventory sold.

Suggested In-Class Exercise: E5-23 LO 4. Adjust and close the accounts of a merchandising business

a) Adjusting merchandise inventory for inventory shrinkage i.

Inventory shrinkage

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b) Closing the accounts of a merchandiser c) Exhibit F:5-6: Adjusted Trial Balance and Closing Entries Lecture Notes: The only way to ensure a correct inventory balance is to take a physical count. Every company should take a physical count at least once a year—even those using the perpetual inventory method. Transactions can take place that are not recorded, such as theft, damage, and errors. Define inventory shrinkage and demonstrate how to write off this amount to Cost of Goods Sold.

As the closing entries for a merchandising firm are the same as those of a service firm, provide a brief refresher of this concept, introduced in Chapter 4.

Suggested In-Class Exercises: E5-26 LO 5. Prepare a merchandiser’s financial statements

a) Income statement i.

Single-step income statement (Exhibit F:5-7: Single-Step Income Statement)

ii.

Multi-step income statement (Exhibit F:5-8: Multi-Step Income Statement)

iii.

Selling expenses

iv.

Administrative expenses

v.

Operating income

vi.

Other income and expenses

vii.

Income tax expense

b) Statement of retained earnings and the balance sheet Lecture Notes: Introduce new accounts related to merchandising. Walk students through the calculation of the multi-step income statement and explain the purpose of each section. Note that the statement of retained earnings is no different for a merchandiser than one of a service business. However, the balance sheet will have additional assets (merchandise inventory and estimated returns inventory) as well as an additional liability (refunds payable).

Suggested In-Class Exercises: E5-27, E5-28 LO 6. Use the gross profit percentage to evaluate business performance

a) The gross profit percentage .

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b) Gross profit percentage = Gross profit / Net sales revenue Lecture Notes: Students may be surprised to see the dollar amount differences between gross profit and net income. Just because a company has gross profit doesn’t mean it will have net income. It must price its products to have enough revenue to cover the remaining expenses incurred and to earn net income. Thus, it is important to assess the profitability of each sales dollar above the cost of goods sold to ensure that a company is earning a sufficient profit on its merchandise inventory.

Suggested In-Class Exercise: E5-29 LO 7. Account for the purchase and sale of merchandise inventory using a periodic inventory

system (Appendix 5A) a) Purchases of merchandise inventory—periodic inventory system i.

Purchases

b) Purchase returns and allowances—periodic inventory system c) Purchase discounts—periodic inventory system d) Transportation costs—periodic inventory system e) Net cost of inventory purchased f) Sale of merchandise inventory—periodic inventory system g) Preparing financial statements—periodic inventory system h) Adjusting and closing entries—periodic inventory system i) Exhibit 5A-1: Adjusted Trial Balance and Closing Entries Lecture Notes: In a perpetual inventory system, the journal entry for any transaction that affects inventory will always include an entry to the Merchandise Inventory account. In contrast, in a periodic inventory system, the journal entry for any transaction that affects inventory will never include an entry to the Merchandise Inventory account. Instead, the journal entries will affect one of the accounts related to net purchases: Purchases, Purchase Discounts, Purchase Returns and Allowances, or Freight In. Furthermore, in a perpetual inventory system, when merchandise is sold, there are two journal entries made: one to record the sales revenue and the second to remove merchandise from inventory and charge it to Cost of Goods Sold. In contrast, in a periodic inventory system, only the journal entry to record the sales revenue is made at the time of the sale.

Then, the Merchandise Inventory account will be updated at the end of the period by the adjusting entry to close all those accounts related to net purchases, correct the Merchandise

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Inventory ending balance to equal the physical count, and charge the balancing amount to Cost of Goods Sold.

Suggested In-Class Exercises: E5B-33, E5B-34 LO 8. Account for the sale of merchandise inventory using the net method (Appendix 5B) a) Sale on account, with discount, net method b) Collection on account, discount forfeited, net method c) Comparison between gross and net methods i) Exhibit F:5B-1

Chapter 5: Handout for Student Notes LO 1. What are merchandising operations?

o The operating cycle of a merchandising business

o Merchandise inventory systems: Perpetual and periodic inventory systems

LO 2. How are purchases of merchandise inventory recorded in a perpetual inventory system?

o Purchase of merchandise inventory

o Purchase returns and allowances

o Purchase discounts

o Transportation costs

▪

Freight in

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▪

Freight in within discount period

o Net cost of inventory purchased

LO 3. How are sales of merchandise inventory recorded in a perpetual inventory system?

o Cash and credit card sales

o Sales on account, no discount

o Sales returns and allowances

o Sales on account, with discount

o Transportation costs—Freight out

LO 4. What are the adjusting and closing entries for a merchandiser?

o Adjusting merchandise inventory for inventory shrinkage

o Closing the accounts of a merchandiser

LO 5. How are a merchandiser’s financial statements prepared?

o Income statement

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▪

Single-step income statement

▪

Multi-step income statement

o Statement of retained earnings and the balance sheet

LO 6. How do we use the gross profit percentage to evaluate business performance?

LO 7. How are merchandise inventory transactions recorded in a periodic inventory system?

(Appendix 5A)

o Purchases of merchandise inventory—periodic inventory system

o Purchases

o Purchase returns and allowances—periodic inventory system

o Purchase discounts—periodic inventory system

o Transportation costs—periodic inventory system

o Net cost of inventory purchased

o Sale of merchandise inventory—periodic inventory system

o Preparing financial statements—periodic inventory system

o Adjusting and closing entries—periodic inventory system

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LO 8. Account for the sale of merchandise inventory using the net method (Appendix 5B)

o Sale on account, with discount, net method

o Collection on account, discount forfeited, net method

o Comparison between gross and net methods

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Chapter 5: Student Chapter Summary LO 1. Describe merchandising operations and the two types of merchandise inventory

systems A merchandiser is a business that sells merchandise, or goods, to customers. Two main types of inventory accounting systems are used by merchandisers: (1) A perpetual inventory system, which keeps a running record of merchandise inventory, and (2) a periodic inventory system, which requires businesses to obtain a physical count of inventory to determine quantities on hand.

LO 2. Account for the purchase of merchandise inventory using a perpetual inventory system

The operating cycle of a merchandising business begins with purchase of inventory from a seller. Purchases are documented by an invoice from the seller, requesting payment for the purchases. Purchase discounts, purchase returns, and purchase allowances decrease the amount of net purchases, while freight in increases the amount of net purchases.

Sellers offer purchase discounts to purchasers as an incentive for early payment. Purchase returns arise when businesses allow purchasers to return merchandise that is defective, damaged, or otherwise unsuitable, while a purchase allowance is granted to the purchaser as an incentive to keep goods that are not “as ordered.” To determine when title to the purchased goods transfers to the purchaser, the purchase agreement specifies FOB (free on board) terms either as FOB shipping point, in which case the buyer takes ownership of the goods at the shipping point, and the buyer pays the freight, or as FOB destination point, in which case the buyer takes ownership at the delivery destination point, and the seller pays the freight. The net cost of inventory purchased is calculated as: Purchases of inventory − Purchase returns and allowances − Purchase discounts + Freight in LO 3. Account for the sale of merchandise inventory using a perpetual inventory system

Sales revenue is the amount that a merchandiser receives from selling its inventory. Sales discounts, offered by the seller as an incentive for the purchaser to pay early, reduce the amount of cash received from a customer for early payment. Sales can either be recorded at the gross method or the net method of the sales less any sales discounts. The net method of reporting sales discounts is discussed in Appendix 5B. Sales returns are a reduction in the amount owed by a customer due to the return of merchandise. This is completed in two journal entries. The first entry is to debit Sales Returns and Allowances for the amount of the refund, and credit cash. The second is to correct the inventory by debiting Merchandise inventory and crediting Costs of Good Sold. Freight out is an operating expense and is debited to the seller’s Delivery Expense account.

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LO 4. Adjust and close the accounts of a merchandising business

An adjusting entry must be made for inventory shrinkage—loss of inventory that occurs because of theft, damage, and errors. The closing entries are similar to those discussed earlier, except for including the new accounts (Sales Revenue, Sales Discounts Forfeited, Delivery Expense, and Cost of Goods Sold).

LO 5. Prepare a merchandiser’s financial statements

There are two formats for the income statement: (1) a single-step income statement that groups all revenues together and all expenses together, without calculating other subtotals, or (2) a multi-step income statement that lists several important subtotals, including gross profit, operating income, and income before income tax expense. A merchandiser’s statement of retained earnings looks exactly like that of a service business. The balance sheet will also look the same, except merchandisers list additional current assets, Merchandise Inventory. LO 6. Use the gross profit percentage to evaluate business performance The gross profit percentage measures the profitability of each sales dollar above the cost of goods sold. Gross profit percentage is calculated as gross profit divided by net sales revenue.

LO 7. Account for the purchase and sale of merchandise inventory using a periodic inventory system (Appendix 5A) Companies are required to identify the performance obligations associated with each contract. When contracts involve multiple performance obligations, the company is required to allocate the transaction price to each performance obligation separately. A company should recognize revenue only when, or as, it satisfies each performance obligation. A contract is recorded as Unearned Revenue when the company has not satisfied the obligation of servicing or fulfilling the service contract and the customer has paid in advance.

LO 8. Account for the sale of merchandise inventory using the net method(Appendix 5B) Using the net of sales method for sales discounts, the seller assumes that all customers will take advantage of the sales discounts. In this case, the seller records the sale at the net (or discounted) amount. If the customer does not pay within the discount period, the seller records the additional revenue to Sales Discounts Forfeited (listed on the Income Statement under the Other Income section).

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Chapter 5: Assignment Grid and Other Materials S5-1 S5-2 S5-3 S5-4 S5-5 S5-6 S5-7 S5-8 S5-9 S5-10 S5-11 S5-12 S5-13 S5-14 S5A-15 S5B-16 S5B-17 S5B-18 S5B-19 S5B5-20 E5-21 E5-22 E5-23 E5-24 E5-25 E5-26 E5-27 E5-28 E5-29 E5A-30 E5B-31 E5B-32

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E5B-33 E5B-34 E5B-35 E5B-36 E5B-37 E5B-38 P5-39A, P5-47B P5-40A, P5-48B P5-41A, P5-49B P5-42A, P5-50B P5-43A, P5-51B P5B-44A, P5-52B

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S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem Part 1 F:5-1 Continuing Problem Part 2 F:5-2 Practice Set F:5-1 Tying It All Together Case F:5-1 Decision Case F:5-1 Ethical Issue F:5-1 Fraud Case F:5-1 Financial Statement Case F:5-1

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

1. The journal entry for the purchase of inventory on account using a perpetual inventory system includes a A. Debit to Purchases B. Credit to Purchases C. Debit to Merchandise Inventory D. Credit to Merchandise Inventory 2. The journal entry for the purchase of inventory on account using a periodic inventory system includes a A. Debit to Purchases B. Credit to Purchases C. Debit to Merchandise Inventory D. Credit to Merchandise Inventory 3. A perpetual inventory system A. does not maintain control over inventory as strongly as a periodic inventory system does.

B. keeps inventory continuously updated.

C. updates inventory at the end of the month, based on a physical count.

D. is used by both merchandising companies and service companies.

4. Georgia Industrial purchased inventory for $5,000 and paid a $400 freight bill.

Georgia Industrial returned $700 of the goods to the seller and then took a 2% purchase discount. What is Georgia Industrial’s final cost of the inventory that it kept?

A. $3,814 B. $4,600 C. $4,614 D. $4,794 5. Outdoor Apparel had net sales of $562,000 and Cost of Goods Sold of $290,000.

How much gross profit did Outdoor Apparel report?

A. $562,000 B. $852,000 C. $272,000 D. $290,000

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6. Suppose the Carol’s Candles Merchandise Inventory account shows an unadjusted balance of $15,000. On December 31, 2024, the physical count of goods on hand totaled $14,200. To adjust the accounts, Carol’s Candles would make which of the following entries?

Accounts and Explanations Debit Credit A. Merchandise Inventory 800 Costs of Goods Sold 800 B. Costs of Goods Sold 800 Merchandise Inventory 800 C. Merchandise Inventory 800 Purchases 800 D. Purchases 800 Merchandise Inventory 800 7. FOB shipping point refers to the situation in which title to goods in transit rests with the A. seller.

B. buyer.

C. shipping company.

D. transportation company.

8. Using the perpetual inventory system, which account is used to record the payment of freight for inventory purchased?

A. Cost of Goods Sold B. Sales Revenue C. Delivery Expense D. Merchandise Inventory 9. Assume Sports Warehouse had Net Sales Revenue of $100,000 and Cost of Goods Sold of $75,000. Average Merchandise Inventory was $15,000. What is the gross profit percentage for Sports Warehouse for this period?

A. 90% B. 75% C. 40% D. 25% 10. Camera Emporium uses a perpetual inventory system. Suppose Camera Emporium’s Purchases totaled $68,000, Purchase Returns totaled $5,200, Purchase Allowances totaled $1,500, Purchase Discounts totaled $2,800, and Freight In totaled $5,000.

What is Camera Emporium’s net cost of inventory purchases?

A. $ 63,500 B. $ 58,500 C. $ 55,000 D. $ 53,500

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Answer Key to Ten-Minute Quiz: 1. C 2. A 3. B 4. C Net Cost of Inventory Purchased = Purchase cost of inventory − Purchase returns and allowances − Purchase discounts + Freight in = $5,000 − $700 − [(5,000 − $700) × 0.02] + $400 = $4,614 5. C Gross profit = Net sales revenue − COGS = $562,000 − $290,000 = $272,000 6. B 7. B 8. D 9. D Gross profit = Net sales revenue − COGS = $100,000 − $75,000 = $25,000 Gross profit percentage = Gross profit / Net sales revenue = $25,000 / $100,000 = 25% 10. A Net Cost of Inventory Purchased = Purchase cost of inventory − Purchase returns and allowances − Purchase discounts + Freight in = $68,000 − $5,200 − $1,500 − $2,800 + $5,000 = $63,500

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Extra Critical Thinking Questions Decision Case F:5-2 Stockholders of Sammy’s Sandwich Shop have prospered during the company’s second year of operation. In order to help with decisions about whether to open another sandwich shop, Sammy’s has prepared the current income statement of the business. Sheila Lewis, the controller, read in an industry trade journal that a successful two-year-old sandwich shop meets the following criteria: a. Gross profit percentage is at least 60%. b. Net income is at least $90,000.

Lewis believes the business meets both criteria. She intends to go ahead with the expansion plan and asks your advice on preparing the income statement in accordance with Generally Accepted Accounting Principles. When you point out that the statement includes errors, Lewis assures you that all amounts are correct. But some items are listed in the wrong places.

Sammy’s Sandwich Shop Income Statement Year Ended December 31, 20XX Net Sales Revenue Gain on Sale of Land Total Revenue Cost of Goods Sold Gross Profit Operating Expenses: Salaries Expense Interest Expense Depreciation Expense Utilities Expense Total Operating Expense Income from Operations Other Income: Sales Discounts Forfeited Net Income

.

$ 195,000 24,600 219,600 85,200 134,400 35,600 6,000 4,800 3,700 50,100 84,300 10,700 $ 95,000

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Requirement Prepare a corrected multi-step income statement and make a recommendation to Lewis about whether Sammy’s Sandwich Shop should undertake the expansion. Ignore classifying the expenses as selling or administrative.

Decision Case F:5-2: Solution Recommendation: Sheila Lewis should not expand. The gross profit percentage is only 56.3% ($109,800 / $195,000), which does not meet the criterion of 60%. The net income is $95,000, which does meet the criterion of $90,000.

SAMMY’S SANDWICH SHOP Income Statement Year Ended December 31, 20XX Net Sales Revenue Cost of Goods Sold Gross Profit Operating Expenses: Salaries Expense Depreciation Expense Utilities Expense Total Operating Expenses Operating Income Other Income and (Expenses): Sales Discounts Forfeited Gain on Sale of Land Interest Expense Total Other Income and (Expenses) Net Income

$ 195,000 85,200 109,800 35,600 4,800 3,700 44,100 65,700 10,700 24,600 (6,000) 29,300 $ 95,000

Team Project F:5-1 With a small team of classmates, visit one or more merchandising businesses in your area.

Interview a responsible manager of the company to learn about its inventory policies and accounting system. Obtain answers to the following questions, write a report, and be prepared to make a presentation to the class if your instructor so directs.

Requirements 1. What merchandise inventory does the business sell?

2. From whom does the business buy its inventory? Is the relationship with the supplier new or longstanding?

3. What are the FOB terms on inventory purchases? Who pays the freight: the buyer or the seller? Is freight a significant amount? What percentage of total inventory cost is the freight?

4. What are the credit terms on inventory purchases: 2/10, n/30, or other? Does the business pay

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5.

6.

7.

8.

9.

early to get purchase discounts? If so, why? If not, why not?

How does the business actually pay its suppliers? Does it mail a check or pay electronically?

What is the payment procedure?

Which type of inventory accounting system does the business use: perpetual or periodic? Is this system computerized?

How often does the business take a physical count of its inventory? When during the year is the count taken? Describe the company’s count procedures.

Does the manager use the gross profit percentage to evaluate the business? If not, show the manager how to use this ratio in decision making.

Ask any other questions your group considers appropriate.

Team Project F:5-1: Solution Students will be visiting different companies, so their answers will vary.

Communication Activity F:5-1 In 100 words or fewer, explain the difference between freight in and freight out.

Communication Activity F:5-1: Solution Freight in is the transportation cost to ship goods from the seller into the purchaser’s warehouse.

It is the freight on purchased goods. Freight out is the transportation cost to ship goods out of the seller’s warehouse. It is the freight on goods sold to the customer. Freight in becomes part of the cost of merchandise inventory. Freight out is recorded as a delivery expense.

.

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Chapter 6 Merchandise Inventory

Chapter 6: Overview The chapter examines the accounting for merchandise inventory. The accounting principles and concepts that affect merchandise inventory—the consistency principle, the disclosure principle, the materiality concept, and conservatism—are explained. Controls over merchandise inventory are discussed. A Data Analytics in Accounting feature introduces data analytics as a tool companys can use for evaluating and tracking inventory. Accounting for merchandise inventory costs under a perpetual inventory system is described. Four different costing methods—specific identification; first-in, first-out (FIFO); last-in, first-out (LIFO); and weighted-average—for a perpetual inventory system are explained in the main portion of the chapter. The differences among the effects of these various inventory costing methods on the financial statements are detailed. The lower-of-cost-or-market rule is explained. The effects of merchandise inventory errors are illustrated. Inventory turnover and days’ sales in inventory are used to evaluate business performance. Appendix 6A illustrates merchandise inventory costing in a periodic system for FIFO, LIFO, and weighted-average.

A Tying It All Together feature analyzes inventory costing of Dick’s Sporting Goods. An Ethics feature gives perspective on an ethical dilemma involving truthful reporting of inventories. The Review includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem allows students to practice preparing three perpetual inventory records; preparing journal entries using FIFO, LIFO, and weighted-average; and computing gross profit for each method. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 6: Learning Objectives LO 1. Identify accounting principles and controls related to merchandise inventory LO 2. Account for merchandise inventory costs under a perpetual inventory system LO 3. Compare the effects on the financial statements when using the different inventory costing methods LO 4. Apply the lower-of-cost-or-market rule to merchandise inventory LO 5. Measure the effects of merchandise inventory errors on the financial statements LO 6. Use inventory turnover and days’ sales in inventory to evaluate business performance LO 7. Account for merchandise inventory costs under a periodic inventory system (Appendix 6A)

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Chapter 6: Teaching Outline with Lecture Notes LO 1. Identify accounting principles and controls related to merchandise inventory a) Accounting principles i.

Consistency principle

ii.

Disclosure principle

iii.

Materiality concept

iv.

Conservatism

b) Control over merchandise inventory Lecture Notes: Discuss the implied ramifications of these principles. The implication of the consistency principle is that accounting rules are not necessarily identical for every company. Some rules allow companies to choose which rule will apply to them, such as inventory valuation. What is most important is that companies consistently apply the rules they have chosen. The implication of the disclosure principle is that the body of the financial statements tells only part of the story; the footnotes are an integral part of the financial statements. The materiality principle implies that the financial statements may not include every single detail about companies’ transactions, just the important (materially significant) details. Conservatism also implies judgment is involved in deciding what represents the “truth” contained within the financial statement. Discuss good measures for maintaining control over merchandise inventory.

Suggested In-Class Exercise: S6-1 LO 2. Account for merchandise inventory costs under a perpetual inventory system a) Ending Merchandise Inventory = Number of units on hand × Unit cost b) Cost of Goods Sold = Number of units sold × Unit cost i.

Exhibit F:6-1: Perpetual Inventory Record

ii.

Exhibit F:6-2: Perpetual Inventory Record—Changes in Cost per Unit

c) Specific identification method i.

Exhibit F:6-3: Perpetual Inventory Record: Specific Identification

d) First-in, first-out (FIFO) method i.

Inventory calculations—FIFO

ii.

Exhibit F:6-4: Perpetual Inventory Record: First-In, First-Out (FIFO)

iii.

Journal entries—FIFO .

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e) Last-in, first-out (LIFO) method i.

Inventory calculations—LIFO

ii.

Exhibit F:6-5: Perpetual Inventory Record: Last-In, First-Out (LIFO)

iii.

Journal entries—LIFO

f) Weighted-average method i.

Inventory calculations—weighted-average

ii.

Exhibit F:6-6: Perpetual Inventory Record: Weighted-Average

iii.

Journal entries—weighted-average

Lecture Notes: FIFO, LIFO, and weighted-average are costing methods and may not be representative of the physical movement of merchandise inventory; for example, LIFO will result in “old” costs remaining in ending merchandise inventory, but this does not mean that the “old” merchandise inventory is actually still on hand. Furthermore, it is useful to think of these methods as describing the cost of the merchandise inventory sold, not the cost of what’s left in ending inventory. For example, with FIFO, the cost of goods sold will consist of the first (or old) costs; however, ending merchandise inventory will consist of the last (or new) costs.

The weighted-average method is a weighted-average computation based on the number of units for each cost level. Students may want to simply average the unit costs of merchandise inventory levels without taking into account the number of units at each level. Emphasize the importance of the inventory layers and the total cost of each layer in the weighted calculation.

For each costing method, walk through examples of the calculation of cost of goods sold and ending inventory. Next, record the related journal entries for the purchase and sale of inventory under each costing method.

Suggested In-Class Exercise: E6-15 LO 3. Compare the effects on the financial statements when using the different inventory costing methods a) Income statement i.

Exhibit F:6-7: Comparative Results for Specific Identification, FIFO, LIFO, and Weighted-Average—Income Statement

b) Balance sheet i.

Exhibit F:6-8: Comparative Results for Specific Identification, FIFO, LIFO, and Weighted-Average—Balance Sheet

ii.

Exhibit F:6-9: Effects on the Financial Statements During Periods of Rising and Declining Inventory Costs

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Lecture Notes: The financial statement effect of choosing an inventory method depends on whether costs are increasing or decreasing. For example, the general description of LIFO is that it results in lower net income and lower inventory balances. However, this assumes increasing costs, which may not always be true in certain industries.

Suggested In-Class Exercise: E6-19 LO 4. Apply the lower-of-cost-or-market rule to merchandise inventory a) Computing the lower-of-cost-or-market b) Recording the adjusting journal entry to adjust merchandise inventory Lecture Notes: The term market in lower-of-cost-or-market refers to replacement cost, not the company’s retail sales price. Merchandise inventory may need to be written down due to lower-of-costor-market (LCM), but it can’t be written back up at a later date due to the conservatism principle.

Suggested In-Class Exercise: E6-21 LO 5. Measure the effects of merchandise inventory errors on the financial statements a) Inventory errors and their effects i.

Exhibit F:6-10: Inventory Errors

ii.

Exhibit F:6-11: Effects of Inventory Errors

Lecture Notes: Point out that inventory errors are self-correcting because, if one month’s ending inventory is wrong, the next month’s beginning inventory will be wrong by the same amount, which has the opposite effect in the determination of the Cost of Goods Sold. This is made more apparent in the calculation of Cost of Goods Sold under the periodic method.

Suggested In-Class Exercise: E6-24 LO 6. Use inventory turnover and days’ sales in inventory to evaluate business performance a) Inventory turnover = Cost of goods sold / Average merchandise inventory b) Days’ sales in inventory = 365 days / Inventory turnover Lecture Notes: The formula provided for days’ sales in inventory is represented in a way that is easy to remember but presumes that inventory turnover has already been determined. The formula provided is mathematically equivalent to: Average merchandise inventory / One day’s cost of goods sold where one day’s cost of goods sold is calculated as cost of goods sold (for the year) divided by 365 days in a year. .

6-5

Suggested In-Class Exercise: E6-25 LO 7. Account for merchandise inventory costs under a periodic inventory system (Appendix 6A) a) Exhibit F:6A-1: Perpetual Inventory Record—Changes in Cost per Unit b) First-in, first-out (FIFO) method c) Last-in, first-out (LIFO) method d) Weighted-average method Lecture Notes: If you are going to include coverage of the periodic method, consider covering it before discussing the perpetual method because doing so enables students to see the big picture about differences among the various methods more easily, which often translates into faster understanding of those differences under the perpetual method. Sometimes students focus too much on the micro-level details of each individual transaction in the perpetual method and fail to grasp the macro-level effects of the differences among the various inventory valuation methods.

Suggested In-Class Exercise: E6A-26

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Chapter 6: Handout for Student Notes LO 1. What are the accounting principles and controls that relate to merchandise inventory?

o Accounting principles

▪

Consistency principle

▪

Disclosure principle

▪

Materiality concept

▪

Conservatism

o Control over merchandise inventory

LO 2. How are merchandise inventory costs determined under a perpetual inventory system?

o Specific identification method

o First-in, first-out (FIFO) method

▪

Inventory calculations—FIFO

▪

Journal entries—FIFO

o Last-in, first-out (LIFO) method

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6-7

▪

Inventory calculations—LIFO

▪

Journal entries—LIFO

o Weighted-average method

▪

Inventory calculations—weighted-average

▪

Journal entries—weighted-average

LO 3. How are financial statements affected by using the different inventory costing methods?

o Income statement

o Balance sheet

LO 4. How is merchandise inventory valued using the lower-of-cost-or-market rule?

o Computing the lower-of-cost-or-market

o Recording the adjusting journal entry to adjust merchandise inventory

LO 5. What are the effects of merchandise inventory errors on the financial statements?

LO 6. How do we use inventory turnover and days’ sales in inventory to evaluate business performance?

o Inventory turnover

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6-8

o Days’ sales in inventory

LO 7. How are merchandise inventory costs determined under a periodic inventory system? (Appendix 6A)

o First-in, first-out (FIFO) method

o Last-in, first-out (LIFO) method

o Weighted-average method

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Chapter 6: Student Chapter Summary LO 1. Identify accounting principles and controls related to merchandise inventory Four accounting principles are introduced: o Consistency principle: Businesses should use the same accounting methods and procedures from period to period. o Disclosure principle: A company’s financial statements should report enough information for outsiders to make knowledgeable decisions about the company. o Materiality concept: A company must perform strictly proper accounting only for significant items. o Conservatism: A company should exercise caution in reporting items in the financial statements.

Controls over merchandise inventory ensure that inventory purchases and sales are properly authorized and accounted for by the accounting system.

LO 2. Account for merchandise inventory costs under a perpetual inventory system Four costing methods can be used to determine merchandise inventory costs: o Specific identification method: The specific cost of each unit of inventory determines ending inventory and cost of goods sold. o First-in, first-out (FIFO) method: The first costs into inventory are the first costs out to cost of goods sold; ending inventory is based on the costs of the most recent purchases. o Last-in, first-out (LIFO) method: The last costs into inventory are the first costs out to cost of goods sold; ending inventory is based on the costs of the oldest inventory. o Weighted-average method: This method is based on the weighted-average cost per unit of inventory after each purchase. Weighted-average cost per unit is determined by dividing the cost of goods available for sale by the number of units available for sale.

LO 3. Compare the effects on the financial statements when using the different inventory costing methods The FIFO method results in the lowest cost of goods sold and the highest gross profit when costs are rising. The LIFO method results in the highest cost of goods sold and the lowest gross profit when costs are rising. The weighted-average method generates amounts for cost of goods sold and gross profit that fall between FIFO and LIFO if costs are consistently increasing or decreasing.

LO 4. Apply the lower-of-cost-or-market rule to merchandise inventory Lower-of-cost-or-market (LCM) requires that merchandise be reported in the financial statements at whichever is lower: the historical cost of the inventory or the market value of the inventory. An adjusting entry must be recorded to write down merchandise inventory if the market value is lower than the historical cost. Market value is defined for LCM as the current replacement cost of the inventory, not the retail value.

LO 5. Measure the effects of merchandise inventory errors on the financial statements An error in ending merchandise inventory creates errors in other related accounts. One period’s ending merchandise inventory becomes the next period’s beginning merchandise inventory. .

6-10

LO 6. Use inventory turnover and days’ sales in inventory to evaluate business performance Inventory turnover measures how rapidly merchandise inventory is sold and is calculated as: Cost of goods sold / Average merchandise inventory where Average merchandise inventory = (Beginning inventory + Ending inventory) / 2 Days’ sales in inventory measures the average number of days merchandise inventory is held by the company and is calculated as: 365 days / Inventory turnover LO 7. Account for merchandise inventory costs under a periodic inventory system (Appendix 6A) Specific identification, FIFO, LIFO, and weighted-average can be used in a periodic inventory system. Specific identification and FIFO will produce the same amounts for ending merchandise inventory and cost of goods sold under both the perpetual and periodic inventory systems. LIFO and weighted-average generally result in different amounts for ending merchandise inventory and cost of goods sold under the perpetual and periodic inventory systems.

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Chapter 6: Assignment Grid and Other Materials LO 1 S6-1 X S6-2 S6-3 S6-4 S6-5 S6-6 S6-7 S6-8 S6-9 S6-10 S6A-11 S6A-12 S6A-13 E6-14 X E6-15 E6-16 E6-17 E6-18 E6-19 E6-20 E6-21 E6-22 E6-23 E6-24 E6-25 E6A-26 E6A-27 P6-28A, P6-33B P6-29A, P6-34B P6-30A, P6-35B X P6-31A, P6-36B P6A-32A, P6A-37B S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

.

LO 2

LO 3

LO 4

LO 5

LO 6

LO 7

X X X X X X X X X X X X X X X X X X X

X X X X X X X X X

X X

X X X X

X

X

X X

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Other End-of-Chapter Materials:

Continuing Problem F:6-1 Practice Set F:6-1 Comprehensive Problem for Chapters F:5 and F:6 Tying It All Together Case F:6-1 Decision Case F:6-1 Financial Statement Case F:6-1 Team Project F:6-1

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

1.

Which principle or concept states that a business’s financial statements must report enough information for outsiders to make knowledgeable decisions about the company?

A. Conservatism B. Materiality concept C. Disclosure principle D. Consistency principle

2.

Which inventory costing method assigns to Cost of Goods Sold the most recent purchases incurred during the period?

A. Weighted-average B. Last-in, first-out (LIFO) C. First-in, first-out (FIFO) D. Specific identification

3.

Assume Harold’s Hats began August with 52 units of merchandise inventory, with a cost of $17 per unit. During August, Harold’s Hats purchased and sold goods as follows: AugustAugust Purchase 8 14 Sale

42 units @ $15

22 Purchase

28 units @ $25

27 Sale

42 units @ $40

60 units @ $40

Under the FIFO inventory costing method, how much is Harold’s Hats’s cost of goods sold for the sale on August 14?

A. $510 B. $2,400 C. $1,004 D. $936 4.

After the sale on August 14, what is Harold’s Hats’s cost of the merchandise inventory on hand, assuming that Harold’s Hats uses FIFO? (Reference Question 3 information.)

A. $510 B. $2,400 C. $1,004 D. $936

5.

After the sale on August 14, what is Harold’s Hats’s cost of the merchandise inventory on hand, assuming that Harold’s Hats uses LIFO? (Reference Question 3 information.)

A. $510 B. $578 C. $900 D. $2,400 .

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6.

Suppose Harold’s Hats uses the weighted-average method and the perpetual inventory system.

Use the Harold’s Hats data from Question 3 to compute the weighted-average unit cost of the company’s inventory on hand on August 8. Round unit cost to the nearest cent.

A. $16.11 B. $16.50 C. $18.15 D. $19.00

7.

Which inventory costing method results in the lowest ending inventory during a period of rising merchandise inventory cost?

A. Weighted-average B. Specific identification C. First-in, first-out (FIFO) D. Last-in, first-out (LIFO)

8.

Some companies account for purchases of equipment less than $500 as expenses instead of as assets. This policy is most closely linked to which accounting principle?

A. Conservatism B. Lower-of-cost-or-market C. Materiality concept D. Consistency principle

9.

On December 31, 20X8, Simpson Company understated ending inventory by $72,000. How does this error affect Cost of Goods Sold and Net Income for 20X8?

A. Overstates Cost of Goods Sold and understates Net Income B. Overstates both Cost of Goods Sold and Net Income C. Understates Cost of Goods Sold and overstates Net Income D. Leaves both Cost of Goods Sold and Net Income correct because the errors cancel each other

10. Finley Corporation had the following financial data for the year ended December 31, 20X8: Cost of Goods Sold

$ 256,000

Beginning Merchandise Inventory

$ 58,000

Ending Merchandise Inventory

$107,200

What is the inventory turnover for Finley Corporation (rounded to one decimal place)?

A. 0.7 times per year B. 1.6 times per year C. 2.4 times per year D. 3.1 times per year

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Answer Key to Ten-Minute Quiz: 1. C 2. B 3. C (52 units × $17) + (8 units × $15) = $1,004

4. A 34 units × $15 = $510

5. B 34 units × $17 = $578

6. A (52 units × $17) + (42 units × $15) = $1,514; $1,514 / 94 units = $16.11 (rounded)

7. D 8. C 9. A 10. D Inventory turnover = Cost of goods sold / Average merchandise inventory = $256,000 / $82,600* = 3.1 times per year (rounded) *Average merchandise inventory = ($58,000 + $107,200) / 2 = $82,600

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Extra Critical Thinking Questions Decision Case F:6-2 Assume you are opening a bicycle shop. To finance the business, you need a $1,000,000 loan, and your banker requires a set of forecasted financial statements. Assume you are preparing the statements and must make some decisions about how to do the accounting for the business.

Requirements Answer the following questions: 1. Which type of inventory system will you use: perpetual or periodic? Explain your reason.

2. How often do you plan to do a physical count of inventory on hand? What will the physical count accomplish?

3. Inventory costs are rising. Which inventory costing method would have the effect of a. maximizing net income? b. minimizing the amount of income tax?

Decision Case F:6-2: Solution Requirement 1 I would use a perpetual inventory system rather than a periodic inventory system. A perpetual inventory system provides more complete and timely information about merchandise inventory levels, cost of goods sold, and gross profit. Better control over merchandise inventory is important for managing costs, the flow of inventory, purchasing, and stocking. Although accounting is simpler in a periodic inventory system, there is no daily running record of merchandise inventory on hand, and the only way to determine ending inventory is to take a physical inventory. A physical count of merchandise inventory is also taken in a perpetual inventory system, but the system maintains accounting records against which the physical count can be compared.

Requirement 2 Although a perpetual inventory system provides a daily running record of merchandise inventory on hand, taking a physical count of inventory at least once a year is important for determining the actual quantity of inventory on hand and testing the accuracy of the perpetual inventory records. Because a perpetual inventory system maintains accounting records against which the physical count can be compared, it provides better control over inventory and possible loss due to damage or theft (inventory shrinkage).

Requirement 3 a. If inventory costs are rising, the FIFO inventory costing method maximizes net income. b. If inventory costs are rising, the LIFO inventory costing method results in paying the least amount of income tax.

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Ethical Issue F:6-1 During 20X4, Ashley’s Attic, an antique furniture store, changed to the LIFO inventory costing method of accounting for inventory. Suppose that during 20X5, Ashley’s Attic switches back to the FIFO inventory costing method and the following year switches back to LIFO again.

Requirements 1. What would you think of a company’s ethics if it changed accounting methods every year?

2. What accounting principle would changing methods every year violate?

3. Who can be harmed when a company changes its accounting methods too often? How? Ethical Issue F:6-1: Solution Requirement 1 Changing accounting methods from year to year may compromise a company’s credibility, which can create difficulties with external stakeholders. For example, it might be more difficult for the company to borrow or raise money from outside investors at a reasonable cost. It might also raise the question, “What does the company have to hide?”

Requirement 2 Changing accounting methods every year violates the consistency principle.

Requirement 3 The company and its various stakeholders could be harmed when the company changes accounting methods too often. External decision makers often find it challenging to track and interpret a company’s operating results and financial position over time. It becomes difficult to ascertain what aspects of the company’s financial results are “real” and what aspects are simply due to changes in accounting methods.

Ultimately, the company suffers if it is unable to raise capital required to survive and grow. Potential creditors may not extend loans at reasonable interest rates, and potential investors will be less likely to invest in the company.

Communication Activity F:6-1 In 75 words or fewer, explain the difference in calculating cost of goods sold using the FIFO, LIFO, and weighted-average inventory costing methods when using a perpetual inventory system.

Communication Activity F:6-1: Solution FIFO assumes the first costs into inventory are the first costs out to cost of goods sold. LIFO assumes the last costs in are the first costs out to cost of goods sold. The weighted-average method uses the weighted-average cost of inventory during the period, determined by dividing cost of goods available for sale by the number of units available.

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Chapter 7 Internal Control and Cash

Chapter Overview The chapter discusses the purposes and characteristics of an effective system of internal control. The text describes four objectives of a good system of internal control and discusses the provisions of the Sarbanes-Oxley Act (SOX) and its effect on corporate governance and the accounting profession. The five components of internal control are identified: control procedures, risk assessment, information system, monitoring of controls, and environment. Basic internal control procedures are listed, including competent, reliable, and ethical personnel; assignment of responsibilities; separation of duties; internal and external audits; documents; electronic devices; and e-commerce and other controls. A Data Analytics in Accounting feature discusses cryptocurrencies and their security benefits. The limitations of internal control systems are identified.

The chapter continues with an explanation of internal control over cash receipts and cash payments. The section covering cash receipts emphasizes over-the-counter receipts and receipts by mail. The section covering controls over cash payments emphasizes controls over purchases and payments, including streamlined payment procedures such as evaluated receipts settlement (ERS) and electronic data interchange (EDI). Petty cash and credit card sales are explained, and related transactions are journalized. The bank account is introduced as a control device related to cash. The discussion of the bank account includes the most common controls applied to bank accounts: the signature card, deposit ticket, check, bank statement, and electronic funds transfers (EFT). The bank reconciliation is illustrated as a process of comparing and explaining the differences between cash balance on the company’s books and cash balance according to the bank. Various reconciling items discussed include deposits in transit, outstanding checks, bank collections, electronic funds transfers, service charges, interest revenue, NSF checks, and various errors. The adjusting entries required by the reconciliation are presented. The chapter concludes with discussions about how the cash ratio is used to evaluate a company’s ability to meet short-term obligations.

A Tying It All Together feature provides real-world perspective on internal controls related to the security of credit and debit card payments for Shake Shack, Inc. A Decisions feature helps students see what e-commerce internal controls to put into place. The Review includes Things You Should Know which highlights the information students should have acquired from the chapter. The first Check Your Understanding problem reviews internal control weaknesses, petty cash journal entries, and the petty cash account balance. The second Check Your Understanding problem allows students to prepare a bank reconciliation and the entries based on the bank reconciliation. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 7: Learning Objectives LO 1. Define internal control and describe the components of internal control and control procedures LO 2. Apply internal controls to cash receipts LO 3. Apply internal controls to cash payments LO 4. Explain the internal controls associated with and journalize petty cash transactions LO 5. Explain the internal controls associated with and journalize debit and credit card sales LO 6. Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries LO 7. Use the cash ratio to evaluate business performance

.

7-2

Chapter 7: Teaching Outline with Lecture Notes LO 1. Define internal control and describe the components of internal control and control procedures a) Define internal control i.

Safeguard assets

ii.

Encourage employees to follow company policies

iii.

Promote operational efficiency

iv.

Ensure accurate, reliable accounting records

b) Explain the Sarbanes-Oxley Act i.

Committee of Sponsoring Organizations (COSO)

ii.

Internal control and the Sarbanes-Oxley Act

iii.

Public Company Accounting Oversight Board (PCAOB)

iv.

Effect on corporate governance

v.

Effect on accounting profession

c) Five components of internal control i.

Control procedures

ii.

Risk assessment

iii.

Information system

iv.

Monitoring of controls ▪

v.

Internal auditor versus external auditor

Environment ▪

“Tone at the top”

d) Internal control procedures i.

Competent, reliable, and ethical personnel

ii.

Assignment of responsibilities

iii.

Separation of duties

.

7-3

▪

Separating operations from accounting

▪

Separating custody of assets from accounting

iv.

Audits

v.

Documents

vi.

Electronic devices

vii.

E-commerce

viii.

Other controls

e) The limitations of internal control—Costs and benefits Lecture Notes: When beginning a discussion of internal control, ask students to provide examples of theft and abuse they have witnessed. Many students will have worked, or will currently be working, especially in some type of retail setting, and many are eager to provide real-world examples. These examples can then lead to a discussion of the types of controls that may have prevented or detected the examples provided. Similarly, ask students for examples of internal controls their employers have in place and match them to the controls discussed in the textbook.

Point out examples of internal controls that are likely to be familiar to most students as consumers and shoppers in a modern marketplace: sales return procedures that require manager approval, signs that alert buyers to get a sales receipt, and employment procedures that require background checks of applicants, among others.

Point out that an internal control system may not be 100% effective. It may not prevent all theft, abuse, and errors, but hopefully it can detect them very quickly so corrective action can be taken. Employees can attempt to circumvent the system through collusion. A discussion of the costs versus the benefits of an internal control system, as well as the requirements for public companies under the Sarbanes-Oxley Act, can help students better understand the importance of a good internal control system.

Suggested In-Class Exercise: E7-13 LO 2. Apply internal controls to cash receipts a) Cash receipts over the counter b) Cash receipts by mail

i.

Exhibit F:7-1: Cash Receipts by Mail

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Lecture Notes: Tell students to imagine being a manager responsible for employees who open mail that contains check payments by customers. Ask them how they can be sure that their employees are not taking the checks for themselves. What can they do to prevent this from happening? What can they do to detect it if it does happen?

Suggested In-Class Exercise: E7-14 LO 3. Apply internal controls to cash payments a) Controls over payment by check b) Controls over purchases and payments i.

Exhibit F:7-2: Cash Payments by Check

ii.

Exhibit F:7-3: Payment Packet

c) Streamlined Payment Procedures

Lecture Notes: Tell students to imagine being a manager responsible for employees who make company payments to suppliers. Ask them how they can be sure that their employees are not making payments to themselves. What can they do to prevent this from happening? What can they do to detect it if it does happen?

Suggested In-Class Exercise: E7-15 LO 4.

Explain the internal controls associated with and journalize petty cash transactions a) Petty cash b) Setting up the petty cash fund

i.

Exhibit F:7-4: Petty Cash Ticket

c) Replenishing the petty cash fund d) Changing the amount of the petty cash fund

Lecture Notes: As a first step to establishing a petty cash fund, business needs are evaluated. Consider how cash is conveniently used throughout a typical day, specifically how much money is spent on small purchases and what types of change are supplied to cash registers. Use this information to set the cashholding limit. It can be anything from a few dollars to a few hundred dollars.

Other control procedures can be discussed, including the need to carry out periodic unannounced spot checks to ensure that employees are managing the petty cash fund properly, the need to carry out a reconciliation with a manager without the petty cash custodian being present, and the need to check whether slips, receipts, and the log are in order and whether there are any unexplained overs or shorts.

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The balance in Petty Cash does not change unless the original established amount is increased or decreased. The replenishment entry credits the Cash account, not the Petty Cash account. Cash is taken from the regular bank account and placed into the petty cash box. The balance of the Petty Cash account, which represents the value of currency and receipts contained in the petty cash box, does not change.

The replenishment transaction only exchanges receipts for currency but does not change the total value.

The balance of the Petty Cash account changes only when the value currency and receipts contained within the petty cash box is increased or decreased, not when it is replenished.

Suggested In-Class Exercise: E7-18 LO 5. Explain the internal control associated with and journalize debit and credit card sales Lecture Notes: With credit card sales, the company collects cash from the card issuer up front, and the risk of collection from the customer passes to the card issuer. The risk of employees handing cash is also eliminated. The cost to the company of eliminating this risk is the credit card fee, which is recorded as an expense along with the sales revenue.

Accepting debit and credit cards adds the risk of handling customers’ debit and credit card information.

Therefore, internal controls to protect that data must be established. Review the internal control procedures with students.

Emphasize that credit card sales do not result in creation of a receivable. Instead, credit card receipts are deposited into a company’s bank account in the same way that currency is deposited and funds equal to the gross sales value minus the credit card processing fee become available to the company almost immediately. Thus, credit card issuers make their profits from fees paid by companies that accept customers’ credit cards and from the customers in the form of interest revenue and perhaps other fees.

Debit cards work in a similar fashion, except customers do not pay interest because the cash is transferred from their bank accounts to the credit card issuer almost immediately.

Suggested In-Class Exercise: E7-19 LO 6. Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries a) Signature card b) Deposit ticket c) Check i.

Maker

ii.

Payee

iii.

Routing number

iv.

Account number

.

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v.

Exhibit F:7-5: Check with Remittance Advice

d) Bank statement

i.

Exhibit F:7-6: Bank Statement

e) Electronic funds transfer (EFT) f) Bank reconciliation

i.

Timing differences

ii.

Preparing the bank side of the reconciliation

iii.

iv.

▪

Deposits in transit

▪

Outstanding checks

▪

Bank errors

Preparing the book side of the reconciliation ▪

Bank collections

▪

Electronic funds transfers

▪

Service charges

▪

Interest revenue on a checking account

▪

Nonsufficient funds (NSF) checks

▪

Book errors

Completing the bank reconciliation ▪

Exhibit F:7-7: Bank Reconciliation

g) Examining a bank reconciliation

i.

Bank side of the reconciliation

ii.

Book side of the reconciliation

h) Journalizing transactions from the bank reconciliation

Lecture Notes: Some students may have trouble thinking about the debits and credits associated with bank statements. A bank account is an asset for the company and a liability for the bank. Students are accustomed to thinking about the bank statement as it is presented from the bank’s perspective⎯the

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bank account is a liability to the bank and increases with a credit and decreases with a debit. It may be helpful to provide journal entries for the company and the bank side-by-side for a deposit transaction to display the difference.

When reconciling the bank statement, errors should be adjusted by the party that made them. A bank error should be adjusted by the bank through the bank statement balance, and a book error should be adjusted by the company through the book balance. The increase or decrease of the adjustment depends on whether too much or too little was added to or taken from the balance.

Journal entries are required for the book balance section only. These transactions have been recorded by the bank but not by the company. If journal entries aren’t posted, the ledger accounts will not be up-todate. The company will have a reconciled bank statement but out-of-date account balances.

Suggested In-Class Exercise: E7-20 LO 7. Use the cash ratio to evaluate business performance a) Cash ratio = (Cash + Cash equivalents) / Total current liabilities Lecture Notes: The cash ratio is a measure of a company’s ability to pay current liabilities from cash and cash equivalents. Students are not always familiar with cash equivalents. Point out that they are highly liquid investments that can be converted into cash in three months or less. Provide examples, such as money-market accounts and investments in U.S. government securities.

Suggested In-Class Exercise: S7-11

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Chapter 7: Handout for Student Notes LO 1. What is internal control, and how can it be used to protect a company’s assets?

o Internal control and the Sarbanes-Oxley Act

o The components of internal control

▪

Control procedures

▪

Risk assessment

▪

Information systems

▪

Monitoring of controls

▪

Environment

o Internal control procedures

▪

Competent, reliable, and ethical personnel

▪

Assignment of responsibilities

▪

Separation of duties

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▪

Audits

▪

Documents

▪

Electronic devices

▪

E-commerce

▪

Other controls

o The limitations of internal control—Costs and benefits

LO 2. What are the internal control procedures with respect to cash receipts?

o

Cash receipts over the counter

o

Cash receipts by mail

LO 3. What are the internal control procedures with respect to cash payments?

o

Controls over payment by check

▪ Controls over purchases and payments

▪ Streamlined procedures

.

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LO 4. What are the internal controls procedures needed for petty cash, and how are petty cash transactions recorded?

o

Setting up the petty cash fund

o

Replenishing the petty cash fund

o

Changing the amount of the petty cash fund

LO 5. What are the internal controls needed with debit and credit card sales and how are these types of sales recorded?

LO 6. How can the bank account be used as a control device?

o

Signature card

o

Deposit ticket

o

Check

o

Bank statement

o

Electronic funds transfers

o

Bank reconciliation

▪ Preparing the bank side of the reconciliation

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▪ Preparing the book side of the reconciliation

▪ Completing the bank reconciliation

o

Examining a bank reconciliation

▪ Bank side of the reconciliation

▪ Book side of the reconciliation

o

Journalizing transactions from the bank reconciliation

LO 7. How can the cash ratio be used to evaluate business performance?

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Chapter 7: Student Chapter Summary LO 1. Define internal control and describe the components of internal control and control procedures Internal control is the organizational plan and all the related measures designed to safeguard assets, encourage employees to follow company policies, promote operational efficiency, and ensure accurate and reliable accounting records. The Sarbanes-Oxley Act was passed by Congress to revamp corporate governance in the United States. Internal control includes five components: control procedures, risk assessment, information system, monitoring of controls, and environment.

LO 2. Apply internal controls to cash receipts A point-of-sale terminal provides control over cash receipts over the counter. Companies control cash by mail by ensuring appropriate separation of duties when handling cash and recording the transaction.

LO 3. Apply internal controls to cash payments Good separation of duties between operations of the business and writing checks for cash payments should exist. Many companies use technology to make secure payments.

LO 4. Explain the internal controls associated with and journalize petty cash transactions A petty cash fund allows a business to keep cash on hand to pay for small miscellaneous items such as postage, office supplies, and taxi fares. However, petty cash is more liquid than cash in the bank because none of the bank controls are in place. Internal controls associated with petty cash include (1) designation of a custodian, (2) setting a specific amount of cash to be kept in petty cash, and (3) supporting all petty cash fund payments with petty cash tickets. When the petty cash fund is established, the company records a debit to Petty Cash and a credit to Cash.

The petty cash fund is replenished by debiting the associated asset and expense accounts and crediting Cash. Discrepancies in petty cash funds are either debited or credited to the Cash Short & Over account.

LO 5. Explain the internal controls associated with and journalize debit and credit card sales Debit and credit card sales eliminates two risks—the risk of cash handling by employees and the risk of collecting cash from customers associated with sales on account. Debit and credit card sales are journalized similar to cash sales and typically include a fee (Credit Card Expense) that is paid by the business to the credit card processor. Sales can be either recorded using the net or gross method. The net method records the amount of the sale less the processing fee at the time of sale. The gross method records the gross amount of the sale at the time of sale and the credit card fees are recorded at a later time.

Companies that choose to accept debit and credit cards must establish internal controls to protect customer data, including the use of POS terminals and storage of cardholder data on a secure and encrypted network.

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LO 6. Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries Bank accounts provide established practices that safeguard a business’s money. These controls include use of signature cards, deposit tickets, checks, bank statements, and electronic funds transfers. A bank reconciliation can also be used as a form of internal control. The bank reconciliation compares and explains the difference between cash on the company’s books and cash according to the bank’s records on a specific date. After the bank reconciliation has been prepared, journal entries must be completed for all items on the book side of the bank reconciliation.

LO 7. Use the cash ratio to evaluate business performance The cash ratio measures a company’s ability to pay its current liabilities from cash: Cash ratio = (Cash + Cash equivalents) / Total current liabilities

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Chapter 7: Assignment Grid and Other Materials

S7-1 S7-2 S7-3 S7-4 S7-5 S7-6 S7-7 S7-8 S7-9 S7-10 S7-11 E7-12 E7-13 E7-14 E7-15 E7-16 E7-17 E7-18 E7-19 E7-20 E7-21 E7-22 E7-23 P7-24A, P7-30B P7-25A, P7-31B P7-26A, P7-32B P7-27A, P7-33B P7-28A, P7-34B P7-29A, P7-35B

LO 1 X

LO 2

LO 3

LO 4

LO 5

LO 6

LO 7

X X X X X X X X X X X X X X

X

X X X X X X X X X

X X

X

X X X X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

.

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Other End-of-Chapter Materials:

Continuing Problem F:7-1 Practice Set F:7-1 Tying It All Together Case F:7-1 Decision Case F:7-1 Decision Case F:7-2 Fraud Case F:7-1 Financial Statement Case F:7-1 Communication Activity F:7-1

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CHAPTER 7 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Which of the following is not a primary objective that internal control is designed to accomplish?

A. Safeguard assets B. Promote operational efficiency C. Monitor risk assessment D. Ensure accurate, reliable records 2. The Sarbanes-Oxley Act A. stipulates that violators of the act may serve 5–10 years in prison for securities fraud and/or falsifying financial statements.

B. requires the Financial Accounting Standards Board to oversee auditors of public companies.

C. requires that the internal control environment must reflect the “tone at the top.”

D. prohibits auditors of public companies from performing certain consulting services for those companies.

3. Natalie Smith, who receives cash from customers, conspires with Joe Gonzalez, who posts the collections to customer Accounts Receivable, to falsify records so they can take the cash for themselves. This is an example of A. separation of duties.

B. assignment of responsibilities.

C. collusion.

D. cost/benefits limitations.

4. A firewall A. eliminates the need for separation of duties.

B. limits access into a local computer network.

C. protects buildings by preventing the spread of flames.

D. rearranges plain-text messages by a mathematical process.

5. The document that accompanies a payment to explain the reason for the payment is a(n) A. remittance advice.

B. bank reconciliation.

C. electronic fund transfer.

D. lock-box document.

6. The petty cash fund had an initial balance of $250. It currently has $30 and petty cash tickets totaling $170 for office supplies. The entry to replenish the fund would contain a A. debit to Cash Short & Over for $50.

B. credit to Cash Short & Over for $50.

C. debit to Petty Cash for $220.

D. credit to Petty Cash for $220.

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7. Thompson Corporation has a sale in the amount of $20,000. The customer pays by credit card. The credit card processor charges 3% and uses the gross method. The journal entry to record the transaction on the date of sale would include a A. debit to Cash for $19,400.

B. credit to Cash for $19,400.

C. debit to Cash for $20,000.

D. credit to Cash for $20,000.

8. Celebration Corporation’s Cash account shows an ending balance of $1,850. The bank statement shows a $52 service charge and an NSF check for $280. Other records indicate that a $240 deposit is in transit, and outstanding checks total $535. What is RT’s adjusted cash balance?

A. $1,223 B. $1,518 C. $1,555 D. $2,078 9. Which of the following bank reconciliation items is correctly described?

A. Deposits in transit increase the book side of the reconciliation.

B. NSF checks increase the book side of the reconciliation.

C. Outstanding checks decrease the bank side of the reconciliation.

D. Service charges decrease the bank side of the reconciliation.

10. Outdoor Adventures Company had the following select financial data as of December 31, 201X4 Cash Cash Equivalents Total Current Assets Total Current Liabilities

$15,000 3,000 40,000 30,000

What is Outdoor Adventures Company’s cash ratio? (Round your answer if necessary.)

A. 5.00 B. 0.60 C. 0.50 D. 0.45

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Answer Key to Ten-Minute Quiz: 1. C 2. D 3. C 4. B 5. A 6. A

Fund balance Cash on hand Petty cash tickets

$ 250 $ 30 170

Total accounted for Amount of cash shortage

200 $ 50

7. C 8. B $1,850 Book balance −$52 Service charge −$280 NSF check = $1,518 adjusted book balance 9. C 10. B Cash ratio = (Cash + Cash equivalents) / Total current liabilities = ($15,000 + 3,000) / $30,000 = 0.60

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Extra Critical Thinking Questions Decision Case F:7-3 Blue Ridge Hiking Adventures has poor internal control over cash. Barry Spearman, the manager, suspects the cashier of stealing. Here are some details of company cash on September 30: a. The Cash account in the ledger shows a balance of $6,450. b. The September 30 bank statement shows a balance of $4,300. The bank statement lists a $200 bank collection, a $10 service charge, and a $40 NSF check. c. On September 30, the following checks are outstanding: Check Number 1155 1156 1157 1158

Amount $ 100 300 600 200

d. There is a $3,000 deposit in transit on September 30. e. The cashier handles all incoming cash and makes bank deposits. He also writes checks and reconciles the monthly bank statement.

Requirements 1. Perform your own bank reconciliation, using the format illustrated in the chapter. There are no bank or book errors.

2. Assume that the adjusted bank balance is the correct cash amount and that all timing differences have been accounted for. How much has the cashier stolen? How can you tell?

3. Explain how Spearman can improve his internal controls.

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Decision Case F:7-3: Solution Requirement 1 BLUE RIDGE HIKING ADVENTURES Bank Reconciliation September 30 BOOK

BANK Balance, September 30 ADD: Deposit in transit

$ 4,300 3,000 $ 7,300

Balance, September 30 ADD: Bank collection

$ 6,450 200 $ 6,650

LESS: Outstanding checks $ 100 300 600 200 Adjusted bank balance, September 30

1,200 $ 6,100

LESS: Service charge NSF check Adjusted book balance, September 30

$ 10 40

50 $ 6,600

Requirement 2 Based on the above reconciliation, $500 is unaccounted for: the difference between the adjusted book and bank amounts ($6,600 − $6,100). Because there are no bank or book errors, and all timing differences have been accounted for, it appears that the cashier has stolen $500.

Requirement 3 Spearman should assign another employee with no cash-handling or recordkeeping duties to prepare the bank reconciliation. Most importantly, the reconciliation should be reviewed at a higher level, possibly by the manager himself, for additional control. Other important control principles are as follows: There should be separation of duties between the cashier who issues checks and collects receipts, the person who makes deposits, and the person who records transactions in the journal. If one person combines all of the above duties, that person could steal cash and manipulate the ledger and the bank reconciliation to cover the theft.

Ethical Issue F:7-1 Anna Tuttle operates rental properties in Michigan. Each property has a manager who collects rent, arranges for repairs, and runs advertisements in the local newspaper. The property managers transfer cash to Tuttle monthly and prepare their own bank reconciliations. The manager in Lansing has been stealing from the company. To cover the theft, he overstates the amount of the outstanding checks on the monthly bank reconciliation. As a result, each monthly bank reconciliation appears to balance. However, the balance sheet reports more cash than Tuttle actually has in the bank. Tuttle is currently putting her entire business up for sale. In negotiating the sale of the business, Tuttle is showing the balance sheet to prospective buyers.

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Requirements 1. Identify who, other than Tuttle, could be harmed by this theft. In what ways could they be harmed?

2. Discuss the role accounting plays in this situation.

Ethical Issue F:7-1: Solution Requirement 1 Potential buyers might be harmed if they acquire the business and later find they have less cash than indicated by the statements.

Requirement 2 Accounting plays the critical role of providing information to Tuttle and to persons who do business with Tuttle. A common way for a business to represent itself to outsiders is through its financial statements. People make business and financial decisions based on the information reported in these statements. To serve their intended purpose, financial statements must be complete and accurate.

Team Project F:7-1 You are promoting a music festival in your area. Each member of your team will invest $25,000 of his or her hard-earned money in this venture. It is February 1, and the festival is scheduled for May 30.

Your promotional activities begin immediately, and ticket sales start April 1. You expect to sell all the business’s assets, pay all the liabilities, and distribute all remaining cash to the group members by June 30.

Write an internal control manual that will help safeguard the assets of the business. The starting point of the manual is to assign responsibilities among the group members. Authorize individuals, including group members and any outsiders you need to hire, to perform specific jobs. Separate duties among the group and any employees.

Team Project F:7-1: Solution The first component of internal control is assignment of responsibility. Each person should know what authority and responsibilities he or she has been assigned. One person should act as treasurer and have authority over banking; that person should approve the bank reconciliations. A separate person should be charged with keeping accounting records, and a third person should be responsible for cash disbursements and receipts. Another person should be responsible for safeguarding any physical assets acquired. Operational responsibilities, such as hiring workers or contracting for services, should be separated from financial and accounting responsibilities. All transactions over a certain dollar limit should require approval of the executive.

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Chapter 8 Receivables

Chapter 8: Overview The chapter begins with an overview of various types of receivables: accounts receivable, notes receivable, and other receivables. Internal controls over receivables, the duties of the credit department, recording sales on credit, and factoring and pledging receivables are presented. Two methods for recording uncollectible accounts are discussed: the direct write-off method and the allowance method.

Under the direct write-off method, entries are illustrated for writing off uncollectible accounts as an expense in the period in which they are recognized as being uncollectible and for recovering accounts previously written off. The limitations of the direct write-off method are discussed. Next, the allowance method is presented, and the contra asset account, Allowance for Bad Debts, is introduced as the means by which receivables are reported on the balance sheet at their net realizable value. Journal entries for estimating the expense associated with uncollectible accounts and creating the related allowance in the period sold, writing off uncollectible accounts against the allowance previously created, and recovering an account previously written off are illustrated under the allowance method. Three methods for estimating bad debts expense under the allowance method are presented and illustrated: the percent-ofsales method, the percent-of-receivables method, and the aging-of-receivables method. A comparison of the allowance method and the direct write-off method emphasizes that the allowance method conforms to GAAP and the direct write-off method does not.

Next, notes receivable are presented, including terms and calculations. The journal entries are illustrated for accepting a promissory note in exchange for cash, sales, or an account receivable; for accruing interest revenue at the end of the accounting period; and for collecting payment of a note. Students learn how to account for a dishonored note. The role that the acid-test ratio, accounts receivable turnover, and days’ sales in receivables play in evaluating business performance is demonstrated.

A Tying It All Together feature provides a closer look at the accounts receivable balance of Amazon.com, Inc. An Ethics feature helps give perspective on real-world ethical dilemmas involving motives to underestimate uncollectible accounts. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem allows students to practice estimating net realizable value of receivables, bad debts expense, and allowance for bad debts. A second Check Your Understanding Problem reviews notes receivable calculations and entries. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 8: Learning Objectives LO 1. Define and explain common types of receivables and journalize sales on credit LO 2. Record transactions using the direct write-off method for uncollectibles LO 3. Record transactions using the allowance method for uncollectibles LO 4. Estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-ofreceivables methods LO 5. Account for notes receivable including computing interest and recording honored and dishonored notes LO 6. Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance

.

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Chapter 8: Teaching Outline with Lecture Notes LO 1. Define and explain common types of receivables and journalize sales on credit a) Types of receivables b) Exercising internal control over receivables c) Recording sales on credit d) Decreasing collection time and credit risk Lecture Notes: Define and explain the three major types of receivables and demonstrate how to journalize sales on credit. Point out to students that most large companies have a credit department to evaluate customers’ credit applications to determine whether they meet the company’s credit approval standards. The extension of credit is a balancing act, involving extending credit to good customers while avoiding uncollectible receivables. Accepting credit or debit cards as well as factoring and pledging receivables are ways to decrease collection time and credit risk.

Suggested In-Class Exercises: E8-14 and E8-16 LO 2. Record transactions using the direct write-off method for uncollectibles a) Bad debts expense (or doubtful accounts expense or uncollectible accounts expense) b) Recording and writing off uncollectible accounts—direct write-off method c) Recovery of accounts previously written off—direct write-off method d) Limitations of the direct write-off method Lecture Notes: Emphasize that GAAP requires that Accounts Receivable is valued on the balance sheet at the amount expected to be collected, not the amount owed. The direct method does not conform to GAAP. Accordingly, some instructors present the allowance method first as the preferred method, then introduce the direct method as an alternative sometimes used by small businesses that do not prepare financial statements in accordance with GAAP. Point out that account titles related to bad debts can vary, such as uncollectible accounts and doubtful accounts. Bad debts arise from credit sales only. Cash sales are collected during the sales transaction.

Suggested In-Class Exercises: S8-3 and S8-4 LO 3. Record transactions using the allowance method for uncollectibles a) Allowance for bad debts (or allowance for doubtful accounts)

.

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b) Recording bad debts expense—allowance method c) Writing off uncollectible accounts—allowance method d) Recovery of accounts previously written off—allowance method e) Comparison of recording transactions for uncollectibles using the direct write-off method versus the allowance method i.

Exhibit F:8-1: Direct Write-off Method Versus Allowance Method

LO 4. Estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-ofreceivables methods 1) a) Estimating and recording bad debts expense—allowance method i.

Percent-of-sales (income statement approach): Bad Debt Expense = Net Credit Sales × Percentage

ii.

Percent-of-receivables and aging-of-receivables (balance sheet approach): Two-step process ▪

iii.

Exhibit F:8-2: Aging of Accounts Receivable

Comparison of income statement approach versus balance sheet approach ▪

Exhibit F:8-3: Comparison of Income Statement Approach Versus Balance Sheet Approach

Lecture Notes: The amount expected to be collected is referred to as net realizable value and is calculated as the total amount owed minus an allowance for an estimated amount not expected to be collected.

Thus, the allowance account (which is referred to as Allowance for Bad Debts or Allowance for Uncollectible Accounts, or Allowance for Doubtful Accounts) is a contra-asset account, not a liability, and is included in the asset section of the balance sheet. The allowance account is combined with (subtracted from) Accounts Receivable to determine net receivables, which reflects what the company expects to collect.

The difference between the direct write-off method and the allowance method is the timing of expense recognition. The allowance method expenses bad debts in the period in which the sale occurs (consistent with the matching principle), whereas the direct write-off method expenses bad debt when the account is deemed uncollectible at a later date (and therefore is not matched to the related revenue).

Two approaches for recording bad debts under the allowance method are the income statement approach, which is the percent-of-sales method, and the balance sheet approach, which includes the percent-of-receivables method and the aging-of-receivables method. The income statement approach .

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(percent-of-sales method) focuses on the amount of expense on the income statement, whereas the balance sheet approach (percent-of-receivables method and aging-of-receivables method) focuses on the amount of net receivables on the balance sheet.

When using the income statement approach, the dollar amount of the journal entry is a predetermined percentage of sales.

When using the balance sheet approach, the amount of the journal entry is the dollar amount needed to change the balance of the allowance account so that it is equal to a predetermined percentage of total receivables; that is, the dollar amount of the adjusting journal entry is the difference between the unadjusted balance of the allowance account and the desired balance.

Under the percent-of-receivables method, one percentage is applied to total gross receivables. Under the aging-of-receivables method, different percentages are applied to the various aging categories of receivables. Either way, some portion of receivables is estimated to be uncollectible, and that amount represents the desired balance of the allowance account after the adjusting journal entry is made.

It is important to note that any given company will consistently use only one method. The method chosen depends on whether the company has decided to focus on the income statement effect (debit to Bad Debt Expense) or the balance sheet effect (credit to Allowance for Bad Debts) of the adjusting journal entry. Most large companies use the aging-of-receivables method.

Suggested In-Class Exercises: E8-19 and E8-20 LO 5. Account for notes receivable including computing interest and recording honored and dishonored notes a) Define and explain the following terms: i.

Promissory note

ii.

Maker of a note (debtor)

iii.

Payee of a note (creditor)

iv.

Principal

v.

Interest

vi.

Interest period

vii.

Interest rate

viii.

Maturity date

ix.

Maturity value ▪

Exhibit F:8-5: Promissory Note .

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b) Identifying maturity date c) Computing interest on a note d) Accruing interest revenue and recording honored notes receivable e) Recording dishonored notes receivable Lecture Notes: Take the opportunity to revisit the adjusting entry for accrued interest revenue, as students frequently struggle with adjusting entries. Remind students that they may already be familiar with promissory notes in the form of car loans. Buying a car (or a major appliance) and “signing a note” results in periodic payments of principle and interest.

Introduce students to notes structured with payment of all principal and interest on the maturity date as they may not be as familiar with this concept. When computing interest on notes receivable, the interest rate is expressed annually and must be adjusted to the appropriate time period (Principal × Rate × Time). Time may be expressed as a fraction of a year in months (number of months/12) or a fraction of a year in days (number of days/365). When the period is given in days, the maturity date is determined by counting the actual days from the date of issue. When counting the number of days in a note term, remind students to count the maturity date but omit the date the note was issued.

Suggested In-Class Exercise: E8-24 LO 6. Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance a) Acid-test (or quick) ratio b) Accounts receivable turnover ratio c) Days’ sales in receivables Lecture Notes: Demonstrate the formula for and explain the purpose of each of the three ratios. The quick ratio is related to the current ratio. Both are measures of liquidity. In addition, point out the similarity of the two inventory ratios (Inventory Turnover and Days’ Sales in Inventory) to the two similarly named receivables ratios.

Suggested In-Class Exercise: E8-27

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Chapter 8: Handout for Student Notes LO 1. What are common types of receivables, and how are credit sales recorded?

o Types of receivables

▪

Accounts receivable

▪

Notes receivable

▪

Other receivables

o Exercising internal control over receivables

o Recording sales on credit

o Decreasing collection time and credit risk

▪

Credit card and debit card sales

▪

Factoring and pledging receivables

LO 2. How are uncollectibles accounted for when using the direct write-off method?

o Recording and writing off uncollectible accounts—Direct write-off method

o Recovery of accounts previously written off—Direct write-off method

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o Limitations of the direct write-off method

LO 3. How are uncollectibles accounted for when using the allowance method?

o Recording bad debts expense—Allowance method

o Writing off uncollectible accounts—Allowance method

o Recovery of accounts previously written off—Allowance method

o Comparison of recording transactions for uncollectibles using the direct write-off method versus the allowance method

o Estimating and recording bad debts expense—Allowance method

▪

Percent-of-sales method (income statement approach)

▪

Percent-of-receivables and aging-of-receivables methods (balance sheet approach)

1. Percent of receivables method

2. Aging-of-receivables method

3. Comparison of income statement approach versus balance sheet approach

LO 4. How is the estimation for bad debts expense performed using the allowance method?

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o Estimating and recording bad debts expense—Allowance method

▪

Percent-of-sales method (income statement approach)

▪

Percent-of-receivables and aging-of-receivables methods (balance sheet approach)

1. Percent of receivables method

2. Aging-of-receivables method

3. Comparison of income statement approach versus balance sheet approach

LO 5. How are notes receivable accounted for?

o Identifying maturity date

o Computing interest on a note

o Accruing interest revenue and recording honored notes receivable

o Recording dishonored notes receivable

LO 6. How do we use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance?

o Acid-test (or quick) ratio

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o Accounts receivable turnover ratio

o Days’ sales in receivables

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Chapter 8: Student Chapter Summary LO 1. Define and explain common types of receivables and journalize sales on credit A receivable is a monetary claim against a business or an individual. There are three major types of receivables: accounts receivable, which represent the right to receive cash in the future from customers for goods sold or for services performed; notes receivable, which represent a written promise that the customer will pay a fixed amount of principal plus interest by a certain date in the future; and other receivables, which represent a miscellaneous category that includes any other type of receivables where there is a right to receive cash in the future.

A critical component of internal control over receivables is the separation of cash-handling and cash-accounting duties. A separate accounts receivable account (called a subsidiary account) must be maintained for each customer in order to account for payments received from the customer and amounts still owed. The sum of all balances in the subsidiary accounts receivable will equal a control account balance, Accounts Receivable. Companies can decrease collection time and credit risk by accepting credit cards and debit cards or by factoring or pledging their receivables.

LO 2. Record transactions using the direct write-off method for uncollectibles Writing off uncollectible accounts when using the direct write-off method involves a debit to Bad Debts Expense and a credit to Accounts Receivable. Recovery of accounts previously written off is recorded by reversing the write-off entry and then recording an entry to receive the cash. The direct write-off method violates the matching principle and is not the method required by GAAP. LO 3. Record transactions using the allowance method for uncollectibles When using the allowance method, companies estimate bad debts expense at the end of the period and record an adjusting entry that debits Bad Debts Expense and credits Allowance for Bad Debts.

Writing off uncollectible accounts involves a debit to Allowance for Bad Debts and a credit to Accounts Receivable. Recovery of accounts previously written off is recorded by reversing the write-off entry and then recording an entry to receive the cash. The allowance method follows the matching principle and is required by GAAP.

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LO 4. Estimate bad debts expense based on the percent-of-sales, percent-of-receivables, and aging-ofreceivables methods There are three ways to estimate bad debts expense: • Percent-of-sales method: Computes bad debts expense as a percentage of net credit sales.

• Percent-of-receivables method: Determines the balance of the Allowance for Bad Debts account based on a percentage of accounts receivable.

• Aging-of-receivables method: Determines the balance of the Allowance for Bad Debts account based on the age of individual accounts receivable.

LO 5. Account for notes receivable including computing interest and recording honored and dishonored notes Notes receivable involve interest that is expressed annually and must be adjusted to the appropriate time period (Principal × Rate × Time). Time may be expressed as a fraction of a year in months (number of months/12) or a fraction of a year in days (number of days/365). When the period is given in days, the maturity date is determined by counting the actual days from the date of issue. When counting the number of days in a note term, remember to count the maturity date but omit the date the note was issued.

Interest on notes must be accrued at the end of the each period, and an adjusting entry must be recorded by debiting Interest Receivable and crediting Interest Revenue. The receipt of cash at a note’s maturity includes the principal plus interest. When a customer dishonors a note, the business can transfer the note receivable (plus interest earned) to an accounts receivable.

LO 6. Use the acid-test ratio, accounts receivable turnover ratio, and days’ sales in receivables to evaluate business performance The acid-test ratio reveals whether an entity could pay all its current liabilities if they were due immediately.

Acid-test ratio = (Cash including cash equivalents + Short-term investments + Net current receivables) / Total current liabilities The accounts receivable turnover ratio measures the number of times the company collects the average accounts receivable balance in a year.

Accounts receivable turnover ratio = Net credit sales / Average net accounts receivable The days’ sales in receivables indicates how many days it takes to collect the average level of accounts receivable.

Days’ sales in receivables = 365 days / Accounts receivable turnover ratio

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Chapter 8: Assignment Grid and Other Materials LO 1 S8-1 S8-2 S8-3 S8-4 S8-5 S8-6 S8-7 S8-8 S8-9 S8-10 S8-11 S8-12 S8-13 E8-14 E8-15 E8-16 E8-17 E8-18 E8-19 E8-20 E8-21 E8-22 E8-23 E8-24 E8-25 E8-26 E8-27 E8-28 P8-29A, P8-36B P8-30A, P8-37B P8-31A, P8-38B P8-32A, P8-39B P8-33A, P8-40B P8-34A, P8-41B P8-35A, P8-42B

LO 2

LO 3

LO 4

LO 5

LO 6

X X X X X X X X X X X X X X X X X X X X X X

X

X

X X X X X

X X X X X X X X X

X X X X

X

X X X X

X X X X

X X X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials:

Continuing Problem F:8-1 Practice Set F:8-1 Tying It All Together Case F:8-1 Decision Case F:8-1 Decision Case F:8-2 Fraud Case F:8-1 Financial Statement Case F:8-1

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CHAPTER 8 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Which of the following is an example of a good internal control for the credit department?

A. Employees who grant credit to customers should not also evaluate customer financial position.

B. Employees who handle cash receipts should not also grant credit to customers.

C. Only employees who are responsible for billing customers should also grant credit to customers.

D. All of these are good internal controls for the credit department.

2. What is the term that describes an entity that purchases the accounts receivables of a seller?

A. Honorer B. Buyer C. Pledger D. Factor 3. The person who signs a note receivable and promises to pay the principal and interest is called the A. payee.

B. principal.

C. maker.

D. signer.

4. What is the amount of interest accrued on $7,200 at 7% for 60 days (rounded to nearest dollar)?

A. $83 B. $120 C. $504 D. $1,200 5. A company estimates that $534 of its $28,720 Accounts Receivable are uncollectible. What is the net realizable value of Accounts Receivable?

A. $534 B. $28,186 C. $28,720 D. $29,274 6. The direct write-off method of accounting for uncollectible receivables is A. an example of the balance sheet approach.

B. an example of the income statement approach.

C. not in conformity with GAAP. D. in conformity with the matching principle.

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7. Beeman Corp. uses the percentage-of-sales method to account for uncollectible receivables. At the beginning of the year, Allowance for Bad Debts has a credit balance of $1,500. During the year Beeman Corp. writes off uncollectible receivables of $1,200. At the end of the year, Beeman Corp. has net credit sales $135,000, of which 2% are deemed uncollectible. What is Beeman’s year-end balance in Allowance for Bad Debts?

A. $300 B. $2,400 C. $2,700 D. $3,000 8. On December 12, Lee Building Supply sells materials for $7,800 to Jacob Miller. Smith signs a 60day promissory note at 7% annual interest. On December 12, the journal entry made by Lee Building Supply for the sale to Jacob Miller will include a A. credit to Sales Revenue for $7,800.

B. debit to Accounts Receivable for $7,710.

C. credit to Interest Revenue for $90.

D. debit Interest Receivable for $90.

9. At year-end, Simon Company has Cash of $15,500, Accounts Receivable of $52,300, Inventory of $28,700, and Prepaid Expenses totaling $7,200. Total Current Liabilities are $48,800 and Total Assets are $195,500. What is the quick ratio (rounded)?

A. 0.32 B. 0.95 C. 1.39 D. 1.98 10. Accounts receivable turnover for Alpha Company was 8.7 for this year and 9.8 for last year. For Zeta, Inc., accounts receivable turnover was 9.4 for this year and 8.9 for last year. These results indicate that A. Alpha Company has better turnover than Zeta, Inc. for both years.

B. Zeta, Inc. is collecting its receivables more quickly this year than last year.

C. Turnover for Alpha Company is improving.

D. Credit policies for Zeta, Inc. are too strict for its customer base.

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Answer Key to Ten-Minute Quiz: 1. B 2. D 3. C 4. A

Amount of interest = Principal × Interest rate × Time = $7,200 × 7% × 60/365 = $83 (rounded) 5. B

Net realizable value = Accounts Receivable −Allowance for Bad Debts = $28,720 −$534 = $28,186 6. C 7. D

Allowance for Bad Debts 1,500 Write-offs

Unadj. Bal.

1,200 2,700*

Adj.

3,000

Bal.

*$135,000 × 2% = $2,700 8. A 9. C

Acid-test ratio = (Cash including cash equivalents + Short-term investments + Net current receivables) / Total current liabilities = ($15,500 + $0 + $52,300) / $48,800 = 1.39 (rounded) 10. B

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Extra Critical Thinking Questions Ethical Issue F:8-1 E-Z Loan Co. makes loans to high-risk borrowers. E-Z borrows from its bank and then lends money to people who have bad credit. The bank requires E-Z Loan to submit quarterly financial statements in order to keep its line of credit. E-Z’s main asset is Accounts Receivable. Therefore, Bad Debts Expense and Allowance for Bad Debts are important accounts.

Slade McMurphy, the controller of E-Z Loan, wants net income to increase in a smooth pattern rather than increase in some periods and decrease in others. To report smoothly increasing net income, McMurphy underestimates Bad Debts Expense in some periods. In other periods, McMurphy overestimates the expense. He reasons that over time, the income overstatements roughly offset the income understatements.

Is McMurphy’s practice of smoothing income ethical? Why or why not?

Ethical Issue F:8-1: Solution E-Z Loan’s practice of smoothing income is unethical because the controller deliberately underestimates Bad Debts Expense in some periods and overstates the expense in other periods. The purpose is to manipulate income. Instead, the company should be using accounting information, specifically the company’s past collection history, to develop a consistent method of calculating the Allowance for Bad Debts. This would be in conformance with the principles of consistency and reliability and would represent the business truthfully to the bank.

Team Project F:8-1 Companies want to maximize sales by extending credit to customers. However, this comes with risk.

How do companies know that customers will be both willing and able to pay invoices as they are due?

Perform an Internet search using the search term “steps to ensure your client is credit worthy.” Write a report (or prepare an oral presentation, as directed by your professor) to address at least four key steps companies should take to reduce credit risk. As a team, decide which company would be best to use and explain why.

Team Project F:8-1: Solution Student answers will vary. Report topics may include creation of a credit policy, having customers complete a credit application, running a credit check, reviewing financials, checking trade references, setting credit limits, and/or setting payment terms.

Communication Activity F:8-1 In 100 words or fewer, explain the difference between the percent-of-sales method and the aging-ofreceivables method for calculating the journal entry to adjust the Allowance for Bad Debts.

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Communication Activity F:8-1: Solution The percent-of-sales method computes bad debts expense as a percentage of net credit sales and focuses on the amount of expense that is reported on the income statement. The aging-of-receivables method focuses on Accounts Receivable (a balance sheet account) and determines the target allowance balance based on the aging-of-receivables. Individual accounts are grouped according to how long the receivable has been outstanding and a different percentage uncollectible is applied on each aging category.

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Chapter 9 Plant Assets, Natural Resources, and Intangibles

Chapter 9: Overview The chapter begins by describing the nature of property, plant, and equipment; identifying the different categories of property, plant, and equipment; and explaining the concept of depreciation. Students learn how to measure the costs of various property, plant, and equipment, including land, land improvements, buildings, machinery, equipment, furniture, and fixtures. The relative-market-value method is used for allocating the cost of a lump-sum purchase among the various assets included in the purchase. The difference between capital and revenue expenditures is explained. A Data Analytics in Accounting feature highlights how companies who own a large amount of properties can use data analytics to help maximize profits.

Factors in computing depreciation (capitalized cost, estimated useful life, and estimated residual value) are identified. Three methods for determining the amount of periodic depreciation expense are presented: straight-line, units-of-production, and double-declining-balance. The methods are illustrated and compared, demonstrating that although the methods result in different amounts of depreciation for each period, an equal amount of depreciation is taken over the total useful life of the asset. A discussion of depreciation for tax purposes is included. Accounting procedures for calculating partial-year depreciation and for changing estimates are discussed. Next, students learn about the gains and losses on the disposal of plant assets by discarding them or selling them in various situations.

The chapter continues with coverage of depletion of natural resources and amortization of intangible assets, including patents, copyrights, trademarks, franchises, licenses, and goodwill. The asset turnover ratio is used to evaluate business performance. The appendix discusses accounting for exchanges of plant assets where those exchanges may result in gains or losses.

A Tying It All Together provides a look into the property, plant, and equipment of McDonald’s Corporation. A Decisions feature discusses issues to be considered when deciding which deprecation method should be selected. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem allows students to practice using the different depreciation methods, partial-year calculations, and sale of plant assets. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 9: Learning Objectives LO 1. Measure the cost of property, plant, and equipment LO 2. Account for depreciation using the straight-line, units-of-production, and double-decliningbalance methods LO 3. Journalize entries for the disposal of plant assets LO 4. Account for natural resources LO 5. Account for intangible assets LO 6. Use the asset turnover ratio to evaluate business performance LO 7. Journalize entries for the exchange of plant assets (Appendix 9A)

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Chapter 9: Teaching Outline with Lecture Notes LO 1. Measure the cost of property, plant, and equipment a) Property, plant, and equipment and depreciation ▪ Exhibit F:9-1: Life Cycle of a Plant Asset b) Cost principle and capitalization c) Land and land improvements ▪ Exhibit F:9-2: Measuring the Cost of Land d) Buildings e) Machinery and equipment f) Furniture and fixtures g) Lump-sum purchase h) Capital and revenue expenditures ▪ Exhibit F:9-3: Delivery Truck Expenditures—Capital Expenditure and Revenue Expenditure Lecture Notes: Improper handling of capital expenditures can result in incorrect financial statements. Incorrect expensing will understate net income and understate assets. Incorrect capitalization will overstate income and overstate assets. This can be a gray area in practice and results in accountants having to use their professional judgment.

Suggested In-Class Exercises: E9-17, E9-18, and E9-19 LO 2. Account for depreciation using the straight-line, units-of-production, and double-decliningbalance methods a) Factors in computing depreciation i. Capitalized cost ii. Estimated useful life iii. Estimated residual value b) Depreciation methods ▪ Exhibit F:9-4: Data for Truck

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i. Straight-line method ▪ Exhibit F:9-5: Straight-Line Depreciation Schedule ii.

Units-of-production method ▪ Exhibit F:9-6: Units-of-Production Depreciation Schedule

iii.

Double-declining-balance method (accelerated depreciation method) ▪ Exhibit F:9-7: Double-Declining-Balance Depreciation Schedule

iv.

Comparing depreciation methods ▪ Exhibit 9-9: Annual Depreciation by Method

v.

Depreciation for tax purposes ▪ Modified Accelerated Cost Recovery System (MACRS)

c) Partial-year depreciation d) Changing estimates of a depreciable asset e) Reporting property, plant, and equipment ▪ Exhibit F:9-10: Reporting Property, Plant, and Equipment Lecture Notes: Depreciation is an allocation of cost to expense and doesn’t reflect the fair market value (FMV) changes in an asset. An asset could be worth a lot more than its book value on the balance sheet (land and buildings, for example). Depreciation is also a noncash expense. It reduces income but not cash flow.

The three depreciation methods in the textbook all result in the same total depreciation over the estimated useful life of the asset. What can vary is the annual depreciation. Accumulated Depreciation is a contra-asset account, not a liability account, and is subtracted from the asset cost to arrive at book value. Again, book value doesn’t reflect fair market value.

When using the units-of-production method, don’t over-depreciate the asset. The total units of production are an up-front estimate; once that amount is reached, depreciation should cease. When using the double-declining-balance method, residual value is ignored for calculation purposes but not for book value purposes. The asset can’t be depreciated below residual value.

Tax depreciation is based on IRS regulations and can result in different amounts of depreciation for financial statements and the tax return, called book-tax differences.

Various methods can be used for partial-year depreciation, but a company should be consistent in the application. When purchasing an asset mid-year, don’t forget about the carryover depreciation

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in the last year. For example, a company using straight-line for a five-year asset purchased midyear will report depreciation expense in six separate years for financial statements.

Suggested In-Class Exercises: E9-20 and E9-21 LO 3. Journalize entries for the disposal of plant assets a) Discarding plant assets b) Selling plant assets i.

At book value

ii.

Above book value

iii.

Below book value ▪ Exhibit F:9-11: Disposals of Plant Assets

Lecture Notes: When an asset is disposed of, the journal entry should (1) bring the depreciation up to date, (2) remove the old, disposed-of asset and associated Accumulated Depreciation from the books, (3) record the value of any Cash received, and (4) record the loss or gain by debiting a loss or crediting a gain. These amounts cannot be netted into one number because they involve separate accounts. Students may want to credit the asset for the net amount, which would still result in the correct gain or loss being recognized but would be an incorrect entry and leave a remaining balance in the disposed asset account.

Suggested In-Class Exercise: E9-22 LO 4. Account for natural resources a) Natural resource b) Depletion Lecture Notes: Explain terminology differences for plant assets and for natural resources. Plant assets are depreciated, and natural resources are depleted. Generally speaking, depletion is recorded for natural resources using the units-of-production method. Natural resources have an Accumulated Depletion account similar to Accumulated Depreciation.

Suggested In-Class Exercise: E9-24 LO 5. Account for intangible assets a) Accounting for intangibles i. Amortization ii. Impairment

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b) Specific intangibles i. Patents ii. Copyrights and trademarks iii. Franchises and licenses iv. Goodwill c) Reporting of intangible assets ▪ Exhibit F:9-12: Assets and Their Related Expenses Lecture Notes: There are terminology differences for natural resources and intangibles. While natural resources are depleted, intangible assets (with a definite life) are amortized. Generally speaking, the straight-line method is used for intangibles (with a definite life). There is no Accumulated Amortization account for intangibles; the Asset account is directly credited in the amortization journal entry. When evaluating intangibles with definite lives, there can be differences between legal life and useful economic life. The shorter of the two (usually the useful economic life) is used for amortization purposes.

Emphasize that goodwill is only reported as an asset in the financial statements when a business unit has been acquired by another company. While many companies have created internal goodwill as a result of a variety of qualitative factors such as quality of management or good business reputation, the valuation of this intangible quality of internal goodwill is too subjective to be reliably measured for accounting purposes without an objective measure of value provided by the acquisition, an observable transaction of known value.

Suggested In-Class Exercises: E9-25 and E9-26 LO 6. Use the asset turnover ratio to evaluate business performance Asset turnover ratio = Net sales revenue / Average total assets Lecture Notes: As with other ratios, the specific value of an asset turnover ratio lacks meaning in and of itself. It can be evaluated only in relation to the same ratio for other companies or in relation to the trend of the ratios of the same company over a number of periods.

Suggested In-Class Exercise: E9-27 LO 7. Journalize entries for the exchange of plant assets (Appendix 9A) a) Exchange of plant assets—Gain situation b) Exchange of plant assets—Loss situation Lecture Notes: Demonstrate the calculations and journal entries for the exchange of plant assets.

An exchange is simply another type of disposal, so the procedure for accounting for exchanges is similar to that for accounting for the sale of an asset. When an asset is exchanged, the journal entry .

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should (1) remove the old asset account, (2) remove the related Accumulated Depreciation for the old asset, (3) pay (or sometimes receive) Cash, (4) add the new asset at its current market value, and (5) make the journal entry balance by debiting a loss or crediting a gain.

Suggested In-Class Exercise: E9A-28

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Chapter 9: Handout for Student Notes

LO 1. How does a business measure the cost of property, plant, and equipment?

o Land and land improvements

o Buildings

o Machinery and equipment

o Furniture and fixtures

o Lump-sum purchase

o Capital and revenue expenditures

LO 2. What is depreciation, and how is it computed?

o Factors in computing depreciation

o Depreciation methods

▪

Straight-line method

▪

Units-of-production method

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▪

Double-declining-balance method

▪

Comparing depreciation methods

▪

Depreciation for tax purposes

o Partial-year depreciation

o Changing estimates of a depreciable asset

o Reporting property, plant, and equipment

LO 3. How are disposals of plant assets recorded?

o Discarding plant assets

o Selling plant assets

▪

Selling a plant asset at book value

▪

Selling a plant asset above book value

▪

Selling a plant asset below book value

▪

Summary

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LO 4. How are natural resources accounted for?

LO 5. How are intangible assets accounted for?

o Accounting for intangibles

o Specific intangibles

▪

Patents

▪

Copyrights and trademarks

▪

Franchises and licenses

▪

Goodwill

o Reporting of intangible assets

LO 6. How do we use the asset turnover ratio to evaluate business performance?

LO 7. How are exchanges of plant assets accounted for? (Appendix 9A)

o Exchange of plant assets—Gain situation

o Exchange of plant assets—Loss situation

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Chapter 9: Student Chapter Summary LO 1. Measure the cost of property, plant, and equipment Property, plant, and equipment are long-lived, tangible assets used in the operations of a business.

Property, plant, and equipment are recorded at historical cost—the amount paid for the asset. This includes the purchase price plus taxes, purchase commissions, and all other amounts paid to ready the asset for its intended use. A lump-sum purchase involves paying a single price for multiple assets. The cost of each asset purchased must be identified based on the relative-market-value method. Two additional types of expenditures are often incurred on property, plant, and equipment: capital expenditures, which are debited to an asset account because it increases the asset’s capacity or efficiency or extends the asset’s useful life, and revenue expenditures, which are debited to Repairs and Maintenance Expense because they are incurred to maintain the asset in working order.

LO 2. Account for depreciation using the straight-line, units-of-production, and double-declining-balance methods Depreciation is the allocation of a plant asset’s cost to expense over its useful life. Three common depreciation methods are: • • •

Straight-line method: A method that allocates an equal amount of depreciation to each year Units-of-production method: A method that allocates a varying amount of depreciation each year based on an asset’s usage Double-declining-balance method: An accelerated depreciation method that computes annual depreciation by multiplying the depreciable asset’s book value by a constant percentage that is two times the straight-line rate

In addition, the Modified Accelerated Cost Recovery System (MACRS) is used for tax purposes.

Occasionally a business may change its estimated residual value or estimated useful life of a depreciable asset. This change requires depreciation to be recalculated in the year of change and moving forward. Plant assets are reported on the balance sheet at book value (Cost − Accumulated Depreciation).

LO 3. Journalize entries for the disposal of plant assets There are four steps to recording disposals: Step 1: Bring the depreciation up to date.

Step 2: Remove the old, disposed-of asset and associated accumulated depreciation from the books.

Step 3: Record the value of any cash received (or paid) in the disposal of the asset.

Step 4: Determine the amount of any gain or loss (market value of assets received compared to the book value of the asset disposed of).

Review Exhibit 9-10 for a summary of journal entries for the disposal of plant assets.

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LO 4. Account for natural resources Natural resources are assets that come from the earth and are consumed. Depletion is the process by which businesses spread the allocation of a natural resource’s cost over its usage. Depletion expense is computed by the units-of-production method.

LO 5. Account for intangible assets Intangible assets are assets that have no physical form and are valuable because of special rights they carry. Amortization is the process by which businesses spread the allocation of an intangible asset’s cost over its useful life. Amortization expense is computed by the straight-line method.

LO 6. Use the asset turnover ratio to evaluate business performance The asset turnover ratio measures the amount of net sales generated for each average dollar of total assets invested.

Asset turnover ratio = Net sales revenue / Average total assets LO 7. Journalize entries for the exchange of plant assets (Appendix 9A) Exchanges that have commercial substance require the recording of any gain or loss on the transaction. Exchanges that lack commercial substance ignore any gain or loss on the transaction, except in a few limited cases.

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Chapter 9: Assignment Grid and Other Materials LO 1 S9-1 S9-2 S9-3 S9-4 S9-5 S9-6 S9-7 S9-8 S9-9 S9-10 S9-11 S9-12 S9-13 S9-14 S9A-15 S9A-16 E9-17 E9-18 E9-19 E9-20 E9-21 E9-22 E9-23 E9-24 E9-25 E9-26 E9-27 E9A-28 E9A-29 P9-30A, P9-36B P9-31A, P9-37B P9-32A, P9-38B P9-33A, P9-39B P9-34A, P9-40B P9A-35A, P9A-41B

LO 2

LO 3

LO 4

LO 5

LO 6

LO 7

X X X X X X X X X X X X X X X X X X X X X X X

X X X

X

X X X

X X X X

X X X X

X X

X X X

X

X

X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem F:9-1 Comprehensive Problem for Chapters F:7, F:8, and F:9 Tying It All Together Case F:9-1 Ethical Issue F:9-1 Fraud Case F:9-1 Financial Statement Case F:9-1 Communication Activity F:9-1

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CHAPTER 9 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Property, plant, and equipment are A. tangible assets used in the operation of a business that have a useful life of more than one year.

B. tangible assets used in the operation of a business that have a useful life of less than one year.

C. intangible assets used in the operation of a business that have a useful life of more than one year.

D. intangible assets used in the operation of a business that have a useful life of less than one year.

2. A company paid $150,000 plus a 6% commission and $4,000 in closing costs for a property. The property included land appraised at $87,500, land improvements appraised at $35,000, and a building appraised at $52,500. What should be the allocation of this property’s costs in the company’s accounting records?

A. Land $75,000; Land Improvements $30,000; Building $45,000 B. Land $79,500; Land Improvements $32,600; Building $47,700 C. Land $81,500; Land Improvements $32,600; Building $48,900 D. Land $87,500; Land Improvements $35,000; Building $52,500 3. Land improvements are assets that increase the usefulness of land A. and, like land, are not depreciated.

B. and are subject to depreciation.

C. and are included in the cost of land.

D. and are also referred to as lump-sum purchases.

4. Which of the following statements about intangible assets is FALSE? A. The acquisition cost of a franchise or license is amortized over its useful life.

B. Goodwill is recorded only by an acquiring company when it purchases another company.

C. Patents are amortized over their useful life not their legal life.

D. A trademark is the exclusive right to reproduce and sell a work of art.

5. A company bought a new display case for $42,000 and estimated residual value to be $2,000 and the useful life to be eight years. Using straight-line depreciation, what is the book value of the display case after three years?

A. $15,000 B. $15,750 C. $26,250 D. $27,000

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6. A company purchased a point-of-sale self-service cash register on January 1 for $5,400. This register has a useful life of 10 years and a salvage value of $400. What would be the depreciation expense for the second year of its useful life, using the double-declining-balance method?

A. $500 B. $800 C. $864 D. $1,080 7. A commercial printing press costs $35,000 when new and has accumulated depreciation of $26,000.

Suppose Quick Copy disposes of this machine and receives nothing. What is the gain or loss on the transaction?

A. Loss of $9,000 B. Loss of $35,000 C. Loss of $61,000 D. Gain of $61,000 8. A company purchases a truck with an estimated useful life of seven years. The truck cost $68,000 and its estimated salvage value is $5,000. After five years of straight-line depreciation, the asset’s total estimated useful life was revised from seven years to nine years, and there was no change in the estimated salvage value. What is the depreciation expense in year 6?

A. $9,000 B. $7,000 C. $5,750 D. $4,500 9. An ore deposit costing $800,000 is expected to produce 1,600,000 tons of ore over the next 10 years.

A total of 70,000 tons are mined and sold in the current year. What is the depletion expense for the current year?

A. $35,000 B. $56,000 C. $80,000 D. $140,000 10. A total asset turnover ratio of 4.5 indicates that for every $1 in average total assets invested, A. the firm acquired $4.50 in assets during the period.

B. the firm produced $4.50 in net sales revenue during the period.

C. the firm earned gross profit of $4.50 during the period.

D. the firm earned net income of $4.50 during the period.

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Answer Key to Ten-Minute Quiz: 1. A 2. C

Asset

Market Value

Land Land Improvements Building Total

$87,500 $35,000 $52,500 $175,000

=

Assigned Cost of Each Asset

50%  $163,000 = 20%  $163,000 = 30%  $163,000 = 100%

$81,500 $32,600 $48,900 $163,000

Percentage of Total Value

$87,500 / $175,000 $35,000 / $175,000 $52,500 / $175,000

= = =



Total Purchase Price*

* Total Purchase Price = Purchase price + Commission + Closing costs = $150,000 + ($150,000 × 0.06) + $4,000 = $163,000

3. B 4. D 5. D Straight-line depreciation = (Cost – Residual value) / Useful life = ($42,000 − $2,000) / 8 years = $5,000 per year Accumulated depreciation after three years = $5,000 per year × 3 years = $15,000 Book value at the end of the third year = Cost – Accumulated depreciation = $42,000 − $15,000 = $27,000 6. C Double-declining-balance depreciation = (Cost − Accumulated depreciation)  2  (1 / Useful life) For the first year of the cash register: = ($5,400 − $0)  2  (1 / 10 years) = $1,080 For the second year of the cash register: = ($5,400 − $1,080)  2  (1 / 10 years) = $864

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7. A Market value of assets received

$

Less: Book value of assets disposed of: Cost Less: Accumulated Depreciation Gain or (Loss)

$

35,000 (26,000)

0

9,000 $ (9,000)

8. D Straight-line depreciation = (Cost − Residual value) / Useful life = ($68,000 − $5,000) / 7 years = $9,000 per year  5 years = $45,000 Revised depreciation = (Book value* − Revised residual value) / Revised useful life remaining = ($23,000 − $5,000) / 4 years = $4,500 per year *Book value = Cost − Accumulated depreciation = $68,000 − $45,000 = $23,000 9. A Depletion per unit = (Cost − Residual value) / Estimated total units = ($800,000 −$0) / 1,600,000 tons = $0.50 per ton Depletion expense = Depletion per unit x Number of units extracted = $0.50 per ton x 70,000 tons = $35,000 10. B

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Extra Critical Thinking Questions Decision Case F:9-1 Suppose you are an investment advisor and are looking at two companies to recommend to your clients, Shelly’s Seashell Enterprises and Jeremy Feigenbaum Systems. The two companies are virtually identical, and both began operations at the beginning of the current year.

In early January 20X4, both companies purchased equipment costing $143,000, with a 10-year estimated useful life and a $20,000 residual value. Shelly uses the straight-line depreciation method. By contrast, Feigenbaum uses the double-declining-balance method. Both companies’ trial balances at December 31, 20X4, included the following: Net Sales Revenue Cost of Goods Sold Operating Expenses (other than depreciation)

$ 270,000 70,000 80,700

Requirements 1. Prepare both companies’ income statements. (Disregard income tax expense.)

2. Write a letter to address the following questions for your clients: Which company appears to be more profitable? Which company would you prefer to invest in? Why?

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Decision Case F:9-1: Solution Requirement 1 Depreciation using the straight-line method: Straight-line depreciation

= = =

(Cost − Residual value) / Useful life ($143,000 − $20,000) / 10 years $12,300 per year

Depreciation using the double-declining-balance method: Double-declining-balance depreciation

= = =

(Cost − Accumulated depreciation) × 2 × (1 / Useful life) ($143,000 − $0) × 2 × (1 / 10 years) $28,600 for year 1 (20X8)

Shelly’s Seashell Enterprises and Jeremy Feigenbaum Systems Income Statement For the Year Ended December 31, 20X4

Net Sales Revenue Cost of Goods Sold Gross Profit Selling and Administrative Expenses: Operating Expenses Depreciation Expense Operating Income

.

Shelly’s (SL) $ 270,000 70,000 200,000 $ 80,700 12,300

93,000 $ 107,000

Jeremy’s (DDB) $ 270,000 70,000 200,000 $ 80,700 28,600

109,300 $ 90,700

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Requirement 2 INVESTMENT LETTER TO:

Our Clients

FROM:

Student Name

RE:

Selecting Shelly’s Seashell Enterprises or Jeremy Feigenbaum Systems for a long-term investment

In picking an investment, we suggest you consider the following factors: Shelly’s Seashell Enterprises and Jeremy Feigenbaum Systems are basically identical companies. The two companies started operations at the same time and are engaged in similar transactions. The main difference between the two lies in the accounting methods they use.

Shelly’s income statement reports operating income of $107,000 compared to $90,700 for Jeremy. On the surface, Shelly’s appears to be more profitable. This difference does not tell the full story, however, because Shelley’s uses the straight-line method to account for depreciation. This method results in higher reported operating income.

Jeremy reports lower operating income than Shelley because Jeremy uses the double-declining-balance method for depreciation. This method results in lower reported operating income.

There may be some timing differences involved. As a result, Feigenbaum will have lower income tax liabilities in the near term and thus higher cash flow. These differences, however, will even out over time.

Our conclusion is that despite apparent differences in the income statements of the two companies, when corrected for the effects of using different accounting methods, they both demonstrate equal performance, and both represent good investment opportunities.

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Team Project F:9-1 Visit a local business.

Requirements 1. List all of the company’s property, plant, and equipment.

2. If possible, interview the manager. Gain as much information as you can about the business’s property, plant, and equipment. For example, try to determine the costs of the assets, the depreciation method the company is using, and the estimated useful life of each asset category. If an interview is impossible, then develop your own estimates of the assets’ costs, useful lives, and book values, assuming an appropriate depreciation method.

3. Determine whether the business has any intangible assets. If so, list them and learn as much as possible about their nature, costs, and estimated useful lives.

4. Write a detailed report of your findings and be prepared to present it to the class.

Team Project F:9-1: Solution Student reports will vary, depending on the nature of the business they interview.

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Chapter 10 Investments Chapter 10: Overview The chapter introduces the student to investments. The reasons companies invest and the classification and reporting of debt and equity investments are presented. The differences between debt and equity securities are discussed. Accounting for investments in debt securities is described in detail. Journal entries illustrate the purchase of debt securities, interest revenue, and disposition at maturity. The discussion then focuses on accounting for investments in equity securities. First, journal entries illustrate the purchase of equity securities, dividend revenue, and disposition for equity securities with no significant influence, then for equity securities with significant influence. Consolidation accounting for equity securities with control is briefly discussed.

The next section deals with how debt and equity securities are reported. Debt investments— trading debt investments, available-for-sale debt investments, held-to-maturity debt investments, and equity investments with no significant influence—are discussed, and comprehensive income is presented. The calculation of the rate of return on total assets is shown, and the evaluation of business performance using this ratio is discussed.

An Ethics feature helps give perspective on a real-world ethical dilemma involving insider trading. A Tying It All Together provides a look at investment reporting on Berkshire Hathaway, Inc.’s balance sheet. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem reviews the various methods of accounting for investments and journal entries for adjusting securities to fair value and for accounting for securities under the equity method. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 10: Learning Objectives LO 1. Identify why companies invest in debt and equity securities and classify investments LO 2. Account for investments in debt securities LO 3. Account for investments in equity securities LO 4. Describe and illustrate how debt and equity securities are reported LO 5. Use the rate of return on total assets to evaluate business performance

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Chapter 10: Teaching Outline with Lecture Notes LO 1. Identify why companies invest in debt and equity securities and classify investments a) Debt securities versus equity securities b) Reasons to invest c) Classification and reporting of investments ▪

Debt securities

▪

Equity securities

▪

Exhibit F:10-1: Types of Investments

Lecture Notes: Most students are familiar with the fact that individuals invest in stocks and bonds.

However, most students are not familiar with the fact that companies do the same thing. Upon starting this chapter, point out to students that companies invest excess cash in corporations’ stocks and bonds, just like individuals do. Explain the reasons companies invest in securities and the different classifications of investments.

Explain the difference between equity financing and debt financing. Highlight that investing in stock is commonly referred to as investing in equity securities, and investing in bonds is commonly referred to as investing in debt securities. Refer students to Exhibit F:10-1 and go through the definition of each investment and whether the investment is a debt investment, an equity investment, or both. Point out to students that these are the same types of investments that individuals can invest in. Briefly explain that different investments have different tax implications.

Suggested In-Class Exercise: S10-1 LO 2. Account for investments in debt securities a) Purchase of debt securities b) Interest revenue c) Disposition at maturity d) Other accounting issues for debt investments Lecture Notes: Emphasize that investing in debt securities is like loaning money to a company.

When you purchase debt securities from a company, you are lending your money to that company, and you will get back that money plus interest. Debt securities typically pay interest semiannually.

Debt securities can be held-to-maturity debt investments, trading debt investments, and availablefor-sale debt investments. The accounting for all three of these is the same. The only difference is

.

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the use of a different account name for the investment. In addition, debt securities can be purchased at face value, at a discount, or at a premium.

Suggested In-Class Exercise: E10-10 LO 3. Account for investments in equity securities a) Equity securities with no significant influence (fair value method) a. Purchase b. Dividend revenue c. Disposition b) Equity securities with significant influence (equity method) a. Purchase b. Dividends received and share of net income c. Disposition c) Equity securities with controlling interest (consolidation method) Lecture Notes: Discuss with students that there is typically a gain or loss associated with disposing of equity securities. Remind students that a loss is always a debit, and a gain is always a credit. Point out to students that under the cost method, there is a credit to Dividend Revenue for dividends earned, but under the equity method, a dividend is a decrease in the investor’s equity and therefore the credit is to Equity Investments. With consolidations, the investor owns a controlling interest, creating a parent/subsidiary relationship. This requires a single set of financial statements, as if the parent and its subsidiaries were the same entity.

Suggested In-Class Exercises: S10-3 and S10-4 LO 4. Describe and illustrate how debt and equity securities are reported a) Trading debt investments (fair value method) ▪

Disposition

b) Available-for-sale debt investments (fair value method) ▪

Exhibit F:10-2: Comprehensive Income

▪

Disposition

c) Held-to-maturity debt investments (amortized cost)

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d) Equity investments with no significant influence (fair value method) ▪

Exhibit F:10-3: Debt and Equity Securities—Accounting Methods and Financial Statement Effects

Lecture Notes: Highlight that unrealized gains or losses occur when a company adjusts an asset to fair value but has not yet disposed of the asset, and realized gains or losses occur when a company disposes of an asset and represents the difference between the cash received at time of disposal and the basis of the asset.

Suggested In-Class Exercise: E10-12 LO 5. Use the rate of return on total assets to evaluate business performance Lecture Notes: Rate of return on total assets = (Net income + Interest expense) / Average total assets Also known as return on assets, this ratio measures a company’s success in using assets to earn profits. Point out that adding interest expense to net income in the numerator of this ratio permits comparison of companies that finance their operations in different ways (debt or equity). Consider two similarly sized companies, one financed more by debt than the other. The company that has more debt will pay for its debt financing by paying more interest expense. The second company that has more equity and less debt will likely pay more dividends and less interest expense.

Suggested In-Class Exercise: E10-17

.

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Chapter 10: Handout for Student Notes

LO 1. Why do companies invest?

o Debt securities versus equity securities

o Reasons to invest

o Classification and reporting of investments

o Debt securities

o Equity securities

LO 2. How are investments in debt securities accounted for?

o Purchase of debt securities

o Interest revenue

o Disposition at maturity

o Other accounting issues for debt investments

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LO 3. How are investments in equity securities accounted for?

o Equity securities with no significant influence (fair value method)

▪

Purchase

▪

Dividend revenue

▪

Disposition

o Equity securities with significant influence (equity method)

▪

Purchase

▪

Dividends received and share of net income

▪

Disposition

o Equity securities with controlling interest (consolidation method)

LO 4. How are debt and equity securities reported?

o Trading debt investments (fair value method)

▪

Disposition

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o Available-for-sale debt investments (fair value method)

▪

Disposition

o Held-to-maturity debt investments (amortized cost)

o Equity investments with no significant control (fair value method)

LO 5. How do we use the rate of return on total assets to evaluate business performance?

.

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Chapter 10: Student Chapter Summary LO 1. Identify why companies invest in debt and equity securities and classify investments Companies invest in debt or equity securities to generate investment income or to pursue a certain business strategy. A debt security represents a credit relationship with another company or governmental entity, and typically pays interest for a fixed period. An equity security represents stock ownership in another company and sometimes pays dividends. Investments are classified as either short-term or long-term investments and can be further classified into debt and equity categories: o Debt securities o Trading debt investments: Debt securities that the investor intends to sell in the very near future with the intent of generating a profit on a quick sale o Held-to-maturity (HTM) debt investments: Debt securities the investor intends to hold until they mature o Available-for-sale (AFS) debt investments: Debt securities that aren’t trading debt investments or held-to-maturity debt investments o Equity securities o No significant influence equity investments: Equity securities in which the investor lacks the ability to participate in the decisions of the investee company o Significant influence equity investments: Equity securities in which the investor has the ability to exert influence over operating and financial decisions of the investee company o Controlling interest equity investments: Equity securities in which the investor owns more than 50% of the investee’s voting stock LO 2. Account for investments in debt securities Debt securities can be held-to-maturity debt investments, trading debt investments, and available-for-sale debt investments. The accounting for all three of these is the same. The only difference is the use of a different account name for the investment. Investments in debt securities are recorded at cost, including any brokerage fees paid. The receipt of interest revenue is recorded with a debit to Cash and a credit to Interest Revenue. Debt securities disposed of at maturity are recorded with a debit to Cash and a credit to the Investment account (Trading Debt Investment, Held-to-Maturity Debt Investment, or Available-for-Sale Debt Investment).

In addition, debt securities can be purchased at face value, at a discount, or at a premium.

LO 3. Account for investments in equity securities Equity securities in which the investor lacks the ability to participate in the decisions of the investee company are initially accounted for at cost. The receipt of dividend revenue is recorded with a debit to Cash and a credit to Dividend Revenue. Equity securities disposed of could involve either a gain or loss on disposal.

.

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Equity securities with significant influence (20% to 50% ownership) are recorded using the equity method. The purchase of the equity securities is recorded at cost. Dividends declared and received are recorded with a debit to Cash and a credit to Equity Investments. A dividend reduces the investor’s investment. The investor’s share of net income is recorded as a debit to Equity Investments and a credit to Revenue from Investments. Net income increases the investor’s investment. Disposition of equity securities could involve either a gain or loss.

Equity securities with control (more than 50% ownership) are recorded using the consolidation method, which involves the parent company preparing consolidated statements.

LO 4. Describe and illustrate how debt and equity securities are reported Trading debt investments and available-for-sale debt investments are reported at fair value on the balance sheet. The unrealized holding gain or loss incurred on trading debt investments is reported on the income statement as Other Income and (Expenses). The unrealized holding gain or loss incurred on available-for-sale debt investments is not included in net income. It is, instead, reported as part of other comprehensive income included in stockholders’ equity on the balance sheet. Held-to-maturity debt investments are reported at amortized cost on the balance sheet. Equity investments with no significant influence must also be reported at fair value. The unrealized holding gain or loss incurred on equity investments with no significant influence is reported on the income statement as Other Income and (Expenses).

LO 5. Use the rate of return on total assets to evaluate business performance The rate of return on total assets measures a company’s success in using its assets to earn a profit before payment of financing costs.

Rate of return on total assets = (Net income + Interest expense) / Average total assets

.

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Chapter 10: Assignment Grid and Other Materials S10-1 S10-2 S10-3 S10-4 S10-5 S10-6 S10-7 E10-8 E10-9 E10-10 E10-11 E10-12 E10-13 E10-14 E10-15 E10-16 E10-17 P10-18A, P10-21B P10-19A, P10-22B P10-20A, P10-23B

LO 1 X

LO 2

LO 3

LO 4

X X X X

X X

LO 5

X

X X X X X X X X X X

X

X X X

X X

X

X X

X X

X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

Other End-of-Chapter Materials: Continuing Problem F:10-1 Tying It All Together Case F:10-1 Decision Case F:10-1 Ethical Issue F:10-1 Fraud Case F:10-1 Financial Statement Case F:10-1 Communication Activity F:10-1

.

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CHAPTER 10 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Debt investments not held to maturity are reported at A. equity value.

B. fair value.

C. net value.

D. amortized cost.

2. Equity securities with less than 20% ownership A. are held-to-maturity debt investments.

B. earn dividend revenue.

C. are accounted for under the equity method.

D. are accounted for under the consolidation method.

3. Gourmet Donuts owns 800 shares of Coffee Express. Coffee Express, which has issued 100,000 shares of stock, declares a cash dividend of $0.50 per share to stockholders. Which journal entry correctly records the cash dividend received by Gourmet Donuts?

A.

Cash

50,000 Dividend Revenue

B. C. D.

Cash

50,000 800

Dividend Revenue Dividend Revenue Cash Cash Dividend Revenue

800 400 400 400 400

4. Unrealized gains or losses occur when A. a company adjusts assets from cost value to book value.

B. a company adjusts assets from fair value to cost value.

C. a company adjusts assets from book value to fair value.

D. a company adjusts assets from fair value to book value.

5. All of the following are reported as other comprehensive income except A. gains or losses from post-retirement benefit plans.

B. foreign currency translation adjustments.

C. unrealized holding gains or losses on held-to-maturity investments.

D. deferred gains or losses from derivatives.

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6. Equity securities with more than 20% but less than 50% ownership A. allow the investor to significantly influence the investee’s decisions.

B. earn dividend revenue.

C. are accounted for under the cost method.

D. are accounted for under the consolidation method.

7. At the beginning of the year, Zesty Corporation purchased 10,000 shares of Scrumptious Company common stock for $80 per share. Scrumptious Company, which has issued 40,000 shares of stock, earned net income of $800,000 for the year and declared a cash dividend of $8 per share to stockholders. At the end of the year, Scrumptious Company stock sells for $85 per share. When Zesty Corporation prepares its balance sheet at the end of the year, what is the balance of the account for Equity Investment—Scrumptious Company?

A. $800,000 B. $850,000 C. $880,000 D. $920,000 8. Trader Company holds a debt investment as an available-for-sale investment. The investment is sold, and Trader realizes a gain. The gain is the excess of the selling price over the investment’s A. market value.

B. initial cost.

C. fair value.

D. present value.

9. Fit and Fab Corporation purchased 20,000 shares of Healthy, Inc. common stock for $22 per share.

Healthy, Inc., which has issued 80,000 shares of stock, declares a cash dividend of $2 per share to stockholders. Which journal entry correctly records the Cash Dividend received by Fit and Fab Corporation?

A. Cash 40,000 Dividend Revenue 40,000 B. Cash 40,000 Equity Investments 40,000 C. Cash 160,000 Dividend Revenue 160,000 D. Cash 440,000 Dividend Revenue 440,000

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10. Use the following data to calculate rate of return on total assets (rounded amounts): Total Assets, May 31, 20X5 Total Assets, May 31, 20X4 For Yr. Ended May 31, 20X5: Depreciation Expense Interest Expense Net Income A. B. C. D.

$ 11,000,000 10,000,000

30,000 98,000 900,000

7.6% 8.6% 9.5% 10.0%

.

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Answer Key to Ten-Minute Quiz: 1. B 2. B 3. D The investor owns less than 20% of the investee’s voting stock and no significant influence exists. So, dividend revenue is recorded.

Cash Dividend Revenue ($0.50 per share × 800 shares)

400 400

Received cash dividend.

4. C 5. C 6. A 7. D Equity investments with 20% to 50% ownership in the investee’s voting stock require using the equity method: Purchase: Equity Investments—Scrumptious Company Cash Purchased investment in stock (equity method).

800,000 800,000

Dividends received and share of net income: Cash Equity Investments—Scrumptious Company ($8 per share × 10,000 shares)

80,000 80,000

Received cash dividend (equity method).

Equity Investment—Scrumptious Company Revenue from Investments ($800,000 × 0.25)

200,000 200,000

Recorded revenue earned from investment (equity method).

.

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Equity Investments—Scrumptious Company 800,000 80,000 200,000 920,000

8. B 9. B Equity investments with 20% to 50% ownership in the investee’s voting stock require using the equity method: Dividends received: Cash Equity Investments—Healthy, Inc. ($2 per share × 20,000 shares)

40,000 40,000

Received cash dividend (equity method).

10. C Rate of return on total assets = (Net income + Interest expense) / Average total assets* = ($900,000 + $98,000) / $10,500,000 = 0.95 or 9.5% *Average total assets = (Beginning total assets + Ending total assets) / 2 = ($10,000,000 + $11,000,000) / 2 = $10,500,000

.

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Chapter 11 Current Liabilities and Payroll

Chapter 11: Overview The chapter begins with the definitions of current and long-term liabilities. Accounting for current liabilities is first discussed and illustrated. The current liabilities of known amounts covered in this chapter are accounts payable, sales tax payable, income tax payable, unearned revenue, short-term notes payable, and current portion of long-term notes payable.

Accounting for payroll is then presented. Gross pay, net pay, and employee payroll withholding deductions (income tax, FICA tax, and optional withholdings) are discussed. A W-4 form and a payroll register are illustrated. The journal entries for employee payroll are illustrated. Employer payroll taxes are explained, including FICA tax and state and federal unemployment taxes. The chapter includes a discussion of internal control over payroll.

The chapter then explains current liabilities that must be estimated, including bonus plans, employee benefits, and warranties. The guidelines for the three categories of contingent liabilities—remote, reasonably possible, and probable—are presented. Using the times-interest-earned ratio to evaluate business performance is discussed.

A Tying It All Together feature provides a look into the current liabilities of UnitedHealth Group Incorporated. A Decisions feature helps students see how a real-world contingency should be reported.

The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. Two Check Your Understanding Problems review sales taxes, interest on a note payable, contingencies, and payroll transactions. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 11: Learning Objectives LO 1.

Account for current liabilities of known amount

LO 2.

Calculate and journalize basic payroll transactions

LO 3.

Account for current liabilities that must be estimated

LO 4.

Account for contingent liabilities

LO 5.

Use the times-interest-earned ratio to evaluate business performance

.

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Chapter 11: Teaching Outline with Lecture Notes LO 1. Account for current liabilities of known amount a) Classification of liabilities as current or long-term b) Accounts payable c) Sales tax payable d) Income tax payable e) Unearned revenues f) Short-term notes payable g) Current portion of long-term notes payable Lecture Notes: As noted later in the chapter, liabilities are recognized if they are at least probable and are of known amount or can be estimated. The chapter begins with liabilities that are certain obligations of known amounts and, therefore, must be recognized in the financial statements.

Emphasize that sales tax is not an expense of the company. It is collected from customers and remitted to the appropriate agency at certain due dates. Concerning income taxes, point out that income tax payable is determined by tax regulations enforced by the Internal Revenue Service, not

by GAAP. While many liabilities are first recognized in conjunction with related expenses and later paid, unearned revenues are created when cash is received for obligations to be fulfilled in the future that result in recognition of related revenues. When discussing short-term notes payable, remind students that the interest rate is expressed annually and needs to be adjusted to the appropriate time period (Principal × Interest rate × Time). The portion of long-term liabilities that become due within the next year are reclassified as current liabilities. Long-term liabilities are discussed more fully in a later chapter.

Suggested In-Class Exercises: S11-1, S11-2, S11-3, and S11-4 LO 2. Calculate and journalize basic payroll transactions a) Gross pay and net (take-home) pay b) Employee payroll withholding deductions i. Withholding for employee income tax ii. Withholding for employee Social Security tax (FICA) iii. Optional withholding deductions c) Payroll register

.

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▪

Exhibit F:11-1 Payroll Register

d) Journalizing employee payroll e) Employer payroll taxes i. Employer FICA tax ii. State and federal unemployment compensation taxes ▪

Exhibit F:11-2: Payroll Costs

iii. Journalizing employer payroll taxes f) Payment of employer payroll taxes and employees’ withholdings g) Internal control over payroll i. Controls for efficiency ii. Controls to safeguard payroll disbursements Lecture Notes: When discussing payroll, point out that gross pay is the expense amount (debit), net pay is the salary/wages payable amount (credit), and the various withholdings represent individual payable accounts (credit). The journal entry should always balance! The various withholding amounts are tracked in separate accounts and can be due on different dates. They are not expenses of the company; they are collected and remitted in a way that is similar to the way sales tax is collected and remitted. There are several journal entries associated with payroll: recording the payroll expense, recording the issuance of the paychecks, recording the payroll tax expense, and remitting withholdings and payroll tax expenses as they come due.

Students who are working should be familiar with FICA tax but may not be aware that there are two parts: OASDI and Medicare. Students are generally surprised to find out that employers also pay FICA tax and unemployment taxes. A company must consider these taxes as well as salaries/wages and benefits when determining the total cost of an employee.

Suggested In-Class Exercise: E11-20 LO 3. Account for current liabilities that must be estimated a) Bonus plans b) Vacation, health, and pension benefits c) Warranties Lecture Notes: Students may not have the life experience to put these concepts into context. Some additional explanation of each of the above may be needed.

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Suggested In-Class Exercise: E11-22 LO 4. Account for contingent liabilities a) Contingent liability b) Remote contingent liability c) Reasonably possible contingent liability d) Probable contingent liability ▪

Exhibit F:11-3: Contingent Liabilities

Lecture Notes: Students may not have the life experience to put these concepts into context. Some additional explanation of each of the above may be needed.

Suggested In-Class Exercise: E11-23 LO 5. Use the times-interest-earned ratio to evaluate business performance a) Also called the interest-coverage ratio b) Times-interest-earned ratio = Earnings before interest and taxes (EBIT) / Interest expense where EBIT = Net income + Income tax expense + Interest expense c) The ratio is an indicator of the relative ease or difficulty in fulfilling interest payment obligations.

Suggested In-Class Exercise: E11-24

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Chapter 11: Handout for Student Notes

LO 1. How are current liabilities of known amounts accounted for?

o Accounts payable

o Sales tax payable

o Income tax payable

o Unearned revenues

o Short-term notes payable

o Current portion of long-term notes payable

LO 2. How do companies account for and record payroll?

o Gross pay and net (take-home) pay

o Employee payroll withholding deductions

▪

Withholding for employee income tax

▪

Withholding for employee Social Security tax (FICA)

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▪

Optional withholding deductions

o Payroll register

o Journalizing employee payroll

o Employer payroll taxes

▪

Employer FICA tax

▪

State and federal unemployment compensation taxes

▪

Journalizing employer payroll taxes

o Payment of employer payroll taxes and employees’ withholdings

o Internal control over payroll

▪

Controls for efficiency

▪

Controls to safeguard payroll disbursements

LO 3. How are current liabilities that must be estimated accounted for?

o Bonus plans

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o Vacation, health, and pension benefits

o Warranties

LO 4. How are contingent liabilities accounted for?

o Remote contingent liability

o Reasonably possible contingent liability

o Probable contingent liability

LO 5. How do we use the times-interest-earned ratio to evaluate business performance?

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Chapter 11: Student Chapter Summary LO 1. Account for current liabilities of known amount Current liabilities are liabilities that must be paid with cash or with goods and services within one year or within the entity’s operating cycle if the cycle is longer than a year. Some examples of current liabilities are accounts payable, sales tax payable, income tax payable, unearned revenues, and short-term notes payable. Current liabilities also include any current portion of long-term notes payable.

LO 2. Calculate and journalize basic payroll transactions Gross pay is the total amount of salary or wages earned by an employee. Net pay is the amount that each employee gets to keep (take-home pay). Payroll withholding deductions are the difference between gross pay and net pay. Examples of payroll deductions that employees pay include income tax withholding (federal, state, and local income tax); employee FICA tax (OASDI: 6.2% on the first $118,500 of annual earnings, Medicare: 1.45% on earnings up to $200,000, and 2.35% on all earnings above $200,000); and optional withholdings (insurance premiums, retirement savings, charitable contributions, union dues, and others).

A payroll register can be used to help summarize the earnings, withholdings, and net pay for each employee. Businesses record a journal entry for payroll and payroll withholdings as a debit to Salaries and Wages Expense and a credit to various liabilities until the amounts are paid.

Employers must pay at least three payroll taxes: employer FICA tax (OASDI: 6.2% on the first $118,500 of each employee’s annual earnings; Medicare: 1.45% on all earnings); state unemployment compensation tax (SUTA), which varies by state but is assumed to be 5.4% on the first $7,000 of each employee’s annual earnings for this class; and federal unemployment compensation tax (FUTA), which is 0.6% on the first $7,000 of each employee’s annual earnings.

Payroll taxes are recorded as a debit to Payroll Tax Expense and a credit to various liabilities until they are paid.

Internal control over payroll involves efficiency and safeguarding of payroll disbursements.

NOTE: Payroll tax rates given in the text are the rates at time of printing and the rates used for all end-of-chapter exercises and problems.

LO 3. Account for current liabilities that must be estimated Bonuses are based on meeting a specific goal and are considered liabilities (Employee Bonus Payable) until paid. Vacation, health, and pension benefits must be estimated and recorded as liabilities until paid. Warranty Expense (DR) and Estimated Warranty Payable (CR) must be recorded in the same period that the company records the revenue related to the warranty. As warranties are honored, the Estimated Warranty Payable account is reduced.

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LO 4. Account for contingent liabilities A contingent liability is a potential liability that depends on some future event. Accounting for contingent liabilities is based on the following likelihoods: •

Remote: Do not disclose.

•

Reasonably possible: Describe the situation in a note to the financial statements.

•

Probable and the amount of loss cannot be estimated: Describe the situation in a note to the financial statements.

•

Probable and the amount of the loss can be estimated: Record an expense and a liability based on estimated amounts.

LO 5. Use the times-interest-earned ratio to evaluate business performance The times-interest-earned ratio measures the number of times earnings before interest and taxes (EBIT) can cover (pay for) interest expense and is calculated as: (Net income + Income tax expense + Interest expense) / Interest expense

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Chapter 11: Assignment Grid and Other Materials

LO 1 S11-1 S11-2 S11-3 S11-4 S11-5 S11-6 S11-7 S11-8 S11-9 S11-10 S11-11 S11-12 S11-13 E11-14 E11-15 E11-16 S11-17 E11-18 E11-19 E11-20 E11-21 E11-22 E11-23 E11-24 P11-25A, P11-30B P11-26A, P11-31B P11-27A, P11-32B P11-28A, P11-33B P11-29A, P11-34B

LO 2

LO 3

LO 4

LO 5

X X X X X X X X X X X X X X X X X

X X X X X X X X

X

X X

X

X X

X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem F:11-1 Tying It All Together Case F:11-1 Decision Case F:11-1 Decision Case F:11-2 Ethical Issue F:11-1 Financial Statement Case F:11-1 Communication Activity F:11-1

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CHAPTER 11 TEN-MINUTE QUIZ Circle the letter of the best response.

1. Liabilities must A. sometimes be estimated.

B. be for specific, known amounts.

C. involve an outflow of cash.

D. be obligations that are certain to be owed.

2. On July 1, 20X4, Working Dog, Inc., borrowed $20,000 on a four-year, 6% note payable. At December 31, 20X4, a journal entry should be made to record A. a note payable of $20,000.

B. interest payable of $1,200.

C. interest payable of $600.

D. cash payment of $1,200.

3. The employee is responsible for which of the following payroll taxes?

A. Federal and state income tax B. State unemployment taxes C. Federal unemployment taxes D. All of the above 4. Alpine Corporation sells $50,000 of goods, and you collect sales tax of 7%. What is the journal entry to record the transaction?

A. Cash 50,000 Sales Tax Expense 3,500 Sales Revenue 53,500 B. Cash 50,000 Sales Tax Expense 3,500 Sales Tax Payable 3,500 Sales Revenue 50,000 C. Cash 50,000 Sales Tax Payable 3,500 Sales Revenue 53,500 D. Cash 53,500 Sales Tax Payable 3,500 Sales Revenue 50,000

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5. Technology Corporation has a lawsuit pending from a customer claiming damages of $128,000.

Technology Corporation’s attorney advises that the likelihood the customer will win is reasonably possible. How is this contingent liability reported?

A. It should be described in the footnotes.

B. It should be recorded as an asset and a liability based on estimated amounts.

C. It should be recorded as an expense and a liability based on estimated amounts.

D. It should not be disclosed.

6. Cooper Company owed Estimated Warranty Payable of $2,200 at the end of 20X4. During 20X5, Cooper Company made sales of $280,000 and expects product warranties to cost the company 3% of the sales. During 20X5, Cooper Company paid $5,000 for warranties. What is Cooper Company’s estimated warranty payable at the end of 20X5?

A. $10,600 B. $ 5,600 C. $ 5,000 D. $ 3,600 7. At December 31, Haute Hardware owes employees for four days of the five-day workweek. The total payroll for the week is $51,000. What journal entry should you make at December 31?

A. Nothing because you will pay the employees on Friday.

B. Salaries and Wages Expense 51,000 Salaries and Wages Payable 51,000 C. Salaries and Wages Payable 40,800 Salaries and Wages Expense 40,800 D. Salaries and Wages Expense 40,800 Salaries and Wages Payable 40,800 8. During 20X8, Insulated Tumbler reported net income of $123,000, income tax expense of $25,000, and interest expense of $11,000. What is Insulated Tumbler’s times-interest-earned ratio for 20X8? (Round to one decimal place.)

A. 7.9 B. 11.2 C. 13.5 D. 14.5 9. As of January 1, 20X5, Hot Shot Hauling owes $60,000 on a truck purchased for use by the business. The company makes principal payments of $1,000 each month plus interest at 8%. At the end of 20X5, after the first 12 months’ payments of principal and interest, which of the following would be included on the balance sheet for December 31, 20X5?

A. Long-term Liabilities $48,000 and Interest Payable for four years’ interest.

B. Long-term Liabilities $36,000; Current Liabilities $12,000; and Interest Payable for four years’ interest.

C. Long-term Liabilities $36,000; Current Liabilities $12,000; and no Interest Payable D. Long-term Liabilities $48,000 and no Interest Payable

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10. Yolanda’s Yoga Studio has Unearned Revenue of $15,000, Salaries Payable of $28,000, and Allowance for Uncollectible Accounts of $4,200. What amount would Yolanda’s Yoga Studio report as total current liabilities?

A. $47,200 B. $43,000 C. $32,200 D. $28,000

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Answer Key to Ten-Minute Quiz: 1. A 2. C Amount of interest = Principal × Interest rate × Time = $20,000 × 0.06 × 6/12 = $600 Journal entry to record accrued interest expense and interest payable: Dec. 31

Interest expense

600

Interest payable To accrue interest expense

600

3. A 4. D Cash

53,500 Sales Tax Payable ($50,000 × 0.07) Sales Revenue

3,500 50,000

5. A 6. B Warranty expense = $280,000 × 0.03 = $8,400 Estimated Warranty Payable 2,200 Bal., 12/31/X8 Warr. paid 5,000 8,400 Accrued warr.

5,600 Bal., 12/31/X9 7. D Amount accrued = (Weekly amount / 5 days) × 4 days Amount accrued = ($51,000 per 5-day week / 5 days) × 4 days = $10,200 × 4 days = $40,800 8. D Times-interest-earned ratio = (Net income + Income tax expense + Interest expense) / Interest expense = ($123,000 + $25,000 + $11,000) / $11,000 = 14.5

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9. C The truck cost $60,000 and is paid in $1,000 monthly installments, plus interest, over five years. In 20X9, $12,000 of principal is paid. The remaining principal balance is $48,000 ($60,000 − $12,000).

Of this remaining principal balance, the portion that must be paid within one year, $12,000, is current. The remaining $36,000 ($48,000 − $12,000) will be classified as long-term. Since interest is paid each month with the principal payment, no interest payable is accrued.

10. B The company’s liabilities include Unearned Revenue and Salaries Payable.

Total liabilities = $15,000 + $28,000 = $43,000

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Extra Critical Thinking Questions Fraud Case F:11-1 Laura Wang knew the construction contractors in her area well. She was the purchasing manager at the power plant, a business that was the major employer in the region. Whenever a repair or maintenance job came up, Laura’s friends would inflate the invoice by 10%. The invoice would then be passed through the accounts payable department, where the clerk was supposed to review and verify the charges before processing the payment. The accounts payable clerk, Veronica Jensen, was happy to have a job and didn’t want anything to jeopardize it. She knew the deal but kept her mouth shut. Laura’s contractor friends would always “kick back” the 10% extra to Laura under the table. One day, Veronica had a heart attack and went into the hospital. The company hired a new accounts payable clerk, Steven French. He had worked construction in his college days and suspected something was fishy, but he couldn’t prove it.

He did, however, wish to protect himself in case the fraud came to light.

Requirements 1. How could an auditor detect fraud of this sort?

2. What can a business do to prevent this kind of fraudulent activity?

3. What should the new accounts payable clerk do to protect himself?

Fraud Case F:11-1: Solution Requirement 1 This kind of fraud is very difficult to detect. An auditor would have to take a sample of invoices and check the amounts against current prices for similar goods and services. If an auditor sees the same contractors being used over and over, this might arouse the auditor’s suspicion. The auditor should get bids or invoices for the same goods or services from the same contractors or other contractors to see if the bids match with the amounts paid. The auditor should not mention the power plant in question.

Requirement 2 From the business’s point of view, separation of duties is critical. The person signing the check, or authorizing the payment, should be different from the person who orders the goods or services. The accounts payable clerk has a responsibility to evaluate the payments for reasonableness. It would be very valuable for that person to be knowledgeable enough about the business to exercise that kind of judgment.

Requirement 3 The accounts payable clerk might be able to use an anonymous hot line, if his company has one. Or, he could discuss the matter confidentially with the controller. For his own protection, he should document all such actions.

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Team Project F:11-1 In recent years, the airline industry has dominated headlines. Consumers are shopping CheapOair.com and other Internet sites for the lowest rates. The airlines have also lured customers with frequent-flyer programs, which award free flights to passengers who accumulate specified miles of travel. Unredeemed frequent-flyer mileage represents a liability that airlines must report on their balance sheets, usually as Air Traffic Liability.

Southwest Airlines, a profitable, no-frills carrier based in Dallas, has been rated near the top of the industry. Southwest controls costs by flying to smaller, less expensive airports; using only one model of aircraft; serving no meals; increasing staff efficiency; and having a shorter turnaround time on the ground between flights. The fact that most of the cities served by Southwest have predictable weather maximizes its on-time arrival record.

With a partner or group, lead your class in a discussion of the following questions or write a report, as directed by your instructor, answering the following questions: Frequent-flyer programs have grown into significant obligations for airlines. Why should a liability be recorded for those programs? Discuss how you might calculate the amount of this liability. Can you think of other industries that offer incentives that create a similar liability?

Team Project F:11-1: Solution Airlines have a liability for their frequent-flyer programs because they are obligated to transport passengers without receiving any cash or earning any revenue for the award travel. In effect, the passengers paid for the award travel as they flew on the airline to earn the award travel, and the airline was accumulating a liability to its customers.

One way to calculate the airline’s liability for award travel is Cost to transport one passenger one mile

×

Number of miles of award travel earned by customers

×

Estimated percentage of miles of award travel that customer will actually use

Other industries that offer incentives similar to the airlines’ frequent-flyer programs include: 1. Hotel chains 2. Credit card and bank card companies 3. Restaurants

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Chapter 12 Long-Term Liabilities Chapter 12: Overview The chapter introduces the student to long-term liabilities as a way to finance operations. Common longterm liabilities, including notes payable, mortgages payable, and bonds, are introduced. General background information is given about bond terminology, types of bonds, interest rates, and bond quotations. The concept of how bond prices are related to present value is briefly explained. Comparisons of financing by borrowing or by issuing stock helps the student understand the advantages and disadvantages of borrowing. Journal entries are illustrated for issuing bonds at par, paying semiannual interest, and paying

bonds at maturity. Students learn about bonds issued at a discount and at a premium. Straight-line amortization of the discount and premium is presented. Adjusting entries to accrue interest and amortize premium or discount at year-end are discussed and illustrated. Retirement and conversion of bonds payable at maturity and prior to maturity are discussed.

The chapter includes a discussion of financial reporting of long-term liabilities on the balance sheet. The chapter concludes with a discussion of how the debt to equity ratio is used to evaluate business performance. Appendix 12A discusses the time value of money to compute present value and future value amounts. Appendix 12B shows students how to journalize transactions for bonds payable and interest expense using the effective-interest amortization method.

A Tying It All Together feature provides a look into the long-term liabilities of The Walt Disney Company. An Ethics feature helps give perspective on a real-world ethical dilemma involving an executive’s decision about whether to finance company growth by issuing new debt or equity. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem reviews issuance of bonds and related transactions. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 12: Learning Objectives LO 1. Journalize transactions for long-term notes payable and mortgages payable LO 2. Describe bonds payable LO 3. Journalize transactions for bonds payable and interest expense using the straight-line amortization method LO 4. Journalize transactions to retire bonds payable LO 5. Report liabilities on the balance sheet LO 6. Use the debt to equity ratio to evaluate business performance LO 7. Use time value of money to compute present value and future value (Appendix 12A) LO 8. Journalize transactions for bonds payable and interest expense using the effective-interest amortization method (Appendix 12B)

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Chapter 12: Teaching Outline LO 1. Journalize transactions for long-term notes payable and mortgages payable a) Long-term notes payable ▪

Exhibit F:12-1: Long-term Notes Payable Amortization Schedule

b) Mortgages payable ▪

Exhibit F:12-2: Mortgages Payable Amortization Schedule

▪

Exhibit F:12-3: Microsoft Excel Loan Amortization Schedule

Lecture Notes: The concept of bonds is foreign to many students. This discussion of notes payable is a good starting point because students may have experience with auto and personal loans. Furthermore, some students will have experience with home loans and mortgages.

Emphasize the mechanics of preparing an amortization schedule. Have students do a short schedule (3–5 years) by hand and consider asking them to create an amortization schedule for a 30-year mortgage in a spreadsheet.

Suggested In-Class Exercise: E12-19 LO 2. Describe bonds payable a) Types of bonds b) Bond prices ▪

Exhibit F:12-4: Bond Price Information

c) Present value and future value d) Bond interest rates ▪

Exhibit F:12-5: Interaction Between Stated Interest Rate, Market Rate, and Price of Bond

e) Issuing bonds versus issuing stock ▪

Exhibit F:12-6: Issuing Bonds Payable Versus Issuing Common Stock

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Lecture Notes: Continue the introduction to bonds by discussing the difference in issuance proceeds and face value for bonds payable and the resulting premium or discount. It may also be helpful to approach bonds from an investor’s standpoint. An investor can choose to invest in a company’s stock or bonds (or both), depending on his or her goals. Whereas you acquire ownership with a stock investment, you let the company borrow your money for a certain time period (with interest) with a bond investment.

Suggested In-Class Exercise: E12-20 LO 3. Journalize transactions for bonds payable and interest expense using the straight-line amortization method a) Issuing bonds payable at face value b) Issuing bonds payable at a discount ▪

Interest expense on bonds payable issued at a discount

▪

Straight-line amortization of bond discount

▪

Exhibit F:12-7: Bonds Payable—Discount Amortization Schedule

c) Issuing bonds payable at a premium ▪

Interest expense on bonds payable issued at a premium

▪

Straight-line amortization of bond premium

▪

Exhibit F:12-8: Bonds Payable—Premium Amortization Schedule

Lecture Notes: There are three transactions with bonds: the issuance, the interest payment, and the amortization of any premium/discount. When issuing bonds, note that the journal entry must balance. The premium/discount is a “plug” in the entry. The bond payable is recorded at face value because this is the amount that the company will repay at maturity. The cash proceeds can be more or less than the face value.

The chapter uses the straight-line method for amortization, which is similar to the straight-line method for depreciation. An equal amount of amortization is recorded at each interest payment date. Remind students that the interest payment (the cash portion) is computed using the bond rate, not the market rate.

The premium/discount balance will decrease over time and will be zero after the last interest payment date. The amortization is recorded as a decrease/increase to interest expense. After the last interest payment, the company will repay the face value of the bonds, which will then be the balance in the bond payable account.

The Bonds Payable account is recorded at face value and never changes until repayment. The book value of the bonds changes over time as the premium/discount is amortized. The book .

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value always moves to the face value. Therefore, a discounted bond will increase to face value, and a premium bond will decrease to face value.

Suggested In-Class Exercise: E12-24 LO 4. Journalize transactions to retire bonds payable a) Retirement of bonds at maturity b) Retirement of bonds before maturity Lecture Notes: When retiring bonds, do not forget to remove any premium or discount balance.

Point out that the entry always balances, so there may be a gain or loss at retirement.

Suggested In-Class Exercise: E12-26 LO 5. Report liabilities on the balance sheet ▪

Exhibit F:12-9: Liabilities

Suggested In-Class Exercise: E12-28 LO 6. Use the debt to equity ratio to evaluate business performance Lecture Notes: The debt to equity ratio shows the relationship between total liabilities and total equity. In other words, it shows the proportion of total liabilities relative to the total equity.

Suggested In-Class Exercise: E12-29 LO 7. Use time value of money to compute present value and future value (Appendix 12A) a) Time value of money concepts i.

Simple interest versus compound interest ▪

ii.

Exhibit F:12A-1: Simple Interest Versus Compound Interest—$10,000 at 6% for 5 years

Future value and present value factors

b) Present value of a lump sum c) Present value of an annuity d) Present value of bonds payable i.

Present value of a bonds payable issued at a discount

ii.

Present value of a bonds payable issued at a premium

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e) Future value of a lump sum f) Future value of an annuity Lecture Notes: The concepts of present value and future value are inextricably linked. So, each can be derived from the other. One approach to teaching time value of money is to begin with the already familiar concept of putting an initial deposit into a savings account and watching it grow over time. This is the concept of future value of a lump sum. For example, say that you deposit $10,000 in a savings account that pays 10% interest. Then, looking at the value at the end of that time period, point out that the present value of that future amount is the amount of the initial deposit.

From this basic example, point out that the amount in the savings account at the end of each period is the beginning amount times 1 plus the interest rate—the beginning principal balance plus the interest earned on that principal. Therefore, at the end of three years, the amount in the savings account—the future value—would be: $10,000 (1.10) (1.10) (1.10) = $13,310 Thus the present value of $13,310 three years in the future is: $13,310 × [1 / (1.10)3] This can be generalized as Present value = Future amount ×Present value factor (i%, n periods), which provides the basis for constructing Table A-1, Present Value of $1. Conversely, Future value = Present amount × Future value factor (i%, n periods).

Then demonstrate that when there are multiple identical future amounts, there are two ways to calculate the present value of that series of future amounts. Before demonstrating those calculations, introduce the term annuity. Emphasize that in the context of present value analysis, the word annuity simply means “same amount every period.” Nothing more, nothing less.

To demonstrate the calculation of the present value of a series of identical amounts, first determine the present value of each individual future amount and then add the present values together to determine the present value of all the future amounts. The second way takes much less time and effort. Because the future amounts are the same amount, one can first add together all the present value factors and then multiply the sum of the present value factors by the amount of the annuity.

Then point out that Table A-2, Present Value of an Ordinary Annuity of $1, is simply the cumulative sums of the factors in Table A-1. The future value of an annuity can also be calculated by using Table A-4 and following the same procedure. Future value of an annuity = Amount of each cash inflow × Annuity FV factor (i%, n periods).

Suggested In-Class Exercise: E12A-30 LO 8. Journalize transactions for bonds payable and interest expense using the effective-interest amortization method (Appendix 12B) a) Effective-interest amortization for a bond discount

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▪

Exhibit F:12B-1: Bonds Payable—Discount Amortization Schedule; Effective-Interest Amortization Method

b) Effective-interest amortization of a bond premium ▪

Exhibit F:12B-2: Bonds Payable—Premium Amortization Schedule; Effective-Interest Amortization Method

Lecture Notes: This appendix is easier to cover if the loan amortization schedule has been emphasized earlier in the chapter. Emphasize for students that GAAP requires interest expense be measured using the effective-interest amortization method unless the straight-line amounts are similar. In that case, either method is permitted due to materiality.

Suggested In-Class Exercise: E12A-31

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Chapter 12: Handout for Student Notes LO 1. How are long-term notes payable and mortgages payable accounted for?

o

Long-term notes payable

o

Mortgages payable

LO 2. What are bonds?

o

Types of bonds

o

Bond prices

o

Present value and future value

o

Bond interest rates

o

Issuing bonds versus issuing stock

LO 3. How are bonds payable accounted for using the straight-line amortization method?

o

Issuing bonds payable at face value

o

Issuing bonds payable at a discount

▪ Interest expense on bonds payable issued at a discount .

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▪ Straight-line amortization of bond discount

o

Issuing bonds payable at a premium

▪ Interest expense on bonds payable issued at a premium

▪ Straight-line amortization of bond premium

LO 4. How is the retirement of bonds payable accounted for?

o

Retirement of bonds at maturity

o

Retirement of bonds before maturity

LO 5. How are liabilities reported on the balance sheet?

LO 6. How do we use the debt to equity ratio to evaluate business performance?

LO 7. What is the time value of money, and how is the present value of a future amount calculated?

(Appendix 12A)

o

Time value of money concepts

▪ Simple interest versus compound interest

▪ Future value and present value factors

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o

Present value of a lump sum

o

Present value of an annuity

o

Present value of bonds payable

▪ Present value of bonds payable issued at a discount

▪ Present value of bonds payable issued at a premium

o

Future value of a lump sum

o

Future value of an annuity

LO 8. How are bonds payable accounted for using the effective-interest amortization method?

(Appendix 12B)

o

Effective-interest amortization for a bond discount

o

Effective-interest amortization of a bond premium

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Chapter 12: Student Chapter Summary LO 1. Journalize transactions for long-term notes payable and mortgages payable Long-term notes payable and mortgages payable are reported in the long-term liabilities section of the balance sheet unless there is a portion due within one year. That portion is shown in the current liabilities section of the balance sheet. An amortization schedule should be prepared that details each loan payment’s allocation between principal and interest and also the beginning and ending balances of the loan. Mortgages payable are long-term debts that are backed with a security interest in specific property.

LO 2. Describe bonds payable Bonds payable represent long-term debt issued to multiple lenders called bondholders, usually in increments of $1,000 per bond. The bond requires a face value payment at maturity and interest payments based on a stated interest rate over the life of the bond. A bond can be issued at face value, at a discount, or at a premium. A bond is issued at face value when the stated interest rate is equal to the market interest rate. A bond is issued at less than face value when the stated interest rate is less than the market interest rate. A bond is issued at more than face value when the stated interest rate is more than the market interest rate.

LO 3. Journalize transactions for bonds payable and interest expense using the straight-line amortization method The basic journal entry to record the issuance of bonds payable debits Cash and credits Bonds Payable. If a bond is issued at a discount, Discount on Bonds Payable will be debited for the difference between the face value and cash received. If a bond is issued at a premium, Premium on Bonds Payable will be credited for the difference between the cash received and face value.

Interest payments must be recorded with a debit to Interest Expense and a credit to Cash.

Discount on Bonds Payable and Premium on Bonds Payable must be amortized over the life of the bond. The straight-line amortization method allocates an equal amount of the bond discount or premium to each interest period.

LO 4. Journalize transactions to retire bonds payable When bonds are retired at maturity, the entry involves a debit to Bonds Payable and a credit to Cash for the face value of the bond. Retirement of bonds before maturity involves writing off the remaining portion of the discount or premium account and crediting a gain or debiting a loss on retirement.

LO 5. Report liabilities on the balance sheet Current and long-term liabilities are reported separately on the balance sheet. Bonds payable are shown at the carrying amount.

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LO 6. Use the debt to equity ratio to evaluate business performance The debt to equity ratio, which shows the proportion of total liabilities relative to the total equity, is calculated as: Total liabilities / Total equity LO 7. Use time value of money to compute present value and future value (Appendix 12A) The fact that invested money earns interest over time is called the time value of money. This concept explains why we would prefer to receive cash sooner rather than later. Lump sum payments are one-time cash payments. Annuities are streams of equal cash payments made at equal time intervals.

To calculate the present value of a lump sum: Present value = Future value × PV factor for i = ?, n = ?

To calculate the present value of an annuity: Present value = Amount of each cash inflow × Annuity PV factor for i = ?, n = ?

To calculate the future value of a lump sum: Future value = Present value × FV factor for i = ?, n = ?

To calculate the future value of an annuity: Future value = Amount of each cash inflow × Annuity FV factor for i = ?, n = ?

LO 8. Journalize transactions for bonds payable and interest expense using the effective-interest amortization method (Appendix 12B) The effective-interest amortization method calculates interest expense based on the current carrying amount of the bond and the market interest rate at issuance and then amortizes the difference between the cash interest payment and calculated interest expense as a decrease to the discount or premium. Using the effective-interest amortization method, the amount of interest expense is calculated using the carrying amount of the bonds and the market interest rate.

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Chapter 12: Assignment Grid and Other Materials LO 1 X X

S12-1 S12-2 S12-3 S12-4 S12-5 S12-6 S12-7 S12-8 S12-9 S12-10 S12-11 S12-12 S12A-13 S12A-14 S12A-15 S12B-16 S12B-17 E12-18 E12-19 E12-20 E12-21 E12-22 E12-23 E12-24 E12-25 E12-26 E12-27 E12-28 E12-29 E12A-30 E12B-31 P12-32A, P12-39B P12-33A, P12-40B P12-34A, P12-41B P12-35A, P12-42B P12-36A, P12-43B P12AB-37A, P12AB-44B P12AB-38A, P12AB-45B

LO 2

LO 3

LO 4

X X X X X X

X X

LO 5

LO 6

LO 7

LO 8

X X

X X X X X X X X X X X

X X

X X X X X

X X

X X

X X X X X

X

X X X X

X X X

X X X

X X X

X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem F:12-1 Tying It All Together Case F:12-1 Decision Case F:12-1 Ethical Issue F:12-1 Fraud Case F:12-1 Financial Statement Case F:12-1

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CHAPTER 12 TEN-MINUTE QUIZ Circle the letter of the best response.

1.

A five-year, $100,000, 4% note payable was issued on December 31, 20X4. The note requires principal payments of $20,000 plus interest due each year beginning December 31, 20X5. The entry to record the annual payment at the end of year 2 on December 31, 20X6, includes a A. debit to Interest Expense for $800.

B. debit to Interest Expense for $3,200.

C. credit to Cash for $24,000.

D. credit to Notes Payable for $20,000.

2.

Bon Voyage Company’s trial balance shows $800,000 face value of bonds with a discount balance of $12,000. The bonds mature in 20 years. How will the bonds be presented on the balance sheet?

A. Bonds payable $800,000 will be listed as a long-term liability. A $12,000 discount on bonds payable will be listed as a current liability.

B. Bonds payable $800,000 will be listed as a long-term liability. A $12,000 discount on bonds payable will be listed as a contra-current liability.

C. Bonds payable $800,000 will be listed as a long-term liability.

D. Bonds payable $788,000 (net of $12,000 discount) will be listed as a long-term liability.

3.

Rivers and Streams Corporation issued $400,000 of 8% serial bonds at face value on December 31, 2018. Half of the bonds mature January 1, 2021, while the other half of the bonds mature January 1, 2029. On December 31, 2020, the balance sheet will show which of the following?

A. Bonds payable of $400,000 will be listed as a long-term liability.

B. Bonds payable of $400,000 will be listed as a current liability C. Bonds payable of $200,000 will be listed as a long-term liability. Bonds payable of $200,000 will be listed as a current liability.

D. Bonds payable of $408,000 will be listed as a long-term liability.

4.

Nolan Corporation has total assets of $500,000. Current liabilities are $10,000, and long-term liabilities are $90,000. What is the debt to equity ratio?

A. 0.180 B. 0.200 C. 0.225 D. 0.250

5.

A $400,000 bond priced at 102 can be bought or issued for A. $102,000.

B. $392,000.

C. $402,000.

D. $408,000.

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6.

Hughes Industries signed a 20-year note payable on January 1, 2018. The note requires annual principal payments plus interest. The entry to record the annual payment on December 31, 2018 includes a A. credit to Interest Expense.

B. debit to Interest Expense.

C. credit to Long-term Notes Payable.

D. debit to Cash.

7.

Which of the following is the correct journal entry to record the issuance of a $250,000 face value bond at 95?

Accounts Debit Credit A. Bonds Payable 237,500 Cash 237,500 B. Cash 250,000 Discount on Bonds Payable 12,500 Bonds Payable 237,500 C. Cash 237,500 Discount on Bonds Payable 12,500 Bonds Payable 250,000 D. Bonds Payable 237,500 Cash 237,500

8.

Cattle Company’s bonds payable carry a stated interest rate of 8%, and the market rate of interest is 5%. The price of the Cattle Company’s bonds will be at A. a premium.

B. a discount.

C. maturity value.

D. par value.

9.

Cooper Corporation issued its 4%, 20-year bonds payable at a price of $288,500 (face value is $300,000). The company uses the straight-line amortization method for the bonds. Interest expense for each year is A. $12,000.

B. $11,540.

C. $15,000.

D. $12,575.

10. Skinny Smoothies has $850,000 of 20-year bonds payable outstanding. These bonds had a discount of $42,000 at issuance, which was 8 years ago. The company uses the straight-line amortization method. The carrying amount of these bonds payable today is A. $808,000.

B. $824,800.

C. $833,200.

D. $892,000.

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Answer Key to Ten-Minute Quiz: 1. B

12/31/20X8 12/31/20X9 12/31/20X0

Interest Expense (Beginning balance × Interest rate × Time)

Beginning Balance

Principal Payment

$ 100,000 80,000

$ 20,000 20,000

$ 4,000 3,200

Total Payment (Principal payment + Interest expense) $ 24,000 23,200

Ending Balance (Beginning balance − Principal payment) $ 100,000 80,000 60,000

Journal Entry: Notes Payable Interest Expense Cash

20,000 3,200 23,200

2. D 3. C 4. D Debt to equity ratio = Total liabilities / Total equity* = $100,000 / $400,000 = 0.250 *Assets = Liabilities + Equity $500,000 = ($10,000 + $90,000) + Equity Equity = $400,000 5. D $400,000 × 1.02 = $408,000 6. B .

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7. C Cash = $250,000 × 0.95 = $237,500 Discount on Bonds Payable = $250,000 − $237,500 = $12,500 Bonds Payable = $250,000 (face value) 8. A 9. D Interest Expense = Stated interest + Amortization of discount = ($300,000 × 0.04) + [($300,000 − $288,500) / 20] = $12,000 + ($11,500 / 20) = $12,000 + $575 = $12,575 10. B Carrying amount (today) = Carrying amount (at issuance) + Discount amortized (to date)* = $808,000 + $16,800 = $824,800 *Discount amortized (to date) = ($42,000 / 20) × 8 years = $2,100 × 8 years = $16,800

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Extra Critical Thinking Questions Team Project F:12-1 Each member of the team should select a large corporation and go to its website. Browse the company’s website until you find the balance sheet. Often the appropriate tab is labeled as one of the following: • Investor Relations • About the Company • Financial Reports • 10-K Report On the company’s balance sheet, find the liabilities.

Requirements 1. List all the company’s liabilities—both current and long-term—along with each amount.

2. Read the company’s notes to the financial statements and include any details that help you identify the amount of a liability.

3. Compute the company’s debt to equity ratio.

4. Bring your findings to your team meeting, compare your results with those of your team members, and prepare either a written report or an oral report, as directed by your instructor.

Team Project F:12-1: Solution Results will vary. Typical examples of project results might include the following.

Liabilities of: Bank Current: Demand deposits payable Accounts payable Accrued liabilities payable (salary, wage, and other compensation payable to employees, interest payable) Payables to the Federal Reserve System Long-term: Notes payable (and bonds payable) to outside investors Certificates-of-deposit payable to depositors Lease liabilities Payables to the Federal Reserve System

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Magazine Publisher Current: Accounts payable Accrued liabilities payable Unearned subscription revenue Short-term notes payable Current portion of long-term notes and bonds payable Current obligations under capital leases Long-term: Notes payable and bonds payable Unearned subscription revenue Lease liabilities Department Store Current: Accounts payable Accrued liabilities payable Sales tax payable Short-term notes payable Current portion of long-term notes and bonds payable Current obligations under capital leases Long-term: Notes payable and bonds payable Lease liabilities Communication Activity F:12-1 In 75 words or fewer, explain why a bond would sell for more than the bond’s face value on the bond issuance date.

Communication Activity F:12-1: Solution A bond will sell for more than the face value if the stated interest rate of the bond is greater than the current market rate. Investors will find this as an attractive investment and be willing to pay more than face value for it.

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Chapter 13 Stockholders’ Equity Chapter Overview The chapter introduces the student to the corporation, the dominant form of business organization in the United States. The characteristics of the corporation, a brief description of how a corporation is organized, an overview of stockholder rights, and the definition of capital stock are presented. The two components of stockholders’ equity, paid-in capital, and retained earnings are discussed. The chapter then describes the different classes of stock (common and preferred), their characteristics, and journal entries for stock issuance. Included is a discussion of issuing common stock (at par, at a premium, and at a discount), no-par stock, stated value stock, stock for assets other than cash, and preferred stock.

The concept of treasury stock is introduced. Entries illustrate the purchase and subsequent sale of treasury stock, which may be at cost, above cost, or below cost. Retirement of stock is discussed briefly.

The discussion then focuses on the accounting for cash dividends. Dividend dates, journal entries for cash dividends, and dividends on cumulative and noncumulative preferred stock are discussed. Stock dividends are discussed, and related calculations and journal entries are presented. Stock splits are described and compared with stock dividends. Preparation of a corporate income statement is introduced, including income from continuing operations and discontinued operations, as well as earnings per share. How equity is reported for a corporation is discussed, including the statement of retained earnings and the statement of stockholders’ equity. Equity ratios used to evaluate business performance are explained, including earnings per share, rate of return on common stockholders’ equity, and the price/earnings ratio.

An Ethics feature helps give perspective on a real-world ethical dilemma concerning the valuation of assets acquired in exchange for capital stock. A Tying It All Together feature provides a look at the stockholders’ equity section of Facebook, Inc.’s balance sheet. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem reviews various concepts covered in the chapter, including stock issuance, cash and stock dividends, and treasury stock. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 13: Learning Objectives LO 1. Identify the characteristics of a corporation LO 2. Journalize the issuance of stock LO 3. Account for the purchase and sale of treasury stock LO 4. Account for cash dividends, stock dividends, and stock splits LO 5. Prepare a corporate income statement including earnings per share LO 6. Explain how equity is reported for a corporation LO 7. Use earnings per share, rate of return on common stockholders’ equity, and the price/earnings ratio to evaluate business performance

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Chapter 13: Teaching Outline with Lecture Notes LO 1. Identify the characteristics of a corporation a) Characteristics of corporations ▪

Exhibit F:13-1: Corporations: Advantages and Disadvantages

b) Stockholders’ equity basics ▪

Exhibit F:13-2: Stock Certificate

▪

Exhibit F:13-3: Categories of Stock

i.

Stockholders’ rights

ii.

Capital stock

iii.

Stockholders’ equity

Lecture Notes: A corporation is a separate legal entity and provides limited liability to stockholders, which is a key advantage. However, regular corporations pay income tax on their profits and then stockholders pay income tax on the dividends paid from those profits. This is known as double taxation, and it is a disadvantage. Double taxation can be avoided with S corporation status. Every corporation, regardless of size, has the same structure. The stockholders elect the board of directors, who in turn hire the officers of the company to manage the day-to-day operations. Students may think that all corporations are large companies, but this is not the case. There are many small companies that incorporate, and some may have only one stockholder.

Stockholders’ equity has two basic sources: Paid-In Capital and Retained Earnings. These account transactions reflect their titles. Paid-in capital represents stock purchases “paid” by stockholders, and retained earnings represent net income/earnings retained by the company and not paid to stockholders as dividends.

Suggested In-Class Exercise: E13-19 LO 2. Journalize the issuance of stock a) Issuing common stock at par value b) Issuing common stock at a premium ▪

Exhibit F:13-4: Stockholders’ Equity

c) Issuing no-par common stock ▪

Exhibit F:13-5: Stockholders’ Equity—No-Par Stock

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d) Issuing stated value common stock e) Issuing common stock for assets other than cash f) Issuing preferred stock ▪

Exhibit F:13-6: Stockholders’ Equity

Lecture Notes: When recording the issuance of common or preferred stock, point out that the entry has to balance. Cash is recorded for the full amount, stock is recorded for par value (or stated value), and the “plug” amount is recorded as paid-in capital in excess of par. When tangible assets are invested instead of cash, the entry still has to balance. The fair market value of the assets greater than par value is recorded as paid-in capital in excess of par.

Suggested In-Class Exercise: E13-24 LO 3. Account for the purchase and sale of treasury stock a) Treasury stock basics b) Purchase of treasury stock c) Sale of treasury stock i.

Sale at cost

ii.

Sale above cost

iii.

Sale below cost ▪

Exhibit F:13-7: Stockholders’ Equity After Treasury Stock Transactions

d) Retirement of stock Lecture Notes: Point out that acquisition of treasury stock is opposite the issuance of common stock.

Treasury stock is a contra equity account, not an asset to the company. It is recorded at cost; the par value is irrelevant. When resold, treasury stock is credited for the related cost amount, not the cash proceeds. Any difference between the cash proceeds and the cost amount is recorded in Paid-In Capital from Treasury Stock Transactions, an equity account. Therefore, gains and losses are not recorded, and there is no effect on income.

Suggested In-Class Exercise: E13-26 LO 4. Account for cash dividends, stock dividends, and stock splits a) Cash dividends i.

Declaring and paying dividends—common stock .

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ii.

Declaring and paying dividends—preferred stock

b) Stock dividends i.

Why issue stock dividends?

ii.

Recording stock dividends

▪ iii.

Exhibit F:13-8: Stockholders’ Equity—Small Stock Dividend Stock splits

c) Cash dividends, stock dividends, and stock splits compared ▪

Exhibit F:13-9: Effects of Dividends and Stock Splits on the Accounting Equation

Lecture Notes: Dividends involve three dates: the declaration date (a liability is recorded), the record date (no journal entry), and the payment date (cash is decreased). When calculating and discussing preferred stock dividends, it is imperative to point out the importance of cumulative versus noncumulative stock.

Point out the differences in stock dividends and stock splits. It is likely that some students have heard of stock splits and may think it is possible to become an “instant millionaire” overnight when this occurs. In reality, there is no immediate economic value to a stock split. The market price and par value are adjusted for the increased number of shares. There is no entry for a stock split. On the other hand, stock dividends do provide an immediate economic value, and an entry is journalized, transferring the market value of the additional stock from Retained Earnings to Paid-in Capital accounts (assuming a small stock dividend). Point out that there is no change in total equity; one equity account goes down, and others go up.

Suggested In-Class Exercises: E13-26 and E13-28 LO 5. Prepare a corporate income statement including earnings per share ▪

Exhibit F:13-10: Kevin’s Vintage Guitars, Inc.—Income Statement

a) Continuing operations b) Discontinued operations c) Earnings per share Suggested In-Class Exercise: E13-34 LO 6. Explain how equity is reported for a corporation a) Statement of retained earnings ▪

Exhibit F:13-11: Statement of Retained Earnings .

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i.

Appropriations of retained earnings

ii.

Prior-period adjustments ▪

Exhibit F:13-12: Statement of Retained Earnings—Prior-Period Adjustment

b) Statement of stockholders’ equity ▪

Exhibit F:13-13: Statement of Stockholders’ Equity

Lecture Notes: Retained Earnings can have a debit or credit balance, although the normal balance is a credit, which indicates a positive amount. The Retained Earnings account increases with net income and decreases with net loss and dividends. The balance of Retained Earnings is not related to the balance of Cash. A company with positive retained earnings could have very little cash on hand.

Remind students that net income is based on accrual accounting, not cash accounting.

Suggested In-Class Exercise: E13-36 LO 7. Use earnings per share, rate of return on common stockholders’ equity, and the price/earnings ratio to evaluate business performance a) Earnings per share b) Price/earnings ratio c) Rate of return on common stockholders’ equity Lecture Notes: Earnings per share provides an “apples-to-apples” comparison of a company’s profitability from one period to the next period but should not be used for comparing different companies. Students may think a company with a higher absolute dollar amount of net income is more profitable and may not consider the possibility that it may have more shares outstanding than comparative companies.

Suggested In-Class Exercises: E13-37 and E13-38

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Chapter 13: Handout for Student Notes LO 1. What is a corporation?

o Characteristics of corporations

o Stockholders’ equity basics

▪ Stockholders’ rights

▪ Capital stock

▪ Stockholders’ equity

LO 2. How is the issuance of stock accounted for?

o Issuing common stock at par value

o Issuing common stock at a premium

o Issuing no-par common stock

o Issuing stated value common stock

o Issuing common stock for assets other than cash

o Issuing preferred stock

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LO 3. How is treasury stock accounted for?

o Treasury stock basics

o Purchase of treasury stock

o Sale of treasury stock

▪ Sale at cost

▪ Sale above cost

▪ Sale below cost

o Retirement of stock

LO 4. How are dividends and stock splits accounted for?

o Cash dividends

▪ Declaring and paying dividends—Common stock

▪ Declaring and paying dividends—Preferred stock

o Stock dividends

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▪ Why issue stock dividends?

▪ Recording stock dividends

▪ Stock splits

o Cash dividends, stock dividends, and stock splits compared

LO 5. How is the complete corporate income statement prepared?

o Continuing operations

o Discontinued operations

o Earnings per share

LO 6. How is equity reported for a corporation?

o Statement of retained earnings

▪ Appropriations of retained earnings

▪ Prior-period adjustments

o Statement of stockholders’ equity

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LO 7. How do we use stockholders’ equity ratios to evaluate business performance?

o Earnings per share

o Price/earnings ratio

o Rate of return on common stockholders’ equity

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Chapter 13: Student Chapter Summary LO 1. Identify the characteristics of a corporation A corporation is a business organized under state law that is a separate legal entity. Corporations have capital stock that represents shares of ownership. Authorized stock is the maximum number of shares of stock that the corporate charter allows the corporation to issue. Outstanding stock is stock that has been issued and is in the hands of stockholders. Corporations can have different classes of stock: common and preferred. Common stock represents the basic ownership of a corporation. Preferred stock gives its owners certain advantages, such as the right to receive preferential dividends. A corporation’s equity is called stockholders’ equity. Stockholders’ equity consists of two basic sources: paid-in capital—amounts received from stockholders in exchange for stock—and retained earnings—equity earned by profitable operations that is not distributed to stockholders.

LO 2. Journalize the issuance of stock Issuance of common stock (and preferred stock) at par value: Accounts and Explanations Debit Cash Par Value Common Stock—$1 Par Value

Credit Par Value

Issuance of common stock (and preferred stock) at a premium: Accounts and Explanations Debit Credit Cash Total Price Common Stock—$1 Par Value Par Value Paid-In Capital in Excess of Par—Common Difference Issuing stated value stock is almost identical to accounting for par value stock. The only difference is the use of the Paid-In Capital in Excess of Stated account. Stock can be issued for assets other than cash. The transaction should be recorded at the market value of the stock issued or the market value of the assets received, whichever is more clearly determinable.

LO 3. Account for the purchase and sale of treasury stock Treasury stock is a corporation’s own stock that it has previously issued and later reacquired.

When treasury stock is purchased, it is recorded at cost, not at par value.

Accounts and Explanations Debit Credit Treasury Stock—Common Cost Cash Cost Treasury Stock is a contra equity account, has a normal debit balance, and is a reduction to total stockholders’ equity. Treasury stock can be sold at cost, below cost, or above cost. As an

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alternative to treasury stock, corporations can retire stock, which removes the stock from the company’s books.

LO 4. Account for cash dividends, stock dividends, and stock splits Cash dividends cause a decrease in both assets (Cash) and equity (Retained Earnings). Preferred stockholders receive a dividend preference which ensures that the preferred stockholders will receive dividends first. There are two categories of preferred stock: cumulative preferred stock— with which owners must receive all dividends in arrears (passed dividends) and current year dividends before the corporation pays dividends to the common stockholders—and noncumulative preferred stock—with which owners do not receive any passed dividends. Stock dividends are distributions of a corporation’s stock and have no effect on total stockholders’ equity, assets, or liabilities. Small stock dividends (less than 20% to 25%) are recorded at the stock’s market value. Large stock dividends (greater than 20% to 25%) are recorded at the stock’s par value. Stock splits increase the number of issued and outstanding shares of stock coupled with a proportionate reduction in the par value of the stock. Stock splits do not affect any account balances, and no journal entry is needed.

LO 5. Prepare a corporate income statement including earnings per share A corporation’s income statement includes income from continuing operations and discontinued operations—a segment of a business that has been discontinued. Earnings per share must be reported either on the face of the income statement or in the notes to the financial statements.

LO 6. Explain how equity is reported for a corporation The statement of retained earnings reports how the company’s Retained Earnings balance changed from the beginning of the period to the end of the period. Retained Earnings can be appropriated (set aside) for a specific use. Prior-period adjustments must be made to beginning Retained Earnings for mathematical mistakes, misapplied accounting principles, or oversight.

The statement of stockholders’ equity reports the changes in all stockholders’ equity accounts.

LO 7. Use earnings per share, rate of return on common stockholders’ equity, and the price/earnings ratio to evaluate business performance Earnings per share calculates the amount of a company’s net income (loss) for each share of its outstanding common stock: (Net income − Preferred dividends) / Average number of common shares outstanding The price/earnings ratio measures the value that the stock market places on $1 of a company’s earnings: Market price per share of common stock / Earnings per share

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Rate of return on common stockholders’ equity shows the relationship between net income available to common stockholders and their average common equity invested in the company: (Net income −Preferred dividends) / Average common stockholders’ equity

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Chapter 13: Assignment Grid and Other Materials S13-1 S13-2 S13-3 S13-4 S13-5 S13-6 S13-7 S13-8 S13-9 S13-10 S13-11 S13-12 S13-13 S13-14 S13-15 S13-16 S13-17 S13-18 S13-19 S13-20 S13-21 S13-22 S13-23 S13-24 S13-25 S13-26 S13-27 S13-28 S13-29 S13-30 S13-31 S13-32 S13-33 S13-34

LO 1 X

LO 2

LO 3

LO 4

LO 5

LO6

LO 7

X X X X X X X X X X X X X X X X X X X X X X X X

X X

X

X X X X X X X X

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LO 1 S13-35 S13-36 S13-37 S13-38 P13-39A, P13-46B P13-40A, P13-47B P13-41A, P13-48B P13-42A, P13-49B P13-43A, P13-50B P13-44A, P13-51B P13-45A, P13-52B

LO 2

LO 3

LO 4

LO 5 X

LO6

LO 7

X X X X X

X X X X

X X X X

X

X

X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

Other End-of-Chapter Materials: Continuing Problem F13-1 Comprehensive Problem for Chapters F:11, F:12, and F:13 Tying It All Together Case F:13-1 Decision Case F:13-1 Financial Statement Case F:13-1 Team Project F:13-1 Communication Activity F:13-1

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CHAPTER 13 TEN-MINUTE QUIZ Circle the letter of the best response.

1.

Which of the following is not a characteristic of a corporation?

A. Double taxation B. Mutual agency C. Unlimited liability D. One or more owners

2.

What is the effect of the purchase of treasury stock?

A. Decrease the number of shares outstanding.

B. Decrease the number of shares issued.

C. Increase the number of shares issued.

D. Both A and B are correct.

3.

Which of the following transactions result in a decrease in stockholders’ equity?

A. Sale of treasury stock B. Small stock dividend C. Cash dividend D. All of the above

4.

A stock dividend A. decreases Common Stock.

B. increases Total Equity.

C. decreases Total Equity.

D. decreases Retained Earnings.

5.

Backyard Emporium issued 500,000 shares of $1 par common stock at $5 per share. Which journal entry correctly records the issuance of this stock?

Accounts and Explanations Debit Credit A. Common Stock 500,000 Paid-In Capital in Excess of Par—Common 2,000,000 Cash 2,500,000 B. Cash 2,500,000 Common Stock 500,000 Paid-In Capital in Excess of Par—Common 2,000,000 C. Common Stock 2,500,000 Cash 2,500,000 D. Cash 2,500,000 Common Stock 2,500,000

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6.

Two years ago, Tonya Williams purchased a building for $210,000. This year, Williams gave the building, which now has a current market value of $240,000, to Beyond Corporation in exchange for 5,000 shares of $10-par common stock. Which journal entry by Beyond Corporation correctly records the issuance of this stock?

Accounts and Explanations Debit Credit A. Building 240,000 Common Stock 50,000 Paid-In Capital in Excess of Par—Common 190,000 B. Building 210,000 Common Stock 50,000 Paid-In Capital in Excess of Par—Common 160,000 C. Building 240,000 Common Stock 240,000 D. Building 210,000 Common Stock 210,000

7.

Good For You Foods has outstanding 6,000 shares of $3 par common stock, which was issued at $15 per share, and 2,000 shares of $10 par cumulative preferred stock, which was issued at par.

Good For You Foods also has a deficit balance in Retained Earnings of $26,000. How much is Good For You Foods’ total stockholders’ equity?

A. $66,000 B. $84,000 C. $110,000 D. $136,000

8.

Happy Pets Corporation has 10,000 shares of 5%, $20 par noncumulative preferred stock, and 37,000 shares of common stock outstanding. Ink declared no dividends in 20X4. In 20X5, Ink declares a total dividend of $54,000. How much of the dividends go to the common stockholders?

A. $54,000 B. $44,000 C. $34,000 D. None; it all goes to preferred stockholders.

9.

Retained Earnings A. is decreased by a stock split.

B. represents an amount of cash available to pay shareholders.

C. represents the total amount of net income earned by the company during its existence.

D. can be subject to appropriation by a corporation’s directors to limit dividends.

10. Stock splits A. increase the number of shares of stock issued.

B. decrease par value per share.

C. both A and B. D. neither A nor B.

.

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Answer Key to Ten-Minute Quiz: 1. C 2. A 3. C 4. D 5. B Cash ($5 per share × 500,000 shares) Common Stock ($1 par value × 500,000 shares) Paid-In Capital in Excess of Par—Common ($4 per share × 500,000 shares)

2,500,000 500,000 2,000,000

6. A Building (at market value) Common Stock ($10 par value × 5,000 shares) Paid-In Capital in Excess of Par—Common ($240,000 − $50,000)

240,000 50,000 190,000

7. B Paid-In Capital: Preferred Stock—$10 Par Value; 2,000 shares authorized, 2,000 shares issued and outstanding Common Stock—$3 Par Value; 6,000 shares authorized; 6,000 shares issued and outstanding Paid-In Capital in Excess of Par—Common Total Paid-In Capital Retained Earnings Total Stockholders’ Equity

.

$ 20,000 18,000 72,000 110,000 (26,000) $ 84,000

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8. B Total Dividend

$ 54,000

Dividend to Preferred Stockholders*: Current Year Dividend (20X9) Total Dividend to Preferred Stockholders Dividend to Common Stockholders

$ 10,000 (10,000) $ 44,000

*Preferred dividend = Outstanding shares × Par value × Preferred dividend rate = 10,000 shares × $20 par value × 0.05 = $10,000 9. D 10. C

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Extra Critical Thinking Questions Decision Case F:13-2 Las Colinas Manufacturing had the following stockholders’ equity on March 31, 20X4: Common Stock—No Par Value; 200,000 shares authorized, 100,000 shares issued and outstanding Retained Earnings Total Stockholders’ Equity

$ 250,000 190,000 $ 440,000

In the past, Las Colinas has paid an annual cash dividend of $0.25 per share. Despite the large Retained Earnings balance, the board of directors wished to conserve cash for expansion. The board delayed the payment of cash dividends and in April distributed a 10% stock dividend. During May, the company’s cash position improved. The board then declared and paid a cash dividend of $0.25 per share in June.

Suppose you owned 1,000 shares of Las Colinas common stock, acquired three years ago, prior to the 10% stock dividend. The market price of the stock was $22 per share before any of these dividends.

Requirements 1. What amount of cash dividends did you receive last year—before the stock dividend? What amount of cash dividends will you receive after the stock dividend?

2. How does the stock dividend affect your proportionate ownership in Las Colinas Manufacturing?

Explain.

3. Immediately after the stock dividend was distributed, the market value of Las Colinas stock decreased from $22 per share to $20 per share. Does this decrease represent a loss to you?

Explain.

Decision Case F:13-2: Solution Requirement 1

Last year This year— after a 10% stock dividend

Shares 1,000

×

Dividend $0.25

1,100

×

$0.25

.

= =

Dividend Received $250 $275

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Requirement 2 The proportionate ownership in Las Colinas Manufacturing stays the same. All other Las Colinas Manufacturing stockholders also receive additional shares equal to 10% of their stock holdings, so all stockholders are in the same relative position after the stock dividend as they were before. With a stock dividend, the total number of shares issued and outstanding increases, but the percentage of total ownership of individual stockholders stays the same.

Requirement 3 The total value of the stock position stays the same. Prior to the stock split, the holdings were worth $22 × 1,000 shares = $22,000. After the stock dividend, the holdings were worth $20 × 1,100 shares = $22,000. So no loss was incurred due to the stock dividend.

Ethical Issue F:13-1 Note: This case is based on an actual situation.

Stan Sewell paid $50,000 for a franchise that entitled him to market software programs in the countries of the European Union. Sewell intended to sell individual franchises for the major language groups of Western Europe—German, French, English, Spanish, and Italian. Naturally, investors considering buying a franchise from Sewell asked to see the financial statements of his business.

Believing the value of the franchise to be $500,000, Sewell sought to capitalize his own franchise at $500,000. The law firm of St. Charles & LaDue helped Sewell form a corporation chartered to issue 500,000 shares of common stock with par value of $1 per share. Attorneys suggested the following chain of transactions: a) Sewell’s cousin, Bob, borrows $500,000 from a bank and purchases the franchise from Sewell. b) Sewell pays the corporation $500,000 to acquire all its stock. c) The corporation buys the franchise from Cousin Bob. d) Cousin Bob repays the $500,000 loan to the bank.

In the final analysis, Cousin Bob is debt-free and out of the picture. Sewell owns all of the corporation’s stock, and the corporation owns the franchise. The corporation’s balance sheet lists a franchise acquired at a cost of $500,000. This balance sheet is Sewell’s most valuable marketing tool.

Requirements 1. What is unethical about this situation?

2. Who can be harmed? How can they be harmed? What role does accounting play?

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Ethical Issue F:13-1: Solution Requirement 1 If the strategy outlined in the problem has, as its objective, to mislead investors and deliberately overstate the value of the franchise, then that would be unethical. The value of the franchise is key to determining how much it is “capitalized” for—the value at which the asset is reported on the balance sheet of the corporation. The information suggests that it may be worth more than the $50,000 that it was originally purchased for, but that it is worth $500,000 appears doubtful.

Requirement 2 If Sewell’s corporation provides fraudulent financial information, then parties who might invest in or loan money to the corporation may be harmed by making a poor decision based on fraudulent data.

Individuals who are considering purchasing a franchise from Sewell will also be harmed. Accounting rules require that assets of this type be recorded at their “fair value.” The accounting rules would require a realistic and accurate appraisal of the value of the franchise.

Fraud Case F:13-1 Elaine Jackson gets a visit from her cousin Phil. He wants to apologize. Last year he regaled her with stories about a small company he had discovered that had just invented a high-tech converter to allow cars to run on water. It was still all hush-hush. The stock was trading for just one penny per share. Phil told Elaine he had put all his savings into it, and he wanted to share the tip with her. She purchased stock using $8,000 that she had been saving for two years. Later, when her money was long gone, she realized she had been the victim of a classic “pump and dump” scheme whereby unscrupulous promoters bought up “penny stocks,” started a rumor about big profits, and when enough suckers bought in and the stock price shot up, the promoters bailed out and made a profit. Phil has just gotten out of prison, and he feels terrible about what he did. Elaine has learned an expensive lesson.

Requirements 1. Why were Phil’s actions considered to be fraudulent?

2. Does the current market price of a share of stock give any indication of the value or success of a company?

3. What sort of information should an investor look for before deciding to invest in the stock of a company?

.

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Fraud Case F:13-1: Solution Requirement 1 Understanding how Phil obtained the information about the company would indicate more about the fraud involved. If he was working for the company or someone working there shared information not publically available, then that would be considered insider trading. Insider trading is the buying or selling of a security by someone who has access to material, nonpublic information about the security.

Requirement 2 Yes and no. The current market price of stock represents what the “market” believes to be the current “true” value of that stock (in terms of earnings and growth potential). This price theoretically reflects all the publicly known information about the company that is readily available to investors. However, whether the price of one share is high or low is not necessarily significant on its own. The value of a share is theoretically equal to the value of the company divided by the number of shares issued, so if one company issues 1 million shares and another identical company issues 2 million shares, the share price of the second company should be one-half the price of the first company. The share price of successful companies varies over a wide range.

Requirement 3 A potential investor should look at the history and earnings record of a company. The balance sheet will give an indication of its stability or level of risk. The investor would also want to know about the management of the company, the company’s products and services, its competitive environment, and, most importantly, its future growth potential. Another piece of information that some investors refer to is publicly available information on stock purchases and sales by officers and directors of the company.

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Chapter 14 The Statement of Cash Flows Chapter 14: Overview The chapter begins with a discussion of the basic concepts and purposes of the statement of cash flows.

Operating, investing, and financing activities are defined. A brief comparison of the direct and indirect methods for determining cash flows from operating activities is given. The five-step process for preparing a statement of cash flows using the indirect method is outlined. Adjustments to net income, including depreciation, gains/losses on the sale of assets, and changes in current assets and current liabilities, are explained. Cash flows from investing and financing activities are illustrated using Taccounts and formulas to aid in the explanations. Non-cash investing and financing activities are discussed. The concept of free cash flow is discussed as a measure used to evaluate business performance. A Data Analytics in Accounting feature highlights how companies can use data analytics software with dashboards to build financial forecasts and better understand their free cash flow.

Appendix 14A explains the preparation of the operating activities section of the statement of cash flows using the direct method. Emphasis is placed on the computation of cash flow from operating activities, recognizing that investing and financing activities follow the same presentation as under the indirect method. The investing, financing, and non-cash activities sections are the same as the indirect method.

A Decisions feature helps students to see what can be done to create a positive cash flow. A Tying It All Together feature gives students a look into Lululemon’s statement of cash flows for a real-world view.

The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding Problem reviews completing a statement of cash flows by the indirect method. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 14: Learning Objectives LO 1. Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows LO 2. Prepare the operating activities section of the statement of cash flows by the indirect method LO 3. Prepare the investing, financing, and non-cash activities sections of the statement of cash flows LO 4. Use free cash flow to evaluate business performance LO 5. Prepare the operating activities section of the statement of cash flows by the direct method (Appendix 14A)

.

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Chapter 14: Teaching Outline LO 1. Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows a) Statement of cash flow reports cash receipts and cash payments and helps: i) Predict future cash flows ii) Evaluate management iii) Predict ability to pay debts and dividends b) Classification of cash flows i) Operating activities ii) Investing activities iii) Financing activities ▪

Exhibit F:14-1: Operating, Investing, and Financing Cash Flows and the Balance Sheet Accounts

c) Non-cash investing and financing activities ▪

Exhibit F:14-2: Sections of the Statement of Cash Flows

d) Two formats for operating activities: i) Indirect method ii) Direct method Lecture Notes: The statement of cash flows is required for GAAP purposes. Cash is “king” and is used to pay outstanding liabilities. This important statement indicates the sources and uses of the company’s cash. Point out that a company may have a positive cash balance, but it is important to know where it came from. Hopefully, over time a company can finance its own activities from operating activities.

Suggested In-Class Exercise: E-F:14-17 LO 2. Prepare the operating activities section of the statement of cash flows by the indirect method a) Cash flows from operating activities ▪

Exhibit F:14-3: Comparative Balance Sheet

.

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▪

Exhibit F:14-4: Income Statement

▪

Exhibit F:14-5: Statement of Cash Flows—Indirect Method

▪

Exhibit F:14-6: Adjustments Made to Reconcile Net Income to Net Cash Provided by Operating Activities

Lecture Notes: The direct and indirect methods use different computations for cash flows from operating activities but arrive at the same amount. For the indirect method, emphasize that changes are made to net income to calculate cash flows from operating activities because we are converting from accrual basis to cash basis. For example, depreciation and losses are non-cash items but reduce net income. Therefore, they should be added back in arriving at cash flow as no cash was actually spent. Gains have the opposite effect of losses. Net income is from the income statement, which is based on accrual accounting. The statement of cash flows focuses on cash transactions. It may be helpful to revisit what accrual-based accounting means as it relates to the timing of revenues and expenses and their related cash receipts and payments, respectively. Also, students may benefit from looking up several 10-Ks on the SEC website to determine differences in operating income and operating cash flow. This exercise will help students better understand the adjustments to net income and why they are necessary.

Note that the investing and financing activities sections are calculated the same way, regardless of whether the direct or indirect method is used for the operating section.

.

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LO 3. Prepare the investing, financing, and non-cash activities sections of the statement of cash flows a) Cash flows from investing activities b) Cash flows from financing activities c) Net change in cash and cash balances d) Non-cash investing and financing activities ▪

Exhibit F:14-7: Non-cash Investing and Financing Activities

Lecture Notes: Students sometimes fail to differentiate cash-based investing transactions from those using liabilities. Emphasize that we are only looking for transactions in which cash changed hands. For example, if a company purchases a delivery truck for a $10,000 down payment and finances the remaining $75,000 with a three-year note, only the $10,000 cash paid is included in the investing activities section. The remaining balance financed with the note appears in the non-cash investing and financing activities section, if material.

The payment of dividends is a financing activity, whereas the receipt of dividends is an investing activity. Borrowing cash is a financing activity, whereas the payment of interest is an operating activity. The ending cash balance of the statement of cash flows should agree with the cash balance on the balance sheet.

Suggested In-Class Exercise: E-F:14-21

LO 4. Use free cash flow to evaluate business performance a) Free cash flow = Net cash provided by operating activities − Cash payments planned for investments in long-term assets − Cash dividends Lecture Notes: Free cash flow is the amount of cash available from operating activities after paying for planned investments in long-term assets and after paying cash dividends to shareholders.

Suggested In-Class Exercise: E-F:14-26 LO 5. Prepare the operating activities section of the statement of cash flows by the direct method (Appendix 14A) a) Cash flows from operating activities ▪

Exhibit F:14A-1: Statement of Cash Flows—Direct Method

Lecture Notes: Lending officers at banks and many investors prefer the direct method for presenting cash flows from operating activities because they consider it more informative than the indirect method. Companies and preparers of the statement of cash flows generally prefer to .

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use the indirect method because they consider it easier to prepare. An experienced financial analyst can reconstruct a direct-method statement from an indirect-method statement with relative ease.

Suggested In-Class Exercise: E-F:14A-27

.

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Chapter 14: Handout for Student Notes LO 1. What is the statement of cash flows?

o

Purpose of the statement of cash flows

o

Classification of cash flows

▪ Operating activities

▪ Investing activities

▪ Financing activities

▪ Non-cash investing and financing activities

o

Two formats for operating activities

LO 2. How is the statement of cash flows prepared using the indirect method?

o

Cash flows from operating activities

▪ Depreciation, depletion, and amortization expenses

▪ Gains and losses on the disposal of long-term assets

▪ Changes in current assets and current liabilities .

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▪ Evaluating cash flows from operating activities

LO 3. Prepare the investing, financing, and non-cash activities sections of the statement of cash flows

o

Cash flows from investing activities

o

Cash flows from financing activities

▪ Long-term liabilities

▪ Common stock and treasury stock

▪ Computing dividend payments

o

Net change in cash and cash balances

o

Non-cash investing and financing activities

LO 4. How do we use free cash flow to evaluate business performance?

LO 5. How is the operating activities section of the statement of cash flows prepared using the direct method? (Appendix 14A)

o

Cash flows from operating activities

▪ Cash collections from customers

.

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▪ Cash receipts of interest revenue

▪ Cash receipts of dividend revenue

▪ Payments to suppliers

▪ Payments to employees

▪ Payments for interest expense and income tax expense

▪ Non-cash expenses and gains and losses on disposal of long-term assets

▪ Net cash provided by operating activities

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Chapter 14: Student Chapter Summary LO 1. Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows The statement of cash flows reports on a business’s cash receipts and cash payments for a specific period. There are three basic types of cash flow activities: • Operating activities—Reports on activities that create revenue or expense in the entity’s business.

• Investing activities—Reports cash receipts and cash payments that increase or decrease longterm assets • Financing activities—Includes cash receipts and cash payments involved in long-term liabilities and equity Non-cash investing and financing activities are not included in the statement of cash flows but appear either in a separate schedule at the bottom of the statement or in the notes to the financial statements. There are two ways to format operating activities on the statement of cash flows: using the indirect method, which starts with net income and adjusts it to net cash provided by operating activities, and using the direct method, which restates the income statement in terms of cash.

LO 2. Prepare the operating activities section of the statement of cash flows by the indirect method Step 1. Complete the cash flows from operating activities section using net income and adjusting for increases or decreases in current assets (other than cash) and current liabilities. Also adjust for gains or losses on long-term assets and non-cash expenses.

LO 3. Prepare the investing, financing, and non-cash activities sections of the statement of cash flows Step 2.

Complete the cash flows from investing activities section by reviewing the longterm assets section of the balance sheet.

Step 3.

Complete the cash flows from financing activities section by reviewing the longterm liabilities and equity sections of the balance sheet.

Step 4.

Compute the net increase or decrease in cash during the year. The change in cash is the key reconciling figure for the statement of cash flows and must match the change in cash reported on the comparative balance sheet Step 5.

Prepare a separate schedule reporting any non-cash investing and financing activities.

LO 4. Use free cash flow to evaluate business performance Free cash flow is the amount of cash available from operating activities after paying for planned investments in long-term assets and after paying cash dividends to shareholders.

Free cash flow = Net cash provided by operating activities − Cash payments planned for investments in long-term assets − Cash dividends

.

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LO 5. Prepare the statement of cash flows by the direct method (Appendix 14A) The operating activities section is the only section that differs between the direct and indirect methods. When using the direct method, each line item on the income statement is converted from accrual basis to cash basis.

LO 6. Prepare the statement of cash flows by the indirect method using a spreadsheet (Appendix 14B) A spreadsheet can be used to help in preparing the statement of cash flows. The spreadsheet helps accountants analyze the changes in balance sheet accounts.

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Chapter 14: Assignment Grid and Other Materials LO 1 S14-1 S14-2 S14-3 S14-4 S14-5 S14-6 S14-7 S14-8 S14-9 S14-10 S14A-11 S14A-12 S14A-13 S14A-14 E14-15 E16-16 E14-17 E14-18 E14-19 E14-20 E14-21 E14-22 E14-23 E14-24 E14-25 E14A-26 E14A-27 E14A-28 E14A-29 P14-30A, P14-36B P14-31A, P14-37B P14-32A, P14-38B P14-33A, P14-39B P14A-34A, P14A-40B P14A-35A, P14A-41B

X X X

LO 2

LO 3

X X X

X

X

LO 4

LO 5

X X X X X X

X X X X

X X X X X

X X X X

X

X

X X X X X X X X X X

X

X

X X X X

X X X X X X

X X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

Other End-of-Chapter Materials:

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Continuing Problem F:14-1 Tying It All Together Case F:14-1 Decision Case F:14-1 Ethical Issue F:14-1 Financial Statement Case F:14-1

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CHAPTER 14 TEN-MINUTE QUIZ Circle the letter of the best response.

1.

Which of the following is not an appropriate use of the statement of cash flows?

A. Predict ability to pay debts B. Evaluate managers’ decisions C. Analyze profitability and liquidity D. Predict future cash flows

2.

The main types of cash flow activities are A. financing, investing, operating, and free.

B. investing, operating, and financing.

C. operating, classifying, and investing.

D. financing, operating, classifying, and noncurrent.

3.

Cash flows from interest received are reported in the statement of cash flows in the A. operating activities section.

B. investing activities section.

C. financing activities section.

D. schedule of noncash activities.

4.

The purchase of equipment by issuing a long-term note payable for the entire amount is reported on the statement of cash flows in the A. operating activities section.

B. investing activities section.

C. financing activities section.

D. schedule of non-cash investing and financing activities.

5.

Jackson’s Feed Store earned net income of $67,000 after deducting depreciation of $5,000 and all other expenses. Current assets decreased by $2,000, and current liabilities increased by $6,000.

Jackson’s paid $9,000 of dividends. How much was Jackson’s cash provided by operating activities?

A. $80,000 B. $71,000 C. $64,000 D. $54,000

6.

Which of the following transactions is not a financing activity of Horizon Company?

A. Purchased 500 shares of stock of XYZ Corporation B. Sold 1,000 shares of treasury stock C. Borrowed $50,000 from Texas National Bank D. Paid dividends of $8,000

.

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7.

The Plant Assets account of Stephanie’s Bakery shows the following: Plant Assets, Net Beg. Bal. 90,000 34,000 Depreciation Acquisition 450,000 58,000 Disposal End. Bal.

448,000

Stephanie’s Bakery sold plant assets at an $8,000 loss. Where on the statement of cash flows should Stephanie’s Bakery report the sale of plant assets? How much should the business report for the sale?

A. Cash flows from financing activities—Cash receipt of $50,000 B. Cash flows from investing activities—Cash receipt of $50,000 C. Cash flows from financing activities—Cash receipt of $66,000 D. Cash flows from investing activities—Cash receipt of $66,000 8.

Beachfront Escapes expects net cash provided by operating activities of $220,000, and the company plans purchases of equipment of $83,000, cash dividends of $10,000, and loan repayments totaling $36,000. What is Beachfront Escapes’ free cash flow?

A. $220,000 B. $137,000 C. $127,000 D. $91,000

9.

Bags Unlimited had Accounts Receivable of $25,000 at the beginning of the year and $44,000 at year-end. Sales revenue for the year totaled $170,000. How much cash did the business collect from customers?

A. $189,000 B. $151,000 C. $126,000 D. $101,000

10. Music City Candle Company had other operating expenses of $52,000. At the beginning of the year, Music City Candle Company owed $15,000 for Accrued Liabilities. At year-end, Accrued Liabilities were $5,000. How much cash did Music City Candle Company pay for other operating expenses?

A. $42,000 B. $47,000 C. $57,000 D. $62,000

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Answer Key to Ten-Minute Quiz: 1. C 2. B 3. A 4. D 5. A Cash Flows from Operating Activities: Net Income Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation Expense—Plant Assets Decrease in Current Assets Increase in Current Liabilities Net Cash Provided by Operating Activities

$ 67,000

$ 5,000 2,000 6,000

13,000 $ 80,000

6. A 7. B Disposal of Plant Assets are cash flows from investing activities.

Disposal = Cost −Accumulated Depreciation Cash received = Cost − Accumulated Depreciation + Gain − Loss = $58,000 − $8,000 = $50,000 8. C Free cash flow = Net cash provided by operating activities − Cash payments planned for investments in long-term assets − Cash dividends = $220,000 − $83,000 − $10,000 = $127,000 9. B Cash receipts from customers = Net Sales Revenue + Beginning Accounts Receivable − Ending Accounts Receivable = $170,000 + $25,000 − $44,000 = $151,000 10. D Cash paid for other operating expenses = Other Operating Expenses + Beginning Accrued Liabilities − Ending Accrued Liabilities = $52,000 + $15,000 − $5,000 = $62,000

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Extra Critical Thinking Questions Decision Case F:14-2 The 20X4 comparative income statement and the 20X4 comparative balance sheet of Golf America, Inc., have just been distributed at a meeting of the company’s board of directors. The members of the board raise a fundamental question: Why is the cash balance so low? This question is especially hard to understand because 20X4 showed record profits. As the controller of the company, you must answer the question.

GOLF AMERICA, INC. Comparative Income Statement Year Ended December 31, 20X4 (in thousands)

Net Sales Revenue Cost of Goods Sold Gross Profit Operating Expenses: Salaries Expense Depreciation Expense Total Operating Expenses Operating Income Other Income and (Expenses): Gain on Sale of Equipment (sales price, $33) Loss on Sale of Land (sales price, $61) Interest Expense Amortization Expense Total Other Income and (Expenses) Net Income

.

20X4 $ 444 221 223

20X3 $ 310 162 148

48 46 94 129

28 22 50 98

0 0 (13) (11) (24) $ 105

18 (35) (20) (11) (48) $ 50

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GOLF AMERICA, INC. Comparative Balance Sheet December 31, 20X4 and 20X3 (in thousands) 20X4 Assets Current Assets: Cash Accounts Receivable Merchandise Inventory Long-term Assets: Plant Assets, net Patents Long-term Investments Total Assets Liabilities Current Liabilities: Accounts Payable Accrued Liabilities Long-term Liabilities: Notes Payable Total Liabilities Stockholders’ Equity Common Stock, no par Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity

20X3

$ 25 72 194

$ 63 61 181

125 177 31 $ 624

61 188 0 $ 554

$ 63 12

$ 56 17

179 254

264 337

149 221 370 $ 624

61 156 217 $ 554

Requirements 1. Prepare a statement of cash flows for 20X4 in the format that best shows the relationship between net income and net cash flows from operating activities. The company sold no plant assets or long-term investments and issued no notes payable during 20X4. There were no noncash investing and financing transactions during the year. Show all amounts in thousands. .

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2. Considering net income and the company’s cash flows during 20X4, was it a good year or a bad year? Give your reasons.

Decision Case F:14-2: Solution Requirement 1 GOLF AMERICA, INC. Statement of Cash Flows Year Ended December 31, 20X4 (in thousands) Cash Flows from Operating Activities: Net Income Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation Expense Amortization Expense Increase in Accounts Receivable Increase in Inventories Increase in Accounts Payable Decrease in Accrued Liabilities Net Cash Provided by Operating Activities Cash Flows from Investing Activities: Acquisition of Plant Assets Acquisition of Long-term Investments Net Cash Used for Investing Activities Cash Flows from Financing Activities: Cash Receipt from Issuance of Common Stock Cash Payment of Notes Payable Cash Payment of Dividends Net Cash Used for Financing Activities Net Increase (Decrease) in Cash Cash Balance, December 31, 20X3 Cash Balance, December 31, 20X4

.

$ 105

$ 46 11 (11) (13) 7 (5)

35 140

$ (110) (31) (141)

$ 88 (85) (40) (37) (38) 63 $ 25

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12/31/20X3 Acquisitions

Plant Assets, Net 61 110 46 Accumulated Depreciation

12/31/20X4

Dividend

125 Retained Earnings 156 12/31/20X3 105 Net Income 40 221 12/31/20X4

Requirement 2 The company shows a strong cash flow from operating activities, and net income has increased $65 thousand from the prior year. The company is investing in plant assets and other long-term investments, which should generate profits in the future. It has also paid down debt by issuing common stock, which will decrease future interest expense. This was a good year for Golf America, Inc. Fraud Case F:14-1 Frank Lou had recently been promoted to construction manager at a development firm. He was responsible for dealing with contractors who were bidding on a multimillion-dollar excavation job for a new high-rise. Times were tough. Several contractors had gone under recently, and the ones left standing were viciously competitive. Each contractor was responsible for submitting financial statements of his or her company along with the bid. Frank knew that the development firm was carefully reviewing each company to ensure that it had the necessary cash flow to complete the project. The last contractor it had hired declared bankruptcy before the project was completed. That morning, four bids were sitting on Frank’s desk. The deadline was midnight, and the bids would be opened the next morning. The first bidder, Bo Freely, was a tough but personable character that Frank had known for years. Frank had lunch with him today, and after a few beers, Bo hinted that he had “inadvertently” left some cash payments of operating expenses out of his statement of cash flows so that his cash flows from operating activities would look better. Bo told Frank that he was waiting on several clients to pay him for past jobs but that he knew he would be receiving the money shortly. After lunch, Frank thought carefully about what Bo had said and decided not to mention anything to his company. He knew that Bo’s firm was a reputable company and would be around a long time.

Requirements 1. Is Frank’s company hurt in any way by this fraudulent action?

2. How could this action hurt Frank?

3. How can a business protect against this kind of fraud?

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Fraud Case F:14-1: Solution Requirement 1 Frank’s company is hurt by not having complete and accurate information from the bidders. They might select Bo Freely’s bid based on the misleading statement of cash flows.

Requirement 2 If Bo Freely’s bid is selected and his company runs into financial difficulty, the bidding process that Frank oversees might be evaluated. If it is determined that he knew the information was inaccurate, he could be fired or charged with fraud. If it goes undetected, Frank might start to be less valiant in the bidding process.

Requirement 3 Controls over the bidding process can be strengthened by separation of duties, having different people involved in receiving the bids, and reviewing bids for completeness. Also, having someone besides Frank involved in reviewing the bidder’s financial statements would be a good idea.

Team Project F:14-1 Each member of the team should obtain the annual report of a different company. Select companies in different industries. Evaluate each company’s trend of cash flows for the most recent two years. In your evaluation of the companies’ cash flows, you may use any other information that is publicly available, such as the other financial statements (income statement, balance sheet, statement of stockholders’ equity, and the related notes) and news stories from magazines and newspapers. Rank the companies’ cash flows from best to worst and write a two-page report on your findings.

Team Project F:14-1: Solution Students’ responses will vary, depending on the companies they select.

Team Project F:14-2 Select a company and obtain its annual report, including all the financial statements. Focus on the statement of cash flows and, in particular, the cash flows from operating activities. Specify whether the company uses the direct method or the indirect method to report cash flows from operating activities.

Team Project F:14-2: Solution Students’ responses will vary, depending on the companies they select.

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Communication Activity F:14-1 In 150 words or fewer, explain the difference between operating, investing, and financing activities.

Communication Activity F:14-1: Solution The three basic types of cash flow activities are operating, investing, and financing. Operating activities create revenue or expenses in the entity’s business. It is important for a business to have a positive cash flow from operating activities. Investing activities represent the company’s investment in long-term assets or the sale of long-term assets. Investing activities let you know whether the company is investing in itself. Financing activities include cash inflows and outflows involved with long-term liabilities and equity. Such activities demonstrate how the company is getting additional sources of cash or whether it is paying down its debt or paying dividends.

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Chapter 15 Financial Statement Analysis Chapter Overview The chapter presents an extensive study of the three elements of financial statement analysis: horizontal, vertical, and ratio analysis. Horizontal analysis, including both dollar changes and percentage changes, is explained and illustrated using a comparative income statement and balance sheet. Trend analysis, a type of horizontal analysis, is also explained and illustrated. Vertical analysis is discussed next. Use of common-size statements, a form of vertical analysis, is presented, along with a discussion of the usefulness of benchmarking and industry comparisons.

The next part of the chapter emphasizes ratio analysis and how ratios are used to help make business decisions. The ratio analysis discussion is divided into these main categories: • • • • •

Evaluating the ability to pay current liabilities: o Working capital, cash ratio, acid-test (or quick) ratio, and current ratio Evaluating the ability to sell merchandise inventory and collect receivables: o Inventory turnover, days’ sales in inventory, gross profit percentage, accounts receivable turnover ratio, and days’ sales in receivables Evaluating the ability to pay long-term debt: o Debt ratio, debt to equity ratio, and times-interest-earned ratio Evaluating profitability: o Profit margin ratio, rate of return on total assets, asset turnover ratio, rate of return on common stockholders’ equity, and earnings per share Evaluating stock as an investment: o Price/earnings ratio, dividend yield, and dividend payout

Red flags that may signal financial trouble are discussed.

A Decisions feature helps students to determine whether an unqualified opinion should be issued. An Ethics feature helps give perspective on a real-world ethical dilemma involving reclassification of shortterm debt as long-term to make ratio analysis look better. The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. Two Check Your Understanding Problems review various concepts covered in the chapter. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Chapter 15: Learning Objectives LO 1. Explain how financial statements are used to analyze a business LO 2. Perform a horizontal analysis of financial statements LO 3. Perform a vertical analysis of financial statements LO 4. Compute and evaluate the standard financial ratios

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Chapter 15: Teaching Outline with Lecture Notes LO 1. Explain how financial statements are used to analyze a business a) Purpose of analysis b) Tools of analysis c) Corporate financial reports i.

Business overview

ii.

Management’s discussion and analysis of financial condition and results of operations

iii.

Report of independent registered public accounting firm

iv.

Financial statements

v.

Notes to financial statements

Lecture Notes: Financial statement analysis is used to measure performance, analyze stock investments, obtain an overall sense of a company’s financial health, determine credit risk, or simply compare financial data in relevant terms. To accurately determine the financial performance of a company, it is necessary to compare its performance from (1) year to year, (2) with a competing company, (3) and with the same industry as a whole. Financial statement analysis tools allow us to judge a company’s present situation and predict what might happen in the near future.

Suggested In-Class Exercise: S15-1 LO 2. Perform a horizontal analysis of financial statements a) Horizontal analysis of the income statement ▪

Exhibit F:15-1: Comparative Income Statement—Horizontal Analysis

b) Horizontal analysis of the balance sheet ▪

Exhibit F:15-2: Comparative Balance Sheet—Horizontal Analysis

c) Trend analysis Lecture Notes: Horizontal analysis is “side to side,” and vertical analysis is “top to bottom.”

With horizontal analysis, the base year is always the previous year; you increase or decrease from the previous year, not the current year. In addition, the percentage change is more useful than the absolute dollar amount change. Students may want to focus on the dollar amount change

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when analyzing a company. Point out that what is material to us may not be material to a business, based on the size of the business.

Suggested In-Class Exercise: E15-13 LO 3. Perform a vertical analysis of financial statements a) Vertical analysis of the income statement ▪

Exhibit F:15-3: Comparative Income Statement—Vertical Analysis

b) Vertical analysis of the balance sheet ▪

Exhibit F:15-4: Comparative Balance Sheet—Vertical Analysis

c) Common-size statements ▪

Exhibit F:15-5: Common-Size Income Statement—Smart Touch Learning Versus Learning School

d) Benchmarking i. Benchmarking against a key competitor ▪

Exhibit F:15-6: Graphical Analysis of Common-Size Income Statement—Smart Touch Learning Versus Learning School

ii. Benchmarking against the industry average Lecture Notes: With vertical analysis, each financial statement has a base number: The income statement uses net sales revenue, and the balance sheet uses total assets or total liabilities and equity. Every account is expressed as a percentage of the base number. Watch out for rounding; the parts should equal the whole. When benchmarking, make sure to use an appropriate competitor within the same industry. For example, it is appropriate to compare Google and Yahoo. It would not be appropriate or useful to compare Google and PepsiCo. Suggested In-Class Exercises: E15-15 and E15-16 LO 4. Compute and evaluate the standard financial ratios ▪ Exhibit F:15-7: Comparative Financial Statements a) Evaluating the ability to pay current liabilities i. Working capital ii. Cash ratio iii. Acid-test (or quick) ratio

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iv. Current ratio b) Evaluating the ability to sell merchandise inventory and collect receivables i. Inventory turnover ii. Days’ sales in inventory iii. Gross profit percentage iv. Accounts receivable turnover ratio v. Day’s sales in receivables c) Evaluating the ability to pay long-term debt i. Debt ratio ii. Debt to equity ratio iii. Times-interest-earned ratio d) Evaluating profitability i. Profit margin ratio ii. Rate of return on total assets iii. Asset turnover ratio iv. Rate of return on common stockholders’ equity v. Earnings per share (EPS) e) Evaluating stock as an investment i. Price/earnings ratio ii. Dividend yield iii. Dividend payout f) Red flags in financial statement analyses ▪

Exhibit F:15-8: Using Ratios in Financial Statement Analysis

Lecture Notes: Students may have trouble expressing their answers in the appropriate format when computing financial ratios. For example, “ratios” and “turnovers” (the current ratio, the acid-test ratio, etc.) are expressed in a number format, not a dollar amount. The textbook

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example indicates a current ratio for 2020 of 1.85, not $1.85. “Rate of return” is expressed in a percentage format; be careful of decimal places! Point out the difference between average and ending as some calculations use an average balance.

Tell students to always double-check their answers for reasonableness. Just because a calculator produces an answer does not mean it is automatically correct. In addition, financial analysis is a two-step process: the calculation and then analysis of the answer. Students may be able to calculate the ratios but may have trouble interpreting them correctly. Point out that the analysis is just as important as the calculation.

It may be helpful to provide additional practice by distributing several 10-Ks to student work groups and have them compute financial ratios for the companies provided.

Suggested In-Class Exercise: P15-27A

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Chapter 15: Handout for Student Notes LO 1. How are financial statements used to analyze a business?

o Purpose of analysis

o Tools of analysis

o Corporate financial reports

▪ Business overview

▪ Management’s discussion and analysis of financial condition and results of operations

▪ Report of independent registered public accounting firm

▪ Financial statements

▪ Notes to financial statements

LO 2. How do we use horizontal analysis to analyze a business?

o Horizontal analysis of the income statement

o Horizontal analysis of the balance sheet

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o Trend analysis

LO 3. How do we use vertical analysis to analyze a business?

o Vertical analysis of the income statement

o Vertical analysis of the balance sheet

o Common-size statements

o Benchmarking

▪ Benchmarking against a key competitor

▪ Benchmarking against the industry average

LO 4. How do we use ratios to analyze a business?

o Evaluating the ability to pay current liabilities

▪ Working capital

▪ Cash ratio

▪ Acid-test (or quick) ratio

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▪ Current ratio

o Evaluating the ability to sell merchandise inventory and collect receivables

▪ Inventory turnover

▪ Days’ sales in inventory

▪ Gross profit percentage

▪ Accounts receivable turnover ratio

▪ Days’ sales in receivables

o Evaluating the ability to pay long-term debt

▪ Debt ratio

▪ Debt to equity ratio

▪ Times-interest-earned ratio

o Evaluating profitability

▪ Profit margin ratio

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▪ Rate of return on total assets

▪ Asset turnover ratio

▪ Rate of return on common stockholders’ equity

▪ Earnings per share (EPS)

o Evaluating stock as an investment

▪ Price/earnings ratio

▪ Dividend yield

▪ Dividend payout

o Red flags in financial statement analyses

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Chapter 15: Student Chapter Summary LO 1. Explain how financial statements are used to analyze a business There are three main ways to analyze financial statements: using horizontal analysis, vertical analysis, and ratio analysis. Annual reports provide information about a company’s financial condition and include the following: business overview, management’s discussion and analysis of financial condition and results of operations (MD&A), report of independent registered public accounting firm, financial statements, and notes to the financial statements.

LO 2. Perform a horizontal analysis of financial statements Horizontal analysis is the study of percentage changes in comparative financial statements. It compares one year to another. Horizontal analysis % = (Dollar amount of change / Base period amount) × 100. Trend analysis is a form of horizontal analysis in which percentages are computed by selecting a base year as 100% and expressing the amounts for following periods as a percentage of the base period amount. Trend % = (Any period amount / Base period amount) × 100.

LO 3. Perform a vertical analysis of financial statements Vertical analysis reveals the relationship of each statement item to its base amount, which is the 100% figure. Vertical analysis % = (Specific item / Base amount) × 100. For the income statement, net sales revenue is the base. For the balance sheet, total assets is the base. Common-size statements are financial statements that report only percentages—the same percentages that appear in vertical analysis. Benchmarking is the practice of comparing a company against a key competitor or the industry average.

LO 4. Compute and evaluate the standard financial ratios Ratios can be used to evaluate a company’s: • Ability to pay current liabilities • Ability to sell merchandise inventory and collect receivables • Ability to pay long-term debt • Profitability • Stock as an investment Exhibit F:15-8 summarizes common ratios that can be used to analyze a business.

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Chapter 15: Assignment Grid and Other Materials LO 1 X

S15-1 S15-2 S15-3 S15-4 S15-5 S15-6 S15-7 S15-8 S15-9 S15-10 S15-11 S15-12 E15-13 E15-14 E15-15 E15-16 E15-17 E15-18 E15-19 E15-20 E15-21 E15-22 P15-23A, P15-30B P15-24A, P15-31B P15-25A, P15-32B P15-26A, P15-33B P15-27A, P15-34B P15-28A, P15-35B P15-29A, P15-36B

LO 2

LO 3

LO 4

X X X X X X X X X X X X X X X X X X X X X X

X X X

X

X X X X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

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Other End-of-Chapter Materials: Continuing Problem F:15-1 Decision Case F:15-1 Ethical Issue F:15-1 Financial Statement Case F:15-1 Team Project F:15-1 Team Project F:15-2

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CHAPTER 15 TEN-MINUTE QUIZ Circle the letter of the best response.

The following information applies to Questions 1–7: Leroy’s Accounts Cash and cash equivalents Net receivables Merchandise inventory Prepaid expenses Total current assets Other assets Total assets Total current liabilities Long-term liabilities Common stock Retained earnings Total liabilities and equity Net sales revenue Cost of goods sold Operating expenses Operating income Interest expense Income tax expense Net income

20X5 $ 5,550 1,813 1,324 1,709 10,396 18,500 $ 28,896 $ 7,230 4,798 6,568 10,300 $ 28,896 $ 25,000 7,055 7,064 6,821 210 2,563 $ 8,107

20X4 $ 5,094 1,611 1,500 2,120 10,325 15,737 $ 26,062 $ 8 ,467 3,792 4,363 9,440 $ 26,062

1.

Horizontal analysis of Leroy’s balance sheet for 20X5 would report (amounts rounded) A. Cash and cash equivalents as 19.2% of Total assets.

B. Inventory Turnover of 5 times.

C. 13.3% decrease in Merchandise inventory.

D. 11.7% decrease in Merchandise inventory.

2.

Vertical analysis of Leroy’s balance sheet for 20X5 would report (amounts rounded) A. Inventory Turnover of 5 times.

B. Current liabilities as 25.0% of Total assets.

C. 8.2% increase in Cash.

D. 9.0% increase in Cash.

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3.

A common-size income statement for Leroy would report (amounts rounded) A. Inventory Turnover of 5 times.

B. Net sales revenue of 86.5%.

C. Net income of 19.6%.

D. Cost of goods sold at 28.2%.

4.

What is Leroy’s current ratio?

A. 0.4 B. 0.8 C. 1.0 D. 1.4

5.

Leroy’s inventory turnover during 20X5 was (amounts rounded) A. 5 times.

B. 6 times.

C. 7 times.

D. none of the above.

6.

Leroy’s debt to equity ratio during 20X5 was (amounts rounded) A. 0.28.

B. 0.42.

C. 0.71.

D. 1.40.

7.

Which measure expresses Leroy’s times-interest-earned ratio (amounts rounded)?

A. 51.8% B. 4 times C. 39 times D. 52 times

8.

The annual report with financial statements that is filed with the SEC by a publicly traded company is called a A. Form 10-K. B. Form 10-Q. C. report of independent registered public accounting firm.

D. management discussion and analysis.

9.

Trend analysis is A. a form of vertical analysis.

B. a form of horizontal analysis.

C. both A and B. D. neither A nor B.

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10. Which ratio provides a measure of a company’s ability to pay long-term debt?

A. Rate of return on total assets B. Price/earnings ratio C. Quick ratio D. Times-interest-earned ratio

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Answer Key to Ten-Minute Quiz: 1. D

Inventory

20X5

20X4

$ 1,324

$ 1,500

Increase (Decrease) Amount Percentage (20X5–20X4) (Amount / 20X4) $ (176) (11.7)%

2. B 20X5 Total assets Total current liabilities

$ 28,896 7,230

Percent of Total (20X5 / Total Assets) 100.0% 25.0%

3. D 20X5 Sales Cost of goods sold

$ 25,000 7,055

Percentage of Total (20X5 / Sales) 100.0% 28.2%

4. D Current ratio = Total current assets / Total current liabilities = $10,396 / $7,320 = 1.4 5. A Inventory turnover = Cost of goods sold / Average merchandise inventory = $7,055 / [($1,500 + $1,324) / 2] = $7,055 / $1,412 = 5 times 6. C Debt to equity ratio = Total liabilities / Total equity = ($7,230 + $4,798) / ($6,568 + $10,300) = $12,028 / $16,868 = 0.71 7. D Times-interest-earned ratio = (Net income + Income tax expense + Interest expense) / Interest expense = ($8,107 + $2,563 + $210) / $210 = $10,880 / $210 = 52 times 8. A 9. B 10. D

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Extra Critical Thinking Questions Decision Case F:15-2 Gary’s Bicycles had a bad year in 20X4; the company suffered net losses. Due to the losses, some of the measures of return deteriorated. Assume top management of Gary’s Bicycles is pondering ways to improve its ratios for the following year. In particular, management is considering the following transactions: 1. Borrow $100 million on long-term debt.

2. Purchase treasury stock for $500 million cash.

3. Expense one-fourth of the goodwill carried on the books.

4. Create a new design division at a cash cost of $300 million.

5. Purchase patents from Johnson Co., paying $20 million cash.

Top management wants to know the effects of these transactions (increase, decrease, or no effect) on the following ratios: a. Current ratio b. Debt ratio c. Rate of return on common stockholders’ equity Decision Case F:15-2: Solution Transaction

1.

2.

3.

4.

5.

Current Ratio

Debt Ratio

Increase Decrease No effect Decrease Decrease

Decrease Increase Increase No effect No effect

Rate of Return on Common Stockholder’s Equity No effect Increase Decrease No effect No effect

Fraud Case F:15-1 Allen Software was a relatively new tech company led by aggressive founder Benjamin Allen. His strategy relied not so much on producing new products as using new equity capital to buy up other software companies. To keep attracting investors, Allen had to show year-to-year revenue growth. When his normal revenue streams stalled, he resorted to the tried-and-true “channel stuffing” technique. First, he improperly recorded shipments to his distributors as sales revenue; these shipments far exceeded the market demand for his products. Then he offered the distributors large payments to hold the excess inventory instead of returning it for a refund. Those payments were disguised as sales promotion expenses. He was able to show a considerable growth in revenues for two years running until one savvy investor group started asking questions. That led to a complaint filed with the SEC. The company is now in bankruptcy, and several criminal cases are pending.

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Requirements 1. What factor may have tipped off the investor group that something was wrong?

2. In what way would those investors have been harmed?

3. If Allen had attracted enough equity capital, do you think he would have been able to conceal the scheme?

Fraud Case F:15-1: Solution Requirement 1 The sales promotion expenses would have shown a very noticeable growth trend and attracted suspicion.

Furthermore, those expenses would have offset much of the bogus gross profit, so investors would have noticed an increase in revenues that was not matched by an increase in net income.

Requirement 2 Investors would have relied on the sales growth percentages in evaluating the company. Some may have invested based partially on that information. When the criminal complaint was filed, the stock price of the company would have dropped, hurting the investors. Once bankruptcy was declared, they would have lost most of the value of their investment.

Requirement 3 Allen may have been able to conceal the scheme if enough equity capital had been received; but once a trend of fraudulent activity is started, it tends to build on itself and become the culture of the business.

Communication Activity F:15-1 In 150 words or fewer, explain the difference between horizontal and vertical analysis. Be sure to include in your answer how each might be used.

Communication Activity F:15-1: Solution Horizontal analysis compares one year of financial statements to another. It allows a company to see the percentage change from one year to the next. The increase in sales can be compared to the increase in net income to see if they are increasing by the same percentage.

Vertical analysis of a financial statement shows the relationship of each item to its base amount, which is the 100% figure. Every other item on the statement is then reported as a percentage of that base. For the income statement, net sales revenue is the base. For the balance sheet, total assets is the base. A company can see what percentage of net sales revenue is being used for various expenses.

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Appendix B Accounting Information Systems

Appendix B: Overview The appendix introduces the student to accounting information systems (AIS) by identifying the characteristics of an effective AIS—control, compatibility, flexibility, relevance, and positive cost/benefit relationship. This first section concludes by detailing the three components of an accounting information system—source documents and input devices, processing and storage, and outputs.

The next section of the chapter describes how sales and cash receipts are recorded in a manual system.

Included is a discussion of special journals, subsidiary ledgers, the sales journal, and the cash receipts journal. The discussion then focuses on how purchases, cash payments, and other transactions are recorded in a manual system. This discussion includes the purchases journal, the cash payments journal, and the general journal.

The chapter concludes by discussing how transactions are recorded in a computerized accounting information system. Included is a discussion of software packages for small businesses and enterprise resource planning (ERP).

An Ethics feature focuses on proper accounting recording procedures. A Tying It All Together feature provides a real-world look at information technology systems at McCormick & Company, Incorporated.

The Review section includes Things You Should Know which highlights the information students should have acquired from the chapter. A Check Your Understanding problem provides students the opportunity to work with the cash receipts journal and accounts receivable subsidiary ledger. A list of Key Terms is provided. A Quick Check gives students a chance to assess their knowledge of the chapter learning objectives.

Appendix B: Learning Objectives LO 1. Describe an effective accounting information system LO 2. Journalize and post sales and cash receipts in a manual accounting information system using

special journals and subsidiary ledgers LO 3. Journalize and post purchases, cash payments, and other transactions in a manual accounting

information system using special journals and subsidiary ledgers LO 4. Describe how transactions are recorded in a computerized accounting information system

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Appendix B: Teaching Outline LO 1. Describe an effective accounting information system

a) Effective accounting information systems ▪

Exhibit B-1: Business Transactions and AIS Activities

b) Components of an accounting information system Lecture Notes: Most students have heard of software packages such as QuickBooks and SAP but are not familiar with what an accounting information system is. Start off the discussion by explaining that an accounting information system is any type of system that houses a company’s accounting data, such as QuickBooks, or a complex accounting software system like SAP. Point out that accounting information systems are commonly referred to as AIS. Explain that in order to have an effective accounting information system, a number of elements need to be present. Discuss the various elements, such as control, compatibility, flexibility, relevance, and a positive cost/benefit relationship. Point out that a positive cost/benefit relationship means the benefits received outweigh the costs. Use the element control as an example to illustrate the cost/benefit principle. Discuss with students the fact that an effective accounting information system has adequate internal controls in place to safeguard company and client information, and reduce errors and frauds.

Point out to students that a simple internal control, like passwords, helps protect an accounting information system from unauthorized users and is relatively inexpensive. The benefits of creating passwords exceed the cost of creating passwords. However, note that there are times when the benefits received do not outweigh the costs and, therefore, companies should not implement those controls.

Suggested In-Class Exercise: SB-2 LO 2. Journalize and post sales and cash receipts in a manual accounting information system using

special journals and subsidiary ledgers a) Special journals ▪

Exhibit B-2: Types of Special Journals

c) Subsidiary ledgers ▪

Exhibit B-3: Accounts Receivable Subsidiary Ledger

d) The sales journal ▪

Exhibit B-4: Sales Journal with Posting

e) The cash receipts journal

.

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▪

Exhibit B-5: Cash Receipts Journal with Posting

Lecture Notes: If a company has many similar transactions, it uses special accounting journals. This section presents special accounting journals related to sales to customers and receipts of cash: •

Sales journals record all sales a business makes to customers on account, which means no money changes hands between the company and the customer at the time of the sale. These transactions all require a debit to Accounts Receivables and a credit to Sales Revenue, including use of the Accounts Receivable subsidiary ledger.

•

Cash receipts journals record cash sales, customer payments on account, or interest and dividend receipts. These transactions all require a debit to Cash and credit to various commonly used accounts for which cash receipts are applicable.

Suggested In-Class Exercises: EB-14 and EB-15 LO 3. Journalize and post purchases, cash payments, and other transactions in a manual accounting

information system using special journals and subsidiary ledgers a) The purchases journal ▪

Exhibit B-6: Purchases Journal with Posting

b) The cash payments journal ▪

Exhibit B-7: Cash Payments Journal with Posting

c) The general journal ▪

Exhibit B-8: Recording Transactions in Special Journals

Lecture Notes: This section presents special accounting journals related to purchases from suppliers, payments of cash, and transactions not recorded in special journals: •

Purchases journals show purchases a company makes on account. These transactions all require a debit to Merchandise Inventory and a credit to Accounts Payable, including use of the Accounts Payable subsidiary ledger.

•

Cash disbursement journals show any payment the business makes using a form of cash. These entries include purchases transactions or payments on debt. These transactions all require a credit to Cash and debit to various commonly used accounts for which cash payments are applicable.

•

The general journal is used when transactions do not fit a special journal. Examples include adjusting entries and closing entries.

Suggested In-Class Exercises: EB-19 and EB-20 LO 4. Describe how transactions are recorded in a computerized accounting information system

.

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a) Accounting software for small businesses b) Enterprise resource planning (ERP) systems c) QuickBooks ▪

Exhibit B-9: QuickBooks Invoice

▪

Exhibit B-10: QuickBooks Bill

▪

Exhibit B-11: QuickBooks Income Statement

Lecture Notes: Point out that due to the increased availability of affordable computerized accounting information systems, more and more businesses are completing all of their accounting on computers.

Discuss the fact that small businesses often use QuickBooks or Sage 50 Accounting because they are relatively easy-to-use packages and require little knowledge of accounting or GAAP. Discuss the fact that larger companies often use enterprise resource planning (ERP) systems, like SAP and Oracle, which integrate all company data into a single database. Point out that while these systems are very costly to implement, they will, over time, reduce operating costs and help companies adjust to change. With a current business environment that changes rapidly, systems like this are helpful. Note that ERP systems aid in the audit function. Cloud computing has become a popular buzzword. Most students are probably familiar with “the cloud,” but it’s worth discussing for those who are not familiar with this concept.

Suggested In-Class Exercise: SB-13

.

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Appendix B: Handout for Student Notes LO 1. What is an accounting information system?

o Effective accounting information systems

▪ Control

▪ Compatibility

▪ Flexibility

▪ Relevance

▪ Positive cost/benefit relationship

o Components of an accounting information system

▪ Source documents and input devices

▪ Processing and storage

▪ Outputs

LO 2. How are sales and cash receipts recorded in a manual accounting information system?

o Special journals

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o Subsidiary ledgers

▪ Accounts receivable subsidiary ledger

▪ Accounts payable subsidiary ledger

o The sales journal

▪ Recording sales on account transactions

▪ Posting from the sales journal

o The cash receipts journal

▪ Recording cash receipt transactions

▪ Posting from the cash receipts journal

LO 3. How are purchases, cash payments, and other transactions recorded in a manual accounting

information system?

o The purchases journal

▪ Recording purchases on account transactions

▪ Posting from the purchases journal

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o The cash payments journal

▪ Recording cash payment transactions

▪ Posting from the cash payments journal

o The general journal

LO 4. How are accounting transactions recorded in a computerized accounting information system?

o Accounting software for small businesses

o Enterprise resource planning (ERP) systems

o QuickBooks

▪ Creating a sales invoice in QuickBooks

▪ Entering bills in QuickBooks

▪ Viewing financial statements in QuickBooks

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Appendix B: Student Chapter Summary LO 1. Describe an effective accounting information system

An accounting information system (AIS) collects, records, stores, and processes accounting data to produce information that is useful for decision makers. An effective accounting information system provides control, compatibility, flexibility, relevance, and a positive cost/benefit relationship. An accounting information system has three basic components: source documents and input devices, processing and storage, and outputs.

LO 2. Journalize and post sales and cash receipts in a manual accounting information system using

special journals and subsidiary ledgers In a manual system, businesses use special journals that are designed to record specific types of transactions. The four special journals and their uses are: • • • •

Sales journal—Records sales on account Cash receipts journal—Records cash receipts Purchases journal—Records purchases on account Cash payments journal—Records cash payments

Subsidiary ledgers are used to hold individual accounts that support a general ledger account. Two common subsidiary ledgers are the accounts receivable subsidiary ledger and the accounts payable subsidiary ledger. Credit sales are recorded in the sales journal, which uses two columns: Accounts Receivable DR, Sales Revenue CR and Cost of Goods Sold DR, Merchandise Inventory CR. Cash receipts are recorded in the cash receipts journal, which includes a Cash DR column and various other debit and credit columns.

LO 3. Journalize and post purchases, cash payments, and other transactions in a manual accounting

information system using special journals and subsidiary ledgers Purchases on account are recorded in the purchases journal, which includes an Accounts Payable CR column and various other debit columns. Cash payments are recorded in the cash payments journal, which includes a Cash CR column and various other debit and credit columns. The general journal is used for transactions that aren’t recorded in one of the special journals, such as adjusting and closing entries.

LO 4. Describe how transactions are recorded in a computerized accounting information system

A computerized accounting information system has two basic components: • •

Hardware—The electronic equipment Software—The set of programs that drives the computer

Two popular accounting software packages for small businesses are QuickBooks and Sage 50 Accounting. Larger companies use an enterprise resource planning (ERP) system to manage their data.

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Appendix B: Assignment Grid and Other Materials LO 1 SB-1 SB-2 SB-3 SB-4 SB-5 SB-6 SB-7 SB-8 SB-9 SB-10 SB-11 SB-12 SB-13 EB-14 EB-15 EB-16 EB-17 EB-18 EB-19 EB-20 EB-21 EB-22 EB-23 PB-24A, PB-27B PB-25A, PB-28B PB-26A, PB-29B

LO 2

LO 3

LO 4

X X X X X X X X X X X X X X X X X X

X X X

X X X X X X X X

S—Short Exercises (Easy) E—Exercises (Moderate) P—Problems (Difficult)

Other End-of-Chapter Materials: Continuing Problem B-1 Practice Set B-1 Comprehensive Problem for Appendix B Tying It All Together Case B-1 Decision Case B-1 Fraud Case B-1 Team Project B-1 Communication Activity B-1

.

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APPENDIX B TEN-MINUTE QUIZ Circle the letter of the best response.

1.

An accounting information system A. produces information that is useful for decision makers.

B. only collects information.

C. is common referred to as an IAS. D. A, B, and C are all correct.

2.

Which of the following is a component of an accounting information system?

A. Source documents and input devices B. Processing and storage C. Outputs D. A, B, and C are all correct.

3.

The two basic components of a computerized accounting information system are A. QuickBooks and software packages for small businesses.

B. software packages for small businesses and enterprise resource planning.

C. software and hardware.

D. cash basis and accrual basis.

4.

A positive cost/benefit relationship implies A. positive costs will be greater than positive benefits.

B. benefits received outweigh costs.

C. costs incurred outweigh benefits.

D. none of the above.

5.

What is an accounting information system activity for selling merchandise inventory?

A. Request for purchase of goods or services B. Approval of credit sales C. Collection of time records D. Processing of vendor invoices

6.

Which of the following characteristics of an effective accounting information system refers to improving decision making and reducing uncertainty?

A. Relevance B. Control C. Inputs D. Outputs

.

B-11

7.

Consider the following special journals: the purchases journal and the sales journal. Which of these special journals include transactions that are posted to the accounts payable subsidiary ledger?

A. Purchases journal B. Sales journal C. Both purchases journal and sales journal D. Neither purchases journal nor sales journal

8. Which type of transaction should be recorded in the cash receipts journal?

A. Accrual for interest on note payable B. Accrual for depreciation C. Payments to suppliers D. Payments from customers 9. Which component of accounting information systems involves journalizing transactions?

A. Source documents and input devices B. Processing and storage C. Outputs D. Enterprise resource planning 10. In computerized accounting information systems, A. transactions are classified by type.

B. special journals are used.

C. systems are organized by function or task.

D. A, B, and C are correct.

.

B-12

Answer Key to Ten-Minute Quiz: 1. A 2. D 3. C 4. B 5. B 6. A 7. A 8. D 9. B 10. C

.

B-13