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study guide for principles of

accounting Helen Brubeck

San Jose State University

Florence McGovern Bergen Community College

Upper Saddle River, New Jersey 07458

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Library of Congress Cataloging-in-Publication Data Pollard, Meg. Principles of accounting / Meg Pollard, Sherry K. Mills, Walter T. Harrison, Jr. p. cm. Includes index. ISBN 0-13-230479-1 (pbk. : alk. paper) 1.Accounting. 2. Managerial accounting. I. Mills, Sherry K. II. Harrison, Walter T. III. Title. HF5636.P65 2007 657—dc22 2006033723 Executive Editor: Jodi McPherson VP/Editorial Director: Jeff Shelstad Developmental Editors: Claire Hunter, Ralph Moore Executive Marketing Manager: Sharon Koch Marketing Assistant: Patrick Barbera Associate Director, Production Editorial: Judy Leale Production Editor: Michael Reynolds Permissions Supervisor: Charles Morris Manufacturing Manager: Arnold Vila Creative Director: Maria Lange Cover Design: Solid State Graphics Director, Image Resource Center: Melinda Patelli Manager, Rights and Permissions: Zina Arabia Manager, Visual Research: Beth Brenzel Manager, Cover Visual Research & Permissions: Karen Sanatar Image Permission Coordinator: Nancy Seise Photo Researcher: Vanessa Moore Manager, Print Production: Christy Mahon Composition/Full-Service Project Management: BookMasters, Inc Printer/Binder: RR Donnelley Typeface: New Century Schoolbook 10/12.5 Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on page PC-1. Copyright © 2007 by Pearson Education, Inc., Upper Saddle River, New Jersey, 07458. Pearson Prentice Hall. All rights reserved. Printed in the United States of America. This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. Pearson Prentice Hall™ is a trademark of Pearson Education, Inc. Pearson® is a registered trademark of Pearson plc Prentice Hall® is a registered trademark of Pearson Education, Inc. Pearson Education LTD. Pearson Education Singapore, Pte. Ltd Pearson Education, Canada, Ltd Pearson Education–Japan

Pearson Education Australia PTY, Limited Pearson Education North Asia Ltd Pearson Educación de Mexico, S.A. de C.V. Pearson Education Malaysia, Pte. Ltd

10 9 8 7 6 5 4 3 2 1 ISBN 0-13-179207-5

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Brief Contents CHAPTER 1

Accounting and the Business Environment 2

CHAPTER 15 Introduction to Management

CHAPTER 2

Recording Business Transactions 56

CHAPTER 16 Job Order Costing

CHAPTER 3

The Adjusting Process

CHAPTER 4

Completing the Accounting Cycle 178

Accounting

CHAPTER 17 Process Costing

124

Responsibility Accounting

CHAPTER 6

Internal Control and Cash

CHAPTER 7

Receivables

CHAPTER 8

Inventory

CHAPTER 9

Long-Term Assets: Plant Assets and Intangibles 468

292

CHAPTER 11 Corporations and Stockholders’

568

CHAPTER 14 Financial Statement

Analysis

746

CHAPTER 21 Special Decisions and Capital

1116

A-1

Appendix B: Accounting Information Systems and Special Journals B-1 Appendix C: Partnerships

C-1

Appendix D: Present Value and Future Value Tables D-1

520

688

1006

1066

Appendix A: Target Annual Report

CHAPTER 10 Current Liabilities and

Flows

Costs

Budgeting

404

CHAPTER 13 The Statement of Cash

956

CHAPTER 20 Flexible Budgets and Standard

348

CHAPTER 12 Long-Term Liabilities

896

CHAPTER 19 The Master Budget and

Accounting for a Retail Business 228

Equity

846

CHAPTER 18 Cost-Volume-Profit Analysis

CHAPTER 5

Payroll

800

Appendix E: Check Figures Photo Credits

624

Glindex

PC-1

G-1

Company Index

I-1

E-1

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Contents

1

Accounting and the Business Environment Business Organizations 4 Types of Business Organizations Forms of Business Organizations

2

4 4

Accounting and Accountability 5 Organization Accountability 6 Financial Accounting and Management Accounting Accounting Concepts and Principles The Entity Concept 8 The Reliability (Objectivity) Principle 8 The Cost Principle 8 The Going-Concern Concept 9

6

7

The Accounting Equation 9 Assets, Liabilities, and Owner’s Equity 9 Components of Owner’s Equity 10 Accounting for Business Transactions 11 Evaluating Business Transactions 16 Financial Statements 16 The Income Statement 16 The Statement of Owner’s Equity 19 The Balance Sheet 19 Statement of Cash Flows 20 Relationships Among the Financial Statements Ethical Decision Making 21 Ethics in Accounting and Business Standards of Professional Conduct

20

21 23

! Chapter 1 Demo Doc: Transaction Analysis Using the Accounting

Equation/Financial Statement Preparation

"

Accounting in Action

Review and Assignment Material

2

24

34

35

Recording Business Transactions

56

The Role of Accounts in Summarizing Business Transactions Transactions 58 Accounts 58 Assets 58 Liabilities 59 Owner’s Equity 59 Chart of Accounts 60 Double-Entry Accounting 60 Rules of Debits and Credits 61 T-Account 61 Normal Balance 3 Recording and Summarizing Business Transactions The Transaction Analysis 65

63

58

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Contents

Applying Transaction Analysis 66 Balancing the Accounts 76 Accounts After Posting to the Ledger Details of Journals and Ledgers 77 Posting 79 Four-Column Account 79

77

Trial Balance 80 Trial Balance Errors 80 Using the Trial Balance to Prepare Financial Statements ! Chapter 2 Demo Doc: Debit/Credit Transaction Analysis "


97


3

83

84


98

124

Measuring Business Income Using Accounting Principles Types of Adjusting Entries

126

127

Adjusting the Accounts 129 Deferrals 130 Accruals 136 Summary of the Adjusting Process The Adjusted Trial Balance

138

140

Preparing the Financial Statements 141 Relationships Between the Financial Statements

143

! Chapter 3 Demo Doc: Preparation of Adjusting Entries, Adjusted Trial Balance,

and Financial Statements

"


144

156


4

157

Completing the Accounting Cycle The Accounting Cycle The Worksheet

178

180

182

Completing the Accounting Cycle 185 Preparing the Financial Statements 186 Recording the Adjusting Entries 186 Closing the Accounts 186 The Four Closing Entries 190 Post-Closing Trial Balance 194 Classifying Assets and Liabilities Assets 195 Liabilities 195 A Classified Balance Sheet 195

194

! Chapter 4 Demo Doc: Preparing Closing Entries "


203


5

197

204

Accounting for a Retail Business The Supply Chain 230 The Supplier/Retailer Relationship 230 Retail Inventory Systems 232 The Retailer/Customer Relationship 233

228

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Accounting for the Supplier/Retailer Relationship Cash and Credit Purchases 234 Purchase Discounts 234 Purchase Returns and Allowances 236

233

Accounting for the Retailer/Customer Relationship 237 Cash Sales 237 Credit Sales 239 Sales Discounts to Other Businesses—The Supplier’s Perspective 239 Sales Returns and Allowances 240 Accounting for Delivery and Other Selling Expenses Costs to Receive Goods from Suppliers 243 Costs to Deliver Goods to Customers 245 Other Selling Costs 247 Preparing a Retailer’s Financial Statements Income Statement 248 Statement of Owner’s Equity 250 Balance Sheet 251 Two Key Ratios for Decision Making The Gross Profit Percentage 251 The Rate of Inventory Turnover 251

242

248

251

! Chapter 5 Demo Doc: Inventory Transaction Analysis (Perpetual System) "


259


6


260

292

Fraud in Business 294 The Fraud Triangle 294 Fraud 295 Organization Accountability for Fraud Objectives of Internal Control 297 Control Activities 297 Accountability for Internal Control 299 Limitations of Internal Control 300

297

Internal Control for Cash 300 Internal Control over Cash Receipts 300 Internal Controls over Cash Payments 301 The Bank Account 303 Preparing the Bank Reconciliation 304 Online Banking 310 Petty Cash 311 Setting Up the Petty Cash Fund 311 Replenishing the Petty Cash Fund 312 Changing the Petty Cash Fund 313 Reporting Cash on the Balance Sheet ! Chapter 6 Demo Doc: Bank Reconciliations "


324


7

Receivables

348

Sales and Receivables 350 Types of Sales 350 Types of Receivables 353

326

313 315

253

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Internal Control over Receivables 355 Managing the Collection of Receivables 355

The Direct Write-Off Method

356

The Allowance Method 357 Estimating Uncollectibles 358 Notes Receivable 363 Overview 363 Accounting for Notes Receivable 365 Accruing Interest Revenue 367 Dishonored Notes Receivable 368 More Ratios for Decision Making Quick Ratio 369 Days’ Sales in Receivables 370

369

! Chapter 7 Demo Doc: Bank Reconciliations "



8

Inventory

372

379

380

404

Inventory 406 Types of Inventory 406 Inventory Shrinkage 407 Internal Controls over Inventory

407

Inventory Costing Methods 409 Inventory Cost Flows 409 First-In, First-Out (FIFO) Method 412 Last-In, First-Out (LIFO) Method 413 Average Cost Method 415 Journalizing Inventory Transactions 416 Comparing FIFO, LIFO, and Average Cost

417

Valuing Inventory Using Lower-of-Cost-or-Market (LCM)

418

Reporting Inventory on the Balance Sheet 419 Financial Statement Presentation of Inventory 420 Effects of Inventory Errors 421 Using the Gross Profit Method to Estimate Ending Inventory ! Chapter 8 Demo Doc: Inventory Costing "


441


9

442

Long-Term Assets: Plant Assets and Intangibles Long-Term Assets

423

425

470

Measuring the Cost of Plant Assets 472 Land and Land Improvements 473 Buildings, Equipment, Machinery, Furniture, and Fixtures A Lump-Sum (Basket) Purchase of Assets 474 Capital Expenditures 474 Measuring Plant Asset Depreciation 476 Depreciation Methods 477 Comparing Depreciation Methods 480 Other Issues in Accounting for Plant Assets 481 Disposing of a Plant Asset Selling a Plant Asset 485

483

473

468

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Contents

Exchanging Plant Assets 486 Retiring a Plant Asset 486

Accounting for Natural Resources Accounting for Intangible Assets Patents 488 Copyrights 489 Trademarks and Trade Names 489 Franchises and Licenses 489 Goodwill 489

487 488

Presenting Long-Term Assets on the Balance Sheet

490

! Chapter 9 Demo Doc: Depreciation and Disposal of Depreciable Assets "


500


10

501

Current Liabilities and Payroll

520

Current Liabilities of Known Amount 522 Accounts Payable 522 Short-Term Notes Payable and Interest Payable 523 Sales Tax Payable 524 Current Portion of Long-Term Notes Payable 525 Accrued Expenses 526 Unearned Revenues 526 Estimated and Contingent Liabilities Estimated Warranty Payable 527 Contingent Liabilities 528 More Ratios for Decision Making

527

529

Accounting for Payroll 531 Gross Pay and Net Pay 531 Employee Payroll Deductions 532 Optional Deductions 533 Employer Payroll Taxes 533 Other Payroll Considerations 534 The Payroll Process 534 Payroll Register 536 Payroll Checks 536 Employee Earnings Record 537 Internal Control over Payroll 537 Payroll Entries 539 Record Employee Compensation 539 Record Employer Payroll Taxes and Contributions to Employee Benefits 539 Record Payments of Compensation, Taxes, and Benefits 540 Reporting Current Liabilities

541

! Chapter 10 Demo Doc: Known and Estimated Current Liabilities "

11


548


549

Corporations and Stockholders’ Equity Forms of Business Organizations Corporations: An Overview Organizing a Corporation 572 Stockholders’ Equity 573

571

570

568

543

492

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Contents

Classes of Stock 574 Stockholders’ Equity Transactions: An Overview

575

Issuing Stock 576 Issuing Common Stock 576 Issuing Preferred Stock 578 Accounting for Cash Dividends 579 Dividend Dates 579 Dividends on Preferred and Common Stock 579 Dividends on Cumulative and Noncumulative Preferred Stock

581

Stock Dividends and Stock Splits 582 Stock Dividends 583 Stock Splits 584 Comparison of Cash Dividends, Stock Dividends, and Stock Splits

584

Treasury Stock 585 Purchase of Treasury Stock 585 Sale of Treasury Stock 587 Reporting Stockholders’ Equity 588 Stockholders’ Equity Section of the Balance Sheet Statement of Stockholders’ Equity 590 ! Chapter 11 Demo Doc: Equity Transactions "


591

597


12

588

Long-Term Liabilities

599

624

Long-Term Liabilities: Mortgages and Leases Mortgage Note Payable 626 Lease Liabilities 628

626

Bonds Payable 630 Types of Bonds 631 Present Value 632 Bond Interest Rates 633 Bond Prices 634 Issuing Bonds Payable and Paying Interest Issuing Bonds Payable at Maturity Value 635 Issuing Bonds Payable at a Discount 635 Issuing Bonds Payable at a Premium 637 Adjusting Entries for Interest Expense 640

635

Retirement of Bonds 641 Redeeming Bonds at Maturity 641 Early Retirement of Bonds Payable 642 Reporting Liabilities on the Balance Sheet ! Chapter 12 Demo Doc: Bonds Payable "


643

644

649


650

CHAPTER APPENDIX 12A: Time Value of Money: Future Value and Present Value 671 CHAPTER APPENDIX 12B: Effective-Interest Method 681

13

The Statement of Cash Flows

688

Basic Concepts: Statement of Cash Flows

690

Operating, Investing, and Financing Activities Two Formats for Operating Activities 692

691

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Contents

Noncash Investing and Financing Activities

692

Preparing the Statement of Cash Flows by the Indirect Method Cash Flows from Operating Activities 696 Cash Flows from Investing Activities 697 Cash Flows from Financing Activities 698 Noncash Investing and Financing Activities 701

693

Preparing the Statement of Cash Flows by the Direct Method Cash Flows from Operating Activities 704

702

! Chapter 13 Demo Doc: Preparing the Statement of Cash Flows Using the Indirect

Method

"

708


718


14

719

Financial Statement Analysis

746

Purpose of Financial Statement Analysis

748

Horizontal Analysis 749 Trend Percentages 751 Vertical Analysis 752 How Do We Compare One Company with Another? Using Ratios to Make Decisions Liquidity Ratios 756 Profitability Ratios 758 Asset Utilization Ratios 760 Debt Utilization Ratios 761 Analyzing Stock Investments 762 Economic Value Added

756

763

Analyzing Nonfinancial Data 764 President’s Letter to the Stockholders 765 Management Discussion and Analysis (MD&A) Auditor Report 765

765

! Chapter 14 Demo Doc: Horizontal and Vertical Analysis "


766

773


15

753

775

Introduction to Management Accounting Management Accountability Today’s Business Environment

800

802 805

Service Companies, Merchandising Companies, and Manufacturing Companies 806 Merchandising Companies 807 Manufacturing Companies 808 Ethical Standards

814

! Chapter 15 Demo Doc: Introduction to Management Accounting "


822


16

Job Order Costing

816

824

846

How Much Does It Cost to Make a Product? Two Approaches Job Order Costing for Manufacturing Products 849 Job Order Costing: Accounting for Materials and Labor 850

848

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Contents Contents

Job Order Costing: Allocating Manufacturing Overhead Allocating Manufacturing Overhead to Jobs 855

854

Accounting for Completion and Sale of Finished Goods and Adjusting Manufacturing Overhead 858 Accounting for the Completion and Sale of Finished Goods 858 Adjusting Underallocated or Overallocated Manufacturing Overhead at the End of the Period 859 Overview of Job Order Costing in a Manufacturing Company 861 Job Order Costing in a Service Company 862 ! Chapter 16 Demo Doc: Job Order Costing for Manufacturers "



17

Process Costing

865

869

871

896

Process Costing: An Overview 898 Two Basic Costing Systems: Job Order Costing and Process Costing 898 How Does the Flow of Costs Differ Between Job and Process Costing? 899 Building Blocks of Process Costing Conversion Costs 902 Equivalent Units of Production 902

901

Process Costing in the First Department with No Beginning Inventory 903 Step 1: Summarize the Flow of Physical Units 905 Step 2: Compute Output in Terms of Equivalent Units 906 Step 3: Compute the Cost per Equivalent Unit 907 Step 4: Assign Costs to Units Completed and to Units in Ending Work in Process Inventory 908 Process Costing in a Second Department 910 The Weighted-Average Process Costing Method 910 Steps 1 and 2: Summarize the Flow of Physical Units and Compute Output in Terms of Equivalent Units 912 Step 3: Summarize Total Costs to Account For and Compute the Cost per Equivalent Unit 913 Step 4: Assign Total Costs to Units Completed and to Units in Ending Work in Process Inventory 914 How Managers Use a Production Cost Report 916 ! Chapter 17 Demo Doc: Weighted-Average Process Costing "


918

923


925

CHAPTER APPENDIX 17A: The FIFO Process Costing Method 946

18

Cost-Volume-Profit Analysis

956

Cost Behavior 958 Variable Costs 958 Fixed Costs 959 Mixed Costs 960 High-Low Method to Separate Fixed Cost from Variable Cost Relevant Range 962

961

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Contents

Basic CVP Analysis: What Must We Sell to Break Even? 963 Assumptions 963 How Much Must Chan Sell to Break Even? Three Approaches 964 Using CVP to Plan Profits 967 How Much Must Chan Sell to Earn a Profit? 967 Graphing Cost-Volume-Profit Relations 967 Using CVP for Sensitivity Analysis 969 Changing the Selling Price 970 Changing Variable Costs 970 Changing Fixed Costs 970 Margin of Safety 971 Information Technology and Sensitivity Analysis Effect of Sales Mix on CVP Analysis

972

! Chapter 18 Demo Doc: Using CVP to Plan Profits "


975

982


19

972

984

CHAPTER APPENDIX 18A: Variable Costing and Absorption Costing

1001

The Master Budget and Responsibility Accounting

1006

Why Managers Use Budgets 1008 Using Budgets to Plan and Control 1008 The Benefits of Budgeting 1009 Preparing the Master Budget Components of the Master Budget

1011 1011

Preparing the Operating Budget 1016 The Sales Budget 1014 The Inventory, Purchases, and Cost of Goods Sold Budget The Operating Expenses Budget 1016 The Budgeted Income Statement 1016

1015

Preparing the Financial Budget 1017 Preparing the Cash Budget 1017 The Budgeted Balance Sheet 1021 Getting Employees to Accept the Budget 1022 Using Information Technology for Sensitivity Analysis and Rolling Up Unit Budgets 1023 Sensitivity Analysis 1024 Rolling Up Individual Unit Budgets into the Companywide Budget 1024 Responsibility Accounting 1025 Four Types of Responsibility Centers 1025 Responsibility Accounting Performance Reports ! Chapter 19 Demo Doc: Master Budget "


1027

1030

1037


1038

CHAPTER APPENDIX 19A: Departmental Accounting

20

Flexible Budgets and Standard Costs How Managers Use Flexible Budgets What Is a Flexible Budget? 1068

1068

1059

1066

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Contents

Using the Flexible Budget

1070

Standard Costing 1072 Price Standards 1072 Application 1072 Quantity Standards 1074 Why Do Companies Use Standard Costs? Variance Analysis 1075

1074

How Pluto Uses Standard Costing: Analyzing the Flexible Budget Variance 1076 Direct Material Variances 1076 Direct Labor Variances 1079 Manufacturing Overhead Variances 1080 Allocating Overhead in a Standard Cost System 1081 Overhead Flexible Budget Variance 1082 Production Volume Variance 1083 Summary of Overhead Variances 1083 Standard Cost Accounting Systems 1083 Journal Entries 1083 Standard Cost Income Statement for Management

1085

! Chapter 20 Demo Doc: Flexible Budgets and Income Statement Performance

Report

"

1088


1095


21

1097

Special Decisions and Capital Budgeting

1116

Relevant Information 1118 How Managers Make Decisions 1118 What Information Is Relevant to a Special Business Decision?

1118

How to Make Short-Term Special Decisions 1119 Special Sales Order Decision 1120 Dropping a Business Segment (a Product, a Department, or a Territory) 1122 Product Mix: Which Product to Emphasize 1124 Outsourcing (Make or Buy) Decisions 1125 Sell As-Is or Process Further? 1127 How Do Short-Term and Long-Term Special Decisions Differ?

1128

Using Payback and Accounting Rate of Return to Make Capital Budgeting Decisions 1129 Payback Period 1129 Accounting Rate of Return 1131 Using Discounted Cash-Flow Models to Make Capital Budgeting Decisions 1133 Net Present Value 1133 Internal Rate of Return 1137 Comparing Capital Budgeting Methods ! Chapter 21 Demo Doc: Special Business Decisions "


1138 1139

1144


1146

Appendix A: Target Annual Report

A-1

Appendix B: Accounting Information Systems and Special Journals B-1

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Contents

Appendix C: Partnerships

C-1

Appendix D: Present Value and Future Value Tables Appendix E: Check Figures Photo Credits Glindex

PC-1

G-1

Company Index

I-1

E-1

D-1

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The Principles of Accounting Demo Doc System: For professors whose greatest joy is hearing students say “I get it!”

Help your students achieve “I get it!” moments when you’re with them AND when you’re NOT.


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When you’re there showing how to solve a problem in class, students “get it.” When you’re not there, they get stuck—it’s only natural. Our system is designed to help you deliver the best “I get it!” moments. (Instructor’s Edition, Instructor Demo Docs) But it’s the really tricky situations that no one else has zeroed in on— the 2 A.M. outside-of-class moments, when you’re not there—that present the greatest challenge. That’s where we come in: at these critical “they have the book, but they don’t have you” moments. Principles of Accounting’s Demo Doc System will help in those critical times. The ability of the Horngren System to help in those times is what makes this package different from all other textbooks.


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The Principles of Accounting Demo Doc System Duplicate the classroom experience anytime, anywhere. When is your “I get it!” moment?

1

THE FIRST EDITION 1. A system of instruction that duplicates the classroom experience anytime, anywhere. 2. Demo Docs: entire problems worked through step-by-step from start to finish with the kind of comments around it that YOU would say in class. Available in Flash and in print. 3. A “no clutter” layout, so critical content is clear. 4. Consistency of voice and visual exhibits across all mediums. 5. MyAccountingLab Online Homework and Assessment tool: Marry the “I get it!” moment with the Power of Practice. 6. Your “I get it!” moment on your time.

Details 1. CHAPTERS 1–4 We know it’s critical that students nail the fundamentals and language before they can move to practice. We’re spending extra time developing the accounting cycle chapters (Chs 1-4) to make sure they will help students succeed. We’re including extra visuals, comprehensive problems, and a Demo Doc for every chapter to give students enough to go on. 2. THE ULTIMATE SYSTEM: FUELED BY DEMO DOCS–This is the System of Learning (Text + Study Guide with Demo Docs + MyAccountingLab). ! NEW DEMO DOCS – Introductory

accounting students consistently tell us, Demo Doc “When doing homework, I get stuck trying Debit/Credit Transaction Analysis to solve problems the way they were demonstrated in class.” Instructors consistently tell us, “I have so much to cover in so little time; I can’t afford to go backward and review homework in class.” Those challenges inspired us to develop Demo Docs. Demo Docs are comprehensive worked-through problems available for every chapter of our introductory accounting text to help students when they are trying to solve exercises and problems on their own.

Demo Doc: To make sure you understand this material, work through the following demonstration "demo doc" with detailed comments to help you see the concept within the framework of a worked through problem. Learning Objectives

1–3

On September 1, 2008, Michael Moe opened Moe’s Mowing, a company that provides mowing and landscaping services. During the month of September, the business incurred the following transactions: a. To begin operations, Michael deposited $10,000 of personal funds in the business’s bank account. The business received the cash and gave Michael an ownership interest. b. Purchased equipment for $3,500 on account. c. Purchased office supplies for $800 cash.

d. Provided $2,600 of services to a customer on account.

e. Paid $500 cash toward the equipment previously purchased on account in transaction b. f. Received $2,000 in cash for services provided to a new customer.

g. Paid $200 cash to repair equipment. h. Paid $900 cash in salary expense.

i. Received $2,100 cash from customers on account.

j. Michael withdrew $1,500 cash from the business for personal use.

Requirements

1. Create blank T-accounts for the following accounts:

The idea is—help students duplicate the classroom experience outside of class.

Cash, 111; Accounts Receivable, 121; Supplies, 131; Equipment, 141; Accounts Payable, 211; Michael Moe, Capital, 311; Michael Moe, Withdrawals, 312; Service Revenue, 411; Salary Expense, 511; and Repairs Expense, 521. 2. Journalize the transactions and show how they are posted in T-accounts. 3 Total all the T accounts to determine their balances at the end of the month


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Entire problems that mirror the end-of-chapter material are shown solved and annotated with explanations written in a conversational style, essentially imitating what an instructor might say if standing over a student’s shoulder. All Demo Docs will be available online in Flash and in print so students can easily refer to them when they need them. 3. CONSISTENCY – The small, incremental stuff matters. Consistency in form, function, and language. From medium to medium. So when students ask “Where do the numbers come from?” they can go to our text OR go online and know what to do. If it’s worded one way here, it’s worded the same way there. In the case where alternate terms could be used, we reference them in the definition at the end of the chapter for students so they “get it.” It looks one way here, it looks the same way there. 4. CLUTTER-FREE – We’re getting rid of clutter. Less is more. Extraneous boxes and features, non-essential bells and whistles…gone. Too much excess crowds out what really matters—the concepts, the problems, the learning objectives. Instructors asked for fewer ”features“ in favor of more exercises with better cross referencing. So, that's what we’ve done. Based on feedback, important items such as ethics and business cases are now located as part of the end of chapter materials so that the student can follow the sequence of learning accounting uninterrupted. Exhibit 2-9

Trial Balance for Kay Torres Travel Agency KAY TORRES TRAVEL AGENCY Trial Balance June 30, 2008

1 2 3 4 5 6 7 8 9 10 11 12 13

Account Title Cash Accounts receivable Supplies Equipment Accounts payable Notes payable Kay Torres, Capital Kay Torres, Withdrawals Service revenue Building rent expense Salary expense Utilities expense Total

Balance Debit Credit Financial Statement Preparation $24,400 5,200 1,200 9,000 $ 600 15,000 Balance 20,000 Sheet 1,000 7,500 Statement of Income 900 Owner’s Equity Statement 1,100 300 $43,100 $43,100

Trial Balance Errors When recording and posting transactions, accounting errors can—and do—occur in both manual and computerized accounting systems. The trial balance helps us find those errors that cause total debits and total credits to be unequal. To find an error, you start with the trial balance and work back through the accounting records—through the ledger and through the journal—to the transaction. Errors can occur in the following activities: • Preparing the trial balance • Calculating account balances


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5. MyAccountingLab – This online homework and assessment tool represents when the “I get it!” moment meets the power of practice. The power of repetition, when you get it, means that learning happens. MyAccountingLab is about helping students at their teachable moment, whether that is 1 P.M. or 1 A.M., but whenever you are not there. MyAccountingLab is packed with algorithmic problems because practice makes perfect. It’s also packed with the exact same end-of-chapter material that you’re used to assigning for homework. It includes a Demo Doc for each of the end-of-chapter exercises and problems that students can refer to as they work through the question. It helps students when it’s 1 A.M., and they’re trying to solve a problem the way it was demonstrated in class.

6. Your “I get it!” moment on your time.


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INSTRUCTOR SUPPLEMENTS Instructor’s Edition featuring Instructor Demo Docs ! The New Look Instructor’s Edition

We’ve asked a lot of instructors how we can help them successfully implement new course-delivery methods (e.g. online) while maintaining their regular campus schedule of classes and academic responsibilities. In response, we developed a system of instruction for those of you who are long on commitment and expertise—but short on time and assistance. The primary goal of the Instructor’s Edition is ease of implementation, using any delivery method— traditional, self-paced, or online. That is, the Instructor’s Edition quickly answers for you, the professor, the question “What must the student do?” Likewise, the Instructor’s Edition quickly answers for the student, “What must I do?”, and offers time saving tips with “best of” categories for in class discussion and strong examples to illustrate difficult concepts to a wide variety of students. The Instructor’s Edition also offers a quick one-shot cross reference at the exact point of importance with key additional teaching resources, so everything is in one place. The Instructor’s Edition includes summaries and teaching tips, pitfalls for new students, and “best of” practices from instructors from across the world. ! The Instructor’s Edition also includes Instructor Demo Docs

In Instructor Demo Docs, we walk the students through how to solve a problem, as if it were the first time they’ve seen it. There are no lengthy passages of text. Instead, bits of expository text are woven into the steps needed to solve the problem, in the exact sequence—for you to provide at the teachable “I get it!” moment. This is the point at which the student has a context within which he or she can understand the concept. We provide conversational text around each of the steps so the student stays engaged in solving the problem. We provide notes to the instructor for key teaching points around the Demo Docs, and “best of” practice tid-bits before each Instructor Demo Doc. The Instructor Demo Docs are written with all of your everyday classroom realities in mind—and trying to save your time in prepping new examples each time your book changes. Additionally, algorithmic versions of these Demo Docs are provided to students in their student guide. We keep the terminology consistent with the text, so there are no surprises for students as they try and work through a problem the first time.

Solutions Transparencies These transparency masters are the Solutions Manual in an easy-to-use format for class lectures.

Instructor’s Resource Center CD or www.prenhall.com The password protected site and resource CD includes the following: "

The Instructor’s Edition with Instructor Demo Docs

"

Problem Set C


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Solutions Manual with Interactive Excel Solutions The Solutions Manual contains solutions to all end-of-chapter questions, multiple-choice questions, short exercises, exercise sets, problems sets, and Internet exercises. The Solutions Manual is available in Microsoft Excel, Microsoft Word, and in print. You can access the solutions in MS Excel and MS Word formats by visiting the Instructor’s Resource Center on the Prentice Hall catalog site at www.prenhall.com or on the Instructor’s CD. You will need a Pearson Educator username and password to retrieve materials from the Web site. Solutions to select end-of-chapter exercises and problems are available in interactive MS Excel format so that instructors can present material in dynamic, step-by-step sequences in class. The interactive solutions were prepared by Kathleen O’Donnell of the State University of New York, Onondaga Community College.

"

" "

Test BankThe test item file includes more than 2,000 questions: #

Multiple Choice

#

Matching

#

True/False

#

Computational Problems

#

Essay

Test Bank is formatted for use with WebCT, Blackboard, and Course Compass. PowerPoints (instructor and student) summarize and reinforce key text materials. They capture classroom attention with original problems and solved step-by-step exercises. These walk-throughs are designed to help faciliate classroom discussion and demonstrate where the numbers come from and what they mean to the concept at hand. There are approximately 35 slides per chapter. PowerPoints are available on the Instructor’s CD and can be downloaded from www.prenhall.com.

MyAccountingLab Online Homework and Assessment Manager The “I get it” moment meets power of practice. The power of repetition when you “get it” means learning happens. MyAccountingLab is about helping students at their teachable moments, whether it’s 1 P.M. or 1 A.M. MyAccountingLab is an online homework and assessment tool, packed with algorithmic versions of every text problem since practice makes perfect. It’s also packed with the exact same end of chapter that you’re used to assigning for homework. Additionally, MyAccountingLab includes: 1. A Demo Doc for each of the end-of-chapter exercises and problems that students can refer to as they work through the question. 2. A Guided Solution to the exact problem they are working on. It helps students when they’re trying to solve a problem the way it was demonstrated in class. 3. A full e-book so the students can reference the book at the point of practice. 4. New topic specific videos that walk students through difficult concepts.


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Companion Web Site The book’s Web site at www.prenhall.com/pollard—contains the following: " "

"

Self-study quizzes—interactive study guide for each chapter MS Excel templates that students can use to complete homework assignments for each chapter (e-working papers) Samples of the Flash Demo Docs for students to work through the accounting cycle

Online Courses with WebCT/BlackBoard Prentice Hall offers a link to MyAccountingLab through the Bb and WebCT Course Management Systems.

Classroom Response Systems (CRS) CRS is an exciting new wireless polling technology that makes large and small classrooms even more interactive, because it enables instructors to pose questions to their students, record results, and display those results instantly. Students can easily answer questions using compact remote control–type transmitters. Prentice Hall has partnerships with leading classroom response-systems providers and can show you everything you need to know about setting up and using a CRS system. Prentice Hall will provide the classroom hardware, text-specific PowerPoint slides, software, and support. Visit www.prenhall.com/crs to learn more.

STUDENT SUPPLEMENTS Runners Corporation PT Lab Manual Containing numerous simulated real-world examples, the Runners Corporation practice set is available complete with data files for Peachtree, QuickBooks, and PH General Ledger. Each practice set also includes business stationery for manual entry work.

A-1 Photography-Manual PT Lab Manual Containing numerous simulated real-world examples, the A-1 Photography practice set is available complete with data files for Peachtree, QuickBooks, and PH General Ledger. Each set includes business stationery for manual entry work.

Study Guide including DEMO DOCS and e-Working Papers Introductory accounting students consistently tell us, “When doing homework, I get stuck trying to solve problems the way they were demonstrated in class.” Instructors consistently tell us, “I have so much to cover in so little time; I can’t afford to go backwards and review homework in class.” Those challenges inspired us to develop Demo Docs. Demo Docs are comprehensive worked-through problems available for nearly every chapter of our introductory accounting text to help students when they are trying to solve exercises and problems on their own. The idea is to help students duplicate the


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classroom experience outside of class. Entire problems that mirror end-of-chapter material are shown solved and annotated with explanations written in a conversational style, essentially imitating what an instructor might say if standing over a student's shoulder. All Demo Docs will be available in the Study Guide—in print and on CD in Flash, so students can easily refer to them when they need them. The Study Guide also includes a summary overview of key topics and multiple-choice and short-answer questions for students to test their knowledge. Free electronic working papers are included on the accompanying CD.

MyAccountingLab Online Homework and Assessment Manager The “I get it!” moment meets power of practice. The power of repetition when you get it; means that learning happens. MyAccountingLab is about helping students at their teachable moment, whether that is 1 P.M. or 1 A.M. MyAccountingLab is an online homework and assessment tool, packed with algorithmic versions of every text problem because practice makes perfect. It’s also packed with the exact same end-of-chapter that you’re used to assigning for homework. Additionally, MyAccountingLab includes: 1. A Demo Doc for each of the end-of-chapter exercises and problems that students can refer to as they work through the question. 2. A Guided Solution to the exact problem they are working on. It helps students when they’re trying to solve a problem the way it was demonstrated in class. 3. A full e-book so the students can reference the book at the point of practice. 4. New topic specific videos that walk students through difficult concepts.

PowerPoints For student use as a study aide or note-taking guide, these PowerPoint slides may be downloaded at the Companion Web site at www.prenhall.com/pollard.

Companion Web Site – www.prenhall.com/pollard The book’s Web site at www.prenhall.com/pollard—contains the following: " "

"

Self-study quizzes—interactive study guide for each chapter MS Excel templates that students can use to complete homework assignments for each chapter (e-working papers) Samples of the Flash Demo Docs for students to work through the accounting cycle.

Classroom Response Systems (CRS) CRS is an exciting new wireless polling technology that makes large and small classrooms even more interactive because it enables instructors to pose questions to their students, record results, and display those results instantly. Students can easily answer questions using compact remotecontrol–type transmitters. Prentice Hall has partnerships with leading classroom response-systems providers and can show you everything you need to know about setting up and using a CRS system. Prentice Hall will provide the classroom hardware, text-specific PowerPoint slides, software, and support. Visit www.prenhall.com/crs to learn more.


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• VangoNotes in MP3 Format Students can study on the go with VangoNotes, chapter reviews in downloadable MP3 format that offer brief audio segments for each chapter: #

Big Ideas: the vital ideas in each chapter

#

Practice Test: lets students know if they need to keep studying

#

Key Terms: audio “flashcards” that review key concepts and terms

#

Rapid Review: a quick drill session—helpful right before tests

Students can learn more at www.vangonotes.com


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Acknowledgments We’d like to thank the following contributors: Florence McGovern Bergen Community College Helen Brubeck San Jose State University

Suzanne Oliver Okaloosa Walton College Bill Smith New Mexico State University

We’d like to extend a special thank-you to the following members of our advisory panel: Laurel Berry Bryant and Stratton College Jerry Millier Chaparral College Kathy Hepner Central Pennsylvania College Trisha King Colorado Technical University Karen Wisniewski County College of Morris Michael Stamos Devry University

Patty Holmes DMACC Georgia Buckles Manchester Community College Bill Smith New Mexico State University Jane Konditi Northwood University Barbara Pughsley South University Jay Siegel Union County College

We’d also like to thank the following reviewers:

Joseph Adamo Cazenovia College Julie Dailey Central Virginia Community College Jeannie Folk College of DuPage Lawrence Steiner College of Marin Dennis Kovach Community College Allegheny County Allegheny Norma Montague Central Carolina Community College Debbie Schmidt Cerritos College Janet Grange Chicago State University Bruce Leung City College of San Francisco Pamela Legner College of DuPage Bruce McMurrey Community College of Denver Martin Sabo Community College of Denver Jeffrey Jones Community College of Southern Nevada Tom Nohl Community College of Southern Nevada Christopher Kelly Community College of Southern Nevada Patrick Rogan Cosumnes River College Kimberly Smith County College of Morris

Shi-Mu (Simon)Yang Adelphi University Thomas Stolberg Alfred State University Thomas Branton Alvin Community College Maria Lehoczky American Intercontinental University Suzanne Bradford Angelina College Judy Lewis Angelo State University Roy Carson Anne Arundel Community College Paulette Ratliff-Miller Arkansas State University Joseph Foley Assumption College Jennifer Niece Assumption College Bill Whitley Athens State University Shelly Gardner Augustana College Becky Jones Baylor University Betsy Willis Baylor University Michael Robinson Baylor University Kay Walker-Hauser Beaufort County Community College, Washington Joe Aubert Bemidji State University Florence McGovern Bergen Community College Calvin Fink Bethune Cookman College Michael Blue Bloomsburg University Scott Wallace Blue Mountain College Lloyd Carroll Borough Manhattan Community College Ken Duffe Brookdale Community College Chuck Heuser Brookdale Community College Shafi Ullah Broward Community College South Lois Slutsky Broward Community College South Ken Koerber Bucks County Community College Julie Browning California Baptist University Richard Savich California State University – San Bernardino David Bland Cape Fear Community College Robert Porter Cape Fear Community College Vickie Campbell Cape Fear Community College Cynthia Thompson Carl Sandburg College – Carthage Liz Ott Casper College

Jerold Braun Daytona Beach Community College Greg Carlton Davidson County Community College Irene Bembenista Davenport University Thomas Szczurek Delaware County Community College Charles Betts Delaware Technical and Community College Patty Holmes Des Moines Area Community College – Ankeny Tim Murphy Diablo Valley College Phillipe Sammour Eastern Michigan University Saturnino (Nino) Gonzales El Paso Community College Lee Cannell El Paso Community College John Eagan Erie Community College Ron O’Brien Fayetteville Technical Community College Patrick McNabb Ferris State University John Stancil Florida Southern College Lynn Clements Florida Southern College


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Alice Sineath Forsyth Technical Community College James Makofske Fresno City College Marc Haskell Fresno City College James Kelly Ft. Lauderdale City College Christine Jonick Gainesville State College Bruce Lindsey Genesee Community College Constance Hylton George Mason University Cody King Georgia Southwestern State University Lolita Keck Globe College Kay Carnes Gonzaga University, Spokane Carol Pace Grayson County College Rebecca Floor Greenville Technical College Geoffrey Heriot Greenville Technical College Jeffrey Patterson Grove City College Lanny Nelms Gwinnet Technical College Chris Cusatis Gwynedd Mercy College Tim Griffin Hillsborough Community College Clair Helms Hinds Community College Michelle Powell Holmes Community College Greg Bischoff Houston Community College Donald Bond Houston Community College Marina Grau Houston Community College Carolyn Fitzmorris Hutchinson Community College Susan Koepke Illinois Valley Community College William Alexander Indian Hills Community College – Ottumwa Dale Bolduc Intercoast College Thomas Carr International College of Naples Lecia Berven Iowa Lakes Community College Nancy Schendel Iowa Lakes Community College Michelle Cannon Ivy Tech Vicki White Ivy Tech Chuck Smith Iowa Western Community College Stephen Christian Jackson Community College DeeDee Daughtry Johnston Community College Richard Bedwell Jones County Junior College Ken Mark Kansas City Kansas Community College Ken Snow Kaplan Education Centers Charles Evans Keiser College Bunney Schmidt Keiser College Amy Haas Kingsborough Community College Jim Racic Lakeland Community College Doug Clouse Lakeland Community College Patrick Haggerty Lansing Community College Patricia Walczak Lansing Community College Humberto M. Herrera Laredo Community College Christie Comunale Long Island University Ariel Markelevich Long Island University Randy Kidd Longview Community College Kathy Heltzel Luzerne County Community College

Lori Major Luzerne County Community College Fred Jex Macomb Community College Glenn Owen Marymount College Behnaz Quigley Marymount College Penny Hanes Mercyhurst College, Erie John Miller Metropolitan Community College Denise Leggett Middle Tennessee State University William Huffman Missouri Southern State College Ted Crosby Montgomery County Community College Beth Engle Montgomery County Community College David Candelaria Mount San Jacinto College Linda Bolduc Mount Wachusett Community College Barbara Gregorio Nassau Community College James Hurat National College of Business and Technology Denver Riffe National College of Business and Technology Asokan Anandarajan New Jersey Institute of Technology Robert Schoener New Mexico State University Stanley Carroll New York City Technical College of CUNY Audrey Agnello Niagara County Community College Catherine Chiang North Carolina Central University Karen Russom North Harris College Dan Bayak Northampton Community College Elizabeth Lynn Locke Northern Virginia Community College Debra Prendergast Northwestern Business College Nat Briscoe Northwestern State University Tony Scott Norwalk Community College Deborah Niemer Oakland Community College Suzanne Oliver Okaloosa Walton Junior College John Boyd Oklahoma City Community College Kathleen O’Donnell Onondaga Community College J.T. Ryan Onondaga Community College Toni Clegg Palm Beach Atlantic College David Forsyth Palomar College John Graves PCDI Carla Rich Pensacola Junior College Judy Grotrian Peru State College Judy Daulton Piedmont Technical College John Stone Potomac State College Betty Habershon Prince George’s Community College Kathi Villani Queensborough Community College William Black Raritan Valley Community College Verne Ingram Red Rocks Community College Paul Juriga Richland Community College Patty Worsham Riverside Community College Margaret Berezewski Robert Morris College Phil Harder Robert Morris College Shifei Chung Rowan University of New Jersey


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Charles Fazzi Saint Vincent College Lynnette Yerbuy Salt Lake Community College Susan Blizzard San Antonio College Hector Martinez San Antonio College Audrey Voyles San Diego Miramar College Margaret Black San Jacinto College Merrily Hoffman San Jacinto College Randall Whitmore San Jacinto College Carroll Buck San Jose State University Helen Brubeck San Jose State University Cynthia Coleman Sandhills Community College Barbara Crouteau Santa Rosa Junior College Pat Novak Southeast Community College Susan Pallas Southeast Community College Al Case Southern Oregon University Gloria Worthy Southwest Tennessee Community College Melody Ashenfelter Southwestern Oklahoma State University Douglas Ward Southwestern Community College Brandi Shay Southwestern Community College John May Southwestern Oklahoma State University Jeffrey Waybright Spokane Community College Renee Goffinet Spokane Community College Susan Anders St. Bonaventure University John Olsavsky SUNY at Fredonia Peter Van Brunt SUNY College of Technology at Delhi David L. Davis Tallahassee Community College Kathy Crusto-Way Tarrant County Community College Sally Cook Texas Lutheran University Bea Chiang The College of New Jersey Matt Hightower Three Rivers Community College Susan Pope University of Akron Joe Woods University of Arkansas Allen Blay University of California, Riverside Barry Mishra University of California, Riverside Laura Young University of Central Arkansas

Jane Calvert University of Central Oklahoma Bambi Hora University of Central Oklahoma Joan Stone University of Central Oklahoma Kathy Terrell University of Central Oklahoma Harlan Etheridge University of Louisiana Pam Meyer University of Louisiana Sandra Scheuermann University of Louisiana Tom Wilson University of Louisiana Lawrence Leaman University of Michigan Larry Huus University of Minnesota Brian Carpenter University of Scranton Ashraf Khallaf University of Southern Indiana Tony Zordan University of St. Francis Gene Elrod University of Texas, Arlington Cheryl Prachyl University of Texas, El Paso Karl Putnam University of Texas, El Paso Stephen Rockwell University of Tulsa Chula King University of West Florida Charles Baird University of Wisconsin – Stout Mary Hollars Vincennes University Lisa Nash Vincennes University Elaine Dessouki Virginia Wesleyan College Sueann Hely West Kentucky Community and Technical College Darlene Pulliam West Texas A&M University, Canyon Judy Beebe Western Oregon University Michelle Maggio Westfield State College Kathy Pellegrino Westfield State College Nora McCarthy Wharton County Junior College Sally Stokes Wilmington College Maggie Houston Wright State University Gerald Caton Yavapai College Chris Crosby York Technical College Harold Gellis York College of CUNY

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About the Authors is Professor of Accounting at American River College in Sacramento, California. She received her B.A. in Economics-Business from UCLA and her M.B.A. in Business Administration from California State University, Sacramento, graduating as the Outstanding Graduate Student of the Year with memberships in Phi Kappa Phi Honor Society and Beta Gamma Sigma Honor Society. Professor Pollard began her career in accounting in the audit department of the Los Angeles office of Touche Ross & Co. and was employed as a financial analyst in the corporate headquarters of the Fortune 500 firm, Lear Siegler, Inc. Her industry experience also has included service as director of finance for a nonprofit organization. Pollard is a Certified Public Accountant with an active license in California and is a member of the California Society of Certified Public Accountants, CalCPA. She is listed in both Who’s Who Among Executive and Professional Women Educators and Who’s Who Among America’s Teachers. Professor Pollard has taught Fundamentals of College Accounting, Financial Accounting, Managerial Accounting, Intermediate Accounting, Payroll Accounting, Auditing, Computer Spreadsheet Applications for Accounting, Careers in Accounting, Concepts in Personal Finance, and Business Mathematics. She is co-founder and co-instructor of the Volunteer Income Tax Assistance (VITA) program at American River College, an Internal Revenue Service program in which student volunteers electronically prepare and file income tax returns for low-income individuals free of charge.

is Associate Professor of Accounting at New Mexico State University. She received her M.A. and Ph.D. in Accounting from Texas Tech University. Professor Mills also has taught at the University of Texas, San Antonio, and Texas Tech University. She is the recipient of numerous teaching awards including NMSU’s Westhafer Award for Teaching Excellence, the New Mexico Professor of the Year Award, New Mexico Society of CPA’s Accounting Educator of the Year, and the Award for Innovation in Accounting Education by the American Accounting Association. As a member of the American Accounting Association and the American Institute of Certified Public Accountants, Professor Mills has served on numerous committees representing innovation in accounting education.

. is Professor Emeritus of Accounting at the Hankamer School of Business, Baylor University. He received his B.B.A. degree from Baylor University, his M.S. from Oklahoma State University, and his Ph.D. from Michigan State University. Professor Harrison, recipient of numerous teaching awards from student groups as well as from university administrators, has also taught at Cleveland State Community College, Michigan State University, the University of Texas, and Stanford University. xxix


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About the Authors

A member of the American Accounting Association and the American Institute of Certified Public Accountants, Professor Harrison has served as Chairman of the Financial Accounting Standards Committee of the American Accounting Association, on the Teaching/Curriculum Development Award Committee, on the Program Advisory Committee for Accounting Education and Teaching, and on the Notable Contributions to Accounting Literature Committee. Professor Harrison has lectured in several foreign countries and published articles in numerous journals, including The Accounting Review, Journal of Accounting Research, Journal of Accountancy, Journal of Accounting and Public Policy, Economic Consequences of Financial Accounting Standards, Accounting Horizons, Issues in Accounting Education, and Journal of Law and Commerce. He is co-author of Financial Accounting, Sixth Edition, 2006 (with Charles T. Horngren), published by Prentice Hall. Professor Harrison has received scholarships, fellowships, and research grants or awards from PriceWaterhouse Coopers, Deloitte & Touche, the Ernst & Young Foundation, and the KPMG Foundation.


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study guide for principles of

accounting


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1

Accounting and the Business Environment

WHAT YOU PROBABLY ALREADY KNOW Accounting is the language of business. Although the textbook and your teacher have both made this statement, what does it mean? It means that accounting is how businesses communicate, both with each other and with investors. Accounting terms and concepts are encountered every day in the business world. Imagine that you decide to move to or visit a foreign country for an extended period of time. If you hope to become a part of this world, you must learn the language. Even though you may know you will not live in that country for the rest of your life, you will need to understand the basic terms of the language in order to get by on a daily basis. Likewise, even though you may not want to become an accountant, you will need to understand the language, such as assets, revenues, cost of goods sold, payables, and so forth, in order to effectively communicate with your boss, your co-workers, and your clients. Suppose you go to a job interview and the interviewer asks you what you think about their depreciation policy. If you cannot answer, then you likely will not get the job. One objective of this textbook is to help you learn and understand these terms so that you will be able to express yourself in “business language” when you graduate. If you think about it, this goal is not so unusual. Every field or type of job has its own language. Think about the language of football, for example. Touchdown, field goal, offside, power sweep . . . even though you may not want to work in a football-related career, if you are to understand and enjoy the sport, you need to understand its language as well. The primary way that businesses communicate with outsiders (that is, people who are not employed by or owners of the business) is through financial statements. This chapter introduces the primary financial statements and shows you the kinds of accounting items (called accounts) that you are likely to find on each one and how they flow through to these statements. It also explains the importance of these statements to people who use them.

Learning Objectives

1

Describe the nature and types of business organizations. A business can be classified by what it provides to customers or by how it is organized. The types of businesses are service companies, which provide services to customers; merchandise companies, which sell products to customers; or manufacturing companies, which manufacture

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goods for sale to customers. Any of these businesses can be organized as a proprietorship (the most common form of business entity), a partnership (common for attorneys, doctors, and accountants), or a corporation (which is owned by the stockholders).

2

Explain the role of accounting in business organizations. Accounting is the information system that measures business activity, processes the data into reports, and communicates the results to the users of those reports. Business owners, managers, investors, creditors, and taxing authorities all rely on accounting to provide information they need for making decisions.

3

Define generally accepted accounting principles and describe the basic accounting concepts. Generally accepted accounting principles (GAAP) are the accounting guidelines that govern how accountants measure, process, and communicate financial information so that it is accurate and reliable. GAAP is based on an underlying set of concepts so that each accounting rule (and hence the accounting data) are logical and make sense when compared to other accounting rules.

4

Use the accounting equation to analyze business transactions. It is critical to understand each of the basic components of the accounting equation (Assets ! Liabilities " Owner’s Equity). A business transaction is an event that can be measured and affects any of the components of the accounting equation. The accounting equation is used to record the effects of business transactions.

5

Prepare and explain the relationships among the financial statements. Business transactions are analyzed, recorded, classified, and reported in the financial statements, which are commonly prepared on an annual basis and include the income statement, statement of owner’s equity, balance sheet, and statement of cash flows. Financial statements communicate important information to help users evaluate business performance. Refer to Exhibit 1-8 (p. 22) for examples of the four financial statements.

6

Describe the ethical decision-making process. Ethics has received renewed attention since the accounting scandals of Enron, WorldCom, and Tyco early in the twenty-first century. Although most managers, owners, and auditors perform their jobs ethically and competently, financially devastating results happen when they fail to do so. It goes without saying that ethics and standards of professional conduct are important principles to cultivate in any business.

2

Chapter 1 | Accounting and the Business Environment

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Demo Doc 1 Basic Transactions Learning Objectives 1–6 Rick Baldwin opened Rick’s Delivery Service on August 1, 2008. He is the sole proprietor of the business. During the month of August, Rick had the following transactions: a. Rick invested $6,000 of his personal funds in the business. b. The business paid $650 cash for supplies. c. The business paid $1,000 cash for bicycles and purchased $2,000 worth of bicycles on account. d. The business paid $700 on the accounts payable to the bicycle store. e. The business performed delivery services for customers totaling $1,200. These customers paid in cash. f. The business also performed delivery services for customers on account, totaling $2,400. g. The business collected $550 of accounts receivable. h. The business paid rent (for the month of August) of $850. i. The business paid employees $1,800 for the month of August. j. Rick purchased groceries for his own use, paying $100 cash from his personal bank account. k. The business received a telephone bill for $175. As of August 31, 2008, it had not been paid. l. Rick withdrew $900 cash from the business for personal use.

Requirements 1. What kind of business does Rick Baldwin have? What is his relationship with the business? 2. Analyze the preceding transactions in terms of their effects on the accounting equation of Rick’s Delivery Service. 3. Prepare the income statement, statement of owner’s equity, and balance sheet of the business as of August 31, 2008. 4. Was the delivery service profitable for the month of August? Given this level of profit or loss, do you think the withdrawal of $900 was appropriate? Is it ethical for Rick to withdraw money from the business?

Demo Doc 1 | Chapter 1

3

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Demo Doc 1 Solutions Requirement 1

1

Describe the nature and types of business organizations.

2

Explain the role of accounting in business organizations.

What kind of business does Rick Baldwin have? What is his relationship with the business?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

Rick’s Delivery Service is a sole proprietorship because Rick is the sole owner of an unincorporated business. As the owner, Rick is considered an investor in the business. If he is paid a salary, he may also be considered an employee of the business.

Requirement 2

3

Define generally accepted accounting principles and describe the basic accounting concepts.

Analyze the preceding transactions in terms of their effects on the accounting equation of Rick’s Delivery Service.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

a. Rick invested $6,000 of his personal funds in the business. Rick is using his own money, but he is giving it to the business. Because the business is involved, it is a recordable transaction. From the business’s perspective, this transaction increases Cash (an asset) by $6,000 and increases Rick Baldwin, Capital (owner’s equity), by $6,000.

ASSETS

Cash

= LIABILITIES +

Accounts = + Receivable + Supplies + Bicycles

(a) + $6,000

Accounts Payable

+

OWNER’S EQUITY

TYPE OF OWNER’S EQUITY TRANSACTION

Rick Baldwin, Capital + $6,000

Owner investment

Notice that after recording this transaction, the equation balances. In other words, the formula Assets = Liabilities + Owner’s Equity still holds. b. The business paid $650 cash for supplies. Supplies represent an asset that is increased by $650. Because they were paid for with cash, the Cash account (an asset) is decreased by $650. 4

Chapter 1 | Demo Doc 1 Solutions

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ASSETS Cash

= LIABILITIES +

Accounts + Receivable + Supplies + Bicycles =

(b) – $650

Accounts Payable

+


OWNER’S EQUITY Rick Baldwin, Capital

+ $650

c. The business paid $1,000 cash for bicycles and purchased $2,000 worth of bicycles on account. The Bicycles account (an asset) is increased, but by how much? What is the cost of the bicycles? If $1,000 is paid in cash and $2,000 is bought on account, the total cost is $1,000 + $2,000 = $3,000. Why? This total amount is what the business will (eventually) end up paying in order to acquire the bicycles. This accounting is consistent with the cost principle.

3


4

Use the accounting equation to analyze business transactions.

So Bicycles (an asset) is increased by $3,000, whereas Cash (an asset) decreases by $1,000. The $2,000 on account relates to accounts payable (because it will have to be paid later). Because we now owe money that is to be paid later, it increases Accounts Payable (a liability) by $2,000.

ASSETS Cash

= LIABILITIES +


(c) – $1,000

+ $3,000

Accounts Payable

+

OWNER’S EQUITY


Rick Baldwin, Capital

+ 2,000

d. The business paid $700 on the accounts payable to the bicycle store. Think of accounts payable as a list of companies to which the business owes money. In other words, it is a list of companies to which the business will pay money. In this particular problem, the business owes money to the company from which it purchased bicycles on account (see transaction c). When the business pays the money in full, it can cross this company off the list. Right now, the business is paying only part of the money owed to the bicycle store. This payment decreases Accounts Payable (a liability) by $700 and decreases Cash (an asset) by $700.

ASSETS Cash (d) – $700

= LIABILITIES +


Accounts Payable

+

OWNER’S EQUITY



– $700 Demo Doc 1 Solutions | Chapter 1

5

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e. The business performed delivery services for customers totaling $1,200. These customers paid in cash. When the business performs services, it means that it is doing work for customers. Doing work for customers is the way that the business makes money. By performing services, the business is earning revenues. Earning revenues means that Service Revenues is increased (which increases owner’s equity) by $1,200. Because the customers paid in cash, Cash (an asset) is also increased by $1,200.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+

(e) + $1,200

OWNER’S EQUITY



Service revenue

f. The business also performed delivery services for customers on account, totaling $2,400. Again, the delivery service performs services for customers, which means that it earns revenues. Earning revenues results in an increase in Service Revenues (owner’s equity) of $2,400. However, this time the customers charged the services on account. The business will receive this money in the future (when the customers eventually pay) so it is called accounts receivable. Accounts Receivable (an asset) is increased by $2,400.

ASSETS Cash (f)

= LIABILITIES +

Accounts + Receivable + Supplies + Bicycles = + $2,400

Accounts Payable

+

OWNER’S EQUITY



Service revenue

g. The business collected $550 of accounts receivable. Think of accounts receivable as a list of customers from whom the business will collect money. In other words, it is a list of customers from whom the business will receive money at some future time. In this particular problem, these customers received services but did not pay at that time (see transaction f). Later, when the business collects (receives) the cash in full from any particular customer, it can cross that customer off the list. This transaction decreases Accounts Receivable (an asset) by $550. Because the cash is received, Cash (an asset) is increased by $550. 6


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ASSETS Cash (g) + $550

Page 7

= LIABILITIES +


Accounts Payable

+

OWNER’S EQUITY



– $550

h. The business paid rent (for the month of August) of $850. The rent has already been used. By the end of August, the service has been operating and using the space for the entire month. The benefit of the rent has already been received or used up, which makes it a rent expense. [Note that if the rent was paid for September, it would not yet be used up and would still be a future benefit (an asset) and not an expense. This issue will be discussed in Chapter 3.] So Rent Expense is increased by $850, which decreases owner’s equity. The question states that the rent was paid, which means it was paid in cash. Therefore, Cash (an asset) is decreased by $850.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+

OWNER’S EQUITY



(h) – $850

– $850

Rent expense

i. The business paid the employees $1,800 for the month of August. Again, the transaction states that the business paid the employees, meaning that they paid in cash. Therefore, Cash (an asset) is decreased by $1,800. The work the employees have given to the business has already been used. By the end of August, the delivery service has had the employees working and delivering for customers for the entire month and the benefit of the work has already been received, making it a salary expense. So, Salary Expense would increase by $1,800, which decreases owner’s equity.

ASSETS Cash (i) – $1,800

= LIABILITIES +


Accounts Payable

+

OWNER’S EQUITY


Rick Baldwin, Capital – $1,800

Salary expense

Demo Doc 1 Solutions | Chapter 1

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j. Rick purchased groceries for his own use paying $100 cash from his personal bank account. These groceries were purchased with Rick’s personal money for Rick’s personal use. Therefore, the expense does not relate to the business and is not a recordable transaction for the delivery service.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+


OWNER’S EQUITY Rick Baldwin, Capital

(j) Not a transaction of the business.

k. The business received a telephone bill for $175. As of August 31, 2008, it had not been paid. Utilities (such as water, gas, electricity, phone, and Internet service) are generally not billed until after they have been used. If these utilities are already used, then they are utilities expenses. So, utility expense would increase by $175, which is a decrease to owner’s equity. Because the bill has not yet been paid as of August 31, it is an account payable. This transaction increases Accounts Payable (a liability) by $175.

ASSETS Cash

= LIABILITIES +


(k)

Accounts Payable

+

+ $175


OWNER’S EQUITY Rick Baldwin, Capital – $175

Utilities expense

l. Rick withdrew $900 cash from the business for personal use. Although Rick is taking the money, the cash is coming from the business, so it is a recordable transaction for the business. Cash (an asset) is decreased by $900. Because Rick is the owner, this transaction also increases Owner Withdrawals by $900, which is a decrease to owner’s equity.

ASSETS Cash


(l) – $900 8

= LIABILITIES +


Accounts Payable

+

OWNER’S EQUITY


Rick Baldwin, Capital – $900

Owner withdrawal

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Following is a summary of these transactions:

ASSETS Cash

OWNER’S EQUITY

= LIABILITIES +


Accounts Payable

+



Owner investment

+ $1,200

Service revenue

+ $2,400

Service revenue

(h) # $ 850

# $ 850

Rent expense

(i) # $1,800

# $1,800

Salary expense

# $ 175

Utilities expense

# $ 900

Owner withdrawal

(a) + $6,000 + $650

(b) # $ 650

+ $3,000

(c) # $1,000 (d) # $ 700

+ 2,000 # $ 700

(e) + $1,200 (f)

+ $2,400

(g) + $ 550

# $ 550

(j) Not a transaction of the business. (k)

+ $ 175

(l) # $ 900 $1,850 $1,850 $650 $3,000 14444444444244444444443

$1,475 $5,875 144444424444443

$7,350

$7,350

Requirement 3 Prepare the income statement, statement of owner’s equity, and balance sheet of the business as of August 31, 2008. Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

The income statement is the first statement that should be prepared because the other financial statements rely upon the net income number calculated on the income statement. The income statement lists all revenues and expenses. It uses the following formula to calculate net income:

3


5

Prepare financial statements and explain the relationships between them.

Revenues ! Expenses " Net income Demo Doc 1 Solutions | Chapter 1

9

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So, to create an income statement, we only need to list the revenue accounts and then subtract the list of expense accounts to calculate net income. We can read these amounts from the accounting equation worksheet. Two transactions affect service revenue: e and f. Transaction e increases service revenue by $1,200, and transaction f increases service revenue by $2,400. Total service revenue for the month is calculated as follows: $1,200 # $2,400 " $3,600

Rent expense of $850, salary expense of $1,800, and utilities expense of $175 were recorded in transactions h, i, and k, respectively.

RICK’S DELIVERY SERVICE Income Statement Month Ended August 31, 2008 Revenue Service revenue Expenses Salary expense Rent expense Utilities expense Total expenses Net income

$3,600* $ 1,800 850 175 2,825 $ 775

*= $1,200 + $2,400

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

Net income is used on the statement of owner’s equity to calculate the new balance in the Capital account. This calculation uses the following formula: Beginning Capital Amount # Owner Investments # Net Income (or ! Net Loss) ! Owner Withdrawals " Ending Capital Amount

Again, we just have to recreate this formula on the statement:

RICK’S DELIVERY SERVICE Statement of Owner’s Equity Month Ended August 31, 2008 Rick Baldwin, capital, August 1, 2008 Add: Investment by owner Net income for month Less: Withdrawals by owner Rick Baldwin, capital, August 31, 2008

10


$

0 6,000 775 6,775 (900) $ 5,875

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Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

The ending capital amount is used on the balance sheet. The balance sheet is just a listing of all assets, liabilities, and equity, with the accounting equation verified at the bottom:

RICK’S DELIVERY SERVICE Balance Sheet August 31, 2008 Assets Cash Accounts receivable Supplies Bicycles Total assets

Liabilities $ 1,850 Accounts payable 1,850 Owner’s Equity 650 Rick Baldwin, capital 3,000 $ 7,350 Total liabilities and equity

$ 1,475 5,875 $ 7,350

Requirement 4 Was the delivery service profitable for the month of August? Given this level of profit or loss, do you think the withdrawal of $900 was appropriate? Is it ethical for Rick to withdraw money from the business?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

6

Explain the role of ethics in accounting and business.

Demo Doc Complete

From the income statement, we can see that the delivery service earned $775 of profit during the month of August. The level of withdrawals ($900) seems high given that it is more than the amount of profit earned during the month. If the owner continued to withdraw at this rate, the business could end up with a negative equity balance. As the sole owner, it is Rick’s right to withdraw money from the delivery service. As long as the withdrawal is properly recorded in the accounting system, it is ethical for Rick to withdraw money from the business.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete


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Quick Practice Questions True/False 1. Financial accounting produces financial information and reports to be used by managers inside a business. 2. GAAP are the rules that govern financial accounting and must be followed when preparing financial statements. 3. Financing activities include customers buying goods and services. 4. Professional accounting organizations and most companies have standards of ethical behavior. 5. A corporation’s owners are called shareholders. 6. An advantage of the partnership form of business is that the life of the entity is indefinite. 7. The owner of a sole proprietorship is not personally responsible for the debts of the business. 8. The entity concept separates business transactions from personal transactions. 9. A business has a net loss when total revenues are greater than total expenses. 10. The statement of owner’s equity reports the cash coming in and going out.

12

Chapter 1 | Quick Practice Questions

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Multiple Choice 1. What is the private organization that is primarily responsible for formulating accounting standards? a. The Internal Revenue Service b. The Securities and Exchange Commission c. The American Institute of Certified Public Accountants d. The Financial Accounting Standards Board 2. The effect on the accounting equation of providing services to a customer for cash is which of the following? a. Increase liabilities b. Decrease liabilities c. Decrease owner’s equity d. Increase owner’s equity 3. The effect on the accounting equation of payment of utilities each month is which of the following? a. Increase owner’s equity b. Increase expenses c. Increase total assets d. Decrease liabilities 4. What is the purpose of financial accounting information? a. To help managers plan and control business operations b. To comply with the IRS rules c. To help investors, creditors, and others make decisions d. To provide information to employees 5. What characteristic is necessary for information to be useful? a. It is relevant b. It is reliable c. It is comparable d. All of the above 6. Sue Mason owns a bagel shop as a sole proprietorship. Sue includes her personal home, car, and boat on the books of her business. Which of the following is violated? a. Entity concept b. Going-concern concept c. Cost principle d. Reliability principle 7. Which of the following is the accounting equation? a. Assets – Liabilities = Owner’s equity b. Assets + Liabilities = Owner’s equity c. Assets = Liabilities + Owner’s equity d. Assets + Liabilities = Net income 8. If the assets of a business are $410,000 and the liabilities total $200,000, how much is the owner’s equity? a. $150,000 b. $160,000 c. $210,000 d. $610,000 Quick Practice Questions | Chapter 1

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9. Which financial statement contains a listing of assets, liabilities, and owner’s equity? a. Balance sheet b. Statement of owner’s equity c. Income statement d. Statement of cash flows 10. The claim of a business owner to the assets of the business is called what? a. Liabilities b. Owner’s equity c. Revenue d. Withdrawals

14


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Quick Exercises 1-1. Fill in the following statements with the correct type of business organization. a. A _______________________ is a separate legal entity, approved by the state. b. A _______________________ is an entity with one owner where the business and not the owner is liable for the company’s debts. c. A _______________________ is an entity with two or more owners who are personally liable for the company’s debts. 1-2. Match the following terms with the best description. a. Entity concept b. Reliability principle c. Cost principle d. Going-concern concept ____________ 1. An organization or part of an organization is sepa rate from other organizations and individuals. ____________ 2. An item should be recorded at the actual amount paid. ____________ 3. An entity is expected to remain in business in the future. ____________ 4. Accounting data should be neutral, unbiased infor mation that can be confirmed by others. 1-3. Determine the missing amounts: a. Assets = $50,000; Liabilities = $30,000; Owner’s equity = b. Liabilities = $35,000; Owner’s equity = $75,000; Assets = c. Assets = $105,000; Owner’s equity = $50,000; Liabilities = 1-4. Write a brief explanation for the following transactions:

ASSETS

= LIABILITIES +

Accounts Cash + Receivable + Supplies =

a. 20,000 b. c. #2,500 d. e. 3,000

Accounts Payable

+

OWNER’S EQUITY

Capital

20,000 1,000 5,200 #3,000

1,000 #2,500 5,200

a. ______________________________________________________________ b. ______________________________________________________________ c. ______________________________________________________________ d. ______________________________________________________________ e. ______________________________________________________________ Quick Practice Questions | Chapter 1

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1-5. On which of the following three financial statements would you expect to find the items (a) through (f)? Income Statement (IS) Balance Sheet (BS) Statement of Cash Flows (CF) a. ___________ Accounts payable b. ___________ Service revenue c. ___________ Collections from customer d. ___________ Utilities expense e. ___________ Office supplies f. ___________ Payments to suppliers

16


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Do It Yourself! Question 1 Jennifer Hill opened a laundromat business on October 1, 2008. She is the sole proprietor of the business.

Requirements 1. For each transaction of the business during the month of October, analyze and describe the transaction in terms of its effect on the accounting equation of Jennifer’s Laundromat. Summarize the transactions in one table.

3

a. Jennifer invested $10,000 of her personal funds in the business.

ASSETS

= LIABILITIES +

OWNER’S EQUITY



(a)

b. Jennifer’s Laundromat paid $4,000 cash for washing machines and purchased another $5,000 worth on account.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


(b)

c. Jennifer purchased a washing machine for use in her home costing $2,100 on her personal account.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


OWNER’S EQUITY


(c)

d. The business paid $500 cash for supplies.

ASSETS

= LIABILITIES +

(d) Do It Yourself! Question 1 | Chapter 1

17

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e. Jennifer’s Laundromat performed cleaning services for customers totaling $2,500. These customers paid in cash.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


(e)

f. Jennifer’s Laundromat also performed cleaning services for customers on account totaling $3,700.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


(f)

g. Jennifer’s Laundromat paid rent (for the month of October) of $1,000.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


(g)

h. The business paid employees $1,500 for the month of October.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


(h)

i. The business received a utility bill for $750. As of October 31, 2008, it had not been paid.

ASSETS (i) 18

Chapter 1 | Do It Yourself! Question 1

= LIABILITIES +

OWNER’S EQUITY


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j. Jennifer withdrew $2,000 cash from the business for personal use.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


OWNER’S EQUITY


(j)

k. The business collected $2,250 of accounts receivable.

ASSETS

= LIABILITIES +

(k)

l. The business paid $2,400 on the accounts payable to the washing machine store.

ASSETS

= LIABILITIES +

OWNER’S EQUITY


OWNER’S EQUITY


(l)

ASSETS

= LIABILITIES +

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) Do It Yourself! Question 1 | Chapter 1

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Prepare financial statements and explain the relationships between them.

12:35 PM

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2. Prepare the income statement, statement of owner’s equity, and balance sheet of the business as of October 31, 2008.

JENNIFER’S LAUNDROMAT Income Statement Month Ended October 31, 2008

JENNIFER’S LAUNDROMAT Statement of Owner’s Equity Month Ended October 31, 2008

JENNIFER’S LAUNDROMAT Balance Sheet October 31, 2008

20


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Quick Practice Solutions True/False F

1. Financial accounting produces financial information and reports to be used by managers inside a business. False–Financial accounting produces information for people outside the company. (p. 7)

T

2. GAAP are the rules that govern financial accounting and must be followed when preparing financial statements. (p. 6)

F

3. Financing activities include customers buying goods and services. False–Operating activities include customers buying goods and services. (p. 6)

T

4. Professional accounting organizations and most companies have standards of ethical behavior. (p. 23)

T

5. A corporation’s owners are called shareholders. (p. 5)

F

6. An advantage of the partnership form of business is that the life of the entity is indefinite. False–The life of a partnership is limited by the owners’ choices, or death. (p. 5)

F

7. The owner of a sole proprietorship is not personally liable for the debts of the business. False–The owner of a sole proprietorship is personally liable for the debts of the business. (p. 5)

T

8. The entity concept separates business transactions from personal transactions. (p. 8)

F

9. A business has a net loss when total revenues are greater than total expenses. False–A business has net income when total revenues are greater than total expenses. (p. 11)

F

10.The statement of owner’s equity reports the cash coming in and going out. False–The statement of owner’s equity shows the changes in owner’s equity during a time period. The statement of cash flows reports cash coming in and going out. (p. 19)

Quick Practice Solutions | Chapter 1

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Multiple Choice 1. What is the private organization that is primarily responsible for formulating accounting standards? (p. 8) a. The Internal Revenue Service b. The Securities and Exchange Commission c. The American Institute of Certified Public Accountants d. The Financial Accounting Standards Board 2. The effect on the accounting equation of providing services to a customer for cash is which of the following? (p. 10) a. Increase liabilities b. Decrease liabilities c. Decrease owner’s equity d. Increase owner’s equity 3. The effect on the accounting equation of payment of utilities each month is which of the following? (p. 10) a. Increase owner’s equity b. Increase expenses c. Increase total assets d. Decrease liabilities 4. What is the purpose of financial accounting information? (p. 7) a. To help managers plan and control business operations. b. To comply with the IRS rules. c. To help investors, creditors, and others make decisions. d. To provide information to employees. 5. What characteristic is necessary for information to be useful? (p. 8) a. It is relevant b. It is reliable c. It is comparable d. All of the above 6. Sue Mason owns a bagel shop as a sole proprietorship. Sue includes her personal home, car, and boat on the books of her business. Which of the following is violated? (p. 8) a. Entity concept b. Going concern concept c. Cost principle d. Reliability principle 7. Which of the following is the accounting equation? (p. 9) a. Assets – Liabilities = Owner’s equity b. Assets + Liabilities = Owner’s equity c. Assets = Liabilities + Owner’s equity d. Assets + Liabilities = Net income

22

Chapter 1 | Quick Practice Solutions

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8. If the assets of a business are $410,000 and the liabilities total $200,000, how much is the owner’s equity? (p. 9) a. $150,000 b. $160,000 c. $210,000 d. $610,000 9. Which financial statement contains a listing of assets, liabilities, and owner’s equity? (p. 19) a. Balance sheet b. Statement of owner’s equity c. Income statement d. Statement of cash flows 10. The claim of a business owner to the assets of the business is called what? (p. 9) a. Liabilities b. Owner’s equity c. Revenue d. Withdrawals


23

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Quick Exercises 1-1. Fill in the following statements with the correct type of business organization. (p. 4–5) a. A corporation is a separate legal entity, approved by the state. b. A limited liability corporation is an entity with one owner where the business and not the owner is liable for the company’s debts. c. A partnership is an entity with two or more owners who are personally liable for the company’s debts. 1-2. Match the following terms with the best description. (p. 8–9) a. Entity concept b. Reliability principle c. Cost principle d. Going-concern concept a 1. An organization or part of an organization is separate from other organizations and individuals. c 2. An item should be recorded at the actual amount paid. d 3. An entity is expected to remain in business in the future. b 4. Accounting data should be neutral, unbiased information that can be confirmed by others. 1-3. Determine the missing amounts: (p. 9) a. Assets = $50,000; Liabilities = $30,000; Owner’s equity = $20,000 (50,000 – 30,000) b. Liabilities = $35,000; Owner’s equity = $75,000; Assets = $110,000 (35,000 + 75,000) c. Assets = $105,000; Owner’s equity = $50,000; Liabilities = $55,000 (105,000 – 50,000) 1-4. Write a brief explanation for the following transactions: (p. 11–16) OWNER’S = LIABILITIES +

ASSETS

Accounts Cash + Receivable + Supplies =

Accounts Payable

+

a. 20,000 1,000

1,000

c. #2,500 e.

#2,500 5,200

3,000

5,200

#3,000

a. The owner invested $20,000 cash in the business. b. Purchased $1,000 of supplies on account. 24


Capital

20,000

b. d.

EQUITY

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c. Paid $2,500 for an expense OR the owner withdrew $2,500 for personal use. d. Performed services for customer on account, $5,200. e. Received $3,000 cash from customers on account. 1-5. On which of the following three financial statements would you expect to find the items (a) through (f)? (p. 16–21) Income Statement (IS) Balance Sheet (BS) Statement of Cash Flows (CF) a. b. c. d. e. f.

BS IS CF IS BS CF

Accounts payable Service revenue Collections from customer Utilities expense Office supplies Payments to suppliers


25

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Do It Yourself! Question 1 Solutions Requirement 1 For each transaction of the business during the month of October, analyze the transaction in terms of its effect on the accounting equation of Jennifer’s Laundromat. a. Jennifer invested $10,000 of her personal funds in the business. Cash (an asset) is increased by $10,000 and Jennifer Hill, Capital (owner’s equity) is increased by $10,000.

ASSETS

= LIABILITIES +

Accounts Washing + Receivable + Supplies + Machines =

Cash

Accounts Payable

+

(a)+ $10,000

OWNER’S EQUITY


Jennifer Hill, Capital + $10,000

Owner investment

b. Jennifer’s Laundromat paid $4,000 cash for washing machines and purchased another $5,000 worth on account. Washing Machines (an asset) is increased by $9,000, while Cash (an asset) is decreased by $4,000. Accounts Payable (a liability) is increased by $5,000.

ASSETS Cash

= LIABILITIES +

Accounts Washing = + Receivable + Supplies + Machines

(b) #$4,000

+ $9,000

Accounts Payable

+

OWNER’S EQUITY


Jennifer Hill, Capital

+ 5,000

c. Jennifer purchased a washing machine for use in her home costing $2,100 on her personal account. This expense does not relate to the business and is not a recordable transaction for the business.

ASSETS Cash


(c) Not a transaction of the business. 26

= LIABILITIES +

Chapter 1 | Do It Yourself! Question 1 Solutions

Accounts Payable

+

OWNER’S EQUITY Jennifer Hill, Capital


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d. The business paid $500 cash for supplies. Supplies (an asset) is increased by $500 and Cash (an asset) is decreased by $500.

ASSETS Cash

= LIABILITIES +


(d) # $500

Accounts Payable

+

OWNER’S EQUITY



+ $500

e. Jennifer’s Laundromat performed cleaning services for customers totaling $2,500. These customers paid in cash. Service Revenues (owner’s equity) is increased by $2,500. Cash (an asset) is increased by $2,500.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+

(e) + $2,500

OWNER’S EQUITY



Service revenue

f. Jennifer’s Laundromat also performed cleaning services for customers on account totaling $3,700. Service Revenues (owner’s equity) is increased by $3,700. Accounts Receivable (an asset) is increased by $3,700.

ASSETS Cash (f)

= LIABILITIES +

Accounts Washing + Receivable + Supplies + Machines = + $3,700

Accounts Payable

+

OWNER’S EQUITY



Service revenue

Do It Yourself! Question 1 Solutions | Chapter 1

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g. Jennifer’s Laundromat paid rent (for the month of October) of $1,000. Rent Expense is increased by $1,000, which is a decrease to owner’s equity. Cash (an asset) is decreased by $1,000.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+

(g)# $1,000

OWNER’S EQUITY


Jennifer Hill, Capital # $1,000

Rent expense

h. The business paid employees $1,500 for the month of October. Salary Expense is increased by $1,500, which is a decrease to owner’s equity. Cash (an asset) is decreased by $1,500.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+

(h) # $1,500

OWNER’S EQUITY


Jennifer Hill, Capital # $1,500

Salary expense

i. The business received a utility bill for $750. As of October 31, 2008, it had not been paid. Utilities Expense is increased by $750, which is a decrease to owner’s equity. Accounts Payable (a liability) is increased by $750.

ASSETS Cash


(i)

28

= LIABILITIES + Accounts Payable + $750


+

OWNER’S EQUITY


Jennifer Hill, Capital # $750

Utilities expense

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j. Jennifer withdrew $2,000 cash from the business for personal use. This recordable transaction for the business decreases Cash (an asset) by $2,000 and increases Owner Withdrawals, by $2,000, which decreases owner’s equity.

ASSETS Cash

= LIABILITIES +


Accounts Payable

+

(j) # $2,000

OWNER’S EQUITY Jennifer Hill, Capital # $2,000


Owner withdrawal

k. The business collected $2,250 of accounts receivable. This transaction decreases Accounts Receivable (an asset) by $2,250. Because the cash is received, Cash (an asset) is increased by $2,250.

ASSETS Cash (k) + $2,250

= LIABILITIES +


Accounts Payable

+

OWNER’S EQUITY



# $2,250

l. The business paid $2,400 on the accounts payable to the washing machine store. This decrease to Accounts Payable (a liability) of $2,400 also decreases Cash (an asset) by $2,400.

ASSETS

= LIABILITES +

Accounts Washing = Cash + Receivable + Supplies + Machines (l) #$2,400

Accounts Payable

+

OWNER’S EQUITY



#$2,400


29

30


+ 2,500

(e)

!1,500

(h)

+ 2,250 !2,400

(k) (l)

2,250

+ $3,700

+

+ $500

Supplies

+

+ $9,000

Washing = Machines

$14,300

$3,350 $1,450 $500 $9,000 1444444444444442444444444444443

!2,000

(j)

(i)

!1,000

(g)

(f)

!500

Not a transaction of the business.

Accounts Receivable +

!2,000

!750

!1,500

!1,000

+ 3,700

+ 2,500

+ $10,000


$3,350 $10,950 1444444424444443 $14,300

2,400

+ 750

+ 5,000

Accounts Payable

+

Owner withdrawal

Utilities expense

Salary expense

Rent expense

Service revenue Service revenue

Owner investment

12:16 PM

(d)

(c)

!4,000

+

= LIABILITIES

TYPE OF OWNER’S OWNER’S EQUITY EQUITY TRANSACTION

10/20/06

(b)

(a) + $10,000

Cash

ASSETS

Requirement 2

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Requirement 2 Prepare the income statement, statement of owner’s equity, and balance sheet of the business as of October 31, 2008.

JENNIFER’S LAUNDROMAT Income Statement Month Ended October 31, 2008 Revenue Service revenue Expenses Salary expense Rent expense Utilities expense Total expenses Net income

$ 6,200 $ 1,500 1,000 750 3,250 $ 2,950

*= $2,500 + $3,700

JENNIFER’S LAUNDROMAT Statement of Owner’s Equity Month Ended October 31, 2008 Jennifer Hill, capital, October 1, 2008 Add: Investment by owner Net income for month

$ 0 10,000 2,950 12,950 (2,000) $10,950

Less: Withdrawals by owner Jennifer Hill, capital, October 31, 2008

JENNIFER’S LAUNDROMAT Balance Sheet October 31, 2008 Assets Cash Accounts receivable Supplies Furniture Total assets

Liabilities $ 3,350 Accounts payable 1,450 Owner’s Equity 500 Jennifer Hill, capital 9,000 $14,300 Total liabilities and equity

$ 3,350 10,950 $14,300


31

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The Power of Practice For more practice using the skills learned in this chapter, visit MyAccountingLab. There you will find algorithmically generated questions that are based on these Demo Docs and your main textbook’s Review and Assess Your Progress sections. To go to MyAccountingLab and follow these steps: 1. 2. 3. 4. 5.

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 1, Accounting and the Business Environment. 6. Click a link to work on the tutorial exercises.

32

Chapter 1 | The Power of Practice

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2

Recording Business Transactions

WHAT YOU PROBABLY ALREADY KNOW If you have a checking account, you know that once a month you receive a statement from the bank. The statement shows the beginning cash balance, increases, decreases, and the ending cash balance. The account balance is the amount that the bank owes you, their customer. Your balance represents a liability to the bank. The deposits you make increase the bank’s liability to you. The withdrawals or checks you write decrease that liability. Instead of using the terms increase and decrease, businesses have used a system of accounting for more than 500 years with debits and credits. Either a debit or a credit may signify an increase to the account, depending upon the type of account: asset, liability, or owner’s equity. Your checking account balance is a liability to your bank; does a debit or credit indicate an increase? When you take money out of the bank, it decreases the bank’s liability to you because you’ve received back a portion of your account balance and is shown as a debit on the bank statement. When you deposit money into your account, it increases the banks’ liability to you and is reflected as a credit on the bank statement. So, you can see that you probably already know that the rule for a liability account is that increases are shown as credits and decreases as debits.

Learning Objectives

1

Describe the role of accounts in summarizing business transactions. Remember that every business transaction has two sides: You receive something and you give something. Likewise, every transaction affects two or more specific accounts. The first several chapters of this book contain many new terms that are used in the remaining chapters and are important for you to understand. These terms include the journal, account, ledger, trial balance, and chart of accounts. In order to describe the process of recording and summarizing business transactions, it is crucial that you understand these terms now before you proceed with your study of accounting. Also, carefully review the detailed description of the various specific asset, liability, and owner’s equity accounts in the main text.

2

Explain double-entry accounting. A business transaction affects two or more specific accounts. Each account has two sides: the left (debit) side, and the right (credit) side. Remember that debit only means left and credit only means right.

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Increases are recorded on one side and decreases on the other. Depending upon the type of account, a debit may indicate an increase or a decrease. Assets are on the left side of the equation; they increase on the left (debit) side. Liabilities and owner’s equity are on the right side of the equation; they increase on the right (credit) side. Understanding this basic concept is crucial. Review Exhibit 2-2 (p. 62) for the debit and credit rules.

3

Record and summarize business transactions. Business transactions are analyzed and then recorded in the journal. The journal shows the accounts that are debited and credited to record business transactions in chronological order. Debits and credits only reflect increases and decreases to the accounts. To obtain a specific account balance, it is helpful to collect the debit and credit information recorded in the journal in one place. Posting—that is, copying the debits and credits from the journal into the account ledger—provides this information. The difference between the total debits and total credits in each account is the balance. The balance is shown on the larger side, normally the side to record the increase. Review how to record transactions in the journal under “Process of Recording and Summarizing Business Transactions,” and especially the five steps of “The Transaction Analysis.” The more you practice recognizing debits and credits, the easier it will be to understand. Also, review the posting process in Exhibit 2-5 (p. 65).

4

Set up and use a trial balance for preparing financial statements. After transactions are recorded in the journal and posted to the ledger, a trial balance is prepared. The trial balance lists all the accounts with their balances. In a manual accounting system, it is useful as a check to determine that the total debits equal the total credits. If they are unequal, an error has been made and must be investigated before proceeding. Review the trial balance in Exhibit 2-9 (p. 80).

34

Chapter 2 | Recording Business Transactions

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Demo Doc 1 Debit/Credit Transaction Analysis Learning Objectives

1–4

Knight Airlines provides private plane transportation for businesspeople. Knight had the following trial balance on April 1, 2008: KNIGHT AIRLINES Trial Balance April 1, 2008

Account Title Cash Accounts receivable Accounts payable Maureen Knight, capital Total

Balance Debit Credit $50,000 8,000 $16,000 42,000 $58,000 $58,000

During April, the business had the following transactions: a. Purchased a new airplane for $50,000. Knight paid $10,000 down and signed a note payable for the remainder. b. Purchased supplies worth $1,000 on account. c. Paid $5,000 on account. d. Transported customers on their planes for fees totaling $25,000. Received $7,500 in cash, with the remaining fees on account. e. Received $18,000 on account. f. Paid the following in cash: interest, $1,200; utilities $2,300; salaries, $7,000. g. Received a bill for airplane repair costs of $3,500 that will be paid next month. h. Maureen Knight withdrew $6,000 for personal use.

Requirements 1. Open the following accounts, with the balances indicated, in the ledger of Knight Airlines. Use the T-account format. (Account numbers are not required.) • Assets: Cash, $50,000; Accounts Receivable, $8,000; Supplies, no balance; Airplanes, no balance • Liabilities: Accounts Payable, $16,000; Notes Payable, no balance • Owner’s Equity: Maureen Knight, Capital, $42,000; Maureen Knight, Withdrawals, no balance • Revenues: Service Revenue, no balance • Expenses: (none have balances) Interest Expense, Utilities Expense, Salary Expense, Repairs Expense 2. Journalize each transaction. Key journal entries by transaction letter. 3. Post to the ledger. 4. Prepare the trial balance of Knight Airlines at April 30, 2008.

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Demo Doc 1 Solutions Requirement 1 Open the following accounts, with the balances indicated, in the ledger of Knight Airlines. Use the T-account format. (Account numbers are not required.) • Assets: Cash, $50,000; Accounts Receivable, $8,000; Supplies, no balance; Airplanes, no balance • Liabilities: Accounts Payable, $16,000; Notes Payable, no balance • Owner’s Equity: Maureen Knight, Capital, $42,000; Maureen Knight, Withdrawals, no balance • Revenues: Service Revenue, no balance • Expenses: (none have balances) Interest Expense, Utilities Expense, Salary Expense, Repairs Expense

Part 1

1

Describe the role of accounts in summarizing business transactions.

2

Explain double-entry accounting.

3

Record and summarize business transactions.

36

Part 2

Part 3

Part 4

Demo Doc Complete

Remember, an account, the basic summary device, is a record showing increases, decreases, and the balance of a particular asset, liability, or owner’s equity. A T-account is a visual diagram of the additions and subtractions made to the accounts. A chart of accounts is a list of all the business’s account titles and account numbers assigned to those titles. A chart of accounts does not include account balances. Review the sample chart of accounts in Exhibit 2-1 (p. 61) of the main text. Opening a T-account simply means drawing a blank account (the T) and putting the account title on top. To help find the accounts later, they are usually organized into assets, liabilities, owner’s equity, revenue, and expenses (in that order). If the account has a starting balance, it must be put in on the correct side. Remember that debits are always on the left side of the T-account and credits are always on the right side. This rule is true for every account. The correct side is the side of an increase in the account (unless you are specifically told differently in the question), because we expect all accounts to have a positive balance, or more increases than decreases. For assets, an increase is a debit, so we would expect all assets to have a debit balance. For liabilities and owner’s equity, an increase is a credit, so we would expect these accounts to have a credit balance. By the same reasoning, we expect revenues to have a credit balance and expenses and withdrawals to have a debit balance. The balances listed in Requirement 1 are simply the amounts from the starting trial balance. We actually did not need to be told how much to put in each account because we could have read the numbers directly from the April 1 trial balance.


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ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Bal. 50,000

Bal. 16,000

Accounts Receivable

Notes Payable

Bal. 8,000

EXPENSES Interest Expense

Supplies

OWNER’S EQUITY Maureen Knight, Capital Bal. 42,000

Utilities Expense

Airplanes Maureen Knight, Withdrawals

Salary Expense

Repairs Expense

Requirement 2 Journalize each transaction. Key journal entries by transaction letter. Feel free to reference Exhibit 2-5 (p. 64) for help in completing this exercise.

1

Demo Doc Complete


2


3


Part 1

Part 2

Part 3

Part 4

a. Purchased a new airplane for $50,000. Knight paid $10,000 down and signed a note payable for the remainder. The accounts involved are Airplanes, Cash, and Notes Payable. The airplane cost $50,000 and $10,000 was paid in cash, so that means that the note payable was for $40,000 ($50,000 – $10,000). Airplanes (an asset) is increased, which is a debit. Cash (an asset) is decreased, which is a credit. Notes Payable (a liability) is increased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Airplanes

Asset

↑

Dr.

Cash

Asset

↓

Cr.

Notes Payable

Liability

↑

Cr.


37

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Journal Entry: Accounts a.

Dr.

Airplanes (Asset, 1; debit) Cash (Asset, 2; credit) Notes Payable (Liability, 1; credit) Purchased airplane.

Cr.

50,000 10,000 40,000

b. Purchased supplies worth $1,000 on account. One account involved is Supplies. Because the purchase has not yet been paid for in cash, the other account involved is Accounts Payable. Supplies (an asset) is increased, which is a debit. Accounts Payable (a liability) is increased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Supplies

Asset

↑

Dr.

Accounts Payable

Liability

↑

Cr.

Journal Entry: Accounts b.

Dr.

Supplies (Asset,1; debit) Accounts Payable (Liability,1; credit) Purchased supplies on account.

Cr.

1,000 1,000

c. Paid $5,000 on account. The accounts involved are Accounts Payable and Cash. Accounts Payable (a liability) is decreased, which is a debit. Cash (an asset) is decreased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Accounts Payable

Liability

↓

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Accounts c.

38

Accounts Payable (Liability, 2; debit) Cash (Asset, 2; credit) Payment on accounts payable.


Dr.

Cr.

5,000 5,000

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d. Transported customers on their planes for fees totaling $25,000. Received $7,500 in cash, with the remaining fees on account. Knight’s business is flying customers to where they want to go. Transporting customers is “performing a service,” and the business earned service revenue. The other accounts involved are Cash (because cash was received) and Accounts Receivable (because some customers charged to their account). The total revenue was $25,000 and $7,500 was paid in cash, which means that $17,500 ($25,000 – $7,500) was charged to the customer’s account. Service Revenue (revenues) is increased, which is a credit. Cash (an asset) is increased, which is a debit. Accounts Receivable (an asset) is increased, which is a debit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Accounts Receivable

Asset

↑

Dr.

Cash

Asset

↑

Dr.

Service Revenue

Revenue

↑

Cr.

Journal Entry: Accounts d.

Dr.

Accounts Receivable (Asset, 1; debit) Cash (Asset, 1; debit) Service Revenue (Revenue, 1; credit) Provided services for cash and on account.

Cr.

17,500 7,500 25,000

e. Received $18,000 on account. The accounts involved are Cash and Accounts Receivable. Cash (an asset) is increased, which is a debit. Accounts Receivable (an asset) is decreased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Cash

Asset

↑

Dr.

Accounts Receivable

Asset

↓

Cr.

Journal Entry: Accounts e.

Cash (Asset, 1; debit) Accounts Receivable (Asset, 2; credit) Receipt of payment from customer on account.

Dr.

Cr.

18,000 18,000


39

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f. Paid the following` in cash: interest, $1,200; utilities, $2,300; salaries, $7,000. Interest, utilities, and salaries are usually not paid until after the benefit has been received/used. These past benefits are considered expenses. The accounts involved are Interest Expense, Utilities Expense, Salary Expense, and Cash. Interest Expense, Utilities Expense, and Salary Expense (all expenses) are increased, which are debits. Cash (an asset) is decreased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Interest Expense

Expense

↑

Dr.

Utilities Expense

Expense

↑

Dr.

Salary Expense

Expense

↑

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Accounts f.

Dr.

Interest Expense (Expense, 1; debit) Utilities Expense (Expense, 1; debit) Salary Expense (Expense, 1; debit) Cash (Asset, 2; credit) Payment for expenses.

Cr.

1,200 2,300 7,000 10,500

g. Received a bill for airplane repair costs of $3,500 that will be paid next month. Repairs are not billed until after they have been performed. So the bill received was for repairs made in the past. This past benefit is recorded as an expense. So the accounts involved are Repairs Expense and Accounts Payable. Repairs Expense (an expense) is increased, which is a debit. Accounts Payable (a liability) is increased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Repairs Expense

Expense

↑

Dr.

Accounts Payable

Liability

↑

Cr.

Journal Entry: Accounts g.

40

Repairs Expense (Expense, 1; debit) Accounts Payable (Liability, 1; credit) Received repair bill.


Dr.

Cr.

3,500 3,500

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h. Maureen Knight withdrew $6,000 for personal use. The accounts involved are Maureen Knight, Withdrawals, and Cash. Withdrawals is increased, which is a debit. This transaction results in an increase to the Withdrawals account, which is the same as a decrease to owner’s equity, (both are debits). Cash (an asset) is decreased, which is a credit. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Maureen Knight, Withdrawals

Equity

↓

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Accounts h.

Dr.

Maureen Knight, Withdrawals (Equity, 2; debit) Cash (Asset, 2; credit) Cash withdrawal by owner.

Cr.

6,000 6,000

Requirement 3 Post to the ledger.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

The entire group of accounts is called the ledger. A manual system would have a book of account pages and a computerized system would be a printout of all accounts. Amounts in the journal entries are put into the individual ledger T-accounts. Debits go on the left side, and credits go on the right side. To add up a T-account, total the debit/left side and total the credit/right side. Subtract the smaller number from the bigger number and put the difference on the side of the bigger number. This procedure gives the balance in the T-account (the net total of both sides combined). For example, with Accounts Receivable, the two numbers on the left side total $25,500 ($8,000 + $17,500). The credit/right side totals $18,000. The difference is $7,500 ($25,500 – $18,000). We put the $7,500 on the debit side because that was the side of the bigger number of $25,500. Another way to think of totaling T-accounts is:

3


Beginning Balance in T-account ! Increases to T-account " Decreases to T-account T-account Balance (total) Demo Doc 1 Solutions | Chapter 2

41

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ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Bal. 50,000 a. c. d. e.

10,000 5,000

Bal. 16,000 b. 1,000 c.

g.

25,000 25,000

5,000

7,500 18,000 f. h.

d.

3,500 15,500

10,500 6,000

EXPENSES

44,000

Notes Payable a.

Interest Expense

40,000

f.

1,200

40,000

Accounts Receivable

1,200

Bal. 8,000 d. 17,500

Utilities Expense e.

18,000

7,500

f.

OWNER’S EQUITY

2,300 2,300

Maureen Knight, Capital Bal. 42,000 42,000

Supplies b.

1,000

f.

1,000 h.

6,000

Repairs Expense

6,000

50,000

7,000 7,000

Maureen Knight, Withdrawals

Airplanes a.

Salary Expense

g.

50,000

3,500 3,500

Requirement 4 Prepare the trial balance of Knight Airlines at April 30, 2008.

Part 1

4

42

Set up and use a trial balance for preparing financial statements.

Part 2

Part 3

Part 4

Demo Doc Complete

All of the debits and credits are now ready for the trial balance—a listing of all the account titles with their balances at the end of an accounting period. Again, the accounts are listed in the assets, liabilities, equity, revenues, expenses order for consistency.


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KNIGHT AIRLINES Trial Balance April 30, 2008

Account Title Cash Accounts receivable Supplies Airplanes Accounts payable Notes payable Maureen Knight, capital Maureen Knight, withdrawals Service revenue Interest expense Utilities expense Salary expense Repairs expense Total

Part 1

Part 2

Part 3

Balance Debit Credit $ 44,000 7,500 1,000 50,000 $ 15,500 40,000 42,000 6,000 25,000 1,200 2,300 7,000 3,500 $122,500 $122,500

Part 4

Demo Doc Complete


43

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Quick Practice Questions True/False 1. A ledger is a chronological record of transactions. 2. A chart of accounts lists all the accounts and their balances. 3. An asset is an economic resource that will benefit the business in the future. 4. A note receivable is a written pledge that the customer will pay a fixed amount of money by a certain date. 5. Posting is the process of transferring information from the trial balance to the financial statements. 6. Prepaid expenses are listed as expenses on the income statement. 7. When an owner withdraws cash from the business, assets and owner’s equity decrease. 8. When a business makes a payment on account, assets decrease and liabilities increase. 9. Every transaction affects only two accounts. 10. T-accounts help to summarize transactions.

44


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Multiple Choice 1. A business transaction is first recorded in which of the following? a. Chart of accounts b. Journal c. Ledger d. Trial balance 2. A trial balance contains which types of accounts? a. Assets b. Revenue and expense accounts c. All ledger accounts d. Assets and revenue accounts 3. An owner withdrawing cash for personal use would cause which of the following effects? a. No effect on assets b. Decrease in owner’s equity c. Decrease in net income d. Both b and c 4. Which of the following is the account that would be debited when supplies are purchased for cash? a. Cash b. Owner’s Capital c. Accounts Payable d. Supplies 5. A business makes a cash payment of $12,000 to a creditor. Which of the following occurs? a. Cash is credited for $12,000. b. Cash is debited for $12,000. c. Accounts Payable is credited for $12,000. d. Both a and c. 6. The last step in the journalizing process is which of the following? a. Determine the accounts involved in the transaction. b. Post the transaction to the ledger. c. Enter the transaction in the journal. d. Identify the transaction and its data. 7. When you borrow cash from a bank, what two accounts are affected? a. Cash and Notes Receivable b. Cash and Accounts Payable c. Cash and Notes Payable d. The only account affected is Cash

Quick Practice Questions | Chapter 2

45

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8. Which of the following is the correct journal entry for a purchase of supplies for $100 cash?

Journal Entry: Accounts a. b c. d.

Supplies Cash Cash Supplies Accounts Payable Supplies Supplies Owner’s Capital

Dr.

Cr. 100 100 100 100 100 100 100 100

9. Which of the following is the correct journal entry for purchasing $9,000 worth of equipment on account? Journal Entry: Accounts a. b c. d.

Equipment Cash Accounts Payable Equipment Equipment Accounts Payable Cash Equipment

Dr.

Cr.

9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000

10. Which of the following is the correct journal entry to record the receipt of $650 on account for services previously rendered? Journal Entry: Accounts a. b c. d.

46

Service Revenue Cash Accounts Receivable Service Revenue Accounts Receivable Cash Cash Accounts Receivable


Dr.

Cr. 650 650 650 650 650 650 650 650

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Quick Exercises 2-1. Indicate whether a debit or credit is required to record an increase for each of these accounts. _______ Cash _______ Owner, Withdrawals _______ Salary Expense _______ Service Revenue

_______ Prepaid Rent _______ Notes Payable _______ Land _______ Utilities Expense

2-2. Write a brief explanation for the following transactions: Journal Entry: Accounts Cash

Dr.

Cr.

10,000 Owner, Capital

10,000

a. __________________________________________________________ Journal Entry: Accounts

Dr.

Supplies Accounts Payable

Cr. 500 500

b. __________________________________________________________ Journal Entry: Accounts Cash

Dr.

Cr.

3,000 Service Revenue

3,000

c. __________________________________________________________ Journal Entry: Accounts Accounts Receivable Service Revenue

Dr.

Cr.

2,000 2,000

d. _________________________________________________________


47

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Journal Entry: Accounts

Dr.

Accounts Payable Cash

Cr. 300 300

e. __________________________________________________________ 2-3. Identify the following as an asset, liability, owner’s equity, revenue, or expense account. Also indicate the normal balance. Account

Normal Balance

a. Building

________________

________________

b. Accounts Payable

________________

________________

c. Cash

________________

________________

d. Accounts Receivable

________________

________________

e. Prepaid Insurance

________________

________________

f. Supplies

________________

________________

g. Utilities Expense

________________

________________

h. Owner, Capital

________________

________________

i. Owner, Withdrawals

________________

________________

2-4. Journalize the following transactions for the Reid Public elations Company using the following accounts: Cash; Accounts Receivable; Notes Receivable; Supplies; Prepaid Insurance; Accounts Payable; Notes Payable; Reid, Capital; Reid, Withdrawals; Service Revenue; Salary Expense; Rent Expense; and Insurance Expense. March 1

J. Reid invested $25,000 cash to begin her public relations company.

Journal Entry: Date Accounts

March 2

Dr.

Cr.

Dr.

Cr.

Paid $ 3,000 for March rent.


48


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Purchased $825 of supplies on account.


March 5

Dr.

Cr.

Performed $10,000 of services for a client on account.


March 8

Dr.

Cr.

Dr.

Cr.

Paid salaries of $2,500.


March 15 Paid the semiannual insurance premium of $1,800 for the period March 15 through September 15.


Dr.

Cr.

March 20 Signed a bank note and borrowed $20,000 cash.


Dr.

Cr.


49

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March 25 Received $10,000 from customers on account. (See March 5.) Journal Entry: Date Accounts

Dr.

Cr.

2-5. Find the errors in the trial balance presented here and prepare a corrected trial balance. COLEMAN COPY CENTER Trial Balance March 31, 2008

Account Title Cash Accounts receivable Supplies Land Accounts payable Notes payable Jo Coleman, capital Jo Coleman, withdrawals Service revenue Salary expense Rent expense Interest expense Utilities expense Total

Balance Debit Credit $ 30,000 $ 2,000 600 50,000 2,600 35,000 42,550 2,400 9,300 2,500 1,200 500 250 $ 83,200 $ 95,770

COLEMAN COPY CENTER Trial Balance March 31, 2008

Account Title Cash Accounts receivable Supplies Land Accounts payable Notes payable Jo Coleman, capital Jo Coleman, withdrawals Service revenue Salary expense Rent expense Interest expense Utilities expense Total 50


Balance Debit Credit

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Do It Yourself! Question 1 Ted’s Roofing Shop had the following trial balance on September 1, 2008: TED’S ROOFING SHOP Trial Balance September 1, 2008

Account Title Cash Accounts receivable Accounts payable Ted Johnson, capital Total

Balance Debit Credit $ 6,000 1,200 $ 700 6,500 $ 7,200 $ 7,200

Requirements 1. Journalize each of the following transactions. Key journal entries by transaction letter. (Account numbers are not required.)

1

a. Performed roof repairs for customers and earned $800 in cash and $1,500 of revenue on account.


2


3


1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.

Do It Yourself! Question 1 | Chapter 2

51

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b. Paid $200 cash for supplies. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.

c. Took out a loan of $2,000 cash from City Bank. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


52


Dr.

Cr.

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d. Paid $3,000 cash to purchase repair tools. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.

e. Paid the following in cash: interest, $75; repairs, $825; salaries, $1,000. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.


53

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f. Received a telephone bill of $100 that will be paid next month. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.

g. Paid $500 on account. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


54


Dr.

Cr.

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h. Received $1,100 on account. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.

i. Ted withdrew $1,300 for personal use. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.


Dr.

Cr.

2. Open the following accounts, with the balances indicated, in the ledger of Ted’s Roofing Shop. Use the T-account format. • Assets: Cash, $6,000; Accounts Receivable, $1,200, Supplies, no balance; Repair Tools, no balance • Liabilities: Accounts Payable, $700; Notes Payable, no balance • Owner’s Equity: Ted Johnson, Capital, $6,500; Ted Johnson, Withdrawals, no balance • Revenues: Service Revenue, no balance • Expenses: (none have balances) Interest Expense, Repairs Expense, Salary Expense, Utilities Expense Do It Yourself! Question 1 | Chapter 2

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Post all transactions in Requirement 1 to the ledger. ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

EXPENSES Notes Payable

Interest Expense

Accounts Receivable Repairs Expense OWNER’S EQUITY Ted Johnson, Capital Supplies

Salary Expense Ted Johnson, Withdrawals

Repair Tools

4

Set up and use a trial balance for preparing financial statements.

Utilities Expense

3. Prepare the trial balance of Ted’s Roofing Shop at September 30, 2008. TED’S ROOFING SHOP Trial Balance September 30, 2008

Account Title

Balance Debit Credit

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1. A ledger is a chronological record of transactions. False–A journal contains a chronological record of transactions. A ledger is a collection of the accounts and summarizes their balances. (p. 64)

F

2. A chart of accounts lists all the accounts and their balances. False–A chart of accounts lists all the accounts along with account numbers. A trial balance lists all accounts and their balances. (p. 60)

T

3. An asset is an economic resource that will benefit the business in the future. (pp. 58–59)

T

4. A note receivable is a written pledge that the customer will pay a fixed amount of money by a certain date. (p. 59)

F

5. Posting is the process of transferring information from the trial balance to the financial statements. False–Posting is the process of transferring information from the journal to the ledger. (p. 64)

F

6. Prepaid expenses are listed as expenses on the income statement. False–Prepaid expenses are assets and are listed on the balance sheet. Can you name an example of a prepaid expense? (p. 59)

T

7. When an owner withdraws cash from the business, assets and owner’s equity decrease. (p. 62)

F

8. When a business makes a payment on account, assets decrease and liabilities increase. False–When a business makes a payment on account, assets decrease and liabilities decrease. (p. 62)

F

9. Every transaction affects only two accounts. False–Every transaction affects at least two accounts. Watch the wording here! Notice that the question uses the word only instead of at least. Can you describe a transaction that affects more than two accounts? (p. 64)

T

10. T-accounts help to summarize transactions. (p. 61)


57

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Multiple Choice 1. A business transaction is first recorded in which of the following? (p. 64) a. Chart of accounts b. Journal c. Ledger d. Trial balance 2. A trial balance contains which types of accounts? (p. 80) a. Assets b. Revenue and expense accounts c. All ledger accounts d. Assets and revenue accounts 3. An owner withdrawing cash for personal use would cause which of the following effects? (p. 62) a. No effect on assets b. Decrease owner’s equity c. Decrease net income d. Both b and c 4. Which of the following is the account that would be debited when supplies are purchased for cash? (p. 59) a. Cash b. Owner’s Capital c. Accounts Payable d. Supplies 5. A business makes a cash payment of $12,000 to a creditor. Which of the following occurs? (p. 89) a. Cash is credited for $12,000. b. Cash is debited for $12,000. c. Accounts Payable is credited for $12,000. d. Both a and c. 6. The last step in the journalizing process is which of the following? (p. 64) a. Determine the accounts involved in the transaction. b. Post the transaction to the ledger. c. Enter the transaction in the journal. d. Identify the transaction and its data. 7. When you borrow cash from a bank, what two accounts are affected? (p. 68) a. Cash and Notes Receivable b. Cash and Accounts Payable c. Cash and Notes Payable d. The only account affected is Cash

58


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8. Which of the following is the correct journal entry for a purchase of supplies for $100 cash? (p. 88) Journal Entry: Accounts a. b c. d.

Dr.

Supplies Cash Cash Supplies Accounts Payable Supplies Supplies Owner’s Capital

Cr. 100 100 100 100 100 100 100 100

9. Which of the following is the correct journal entry for purchasing $9,000 worth of equipment on account? (p. 87) Journal Entry: Accounts a. b c. d.

Equipment Cash Accounts Payable Equipment Equipment Accounts Payable Cash Equipment

Dr.

Cr.

9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000

10. Which of the following is the correct journal entry to record the receipt of $650 on account for services previously rendered? (p. 93)

Journal Entry: Accounts a. b c. d.

Service Revenue Cash Accounts Receivable Service Revenue Accounts Receivable Cash Cash Accounts Receivable

Dr.

Cr. 650 650 650 650 650 650 650 650


59

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Quick Exercises 2-1. Indicate whether a debit or credit is required to record an increase for each of these accounts. (p. 62) Dr. Dr. Dr. Cr.

Cash Owner, Withdrawals Salary Expense Service Revenue

Dr. Cr. Dr. Dr.

Prepaid Rent Notes Payable Land Utilities Expense

2-2. Write a brief explanation for the following transactions: (pp. 69–76) Journal Entry: Accounts Cash

Dr.

Cr.

10,000 Owner, Capital

10,000

a. Owner investment of cash. Journal Entry: Accounts

Dr.


Cr. 500 500

b. Purchased supplies on account. Journal Entry: Accounts Cash

Dr.

Cr.

3,000 Service Revenue

3,000

c. Received cash for services performed. Journal Entry: Accounts Accounts Receivable Service Revenue

d. Performed services on account. 60


Dr.

Cr.

2,000 2,000

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Journal Entry: Accounts

Dr.

Accounts Payable Cash

Cr. 300 300

e. Paid cash on account. 2-3. Identify the following as an asset, liability, owner’s equity, revenue, or expense account. Also indicate the normal balance. (pp. 58–60) Account

Normal Balance

a. Building

Asset

Debit

b. Accounts Payable

Liability

Credit

c. Cash

Asset

Debit

d. Accounts Receivable

Asset

Debit

e. Prepaid Insurance

Asset

Debit

f. Supplies

Asset

Debit

g. Utilities Expense

Expense

Debit

h. Owner, Capital

Owner’s Equity

Credit

i. Owner, Withdrawals

Owner’s Equity

Debit

2-4. Journalize the transactions for the Reid Public Relations Company using the following accounts: Cash; Accounts Receivable; Notes Receivable; Supplies; Prepaid Insurance; Accounts Payable; Notes Payable; Reid, Capital; Reid, Withdrawals; Service Revenue; Salary Expense; Rent Expense; and Insurance Expense. (pp. 62–65) March 1

J. Reid invested $25,000 cash to begin her public relations company.

Journal Entry: Date

Accounts

March 1

Cash Reid, Capital

March 2

Dr.

Cr.

25,000 25,000

Paid $ 3,000 for March rent.

Journal Entry: Date

Accounts

March 2

Rent Expense Cash

Dr.

Cr.

3,000 3,000


61

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March 4

Page 62

Purchased $825 of supplies on account.

Journal Entry: Date

Accounts

March 4


March 5

Dr.

Cr. 825 825

Performed $10,000 of services for a client on account.

Journal Entry: Date

Accounts

March 5

Accounts Receivable Service Revenue

March 8

Dr.

Cr.

10,000 10,000

Paid salaries of $2,500.

Journal Entry: Date

Accounts

March 8

Salary Expense Cash

Dr.

Cr.

2,500 2,500

March 15 Paid the semiannual insurance premium of $1,800 for the period March 15 through September 15. Journal Entry: Date

Accounts

March 15 Prepaid Insurance Cash

Dr.

Cr.

1,800 1,800

March 20 Signed a bank note and borrowed $20,000 cash. Journal Entry: Date

Accounts

March 20 Cash

Dr.

Cr.

20,000 Notes Payable

20,000

March 25 Received $10,000 from customers on account. (See March 5.) Journal Entry: Date

Accounts

March 25 Cash

Dr.

Cr.

10,000 Accounts Receivable

10,000

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2-5. Find the errors in the trial balance and prepare a corrected trial balance. (pp. 80–83) COLEMAN COPY CENTER Trial Balance March 31, 2008


Balance Debit Credit $30,000 2,000 600 50,000 $ 2,600 35,000 42,550 2,400 9,300 2,500 1,200 500 250 $ 89,450 $ 89,450


63

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Do It Yourself! Question 1 Solutions Requirement 1 Journalize each of the following transactions. Key journal entries by transaction letter. (Account numbers are not required.) a. Performed roof repairs for customers and earned $800 on in cash and $1,500 of revenue on account. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Accounts Receivable

Asset

↑

Dr.

Cash

Asset

↑

Dr.

Service Revenue

Revenue

↑

Cr.

Journal Entry: Date Accounts a.

Dr.

Accounts Receivable (Asset, 1; debit) Cash (Asset, 1; debit) Service Revenue (Revenue, 1; credit) Provided services for cash and on account.

Cr.

1,500 800 2,300

b. Paid $200 cash for supplies 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Supplies

Asset

↑

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Date Accounts b.

Supplies (Asset, 1; debit) Cash (Asset, 2; credit) Purchased supplies for cash.

64


Dr.

Cr. 200 200

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c. Took out a loan of $2,000 cash from City Bank 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Cash

Asset

↑

Dr.

Notes Payable

Liability

↑

Cr.

Journal Entry: Date Accounts c.

Dr.

Cash (Asset, 1; debit) Notes Payable (Liability, 1; credit) Took out loan for cash.

Cr.

2,000 2,000

d. Paid $3,000 cash to purchase repair tools. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Repair Tools

Asset

↑

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Date Accounts d.

Dr.

Repair Tools (Asset, 1; debit) Cash (Asset, 2; credit) Purchased repair tools.

Cr.

3,000 3,000

e. Paid the following in cash: interest, $75; repairs, $825; salaries, $1,000. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Interest Expense

Expense

↑

Dr.

Repairs Expense

Expense

↑

Dr.

Salary Expense

Expense

↑

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Date Accounts e.

Interest Expense (Expense, 1; debit) Repairs Expense (Expense, 1; debit) Salary Expense (Expense, 1; debit) Cash (Asset, 2; credit) Payment for expenses.

Dr.

Cr.

75 825 1,000 1,900


65

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f. Received a telephone bill of $100 that will be paid next month. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Utilities Expense

Expense

↑

Dr.

Accounts Payable

Liability

↑

Cr.

Journal Entry: Date Accounts f.

Dr.

Utilities Expense (Expense, 1; debit) Accounts Payable (Liability, 1; credit) Received utility bill.

Cr. 100 100

g. Paid $500 on account. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Accounts Payable

Liability

↓

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Date Accounts g.

Dr.

Accounts Payable (Liability, 2; debit) Cash (Asset, 2; credit) Payment on accounts payable.

Cr. 500 500

h. Received $1,100 on account. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Cash

Asset

↑

Dr.

Accounts Receivable

Asset

↓

Cr.

Journal Entry: Date Accounts h.

66

Cash (Asset, 1; debit) Accounts Receivable (Asset, 2; credit) Receipt of payment from customer on account.


Dr.

Cr.

1,100 1,100

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i. Ted withdrew $1,300 for personal use. 1

2

3

4

Accounts Affected

Type

↑↓

Dr. or Cr.

Ted Johnson, Withdrawals

Equity

↓

Dr.

Cash

Asset

↓

Cr.

Journal Entry: Date Accounts i.

Ted Johnson, Withdrawals (Equity, 2; debit) Cash (Asset, 2; credit) Cash withdrawal by owner.

Dr.

Cr.

1,300 1,300

Requirement 2 Open the following accounts, with the balances indicated, in the ledger of Ted’s Roofing Shop. Use the T-account format. • Assets: Cash, $6,000; Accounts Receivable, $1,200, Supplies, no balance; Repair Tools, no balance • Liabilities: Accounts Payable, $700; Notes Payable, no balance • Owner’s Equity: Ted Johnson, Capital, $6,500; Ted Johnson, Withdrawals, no balance • Revenues: Service Revenue, no balance • Expenses: (none have balances) Interest Expense, Repairs Expense, Salary Expense, Utilities Expense


67

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Post all transactions in Requirement 1 to the ledger. ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Bal. 6,000 a. 800 c.

h.

Bal. f. b.

200

d. e. g.

3,000 1,900 500

i.

1,300

g.

700 100

a.

2,300

500

2,000

2,300

300 EXPENSES Notes Payable

1,100

c.

2,000

Interest Expense e.

2,000

3,000

75 75

OWNER’S EQUITY Accounts Receivable

Ted Johnson, Capital

Bal. 1,200 a. 1,500

Bal. 6,500 h.

e.

6,500

1,100

1,600

Repairs Expense 825

Ted Johnson, Withdrawals i.

1,300

Salary Expense e.

1,300

200 200 Repair Tools

d.

3,000 3,000

68


1,000 1,000

Supplies b.

825

Utilities Expense f.

100 100

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Requirement 3 Prepare the trial balance of Ted’s Roofing Shop at September 30, 2008.

TED’S ROOFING SHOP Trial Balance September 30, 2008

Account Title Cash Accounts receivable Supplies Repair tools Accounts payable Notes payable Ted Johnson, capital Ted Johnson, withdrawals Service revenue Interest expense Repairs expense Salary expense Utilities expense Total

Balance Debit Credit $ 3,000 1,600 200 3,000 $ 300 2,000 6,500 1,300 2,300 75 825 1,000 100 $ 11,100 $ 11,100


69

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The Power of Practice For more practice using the skills learned in this chapter, visit MyAccountingLab. There you will find algorithmically generated questions that are based on these Demo Docs and your main textbook’s Review and Accounting Practice sections. Go to MyAccountingLab and follow these steps: Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 2, Recording Business Transactions. 6. Click a link to work on the tutorial exercises.

1. 2. 3. 4. 5.

70

The Power of Practice | Chapter 2

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3


WHAT YOU PROBABLY ALREADY KNOW When you receive your car insurance bill, the period of coverage is always in the future. The bill may indicate that your payment must be received no later than 12:01 AM on the day after your current coverage expires to maintain your policy. Your payment is actually a prepayment, prepaid insurance. Prepaid insurance is an asset because the insurance coverage is a future benefit. But every day that the car is protected by the insurance policy, part of the benefit is used up. When an asset is used up, it becomes an expense. Technically, every day you are incurring an expense of 1/365th of your annual premium. Assume that you paid $730 for an annual insurance policy in December 2007 for the period covering January 1–December 31, 2008. Each day beginning January 1, you are using up $2 ($730/365 days) of the prepaid insurance and incurring an expense or benefit of $2. At the end of January 1, what is your future benefit? It is $728 because you’ve benefited from the insurance coverage service you received that day. Technically, you have prepaid insurance with a reduced value of $728 and an expense of $2; the total $730 payment is split between the two accounts. Each day, an additional $2 expense is accrued and the asset account contains $2 less in value. Although it would be too cumbersome to “adjust” these accounts on a daily basis, businesses generally make adjustments to their records whenever financial statements are prepared.

Learning Objectives

1

Describe the accounting principles that help businesses measure income. • The revenue principle tells us when revenue is earned and what amount of revenue to record. The matching principle requires that all of the expenses incurred during a period are recorded and matched (recorded in the same time period) against the revenues. • The time period concept ensures that information is reported often.

Refer to Exhibit 3-1 (p. 127) of the main text for a visual overview of the accounting principles for measuring income.

2

Describe the four types of adjusting entries. Adjusting entries are recorded at the end of the accounting period when financial statements are prepared. The objective of adjusting entries is

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to update the account balances and to accurately measure net income or net loss. The four types of adjusting entries are: • Prepaid expenses: Cost (future expenses) that are paid for in advance of being used. • Unearned revenue: Cash received from customers before revenue is earned. • Accrued expenses: An expense the business has incurred but not yet paid. • Accrued revenue: A revenue that has been earned but not collected in cash.

Review Exhibits 3-2 and 3-3 (pp. 128–129) in the main text for a visual overview of the types of adjusting entries.

3

Make adjusting entries. The following two-step process will facilitate preparing the adjusting journal entries: 1. Determine whether a revenue account needs to be recorded (credited) or an expense account needs to be recorded (debited). 2.The other account in the entry MUST be either an asset or a liability account. Be careful: Cash will never be included in an adjusting journal entry. You will learn how to prepare adjusting entries in Demo Doc 1. Review Exhibits 3-5 through 3-8 (pp. 138–141) carefully for a review of the adjusting journal entry process.

4

Prepare an adjusted trial balance. After the adjusting journal entries are journalized, they are posted and an adjusted trial balance is prepared. The list of updated account balances is prepared to determine that debits equal credits before preparing the financial statements. Exhibit 3-8 (p. 141) shows the flow of information from the trial balance to the adjusted trial balance on the worksheet.

5

Prepare financial statements from an adjusted trial balance. Follow the flow of data from the adjusted trial balance in Exhibit 3-8 (p. 141) to the financial statements in Exhibit 3-9 through 3-11 (p. 142).

72

Chapter 3 | The Adjusting Process

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Demo Doc 1 Adjusting Entries for Accrual Accounting Learning Objectives

1–5

Wood’s Restaurant’s December 31 (year-end) trial balance (before adjustments) is as follows: WOOD’S RESTAURANT Trial Balance Year Ended December 31, 2008

Account Title Cash Accounts receivable Supplies Prepaid rent Furniture Accumulated depreciation, furniture Accounts payable Salary payable Daniel Wood, capital Daniel Wood, withdrawals Service revenue Salary expense Rent expense Supplies expense Depreciation expense Total

Balance Debit Credit $ 10,600 14,000 1,200 3,000 15,000 $ 4,500 2,600 0 40,000 11,500 24,000 10,000 5,000 800 0 $ 71,100 $71,100

Requirements 1. Open the T-accounts and enter their unadjusted balances. 2. Journalize the following adjusting entries at December 31, 2008. Key the entries by letter. a. Employees are paid $200 every Friday for the previous five days of work. December 31, 2008, is a Wednesday. b. Depreciation on the furniture is $1,500 for the year. c. Supplies on hand at December 31, 2008, are $400. d. Six months of rent ($3,000) was paid in advance on November 1, 2008. No adjustment has been made to the Prepaid Rent account since then. e. Accrued revenue totaling $1,800 must be recorded. 3. Post the adjusting entries. 4. Prepare the trial balance on the worksheet, enter the adjusting entries, and prepare an adjusted trial balance. 5. Prepare the income statement, statement of owner’s equity, and balance sheet for Wood’s Restaurant. Demo Doc 1 | Chapter 3

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Demo Doc 1 Solutions Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Requirement 1 Open the T-accounts and enter their unadjusted balances. ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Bal. 10,600

Bal. 2,600

Accounts Receivable

Bal. 24,000

Salary Payable

Bal. 14,000

EXPENSES Rent Expense

Supplies

Bal. 5,000

OWNER’S EQUITY

Bal. 1,200 Daniel Wood, Capital

Salary Expense

Bal. 40,000

Prepaid Rent

Bal. 10,000

Bal. 3,000 Daniel Wood, Withdrawals

Furniture Bal. 15,000

Depreciation Expense

Bal. 11,500 Supplies Expense Bal. 800

Accumulated Depreciation, Furniture Bal. 4,500

Requirement 2 Journalize the following adjusting entries at December 31, 2008. Key the entries by letter. Part 1

2

Describe the four types of adjusting entries.

3

Make adjusting entries.

74

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

a. Employees are paid $200 every Friday for the previous five days of work. December 31, 2008, is a Wednesday. If employees are paid $200 for five days of work, then they are paid $200/5 = $40 per day. By the end of the day on Wednesday, December 31, the employees have worked for three days and have not been paid. Therefore, Wood owes employees $40 × 3 = $120 of salary at December 31. If the salaries have not been paid, then they are payable (or in other words, they are owed) and must be recorded as some kind of payable account. We might consider using Accounts Payable, but this account is usually reserved


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for bills received. The employees do not send Wood a bill, they simply expect to be paid and Wood knows that the salaries are owed. So we put this amount owed into another payable account. In this case, Salary Payable is most appropriate. Because salary is not owed until work is performed, we know that Wood’s employees have already worked. This past benefit is recorded as an expense (in this case, Salary Expense). The result is an increase to Salary Expense (a debit) and an increase to the liability Salary Payable (a credit) of $120.

Journal Entry: Date

Accounts and Explanation

Post Ref.

Dr.

Dec. 31 Salary Expense (3 ! $200/5) (Expense,1; debit) Salary Payable (Liability,1; credit) To accrue salary expense.

Cr.

120 120

b. Depreciation on the furniture is $1,500 for the year.

3


2


3


The entry to record depreciation expense is always the same. It is only the number (dollar amount) in the entry that changes. This adjustment always increases Depreciation Expense (a debit) and increases the contra-asset account of Accumulated Depreciation (a credit). Because we are given the depreciation expense of $1,500, we simply write the entry with that amount.

Journal Entry: Date Accounts and Explanation Dec. 31 Depreciation Expense, Furniture (Expense1; debit) Accumulated Depreciation, Furniture (Contra-Asset,1; credit) To record depreciation on building.

Post Ref.

Dr. 1,500

c. Supplies on hand at December 31, 2008, are $400. Before adjustments, the Supplies account holds $1,200. If only $400 of supplies remains, then the other $800 must have been used: $1,200 ! $400 " $800

Supplies are an asset, a future benefit to Wood. Once the supplies are used, they are a past benefit. When they are no longer assets, the Supplies asset must be decreased by $800 (a credit). Past benefits are expenses, so Supplies Expense is increased (a debit).


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Journal Entry: Date Accounts and Explanation Dec. 31 Supplies Expense ($1,200 – $400) (Expense,1; debit) Supplies (Asset,2; credit) To record supplies expense.

2


3


Post Ref.

Dr. 800

Cr. 800

d. Six months of rent ($3,000) was paid in advance on November 1, 2008. No adjustment has been made to the Prepaid Rent account since. Wood prepaid $3,000 for six months of rent on November 1, which means that Wood pays $3,000/6 = $500 a month for rent. At December 31, two months have passed since the prepayment, so two months of the prepayment have been used. The amount of rent used is: 2 # $500 " $1,000

When something is prepaid, it is a future benefit (an asset) because the business is now entitled to receive goods or services. Once those goods or services are received (in this case, once Wood has occupied the building being rented), it becomes a past benefit, and therefore an expense. So Rent Expense must be increased (a debit) and the Prepaid Rent (an asset) must be decreased (a credit).

Journal Entry: Date

Accounts and Explanation

Post Ref.

Dec. 31 Rent Expense (2 ! $3,000/6) (Expense,1; debit) Prepaid Rent (Asset,2; credit) To record rent expense.

1

Describe the accounting principles that help businesses measure income.

2


3


Dr.

Cr.

1,000 1,000

e. Accrued revenue totaling $1,800 must be recorded. Accrued revenue is another way of saying “accounts receivable” (or receipt of payment in the future). If accrued revenue is recorded, it means that accounts receivable is also recorded (that is, customers received goods or services from the business, but the business has not yet received the cash). The business is entitled to these receivables because the revenue has been earned. Note that not all revenue is accrued revenue. Only the revenue that is earned but not immediately received from the customer (that is, the accounts receivable) is referred to as accrued. Revenues that are earned and received immediately in cash are not accrued revenues. Service Revenue must be increased by $1,800 (a credit) and the Accounts Receivable asset account must be increased by $1,800 (a debit).

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Journal Entry: Post Ref.

Date Accounts and Explanation Dec. 31 Accounts Receivable (Asset,1; debit) Service Revenue (Revenue,1; credit) To accrue service revenue.

Dr. 1,800

Cr. 1,800

Requirement 3 Post the adjusting entries.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Bal. 10,600

Bal. 2,600 e.

24,000 1,800

Bal. 25,800 Accounts Receivable

Salary Payable

14,000 e.

1,800

a.

120

Bal.

120

EXPENSES

Bal. 15,800

Rent Expense 5,000 1,000

OWNER’S EQUITY Supplies 1,200

Bal. 6,000 c.

Bal.

800

Daniel Wood, Capital

400

Bal. 40,000

10,000 120

a.

Prepaid Rent 3,000 d.

Salary Expense

1,000

Bal. 2,000

Daniel Wood, Withdrawals Bal. 11,500

Furniture

Bal. 10,120 Depreciation Expense b.

1,500

Bal.

1,500

Bal. 15,000 Supplies Expense Accumulated Depreciation, Furniture b.

4,500 1,500

c. Bal.

800 800 1,600

Bal. 6,000


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Requirement 4

4

Prepare an adjusted trial balance.

Prepare the trial balance on the worksheet, enter the adjusting entries, and prepare an adjusted trial balance.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

WOOD’S RESTAURANT Preparation of Adjusted Trial Balance Year Ended December 31, 2008


Trial Balance Dr. Cr. $10,600 14,000 1,200 3,000 15,000

Adjusted Trial Balance Dr. Cr. $10,600 e. $1,800 15,800 400 c. $800 d. 1,000 2,000 15,000 Adjustments Dr. Cr.

$ 4,500 2,600 0 40,000

b. 1,500

24,000

e. 1,800

a.

120 11,500

11,500 10,000 5,000 800 0 $71,100

$6,000 2,600 120 40,000

a. 120 d. 1,000 c. 800 b. 1,500 $5,220 $71,100

25,800 10,120 6,000 1,600 1,500 $5,220 $74,520 $74,520

Requirement 5

5

Prepare financial statements from an adjusted trial balance.

Prepare the income statement, statement of owner’s equity, and balance sheet for Wood’s Restaurant.

Part 1

78


Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

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WOOD’S RESTAURANT Income Statement Year Ended December 31, 2008 Revenue: Service revenue Expenses: Salary expense Rent expense Supplies expense Depreciation expense Total expenses Net income

$ 25,800 $ 10,120 6,000 1,600 1,500 19,220 $ 6,580

Remember, the one account that has not yet been updated is Daniel Wood, Capital. The amount of $40,000 in this account is the amount from the beginning of the year (January 1). To update the account, we need to prepare the statement of owner’s equity.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

WOOD’S RESTAURANT Statement of Owner’s Equity Year Ended December 31, 2008 Daniel Wood, capital, January 1, 2008 Add: Net income for month

$40,000 6,580 46,580 (11,500) $35,080

Less: Withdrawals by owner Daniel Wood, capital, December 31, 2008

We use this updated Daniel Wood, capital amount on the balance sheet.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete


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WOOD’S RESTAURANT Balance Sheet December 31, 2008 Assets Cash Accounts receivable Supplies Prepaid rent Furniture Less: Accumulated depreciation Total assets

Part 1

80

Part 2


$10,600 15,800 800 2,000 $15,000 (6,000)

Part 3

9,000 $37,800

Part 4

Liabilities Accounts payable Salary payable Total liabilities

$ 2,600 120 $ 2,720

Owners’ Equity Daniel Wood, capital

35,080

Total liabilities and owner’s equity

Part 5

Part 6

Part 7

$37,800

Demo Doc Complete

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Quick Practice Questions True/False 1. Revenue is recorded when it is earned; usually when a good or service has been delivered to the customer. 2. The time period concept provides for periodic reporting at regular intervals. 3. An accounting year that ends on a date other than December 31 is called an interim year. 4. The revenue principle requires that a cash deposit for future construction be recorded as revenue. 5. Adjusting journal entries are made at the end of the period. 6. The income statement is the first financial statement that is prepared. 7. Every adjusting journal entry affects one income statement account and one balance sheet account. 8. An accrual is an expense that is recorded after it is paid. 9. Accumulated Depreciation is a liability account. 10. Unearned Service Revenue appears on the income statement.


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Multiple Choice 1. What items should be matched according to the matching principle? a. Debits with credits b. Assets with liabilities c. Expenses with revenues d. Accruals with prepaids 2. What is it called when cash is received before revenue is recorded? a. A deferral b. An accrual c. Revenue recognition d. A prepaid expense 3. What do adjusting entries properly measure? a. Net income for the period b. The assets, liabilities, and owner’s equity on the balance sheet c. Both a and b d. Neither a nor b 4. Which of the following entities would most likely have an Unearned Revenue account? a. A local pizza store b. An accounting firm c. A department store d. A magazine publisher 5. Georgia Industries paid $48,000 for two years of insurance coverage on July 1, 2007. The company prepares financial statements on July 31, 2007. What is the amount of insurance expense on July 31? a. $48,000 b. $ 2,000 c. $24,000 d. $46,000 6. Using the information from question 5, what is the adjusted balance in Prepaid Insurance on December 31, 2007? a. $36,000 b. $24,000 c. $12,000 d. $38,000

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7. Sports Illustrated receives $120,000 on September 1, 2008, for one year’s worth of magazine subscriptions for the year beginning September 1, 2008. What is the journal entry to record the prepaid subscriptions? Journal Entry: Date Accounts a. Accounts Receivable Unearned Subscription Revenue b.

Post Ref.

Cash

Dr. 120,000

120,000 120,000

Subscription Revenue c.

Cash

120,000 120,000

Unearned Subscription Revenue d.

Cr.

Accounts Receivable Subscription Revenue

120,000 120,000 120,000

8. Which of the following accounts is depreciated? a. Building b. Land c. Supplies d. Prepaid Insurance 9. What is book value? a. The sum of all the depreciation recorded for the asset b. The cost of the depreciable asset c. The cost of the depreciable asset divided by the useful life d. The cost of the depreciable asset minus accumulated depreciation 10. Mason Company has a weekly payroll of $5,000. Wages are paid every Friday for the work performed Monday through Friday of that week. Assuming that the accounting period ends on a Tuesday, what amount of Wages Expense should be recorded on that date? a. $1,000 b. $2,000 c. $3,000 d. $4,000


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Quick Exercises 3-1. Using the following information, post the required adjustments into the worksheet and extend all the account balances into the adjusted trial balance. a. b. c. d. e.

Supplies of $400 were used up this period. Prepaid insurance expired, $500. Accrued service revenue, $1,200. Depreciation on machinery, $650. Service revenue collected in advance now earned, $750.

Account Cash Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation, equipment Accounts payable Unearned service revenue Joan Reid, capital Joan Reid, withdrawals Service revenue Insurance expense Depreciation expense, equipment Supplies expense Total

84


Trial Balance Dr. Cr. $29,965 3,260 2,475 2,500 13,500 $10,250 4,500 950 18,200 2,700 29,000 3,250 4,550 700 $62,900

$62,900

Adjustments Dr. Cr.

Adjusted Trial Balance Dr. Cr.

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3-2. For each of the following situations, indicate whether an expense or revenue should be recorded and the amount of the adjustment on January 31, 2008.

a. Purchased $1,500 of supplies during January. On January 31, $800 of supplies remains. b. The five-day weekly payroll is $6,000. Employees worked the last two days of January and have not been paid by January 31. c. Earned $750 of Unearned Revenue in January. d. Depreciation on equipment is $3,600 for the year. e. Services of $2,300 were performed on January 31 and have not been recorded.

Revenue or Expense

Adjustment Amount

–––––––––

___________

–––––––––

––––––––––

–––––––––

––––––––––

–––––––––

––––––––––

–––––––––

––––––––––

3-3. Journalize the required adjusting journal entries using the information in Quick Exercise 3-2. a. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

b. Journal Entry: Date Accounts


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c. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

d. Journal Entry: Date Accounts

e. Journal Entry: Date Accounts

3-4. Following is the trial balance for Coleman Copy Center: COLEMAN COPY CENTER Trial Balance March 31, 2008


Balance Debit Credit $30,000 2,000 600 50,000 $ 2,600 35,000 42,550 2,400 9,300 2,500 1,200 500 250 $89,450 $89,450

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Prepare (a) an income statement and (b) a statement of owner’s equity for the month ending March 31, 2008.

COLEMAN COPY CENTER Income Statement Month Ending March 31, 2008

COLEMAN COPY CENTER Statement of Owner’s Equity Month Ending March 31, 2008

3-5. Using the trial balance for Coleman Copy Center in Quick Exercise 3-4, prepare the balance sheet at March 31, 2008.

COLEMAN COPY CENTER Balance Sheet March 31, 2008


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Do It Yourself! Question 1 Angela’s Business Services has the following balances on its December 31 (yearend) trial balance (before adjustments): ANGELA’S BUSINESS SERVICES Trial Balance December 31, 2008

Account Title Cash Prepaid insurance Supplies Office equipment Accumulated depreciation, equipment Accounts Payable Salary Payable Unearned service revenue Angela Waring, capital Angela Waring, withdrawals Service revenue Salary expense Insurance expense Supplies expense Depreciation expense Total

Balance Debit Credit $40,400 4,800 13,000 25,000 $7,500 5,300 0 6,800 60,000 8,000 80,000 45,000 13,200 10,200 0 $159,600 $159,600

Requirements: 1. Journalize the following adjusting entries at December 31, 2008. Key the entries by letter. a. Only $1,500 of the unearned service revenue remains unearned. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

b. Depreciation on the office equipment is $2,500 for the year. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

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c. Employees earned salaries of $4,000 that have not been paid. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

d. Supplies worth $5,100 have been used. Journal Entry: Date Accounts

e. Four months of insurance ($4,800) was paid in advance on December 1, 2008. No adjustment has been made to the prepaid insurance account since. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.


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2. Open T-accounts, enter the unadjusted balances in the accounts, and post the adjusting entries. ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Prepaid Insurance

Salary Payable EXPENSES Insurance Expense Unearned Service Revenue

Supplies Salary Expense Office Equipment

OWNER’S EQUITY Angela Warning, Capital


Angela Warning, Withdrawals

Supplies Expense

Acumulated Depreciation, Equipment

3. Prepare the trial balance on the worksheet, enter the adjusting entries, and prepare an adjusted trial balance.

Account Title Cash Prepaid insurance Supplies Office equipment Accumulated depreciation, equipment Accounts payable Salary payable Unearned service revenue Angela Waring, capital Angela Waring, withdrawals Service revenue Salary expense Insurance Supplies expense Depreciation expense Total

Trial Balance Dr. Cr.

Adjustments Dr. Cr.


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4. Prepare the income statement, statement of owner’s equity, and balance sheet for Angela’s Business Services.

ANGELA’S BUSINESS SERVICES Income Statement Year Ended December 31, 2008 Revenue: Expenses:

Net income

ANGELA’S BUSINESS SERVICES Statement of Owner’s Equity Year Ended December 31, 2008 Angela Waring, capital, January 1, 2008 Add:

Less: Angela Waring, capital, December 31, 2008

ANGELA’S BUSINESS SERVICES Balance Sheet December 31, 2008 Assets

Liabilities

Owner’s Equity

Total assets

Total liabilities and owner’s equity


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Do It Yourself! Question 2 Everly Industries is preparing its financial statements for the year ended December 31, 2009. Three accounting issues have been discovered.

Requirement 1. Make the necessary adjusting entry for each situation. a. Employees work five days a week (Monday through Friday) and are paid $7,500 for the previous week of work each Friday. December 31, 2009, falls on a Thursday. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

b. The Supplies account shows an unadjusted balance of $1,000. However, only $350 of supplies remains on hand at December 31, 2009. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

c. The company forgot to record four months of interest expense ($80 per month) that has been incurred but not yet paid. Journal Entry: Date Accounts

92


Post Ref.

Dr.

Cr.

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Quick Practice Solutions True/False T

1. Revenue is recorded when it is earned; usually when a good or service has been delivered to the customer. (p. 126)

T

2. The time period concept provides for periodic reporting at regular intervals. (p. 126)

F

3. An accounting year that ends on a date other than December 31 is called an interim year. False–An accounting year that ends on a date other than December 31 is called a fiscal year. (p. 127)

F

4. The revenue principle requires that a cash deposit for future construction be recorded as revenue. False–The revenue principle requires that revenue be recorded when it has been earned. The cash received for future construction has not been earned yet. (p. 127)

T

5. Adjusting journal entries are made at the end of the period. (pp. 127–128)

T

6. The income statement is the first financial statement that is prepared. (p. 141)

T

7. Every adjusting journal entry affects one income statement account and one balance sheet account. (p. 138)

F

8. An accrual is an expense that is recorded after it is paid. False–An accrual is an expense that is recorded before it is paid. (pp. 126–129)

F

9. Accumulated depreciation is a liability account. False–Accumulated depreciation is a contra-asset account. (p. 134)

F

10. Unearned Service Revenue appears on the income statement. False–Unearned Service Revenue is a liability and appears on the balance sheet. (pp. 141–143)


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Multiple-Choice 1. What items should be matched according to the matching principle? (p. 126) a. Debits with credits b. Assets with liabilities c. Expenses with revenues d. Accruals with prepaids 2. What is it called when cash is received before revenue is recorded? (p. 128) a. A deferral b. An accrual c. Revenue recognition d. A prepaid expense 3. What do adjusting entries properly measure? (pp. 127–128) a. Net income for the period b. The assets, liabilities, and owner’s equity on the balance sheet c. Both a and b d. Neither a nor b 4. Which of the following entities would most likely have an Unearned Revenue account? (pp. 134–135) a. A local pizza store b. An accounting firm c. A department store d. A magazine publisher 5. Georgia Industries paid $48,000 for two years of insurance coverage on July 1, 2007. The company prepares financial statements on July 31, 2007. What is the amount of insurance expense on July 31? (pp. 130–131) a. $48,000 b. $ 2,000 c. $24,000 d. $46,000 6. Using the information from question 5, what is the adjusted balance in Prepaid Insurance on December 31, 2007? (pp. 130–131) a. $36,000 b. $24,000 c. $12,000 d. $38,000

94


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7. Sports Illustrated receives $120,000 on September 1, 2008, for one year’s worth of magazine subscriptions for the year beginning September 1, 2008. What is the journal entry to record the prepaid subscriptions? (pp. 130–131)

Journal Entry: Date Accounts a. Accounts Receivable Unearned Subscription Revenue b.

Cash

Post Ref.

Dr. 120,000

120,000 120,000

Subscription Revenue c.

Cash

120,000 120,000

Unearned Subscription Revenue d.

Cr.

Accounts Receivable Subscription Revenue

120,000 120,000 120,000

8. Which of the following accounts is depreciated? (pp. 132–134) a. Building b. Land c. Supplies d. Prepaid Insurance 9. What is book value? (p. 134) a. The sum of all the depreciation recorded for the asset b. The cost of the depreciable asset c. The cost of the depreciable asset divided by the useful life d. The cost of the depreciable asset minus accumulated depreciation 10. Mason Company has a weekly payroll of $5,000. Wages are paid every Friday for the work performed Monday through Friday of that week. Assuming that the accounting period ends on a Tuesday, what amount of Wages Expense should be recorded on that date? (pp. 136–137) a. $1,000 b. $2,000 c. $3,000 d. $4,000


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Quick Exercise 3-1. Using the following information, post the required adjustments into the worksheet and extend all of the account balances into the adjusted trial balance. (p. 140) a. b. c. d. e.

Supplies of $400 were used up this period. Prepaid insurance expired, $500. Accrued service revenue, $1,200. Depreciation on machinery, $650. Service revenue collected in advance now earned, $750.

Account Title Cash Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation, equipment Accounts payable Unearned service revenue Joan Reid, capital Joan Reid, withdrawals Service revenue Insurance expense Depreciation expense, equipment Supplies expense Total

96


Trial Balance Dr. Cr. $29,965 3,260 2,475 2,500 13,500

Adjusted Trial Balance Dr. Cr. $29,965 4,460 $400 2,075 500 2,000 13,500

Adjustments Dr. Cr. c. $1,200 a. b.

10,250 4,500 950 e. 18,200

d.

650

750 2,700

2,700 c. 1,200 e. 750

29,000 3,250 4,550 700 $62,900

$10,900 4,500 200 18,200

b. d. a. $62,900

500 650 400 $3,500

3,750 5,200 1,100 $3,500 $64,750

30,950

$64,750

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3-2. For each of the following situations, indicate whether an expense or revenue should be recorded and the amount of the adjustment on January 31, 2008. (p. 138)

a. Purchased $1,500 of supplies during January. On January 31, $800 of supplies remains.

Revenue or Expense

Adjustment Amount

Expense

$ 700

b. The five-day weekly payroll is $6,000. Employees worked the last two days of January and have not been paid by January 31.

Expense

$2,400

c. Earned $750 of Unearned Revenue in January.

Revenue

$ 750

d. Depreciation on equipment is $3,600 for the year.

Expense

$ 300

e. Services of $2,300 were performed on January 31 and have not been recorded.

Revenue

$2,300

3-3. Journalize the required adjusting journal entries using the information in Quick Exercise 3-2. (p. 138) a. Journal Entry: Date Accounts Jan. 31 Supplies Expense Supplies

Post Ref.

Dr. 700

Cr. 700

b. Journal Entry: Date Accounts Jan. 31 Salary Expense Salary Payable

Post Ref.

Dr. 2,400

Cr. 2,400

c. Journal Entry: Date Accounts Jan. 31 Unearned Revenue Service Revenue

Post Ref.

Dr. 750

Cr. 750

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d. Journal Entry: Date Accounts Jan. 31 Depreciation Expense, Equipment Accumulated Depreciation, Equipment

Post Ref.

Dr. 300

Cr. 300

e. Journal Entry: Date Accounts Jan. 31 Accounts Receivable Service Revenue

Post Ref.

Dr. 2,300

Cr. 2,300

3-4. Following is the trial balance for Coleman Copy Center:

COLEMAN COPY CENTER Trial Balance March 31, 2008


98


Balance Debit Credit $30,000 2,000 600 50,000 $2,600 35,000 42,550 2,400 9,300 2,500 1,200 500 250 $89,450 $89,450

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Prepare (a) an income statement and (b) a statement of owner’s equity for the month ending March 31, 2008. (pp. 141–143) a.

COLEMAN COPY CENTER Income Statement Month Ending March 31, 2008 Revenue: Service revenue Expenses: Salary expense Rent expense Interest expense Utilities expense Total expenses Net income

$9,300 2,500 1,200 500 250 4,450 $4,850

b.

COLEMAN COPY CENTER Statement of Owner’s Equity Month Ending March 31, 2008 Jo Coleman, capital, May 1, 2008 Add: Net income Less: Withdrawals Jo Coleman, capital, May 1, 2008

$ 42,550 4,850 $ 47,400 2,400 $ 45,000

3-5. Using the trial balance for Coleman Copy Center in Quick Exercise 3-4, prepare the balance sheet at March 31, 2008. (pp. 141–143)

COLEMAN COPY CENTER Balance Sheet March 31, 2008 Assets Cash Accounts receivable Supplies Land

Total assets

Liabilities $ 30,000 Accounts payable 2,000 Salary payable 600 Total liabilities 50,000 Owner’s Equity Jo Coleman, capital Total liabilities and $82,600 owner’s equity

$ 2,600 35,000 $ 37,600 45,000 $82,600


99

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Do It Yourself! Question 1 Solutions Requirement 1 Journalize the following adjusting entries at December 31, 2008. Key the entries by letter. a. Only $1,500 of the unearned service revenue remains unearned. Journal Entry: Post Date Accounts and Explanation Ref. Dec. 31 Unearned Service Revenue ($6,800 – $1,500) (Liability,2; debit) Service Revenue (Revenue,1; credit) To record service revenue collected in advance that is now earned.

Dr. 5,300

Cr. 5,300

b. Depreciation on the office equipment is $2,500 for the year. Journal Entry: Date Accounts and Explanation Dec. 31 Depreciation Expense, Equipment (Expense1; debit) Accumulated Depreciation, Equipment (Contra-Asset,1; credit) To record depreciation on equipment.

Post Ref.

Dr. 1,500

Cr.

1,500

c. Employees earned salaries of $4,000 that have not been paid. Journal Entry: Date Accounts and Explanation Dec. 31 Salary Expense (Expense,1; debit) Salary Payable (Liability,1; credit) To accrue salary expense.

Post Ref.

Dr. 4,000

Cr. 4,000

d. Supplies worth $5,100 have been used. Journal Entry: Date Accounts and Explanation Dec. 31 Supplies Expense (Expense,1; debit) Supplies (Asset,2; credit) To accrue supplies expense. 100


Post Ref.

Dr. 5,100

Cr. 5,100

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e. Four months of insurance ($4,800) was paid in advance on December 1, 2008. No adjustment has been made to the prepaid insurance account since. Journal Entry: Post Ref.

Date Accounts and Explanation Dec. 31 Insurance Expense (1 3 $4,800/4) (Expense,1; debit) Prepaid Insurance (Asset,2; credit) To record insurance expense.

Dr. 1,200

Cr. 1,200

Requirement 2 Open T-accounts, enter the unadjusted balances in the account, and post the adjusting entries. ASSETS

LIABILITIES

REVENUES

Cash

Accounts Payable

Service Revenue

Bal. 40,400

Bal. 5,300 a.

80,000 5,300

Bal. 85,300 Prepaid Insurance

Salary Payable

4,800 e.

1,200

c.

4,000

Bal.

4,000

Bal. 3,600 Unearned Service Revenue 6,800

Supplies 13,000

a. d.

EXPENSES Insurance Expense 13,200 e. 1,200 Bal. 14,400

5,300 Bal. 1,500

5,100

Bal. 7,900

Salary Expense

Office Equipment

OWNER’S EQUITY

Bal. 25,000

c.

45,000 4,000

Bal. 49,000 Angela Waring, Capital Bal. 60,000

Accumulated Depreciation, Equipment b.

2,500 Bal.

7,500 2,500

Bal. 10,000

Depreciation Expense b.

Angela Waring, Withdrawals Bal.

2,500

Supplies Expense 10,200

8,000 d.

5,100

Bal. 15,300


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Requirement 3 Prepare the trial balance on the worksheet, enter the adjusting entries, and prepare an adjusted trial balance.

ANGELA’S BUSINESS SERVICES Preparation of Adjusted Trial Balance Year Ended December 31, 2008 Trial Balance Dr. Cr. $ 40,400 4,800 13,000 25,000

Account Title Cash Prepaid insurance Supplies Office equipment Accumulated depreciation, equipment Accounts payable Salary payable Unearned service revenue Angela Waring, capital Angela Waring, withdrawals Service revenue Salary expense Insurance expense Supplies expense Depreciation expense Total

$

Adjusted Trial Balance Dr. Cr. $ 40,400 e. $1,200 3,600 d. 5,100 7,900 25,000

Adjustments Dr. Cr.

b. 2,500 7,500 5,300 c. 4,000 0 6,800 a.$ 5,300 60,000

$ 10,000 5,300 4,000 1,500 60,000 8,000

8,000 a. 5,300

80,000 45,000 13,200 10,200 0 $159,600 $159,600

c. 4,000 e. 1,200 d. 5,100 b. 2,500 $18,100

85,300 49,000 14,400 15,300 2,500 $18,100 $166,100 $166,100

Requirement 4 Prepare the income statement, statement of owner’s equity, and balance sheet for Angela’s Business Service.

ANGELA’S BUSINESS SERVICES Income Statement Year Ended December 31, 2008 Revenue: Service revenue Expenses: Salary expense Supplies expense Insurance expense Depreciation expense Total expenses Net income

102


$85,300 $49,000 15,300 14,400 2,500 81,200 $ 4,100

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ANGELA’S BUSINESS SERVICES Statement of Owner’s Equity Year Ended December 31, 2008 Angela Waring, capital, January 1, 2008 Add: Net income for month

$ 60,000 4,100 $ 64,100 (8,000) $ 56,100

Less: Withdrawals by owner Angela Waring, capital, December 31, 2008

ANGELA’S BUSINESS SERVICES Balance Sheet December 31, 2008 Assets Cash Prepaid insurance Supplies Office equipment Less: Accumulated depreciation Total assets

$25,000 (10,000)

Liabilities $40,400 Accounts payable 3,600 Salary payable 7,900 Unearned revenue Total liabilities Owner’s Equity 15,000 Angela Waring, capital $66,900 Total liabilities and owner’s equity

$ 5,300 4,000 1,500 10,800 56,100 $66,900


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Do It Yourself! Question 2 Solutions Requirement 1 Make the necessary adjusting entry for each situation. a. Employees work five days a week (Monday through Friday) and are paid $7,500 for the previous week of work each Friday. December 31, 2009, falls on a Thursday. $7,500/5 days = $1,500 salary per day of work Monday through Thursday = 4 days of work 4 × $1,500 = $6,000

Journal Entry: Date Accounts and Explanation Dec. 31 Salary Expense (4 3 $7,500/5) (Expense,1; debit) Salary Payable (Liability,1; credit) To accrue salary expense.

Post Ref.

Dr. 6,000

Cr. 6,000

b. The Supplies account shows an unadjusted balance of $1,000. However, only $350 of supplies remains on hand at December 31, 2009. $1,000 – $350 = $650 of supplies used Journal Entry: Date Accounts and Explanation Dec. 31 Supplies Expense ($1,000 – $350) (Expense,1; debit) Supplies (Asset,2; credit) To record supplies expense.

Post Ref.

Dr. 650

Cr. 650

c. The company forgot to record four months of interest expense ($80 per month) that has been incurred but not yet paid. 4 months × $80 per month = $320 Journal Entry: Date Accounts and Explanation Dec. 31 Interest Expense (4 3 $80) (Expense,1; debit) Interest Payable (Liability,1; credit) To accrue interest expense.

104


Post Ref.

Dr. 320

Cr. 320

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The Power of Practice For more practice using the skills learned in this chapter, visit MyAccountingLab. There you will find algorithmically generated questions that are based on these Demo Docs and your main textbook’s Review and Accounting Practice sections. 1. Go to MyAccountingLab and follow these steps: 2. 3. 4. 5. 6. 7.

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 3, The Adjusting Process. Click a link to work on the tutorial exercises.


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4

Completing the Accounting Cycle

WHAT YOU PROBABLY ALREADY KNOW If you work, you probably notice that your pay stub includes yearto-date earnings. When a new year begins, the year-to-date totals from last year are gone and the year-to-date earnings include only the current year. Last year’s records are not erased or unimportant. Earnings from last year are reported for each employee on a W-2 form, Wage and Tax Statement. This form is sent to employees in January of the new year to attach to their income tax return. The year-to-date earnings are zeroed out to be ready to accumulate earnings in the new year. The same thing happens in a business. At the end of the accounting year, the earnings and revenue accounts are zeroed out to get ready for the new year.

Learning Objectives

1

Explain the steps in the accounting cycle. The accounting cycle is the process by which companies gather financial information to produce their financial statements. You are already familiar with the first four steps of the accounting cycle by what you have studied and practiced so far in Chapters 1–3. Namely, identify transactions that affect the business, journalize the transactions, post the journal entries to the ledger, and prepare the accounting worksheet. In this chapter, you learn how to use the worksheet to prepare the financial statements, journalize adjusting entries and post them to the ledger, and journalize and post the closing entries. The final step is to prepare a post-closing trial balance. Understanding the accounting cycle is important, so be sure to review Exhibit 4-1 (p. 181) in the main textbook, which summarizes these eight steps.

2

Prepare a worksheet. A worksheet is a multicolumned document or spreadsheet that is used to summarize accounting data at the end of the period. In Chapter 3, Exhibit 3-8 (p. 141) illustrated the first of three columns of data in the worksheet; the trial balance, adjusting journal entries, and the adjusted trial balance. The adjusted balances are brought forward to one of the last two sets of columns, either the income statement columns or the balance sheet columns. The income statement debit column includes expenses and the credit column includes revenue accounts. The balance sheet debit column includes assets and withdrawals; the credit column includes liabilities, owner’s equity, and accumulated depreciation accounts. Review Exhibits 4-2 through 4-6 (p. 184) to understand the flow of steps in preparing the worksheet.

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Prepare financial statements using the worksheet. The worksheet is a working document. It helps to make the adjusting entries, prepare financial statements, and close out the temporary accounts. Review Exhibits 4-7 and 4-8 (pp. 187–188) to understand the flow of information from the worksheet to the financial statements.

4

Close the revenue, expense, and withdrawal accounts. The revenue, expense, and withdrawal accounts are temporary accounts; the account balances are zeroed (closed) out at the end of the year to get ready for recording transactions in the new year. Income Summary is a temporary account that is used only for this process. The closing process also updates the ending Capital account balance for the net income or net loss and withdrawals during the year. Review Exhibits 4-10 through 4-12 (pp. 191–193) to enhance your understanding of the closing process.

5

Classify assets and liabilities as current or long-term. Current assets and liabilities are those that will be dealt with within either a one-year period or the business’s normal operating cycle, whichever is longer. Long-term assets and liabilities are all assets and liabilities that are not current. It’s important to remember that a liability (such as a car loan or a mortgage payment) may need to be split between current and long-term liability classifications on the balance sheet, such as when an installment on a loan is due within one year, but future installments are due thereafter. Refer to Exhibit 4-14 (p. 196) to review the classified balance sheet.

108

Chapter 4 | Completing the Accounting Cycle

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Demo Doc 1 Closing Entries Learning Objectives

1–5

This question continues on from the Wood’s Restaurant problem given in Chapter 3 (see p. 73 of your Study Guide). Use the data from Wood’s Restaurant’s adjusted trial balance at December 31, 2008: WOOD’S RESTAURANT Adjusted Trial Balance December 31, 2008


Adjusted Trial Balance Dr. Cr. $10,600 15,800 400 2,000 15,000 $6,000 2,600 120 40,000 11,500 25,800 10,120 6,000 1,600 1,500 $74,520

$74,520

Requirements 1. Prepare Wood’s accounting worksheet showing the adjusted trial balance, the income statement accounts, and the balance sheet accounts. 2. Journalize and post the closing entries. 3. Which assets are current? Which assets are long-term? 4. Which liabilities are current? Which liabilities are long-term?


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Demo Doc 1 Solutions 1

Explain the steps in the accounting cycle

2

Prepare a worksheet

3

Prepare financial statements using the worksheet

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Requirement 1 Prepare Wood’s accounting worksheet showing the adjusted trial balance, the income statement accounts, and the balance sheet accounts.

WOOD’S RESTAURANT Worksheet December 31, 2008

Account Title Cash Accounts receivable Supplies Prepaid rent Furniture Accumulated depreciation, furniture Accounts payable Salary payable Daniel Wood, capital Daniel Wood, withdrawals Service revenue Salary expense Rent expense Supplies expense Depreciation expense Total Net income

Trial Balance Dr. Cr. $10,600 15,800 400 2,000 15,000

Adjustments Dr. Cr.


$6,000 2,600 120 40,000 11,500 25,800 10,120 6,000 1,600 1,500

Preparing financial statements from the adjusted accounting data is step 5 of the accounting cycle. First, all income statement accounts must be copied over to the income statement columns of the worksheet. Revenues and expenses are on the income statement. Copy these accounts to the income statement section. Remember to copy the debit balances to the debit column and the credit balances to the credit column (on top of next page). The remaining accounts belong on the balance sheet. Copy all assets, liabilities, and equity accounts to the balance sheet section of the worksheet. Remember to copy all debit balances to the debit column and all credit balances to the credit column (on bottom of next page). 110


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Adjustments Dr. Cr.


$6,000 2,600 120 40,000 11,500 $25,800

25,800 $10,120 6,000 1,600 1,500

10,120 6,000 1,600 1,500




Adjustments Dr. Cr.

Adjusted Trial Balance Dr. Cr. $10,600 15,800 400 2,000 15,000 $6,000 2,600 120 40,000

$6,000 2,600 120 40,000 11,500

11,500 $25,800

25,800 10,120 6,000 1,600 1,500

$10,120 6,000 1,600 1,500


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Net income is calculated by subtracting the expenses from the revenues: $25,800 ! $19,220 " $6,580

Net income is added to the credit side of the balance sheet to make total debits equal total credits. Net income increases the Capital account (as seen in Requirement 2 of this question, where the closing entries are journalized). WOOD’S RESTAURANT Worksheet December 31, 2008

Account Title Cash Accounts receivable Supplies Prepaid rent Furniture Accumulated depreciation, furniture Accounts payable Salary payable Daniel Wood, capital Danield Wood, withdrawals Service revenue Salary expense Rent expense Supplies expense Depreciation expense Total Net income

Part 1

1 4

Explain the steps in the accounting cycle Close the revenue, expense, and withdrawals accounts

Part 2


$6,000 2,600 120 40,000

$6,000 2,600 120 40,000 11,500

11,500 $25,800

25,800 10,120 6,000 1,600 1,500 $74,520

Part 3

$74,520

Part 4

$10,120 6,000 1,600 1,500 $19,220 6,580 $25,800

Part 5

$25,800 $55,300 $25,800 $55,300

Part 6

Part 7

$48,720 6,580 $55,300

Demo Doc Complete

Requirement 2 Journalize and post the closing entries. Preparing closing entries is necessary for two reasons. First, we need to clear out the revenue, expense, and withdrawal accounts to a zero balance because they must begin the next year empty. Second, we need to update the Capital account, which is step 7 in the accounting cycle. In Chapter 1, we discussed the formula to calculate the balance in the Capital account: Beginning Capital Amount # Owner Investments Adjusted Capital Amount # Net Income (or ! Net Loss) ! Owner Withdrawals Ending Capital Amount

112

Adjusted Trial Balance Dr. Cr. $10,600 15,800 400 2,000 15,000

Adjustments Dr. Cr.


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Capital Beginning Capital Amount Investments

Withdrawals

Adjusted Capital Amount Net Income Ending Capital Amount

This formula is the key to preparing the closing entries. We will use this formula, but we will do it inside the Capital T-account. What is in the Capital account right now? From the trial balance, we can see it has a balance of $40,000. Where did that balance come from? It is the adjusted capital amount. In this particular problem, because no investments were made (as seen from the problem in Chapter 3), it is also the ending balance from last period. So we have an advantage: The first component of the formula (adjusted capital amount) is already in the T-account. The next component is net income. It is not already in the Capital account. We do not have a T-account with net income in it, but we can create one. We create a new T-account called Income Summary. We place in it all the components of net income and come out with the net income number at the bottom. From Chapter 1, remember the formula for net income: Revenues – Expenses = Net income

To calculate net income, we need to get all revenues and expenses into the Income Summary account. Let’s look at the Service Revenue T-account:

Service Revenue Bal.

25,800

Remember the first reason to prepare closing entries: We need to clear out the income statement accounts so that they are empty to begin the next year. What do we need to do to bring the Service Revenue account to zero? It has a credit balance of $25,800, so to bring that to zero, we need to debit $25,800. We know part of our first closing entry:

Journal Entry:

Step 1

Date Accounts Dec. 31 Service Revenue ?????

Post Ref.

Dr. 25,800

Cr. 25,800

What is the credit side of this entry? The reason we were looking at Service Revenue to begin with was to help calculate net income using the Income Summary. So the other side of the entry must go to the Income Summary: Demo Doc 1 Solutions | Chapter 4

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Journal Entry:

Step 1

Post Ref.

Date Accounts Dec. 31 Service Revenue Income Summary

Dr. 25,800

Cr. 25,800

Service Revenue 25,800

1.

25,800 Bal.

0

Income Summary 1.

25,800

Closing the revenue account to zero is step 1 of journalizing closing entries.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

The next part of net income is the expenses. In this case, we have four different expenses: Rent Expense Bal.

6,000 Salary Expense

Bal.

10,120

Depreciation Expense Bal.

1,500

Supplies Expense Bal.

1,600

Each of these expenses has a debit balance. In order to bring these accounts to zero, we must credit them. The balancing debit will go to the Income Summary account:

Journal Entry:

Step 2

114

Date Accounts Dec. 31 Income Summary Salary Expense Rent Expense Supplies Expense Depreciation Expense


Post Ref.

Dr. 19,220

Cr. 10,120 6,000 1,600 1,500

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Rent Expense 6,000 Bal.

2.

Depreciation Expense 1,500 6,000

0

Bal.

Salary Expense 10,120 Bal.

2.

2.

1,500

0

Supplies Expense 1,600

10,120

0

Bal.

2.

1,600

0

Closing the expense accounts is step 2 of journalizing closing entries.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Now let’s look at the Income Summary account: Income Summary 1. 2.

25,800

19,220 Bal.

6,580

The purpose of creating this account was to get a net income number. (If you did the Chapter 3 problem, note that this balance is the same net income number that appears on the income statement.) We can now take this number and put it into the Capital account. How do we remove it from the Income Summary? The Income Summary has a credit balance of $6,580, which is the net income, so to remove this amount, we must debit the Income Summary for $6,580: Journal Entry:

Step 3

Date Accounts Dec. 31 Income Summary ($25,800 – $19,220) ?????

Post Ref.

Dr. 6,580

Cr. 6,580

What is the credit side of this entry? The reason we created the Income Summary account to begin with was to help calculate the profit or loss for the Capital account. So the credit side of the entry must go to Daniel Wood, Capital:

Journal Entry:

Step 3

Date Accounts Dec. 31 Income Summary ($25,800 – $19,220) Daniel Wood, Capital

Post Ref.

Dr. 6,580

Cr. 6,580


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This entry adds the net income to the Capital account. Note that it also brings the Income Summary account to a zero balance. Income Summary 1. 2.

19,220

3.

6,580

25,800

Bal.

6,580

Bal.

0

Closing the Income Summary account is step 3 of journalizing closing entries.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

The last component of the Capital account formula is withdrawals. A Withdrawals account already exists: Daniel Wood, Withdrawals Bal.

11,500

What do we need to do to bring the Withdrawals account to zero? It has a debit balance of $11,500, so to bring that to zero we need to credit $11,500. The balancing debit will go to the Daniel Wood, Capital account:

Journal Entry:

Step 4

Date Accounts Dec. 31 Daniel Wood, Capital Daniel Wood, Withdrawals

Post Ref.

Dr. 11,500

Cr. 11,500

This entry subtracts the withdrawals from the Capital account. Closing out the Withdrawals account is step 4 of journalizing closing entries. The Capital account now has the following transactions: Daniel Wood, Capital

Withdrawals

4.

3.

40,000 6,580

Beginning Capital Amount Net Income

11,500 Bal. 35,080

Ending Capital Amount

The formula to update the Capital amount has been recreated inside the Capital T-account. 116


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Daniel Wood, Withdrawals Bal. 11,500 4. Bal.

11,500

0

Daniel Wood, Capital 40,000 6,580

3. 4.

11,500 Bal. 35,080

Notice that all temporary accounts (that is, the revenue, the expense, the withdrawals, and the income summary accounts) now show a zero balance.

Requirement 3 Which assets are current? Which assets are long-term?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

Part 7

Current assets are assets whose benefit will be realized within one year (or reporting period). In this problem, the current assets include the following: Cash: Cash is used constantly and its benefits are immediate.

5

Classify assets and liabilities as current or long-term

Accounts Receivable: Generally, customers pay what they owe to the company in less than one year (reporting period). Supplies: Supplies are usually purchased close to the time of use (benefit), well within one year or reporting period. Prepaid Rent: Generally, prepayments are not made more than one year (period) in advance, which means the prepayments (benefits) will be used within one year (reporting period). Total Current Assets " Cash # Account # Supplies # Prepaid " Receivable Rent $10,600 # $15,800

#

$400

# $2,000 " $28,800

Long-term assets are assets whose benefit will be realized in more than one year (or reporting period). In this problem, the only long-term asset is: Furniture: The furniture will be used (benefited from) for many years. We know it is a long-term asset because the use of the furniture is represented as depreciation, which is being taken over many years. Total Long-Term Assets " Furniture ! Accumulated " Depreciation $15,000

! $6,000

" $9,000 Demo Doc 1 Solutions | Chapter 4

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Requirement 4 Which liabilities are current? Which liabilities are long-term?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Current liabilities are liabilities that will be paid (that is, obligations met) within one year (or reporting period). In this problem, the current liabilities include the following: Accounts Payable: Accounts payable generally consists of bills from suppliers (such as utilities, providers of raw materials, and inventory). It is rare that such suppliers would be willing to wait a year (or reporting period) for payment. Most often, such bills are due within 30 days. Salary Payable: Generally, employees are not willing to wait longer than a month to be paid. Total Current Libilities " Accounts " Payable # Salary Payable $2,600

#

$120

" $2,720

This problem does not include any long-term liabilities. Total Long-Term Liabilities " $0

Part 1

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Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. The last step in the accounting cycle is preparing the financial statements. _____ 2. The adjusted trial balance columns of a worksheet contain the account balances that appear on the financial statements. _____ 3. If the sum of the worksheet income statement debit column is greater than the income statement credit column, it indicates net income. _____ 4. Capital, revenue, expenses, and withdrawals are closed out at the end of the year. _____ 5. The postclosing trial balance contains only balance sheet accounts. _____ 6. The entry to close the Withdrawals account would include a debit to the owner’s Capital account. _____ 7. Long-term liabilities are debts that are not due for at least six months. _____ 8. The capital in the balance sheet credit column of a worksheet represents the beginning capital amount plus any additional investments during the period. _____ 9. Permanent accounts include revenue and expenses. _____10. The difference between the debit and credit totals of the balance sheet columns of the worksheet is net income or net loss.


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Multiple Choice 1. What is a worksheet? a. A formal statement issued to investors b. A document required by the Internal Revenue Service c. A replacement for the general journal d. A multicolumn document used by accountants to aid in the preparation of the financial statements 2. Which of the following accounts would appear in the balance sheet credit column of the worksheet? a. Equipment b. Salary Payable c. Rent Revenue d. Insurance Expense 3. Which of the following accounts is not closed out? a. Accumulated Depreciation b. Service Revenue c. Depreciation Expense d. Owner’s Withdrawals 4. What is the measure of how quickly an item can be converted into cash? a. Contribution margin b. Liquidity c. Profitability d. Leverage 5. What type of asset is expected to be converted to cash, sold, or consumed during the next 12 months or within the business’s normal operating cycle if longer than a year? a. Permanent asset b. Quick asset c. Current asset d. Fixed asset 6. What is the time span during which cash is used to acquire goods and services that are sold to customers and collected in cash? a. Operating cycle b. Cash-to-cash cycle c. Liquidity cycle d. Receivables-to-cash cycle 7. In what category would Inventory appear on a classified balance sheet? a. Long-term liability b. Plant asset c. Current asset d. Current liability

120


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8. Consider the following account balances for Philip’s Rentals as of December 31, 2008: Cash Accounts payable Accumulated depreciation Philip Browning, capital Philip Browning, withdrawals

$10,300 7,800 2,000 9,300 2,200

Prepaid rent Equipment Supplies Unearned revenue Notes payable (due 12/31/2010)

$ 3,600 15,000 1,200 1,600 7,500

What are the total current assets and total assets, respectively, for Philip’s Rentals? a. $15,100 and $30,100 b. $13,900 and $27,100 c. $15,100 and $28,100 d. $13,700 and $30,100 9. Use the data from question 8. What are the total current liabilities for Philip’s Rentals? a. $ 7,800 b. $ 9,400 c. $ 9,800 d. $11,400 10. An error has been made on the worksheet if which of the following situations is true? a. The trial balance columns and the adjusted trial balance columns are not equal. b. The income statement columns and the balance sheet columns are not equal. c. The adjusted trial balance debit column and credit column do not equal. d. All of these indicate an error on the worksheet.


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Quick Exercises 4-1. For each of the following accounts, indicate whether it normally has a debit or credit balance and whether it appears in the income statement or balance sheet columns of the worksheet. Normal Debit (Dr.) or Credit (Cr.) Balance

Income Statement (IS) or Balance Sheet (BS)

_______________ _______________ _______________ _______________ _______________ _______________

_____________ _____________ _____________ _____________ _____________ _____________

a. Equipment b. Salary Expense c. Unearned Revenue d. Accumulated Depreciation e. Accounts Payable f. Service Revenue

4-2. Complete the worksheet information in the adjusted trial balance columns.


Account Title Cash Accounts receivable Prepaid insurance Building Accumulated depreciation, building Accounts payable Salary payable D. Wood, capital D. Wood, withdrawals Service revenue Insurance expense Rent expense Salary expense Depreciation expense Supplies expense Total

122


Trial Balance Dr. Cr. $30,800 5,800 2,400 17,000

Adjustments Dr. Cr. a. $6,000 b. $1,200

c.

$8,000 1,600 1,000 50,320

500

d. 2,400

7,500 a. 6,000

25,800 2,500 5,500 11,120 2,000 2,100 $86,720

b. 1,200 d. 2,400 c. 500 $86,720

$10,100

$10,100


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4-3. Complete the remainder of the following worksheet:


Account Title Cash Accounts receivable Supplies Prepaid rent Furniture Accumulated depreciation, furniture Accounts payable Unearned revenue D. Wood, capital D. Wood, withdrawals Service revenue Rent expense Salary expense Depreciation expense Supplies expense Total Net income

Trial Balance Dr. Cr. $8,400 10,100 2,400 4,000 24,400 $4,000 3,100 2,420 42,000 8,000 25,000 6,000 9,820 1,500 1,900 $76,520 $76,520

Adjustments Dr. Cr.



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4-4. Given the following adjusted account balances, record the closing entries for Sports Unlimited on December 31, 2007. Joseph Golf, Capital

$ 85,000

Service Revenue

104,400

Depreciation Expense, Building Salary Expense

2,000 28,000

Supplies Expense

8,500

Interest Revenue

15,400

Rent Expense

15,000

Joseph Golf, Withdrawals

3,000

Journal Entry: Date

Account Title

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Account Title

Journal Entry: Date

Account Title

Journal Entry: Date

124

Account Title


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4-5. Given the following adjusted account balances on December 31, 2007, calculate total (a) current assets, (b) current liabilities, (c) long-term assets, and (d) long-term liabilities. Cash Accounts Receivable Land Joseph Golf, Capital Accounts Payable Building Accum. Depreciation, Building Salary Payable Notes Payable (due 12/31/09)

$ 25,000 12,500 100,000 75,000 15,200 245,000 70,000 1,500 39,000


125

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Do It Yourself! Question 1 This question continues on from the Angela’s Business Services problem given in Chapter 3. Use the data from Angela’s Business Services trial balance at December 31, 2008: ANGELA’S BUSINESS SERVICES Adjusted Trial Balance December 31, 2008

Account Title Cash Prepaid insurance Supplies Office equipment Accumulated depreciation, equipment Accounts payable Salary payable Unearned revenue Angela Waring, capital Angela Waring, withdrawals Service revenue Salary expense Insurance expense Supplies expense Depreciation expense Total

5

Close the revenue, expense, and withdrawals accounts

Adjusted Trial Balance Dr. Cr. $ 40,400 3,600 7,900 25,000 $ 10,000 5,300 4,000 1,500 60,000 8,000 85,300 49,000 14,400 15,300 2,500 $166,100 $166,100

Requirement Journalize and post the closing entries. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

126

Accounts


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Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

Service Revenue

Income Summary

Insurance Expense Angela Waring, Withdrawals Salary Expense Angela Waring, Capital Depreciation Expense

Supplies Expense


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Do It Yourself! Question 2 Krake Theaters has the following data for 2008: Total revenues Total expenses Owner withdrawals Owner investments

$10,000 13,000 1,600 4,000

The Capital account had a balance of $8,200 at January 1, 2008.

Requirement

5

Close the revenue, expense, and withdrawals accounts

Journalize and post the closing entries. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts

Revenues

Income Summary

Expenses Withdrawals

Capital

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1. The last step in the accounting cycle is preparing the financial statements. False–The last step in the accounting cycle is preparing the post-closing trial balance. (p. 182)

T

2. The adjusted trial balance columns of a worksheet contain the account balances that appear on the financial statements. (p. 183)

F

3. If the sum of the work sheet income statement debit column is greater than the income statement credit column, it indicates net income. False–If the sum of the worksheet income statement debit column is greater than the income statement credit column, it indicates a net loss. (p. 185)

F

4. Capital, revenue, expense, and withdrawals are closed out at the end of the year. False–The revenue, expense, and withdrawals are closed out at the end of the year. Capital is a permanent account and is not closed out. (p. 190)

T

5. The post-closing trial balance contains only balance sheet accounts. (p. 194)

T

6. The entry to close the Withdrawals account would include a debit to the owner’s Capital account. (p. 192)

F

7. Long-term liabilities are debts that are not due for at least six months. False–Long-term liabilities are those due beyond one year. (p. 195)

F

8. The capital in the balance sheet credit column of a worksheet represents the beginning capital amount plus any additional capital invstments during the period. (p. 185)

F

9. Permanent accounts include revenue and expenses. False–Permanent accounts include assets, liabilities, and owner’s equity. Revenue and expenses are temporary accounts. (p. 190)

T

10. The difference between the debit and credit totals of the balance sheet columns of the worksheet is net income or net loss. (p. 185)


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Multiple Choice 1. What is a worksheet? (p. 182) a. A formal statement issued to investors b. A document required by the Internal Revenue Service. c. A replacement for the general journal d. A multicolumn document used by accountants to aid in the preparation of the financial statements 2. Which of the following accounts would appear in the balance sheet credit column of the worksheet? (p. 184) a. Equipment b. Salary Payable c. Rent Revenue d. Insurance Expense 3. Which of the following accounts is not closed out? (p. 190) a. Accumulated Depreciation b. Service Revenue c. Depreciation Expense d. Owner’s Withdrawals 4. What is the measure of how quickly an item can be converted into cash? (p. 194) a. Contribution margin b. Liquidity c. Profitability d. Leverage 5. What type of asset is expected to be converted to cash, sold, or consumed during the next 12 months or within the business’s normal operating cycle if longer than a year? (p. 196) a. Permanent asset b. Quick asset c. Current asset d. Fixed asset 6. What is the time span during which cash is used to acquire goods and services that are sold to customers and collected in cash? (p. 195) a. Operating cycle b. Cash-to-cash cycle c. Liquidity cycle d. Receivables-to-cash cycle 7. In what category would Inventory appear on a classified balance sheet? (p. 195) a. Long-term liability b. Plant asset c. Current asset d. Current liability

130


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8. Consider the following account balances for Philip’s Rentals as of December 31, 2008: Cash Accounts payable Accumulated depreciation Philip Browning, capital Philip Browning, withdrawals

$10,300 7,800 2,000 9,300 2,200

Prepaid rent $ 3,600 Equipment 15,000 Supplies 1,200 Unearned revenue 1,600 Notes payable 7,500 (due 12/31/2010)

What are the total current assets and total assets, respectively, for Philip’s Rentals? (p. 195) a. $15,100 and $30,100 b. $13,900 and $27,100 c. $15,100 and $28,100 d. $13,700 and $30,100 9. Use the data from question 8. What are the total current liabilities for Philip’s Rentals? (p. 195) a. $ 7,800 b. $ 9,400 c. $ 9,800 d. $11,400 10. An error has been made on the worksheet if which of the following situations is true? (p. 183) a. The trial balance columns and the adjusted trial balance columns are not equal. b. The income statement columns and the balance sheet columns are not equal. c. The adjusted trial balance debit column and credit column do not equal. d. All of these indicate an error on the worksheet.


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Quick Exercise Solutions 4-1. For each of the following accounts, indicate whether it normally has a debit or credit balance and whether it appears in the income statement or balance sheet columns of the worksheet. (p. 191) Normal Debit (Dr.) or Credit (Cr.) Balance

Income Statement (IS) or Balance Sheet (BS)

a. Equipment

Dr.

BS

b. Salary Expense

Dr.

IS

c. Unearned Revenue

Cr.

BS

d. Accumulated Depreciation

Cr.

BS

e. Accounts Payable

Cr.

BS

f. Service Revenue

Cr.

IS

4-2. Complete the worksheet information in the adjusted trial balance columns. (p. 182)


Account Title Cash Accounts receivable Prepaid insurance Building Accumulated depreciation, building Accounts payable Salary payable D. Wood, capital D,. Wood, withdrawals Service revenue Insurance expense Rent expense Salary expense Depreciation expense Supplies expense Total

132


Trial Balance Dr. Cr. $30,800 5,800 2,400 17,000

Adjusted Trial Balance Dr. Cr. $30,800 a. $6,000 11,800 b. $1,200 1,200 17,000 Adjustments Dr. Cr.

c.

$ 8,000 1,600 1,000 50,320

500

d. 2,400 7,500

7,500 a. 6,000

25,800 2,500 5,500 11,120 2,000 2,100 $86,720

$ 8,500 1,600 3,400 50,320

b. 1,200 d. 2,400 c. 500 $86,720

$10,100

31,800 3,700 5,500 13,520 2,500 2,100 $10,100 $95,620 $95,620

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4-3. Complete the remainder of the following worksheet: (p. 182)


Account Title Cash Accounts receivable Supplies Prepaid rent Furniture Accumulated depreciation, furniture Accounts payable Unearned revenue D. Wood, capital D. Wood, withdrawals Service revenue Rent expense Salary expense Depreciation expense Supplies expense Total Net income

Adjusted Trial Balance Trial Balance Adjustments Dr. Cr. Dr. Cr. Dr. Cr. $8,400 $8,400 10,100 10,100 2,400 2,400 4,000 4,000 24,400 24,400 $4,000 $4,000 3,100 3,100 2,420 2,420 42,000 42,000 8,000 8,000 25,000 25,000 6,000 6,000 9,820 9,820 1,500 1,500 1,900 1,900 $76,520 $76,520 $19,220 $25,000 $57,300 $51,520 5,780 5,780 $25,000 $25,000 $57,300 $57,300

4-4. Given the following adjusted account balances, record the closing entries for Sports Unlimited on December 31, 2007. (pp. 190–194) Joseph Golf, Capital Service Revenue Depreciation Expense, Building Salary Expense

$ 85,000 104,400 2,000 28,000

Supplies Expense

8,500

Interest Revenue

15,400

Rent Expense

15,000

Joseph Golf, Withdrawals

3,000


133

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Journal Entry: Date 12/31/07

Accounts Service Revenue Interest Revenue Income Summary To close out revenue accounts into Income Summary.

Ref.

Post Dr. 104,400 15,400

Cr.

119,800

Journal Entry: Date

Accounts Income Summary Depreciation Expense Salary Expense Supplies Expense Rent Expense To close out expense accounts into Income Summary.

Ref.

Post Dr. 53,500

Cr. 2,000 28,000 8,500 15,000

Journal Entry: Date

Accounts Income Summary Joseph Golf, Capital To close out Income Summary into Capital.

Ref.

Post Dr. 66,300

Cr. 66,300

Journal Entry: Date

134

Accounts Joseph Golf, Withdrawals Joseph Golf, Capital To close out Withdrawals into Capital.


Ref.

Post Dr. 3,000

Cr. 3,000

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4-5. Given the following adjusted account balances on December 31, 2007, calculate total (a) current assets, (b) current liabilities, (c) long-term assets, and (d) long-term liabilities. (p. 196) Cash Accounts Receivable Land

$ 25,000 12,500 100,000

Joseph Golf, Capital

75,000

Accounts Payable

15,200

Building Accum. Depreciation, Building Salaries Payable Notes Payable (due 12/31/09)

245,000 70,000 1,500 39,000

a. Cash Accounts Receivable Total Current Assets

$25,000 12,500 $37,500

b. Accounts Payable Salaries Payable Total Current Liabilities

$15,200 1,500 $16,700

c. Land Building Less: Acc. Depr., Building Total Long-Term Assets

$100,000 245,000 (70,000) $275,000

d. Notes Payable (due 12/31/09) Total Long-Term Liabilities

$39,000 $39,000


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Do It Yourself! Question 1 Solutions Requirement Journalize and post the closing entries.

Journal Entry:

Step 1

Date Accounts Dec. 31 Service Revenue Income Summary

Post Ref.

Dr. 85,300

Cr. 85,300

Journal Entry:

Step 2

Date Accounts Dec. 31 Income Summary Salary Expense Supplies Expense Insurance Expense Depreciation Expense

Post Ref.

Dr. 81,200

Cr. 49,000 15,300 14,400 2,500

Journal Entry:

Step 3

Date Accounts Dec. 31 Income Summary ($85,300 – $81,200) Angela Waring, Capital

Post Ref.

Dr. 4,100

Cr. 4,100

Journal Entry:

Step 4

136

Date Accounts Dec. 31 Angela Waring, Capital Angela Waring, Withdrawals


Post Ref.

Dr. 8,000

Cr. 8,000

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Service Revenue 85,300 85,300

1.

Bal.

2.

Income Summary 1. 85,300 81,200

0

Bal. 4,100 3.

4,100 Bal.

0

Insurance Expense 14,400 2. Bal.

14,400

0

Angela Waring, Withdrawals 8,000

Salary Expense 49,000 2. Bal.

8,000

0

49,000

0

Angela Waring, Capital

Depreciation Expense 2,500 2. 2,500 Bal.

4. Bal.

0

3. 4.

60,000 4,100

8,000 Bal. 56,100

Supplies Expense 15,300 2. Bal.

15,300

0


137

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Do It Yourself! Question 2 Solutions Requirement Journalize and post the closing entries.

Journal Entry:

Step 1

Date Accounts Dec. 31 Revenues Income Summary

Post Ref.

Dr. 10,000

Cr. 10,000

Journal Entry:

Step 2

Date Accounts Dec. 31 Income Summary Expenses

Post Ref.

Dr. 13,000

Cr. 13,000

Journal Entry:

Step 3

Date Accounts Dec. 31 Capital Income Summary ($13,000 – $10,000)

Post Ref.

Dr. 3,000

Cr. 3,000

Journal Entry:

Step 4

138

Date Accounts Dec. 31 Capital Withdrawals


Post Ref.

Dr. 16,000

Cr. 16,000

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Revenues

Income Summary 10,000

1.

10,000

2. Bal.

0

Bal.

3.

3,000

0 Withdrawals

13,000

1,600 2.

Bal.

10,000

3,000

Bal. Expenses

1. 13,000

13,000

4.

0

Bal.

1,600

0

Capital

Net loss Withdrawals

3. 4.

8,200 4,000 Bal. 12,200

Beginning Capital Amount Owner Investments Ending Capital Amount

Bal.

Ending Capital Amount

3,000 1,600 7,600


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The Power of Practice For more practice using the skills learned in this chapter, visit MyAccountingLab. There you will find algorithmically generated questions that are based on these Demo Docs and your main textbook’s Review and Accounting Practice sections. To go to MyAccountingLab and follow these steps: 1. 2. 3. 4. 5. 6.

140

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 4, Completing the Accounting Cycle. Click a link to work on the tutorial exercises.


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5

Accounting for a Retail Business

WHAT YOU PROBABLY ALREADY KNOW You want to order a pair of pants from a mail-order catalog. The price listed in the catalog is $50. You find a 10% off coupon in the catalog for first-time customers that you plan to use. You also see that you will be charged $6.95 for shipping and handling for an order of this size. How much will the pair of pants cost you? The selling price listed is $50, but $50 is not the cost to you. The 10% coupon results in a $5 discount ($50 × 0.10) decreasing the cost to $45 ($50 – 5). However, the shipping and handling charge of $6.95 adds to the cost of the pants. Your cost for the pants is $51.95 ($50.00 – $5.00 + $6.95). Businesses calculate the cost of assets purchased in the same manner. When inventory is acquired, the cost is calculated as: Purchase price on the invoice + Cost of shipping or freight – Discounts taken Total inventory cost

Learning Objectives

1

Describe the supply chain that links suppliers, retailers, and customers. Suppliers, wholesalers, and retailers have different operations and deal with different types of customers. These businesses choose one of two inventory recording methods: the periodic system (where inventory records are updated from time to time on a regular basis) and the perpetual system (where inventory records are updated constantly). See Exhibit 5-1, Panel B (p. 231) for a description of the activities between suppliers and retailers.

2

Journalize transactions between the supplier and retailer. Companies can receive discounts from their suppliers for paying their accounts early (known as purchase discounts). If purchased goods are not acceptable or unnecessary, they may be returned (purchase returns and allowances). See Exhibit 5-1, Panel A (p. 230) for a description of the activities between retailers and suppliers, manufacturers, and wholesalers.

3

Journalize transactions between the retailer and customer. Sellers can offer discounts as an incentive for prompt payment from customers (known as sales discounts). Customers can use credit cards to pay, requiring that commissions be paid to the credit card company by the seller. Customers may return goods to the seller (sales returns and allowances). See Exhibit 5-1, Panel B (p. 231) for a description of the activities between retailers and customers.

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Journalize shipment transactions and identify other selling expenses in a retail business. As seen in the What You Probably Already Know section, many factors can alter an item’s cost, including shipping. Shipping costs can be paid by the seller (FOB destination) or buyer (FOB shipping). See Exhibit 5-6, (p. 243) for a description of FOB terms.

5

Prepare a retailer’s financial statements. The income statement of a merchandiser may be prepared as a single-step income statement (listing all revenues followed by all expenses to determine net income or loss) or as a multi-step income statement (showing various subtotals such as gross profit and income from operations). The other statements are similar to those for a service company. Review a merchandiser’s financial statements in Exhibit 5-7 (p. 249).

6

Compute the gross profit percentage and inventory turnover rate. Two ratios that provide important information for a merchandiser are the gross profit percentage (computed by dividing gross profit by net sales revenue) and inventory turnover (the ratio of cost of goods sold to average inventory). See Exhibit 5-7 (p. 249) for an example of how to use these ratios.

142

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Demo Doc 1 Inventory Transaction Analysis (Perpetual System) Learning Objectives

1–6

Danner Inc. began operations on January 1, 2008. Danner had the following transactions during the year: Jan. 10 Purchased inventory for $400 with credit terms of 2/15, net 30. 12 Paid for the January 1 purchase in full. Feb. 1 Sold 10 units costing $21 each to a customer for $360 on account. This sale had credit terms of 1/15, net 40. 9 Customer returned three units from his February 1 order because he did not like the color of the goods. 18 Customer paid for the February 1 order (less returns) in full. May 5 Purchased inventory for $250 with credit terms of 2/10, net 30. 6 Paid special freight costs of $30 on the May 5 inventory purchase in cash. 14 Found that 15% of the goods purchased on May 5 were defective. Danner returned these goods. June 1 Paid for the May 5 purchase (less returns) in full. Oct. 1 Sold $160 of goods to a customer for $220 with credit terms of 1/20, net 30. 19 Received cash payment in full for the October 1 sale.

Requirements 1. Journalize these transactions using the perpetual method. Explanations are not required. 2. Show the Inventory and COGS T-accounts for the year. 3. Use the COGS formula to calculate COGS for the year. 4. Prepare the top portion of Danner’s 2008 income statement (ending with gross profit). 5. Calculate Danner’s inventory turnover rate for 2008.


143

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Demo Doc 1 Solution Requirement 1 Journalize these transactions using the perpetual method. Explanations are not required. Jan. 1 Purchased inventory for $400 with the credit terms of 2/15, net 30.

Part 1

1

Describe the supply chain that links suppliers, retailers, and customers

2

Journalize transactions between the supplier and retailer

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

The perpetual method requires that inventory and COGS be updated immediately whenever they are changed (unlike the periodic method, which delays most inventory and COGS journal entries until the end of the year). Under the perpetual method, all transactions in this problem must be journalized when they occur. The Inventory account is involved here because inventory was purchased. Inventory is increased by $400 (a debit). Because the inventory was not paid for in cash (it was purchased on account), Accounts Payable must also be increased by $400 (a credit). Note that the actual credit terms do not matter at this point, only that the purchase was not made in cash. However, note that 2/15, net 30 means that the customer will get a 2% discount if the full amount is paid within 15 days. Otherwise, full payment is due in 30 days.


Date Accounts Jan. 1 Inventory Accounts Payable

Dr. 400

Cr. 400

Jan. 12 Paid for the January 1 purchase in full.

2


Remember that 2/15 means that if full payment is made within 15 days, the customer gets a 2% discount. We are paying the supplier, so we can decrease our Accounts Payable by $400 (a debit). Cash also decreases (a credit), but by how much? January 12 is within 15 days of the original purchase, so Danner is entitled to take the discount. Therefore, Danner only has to pay 100% – 2% = 98% of the purchase price to satisfy the debt owed. So the cash paid is: 98% ! $400 " $392

The difference is an adjustment to the Inventory account. The cost principle says that we should journalize assets at cost. The true cost of the inventory is now less than we originally thought. So Inventory is decreased (a credit) by this difference.

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Journal Entry: Date Accounts Jan. 12 Accounts Payable Inventory (to balance*) Cash [(100% – 2%) 3 $400] *400 – 392 = 8

Post Ref.

Dr. 400

Cr. 8 392

The amount of the adjustment to Inventory was made to balance the entry. In all journal entries, total debits equal total credits. The amount of the adjustment to Inventory is the amount needed to make the total debits in the entry equal to the total credits in the entry. In this case, a credit of $400 – $392 = $8 is required. The amount to balance, $8, represents the early payment discount: $400 ! 2% " $8

Feb. 1 Sold 10 units costing $21 each to a customer for $360 on account. This sale had credit terms of 1/15, net 40. This transaction involves two parts. First, Danner earns sales revenue of $360, which increases Sales Revenue (a credit) and (because it is not paid for in cash, but rather sold on account) increases Accounts Receivable (a debit). Second, Danner is also selling inventory. This means that Inventory is decreased (a credit) and COGS is increased (a debit) by:

3

Journalize transactions between the retailer and customer

3


10 ! $21 " $210

Remember that 1/15, net 40 means that the customer will get a 1% discount if the full amount is paid within 15 days. Otherwise, full payment is due in 40 days.

Journal Entry: Date Accounts Feb. 1 Accounts Receivable Sales Revenue COGS (10 units 3 $21) Inventory

Post Ref.

Dr. 360

Cr. 360

210 210

Feb. 9 Customer returned three units from his February 1 order because he did not like the color of the goods. Because the customer is returning goods (and the goods are not defective) to the company, Danner’s Inventory increases (a debit) by 3 × $21 = $63, which then causes COGS to decrease (a credit) by $63. The customer has not yet paid, so the amount of Accounts Receivable Danner can collect from the customer decreases (a credit) by 3/10 × $360 = $108. Instead of decreasing Sales Revenue, we increase Sales Returns and Allowances (a debit) by $108. In this way, Danner can keep track of sales returns and make better business decisions.

Demo Doc 1 Solution | Chapter 5

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Journal Entry: Date Accounts Feb. 9 Inventory (3 3 $21) COGS

Post Ref.


Cr. 63 63

Sales Returns and Allowances [(3/10) 3 $360] Accounts Receivable

3

Dr.

108 108

Feb. 18 Customer paid for the February 1 order (less returns) in full. Remember that 1/15 means that if full payment is made within 15 days, the customer gets a 1% discount. However, the customer is paying 18 days after the sale, which is longer than the 15 days the discount allows. Therefore, the customer must pay the full amount. Cash is increased (a debit) by $360 – $108 = $252 (original sale of $360 less the sales return of $108). Because the customer pays Danner, Accounts Receivable is decreased (a credit) by $252.

Journal Entry: Date Accounts Feb. 18 Cash ($360 – $108) Accounts Receivable

2


Post Ref.

Dr. 252

Cr. 252

May 5 Purchased inventory for $250 with credit terms of 2/10, net 30. Inventory is increased by $250 (a debit). Because the inventory was not paid for in cash but rather on account, Accounts Payable must also be increased by $250 (a credit). Remember that 2/10, net 30 means that the customer will get a 2% discount if the full amount is paid within 10 days. Otherwise, full payment is due in 30 days.

Journal Entry: Date Accounts May 5 Inventory Accounts Payable

4

Journalize shipment transactions and identify other selling expenses in a retail business

146

Post Ref.

Dr. 250

Cr. 250

May 6 Paid special freight costs of $30 on the May 5 inventory purchase in cash. The total cost of the inventory is the purchase price plus any additional purchasing costs (such as shipping or taxes). Therefore, we include the extra $30 of freight as part of the cost of the inventory. Inventory increases by $30 (a debit). Because these costs are being paid in cash, the Cash account decreases (a credit) by $30.


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Journal Entry: Date Accounts May 6 Inventory Cash

Post Ref.

Dr.

Cr. 30 30

May 14 Found that 15% of the goods purchased on May 5 were defective. Danner returned these goods. When these goods are returned to the supplier, they are taken out of inventory, decreasing Inventory (a credit) by 15% × $250 = $37.50. Because Danner has not yet paid for the goods, Accounts Payable also decreases by the related amount (a debit).

2


2


3


Journal Entry: Date Accounts May 14 Accounts Payable (15% 3 $250) Inventory

Post Ref.

Dr. 37.50

Cr. 37.50

June 1 Paid for the May 5 purchase (less returns) in full. Remember that 2/10 means that if full payment is made within 10 days, the customer gets a 2% discount. Accounts Payable is decreased by the original payable less returns made: $250 – $37.50 = $212.50 (a debit). Cash is also decreased (a credit). Although June 1 is 27 days after the original purchase and within the deadline for payment of 30 days, it is not early enough to take the discount. Therefore, the cash paid is the full amount of $212.50. In order for Danner to be entitled to take the discount, the payment must be made by May 15 (May 5 plus 10 days).

Journal Entry: Date Accounts June 1 Accounts Payable Cash

Post Ref.

Dr. 212.50

Cr. 212.50

Oct. 1 Sold $160 of goods to a customer for $220 with credit terms of 1/20, net 40. The company earns sales revenue of $220, increasing Sales Revenue (a credit) and (because it is not paid for in cash) increasing Accounts Receivable (a debit). As the company sells inventory, Inventory decreases (a credit) and COGS increases (a debit) by $160. Note that the actual credit terms do not matter at this point, only that the sale was not made in cash. However, 1/20, net 40 means that the customer will get a 1% discount if the full amount is paid within 20 days. Otherwise, full payment is due in 40 days.


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Even though the sale was on account, the actual sale must be journalized at this time. Journal Entry: Post Ref.

Date Accounts Oct. 1 Accounts Receivable Sales Revenue

Dr. 220

220

COGS Inventory

3


Cr.

160 160

Oct. 19 Received cash for payment in full for the October 1 sale. This payment is within the 20-day period, so the customer is entitled to take the discount. The customer pays 100% – 1% = 99% of the receivable amount, or 99% × $220 = $217.80. Accounts Receivable is decreased by the full amount of $220 (a credit) because the bill has been paid and no more can be collected from the customer. Cash is increased by $217.80 (a debit) and the difference (the amount to balance is the amount of the discount, $220 × 10%) goes to Sales Discounts. Journal Entry: Post Ref.

Date Accounts Oct. 19 Cash [(100% – 1%) 3 $220] Sales Discounts (to balance*) Accounts Receivable *220 = 217.80 – 2.20

Dr. 217.80 2.20

Cr.

220

Requirement 2 Show the Inventory and COGS T-accounts for the year.

Part 1

2 3

Journalize transactions between the supplier and retailer Journalize transactions between the retailer and customer

Part 2

Part 4

Demo Doc Complete

Part 5

The entries are posted into the T-accounts (just as in previous chapters). However, for this question, we only want to see the Inventory and COGS T-accounts in detail: INVENTORY

COGS

Jan. 1 400

Feb. 9 May 5 May 6


Jan. 12 Feb. 1

8 210

May 14 Oct. 1

37.50 160

63 250 30

Bal. 327.50

148

Part 3

Feb. 1

210

Oct. 1 Bal.

160 307

Feb. 9

63

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Requirement 3 Use the COGS formula to calculate COGS for the year. Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Part 5

We can use the COGS formula to calculate COGS: COGS

2

"

Beginning inventory

#

Inventory purchases

"

0

#

"

0

#

392 # 242.50

$

327.50

"

0

#

634.50

$

327.50

"

307

$

(400 – 8) # (250 # 30 $ 37.50) $

Ending inventory

3

327.50


Requirement 4 Prepare the top portion of Danner’s 2008 income statement (ending with gross profit).

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Sales Discounts and Sales Returns and Allowances are contra-accounts to Sales Revenue. As we did with Accumulated Depreciation, these contra-accounts must be shown on the financial statements, then combined with their associated account to create the net value (in this case, net sales revenue).

5

Prepare a retailer’s financial statements

DANNER CORP. Income Statement Year Ended December 31, 2008 Service revenue Less: Sales discounts Sales returns and allowances Net sales revenue Cost of goods sold Gross profit

$580.00 $ 2.20 108.00

(= $360 + $220)

(110.20) $469.80 (307.00) $162.80


149

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Requirement 5 Calculate Danner’s inventory turnover rate for 2008.

6

Compute the gross profit percentage and inventory turnover rate

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Inventory turnover " COGS/Average inventory

Average (when used in a financial ratio) generally means the beginning balance plus the ending balance divided by 2. 2008 Inventory Turnover " $307/[($0 + $327.50)/2] " $307/$163.75 " 1.9 times

Part 1

150


Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. Cost of Goods Sold is included in a merchandiser’s income statement but excluded from a service company’s income statement. _____ 2. Under the periodic inventory system, the only way to determine the cost of goods sold is to take a physical count of the merchandise on hand. _____ 3. Most businesses use the periodic inventory system because it offers management more control over inventory. _____ 4. A sales return requires two entries to be journalized if the seller uses a perpetual inventory system. _____ 5. Sales Returns and Allowances is an expense account. _____ 6. The single-step income statement shows gross profit and income from operations. _____ 7. An inventory count is not performed if the perpetual inventory system is used. _____ 8. Advertising expenses would be considered general expenses on the income statement. _____ 9. A higher inventory turnover is preferable to a lower turnover. _____10. A company with a gross profit percentage of 40% must have a higher net income than one with a gross profit percentage of 30%.


151

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Multiple Choice 1. What do credit terms 1/10, n/30 indicate? a. A 10% discount is available if payment is made within 30 days b. A 10% discount is available if payment is made within 10 days c. A 1% discount is available if payment is made within 30 days d. A 30% discount is available if payment is made within 10 days 2. Which of the following is necessary to journalize the purchase of merchandise under a perpetual inventory system? a. A credit to Cash b. A debit to Accounts Payable c. A credit to Inventory d. A debit to Inventory 3. What account is credited when a discount is taken for prompt payment under a perpetual inventory system? a. Accounts Payable b. Accounts Receivable c. Purchase Discounts d. Inventory 4. What is the entry required to journalize the payment of a $200 freight bill, assuming the shipping terms are FOB shipping point, under a perpetual inventory system? a. Debit Inventory and credit Cash b. Debit Accounts Payable and credit Inventory c. Debit Inventory and credit Purchase Discounts d. Debit Purchase Discounts and credit Inventory 5. How does the purchaser account for transportation charges when goods are shipped to them FOB of destination? a. No journal entry would be made for the transportation charges b. Debit Delivery Expense for the amount of the transportation charges c. Debit Freight In for the amount of the transportation charges d. Debit Inventory for the amount of the transportation charges 6. Which of the following balances is normally a debit? a. Sales Revenue b. Sales Returns and Allowances c. Net Sales Revenue d. Gross Profit 7. When the seller is liable for the shipping costs, what account is debited when payment is made? a. Delivery Expense b. Freight In c. Inventory d. Cash 8. Which of the following is necessary to journalize an adjustment to account for inventory shrinkage under a perpetual system? a. A credit to Miscellaneous Expense b. A credit to Cost of Goods Sold c. A credit to Inventory d. A debit to Miscellaneous Expense 152


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9. Which of the following accounts should be closed to Income Summary? a. Beginning Inventory b. Sales Returns and Allowances c. Owner Withdrawals d. Ending Inventory 10. What does inventory turnover indicate? a. How quickly inventory is received from the supplier after the order is placed b. How many days it takes the inventory to travel between the seller’s warehouse and the buyer’s warehouse c. How rapidly inventory is sold d. How many days it takes from the time an order is received until the day it is shipped


153

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Quick Exercises 5-1. Werner Company purchased $11,000 of merchandise. The purchase invoice is for $11,200, which includes transportation charges of $200. The company returned $2,900 of the goods received before paying the invoice. The company paid the invoice within the discount terms 2/10, n/30.Compute the following amounts: a. The amount of the discount b. The total amount for the merchandise journalized in the Inventory account c. The amount that the purchaser would remit if paid after the discount period 5-2. Indicate whether the following accounts are: Closed out with a debit to the account (DR) Closed out with a credit to the account (CR) Not closed out at all (NC) a. ___________ Sales Revenue b. ___________ Sales Returns and Allowances c. ___________ Salary Expense d. ___________ Inventory e. ___________ Depreciation Expense f. ___________ Accumulated Depreciation g. ___________ Accounts Receivable h. ___________ Interest Revenue i. ___________ Interest Expense j. ___________ Cost of Goods Sold 5-3. The following data are for the Griswold Corporation: Sales revenue Freight-in

42,000

Beginning inventory

77,000

Purchase discounts

19,000

Sales returns and allowances

33,000

Ending inventory

81,000

Inventory purchases

154

$600,000

415,000

Sales discounts

35,000

Purchase returns and allowances

39,000


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Requirements 1. Calculate Net Sales Revenue. 2. Calculate the Cost of Goods Available. 3. Calculate the Cost of Goods Sold. 5-4. Moyer Company had the following transactions during August. Assuming that the perpetual inventory system is used, journalize these transactions. Aug.

1 Purchased $2,900 of merchandise on account from Ryan Company, terms 3/15, n/60. 9 Paid transportation cost of $440 directly to the trucking company for the August 5 purchase. 10 Returned $600 of defective merchandise purchased on August 5. 15 Paid for the August 5 purchase, less the return and the discount.


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.




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5-5. Journalize the transactions in Quick Exercise 5-4 for Ryan Company. Assume that the cost of goods sold is 50% of the sales price. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.






156


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Do It Yourself! Question 1 Franco Bros. began operations on January 1, 2008. Franco had the following transactions during the year: Jan. 1 Purchased inventory for $150 under credit terms 2/10, net 30. 8 Paid for the January 1 purchase in full. Mar. 1 Purchased inventory for $240 under credit terms 2/20, net 45. Apr. 1 Paid for the March 1 purchase in full. July 1 Sold $80 worth of goods to a customer for $120 under credit terms 5/15, net eom (end of month). 12 Received cash payment in full for the July 1 sale. Sept. 1 Found that 10% of the goods purchased on March 1 were defective. Franco Bros. returned these goods. Oct.

1 Received cash refund for the goods returned on September 1.

Dec. 1 Sold $210 worth of goods to a customer for $320 under credit terms 1/10, net eom (end of month). 6 Customer returned 20% of his December 1 order because he did not like the color of the goods. 12 Customer paid for the December 1 order (less returns) in full.

Requirements 1. Journalize these transactions using the perpetual method. Explanations are not required. Jan. 1 Purchased inventory for $150 under credit terms 2/10, net 30.

1

2


Post Ref.

3 Dr.

Cr.

4

Describe the supply chain that links suppliers, retailers, and customers Journalize transactions between the supplier and retailer Journalize transactions between the retailer and customer Journalize shipment transactions and identify other selling expenses in a retail business

Jan. 8 Paid for the January 1 purchase in full. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.


157

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Mar. 1 Purchased inventory for $240 under credit terms 2/20, net 45.


Post Ref.

Dr.

Cr.

Dr.

Cr.

Apr. 1 Paid for the March 1 purchase in full. Journal Entry: Date Accounts

Post Ref.

July 1 Sold $80 worth of goods to a customer for $120 under credit terms 5/15, net eom (end of month).


Post Ref.

Dr.

Cr.

July 12 Received cash payment in full for the July 1 sale.


158


Post Ref.

Dr.

Cr.

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Sept. 1 Found that 10% of the goods purchased on March 1 were defective. Franco Bros. returned these goods.


Post Ref.

Dr.

Cr.

Oct. 1 Received cash refund for the goods returned on September 1.


Post Ref.

Dr.

Cr.

Dec. 1 Sold $210 worth of goods to a customer for $320 under credit terms 1/10, net eom (end of month). Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Dec. 6 Customer returned 20% of his December 1 order because he did not like the color of the goods. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.


159

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Dec. 12 Customer paid for the December 1 order (less returns) in full. Journal Entry: Post Ref.

Date Accounts

2 3


Dr.

Cr.

2. Show the Inventory and COGS T-accounts for the year. INVENTORY

COGS

3. Prepare the top portion of Franco’s 2008 income statement (ending with gross profit).

5

Prepare a retailer’s financial statements

160


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1. Cost of Goods Sold is included in a merchandiser’s income statement but excluded from a service company’s income statement. (p. 237)

T

2. Under the periodic inventory system, the only way to determine the cost of goods sold is to take a physical count of the merchandise on hand. (p. 232)

F

3. Most businesses use the periodic inventory system because it offers management more control over inventory. False–The perpetual inventory system offers management more control over inventory and is the system most businesses use. (p. 233)

T

4. A sales return requires two entries to be journalized if the seller uses a perpetual inventory system. (p. 236)

F

5. Sales Returns and Allowances is an expense account. False–Sales Returns and Allowances is a contra account to Sales Revenue. (p. 240)

F

6. The single-step income statement shows gross profit and income from operations. False–The multi-step income statement shows gross profit and income from operations. (p. 248)

F

7. An inventory count is not performed if the perpetual inventory system is used. False–Inventory counts are performed for all inventory systems. (p. 232–233)

F

8. Advertising expenses would be considered general expenses on the income statement. False–Advertising would be considered a selling expense on the income statement. (p. 247)

T

9. A higher inventory turnover is preferable to a lower turnover. (p. 251–252)

F

10. A company with a gross profit percentage of 40% must have a higher net income than one with a gross profit percentage of 30%. False–The gross profit percentage indicates the amount of gross profit per dollar of sales. It does not consider the operating expenses, which are deducted from gross profit to determine net income. (p. 251)


161

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Multiple Choice 1. What do credit terms 1/10, n/30 indicate? (p. 235) a. A 10% discount is available if payment is made within 30 days b. A 1% discount is available if payment is made within 10 days c. A 1% discount is available if payment is made within 30 days d. A 30% discount is available if payment is made within 10 days 2. Which of the following is necessary to journalize the purchase of merchandise under a perpetual inventory system? (p. 234) a. A credit to Cash b. A debit to Accounts Payable c. A credit to Inventory d. A debit to Inventory 3. What account is credited when a discount is taken for prompt payment under a perpetual inventory system? (p. 237) a. Accounts Payable b. Accounts Receivable c. Purchase Discounts d. Inventory 4. What is the entry required to journalize the payment of a $200 freight bill, assuming the shipping terms are FOB shipping point, under a perpetual inventory system? (p. 244) a. Debit Inventory and credit Cash b. Debit Accounts Payable and credit Inventory c. Debit Inventory and credit Purchase Discounts d. Debit Purchase Discounts and credit Inventory 5. How does the purchaser account for transportation charges when goods are shipped to them FOB of destination? (p. 245) a. No journal entry would be made for the transportation charges. b. Debit Delivery Expense for the amount of the transportation charges. c. Debit Freight In for the amount of the transportation charges. d. Debit Inventory for the amount of the transportation charges. 6. Which of the following balances is normally a debit? (p. 241) a. Sales Revenue b. Sales Returns and Allowances c. Net Sales Revenue d. Gross Profit 7. When the seller is liable for the shipping costs, what account is debited when payment is made? (p. 243) a. Delivery Expense b. Freight In c. Inventory d. Cash

162


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8. Which of the following is necessary to journalize an adjustment to account for inventory shrinkage under a perpetual system? (p. 286) a. A credit to Miscellaneous Expense b. A credit to Cost of Goods Sold c. A credit to Inventory d. A debit to Miscellaneous Expense 9. Which of the following accounts should be closed to Income Summary? (p. 287) a. Beginning Inventory b. Sales Returns and Allowances c. Owner Withdrawals d. Ending Inventory 10. What does inventory turnover indicate? (p. 251–252) a. How quickly inventory is received from the supplier after the order is placed b. How many days it takes the inventory to travel between the seller’s warehouse and the buyer’s warehouse c. How rapidly inventory is sold d. How many days it takes from the time an order is received until the day it is shipped


163

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Quick Exercise 5-1. Werner Company purchased $11,000 of merchandise. The purchase invoice is for $11,200, which includes transportation charges of $200. The company returned $2,900 of the goods received before paying the invoice. The company paid the invoice within the discount terms 2/10, n/30. Compute the following amounts: (p. 235) a. The amount of the discount $11,000 – $2,900 = $8,100 net sales $8,100 × 0.02 = $162 b. The total amount for the merchandise journalized in the Inventory account $11,200 – $2,900 – $162 = $8,138 c. The amount that the purchaser would remit if paid after the discount period $11,200 – $2,900 = $8,300 5-2. Indicate whether the following accounts are: (p. 287) Closed out with a debit to the account (DR) Closed out with a credit to the account (CR) Not closed out at all (NC) a. b. c. d. e. f. g. h. i. j.

DR CR CR NC CR NC NC DR CR CR

Cash Sales Revenue Sales Returns and Allowances Salary Expense Inventory Depreciation Expense Accumulated Depreciation Accounts Receivable Interest Revenue Interest Expense Cost of Goods Sold

5-3. The following data are for the Griswold Corporation: (p. 248) Sales revenue Freight-in

42,000

Beginning inventory

77,000

Purchase discounts

19,000

Sales returns and allowances

33,000

Ending inventory

81,000

Inventory purchases

415,000

Sales discounts

35,000

Purchase returns and allowances

39,000

Requirement 1 Calculate Net Sales Revenue. $600,000 – $33,000 – $35,000 = $532,000

164

$600,000


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Requirement 2 Calculate the Cost of Goods Available. $77,000 + $415,000 + $42,000 – $19,000 – $39,000 = $476,000 Requirement 3 Calculate the Cost of Goods Sold. $476,000 – $81,000 = $395,000 5-4. Moyer Company had the following transactions during August. Assuming that the perpetual inventory system is used, journalize these transactions. (p. 234–236) Aug. 5 Purchased $2,900 of merchandise on account from Ryan Company, terms 3/15, n/60. 9 Paid transportation cost of $440 directly to the trucking company for the August 5 purchase. 10 Returned $600 of defective merchandise purchased on August 5. 15 Paid for the August 5 purchase, less the return and the discount. Journal Entry: Date Aug. 5

Accounts Inventory Accounts Payable

Post Ref.

Dr. 2,900

Cr. 2,900

Journal Entry: Date Aug. 9

Accounts Inventory Cash

Post Ref.

Dr. 440

Cr. 440

Journal Entry: Date Accounts Aug. 10 Accounts Payable Inventory

Post Ref.

Dr. 600

Cr. 600

Journal Entry: Date Accounts Aug. 15 Accounts Payable Inventory Cash

Post Ref.

Dr. 2,300

Cr. 69 2,231


165

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5-5. Journalize the transactions in Quick Exercise 5-4 for Ryan Company. Assume that the cost of goods sold is 50% of the sales price. (p. 237) Journal Entry: Date Aug. 5

Accounts Accounts Receivable Sales

Post Ref.

Dr. 2,900

Cr. 2,900


Accounts Costs of Goods Sold Inventory

Post Ref.

Dr. 1,450

Cr.

Dr.

Cr.

Dr. 600

Cr.


Accounts No entry required

Post Ref.

Journal Entry: Date Accounts Aug. 10 Sales Returns and Allowances Accounts Receivables

Post Ref.

600

Journal Entry: Date Accounts Aug. 10 Inventory Costs of Goods Sold

Post Ref.

Dr. 300

Cr. 300

Journal Entry: Date Accounts Aug. 15 Cash Sales Discounts Accounts Receivable

166


Post Ref.

Dr.

Cr. 2,231 69 2,300

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Do It Yourself! Question 1 Solutions Requirement 1 Journalize these transactions. Explanations are not required. Jan. 1 Purchased inventory for $150 under credit terms 2/10, net 30.

Journal Entry: Date Accounts Jan.1 Inventory Accounts Payable

Post Ref.

Dr. 150

Cr. 150

Jan. 8 Paid for the January 1 purchase in full.

Journal Entry: Date Accounts Jan. 8 Accounts Payable Inventory Cash [(100% – 2%) 3 $150]

Post Ref.

Dr. 150

Cr. 3 147

Mar. 1 Purchased inventory for $240 under credit terms 2/20, net 45.

Journal Entry: Date Accounts Mar. 1 Inventory Accounts Payable

Post Ref.

Dr. 240

Cr. 240

Apr. 1 Paid for the March 1 purchase in full.

Journal Entry: Date Accounts Apr. 1 Accounts Payable Cash

Post Ref.

Dr. 240

Cr. 240


167

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July 1 Sold $80 worth of goods to a customer for $120 under credit terms 5/15, net eom (end of month). Journal Entry: Date Accounts July 1 Accounts Receivable Sales Revenue

Post Ref.

Dr. 120

Cr. 120

COGS Inventory

80 80

July 12 Received cash payment in full for the July 1 sale. Journal Entry: Date Accounts July 12 Cash [(100% – 5%) 3 $120] Sales Discounts (to balance*) Accounts Receivable *120 – 114 = 6

Post Ref.

Dr. 114 6

Cr.

120

Sept. 1 Found that 10% of the goods purchased on March 1 were defective. Franco Bros. returned these goods. Journal Entry: Date Accounts Sept. 1 Accounts Receivable (10% 3 $240) Inventory

Post Ref.

Dr.

Cr. 24 24

Oct. 1 Received cash refund for the goods returned on September 1. Journal Entry: Date Accounts Oct. 1 Cash Accounts Receivable

Post Ref.

Dr.

Cr. 24 24

Dec. 1 Sold $210 worth of goods to a customer for $320 under credit terms 1/10, net eom (end of month). Journal Entry: Date Accounts Dec. 1 Accounts Receivable Sales Revenue COGS Inventory 168


Post Ref.

Dr. 320

Cr. 320

210 210

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Dec. 6 Customer returned 20% of his December 1 order because he did not like the color of the goods. Journal Entry: Post Ref.

Date Accounts Dec. 6 Inventory (20% 3 $210) COGS

Dr.

Cr. 42 42

Sales Returns and Allowances (20% 3 $320) Accounts Receivable

64 64

Dec. 12 Customer paid for the December 1 order (less returns) in full. Journal Entry: Post Ref.

Date Accounts Dec. 12 Cash ($320 – $64) Accounts Receivable

Dr. 256

Cr. 256

Requirement 2 Show the inventory and COGS T-accounts for the year. Jan. 1 Mar. 1

INVENTORY 150 Jan. 8

3

COGS 80 210

Bal.

248

240

Dec. 6 July 1 80 Sept. 1 24 Dec. 1 210

Dec. 6 Bal.

July 1 Dec. 1

42

42 115

Requirement 3 Prepare the top portion of Franco’s 2008 income statement (ending with gross profit). FRANCO BROS. Income Statement Year Ended December 31, 2008 Service revenue Less: Sales discounts Sales returns and allowances Net sales revenue Cost of goods sold Gross profit

$440 $ 6 64

(= $120 + $320)

(70) $370 (248) $122


169

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170

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 5, Accounting for a Retail Business. Click a link to work on the tutorial exercises.


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6


WHAT YOU PROBABLY ALREADY KNOW When you shop in a department store, you probably noticed electronic tags on some of the goods. The cashier removes the tag upon purchase to avoid sounding an alarm when you exit the store through the security gates. You may also notice that fine jewelry is likely displayed in a locked case that can only be opened by an employee. The employee stays with you until the item is returned to the case and locked or purchased. Cartons of cigarettes are also usually secured behind locked doors or cabinets. If you work as a cashier, it’s likely that you have your own cash drawer. Periodically the cash is collected and deposited in a safe or taken to the bank. At the end of the shift, the cash is counted and compared to the sales rung up for the period to determine that the appropriate amount of cash is in the drawer. These observations are just a few of the procedures and policies that businesses employ to achieve a good system of internal control.

Learning Objectives

1

Define fraud and describe the different types of fraud in business. Fraud involves deceit or trickery that causes financial harm to a business or its stakeholders. Two broad types of fraud are employee embezzlement and management fraud, and can include misappropriation (or theft) of business assets and fraudulent financial reporting. Many potential fraudulent activities fall under these broad definitions. Fraud is an intentional behavior and three factors are often included: perceived pressure, perceived opportunity, and rationalization. Be sure to review the “Fraud” and “The Fraud Triangle” sections in the main text, including Exhibit 6-1 (p. 295), which shows the connection between these three factors.

2

Describe an internal control system. An internal control system serves to safeguard assets, encourage accurate financial reporting and efficient and effective operations, and comply with applicable laws and operations. Some components of a good system of internal control include separation of responsibilities, physical safeguards, authorization procedures that check the validity of disbursements, keeping adequate records and documentation, and independent checks and audits to validate performance and accounting records and statements. Review the overview of internal control in Exhibit 6-3 (p. 299). This topic is critical for business owners and managers.

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3

Apply internal controls for cash and prepare a bank reconciliation. Because cash is liquid, desirable, and easily concealed, especially diligent internal controls are required. Challenges exist whether cash is received over the counter or by mail. The assignment and separation of employee responsibilities is important for handling cash. Cashiers should each use a separate drawer. The cash should be counted and checked against the sales register information. Remittances that are mailed in are opened, and the checks and source documentation are forwarded to two separate individuals. A third party verifies that the amount deposited agrees with the source documentation. Review the cash receipt controls in Exhibits 6-4 and 6-5 (pp. 301–302). Often the cash balance on a depositor’s books is different from the amount on the bank statement. The bank reconciliation reconciles, or brings into agreement, the bank account balance on the depositor’s records with the bank’s records. Review the bank statement, cash records, and bank reconciliation in Exhibits 6-8 through 6-10. (pp. 307–309). As you review Exhibit 6-10, think about the objective of the bank reconciliation: to arrive at the correct book balance. This focus should help you understand the rationale for why the various items are added to or subtracted from the balance per bank and the balance per books. When the “Balance per books” is different from the “Adjusted book balance,” journal entries must be recorded for all of the items that appear between those two amounts. These journal entries affect Cash and bring the book balance to the correct amount. Continue to review the journal entries related to Exhibit 6-10.

4

Record journal entries for the petty cash fund. A petty cash fund is a small amount of cash used for minor expenditures such as cab fare, tips, and supplies. When the fund is initially set up, Petty Cash (an asset) is debited and Cash is credited to establish the fund. This entry is only made when the fund is established or the petty cash fund amount is changed. When petty cash is disbursed, tickets are prepared by the custodian as a record of the expenditure. When the cash in the fund becomes low, the custodian submits the petty cash tickets for reimbursement or replenishment. A check is issued to Petty Cash for the total of the petty cash tickets. These activities bring the petty cash fund back to the original amount established. Review the Petty Cash Ticket in Exhibit 6-12 (p. 312) and the “Petty Cash” section of the textbook.

5

Explain the reporting of cash on the balance sheet. Cash is the first item on the balance sheet because it is the most liquid asset. It is not uncommon for companies to have more than one bank account or items included in the Cash amount. Cash includes anything that a bank can accept for deposit. Only cash that is unrestricted (available) should be included as Cash. Often, the first item on the balance sheet may be referred to as “Cash and cash equivalents.” Cash equivalents are short-term investments that can be converted into a known amount of cash. These items mature within 90 days of the balance sheet date and may include time deposits, money market funds, certificates of deposit, and U.S. Treasury bills and Treasury notes. Note that stock and bond investments are not cash equivalents. Review the “Reporting Cash on the Balance Sheet” section of the textbook.

172

Chapter 6 | Internal Control and Cash

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Demo Doc 1 Bank Reconciliations Learning Objectives 1–3 Hunter Corp. has the following information for July 2008: Cash July 1 Bal.

2,100

July 14

300

July 29

120

July 31 Bal.

720

July 8

400

July 25

900

July 30

500

Bank Statement for July 2008 Balance, July 1, 2008

$2,100

Deposits July 14

300

Checks July 8

$400

July 10

230*

July 25

900

(1,530)

Other items: NSF check from Jim Andrews Interest on account balance EFT—collection of installment payments from customers EFT—monthly rent expense Service charges

Balance, July 31, 2008

(150) 25 800 (700) (75)

$770

* The July 10 check was not written by Hunter. It was written by another bank customer and taken from Hunter’s account in error.

Hunter deposits all cash receipts and makes all payments by check.


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Requirements 1. Prepare Hunter’s bank reconciliation at July 31, 2008. 2. Journalize any entries required by Hunter and update Hunter’s Cash T-account. Explanations are not required. 3. The employee at Hunter who opens the mail and physically collects the cash is the same person who updates the cash receipts journal and prepares the bank reconciliation. Is this practice part of a good internal control system?

174

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Demo Doc 1 Solutions Requirement 1 Prepare Hunter’s bank reconciliation at July 31, 2008.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

3 To prepare the bank reconciliation, we need to make adjustments to both the bank balance and Hunter’s Cash balance. First, we must determine what these adjustments are. The bank reconciliation begins with a column for the bank and a column for the company (Hunter). Put the starting Cash balance for each side at the top. Bank Balance, July 31

Apply internal controls for cash and prepare a bank reconciliation

Books (Hunter) $770

Balance, July 31

$720

As we find them, reconciling items will be added to and subtracted from each side. Bank Balance, July 31

Books (Hunter) $770

Balance, July 31

Add:

Add:

Less:

Less:

$720

A reconciling item arises because a valid transaction has not been recorded by both parties. For example, if the bank records service charges and Hunter does not, a reconciling item is required to bring Hunter’s Cash balance to the correct amount. Each reconciling item will be described in the appropriate column and added or subtracted from the Cash balance of the party that has not yet recorded that transaction/entry. Deposits in Transit According to the Cash T-account, Hunter made two deposits: $300 on July 14 and $120 on July 29. Cash July 1

Bal. 2,100

July 14

300

July 29

120

July 31

Bal. 720

July 8

400

July 25

900

July 30

500


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However, the bank statement only shows one (the July 14 deposit for $300). The July 29 deposit for $120 has not yet been recorded by the bank. This deposit in transit increases the bank account when the bank processes and records the deposit. Bank Balance, July 31

Books (Hunter) $770

Balance, July 31

Add:

$720

Add:

Deposits in transit

$120

Less:

Less:

Outstanding Checks and Bank Error According to the Cash T-account, Hunter wrote three checks: July 8, $400; July 25, $900; and July 30, $500. Cash July 1

Bal. 2,100

July 14

300

July 29

120

July 31

July 8

400

July 25

900

July 30

500

Bal. 720

The bank statement shows three checks; however, only two of them were written by Hunter (the July 8 check for $400 and the July 25 check for $900). The July 10 check for $230 shown on the bank statement is a bank error and does not relate to Hunter. This error needs to be corrected by the bank. (It would be a good idea for Hunter to contact the bank to confirm that it is correcting this mistake.) This correction increases Cash on the bank’s side. The July 30 check for $500 has not yet been recorded by the bank. This outstanding check decreases the bank account when it is recorded. The bank records this check in the (near) future when it is cashed. Bank Balance, July 31

Books (Hunter) $770

Add:

$720

Add:

Deposits in transit

$120

Correction of error

$230

Less: Outstanding checks

Balance, July 31

Less: ($500)

NSF Check A check deposited by Hunter for $150 was returned to the bank for insufficient funds. Hunter has not yet recorded the return of this customer check. 176


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The $150 the customer owed has not been paid because Hunter was unable to cash the customer’s check. The account receivable must be reinstated and Hunter’s Cash account decreases. Bank Balance, July 31

Books (Hunter) $770

Add:

Balance, July 31

$720

Add:

Deposits in transit

$120

Correction of error

$230

Less:

Less:

Outstanding checks

($500)

NSF check

($150)

Interest Earned Interest revenue of $25 was earned on Hunter’s bank balance but not yet recorded by Hunter. This amount increases Hunter’s Cash account. Bank Balance, July 31

Books (Hunter) $770

Add:

Balance, July 31

$720

Add:

Deposits in transit

$120

Correction of error

$230

Less:

Interest earned on bank balance

$25

Less:

Outstanding checks

($500)

NSF check

($150)

Installment Payments Received Installment payments from customers of $800 were collected by the bank via EFT but have not yet been recorded by Hunter. These transactions increase Hunter’s Cash account. Bank Balance, July 31

Books (Hunter) $770

Add:

Balance, July 31

$720

Add:

Deposits in transit

$120


$25

Correction of error

$230

Installment payments collected

$800

Less: Outstanding checks

Less: ($500)

NSF check

($150) Demo Doc 1 Solutions | Chapter 6

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Rent Expense The rent payment of $700 was made by the bank (on Hunter’s behalf) but has not yet been recorded by Hunter. This transaction decreases Hunter’s Cash account. Bank Balance, July 31

Books (Hunter) $770

Add:

Balance, July 31

$720

Add:

Deposits in transit

$120


$25

Correction of error

$230


$800

Less:

Less:

Outstanding checks

($500)

NSF check

($150)

Rent payment

($700)

Service Charges Service charges of $75 were incurred with the bank but not yet recorded by Hunter. This entry decreases Hunter’s Cash account. Bank Balance, July 31

Books (Hunter) $770

Add:

Balance, July 31

$720

Add:

Deposits in transit

$120


$25

Correction of error

$230


$800

Less:

Less:

Outstanding checks

Total

Part 1

($500)

$620

Part 2

Part 3

NSF check

($150)

Rent payment

($700)

Service Charges

($75)

Total

$620

Part 4

Demo Doc Complete

After adding in a title and adding up both sides of the reconciliation, we have:

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HUNTER CORP. Bank Reconciliation July 31, 2008 Bank: Balance, July 31, 2008 Add: July 29 deposit in transit Bank error (July 10 check not belonging to Hunter)

$770 120 230 1,120

Less: July 30 outstanding checks

(500)

Adjusted bank balance, July 31, 2008

$620

Books: Balance, July 31, 2008 Add: Bank collection of installment payments Interest earned on account

$720 800 25 1,545

Less: Rent payment NSF check Service charge

$700 150 75

Adjusted book balance, July 31, 2008

(390) (925) $620

Notice that both columns on the reconciliation have the same total. This check helps to ensure that all calculations are correct. If these totals were not the same, it would indicate an error and/or missing data.

Requirement 2 Journalize any entries required by Hunter and update Hunter’s Cash T-account. Explanations are not required. Any reconciling items on Hunter’s side of the bank reconciliation should be journalized. Usually these entries are made in the order in which they appear on the bank reconciliation.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Installment Payments

3

Cash increases (a debit) and Accounts Receivable decreases (a credit) by $800.

Apply internal controls for cash and prepare a bank reconciliation

Journal Entry: Date Accounts July 31 Cash (Asset,1; debit) Accounts Receivable (Asset,2; credit)

Dr. 800

Cr. 800 Demo Doc 1 Solutions | Chapter 6

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Interest Earned Cash increases (a debit) and Interest Revenue increases (a credit) by $25. Journal Entry: Date Accounts July 31 Cash (Asset,1; debit) Interest Revenue (Revenue,1; credit)

Dr.

Cr. 25 25

Rent Payment Cash decreases (a credit) and Rent Expense increases (a debit) by $700. Journal Entry: Date Accounts July 31 Rent Expense (Expense,1; debit) Cash (Asset,2; credit)

Dr. 700

Cr. 700

NSF Check Cash decreases (a credit) and Accounts Receivable increases (a debit) by $150. Journal Entry: Date Accounts July 31 Accounts Receivable (Asset,1; debit) Cash (Asset,2; credit)

Dr. 150

Cr. 150

Service Charges Cash decreases (a credit) and Miscellaneous Expense increases (a debit) by $75. Journal Entry: Date Accounts July 31 Miscellaneous Expense (Expense,1; debit) Cash (Asset,2; credit)

Dr.

75

Post these adjustments to the Cash T-account: Cash July 31 Bal.

720 800 25 July 31

July 31 Bal.

180


620

Cr. 75

700 150 75

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The final Cash balance is $620, which is also the total on the bank reconciliation. Both totals must agree, and this check makes sure that everything was done correctly.

m Requirement 3 The employee at Hunter who opens the mail and physically collects the cash is the same person who updates the cash receipts journal and prepares the bank reconciliation. Is this practice part of a good internal control system?

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

An employee who collects the cash and records the receipt of the cash and performs the bank reconciliation has a substantial opportunity for fraud. The employee could steal the cash and delay recording the cash receipt, or perhaps never record the cash receipt. An employee in such a position could hide this dishonest act for a long period of time by manipulating the bank reconciliations. To avoid this problem, most internal control systems require separation of duties; that is, employees who handle cash (both receipts and payments) are not the same employees who maintain the accounting records and prepare the bank reconciliations.

Part 1

Part 2

Part 3

Part 4

1

2

Define fraud and describe the different types of fraud in business Describe an internal control system

Demo Doc Complete


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Demo Doc 2 Petty Cash Learning Objectives 1, 2, 4, 5 Young Brothers established a $300 petty cash fund on July 1, 2008. On July 31, 2008, the petty cash box contained $70 cash and the following receipts: July 5

Travel expenses

$80

July 12

Donuts for board meeting

50

July 23

Office supplies

60

July 29

Delivery charges

40

On August 1, 2008, the petty cash balance was replenished.

Requirements 1. Journalize the entry to establish the fund. 2. What is the total cash amount paid from petty cash in July? Journalize the entry to record the expenses incurred from petty cash during July. (Assume all charges are recorded as office supplies, delivery expense, travel expense, or meals expense.) On what date(s) are these expenses recorded? 3. A Young employee notices that the petty cash has been short several months in a row. Although the amounts involved are small (immaterial), the trend is consistent. What should the employee do? 4. Is petty cash considered to be cash or a cash equivalent?

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Demo Doc 2 Solutions Requirement 1 Journalize the entry to establish the fund.

Part 1

Part 2

Part 3

Demo Doc Complete

Part 4

When the fund is established, cash is withdrawn from Young’s bank accounts and put into the petty cash box. This transaction increases Petty Cash (a debit) and decreases Cash (a credit) by $300.

4

Record journal entries for the petty cash fund

4

Record journal entries for the petty cash fund

Journal Entry: Date Accounts July 1 Petty Cash (Asset,1; debit) Cash in Bank (Asset,2; credit)

Dr. 300

Cr. 300

Requirement 2 What is the total cash amount paid from petty cash in July? Journalize the entry to record the expenses incurred from petty cash during July. (Assume all charges are recorded as office supplies, delivery expense, travel expense, or meals expense.) On what date(s) are these expenses recorded?

Part 1

Part 2

Part 3

Demo Doc Complete

Part 4

The receipts in the petty cash box total $80 + $50 + $60 + $40 = $230. This receipt total means that $300 – $230 = $70 should be left in the petty cash box. These expenses are not recorded at the time they are incurred. The amounts involved are immaterial, so instead we can wait to record them until the petty cash is replenished.

Journal Entry: Date Accounts Aug. 1 Office Supplies (Asset,1; debit) Delivery Expense (Expense,1; debit) Travel Expense (Expense,1; debit) Meals Expense (Expense,1; debit) Cash in Bank ($300 – $70) (Asset,2; credit)

Dr.

Cr. 60 40 80 50 230 Demo Doc 2 Solutions | Chapter 6

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Requirement 3 A Young employee notices that the petty cash has been short several months in a row. Although the amounts involved are small (immaterial), the trend is consistent. What should the employee do?

Part 1

1

Define fraud and describe the different types of fraud in business

2

Describe an internal control system

Part 2

Part 3

Part 4

Demo Doc Complete

It is easy to have cash overages and shortages from month to month. Record keeping for petty cash is often spotty because it is usually handled by someone who is not familiar with accounting. However, consistent shortages every month suggest the possibility of unethical behavior on the part of the petty cash handler. Having someone review petty cash transactions periodically provides a good internal control. The employee who notices this trend should discuss it with the person responsible for petty cash. If the issue cannot be resolved, then the employee should report it to a supervisor. Young could implement some internal controls to better monitor petty cash. These controls could include requiring the use of petty cash tickets with an authorized signature (the person signing would presumably review the receipts for correctness).

Requirement 4 Is petty cash considered to be cash or a cash equivalent?

Part 1

5

Explain the reporting of cash on the balance sheet

Part 3

Part 4

Demo Doc Complete

Petty cash is actual cash. The only difference between petty cash and a standard Cash T-account is that petty cash is located on the premises of the business rather than in a bank account. Therefore, petty cash is considered to be cash for purposes of balance sheet reporting.

Part 1

184

Part 2


Part 2

Part 3

Part 4

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. A deposit in transit has been recorded by the company but not by the bank. _____ 2. An NSF check would be recorded on the books by debiting Accounts Receivable. _____ 3. Employee embezzlement typically involves fraudulent financial reporting by management. _____ 4. An audit is the assessment of financial statements to determine whether they are fairly presented. _____ 5. Different people should perform various accounting duties to minimize errors and the opportunities for fraud. _____ 6. Funds disbursed from the petty cash fund will be recorded as a credit to the Petty Cash account. _____ 7. The person who prepares checks for payment would be a suitable employee to reconcile the bank account. _____ 8. The party signing a check is referred to as the maker. _____ 9. Outstanding checks would include only those checks written for the current month that have not cleared or been canceled by the bank. _____10. It is a good control to have just one person open the checks and deposit them in the bank.


185

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Multiple Choice 1. Which of the following is not an objective of internal control? a. Help safeguard the assets a business uses in its operations b. Guarantee a company will not go bankrupt c. Encourage adherence to company policies d. Promote operational efficiency 2. Which of the following items used to reconcile cash does not require an adjusting entry? a. Bank service charge b. Interest earned c. A note collected by the bank d. Deposits in transit 3. Which of the following statements about bank reconciliations is correct? a. Should not be prepared by an employee who handles cash transactions b. Is part of a sound internal control system c. Is a formal financial statement d. Both (a) and (b) are correct 4. Which of the following items does not cause a difference between the cash balance per bank and book? a. NSF checks b. Deposits in transit c. Outstanding checks d. Canceled checks 5. The following data are available for Wonder Boutique for October: Book balance, October 31 $5,575 Outstanding checks 584 Deposits in transit 2,500 Service charges 75 Interest revenue 25 What is the adjusted book balance on October 31 for Wonder Boutique based on these data? a. $5,500 b. $5,525 c. $5,550 d. $7,466 6. The bank statement lists a $700 deposit as $70. On a bank reconciliation, the correction for this error will appear as which of the following? a. Addition to the book balance b. Deduction from the book balance c. Addition to the bank balance d. Deduction from the bank balance

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7. Which of the following processes for payment compresses the approval for payment into a single step? a. Electronic funds transfer b. Evaluated receipts settlement c. Electronic data interchange d. Rationalization 8. For which items must journal entries be prepared? a. Any errors made on the books revealed by the bank reconciliation b. Any errors made by the bank revealed by the bank reconciliation c. All items on the bank’s side d. Only outstanding checks 9. Which of the following is not a control over petty cash? a. Keeping an unlimited amount of cash on hand b. Supporting all fund disbursements with a petty cash ticket c. Replenishing the fund through normal cash disbursement procedures d. Designating one employee to administer the fund 10. If the petty cash fund is not replenished on the balance sheet date, which of the following will be true? a. Assets will be overstated b. Income will be overstated c. Neither (a) nor (b) d. Both (a) and (b)

Quick Exercises 6-1. Classify each of the following reconciling items of the Bread and Butter Company as one of the following: a. An addition to the bank balance b. A deduction from the bank balance c. An addition to the book balance d. A deduction from the book balance e. Not a reconciling item __________ 1. Collection of note receivable plus interest revenue by bank __________ 2. Bookkeeper recorded check #849 as $557 instead of the correct amount of $755 __________ 3. Bank service charges __________ 4. Bank credited the account for interest revenue __________ 5. Bank added deposit to Bread and Butter’s account in error __________ 6. Deposits in transit __________ 7. Bank withdrew $1,270 from Bread and Butter’s account for a check written for $12,700 __________ 8. Bookkeeper failed to record a check that was returned with the bank statement __________ 9. Check deposited and returned by the bank marked NSF __________ 10. Outstanding checks Quick Practice Questions | Chapter 6

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6-2. On November 1, 2008, Heather Station established a $300 petty cash fund. At the end of November the petty cash fund contained: Cash on hand Petty cash tickets for: Postage Office supplies Miscellaneous items

$ 48.00 $73.50 87.55 90.95 Total

252.00 $300.00

a. Prepare the journal entry to establish the petty cash fund on November 1, 2008. Journal Entry: Date Accounts

Dr.

Cr.

b. Prepare the journal entry on November 30, 2008, to replenish the petty cash fund.


188


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Cr.

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6-3. Using the following information, journalize the necessary entries after preparing the bank reconciliation for Louis Brothers on May 31, 2008. (Not all items will require an entry.) a. Outstanding checks total $1,533.25. b. The bookkeeper recorded a $1,524 check as $15,240 in payment of the current month’s rent. c. A deposit of $300 from a customer was credited to Louis Brothers for $3,000 by the bank. d. A customer’s check for $1,380 was returned for nonsufficient funds. e. The bank service charge based on the bank statement is $70.


Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.






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6-4. The following data have been gathered for Batter Company to assist you in preparing the September 30, 2008, bank reconciliation: a. The September 30 bank balance was $5,460. b. The bank statement included $30 of service charges. c. There was an EFT deposit of $1,800 on the bank statement for the monthly rent due from a tenant. d. Checks #541 and #543, for $205 and $420, respectively, were not among the canceled checks returned with the statement. e. The September 30 deposit of $3,800 did not appear on the bank statement. f. The bookkeeper had erroneously recorded a $500 check as $5,000. The check was payment for an amount due on account. g. Included with the canceled checks was a check written by Bitter Company for $200, which was deducted from Batter Company’s account. h. The bank statement included an NSF check written by Tate Company for a $360 payment on account. i. The Cash account showed a balance of $2,925 on September 30. Prepare the September 30, 2008, bank reconciliation for Batter Company.

BATTER COMPANY Bank Reconciliation September 30, 2008 Bank: Balance, September 30, 2008 Add:

$

Less:

Adjusted bank balance, September 30, 2008 Books: Balance, September 30, 2008 Add:

$

$

Less:

Adjusted book balance, September 30, 2008

190


$

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6-5. The following data have been gathered for Ragpicker Company. a. The service charges for February amount to $90. b. Outstanding checks amount to $650. c. The bank erroneously credited Ragpicker Company’s account for $300 for a deposit made by another company. d. Check #665 for $3,000 for the cash purchase of office equipment was erroneously recorded by the bookkeeper as $2,080. e. A deposit ticket correctly prepared for $975 appeared on the bank statement as a deposit for $795. f. A customer’s check for $560 was returned with the bank statement and stamped NSF. g. Check #650 for $125 for utilities expense was erroneously recorded by the bookkeeper as $1,250. Calculate the correct cash balance on February 28, 2008, by performing the part of the bank reconciliation beginning with the balance per bank as shown. (Note: Not all of the preceding data may be needed.)

RAGPICKER COMPANY Bank Reconciliation February 28, 2008 Bank: Balance, February 28, 2008 Add:

$7,975

Less:

Adjusted bank balance, February 28, 2008

$


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Do It Yourself! Question 1 Bank Reconciliations Quint Inc. has the following information for May 2008: Cash May 1 Bal.

4,500 May 4

May 9

900

600

May 18

1,000

May 28

700

May 12

2,300

May 22

1,500

May 30

500

May 31 Bal. 1,600

Bank Statement for May 2008 Balance, May 1, 2008

$4,500

Deposits May 9

$600

May 18

1,000

1,600

Checks May 4

900

May 12

2,300

May 22

1,500

(4,700)

Other items: EFT—payment of loan payable

(1,300)

NSF check from Bennet Smith

(400)

Service charges

(100)

EFT—monthly rent collection Interest on account balance Balance, May 31, 2008

1,200 50 $850

The loan payment includes principal of $950 and interest of $350. The rent collection is from tenants leasing extra space in Quint’s office building. Quint deposits all cash receipts and makes all payments by check. 192


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Requirements 1. Prepare Quint’s bank reconciliation at May 31, 2008.

2. Journalize any entries required by Quint and update Quint’s Cash T-account. Explanations are not required. Journal Entry: Date Accounts

Dr.

Cr.

Dr.

Cr.



193

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Dr.

Cr.

Dr.

Cr.

Dr.

Cr.



194


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Do It Yourself! Question 2 Petty Cash Xander Co. established a $400 petty cash fund on May 1, 2008. On May 31, 2008, the petty cash box contained $80 cash and the following receipts: May 6

Office supplies

$75

May 13

Delivery charges

90

May 24

Pizza for office party

70

May 30

Office supplies

85

On May 31, 2008, the petty cash balance was replenished.

Requirements 1. Journalize the entry to establish the fund.


Dr.

Cr.

2. Journalize the entry to record the expenses incurred from petty cash during May. (Assume all charges are recorded as Supplies Expense, Delivery Expense, or Meals Expense.)


Dr.

Cr.


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Quick Practice Solutions True/False

196

T

1. A deposit in transit has been recorded by the company but not by the bank. (p. 304)

T

2. An NSF check would be recorded on the books by debiting Accounts Receivable. (p. 308)

F

3. Employee embezzlement typically involves fraudulent financial reporting by management. False–Employee embezzlement is employee fraud involving misap propriation of assets, which occurs when employees steal from their employers. Management fraud typically involves fraudulent financial reporting by management. (p. 296)

T

4. An audit is the assessment of financial statements to determine whether they are fairly presented. (p. 299)

T

5. Different people should perform various accounting duties to minimize errors and the opportunities for fraud. (p. 297)

F

6. Funds disbursed from the petty cash fund will be recorded as a credit to the Petty Cash account. False–When the petty cash fund is replenished, funds disbursed from the fund will be recorded as a credit to the Cash account. No entries affect Petty Cash for the disbursement of funds. (p. 312)

F

7. The person who prepares checks for payment would be a suitable employee to reconcile the bank account. False–Responsibilities for the custody, approval, and accounting tasks should be held by separate employees. (pp. 297–298)

T

8. The party signing a check is referred to as the maker. (p. 303)

F

9. Outstanding checks would include only those checks written for the current month that have not cleared or been canceled by the bank. False–Outstanding checks include all checks written that have not cleared the bank. They could be from the current month or previous periods. (p. 304)

F

10. It is a good control to have just one person open the checks and deposit them in the bank. False–Separate individuals should be assigned custody, approval, and accounting tasks. (p. 301)


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Multiple Choice 1. Which of the following is not an objective of internal control? (p. 297) a. Help safeguard the assets a business uses in its operations b. Guarantee a company will not go bankrupt c. Encourage adherence to company policies d. Promote operational efficiency 2. Which of the following items used to reconcile cash does not require an adjusting entry? (p. 304) a. Bank service charge b. Interest earned c. A note collected by the bank d. Deposits in transit 3. Which of the following statements about bank reconciliations is correct? (p. 310) a. Should not be prepared by an employee who handles cash transactions b. Is part of a sound internal control system c. Is a formal financial statement d. Both (a) and (b) are correct 4. Which of the following items does not cause a difference between the cash balance per bank and book? (pp. 304–305) a. NSF checks b. Deposits in transit c. Outstanding checks d. Canceled checks 5. The following data are available for Wonder Boutique for October: Book balance, October 31 $5,575 Outstanding checks 584 Deposits in transit 2,500 Service charges 75 Interest revenue 25 What is the adjusted book balance on October 31 for Wonder Boutique based on these data? (pp. 304–306) a. $5,500 b. $5,525 c. $5,550 d. $7,466 6. The bank statement lists a $700 deposit as $70. On a bank reconciliation, the correction for this error will appear as which of the following? (p. 306) a. Addition to the book balance b. Deduction from the book balance c. Addition to the bank balance d. Deduction from the bank balance


197

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7. Which of the following processes for payment compresses the approval for payment into a single step? (p. 303) a. Electronic funds transfer b. Evaluated receipts settlement c. Electronic data interchange d. Rationalization 8. For which items must journal entries be prepared? (p. 306) a. Any errors made on the books revealed by the bank reconciliation b. Any errors made by the bank revealed by the bank reconciliation c. All items on the bank’s side d. Only for outstanding checks 9. Which of the following is not a control over petty cash? (p. 311) a. Keeping an unlimited amount of cash on hand b. Supporting all fund disbursements with a petty cash ticket c. Replenishing the fund through normal cash disbursement procedures d. Designating one employee to administer the fund 10. If the petty cash fund is not replenished on the balance sheet date, which of the following will be true? (pp. 312–313) a. Assets will be overstated b. Income will be overstated c. Neither (a) nor (b) d. Both (a) and (b)

Quick Exercise Solutions 6-1. Classify each of the following reconciling items of the Bread and Butter Company as one of the following: a. An addition to the bank balance b. A deduction from the bank balance c. An addition to the book balance d. A deduction from the book balance e. Not a reconciling item c d d c b a b d d b

198


1. Collection of note receivable plus interest revenue by bank 2. Bookkeeper recorded check #849 as $557 instead of the correct amount of $755 3. Bank service charges 4. Bank credited the account for interest revenue 5. Bank added deposit to Bread and Butter’s account in error 6. Deposits in transit 7. Bank withdrew $1,270 from Bread and Butter’s account for a check written for $12,700 8. Bookkeeper failed to record a check that was returned with the bank statement 9. Check deposited and returned by the bank marked NSF 10. Outstanding checks

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6-2. On November 1, 2008, Heather Station established a $300 petty cash fund. At the end of November the petty cash fund contained: Cash on hand Petty cash tickets for: Postage Office supplies Miscellaneous items

$ 48.00 $73.50 87.55 90.95 Total

252.00 $300.00

a. Prepare the journal entry to establish the petty cash fund on November 1, 2008.

Journal Entry: Date Accounts Nov. 1 Petty Cash Cash in Bank To establish the petty cash fund.

Dr. 300

Cr. 300

b. Prepare the journal entry on November 30, 2008, to replenish the petty cash fund.

Journal Entry: Date Accounts Nov. 30 Postage Expense Office Supplies Miscellaneous Expense Cash To replenish petty cash.

Dr. 73.50 87.55 90.95

Cr.

252.00


199

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6-3. Using the following information, journalize the necessary entries after preparing the bank reconciliation for Louis Brothers on May 31, 2008. (Not all items will require an entry.) a. Outstanding checks total $1,533.25. b. The bookkeeper recorded a $1,524 check as $15,240 in payment of the current month’s rent. c. A deposit of $300 from a customer was credited to Louis Brothers for $3,000 by the bank. d. A customer’s check for $1,380 was returned for nonsufficient funds. e. The bank service charge based on the bank statement is $70.

Journal Entry: Date a.

Accounts

Ref.

Dr.

Cr.

Ref.

Dr.

Cr.

No entry required

Journal Entry: Date b. May 31

Accounts Cash Rent Expense

13,716 13,716

Journal Entry: Date c.

Accounts No entry required

Ref.

Dr.

Cr.

Ref.

Dr.

Cr.

Journal Entry: Date d. May 31

200

Accounts Accounts Receivable Cash


1,380 1,380

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6-4. The following data have been gathered for Batter Company to assist you in preparing the September 30, 2008, bank reconciliation: a. The September 30 bank balance was $5,460. b. The bank statement included $30 of service charges. c. There was an EFT deposit of $1,800 on the bank statement for the monthly rent due from a tenant. d. Checks #541 and #543, for $205 and $420, respectively, were not among the canceled checks returned with the statement. e. The September 30 deposit of $3,800 did not appear on the bank statement. f. The bookkeeper had erroneously recorded a $500 check as $5,000. The check was payment for an amount due on account. g. Included with the canceled checks was a check written by Bitter Company for $200, which was deducted from Batter Company’s account. h. The bank statement included an NSF check written by Tate Company for a $360 payment on account. i. The cash account showed a balance of $2,925 on September 30. Prepare the September 30, 2008, bank reconciliation for Batter Company.

BATTER COMPANY Bank Reconciliation September 30, 2008 Bank: Balance, September 30, 2008 Add: Deposit in transit Bank error—Batter Co. check

$5,460 $3,800 200 4,000

Less: Outstanding checks Check #541 Check #543

205 420 (625) $8,835

Adjusted bank balance, September 30, 2008

Books: Balance, September 30, 2008 Add: EFT rent deposit Bookkeeper error ($5,000 – 500)

$2,925 $1,800 4,500 6,300

Less: Bank service charge NSF check Adjusted book balance, September 30, 2008

30 360 (390) $8,835


201

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6-5. The following data have been gathered for Ragpicker Company. a. The service charges for February amount to $90. b. Outstanding checks amount to $650. c. The bank erroneously credited Ragpicker Company’s account for $300 for a deposit made by another company. d. Check #665 for $3,000 for the cash purchase of office equipment was erroneously recorded by the bookkeeper as $2,080. e. A deposit ticket correctly prepared for $975 appeared on the bank statement as a deposit for $795. f. A customer’s check for $560 was returned with the bank statement and stamped NSF. g. Check #650 for $125 for utilities expense was erroneously recorded by the bookkeeper as $1,250. Calculate the correct cash balance on February 28, 2008, by performing the part of the bank reconciliation beginning with the balance per bank as shown. (Note: Not all of the preceding data may be needed.)

RAGPICKER COMPANY Bank Reconciliation February 28, 2008 Bank: Balance, February 28, 2008 Add: Bank error—deposit of $975 recorded as $795

Less: Outstanding checks Bank error Adjusted bank balance, February 28, 2008 Note: Remember that the adjusted bank balance is the correct book balance.

202


$7,975 180 8,155 $650 300 (950) $7,205

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Do It Yourself! Question 1 Solutions Requirement 1 Prepare Quint’s bank reconciliation at May 31, 2008.

QUINT INC. Bank Reconciliation May 31, 2008 Bank: Balance, May 31, 2008 Add: May 28 deposit in transit

$850 700 1,550

Less: May 30 outstanding check

(500)

Adjusted bank balance, May 31, 2008

$1,050

Books: Balance, May 31, 2008 Add: Bank collection of rent Interest earned on account

Less: Mortgage payment NSF—B. Smith Service charge Adjusted book balance, May 31, 2008

$1,600 1,200 50 2,850 $1,300 400 100

(1,800) $1,050


203

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Requirement 2 Journalize any entries required by Quint and update Quint’s Cash T-account. Explanations are not required.

Journal Entry: Date Accounts May 31 Cash (Asset,1; debit) Rent Revenue (Revenue,1; credit)

Dr. 1,200

1,200

May 31 Cash (Asset,1; debit) Interest Revenue (Revenue,1; credit)

50 50

May 31 Mortgage Payable (Liability,2; debit) Cash (Asset,2; credit)

950

May 31 Interest Expense (Expense,1; credit) Cash (Asset,2; credit)

350

May 31 Accounts Receivable (Asset,1; debit) Cash (Asset,2; credit)

400

May 31 Miscellaneous Expense (Expense,1; debit) Cash (Asset,2; credit)

100

950

350

400

100

Cash May 31 Bal. 1,600 1,200 50 May 31

May 31 Bal. 1,050

204


Cr.

950 350 400 100

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Do It Yourself! Question 2 Solutions Requirement 1 Journalize the entry to establish the fund.

Journal Entry: Date Accounts May 1 Petty Cash (Asset,1; debit) Cash in Bank (Asset,2; credit)

Dr. 400

Cr. 400

Requirement 2 Journalize the entry to record the expenses incurred from petty cash during May.

Journal Entry: Date Accounts May 31 Office Supplies ($75 + $85) (Expense,1; debit) Delivery Expense (Expense,1; debit) Meals Expense (Expense,1; debit) Cash in Bank ($400 – $80) (Asset,2; credit)

Dr. 160 90 70

Cr.

320


205

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206

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 6, Internal Control and Cash. Click a link to work on the tutorial exercises.


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7

Receivables

WHAT YOU PROBABLY ALREADY KNOW You probably already know that if a friend borrows money from you, you may not be repaid. You would not loan the money if you didn’t believe that your friend is creditworthy and will likely repay the debt. However, until the money is received, you have no guarantee. If the friend asks to borrow more money before repaying the original loan, you may be more likely to refuse because your risk of nonpayment is increased. Your friend has no history of successful repayment yet. If the friend never pays, you incur a loss equal to the amount of the loan. The same concerns exist for a business. Sales on account are made only after a customer is approved by the business’s credit department. Despite the most thorough investigation, some customers still may not pay the amount due. The uncollectible accounts receivable results in a reduction to the asset and to net income.

Learning Objectives

1

Describe the types of sales and receivables and discuss the related internal controls. By now, you should understand that whether a business sells goods or services, customers may pay in several different ways: Cash, credit, debit, and bank card sales are all possibilities. The account results in a receivable—either an account receivable or a note receivable. One important feature of a strong system of internal control over both collections and credit management is to separate responsibility for the custody of assets from the accounting and operating departments. The individual handling cash should not be granting credit, nor should that person be accounting for receivables. Understanding the main issues associated with extending credit and handling receivables is an important lesson from this chapter.

2

Use the direct write-off method to account for uncollectible receivables. The direct write-off method is simple to employ, but the method is not in accordance with GAAP. No estimate of the uncollectible accounts expense is journalized. When it is determined which customer’s receivable is uncollectible, the following entry is journalized:

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Journal Entry: Date Accounts Uncollectible Accounts Expense Accounts Recievable

Post Ref.

Dr.

Cr. X X

Check out “The Direct Write-Off Method” in the main text.

3

Use the allowance method to account for uncollectible receivables. The allowance method matches the sales revenues with the uncollectible accounts expense (also known as the bad debt expense). An estimate of the uncollectible accounts expense must be made in the period of sale using either the aging of receivables or the percent-ofsales methods. The entry required at the end of the period is: Journal Entry:

Date Accounts Uncollectible Accounts Expense Allowance for Uncollectible Accounts

Post Ref.

Dr.

Cr. X X

The Allowance for Uncollectible Accounts is a contra-asset account. This account is credited, rather than Accounts Receivable, because it is unknown on the entry date which specific customers will eventually not pay. When it is determined which customer’s receivable is uncollectible, the Allowance account is reduced (debited) and the specific customer accounts receivable is reduced (credited). Accounting for uncollectibles can be a challenging concept, so be sure that you have a good understanding of this topic before moving on to the next chapter.

4

Account for notes receivable. A note receivable is a formal written promise to pay the amount borrowed by the debtor plus interest. Interest must be journalized for the period of indebtedness. Study the key components of a note in Exhibit 7-7 (p. 364). Review “Computing Interest on a Note”, “Accounting for Notes Receivable”, and “Accruing Interest Revenue” in the main text.

5

Calculate the quick ratio and days’ sales in receivables. A measure of liquidity is the quick ratio (also called the acid-test ratio). The current assets most quickly converted into cash are compared to the total current liabilities. A higher result is usually more favorable. The ratio is calculated as follows: Quick ratio =

Cash ! Short-term investments ! Net current receivables Total current liabilities

The days’ sales in receivables indicate the number of days it takes on average to collect from customers. The objective is to minimize the collection period. Review the ratio computations in “More Ratios for Decision Making” in the main text. 208

Chapter 7 | Receivables

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Demo Doc 1 Uncollectible Accounts Receivable Learning Objectives

1–3, 5

Hart Inc.’s December 31, 2007, balance sheet reported: Accounts receivable

$800

Allowance for uncollectible accounts

($40)

Accounts receivable (net)

$760

Requirements 1. Is Hart using the allowance method or the direct write-off method to account for uncollectible receivables? How much of the December 31, 2007, balance of accounts receivable did Hart expect to collect? 2. During 2008, Hart wrote off accounts receivables totaling $35 from Amanda Blake. Journalize these write-offs as one transaction. How does this transaction affect the net accounts receivable balance? How would this transaction have been journalized if the direct write-off method was being used? 3. During 2008, Hart earned $2,800 of service revenues, all on account. Journalize these revenues as one transaction. 4. During 2008, Hart collected $2,745 cash from customers. Journalize this transaction and calculate the gross accounts receivable balance at December 31, 2008. 5. Assume that Hart estimates uncollectible accounts expense to be 1.5% of revenues. Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008 adjusted balance in the allowance account? 6. (Ignore Requirement 5.) Assume that Hart has the following information at December 31, 2008: Gross Accounts Receivable

Percentage Estimated Uncollectible

$100

2%

30–60 days

500

4%

> 60 days

220

10%

Age < 30 days

Total

$820

Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008, balance in the allowance? Show how accounts receivable would be reported on the balance sheet at December 31, 2008. 7. Calculate Hart’s day’s sales in accounts receivable for 2008 (assume Hart uses the aging-of-accounts receivable method in Requirement 6). What does this ratio mean? 8. The employee at Hart who opens the mail and physically collects the cash is the same person who updates the cash receipts journal and accounts receivable ledger. Is this system a good practice of internal control?


209

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Demo Doc 1 Solutions Requirement 1 Is Hart using the allowance method or the direct write-off method to account for uncollectible receivables? How much of the December 31, 2007, balance of accounts receivable did Hart expect to collect?

Part 1

2

3

Use the direct writeoff method to account for uncollectible receivables Use the allowance method to account for uncollectible receivables

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

Hart is using the allowance method, which is indicated by an allowance for uncollectible accounts. If Hart were using the direct write-off method, Hart would not need an allowance for uncollectible accounts. Gross accounts receivable is the total amount of receivables that exist. For Hart, this amount is $800. The allowance is (by definition) the amount of receivables we do not expect to collect. The total receivables minus the amount we do not expect to collect (that is, the gross accounts receivable minus the allowance) is the amount we do expect to collect (that is, the net accounts receivable). Hart expects to collect $760 of the accounts receivable.

Requirement 2 During 2008, Hart wrote off accounts receivables totaling $35 from Amanda Blake. Journalize these write-offs as one transaction. How does this transaction affect the net accounts receivable balance? How would this transaction have been journalized if the direct-write-off method was being used?

Part 1

2

3

Use the direct writeoff method to account for uncollectible receivables Use the allowance method to account for uncollectible receivables

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

Writing off an account receivable means removing it from the accounting books/records because it has been determined that this specific amount will not be collected. We must reduce (credit) the Accounts Receivable. Additionally, now that we find that one of the accounts will not be collected, we can take it out of our estimate of uncollectible accounts (the Allowance for Uncollectible Accounts), which decreases this account (a debit).

Journal Entry: Date

Accounts Allowance for Uncollectible Accounts (Contra-Asset,2; debit) Accounts Receivable—Amanda Blake (Asset,2; credit)

Post Ref.

Dr.

Cr. 35 35

Use this standard format to write off accounts receivable when using the allowance method. The entry structure is always the same, only the amount changes. 210


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Note that this entry does not change the net accounts receivable. Gross accounts receivable decreases, but so does the allowance so overall the change is zero: Gross accounts receivable

change of – 35

– Allowance for uncollectible accounts

(change of – 35)


no change

The impact of this transaction is: Gross accounts receivable – Allowance for uncollectible accounts

$800 – $35 " $765 ($40 – $35 " $ 5)

Accounts receivable (net) (same amount to collect)

$760 – $0 " $760

Under the direct write-off method, no allowance is used, so the debit in the write-off entry increases Uncollectible Accounts Expense. Journal Entry: Date

Accounts Uncollectible Accounts Expense (Expense,1; debit) Accounts Receivable—Amanda Blake (Asset,2; credit)

Post Ref.

Dr.

Cr. 35 35

Requirement 3 During 2008, Hart earned $2,800 of service revenues, all on account. Journalize these revenues as one transaction. Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

When revenues are earned, we increase the Revenue account (a credit). In this case, we are not receiving cash, so instead we increase Accounts Receivable (a debit) to show that we intend to collect this amount later from our customer(s). Journal Entry: Date

Accounts Accounts Receivable (Asset, 1; debit) Service Revenue (Revenue, 1; credit)

Post Ref.

Dr. 2,800

Cr. 2,800


211

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Requirement 4 During 2008, Hart collected $2,745 cash from customers. Journalize this transaction and calculate the gross accounts receivable balance at December 31, 2008. Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Part 8

When cash is collected, we increase the Cash account (a debit) and decrease Accounts Receivable (a credit). Journal Entry: Date

Post Ref.

Accounts Cash (Asset, 1; debit) Accounts Receivable (Asset, 2; credit)

Dr. 2,745

Cr. 2,745

From the initial data given in the question, we can see that gross accounts receivable had a balance of $800 at the beginning of the year ($760 is the net balance). Accounts Receivable increased in the year as revenues were earned. Accounts Receivable decreased when uncollectible accounts were written off and when cash was collected. Using this information, we can calculate the ending balance in (gross) Accounts Receivable: Accounts Receivable Dec. 31, 2007 Bal. 2008 Revenues

800 2,800

2008 Write-Offs 2008 Cash Collections

Dec 31, 2008 Bal.

35 2,745

820

Requirement 5 Assume that Hart estimates uncollectible accounts expense to be 1.5% of revenues. Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008 adjusted balance in the allowance account?

Part 1

2

Use the direct writeoff method to account for uncollectible receivables

212

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

The problem states, “Hart estimates uncollectible accounts expense to be 1.5% of revenues.” The key phrase here is “1.5% of revenues,” which tells us that Hart is using the percentage-of-sales method to calculate the expense and allowance.


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Under the percentage-of-sales method, the percentage of sales equals the uncollectible accounts expense. Therefore, we can calculate that 1.5% of $2,800, or $42, equals the uncollectible accounts expense. We then journalize $42 of Uncollectible Accounts Expense. Journalizing the Uncollectible Accounts Expense increases that account (a debit) and also increases the total estimate of uncollectible accounts: the Allowance (a credit).

Journal Entry: Date

Post Ref.

Accounts Uncollectible Accounts Expense (Expense,1; debit) Allowance for Uncollectible Accounts (Contra-Asset,1; credit)

Dr.

Cr. 42 42

Use this standard journal entry format to journalize uncollectible accounts expense and adjust the allowance. The entry structure is always the same, only the amount changes. The balance in the Allowance account must be calculated. The beginning balance in the allowance for 2008 is the ending balance for 2007 (the $40 shown at the beginning of the question, as shown in the balance sheet presentation on p. 209). During the year, write-offs will decrease the allowance ($35, as in Requirement 2) and the year-end adjustment will increase it ($42, as in this requirement). We can fill in this information to calculate an ending balance of $47 in the Allowance account.

Allowance for Uncollectible Accounts 2008 Write-Offs

Dec. 31, 2007 Bal.

40

2008 Uncollectible Accounts Expense Adjustment

42

Dec. 31, 2008 Bal.

47

35

Requirement 6 (Ignore Requirement 5.) Assume that Hart has the following information at December 31, 2008:

Age < 30 days

Gross Account Receivable


$100

2%

30–60 days

500

4%

> 60 days

220

10%

Total

$820 Demo Doc 1 Solutions | Chapter 7

213

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Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008, balance in the allowance? Show how accounts receivable would be reported on the balance sheet at December 31, 2008.

Part 1

2

Use the direct writeoff method to account for uncollectible receivables

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Part 8

The problem does not explicitly state which method is being used; however, the table clearly shows estimated uncollectible percentages of accounts receivable. This information shows us that Hart is using the aging-of-accounts receivable method to calculate the allowance and then the expense. Under the aging-of-accounts receivables method, the percentage of receivables equals the ending balance in the allowance. Therefore, we can calculate that (2% × $100) + (4% × $500) + (10% × $220) = $44, which is the required (or target) ending balance in the allowance. Gross Accounts Age < 30 days

Percentage Estimated Uncollectible Receivable

Amount Estimated Uncollectible

$100

×

2%

=

$2

30–60 days

500

×

4%

=

20

> 60 days

220

×

10%

=

22

Total

$820

$44 Ending Allowance Balance

We need an additional credit in the T-account to make it balance (to make the total correct). We can use the $44 ending balance in the T-account (along with the beginning balance of $40, the write-offs of $35, and the $5 credit balance) to calculate the uncollectible accounts expense of $39. This amount must be used in the journal entry ($44 required balance – $5 credit balance = $39 amount for journal entry). Allowance for Uncollectible Accounts 2008 Write-Offs

Dec. 31, 2007 Balance

40

2008 Uncollectible Accounts Expense Adjustment

X

Dec. 31, 2008 Target Bal.

44

35

So 40 – 35 ! X " 44

X " 44 – 40 ! 35 " 39 Journal Entry: Date

Accounts Uncollectible Accounts Expense (Expense,1; debit) Allowance for Uncollectible Accounts (Contra-Asset,1; credit)

Post Ref.

Dr.

Cr. 39 39

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Use this standard journal entry format to journalize uncollectible accounts expense and adjust the allowance. The entry structure is always the same, only the amount changes. On the balance sheet, we would see the gross accounts receivable combined with the Allowance contra-account: Accounts receivable

$820


(44)


$776

Requirement 7 Calculate Hart’s day’s sales in accounts receivable for 2008 (assume Hart uses the aging-of-accounts receivable method in Requirement 6). What does this ratio mean?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

The days’ sales ratio is calculated as:

5

Average net accounts receivable x 365 days Days’ sales in average accounts receivable " Net sales

Calculate the quick ratio and days’ sales in receivables

From Requirement 3, we know that service revenues for 2008 are $2,800. From Requirement 6, we know that net accounts receivables were $760 on December 31, 2007, and $776 on December 31, 2008. So for Hart: Days’ sales in average 1/2 # ($760 ! $776) # 365 days accounts receivable " $2,800 " (1/2 # $1,536) # 365 days $2,800 " $768 # 365 days $2,800 " $280,320 $2,800 Days’ sales in average accounts receivable = 100.1 days

For Hart, the average amount of time that it takes to collect an account receivable is 100.1 days (more than three months).


215

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Requirement 8 The employee at Hart who opens the mail and physically collects the cash is the same person who updates the cash receipts journal and accounts receivable ledger. Is this system a good practice of internal control?

Part 1

1

Describe the types of sales and receivables and discuss the related internal controls

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

If an employee collects the cash and journalizes the receipt of the cash and updates the accounts receivable ledger, the opportunity for fraud increases greatly. The employee could steal the cash and delay journalizing the cash receipt, or perhaps never journalize the cash receipt. The employee could also hide this dishonest act for a long period of time by manipulating the accounts receivable ledger. To avoid this problem, most internal control systems require separation of duties; that is, employees who handle cash (both receipts and payments) are not the same employees who maintain the accounting records.

Part 1

216

Part 2


Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

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Demo Doc 2 Notes Receivable Learning Objective 4 On November 1, 2008, Jordan Inc. borrowed $1,800 cash from Donald Corp. Jordan signed a three-month, 10% note. Jordan paid the note plus interest in full on the due date. Both Jordan and Donald have a December 31 year-end.

Requirements 1. When is the note due? What is the total interest that will be paid on this note? What is its maturity value? 2. Prepare all journal entries for this note for both companies from November 1, 2008, through the due date. Explanations are not required.


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Demo Doc 2 Solutions Requirement 1 When is the note due? What is the total interest that will be paid on this note? What is its maturity value? Part 1

4

Account for notes receivable

Demo Doc Complete

Part 2

The note was issued on November 1, 2008. Because it is a three-month note, it is due three months from that date, on February 1, 2009. The amount of interest incurred over the entire life of the note is calculated as: Interest Amount # Annual interest # Time elapsed incurred " of debt rate (in years)

So in this case: Interest " $1,800 incurred

#

10%

#

3 months 12 months

" $45

The maturity value is calculated as: Maturity value " Principal ! Interest incurred over life of the note

So in this case: Maturity value " $1,800 ! $45 " $1,845

Requirement 2 Prepare all journal entries for this note for both companies from November 1, 2008, through the due date. Explanations are not required. Part 1

4

Account for notes receivable

Demo Doc Complete

Part 2

November 1, 2008 Jordan borrowed $1,800 from Donald. Jordan borrowed cash from Donald. Donald decreases (a credit) Cash by $1,800. Because Donald can expect to get this money back (that is, collect it) in the future, we can also set up a Notes Receivable asset (a debit) for $1,800. Donald:

Journal Entry: Date Accounts Nov. 1 Note Receivable (Asset,1; debit) Cash (Asset,2; credit) 218


Post Ref.

Dr. 1,800

Cr. 1,800

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Jordan increases Cash (a debit) and because the money must be paid back, we can set up a Notes Payable liability (a credit) for $1,800. Jordan:


Date Accounts Nov. 1 Cash (Asset,1; debit) Note Payable (Liability,1; credit)

Dr. 1,800

Cr. 1,800

December 31, 2008 Accrued 10% interest on note. Both companies have a December 31 year-end and need to adjust their accounting information on this date. By this time, the note has been outstanding for two months, which means interest has been incurred on the note. The amount of interest incurred is calculated as: Interest " Amount # Annual interest # Time elapsed incurred of debt rate (in years)

So in this case: Interest " $1,800 incurred

#

10%

#

2 months 12 months

" $30

Note that all interest rates given are assumed to be annual rates, unless specifically stated otherwise. Donald earned interest revenue (a credit) of $30. Because the cash has not yet been received, we must also set up an Interest Receivable account (a debit) of $30. Donald: Journal Entry: Date Accounts Dec. 31 Interest Receivable (Asset,1; credit) Interest Revenue ($1,800 ! 10% ! 2/12) (Revenue,1; debit)

Post Ref.

Dr.

Cr. 30 30

Jordan incurred interest expense (a debit) of $30. Because the cash has yet to be paid, we must also set up an Interest Payable account (a credit) of $30. Jordan: Journal Entry: Date Accounts Dec. 31 Interest Expense ($1,800 ! 10% ! 2/12) (Expense,1; debit) Interest Payable (Liability,1; credit)

Post Ref.

Dr. 30

Cr. 30


219

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February 1, 2009 Paid note and interest in full. On this day, the note and interest are fully paid. For Donald, Notes Receivable is decreased (a credit) by $1,800. Additionally, Donald receives the interest accrued on December 31, so Interest Receivable is decreased (a credit) by $30. However, more interest is involved. Donald also earned interest between December 31 and February 1 (one month): Interest " $1,800 incurred

#

10%

#

1 months 12 months

" $15

So Donald journalizes Interest Revenue (a credit) of $15. All of these amounts are being paid in cash, so Donald’s Cash account is increased (a debit) by $1,800 + $30 + $15 = $1,845 (the maturity value). Donald:

Journal Entry: Date Accounts Feb. 1 Cash (maturity value) (Asset,1; debit) Note Receivable (Asset,2; credit) Interest Revenue ($1,800 ! 10% ! 2/12) (Revenue,1; credit) Interest Receivable (Asset,2; credit)

Post Ref.

Dr. 1,845

Cr. 1,800 15 30

With payment of the note and interest, Jordan will decrease Notes Payable by $1,800 and Interest Payable by $30 (debits). Jordan will also journalize additional interest expense of $15 (a debit) and decrease Cash (a credit) by $1,845. Jordan: Journal Entry: Date Accounts Feb. 1 Note Payable (Liability,2; debit) Interest Payable (Liability,2; debit) Interest Expense ($1,800 ! 10% ! 2/12) (Expense,1; debit) Cash (to balance) (Asset,2; credit)

Part 1

220


Part 2

Post Ref.

Dr. 1,800 30 15

Cr.

1,845

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. The Allowance for Uncollectible Accounts is a contra-account to Accounts Receivable. _____ 2. Under the allowance method, the recovery of an account previously written off has no effect on net income. _____ 3. Under the allowance method, the entry to write off an account that is determined to be uncollectible includes a credit to Allowance for Uncollectible Accounts. _____ 4. Under the allowance method, the entry to write off an account deemed uncollectible has no effect on the total assets of the firm. _____ 5. The direct write-off method is the preferred way to apply the accrual basis for measuring uncollectible account expense because it matches revenues and expenses on the income statement. _____ 6. Under the direct write-off method, the entry to write off an account deemed uncollectible has no effect on the total assets of the firm. _____ 7. A written promise to pay a specified amount of money at a particular future date is referred to as a promissory note. _____ 8. If the maker of a note does not pay at maturity, the maker is said to dishonor the note. _____ 9. The quick ratio includes cash, inventory, and net accounts receivable in the numerator. _____10. Retailers must pay a small fee for accepting credit cards from customers as payment for goods.


221

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Multiple Choice 1. Chuck Battle’s account of $5,000 must be written off. Which of the following would be journalized assuming that the allowance method is used? a. A debit to Battle’s Accounts Receivable and a credit to Allowance for Uncollectible Accounts b. A debit to Allowance for Uncollectible Accounts and a credit to Battle’s Accounts Receivable c. A debit to Cash and a credit to Uncollectible Accounts Expense d. A debit to Cash and a credit to Battle’s Accounts Receivable 2. The current credit balance in Allowance for Uncollectible Accounts before adjustment is $658. An aging schedule reveals $3,700 of uncollectible accounts. What is the ending balance in the Allowance for Uncollectible Accounts? a. $3,042 b. $3,700 c. $4,029 d. $4,358 3. The current debit balance in Allowance for Uncollectible Accounts before adjustment is $742. An aging schedule reveals $3,500 of uncollectible accounts. What is the amount of the journal entry for Estimated Uncollectible Accounts? a. $ 742 b. $2,758 c. $3,500 d. $4,242 4. What is the type of account and normal balance of Allowance for Uncollectible Accounts? a. Asset, debit b. Contra-asset, credit c. Liability, credit d. Contra-liability, debit 5. If the direct write-off method is used for uncollectible receivables, what account is debited when writing off a customer’s account? a. Accounts Receivable b. Allowance for Uncollectible Accounts c. Uncollectible Accounts Expense d. Sales Returns and Allowances 6. What is the effect on the financial statements of writing off an uncollectible account under the direct write-off method? a. Increases expenses and decreases liabilities b. Decreases net income and decreases assets c. Decreases assets and increases owner’s equity d. Increases expenses and increases assets 7. A 90-day note dated August 26 matures on which of the following dates? a. November 24 b. November 23 c. November 25 d. November 26 222


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8. A 90-day, 12% note for $20,000, dated July 10, is received from a customer. What is the maturity value of the note? a. $20,000 b. $20,600 c. $21,200 d. $22,400 9. Carolina Supply accepted an 8-month, $16,000 note receivable, with 8% interest, from Reading Corporation on August 1, 2008. Carolina Supply’s year-end is December 31. What is the amount of interest to be accrued on December 31, 2008? a. $ 320 b. $ 533 c. $ 853 d. $1,280 10. Which of the following is journalized on the payee’s books when a debtor dishonors a note receivable? a. Debit Uncollectible Accounts Expense b. Debit Accounts Receivable c. No entry required d. Debit Notes Receivable


223

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Quick Exercises 7-1. Prepare the adjusting journal entry on December 31, 2008, for the following independent situations: a. The Allowance for Uncollectible Accounts shows a $700 credit balance prior to adjustment. Net credit sales during the year are $216,000 and 4% are estimated to be uncollectible.

Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

b. The Allowance for Uncollectible Accounts shows a $500 credit balance prior to adjustment. An aging schedule prepared on December 31 reveals an estimated uncollectible accounts amount of $7,300.

Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

c. The Allowance for Uncollectible Accounts shows a $525 debit balance prior to adjustment. An aging schedule prepared on December 31 reveals an estimated uncollectible accounts amount of $5,100.

Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

d. The Allowance for Uncollectible Accounts shows an $800 credit balance prior to adjustment. Net credit sales during the year are $229,000 and 3.5% are estimated to be uncollectible. 224


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Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Dr.

Cr.

7-2. Compute the ending balance in the Allowance for Uncollectible Accounts after the adjusting entries in Exercise 7-1 have been prepared for the four independent situations, a – d. a. ___________ b. ___________ c. ___________ d. ___________ 7-3. Journalize the following independent transactions assuming the allowance method is used. a. August 5, 2008 b. August 17, 2008 c. August 31, 2008

Wrote off Jones Corp.’s account receivable for $2,200 as uncollectible. Collected the $2,200 from Jones Corp. in full. Recorded Uncollectible Accounts Expense of $16,500.

Journal Entry:

Date

Accounts

Journal Entry:

Journal Entry:

Journal Entry:

Post Ref.

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7-4. On December 31, 2008, Rainbow Appliances has $275,000 in Accounts Receivable and an Allowance account with a credit balance of $240. Current period net credit sales were $771,000 and cash sales were $68,000. Rainbow Appliances performs an aging schedule, and the results are summarized here, along with the appropriate percentages that Rainbow applies to each category. Gross Accounts Receivable


$150,000

1%

31–60 days past due

50,000

5%


40,000

10%


25,000

25%

Over 120 days past due

10,000

50%

Age Not yet due

Total

$275,000 a. Assuming Rainbow uses the aging approach of accounting for uncollectible accounts, prepare the adjusting entry required at the end of the accounting period.

Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

b. Assume now Rainbow uses the percentage-of-sales method of accounting for uncollectible accounts. If historical data indicate that approximately 3% of net credit sales are uncollectible, what is the amount of uncollectible accounts expense that should be journalized? _______________ What is the balance in the Allowance for Uncollectible Accounts after adjustment? _______________

226


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7-5. Peterson Company, which has a December 31 year-end, completed the following transactions during 2008 and 2009: 2008 Oct. 14

Dec. 13 31

Sold merchandise to Bruce Company, receiving a 60-day, 9% note for $10,000. Sold merchandise to Marine Company receiving a 72-day, 8% note for $9,100. Received amount due from Bruce Company. Accured interest on the Marine Company note.

2009 Jan. 27

Collected in full from Marine Company.

Nov. 16

Requirement 1. Prepare the necessary journal entries for the preceding transactions. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts

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Do It Yourself! Question 1 Uncollectible Accounts Receivable Now Company’s December 31, 2007, balance sheet reported: Accounts receivable

$1,000

Allowance for uncollectible accounts Accounts receivable (net)

(85) $ 915

Requirements 1. How much of the December 31, 2008, balance of accounts receivable did Now expect to collect?

2. During 2008, Now wrote off accounts receivable totaling $110. Journalize these write-offs as one transaction. How does this transaction affect the net accounts receivable balance? Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

3. During 2008, Now earned $13,000 of service revenues, all on account. Journalize these revenues as one transaction. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

4. During 2008, Now collected $12,840 cash from customers. Journalize this transaction and calculate the gross accounts receivable balance at December 31, 2008. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

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Accounts Receivable

5. Assume that Now estimates uncollectible accounts expense to be 0.75% of revenues. Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008, balance in the allowance? Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

Dr.

Cr.

Allowance for Uncollectible Accounts

6. (Ignore Requirement 5.) Assume that Now has the following information at December 31, 2008: Age < 30 days

Gross Accounts Receivable


$500

1%

30–60 days

450

10%

> 60 days

100

15%

Total

$1,050

Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008, balance in the allowance? Show how accounts receivable would be reported on the balance sheet at December 31, 2008. Journal Entry: Date

Post Ref.

Accounts

Allowance for Uncollectible Accounts


229

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Do It Yourself! Question 2 Notes Receivable On June 1, 2008, Anderson Corp. borrowed $6,000 cash from Neo Enterprises. Anderson signed a 10-month, 5% note. Anderson paid the note plus interest in full on the due date. Both Anderson and Neo have December 31 year-ends.

Requirements 1. When is the note due? What is the total interest incurred over the life of the note? What is the maturity value of the note?

2. Prepare all journal entries for this note for both companies from June 1, 2008, through the due date. Explanations are not required. June 1, 2008 Neo:

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Anderson:

Journal Entry: Date

230

Accounts


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December 31, 2008 Neo:

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Anderson:

Journal Entry: Date

Accounts

March 31, 2009 Neo:

Journal Entry: Date

Accounts

Anderson:

Journal Entry: Date

Accounts


231

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232

T

1. The Allowance for Uncollectible Accounts is a contra-account to Accounts Receivable. (p. 357)

T

2. Under the allowance method, the recovery of an account previously written off has no effect on net income. (p. 357)

F

3. Under the allowance method, the entry to write off an account that is determined to be uncollectible includes a credit to Allowance for Uncollectible Accounts. False–The entry to write off an account that is determined to be uncollectible includes a debit to Allowance for Uncollectible Accounts and a credit to Accounts Receivable. (p. 358)

T

4. Under the allowance method, the entry to write off an account deemed uncollectible has no effect on the total assets of the firm. (p. 358)

F

5. The direct write-off method is the preferred way to apply the accrual basis for measuring uncollectible accounts expense because it matches revenues and expenses on the income statement. False–The allowance method is the preferred way to apply the accrual basis for measuring uncollectible account expense because it matches revenues and expenses on the income statement. (pp. 356–357)

F

6. Under the direct write-off method, the entry to write off an account deemed uncollectible has no effect on total assets of the firm. False–The write off of an account under the direct write-off method results in a credit to Accounts Receivable, which reduces total assets. (p. 356 )

T

7.

T

8. If the maker of a note does not pay at maturity, the maker is said to dishonor the note. (p. 368)

F

9. The quick ratio includes cash, inventory, and net accounts receivable in the numerator. False–The quick ratio includes cash, short-term investments, and net accounts receivable in the numerator. (p. 369)

T

10. Retailers must pay a small fee for accepting credit cards from customers as payment for goods. (p. 352)

A written promise to pay a specified amount of money at a particular future date is referred to as a promissory note. (p. 363)


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Multiple Choice 1. Chuck Battle’s account of $5,000 must be written off. Which of the following would be journalized assuming that the allowance method is used? (pp. 361–362) a. A debit to Battle’s Accounts Receivable and a credit to Allowance for Uncollectible Accounts b. A debit to Allowance for Uncollectible Accounts and a credit to Battle’s Accounts Receivable c. A debit to Cash and a credit to Uncollectible Accounts Expense d. A debit to Cash and a credit to Battle’s Accounts Receivable 2. The current credit balance in Allowance for Uncollectible Accounts before adjustment is $658. An aging schedule reveals $3,700 of uncollectible accounts. What is the ending balance in the Allowance for Uncollectible Accounts? (pp. 361–362) a. $3,042 b. $3,700 c. $4,029 d. $4,358 3. The current debit balance in Allowance for Uncollectible Accounts before adjustment is $742. An aging schedule reveals $3,500 of uncollectible accounts. What is the amount of the journal entry for Estimated Uncollectible Accounts? (p. 362) a. $ 742 b. $2,758 c. $3,500 d. $4,242 4. What is the type of account and normal balance of Allowance for Uncollectible Accounts? (p. 362) a. Asset, debit b. Contra-asset, credit c. Liability, credit d. Contra-liability, debit 5. If the direct write-off method is used for uncollectible receivables, what account is debited when writing off a customer’s account? (pp. 356–357) a. Accounts Receivable b. Allowance for Uncollectible Accounts c. Uncollectible Accounts Expense d. Sales Returns and Allowances 6. What is the effect on the financial statements of writing off an uncollectible account under the direct write-off method? (pp. 356–357) a. Increases expenses and decreases liabilities b. Decreases net income and decreases assets c. Decreases assets and increases owner’s equity d. Increases expenses and increases assets


233

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7. A 90-day note dated August 26 matures on which of the following dates? (p. 364) a. November 24 b. November 23 c. November 25 d. November 26 8. A 90-day, 12% note for $20,000, dated July 10, is received from a customer. What is the maturity value of the note? (p. 365) a. $20,000 b. $20,600 c. $21,200 d. $22,400 9. Carolina Supply accepted an 8-month, $16,000 note receivable, with 8% interest, from Reading Corporation on August 1, 2008. Carolina Supply’s year-end is December 31. What is the amount of interest to be accrued on December 31, 2008? (p. 365) a. $ 320 b. $ 853 c. $ 533 d. $1,280 10. Which of the following is journalized on the payee’s books when a debtor dishonors a note receivable? (p.368) a. Uncollectible Accounts Debt Expense b. Debit Accounts Receivable c. No entry required d. Debit Notes Receivable

234


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Quick Exercise 7-1. Prepare the adjusting journal entry on December 31, 2008 for the following independent situations: (pp. 358–359) a. The Allowance for Uncollectible Accounts shows a $700 credit balance prior to adjustment. Net credit sales during the year are $216,000 and 4% are estimated to be uncollectible. Journal Entry: Date Accounts 12/31/08 Uncollectible Accounts Expense Allowance for Uncollectible Accounts ($216,000 3 0.04) = $8,640

Post Ref.

Dr. 8,640

Cr. 8,640

b. The Allowance for Uncollectible Accounts shows a $500 credit balance prior to adjustment. An aging schedule prepared on December 31 reveals an estimated uncollectible accounts amount of $7,300. Journal Entry: Date Accounts 12/31/08 Uncollectible Accounts Expense Allowance for Uncollectible Accounts ($73,000 – $500) = $6,800

Post Ref.

Dr. 6,800

Cr. 6,800

c. The Allowance for Uncollectible Accounts shows a $525 debit balance prior to adjustment. An aging schedule prepared on December 31 reveals an estimated uncollectible accounts amount of $5,100. Journal Entry: Date Accounts 12/31/08 Uncollectible Accounts Expense Allowance for Uncollectible Accounts ($5,100 – $525) = $5,625

Post Ref.

Dr. 5,625

Cr. 5,625

d. The Allowance for Uncollectible Accounts shows an $800 credit balance prior to adjustment. Net credit sales during the year are $229,000 and 3.5% are estimated to be uncollectible. Journal Entry: Date Accounts 12/31/08 Uncollectible Accounts Expense Allowance for Uncollectible Accounts ($229,000 3 0.035) = $8,015

Post Ref.

Dr. 8,015

Cr. 8,015

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7-2. Compute the ending balance in the Allowance for Uncollectible Accounts after the adjusting entries in Exercise 7-1 have been prepared for the four independent situations, a – d. (p. 362) a. $9,340 b. $7,300 c. $5,100 d. $8,815

($ 700 + $8,640) ($ 500 + $6,800) ($5,625 – $ 525) ($ 800 + $8,015)

7-3. Journalize the following independent transactions assuming the allowance method is used. (pp. 357–367) a. August 5, 2008 b. August 17, 2008 c. August 31, 2008

Wrote off Jones Corp.’s account receivable for $2,200 as uncollectible. Collected the $2,200 from Jones Corp. in full. Recorded uncollectible accounts expense of $16,500.


Accounts Allowance for Uncollectible Accounts Accounts Receivable—Jones Corp. To write off Jones Corp. account receivable.

Post Ref.

Dr. 2,200

Cr. 2,200

Journal Entry: Date Accounts 8/17/08 Accounts Receivable —Jones Corp. Allowance for Uncollectible Accounts To write off Jones Corp. accounts receivable.

Post Ref.

Dr. 2,200

Cr. 2,200

Journal Entry: Date Accounts 8/17/08 Cash Accounts Receivable—Jones Corp. To record cash collected from Jones Corp.

Post Ref.

Dr.

Cr. 2,200 2,200

Dr. 16,500

Cr.

Journal Entry: Date Accounts 8/31/08 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts.

236


Post Ref.

16,500

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7-4. On December 31, 2008, Rainbow Appliances has $275,000 in Accounts Receivable and an Allowance account with a credit balance of $240. Current period net credit sales were $771,000, cash sales were $68,000. (pp. 359–361) Rainbow Appliances performs an aging schedule, and the results are summarized here, along with the appropriate percentages that Rainbow applies to each category. Gross Accounts Receivable


$150,000

1%


50,000

5%


40,000

10%


25,000

25%

Over 120 days past due

10,000

50%

Age Not yet due

Total

$275,000 a. Assuming Rainbow uses the aging approach of accounting for uncollectible accounts, prepare the adjusting entry required at the end of the accounting period.

Journal Entry: Date Accounts 12/31/08 Uncollectible Accounts Expense Allowance for Uncollectible Accounts ($150,000 3 0.01) + ($50,000 3 0.05) + ($40,000 3 .10) + ($25,000 3 0.25) + ($10,000 3 0.5) = $19,250 – $240

Post Ref.

Dr. 19,010

Cr. 19,010

b. Assume now Rainbow uses the percentage-of-sales method of accounting for uncollectible accounts. If historical data indicate that approximately 3% of net credit sales are uncollectible, what is the amount of uncollectible accounts expense that should be journalized? $23,130 What is the balance in the allowance for uncollectible accounts after adjustment? $23,370 ($240 + 23,130)


237

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7-5. Peterson Company, which has a December 31 year-end, completed the following transactions during 2008 and 2009: (pp. 365–367) 2008 Oct. 14

Dec. 13 31

Sold merchandise to Bruce Company, receiving a 60-day, 9% note for $10,000. Sold merchandise to Marine Company receiving a 72-day, 8% note for $9,100. Received amount due from Bruce Company. Accrued interest on the Marine Company note.

2009 Jan. 27

Collected in full from Marine Company.

Nov. 16

Requirement 1 Prepare the necessary journal entries for the preceding transactions. Journal Entry: Date Accounts 10/14/08 Notes Receivable Sales Revenue

Post Ref.

Dr. 10,000

Cr. 10,000

Journal Entry: Date Accounts 11/16/08 Notes Receivable Sales Revenue

Post Ref.

Dr. 9,100

Cr. 9,100

Journal Entry: Date Accounts 12/13/08 Cash Notes Receivable Interest Revenue

Post Ref.

Dr. 10,150

Cr. 10,000 150

Journal Entry: Date Accounts 12/31/08 Interest Receivable Interest Revenue

Post Ref.

Dr.

Cr. 91 91

Journal Entry: Date Accounts 12/13/08 Cash Notes Receivable Interest Revenue Interest Receivable

Post Ref.

Dr. 9,246

Cr. 9,100 55 91

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Do It Yourself! Question 1 Solutions Requirement 1 How much of the December 31, 2007, balance of accounts receivable did Now expect to collect? Now expects to collect $915 of the accounts receivable balance.

Requirement 2 During 2008, Now wrote off accounts receivables totaling $110. Journalize these write-offs as one transaction. How does this transaction affect the net accounts receivable balance?

Journal Entry: Date

Accounts Allowance for Uncollectible Accounts (Contra-Asset, 2; debit) Accounts Receivable—Amanda Blake (Asset, 2; credit)

Post Ref.

Dr. 110

Cr. 110

This transaction has no impact on the net receivables balance.

Requirement 3 During 2008, Now earned $13,000 of service revenues, all on account. Journalize these revenues as one transaction. Journal Entry: Date

Accounts Accounts Receivable (Asset, 1; debit) Service Revenue (Revenue, 1; credit)

Post Ref.

Dr. 13,000

Cr. 13,000

Requirement 4 During 2008, Now collected $12,840 cash from customers. Journalize this transaction and calculate the gross accounts receivable balance at December 31, 2008.

Journal Entry: Date

Accounts Cash (Asset, 1; debit) Accounts Receivable (Asset, 2; credit)

Post Ref.

Dr. 12,840

Cr. 12,840


239

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Accounts Receivable Dec. 31, 2007 Bal. 2008 Revenues

1,000 13,000

Dec. 31, 2008 Bal.

1,050

2008 Write-Offs 110 2008 Cash Collections 12,840

Requirement 5 Assume that Now estimates uncollectible accounts expense to be 0.75% of revenues. Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008, balance in the allowance? 0.75% # $13,000 " $97.50

Journal Entry: Date

Accounts Uncollectible Accounts Expense (Expense, 1; debit) Allowance for Uncollectible Accounts (Contra-Asset, 1; credit)

Post Ref.

Dr. 97.50

Cr. 97.50

Allowance for Uncollectible Accounts 2008 Write_Offs

Dec. 31, 2007 Bal.

85.00

2008 Uncollectible Accounts Expense

97.50

Dec. 31, 2008 Bal.

72.50

110

Requirement 6 (Ignore Requirement 5.) Assume that Now has the following information at December 31, 2008: Gross Accounts Receivable


$500

1%

30–60 days

450

10%

> 60 days

100

15%

Age < 30 days

Total

240


$1,050

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Journalize the entry to adjust the allowance at December 31, 2008. What is the December 31, 2008, balance in the allowance? Show how accounts receivable would be reported on the balance sheet at December 31, 2008. Gross Amount Receivable

Age


Amount Estimated Uncollectible

< 30 days

$500

#

1%

=

$5

30–60 days

$450

#

10%

=

45

> 60 days

$100

#

15%

=

15

Total

$1,050

$65

Allowance for Uncollectible Accounts 2008 Write-Offs

Dec. 31, 2007 Bal.

85

2008 Uncollectible Accounts Expense

X

Dec. 31, 2008 Bal.

65

110

So 85 – 110 ! X " 65

X " 65 – 85 ! 110 " 90

Journal Entry: Date

Accounts Uncollectible Accounts Expense (Expense, 1; debit) Allowance for Uncollectible Accounts (Contra-Asset, 1; credit)

Post Ref.

Dr.

Cr. 90 90

On the balance sheet: Accounts receivable

$1,050


($65)


$985


241

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Do It Yourself! Question 2 Solutions Requirement 1 When is the note due? What is the total interest incurred over the life of the note? What is the maturity value of the note? The note is due 10 months from June 1, 2008, on April 1, 2009. The amount of interest incurred over the entire life of the note is calculated as: Interest " Amount Annual interest Time elapsed # # incurred of debt rate (in years) " $6,000

# 5%

#

10 months 12 months

" $250 Maturity

"

Principal !

"

$6,000 !

"

$6,250

Interest incurred over life of note $250

Requirement 2 Prepare all journal entries for this note for both companies from June 1, 2008, through the due date. Explanations are not required. June 1, 2008

Anderson borrowed $6,000 from Neo.

Neo: Journal Entry: Date Accounts June 1 Note Receivable (Asset,1; debit) Cash (Asset,2; credit)

Post Ref.

Dr. 6,000

Cr. 6,000

Anderson:

Journal Entry: Date Accounts June 1 Cash (Asset,1; debit) Note Payable (Liability,1; credit)

242


Post Ref.

Dr. 6,000

Cr. 6,000

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Accrued 5% interest on note.

Neo: Journal Entry: Date Accounts Dec. 31 Interest Receivable (Asset,1; debit) Interest Revenue ($6,000 ! 5% ! 7/12) (Revenue,1; credit)

Post Ref.

Dr. 175

Cr. 175

Anderson: Journal Entry: Date Accounts Dec. 31 Interest Expense ($6,000 ! 5% ! 7/12) (Expense,1; debit) Interest Payable (Liability,1; credit)

March 31, 2009

Post Ref.

Dr. 175

Cr. 175

Paid note and interest in full.

Neo:

Journal Entry: Date Mar. 31

Accounts Cash (to balance) (Asset,1; debit) Note Receivable (Asset,2; credit) Interest Revenue ($6,000 ! 5% ! 3/12) (Revenue,1; credit) Interest Receivable (Asset,2; credit)

Post Ref.

Dr. 6,250

Cr. 6,000 75 175

Anderson:


Accounts Note Payable (Liability,2; debit) Interest Payable (Liability,2; debit) Interest Expense ($6,000 ! 5% ! 3//12) (Expense,1; debit) Cash (to balance) (Asset,2; credit)

Post Ref.

Dr. 6,000 175 75

Cr.

6,250


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244

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 7, Receivables. Click a link to work on the tutorial exercises.


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8

Inventory

WHAT YOU PROBABLY ALREADY KNOW Assume that you want to invest in the stock market. You purchase 100 shares of a stock mutual fund in January at $24 per share, another 100 shares in February at $27 per share, and another 100 shares in April at $30 per share. In December, you decide to sell 200 shares of stock to purchase a used car. The market value of the stock at the date of sale is $35 per share. You know that you will receive $7,000 (200 shares × $35/share) and that the market price of the shares is higher than what you paid, so you have a gain. To compute the amount of the gain you will have to report on your tax return, you must determine the cost of the shares. Because purchases were made over a period of time at several different prices, how is the cost computed for the 200 shares sold? Can we assume that the shares sold were the first 100 shares we purchased at $24 per share plus the next 100 shares purchased at $27 per share for a total cost of $5,100, that is, (100 shares × $24) + (100 shares × $27)? Can we calculate the cost using an average? Yes, either of these methods is allowed by the Internal Revenue Service. The same problem exists for businesses in determining the cost of the inventory units sold when the unit cost varies. Generally accepted accounting principles (GAAP) also allows a choice from several methods to calculate the cost of goods sold.

Learning Objectives

1

Describe inventory and discuss the related internal controls. Recall from Chapter 5 that Inventory is the account that holds the cost of goods purchased for resale, not for use, by the business. This chapter deals with inventory of retail businesses. It is important that inventory is the subject of internal controls to account for any discrepancies between the physical count of inventory and its value in the accounting records. Carefully review the inventory shrinkage and internal controls sections of the main textbook, especially Exhibit 8-2 (p. 408).

2

Compute inventory costs using first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost methods and journalize inventory transactions. The inventory cost method selected for use is an assumed outflow of goods to determine the cost of goods sold expense and ending inventory; the actual physical outflow of goods sold may differ. FIFO is a popular method that assumes the oldest goods are sold first, leaving the newest goods in ending inventory. LIFO is the opposite assumption;

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it assumes that the newest goods are sold first, leaving the oldest goods in ending inventory. Average cost assumes that the goods sold as well as those in ending inventory have the same cost. Review the inventory records and journal entries for these methods in Exhibits 8-5 (p. 413) and 8-7 through 8-9 (pp. 414–416).

3

Compare the effects of the different costing methods on the financial statements. The cost of goods sold will usually be different for each of the methods. In times of inflation, FIFO will result in higher net income and higher ending inventory amounts than LIFO. The average method falls between FIFO and LIFO results. Review the comparative results of these methods in Exhibits 8-10 and 8-11 (p. 417).

4

Apply the lower-of-cost-or-market (LCM) rule to value inventory The inventory amount on the balance sheet is reduced to the market value if that amount is lower than the cost. This rule is an application of the conservatism concept. Review the “Lower-of Cost-or-Market Rule” section in the main text. Note the required journal entry and balance sheet presentation.

5

Report inventory on the balance sheet and measure the effect of inventory errors. When measuring the effects of inventory errors, it is helpful to remember that: Cost of Goods Sold ! Cost of Ending Inventory " Cost of Goods Available

The cost of goods available is a defined amount. Therefore, if the cost of ending inventory is understated, the cost of goods sold must be overstated by the same amount to compensate for the error. The reverse is also true; if the cost of ending inventory is overstated, the cost of goods sold will be understated by the same amount to compensate for the error. Understating ending inventory results in an understatement of net income. The reverse is also true; overstating ending inventory results in an overstatement of net income. The ending inventory for one period becomes the beginning inventory for the next. An error in ending inventory is carried over into the succeeding period. Whatever effect the ending inventory error had on the income statement in the initial period causes the opposite effect on net income in the next period.

Review the impact of ending inventory errors in Exhibit 8-13 through 8-15 (pp. 421–422).

6

Estimate ending inventory by the gross profit method. Sometimes a business may need to estimate its ending inventory. When a natural disaster occurs and inventory is destroyed, an estimate must be determined for insurance purposes. The gross profit method is used in this type of case. Review the gross profit method of estimating inventory in Exhibits 8-16 and 8-17. (pp. 423–424).

246

Chapter 8 | Inventory

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Demo Doc 1 Inventory Costing Methods and Lower-of-Cost-or-Market Rule Learning Objectives

1–4

Collins Industries perpetual inventory records show the following data for 2008:

Inventory at January 1

400 units

@

$2 each

Inventory purchases, March

200 units

@

$3 each

Sales, May

160 units

Inventory purchases, July

100 units

@

$4 each

Sales, September

460 units

Inventory purchases, November

250 units

@

$5 each

Ignore any effects of inventory shrinkage for this problem.

Requirements 1. Calculate COGS for the year ended December 31, 2008, and inventory at December 31, 2008, under each of the following costing assumptions: • FIFO • LIFO • Average cost 2. Sales revenues were $4,000 for 2008. Calculate gross profit under each method. 3. Now assume that Collins has a periodic inventory system. Which method would maximize net income? Which method would minimize income taxes? 4. Assume that Collins is using FIFO. The ending inventory has a market price of $4.50 per unit. Calculate the lower-of-cost-or-market and make any necessary adjustment.


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Demo Doc 1 Solutions Requirement 1 Calculate COGS for the year ended December 31, 2008, and inventory at December 31, 2008, under each of the following costing assumptions: • FIFO • LIFO • Average cost

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Before doing any costing calculations, it is important to determine the goods available for sale (both in units and dollars). We must also determine the number of units that were sold and the number of units in ending inventory. Goods Available for Sale

"

Beginnning Inventory

!

Purchases

Beginning inventory 400 units

@

$2

"

$ 800

200 units

@

$3

"

$ 600

Inventory purchases

Goods available for sale

100 units

@

$4

"

$ 400

250 units

@

$5

"

$1,250

950 units

$3,050

Number of Units Sold " 160 in May ! 460 in September " 620 Units for the Year COGS

"

Beginning Inventory

!

Inventory Purchases

–

Ending Inventory

or COGS

"

Goods Available for Sale

–

Ending Inventory

This formula is expressed in dollars, but it also works in units:

Units Sold

248


"

Units in Beginning Inventory

!

Units Purchased

–

Units in Ending Inventory

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Units Sold

"

Units Available for Sale

–


620 Units

"

950 Units

–


or

Units in Ending Inventory " 330

FIFO

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

FIFO means first-in, first-out. In other words, we always sell the oldest item we have. So what is left in inventory? The newest units. The beginning inventory was 400 units at $2 each, totaling $800 (400 × $2).

Purchases Date

Quantity

Unit Cost

Cost of Goods Sold Total Cost

Quantity

Unit Cost

Total Cost

2

Compute inventory costs using first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost methods and journalize inventory transactions.

Inventory on Hand Quantity

Unit Cost

Total Cost

400

$2.00

$800

Jan.

In March, 200 units costing $3 each were purchased for $600 (200 × $3). After this purchase, the original 400 units and the 200 units just purchased were in inventory.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

Jan. Mar.

200

$3.00

$600

In May, 160 units were sold. Under FIFO, the oldest inventory units are sold first. The oldest inventory is the beginning inventory of 400 units at $2 per unit. The units sold must have come from this group.


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What remains in inventory are the 240 units (400 – 160) from the beginning inventory group and the entire March purchase of 200 units.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

160

$2.00

$320


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

In July, another 100 units costing $4 each were purchased for a total of $400 (100 × $4). These 100 units were added to the inventory already present at the end of May.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

July

160

100

$4.00

$400

$2.00

$320


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

100

$4.00

$400

In September, 460 units were sold. At this time, the oldest units in inventory were the remaining 240 units from the beginning inventory group that cost $2 each. These units must have been sold.

250


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Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

100

$4.00

$400

Jan. Mar.

200

$3.00

$600

May

July

160

100

$4.00

$2.00

$320

$400

Sept.

240

$2.00

$480

However, 240 units are not enough; another 460 – 240 = 220 units were sold. Some of these units must be from the next oldest inventory: the March purchase of 200 units at $3 per unit.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

100

$4.00

$400

Jan. Mar.

200

$3.00

$600

May

July

Sept.

160

100

$4.00

$2.00

$320

$400

240

$2.00

$480

200

$3.00

$600

In addition, 220 – 200 = 20 other units were sold. These other units must have come from the July purchase of 100 units at $4 per unit (the next oldest units). After the September sale, 80 (100 – 20) units costing $4 each are left in inventory.


251

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Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

July

160

100

$4.00

$2.00

$320

$400

Sept.

240

$2.00

$480

200

$3.00

$600

20

$4.00

$ 80


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

240

$2.00

$480

200

$3.00

$600

100

$4.00

$400

80

$4.00

$320

In November, 250 more units costing $5 each were purchased for a total of $1,250 (250 × $5). These units were added to the 80 that remained in inventory after the September sale.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$ 600

May

July

160

100

$4.00

252

250

$5.00

$320

$ 400

Sept.

Nov.

$2.00

$1,250


240

$2.00

$480

200

$3.00

$600

20

$4.00

$ 80


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

240

$2.00

$ 480

200

$3.00

$ 600

240

$2.00

$ 480

200

$3.00

$ 600

100

$4.00

$ 400

80

$4.00

$ 320

80

$4.00

$ 320

250

$5.00

$1,250

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Now we must total all of the columns in the table. FIFO Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Inventory on Hand

Total Cost

Quantity

Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

240

$2.00

$ 480

200

$3.00

$ 600

240

$2.00

$ 480

200

$3.00

$ 600

100

$4.00

$ 400

80

$4.00

$ 320

80

$4.00

$ 320

250

$5.00

$1,250

Jan. Mar.

200

$3.00

$ 600

May

160

July

100

$4.00

250

Dec.

$5.00

550

$ 320

$ 400

Sept.

Nov.

$2.00

240

$2.00

$ 480

200

$3.00

$ 600

20

$4.00

$

80

$1,250 $2,250

620

$1,480

So under FIFO, COGS = $1,480 and inventory at December 31, 2008 = $1,570. We can use the inventory formula to check our calculation.

330

$1,570

1

Describe inventory and discuss the related internal controls.

2


COGS " Beginning Inventory ! Purchases – Ending Inventory COGS " $800 ! $2,250 – $1,570 " $1,480

or COGS " $3,050 – $1,570 " $1,480

Checking the calculation in this way is one method of determining whether any inventory shrinkage occurred. LIFO

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Under LIFO, the newest units are sold first. We must track each sale individually as it is made under the perpetual recording system. Such a system prevents us from selling units that we have not yet acquired.


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Beginning inventory is 400 units at $2 each for a total of $800 (400 × $2). Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan.

Inventory on Hand Quantity 400

Unit Cost

Total Cost

$2.00

$800

We purchase 200 units at $3 each in March for a total of $600 (200 × $3). These units and the beginning 400 units are now in inventory. Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

The first sale is in May, when 160 units are sold. At this time, what were the newest units in stock? The 200 units at $3 per unit purchased in March. So the 160 units sold must have come from this group. The calculation is as follows: May COGS " 160 × $3 " $480

The original 400 units from beginning inventory are still in inventory. In addition, 40 units (200 – 160) from the March purchase at $3 per unit remain in inventory. Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

160

$3.00

$480

Inventory on Hand Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

400

$2.00

$800

40

$3.00

$120

Quantity

In July, 100 more units costing $4 each were purchased for a total of $400 (100 × $4). These units are added into the inventory that is already there (from the end of May).

254


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Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Inventory on Hand

Jan. Mar.

200

$3.00

$600

May

July

160

100

$4.00

$3.00

Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

400

$2.00

$800

40

$3.00

$120

400

$2.00

$800

40

$3.00

$120

100

$4.00

$400

Quantity

$480

$400

A second sale took place in September, when 460 units were sold. At that time, what were the newest units in stock? The 100 units at $4 per unit purchased in July. These units must have been sold.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

July

Sept.

160

100

$4.00

$3.00

$480

$400

100

$4.00


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

400

$2.00

$800

40

$3.00

$120

400

$2.00

$800

40

$3.00

$120

100

$4.00

$400

$400

This quantity is not enough to cover the entire sale, because another 460 – 100 = 360 units were sold. Some of these other units must have come from the next newest group, the 200 units at $3 per unit purchased in March. However, only 40 of these units are left after the sale in May.


255

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Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

July

160

100

$4.00

$3.00

$480

$400

Sept.

100 40

$4.00 $3.00


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

400

$2.00

$800

40

$3.00

$120

400

$2.00

$800

40

$3.00

$120

100

$4.00

$400

$400 $120

Another 360 – 40 = 320 units sold in September still must be accounted for. These other units must come from the beginning inventory of 400 units at $2 per unit. After the sale, 80 of the beginning units (costing $2 each) are still in inventory.

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May

July

160

100

$4.00

$3.00

$480

$400

Sept.

100

$4.00

$400

40

$3.00

$120

320

$2.00

$640


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

400

$2.00

$800

40

$3.00

$120

400

$2.00

$800

40

$3.00

$120

100

$4.00

$400

80

$2.00

$160

In November, another purchase of 250 units for $5 each was made, totaling $1,250 (250 × $5). These units joined the previous 80 units (from the end of September) in inventory.

256


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Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$ 600

May July

160 100

$4.00

250

$5.00

$480

$ 400

Sept.

Nov.

$3.00

100

$4.00

$400

40

$3.00

$120

320

$2.00

$640

$1,250


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

400

$2.00

$ 800

40

$3.00

$ 120

400

$2.00

$ 800

40

$3.00

$ 120

100

$4.00

$ 400

80

$2.00

$ 160

80

$2.00

$ 160

250

$5.00

$1,250

Now the table must be totaled. LIFO Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$ 600

May July

160 100

$4.00

Dec.

250 550

$5.00

$ 480

$ 400

Sept.

Nov.

$3.00

100

$4.00

$ 400

40

$3.00

$ 120

320

$2.00

$ 640

$1,250 $2,250

620

$1,640


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

400

$2.00

$ 800

40

$3.00

$ 120

400

$2.00

$ 800

40

$3.00

$ 120

100

$4.00

$ 400

80

$2.00

$ 160

80

$2.00

$ 160

250

$5.00

$1,250

330

$1,410


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From these columns, we can see that COGS for the year is $1,640 and ending inventory at December 31 is 330 units costing $1,410. We can use the inventory formula to check our calculations:


COGS " Beginning Inventory ! Purchases – Ending Inventory COGS " $800 ! $2,250 – $1,410 " $1,640

or COGS " $3,050 – $1,410 " $1,640

Average Cost

2


Part 1

Part 2

Quantity

Part 4

Part 5

Unit Cost


Quantity

Unit Cost

Total Cost

Jan. Mar.

200

Part 6

Part 7

Demo Doc Complete

The beginning inventory of 400 units costing $2 each and March purchase of 200 units at $3 each are recorded as they were for FIFO and LIFO:

Purchases Date

Part 3

$3.00

$600


Unit Cost

Total Cost

400

$2.00

$800

400

$2.00

$800

200

$3.00

$600

Under the average cost method, we need to calculate the average cost per unit with every sale. The first sale was in May. At that time in inventory, we had: 400 units # $2 per unit

"

$800

200 units # $3 per unit

"

$600

600 units

$1,400

So at this time, the average cost per unit was: Average Cost per Unit Average Cost per Unit

"

"

Cost of Units in Inventory Units in Inventory $1.400 600 units

"

$2.33 per unit

The COGS for the May sale is: 160 units × $2.33 per unit " $373

We have 600 units – 160 units = 440 units left in inventory at $2.33 per unit = $1,025.

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Purchases Date

Quantity

Cost of Goods Sold

Unit Cost

Total Cost

Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

440

$2.33

$1,025

Jan. Mar.

200

$3.00

$600

May

160

$2.33

$373

In July, 100 more units were purchased for $4 each. These units were added to the inventory that remained after the May sale.

Purchases Date

Quantity

Cost of Goods Sold

Unit Cost

Total Cost

Quantity

Unit Cost

Total Cost

Jan. Mar.

200

$3.00

$600

May July

160 100

$4.00

$2.33

$373

$400


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

440

$2.33

$1,025

440

$2.33

$1,025

100

$4.00

$ 400

The next sale was in September. At this time in inventory, we had: 440 units ! $2.33/unit

"

$1,025

100 units ! $4/unit

"

$ 400

540 units

$1,425

So at this time, the average cost per unit was: Averagae Cost per Unit

"

$1,425 540 units

"

$2.64 per unit

September COGS " 460 units x $2.64/unit " $1,214

Now 540 units – 460 units = 80 units are left in inventory at the average cost of $2.64 = $211.


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Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

440

$2.33

$1,025

440

$2.33

$1,025

100

$4.00

$ 400

80

$2.64

$ 211

Jan. Mar.

200

$3.00

$600

May July

160 100

$4.00

$2.33

$ 373

$400

Sept.

460

$2.64

$1,214

In November, 250 units costing $5 each were purchased. These units were added to the 80 already in inventory (after the September sale).

Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Inventory on Hand

Jan. Mar.

200

$3.00

$ 600

May July

160 100

$4.00

460 250

$5.00

$ 373

$ 400

Sept. Nov.

$2.33

$2.64

$1,214

$1,250

Now we add up all the columns in the table:

260


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

440

$2.33

$1,025

440

$2.33

$1,025

100

$4.00

$ 400

80

$2.64

$ 211

80

$2.64

$ 211

250

$5.00

$1,250

Quantity

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Average cost Purchases Date

Unit Cost

Quantity


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

400

$2.00

$ 800

400

$2.00

$ 800

200

$3.00

$ 600

440

$2.33

$1,025

440

$2.33

$1,025

100

$4.00

$ 400

80

$2.64

$ 211

80

$2.64

$ 211

250

$5.00

$1,250

Jan. Mar.

200

$3.00

$ 600

May

160

July

100

$4.00

$2.33

$ 400

Sept.

460

Nov.

250

Dec.

$5.00

550

$ 373

$2.64

$1,214

$1,250 $2,250

620

$1,587

So under average cost, COGS = $1,587 and inventory at December 31, 2008 = $1,461. We can check our calculations using the inventory formula:*

330

$1,461

1


3

Compare the effects of the different costing methods on the financial statements.

COGS " Beginning Inventory ! Purchases – Ending Inventory COGS " $800 ! $2,250 – $1,461 " $1,589 *Note that the $2 difference is due to rounding the per-unit cost under the average cost method.

Requirement 2 Sales revenues were $4,000 for 2008. Calculate gross profit under each method.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Gross Profit " Sales Revenue – COGS

Sales Revenue – COGS Gross Profit

FIFO

LIFO

Average Cost

$4,000

$4,000

$4,000

1,480

1,640

1,587

$2,520

$2,360

$2,413

Requirement 3 Now assume that Collins has a periodic inventory system. Which method would maximize net income? Which method would minimize income taxes?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete


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For the different methods, we have the following COGS: FIFO

$1,480

LIFO

$1,640

Average cost

$1,587

Of these, FIFO is the lowest and LIFO is the highest. Note that FIFO and LIFO will usually be the extremes, with average cost somewhere in the middle. FIFO gives the lowest COGS, which means that it gives the highest gross profit. You can see this result in Requirement 2. Therefore, FIFO would maximize net income. LIFO gives the highest COGS, which means that it gives the lowest gross profit. You can also see this result in Requirement 2. LIFO minimizes net income, which in turn minimizes income taxes. Note that if prices are decreasing over time (such as for high-tech items that quickly become obsolete), then the reverse of this analysis is true (FIFO gives highest COGS).

Requirement 4 Presume that Collins is using FIFO. The ending inventory has a market price of $4.50 per unit. Calculate the lower-of-cost-or-market and make any necessary adjustment.

Part 1

4

Apply the lower-ofcost-or-market (LCM) rule to value inventory.

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

We already determined that 330 units remain in ending inventory. Under FIFO, the cost of these units is $1,570. The market price of these units is: 330 units × $4.50 per unit " $1,485

If cost is $1,570 and market is $1,485, the lower-of-cost-or-market is $1,485 (the market value of the inventory). The balance in the Inventory T-account is currently the cost of $1,570. Therefore, Inventory must be decreased to the market value of $1,485. So Inventory is decreased (credit) by: $1,570 – $1,485 " $85

The other side of the journal entry is an adjustment to COGS. This entry will have to be a debit to balance out the credit to inventory.

Journal Entry: Date Accounts Dec. 31 Cost of Goods Sold Inventory ($1,570 – $1,485)

Part 1

262


Part 2

Part 3

Part 4

Dr.

Cr. 85 85

Part 5

Part 6

Part 7

Demo Doc Complete

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Demo Doc 2 Gross Profit Method and Inventory Errors Learning Objectives

5, 6

On December 31, 2008, Talon Corp.’s warehouse and accounting records were destroyed in a flood. For insurance purposes, Talon must estimate the value of the inventory lost. Through records from their bank and suppliers, Talon compiled the following information: Sales revenue for 2008

$20,000

Inventory at December 31, 2007

$ 6,000

Inventory purchases for 2008

$23,000

Talon has historically had a gross profit rate of 10%.

Requirements 1. Estimate Talon’s ending inventory value for 2008 using the gross profit method. 2. Assume that the actual value of inventory lost was $12,000. What is Talon’s true COGS? Is COGS overstated or understated? How will the value of COGS affect Talon’s estimate of net income for 2008?


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Demo Doc 2 Solutions Requirement 1 Estimate Talon’s ending inventory value for 2008 using the gross profit method.

Part 1

6

Estimate ending inventory by the gross profit method.

Demo Doc Complete

Part 2

The gross profit method uses the COGS formula: COGS

"

Beginning Inventory

Inventory Purchases

!

–

Ending Inventory

We are given information about purchases and beginning inventory, but to calculate ending inventory, we will need an estimate for COGS. The formula for the gross profit percentage is: Gross Profit Percentage

"

Gross Profit Sales Revenue

"

Sales – COGS Sales

So we know that 10% = ($20,000 – COGS)/$20,000. 10%

"

$20,000 – COGS $20,000

From this, we can calculate COGS = $18,000. Using this figure in the COGS formula: $18,000 " $6,000 ! $23,000 – Ending Inventory $11,000 " Ending Inventory

Requirement 2 Assume that the actual value of inventory lost was $12,000.What is Talon’s true COGS? Is COGS overstated or understated? How will the value of COGS affect Talon’s estimate of net income for 2008?

Part 1

5

Report inventory on the balance sheet and measure the effect of inventory errors.

Part 2

Demo Doc Complete

Using the actual value of $12,000 for ending inventory, we can recalculate COGS as: COGS " $6,000 ! $23,000 – $12,000 " $17,000

Because Talon is estimating COGS of $18,000, COGS is overstated by: $18,000 – $17,000 " $1,000

If Talon uses the wrong COGS number of $18,000 to calculate net income, then net income will be understated by $1,000. Part 1 264


Part 2

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. Under FIFO, the ending inventory cost comes from the oldest purchases. _____ 2. FIFO is the opposite of LIFO. _____ 3. The LIFO method can result in misleading inventory costs on the balance sheet because the oldest prices are left in ending inventory. _____ 4. When inventory costs are rising, LIFO will result in the lowest gross profit. _____ 5. When using a perpetual inventory system, a business will debit Inventory and credit Cost of Goods Sold each time a sale is recorded. _____ 6. If a company had 10 units of beginning inventory with a unit cost of $10 and a subsequent purchase of 15 units at a unit cost of $12, the average cost of one unit sold would be $11. _____ 7. When applying lower-of-cost-or-market rules to ending inventory valuation, market value generally refers to the company’s current selling price for its inventory. _____ 8. Understating beginning inventory in the current year will understate cost of goods sold in the current year. _____ 9. Overstating ending inventory in 2007 will understate cost of goods sold for 2008. _____10. The gross profit method is a method used to estimate inventory that can be used to determine losses for insurance claims due to a fire or natural disaster.


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Multiple Choice 1. Anticipating no gains but providing for all probable losses can be most closely associated with which of the following? a. Conservatism b. Disclosure principle c. Consistency principle d. Materiality concept 2. Which of the following are required to record the sale of merchandise on credit under a perpetual inventory system? a. Debit Accounts Receivable; credit Sales Revenue b. Debit Cost of Goods Sold; credit Purchases c. Debit Cost of Goods Sold; credit Inventory d. Both (a) and (c) are necessary entries 3. What is the effect of using FIFO during a period of rising prices under a perpetual inventory system? a. Less net income than LIFO b. Less operating expenses than LIFO c. Higher gross profit than LIFO d. Higher cost of goods sold than average costing 4. Which of the following is not a reason for choosing the LIFO method? a. LIFO reports the most up-to-date inventory values on the balance sheet. b. LIFO uses more current costs in calculating cost of goods sold. c. LIFO allows owners and managers to manage reported income. d. LIFO generally results in lower income taxes paid. 5. Which of the following is true for ending inventory when prices are falling and the LIFO inventory system is used? a. LIFO ending inventory is less than FIFO. b. LIFO ending inventory is greater than FIFO. c. LIFO ending inventory is equal to FIFO. d. LIFO ending inventory is equally likely to be higher or lower than FIFO. 6. The following data are for Daisy’s Florist Shop for the first seven months of its fiscal year: Beginning inventory $53,500 Purchases 75,500 Net sales revenue 93,700 Normal gross profit percent 30% What is the estimated inventory on hand as determined by the gross profit method? a. $ 28,110 b. $ 63,410 c. $ 65,590 d. $100,890

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7. Which of the following statements is true about a company making an accounting change in its financial statements? a. It is generally entitled to make one accounting change per year. b. It must report the change in accounting method. c. Companies can never make accounting changes because of the consistency principle. d. It must petition the Financial Accounting Standards Board for permission to make the change. 8. When is an item considered material? a. When it facilitates comparison with the financial statements of another company in the same industry b. When its inclusion in the financial statements would cause a statement user to change a decision c. When its dollar value is greater than 10% of net income d. When it is accounted for using a treatment that is not normally allowed by generally accepted accounting principles 9. Ending inventory for Commodity X consists of 20 units. Under the FIFO method, the cost of the 20 units is $5 each. Current replacement cost is $4.50 per unit. Using the lower-of-cost-ormarket rule to value inventory, the balance sheet would show ending inventory at what amount? a. $ 4.75 b. $ 5.00 c. $ 90.00 d. $100.00 10. Inventory at the end of the current year is overstated by $20,000. What effect will this error have on the following year’s net income? a. Net income will be overstated $20,000 b. Net income will be understated $20,000 c. Net income will be correctly stated d. Net income will be understated $40,000


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Quick Exercises 8-1. Compute the missing income statement amounts for each of the following independent companies:

Net Sales

Beginning Inventory

Purchases

Ending Inventory

Cost of Goods Sold

Gross Profit

A

$ 93,000

$14,600

$65,000

(a) ______

$58,300

(b) ______

B

(c) ______

$31,600

(d) ______

$23,600

$96,200

$52,500

C

$ 89,300

$23,600

$54,000

(f ) ______

(e) ______

$23,900

D

$105,000

$11,200

(h) ______

$ 9,400

(g) ______

$48,200

Company

8-2. Which inventory method would best meet each of the following specific management goals? Show your answer by inserting the proper letter beside each statement. a. Specific unit cost b. LIFO c. FIFO

__________ 1. Management desires to properly match net sales revenue with the most recent cost of goods. __________ 2. Management desires to minimize the company’s ending inventory balance during a period of falling prices. __________ 3. The company sells rare antique items. __________ 4. Management desires to show the current value of inventory on the balance sheet. __________ 5. Management desires to minimize the company’s tax liability during a period of rising prices. 8-3. The following data are available for the month of March: March 1 balance

20 units at $16 each

March 10 purchase


March 17 purchase


March 30 purchase


On March 31, 35 units are on hand. 268


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Requirement 1. Calculate cost of goods sold under the following methods: a. FIFO

b. LIFO

c. Average cost (round the per unit cost to the nearest cent; round the final answer to the nearest dollar)

8-4. Plastic Products Company lost some of its inventory due to a flood and needs to determine the amount of the inventory lost. The following data are available for 2008: Net sales revenue Estimated gross profit rate January 1, beginning inventory Net purchases Inventory on hand, after flood

$400,000 35% 11,600 275,000 6,500

Requirements 1. Compute what the estimated ending inventory should be using the gross profit method.

2. Calculate the amount of the inventory loss.

8-5. Determine the effect on cost of goods sold and net income for the current year of the following inventory errors. Indicate your answer with either a + (overstated) or a – (understated).

Item

Error

1.

Beginning inventory is understated.

2.

Ending inventory is understated.

3.

Beginning inventory is overstated.

4.

Ending inventory is overstated.

Effect on Cost Effect on Net of Goods Sold Income

Quick Practice | Chapter 8

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Do It Yourself! Question 1 Sam Inc., inventory records show the following data for July 2008: Inventory at July 1

10 units

@

$1 each

Inventory purchases, July 5

80 units

@

$2 each

Sales, July 10

50 units


20 units

@

$3 each

Sales, July 20

40 units


30 units

@

$4 each

Ignore any effects of inventory shrinkage for this problem.

2


Requirements 1. Calculate COGS for the month ended July 31, 2008, and inventory at July 31, 2008, using the FIFO method.

FIFO Purchases Date

Quantity

Unit Cost


July 1 July 5 July 10 July 15 July 20 July 25 July 31

270


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

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2. Calculate COGS for the month ended July 31, 2008 and inventory at July 31, 2008, using the LIFO method.

2

Compute inventory costs using first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost methods and journalize inventory transactions

LIFO Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost



271

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3. Calculate COGS for the month ended July 31, 2008, and inventory at July 31, 2008, using the average cost method.


Average Cost Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost


3


4

Apply the lower-ofcost-or-market (LCM) rule to value inventory.

4. Sales revenues were $500 for July 2008. Calculate gross profit under each method.

5. The market value of ending inventory is $180. If Sam uses LIFO, give any necessary adjustment for the lower-of-cost-or-market rule.


272


Dr.

Cr.

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Do It Yourself! Question 2 On December 31, 2008, Virga Brothers lost all its inventory during a hurricane. Virga was able to gather the following information. Inventory at January 1, 2008

$ 40,000

Inventory purchases for 2008

$ 90,000

Sales revenue for 2008

$180,000

Historically, Virga experienced gross profit of 40%.

Requirements 1. Estimate the value of Virga’s lost inventory.

6

Estimate ending inventory by the gross profit method.


273

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274

F

1. Under FIFO, the ending inventory cost comes from the oldest purchases. False–FIFO leaves in ending inventory the last or newest costs. (p. 412)

T

2. FIFO is the opposite of LIFO. (p. 413)

T

3. The LIFO method can result in misleading inventory costs on the balance sheet because the oldest prices are left in ending inventory. (p. 417)

T

4. When inventory costs are rising, LIFO will result in the lowest gross profit. (p. 417)

F

5. When using a perpetual inventory system, a business will debit Inventory and credit Cost of Goods Sold each time a sale is recorded. False–Using a perpetual inventory system, a business will debit Cost of Goods Sold and credit Inventory each time a sale is recorded. (pg. 421)

F

6. If a company had 10 units of beginning inventory with a unit cost of $10 and a subsequent purchase of 15 units at a unit cost of $12, the average cost of one unit sold would be $11. False–Average cost is determined by dividing the cost of goods available, (10 units × $10) + (15 units × $12) = $280, by the number of units available (10 + 15 = 25): $280/25 = $11.20. (p. 415)

F

7. When applying lower-of-cost-or-market rules to ending inventory valuation, market value generally refers to the company’s current selling price for its inventory. False–Market value generally means current replacement cost. (p. 418)

T

8. Understating beginning inventory in the current year will understate cost of goods sold in the current year. (p. 422)

F

9. Overstating ending inventory in 2007 will understate cost of goods sold for 2008. False–Overstating ending inventory in 2007 will overstate cost of goods sold for 2008. (p. 422)

T

10. The gross profit method is a method used to estimate inventory that can be used to determine losses for insurance claims due to a fire or natural disaster. (p. 423)


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Multiple Choice 1. Anticipating no gains but providing for all probable losses can be most closely associated with which of the following? (p. 418) a. Conservatism b. Disclosure principle c. Consistency principle d. Materiality concept 2. Which of the following are required to record the sale of merchandise on credit under a perpetual inventory system? (p. 409) a. Debit Accounts Receivable; credit Sales Revenue b. Debit Cost of Goods Sold; credit Purchases c. Debit Cost of Goods Sold; credit Inventory d. Both a and c are necessary entries 3. What is the effect of using FIFO during a period of rising prices under a perpetual inventory system? (p. 417) a. Less net income than LIFO b. Less operating expenses than LIFO c. Higher gross profit than LIFO d. Higher cost of goods sold than average costing 4. Which of the following is not a reason for choosing the LIFO method? (p. 417) a. LIFO reports the most up-to-date inventory values on the balance sheet. b. LIFO uses more current costs in calculating cost of goods sold. c. LIFO allows owners and managers to manage reported income. d. LIFO generally results in lower income taxes paid. 5. Which of the following is true for ending inventory when prices are falling and the LIFO inventory system is used? (p. 413) a. LIFO ending inventory is less than FIFO. b. LIFO ending inventory is greater than FIFO. c. LIFO ending inventory is equal to FIFO. d. LIFO ending inventory is equally likely to be higher or lower than FIFO. 6. The following data are for Daisy’s Florist Shop for the first seven months of its fiscal year: Beginning inventory $53,500 Purchases 75,500 Net sales revenue 93,700 Normal gross profit percent 30% What is the estimated inventory on hand as determined by the gross profit method? (p. 423) a. $ 28,110 b. $ 63,410 c. $ 65,590 d. $100,890


275

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7. Which of the following statements is true about a company making an accounting change in its financial statements? (p. 420) a. It is generally entitled to make one accounting change per year. b. It must report the change in accounting method. c. Companies can never make accounting changes because of the consistency principle. d. It must petition the Financial Accounting Standards Board for permission to make the change. 8. When is an item considered material? (p. 419) a. When it facilitates comparison with the financial statements of another company in the same industry b. When its inclusion in the financial statements would cause a statement user to change a decision c. When its dollar value is greater than 10% of net income d. When it is accounted for using a treatment that is not normally allowed by generally accepted accounting principles 9. Ending inventory for Commodity X consists of 20 units. Under the FIFO method, the cost of the 20 units is $5 each. Current replacement cost is $4.50 per unit. Using the lower-of-cost-ormarket rule to value inventory, the balance sheet would show ending inventory at what amount? (p. 418) a. $ 4.75 b. $ 5.00 c. $ 90.00 d. $100.00 10. Inventory at the end of the current year is overstated by $20,000. What effect will this error have on the following year’s net income? (p. 422) a. Net income will be overstated $20,000 b. Net income will be understated $20,000 c. Net income will be correctly stated d. Net income will be understated $40,000

276


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Quick Exercise 8-1. Compute the missing income statement amounts for each of the following independent companies: (p. 423)

Company Net Sales

Beginning Inventory

Purchases

Ending Inventory

Cost of Goods Sold

Gross Profit

A

$ 93,000

$14,600

$65,000

(a)

$58,300

(b)

B

(c)

$31,600

(d)

$23,600

$96,200

$52,500

C

$ 89,300

$23,600

$54,000

(f)

(e)

$23,900

D

$105,000

$11,200

(h)

$ 9,400

(g)

$48,200

(a)

$ 14,600 + $65,000 – $ 58,300 = $21,300

(b)

$ 93,000 – $58,300 = $ 34,700

(c)

$ 96,200 + $52,500 = $148,700

(d)

$ 23,600 + $96,200 – $ 31,600 = $88,200

(e)

$ 89,300 – $23,900 = $ 65,400

(f)

$ 23,600 + $54,000 – $ 65,400 = $12,200

(g)

$105,000 – $48,200 = $ 56,800

(h)

$

9,400 + $56,800 – $ 11,200 = $55,000

8-2. Which inventory method would best meet each of the following specific management goals? Show your answer by inserting the proper letter beside each statement. (pp. 409–416) a. Specific unit cost b. LIFO c. FIFO b c a c b

1. Management desires to properly match net sales revenue with the most recent cost of goods. 2. Management desires to minimize the company’s ending inventory balance during a period of falling prices. 3. The company sells rare antique items. 4. Management desires to show the current value of inventory on the balance sheet. 5. Management desires to minimize the company’s tax liability during a period of rising prices.

8-3. The following data are available for the month of March: (pp. 412–416) March 1 balance


March 10 purchase


March 17 purchase


March 30 purchase


On March 31, 35 units are on hand.


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Requirement 1 Calculate cost of goods sold under the following methods: a. FIFO 115 units available – 35 ending units " 80 units sold Cost of goods sold: (20 × $16) ! (40 × $18) ! (20 × $20) " $320 ! $720 ! $400 " $1,440

b. LIFO (25 × $21) ! (30 × $20) ! (25 × $18) " $525 ! $600 ! $450 " $1,575

c. Average cost (round the per unit cost to the nearest cent; round the final answer to the nearest dollar) (20 × $16) ! (40 × $18) ! (30 × $20) ! (25 × $21) " $320 ! $720 ! $600 ! $525 " $2,165 $2,165/115 units " $18.83 × 80 " $1,506

8-4. Plastic Products Company lost some of its inventory due to a flood and needs to determine the amount of the inventory lost. The following data are available for 2008: (p. 423) Net sales revenue

$400,000

Estimated gross profit rate

35%

January 1, beginning inventory Net purchases

11,600 275,000

Inventory on hand, after flood

6,500

Requirement 1 Compute what the estimated ending inventory should be using the gross profit method. Beginning inventory Net purchases Cost of goods available Estimated cost of goods sold: Net sales revenue Less: Estimated gross profit of 35% Estimated cost of goods sold Estimated cost of ending inventory

$ 11,600 275,000 286,600 $400,000 (140,000) 260,000 $ 26,600

Requirement 2 Calculate the amount of the inventory loss. Estimated cost of ending inventory Less: Inventory on hand, after flood Amount of inventory loss

278


$26,600 6,500 $20,100

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8-5. Determine the effect on cost of goods sold and net income for the current year of the following inventory errors. Indicate your answer with either a + (overstated) or a – (understated). (p. 421)

Item Error

Effect on Cost of Goods Sold

Effect on Net Income

1.

Beginning inventory is understated.

–

+

2.

Ending inventory is understated.

+

–

3.

Beginning inventory is overstated.

+

–

4.

Ending inventory is overstated.

–

+


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Do It Yourself! Question 1 Solutions Requirement 1 Calculate COGS for the month ended July 31, 2008, and inventory at July 31, 2008, using the FIFO method. Beginning inventory 10 units

@ $1 per unit

=

$ 10

July 5

80 units

@ $2 per unit

=

$160

July 15

20 units

@ $3 per unit

=

$ 60

July 25

30 units

@ $4 per unit

=

$120

Inventory purchases

Goods available for sale

130 units

$350

Number of Units Sold " 50 on July 10 ! 40 on July 20 " 90 units 90 units " 10 units ! 130 units – Units in Ending Inventory

or 90 units " 140 units – Units in Ending Inventory Units in Ending Inventory " 50 units

FIFO Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

July 1 July 5

80

$2.00

$160

July 10 July 15

10 40 20

$3.00

July 31

40 30

$4.00

130

$ 10 $ 80

$ 60

July 20 July 25

$1.00 $2.00

$2.00

$ 80

$120 $340

90

$170


Unit Cost

Total Cost

10

$1.00

$ 10

10

$1.00

$ 10

80

$2.00

$160

40

$2.00

$ 80

40

$2.00

$ 80

20

$3.00

$ 60

20

$3.00

$ 60

20

$3.00

$ 60

30

$4.00

$120

50

Check: COGS " $10 ! $340 – $180 " $170

or COGS " $350 – $180 " $170

280


$180

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Requirement 2 Calculate COGS for the month ended July 31, 2008, and inventory at July 31, 2008, using the LIFO method. LIFO Purchases Date

Cost of Goods Sold

Quantity

Unit Cost

Total Cost

80

$2.00

$160

Quantity

Unit Cost

Total Cost


Unit Cost

Total Cost

10

$1.00

$ 10

10 80

$1.00 $2.00

$ 10 $160

10 30 10 30 10 10 10 10 30 50

$1.00 $2.00 $1.00 $2.00 $1.00 $2.00 $1.00 $2.00 $4.00

$ 10 $ 60 $ 10 $ 60 $ 10 $ 20 $ 10 $ 20 $120 $150

July 1 July 5 July 10 July 15

20

$3.00

30

July 31

130

$4.00

$1.00

$100

20 20

$3.00 $2.00

$ 60 $ 40

$ 60

July 20 July 25

50

$ 120

$340

90

$200

Check: COGS ! $10 " $340 – $150 ! $200

or COGS ! $350 – $150 ! $200

Requirement 3 Calculate COGS for the month ended July 31, 2008, and inventory at July 31, 2008, using the average cost method. Average Cost Purchases Date

Quantity

Unit Cost


Quantity

Unit Cost

Total Cost

Quantity

Unit Cost

Total Cost

10

$1.00

$ 10

10 80

$1.00 $2.00

$ 10 $160

40

$1.89

$ 76

40 20

$1.89 $3.00

$ 76 $ 60

$ 91

20

$2.27

$ 45

$2.27 $4.00

$185

20 30 50

$ 45 $120 $165

July 1 July 5

80

$2.00

$160

July 10 July 15

50 20

$3.00

40 30

July 31

130

$4.00

$ 94

$ 60

July 20 July 25

$1.89

$2.27

$120 $340

90

Inventory on Hand


281

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Check: COGS " $10 ! $340 – $165 " $185

or COGS " $350 – $165 " $185

Requirement 4 Sales revenues were $500 for July 2008. Calculate gross profit under each method.

Sales Revenue – COGS Gross Profit

FIFO

LIFO

Average Cost

$500

$500

$500

170

200

185

$330

$300

$315

Requirement 5 The market value of ending inventory is $180. If Sam uses LIFO, give any necessary adjustment for the lower-of-cost-or-market rule. Cost (under LIFO) " $200

Market " $180

Lower of cost or market " $180

Journal Entry: Date Accounts July 31 Cost of Goods Sold Inventory ($200 – $180)

282


Dr.

Cr. 20 20

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Do It Yourself! Question 2 Solution Requirement 1 Estimate the value of Virga’s lost inventory. Gross Profit Percentage

"


Sales – COGS Sales

"

40% " ($180,000 – COGS)/$180,000 COGS " $108,000 COGS

"

Beginning Inventory

!

Inventory Purchases

–

$108,000

"

$40,000

!

$90,000

–

Ending Inventory Ending Inventory

Ending Inventory " $22,000


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284

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 8, Inventory. Click a link to work on the tutorial exercises.


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9

Long-Term Assets: Plant Assets and Intangibles

WHAT YOU PROBABLY ALREADY KNOW You probably already know that when you decide to get a car, you must decide whether you want to purchase or lease it. If you lease a car, you pay a monthly amount for the use of that vehicle, which is a benefit or expense to you. If you purchase a car for cash instead, you still receive a monthly benefit, although you make no future payments. The benefit or cost incurred is called depreciation expense. The more a car is used, the less remaining future value can be derived from that asset. In business, the asset is reduced for the loss in usefulness or future benefit as the asset is used.

Learning Objectives

1

Define and describe the life cycle of long-term assets. As you learned in Chapter 3 a long-term asset is defined as a long-lived, asset—one that will generally be used by the business for longer than one year. Long-term assets include plant assets, such as land, buildings, equipment, and natural resources. Long-term assets can also be intangible assets, such as rights, patents, and trademarks. Because such assets have future service potential over the life of the asset, a portion of its cost is expensed against the revenues earned from its use over time. Remember that accounting covers the stages of the life of a plant asset: acquisition (make-ready costs), ownership (expenditures and depreciation), and disposal (sell, trade in, or junk the asset), and various factors affect the costs associated with each stage. Review Exhibit 9-1 (p. 471) for factors that affect long-term assets.

2

Calculate and record the cost to acquire plant assets. The cost of a plant asset should include all of the necessary costs to acquire the asset and get it ready for use. In addition to the purchase price of the plant asset, other items that may be necessary and would increase the cost amount of the asset are shown in Exhibit 9-2 (p. 472) of the main textbook. If discounts are available and taken advantage of, those amounts would reduce the cost of the plant asset. Review Exhibit 9-2 for examples of items that are considered in the cost of plant assets. Review the section “A Lump-Sum (Basket) Purchase of Assets” in the main text to see how the cost of individual plant assets is determined when a single price is charged for the group.

3

Calculate and record depreciation of plant assets. Depreciation is the allocation of cost over a plant asset’s useful life. The expense of depreciation is matched against the revenue generated, as shown in Exhibit 9-4 (p. 476). The three most popular methods of

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depreciation are straight-line, units-of-production, and double-decliningbalance. The adjusting entry to depreciate any plant asset is to debit Depreciation Expense and credit Accumulated Depreciation. Three elements necessary to calculate depreciation are: a. Asset cost: known amount on the books b. Estimated useful life: period of asset usefulness c. Estimated residual value: expected value at the end of the useful life

Review “Depreciation Methods” in the main text for examples of the various depreciation methods.

4

Calculate and record the disposal of plant assets. When a plant asset is sold, it should be depreciated until the date of disposal. To account for an asset’s disposal, you would debit the cash or other proceeds received, debit the accumulated depreciation, and credit the plant asset cost. The difference between the asset cost and accumulated depreciation is book value. If the book value is greater than the proceeds, a debit must also be recorded as a loss on disposal. If the book value is less than the proceeds, a credit must also be recorded as a gain on disposal. A plant asset may also be exchanged for a new asset. The book value of the old asset is removed as already described. The cash paid on exchange is credited and the market value of the new asset is debited. Any difference between the market value of the new asset and the book value of the old asset plus cash paid is the gain or loss. Review the related examples in “Disposing of a Plant Asset” in the main text.

5

Calculate and record depletion of natural resources. Natural resources are long-term assets that include iron ore, natural gas, and timber. As the inventory of the iron, gas, or other natural resource is used up, it is considered to be depleted. The depletion entry is similar to depreciation (debit Depletion Expense and credit Accumulated Depletion). The depletion amount is determined using the units-of-production formula. Accumulated Depletion is a contra-asset account like Accumulated Depreciation. Review “Accounting for Natural Resources” in the main text.

6

Account for intangible assets. Intangible assets are rights that provide future value or benefit to the organization. Patents, copyrights, franchises, and trademarks are examples of these assets. Those intangible assets with a defined useful life are amortized by the straight-line method. The entry to amortize the intangible asset is to debit Amortization Expense and credit the intangible asset account. Goodwill represents the excess of the amount paid to purchase a company over the equity of the company. Goodwill is not amortized but may need to be written down due to a loss of value. Review “Accounting for Intangibles,” especially the treatment of goodwill, in the main text.

7

Report long-term assets on the balance sheet. Review Exhibit 9-11 (p. 491) to see how plant and intangible assets are presented on the balance sheet.

286

Chapter 9 | Long-Term Assets: Plant Assets and Intangibles

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Demo Doc 1 Depreciation Learning Objectives

1–4, 7

Peters Corp. purchased a truck for $13,800 cash on January 1, 2008. Peters also had to pay taxes of $1,200 cash. The truck had a residual value of $1,000 and a useful life of 7 years or 100,000 miles driven. Peters has a December 31 year-end. The truck was driven for 15,000 miles in 2008, 12,000 miles in 2009, and 17,000 miles in 2010.

Requirements 1. Calculate the total cost of the truck. 2. Calculate the depreciation expense and accumulated depreciation balance at December 31, 2008, 2009, and 2010, using the straight-line, units-ofproduction, and double-declining-balance methods. 3. Using the double-declining-balance method only, show how the truck account would look on the December 31 balance sheet for 2008, 2009, and 2010. 4. Which of the three methods maximizes income for 2008? Which method minimizes income taxes for 2008? 5. Peters sold the truck on September 1, 2011, for $7,000 cash. Journalize the sale transaction using each method. (The truck was driven for 8,000 miles in 2011.)


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Demo Doc 1 Solutions Requirement 1 Calculate the total cost of the truck.

Part 1

2

Calculate and record the cost to acquire plant assets.

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Part 9

Demo Doc Complete

The total cost of the truck is the total cost to make it ready for use. Any expenditure that must be paid in order to use the asset is part of the asset’s total cost. In this case, the truck cannot be used until the taxes are paid on the truck. Therefore, the taxes are added to the total cost of the truck. Purchase price

$13,800

Taxes

1,200

Total cost of truck

$15,000

Requirement 2 Calculate the depreciation expense and accumulated depreciation balance at December 31, 2008, 2009, and 2010, using the straight-line, units-of-production, and double-declining-balance methods.

Part 1

1 3

Define and describe the life cycle of longterm assets Calculate and record depreciation of plant assets

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Part 9

Demo Doc Complete

Straight-Line Method The straight-line method allocates an equal amount of depreciation over the useful life. Straight-line depreciation is calculated as: Cost ! Residual Value Years of Useful Life

"

Annual Depreciation Expense

Remember that cost minus residual value is sometimes called depreciable cost because it is the total depreciation that will be recorded over the asset’s life. At the end of the asset’s life, the book value equals the residual value. In this particular question: $15, 000 ! $1, 000 7 years

"

xpense per Year $2, 000 Depreciation Ex

Remember that the depreciation expense will be the same for each year. Depreciation expense does not change (unless the asset is used for a partial year, as demonstrated in Requirement 5 of this question). This is why the method is called straight-line: Because if the annual depreciation expense were charted on a graph, it would be a straight line. 288


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Depreciation Expense in 2008 " Depreciation Expense in 2009 " Depreciation Expense in 2010 " $2,000

Accumulated depreciation is the total of all the depreciation expense that the company has accumulated up to a certain time. In other words, it is the sum of the depreciation expense in every year that has passed. You can use a T-account to calculate accumulated depreciation each year: Accumulated Depreciation, Truck 12/31/08 2,000 2008 Bal. 2,000 12/31/09 2,000 2009 Bal. 4,000 12/31/10 2,000 2010 Bal. 6,000

So in 2008, accumulated depreciation is the 2008 depreciation expense (because it is the only year of depreciation so far), which equals $2,000. In 2009, accumulated depreciation is the sum of the 2008 and 2009 depreciation expense, or $2,000 + $2,000 = $4,000. In 2010, accumulated depreciation is the sum of the 2008, 2009, and 2010 depreciation expense: $2,000 + $2,000 + $2,000 = $6,000. If you want to make things a little easier on yourself, instead of adding up all of the accumulated depreciation from scratch, you can instead add the current year’s depreciation expense to the prior balance. In other words: Accumulated Depreciation This Year " Accumulated Depreciation Last Year # This Year’s Depreciation Expense

The 2009 accumulated depreciation is $4,000, plus $2,000 depreciation expense for 2010 equals $6,000 accumulated depreciation for 2010. The truck’s book value is its cost minus its accumulated depreciation. This net value (that is, book value) is shown for the truck on the balance sheet.

Straight-Line Method Depreciation for the Year Asset Cost

Date 1-1-2008

Depreciation Rate

Depreciable Cost


$15,000

Accumulated Depreciation

Book Value

$15,000

12-31-2008

14/7

!

$1,000

=

$2,000

$2,000

13,000

12-31-2009

14/7

!

1,000

=

2,000

4,000

11,000

12-31-2010

14/7

!

1,000

=

2,000

6,000

9,000

Part 5

Part 6

Part 1

Part 2

Part 3

Part 4

Part 7

Part 8

Part 9

Demo Doc Complete


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Define and describe the life cycle of longterm assets Calculate and record depreciation of plant assets

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Units-of-Production Method The unit method is similar to the straight-line method, but instead of calculating depreciation expense per year, we calculate it per unit. It allocates an equal amount of depreciation for each unit of production. Notice how the formula is similar to the straight-line method: Cost " Residual Value Units of Production in Useful Life

!

Depreciation Expense per Unit

Or, in this particular question: $15,000 – $1,000 100,000 miles

!

$0.14 Depreciation Expense per Actual Mile Driven

Because a different number of miles is driven every year, the annual depreciation expense will be different from year to year; however, the depreciation rate per unit (mile) remains constant. Units of production is another way of measuring an asset’s life or productivity. For example, we could say that a machine will last for 5 years, or we might say that it will have 50,000 hours of operation. Both statements are reasonable ways to express how long the machine will last. The straight-line method focuses on the years (for example, 5 years of life) and the unit method focuses on the production (such as the 50,000 hours). Assessing the situation will indicate whether any ways can be used to measure an asset’s life other than by years. In this question, the miles driven were highlighted and are the only other measure of asset life we can use for this particular situation. Under the unit method, we calculate depreciation as: Depreciation Expense Depreciation Expense ! Units Used This Year # This Year Unit

So, in this question, we can calculate depreciation expense on the truck each year as:

Actual

Rate

Annual Expense

2008

15,000 miles × $0.14 per mile = $2,100

2009

12,000 miles × $0.14 per mile = $1,680

2010

17,000 miles × $0.14 per mile = $2,380

We calculate accumulated depreciation the same way we did for the straight-line method (only the depreciation expense is calculated differently from method to method). We can use a T-account to calculate accumulated depreciation each year: Accumulated Depreciation, Truck 12/31/08 2,100 2008 Bal. 2,100 12/31/09 1,680 2009 Bal. 3,780 12/31/10 2,380 2010 Bal. 6,160 290


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We can also calculate accumulated depreciation directly: Accumulated Depreciation This Year " Accumulated Depreciation Last Year # This Year’s Depreciation Expense

So, in this question, we can calculate accumulated depreciation each year as: 2008

$0 # $2,100 " $2,100

2009

$2,100 # $1,680 " $3,780

2010

$3,780 # $2,380 " $6,160

Units-of-Production Method Depreciation for the Year Asset Cost

Date 1-1-2008

Depreciation per Unit

Number of Units



$15,000

Book Value $15,000

12-31-2008

$0.14

!

15,000

=

$2,100

$2,100

12,900

12-31-2009

0.14

!

12,000

=

1,680

3,780

11,220

12-31-2010

0.14

!

17,000

=

2,380

6,160

8,840

Part 5

Part 6

Part 7

Part 1

Part 2

Part 3

Part 4

Part 8

Part 9

Demo Doc Complete

Double-Declining-Balance Method This method is somewhat more complicated than straight-line or units-of-production depreciation. It allocates more depreciation in the early years than in the later years. Instead of a set depreciation amount, we use a depreciation rate: Double-Declining-Balance (DDB) Depreciation Rate " 2/Years of Useful Life

1

Define and describe the life cycle of longterm assets

3

Calculate and record depreciation of plant assets

Or, in this particular question: DDB rate " 2/7

You may notice that the years of useful life is the same denominator as we used in the straight-line method. For this reason, the method is called doubledeclining-balance: it is two times the amount used for straight-line (that is, 2 × 1/years of useful life). To get the depreciation expense each year, we need to use the following formula: This Year’s Depreciation Expense " Book Value × Depreciation Rate

where Book Value " Cost – Last Year’s Accumulated Depreciation

Sometimes the cost – last year’s accumulated depreciation is called the net value of the asset. You will see why in Requirement 3 of this question. Because the accumulated depreciation is used in the depreciation expense formula, we need to calculate both together every year; however, the methods we can use to calculate accumulated depreciation are the same as before. Demo Doc 1 Solutions | Chapter 9

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2008 Depreciation Expense " ($15,000 – $0) $2/7 " $4,286 Accumulated Depreciation " $0 # $4,286 " $4,286 2009 Depreciation Expense " ($15,000 – $4,286) $ 2/7 " $3,061 Accumulated Depreciation " $4,286 # $3,061 " $7,347 2009 Depreciation Expense " ($15,000 – $7,347) $ 2/7 " $2,187 Accumulated Depreciation " $7,347 # $2,187 " $9,534

We can also use a T-account to calculate accumulated depreciation each year: Accumulated Depreciation, Truck 12/31/08 4,286 2008 Bal. 4,286 12/31/09 3,061 2009 Bal. 7,347 12/31/10 2,187 2010 Bal. 9,534

It is important to keep an eye on accumulated depreciation with the doubledeclining-balance method. Remember, we did not use the residual value to calculate depreciation expense. However, we need to ensure that the book value of the asset does not go below the residual value. When the book value of the asset reaches the residual value, we stop taking depreciation expense (even if the asset is still being used). Double-Declining-Balance Method Depreciation for the Year Asset Cost

Date 1-1-2008

DDB Rate


Book Value


$15,000

Book Value $15,000

12-31-2008

2/7

!

$15,000

=

$4,286

$4,286

10,714

12-31-2009

2/7

!

10,714

=

3,061

7,347

7,653

12-31-2010

2/7

!

7,653

=

2,187

9,534

5,466

292


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Requirement 3 Using the double-declining-balance method only, show how the truck account would look on the December 31 balance sheet for 2008, 2009, and 2010.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Demo Doc Complete

Part 9

Although the question only requires an answer for the double-declining-balance method, keep in mind that the balance sheet presentation is the same for all depreciation methods:

7

Report long-term assets on the balance sheet

3


Cost – Accumulated Depreciation Net Value of Asset

This net value of the asset is the same amount that is used in the double-decliningbalance calculation for depreciation expense in the following year. So on the balance sheet for each year (under the double-declining-balance method), you would see: 2008

2009

2010

Truck Accumulated Depreciation

$15,000

$15,000

$15,000

Truck (net)

$10,714

(4,286)

(7,347)

(9,534)

$7,653

$5,466

Requirement 4 Which of the three methods maximizes income for 2008? Which method minimizes income taxes for 2008?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Part 9

Demo Doc Complete

The depreciation expense for each method in 2008 is: Straight-line

$2,000

Units-of-production

$2,100

Double-declining-balance

$4,286

Revenues – Expenses " Net Income

So higher expense (holding revenue constant) gives a lower net income. In this example, the straight-line method has the lowest depreciation expense, which means that it has the highest net income. The double-declining-balance method has the highest depreciation expense, which means that it has the lowest net income, and therefore the lowest income taxes. Demo Doc 1 Solutions | Chapter 9

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Requirement 5 Peters sold the truck on September 1, 2011, for $7,000 cash. Journalize the sale transaction using each method. (The truck was driven for 8,000 miles in 2011.)

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Part 9

Demo Doc Complete

Straight-Line Method

3


4

Calculate and record the disposal of plant assets

When an asset is sold, we must journalize that sale. However, before we journalize the disposal, we must update the depreciation on the asset. Depreciation represents the portion (the benefit) of the asset that has been used. The truck was sold on September 1, which means that Peters got to use it for 8 months of 2011 before it was sold. We must represent that use as depreciation expense. The depreciation expense that we record for 8 months is not the same as the amount we would record for an entire year, because it is a shorter period of time (and therefore the asset was used less). Therefore, we must calculate a partial year’s depreciation. Under straight-line depreciation, the annual depreciation expense is $2,000 (that is, for 12 months). So for 8 months: 8 months 2011 Depreciation " $1,333 " $2,000 $ Expense 12 months

This depreciation would then be recorded as:

Journal Entry: Date Accounts Sept. 1 Depreciation Expense Accumulated Depreciation, Truck

Post Ref.

Dr. 1,333

Cr. 1,333

This amount for 2011 brings the total accumulated depreciation to: $6,000 # $1,333 " $7,333.

Now we can record the sale of the truck. Cash was received, so it increases (a debit) by $7,000. The truck has been sold, so that account decreases to a zero balance (a credit) by $15,000. The Accumulated Depreciation goes along with it (contraaccounts always go with their associated account), so that account decreases to a zero balance (a debit) as well by $7,333.

294


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These amounts are shown in the following journal entry:


Date Accounts Sept. 1 Cash Accumulated Depreciation, Truck ????? Truck

Dr. 7,000 7,333 ?????

Cr.

15,000

Obviously, the entry is not complete because it does not balance. In order to get it to balance, we need equal debits and credits, which means that we need a $15,000 – $7,000 – $7,333 = $667 debit for the entry to work. This $667 is the balancing amount. It is either a gain on sale or a loss on sale. Because the balancing amount is a debit, it is a loss (an increase in expenses is a debit, which is like a loss). So the completed entry is:


Date Accounts Sept. 1 Cash Accumulated Depreciation, Truck Loss on Sale of Truck (to balance) Truck

Part 1

Part 2

Part 3

Part 4

Part 5

Dr. 7,000 7,333 667

Cr.

15,000

Part 6

Part 7

Part 8

Part 9

Demo Doc Complete


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Units-of-Production Method

3


4


We must record the depreciation expense for the first eight months of the year:

2011 Depreciation Expense

"

Actual 8,000 miles

Rate $

$0.14

"

$1,120

Notice that we did not need to multiply by 8/12 like we did in the straight-line method because the short period of use is already incorporated into the 8,000 miles. If the truck had been used for a full year, the number of miles would have been bigger, and so depreciation expense would have been higher. With the unitsof-production method, all that matters is the actual number of miles the truck was driven. Depreciation is recorded as:


Post Ref.

Dr. 1,120

Cr. 1,120

Accumulated depreciation is now: $6,160 # $1,120 " $7,280

Cash was received, so it increases (a debit) by $7,000. The truck has been sold, so that account decreases to a zero balance (a credit) by $15,000. Accumulated Depreciation decreases to a zero balance (a debit) by $7,280. These amounts are shown in the following journal entry:

Journal Entry: Date Accounts Sept. 1 Cash Accumulated Depreciation, Truck ????? Truck

Post Ref.

Dr. 7,000 7,280 ?????

Cr.

15,000

In order to get it to balance, we need a $15,000 – $7,000 – $7,280 = $720 debit. Because the balancing amount is a debit, it is a loss (an increase in expenses is a debit, which is like a loss).

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So the completed entry is shown here:


Date Accounts Sept. 1 Cash Accumulated Depreciation, Truck Loss on Sale of Truck (to balance) Truck

Part 1

Part 2

Part 3

Part 4

Part 5

Dr. 7,000 7,280 720

Cr.

15,000

Part 6

Part 7

Part 8

Part 9

Demo Doc Complete

Double-Declining-Balance Method

2011 Depreciation Expense " ($15,000 ! $9,534) $ 2/7 " $1,561.71 " 12 months of depreciation $1,561.71 $

8 months 8 months of " $1,041 " depreciation 12 months

3


4



Post Ref.

Dr. 1,041

Cr. 1,041

This amount brings the accumulated depreciation to: $9,534 # $1,041 " $10,575

Cash was received, so it increases (a debit) by $7,000.


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Date Accounts Sept. 1 Cash Accumulated Depreciation, Truck ????? Truck

Dr. 7,000 10,575

Cr.

????? 15,000

The truck has been sold, so that account decreases to a zero balance (a credit) by $15,000. Accumulated Depreciation decreases to a zero balance (a debit) by $10,575. These amounts are shown in the following journal entry: We need a $7,000 + $10,575 – $15,000 = $2,575 credit for the entry to work. Because the balancing amount is a credit, it is a gain (an increase in revenues is a credit, which is like a gain). So the completed entry is:


Date Accounts Sept. 1 Cash Accumulated Depreciation, Truck Gain on Sale of Truck (to balance) Truck

Part 1

298


Part 2

Part 3

Part 4

Part 5

Part 6

Dr. 7,000 10,575

Cr.

2,575 15,000

Part 7

Part 8

Part 9

Demo Doc Complete

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Demo Doc 2 Natural Resource Assets Learning Objective

5

Xander Inc. purchased a coal mine for $900 million cash on January 1, 2008. After the purchase, an independent analyst determined that the value of the land was $200 million and that the value of the coal was $800 million (based on an estimate of 20 million tons of coal below the ground). In 2008, Xander mined and sold 1 million tons of coal.

Requirements 1. Give Xander’s journal entry to record the purchase of the mine. 2. Give Xander’s journal entry to record depletion expense for 2008.


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Demo Doc 2 Solutions Requirement 1 Give Xander’s journal entry to record the purchase of the mine.

Part 1

2

Calculate and record the cost to acquire plant assets

5

Calculate and record depletion of natural resources

Demo Doc Complete

Part 2

Xander purchased two assets at one time for one price. In this lump-sum purchase, we need to determine how much of the purchase price to allocate to each asset. Making this distinction is important because it affects depletion calculations in the future (because the cost of the asset is an important number in these calculations). We use the independent valuations to determine a proportional value for the assets. According to the analyst, the total value of the assets purchased is: $200 million # $800 million " $1 billion

Land has a proportion of 200,000,000/1,000,000,000 = 20%. The coal has a proportion of 800,000,000/1,000,000,000 = 80%. The cost of each asset is assigned as this proportion of the total cost. So the cost of the land is: 20% × $900 million total cost " $180 million

The cost of the coal is: 80% × $900 million total cost " $720 million

In the journal entry, Land and Coal Reserves are increased (debited) by these amounts and Cash is decreased (credit).

Journal Entry: Date

300

Accounts Land (20% 3 $900,000,000) Coal Reserves (80% 3 $900,000,000) Cash


Post Ref.

Dr. 180,000,000 720,000,000

Cr.

900,000,000

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Requirement 2 Give Xander’s journal entry to record depletion expense for 2008.

Part 1

Demo Doc Complete

Part 2

Depletion expense is the same as depreciation expense, except that this term is only used for natural resource assets. Depletion is always calculated using the units-of-production method (never the straight-line or double-declining-balance methods). The units are the amount of natural resources purchased. In this case, the units are tons of coal. Cost Units of Prod duction in Useful Life $720,000,000 20,000,000 tons

"

Depletion Expense per Unit

"

$36 per ton

1

Define and describe the life cycle of longterm assets

5


Under the unit method, we calculate depletion as: Depletion Expense " Actual Units Used This Year $ Depletion Expense per Unit This Year Depletion Expense " 1,000,000 tons $ $36 per ton " $36,000,000 for 2008

When we journalize depreciation, we increase (debit) Depreciation Expense and increase (credit) Accumulated Depreciation. The entry for depletion is the same, except that we use Depletion Expense (debit) and Accumulated Depletion (credit).

Journal Entry: Date

Accounts Depletion Expense ($36 3 1,000,000) Accumulated Depletion, Coal Reserves

Part 1

Part 2

Post Ref.

Dr. 36,000,000

Cr. 36,000,000

Demo Doc Complete


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Demo Doc 3 Intangible Assets Learning Objective

6

On July 1, 2008, Franco Co. acquired a patent from Juarez Inc. for $5,000 cash and by signing a $10,000, 6% note payable. Franco believes that the patent will have a life of 10 years. On the same date, Franco purchased all outstanding shares of Germano Inc. for $50,000. The book value of Germano’s net assets at this time was $35,000 and the market value was $40,000.

Requirements 1. Journalize Franco’s purchase of the patent. What kind of asset is the patent? Why do you think so? 2. Journalize Franco’s amortization expense for the patent in 2008. 3. Franco did not make any interest payments on the note in 2008. Journalize Franco’s interest expense for the year. 4. Calculate the amount of goodwill that will be recorded for Franco as a result of the Germano purchase. 5. Give any necessary entry to adjust the value of Franco’s goodwill if it is determined to be worth $2,500 at the end of the year.

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Demo Doc 3 Solutions Requirement 1 Journalize Franco’s purchase of the patent. What kind of asset is the patent? Why do you think so?

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Cash decreases (a credit) by $5,000 and Notes Payable increases (a credit) by $10,000. The Patent account is also increased (a debit) by:

6

Account for intangible assets

6


$5,000 # $10,000 " $15,000


Date Accounts July 1 Patent Cash Note Payable

Dr. 15,000

Cr. 5,000 10,000

The patent is an intangible asset, because the patent is a right to produce a certain product or use a certain technology. A right is not a physical asset: It cannot be touched, which means it is intangible.

Requirement 2 Journalize Franco’s amortization expense for the patent in 2008.

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Intangible assets are amortized. Amortization is essentially the same process as depreciation for tangible assets. The only difference is that for intangible assets, we usually do not keep an Accumulated Amortization account, but instead directly reduce the asset account. Amortization expense is usually calculated using the straight-line method.

Amortization Expense (annual)

"

$15,000 10 years

"

"

Cost of Intangible Asset Years of Useful Life $1,500 per year Demo Doc 3 Solutions | Chapter 9

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Because the patent was purchased on July 1, only six months have been used. Therefore, we must calculate a partial year’s amortization: $1,500 $

6 months $750 amortization expense for 6 " months 12 months

Amortization Expense, Patents increases (a debit) by $750. Remember that for intangible assets, we do not have an accumulated account. Instead we must decrease the Patent account (a credit) directly for $750.


Date Accounts Dec. 31 Amoritization Expense, Patents Patent

Dr. 750

Cr. 750

Requirement 3 Franco did not make any interest payments on the note in 2008. Journalize Franco’s interest expense for the year.

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Interest expense for the year is: $10,000 $ 6% $

6 months " $300 12 months

Interest Expense is increased (a debit) and Interest Payable is increased (a credit) by $300.

Journal Entry: Date Accounts Dec. 31 Interest Expense ($10,000 3 6% 3 6/12) Interest Payable

304


Post Ref.

Dr. 300

Cr. 300

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Requirement 4 Calculate the amount of goodwill that will be journalized for Franco as a result of the Germano purchase.

Part 1

Goodwill

Part 2

" "

Part 3

Purchase Price $50,000

! !

Part 4

Part 5

Market Value of Net Assets $40,000

Demo Doc Complete

6 "


$10,000

This figure for goodwill could also be calculated by preparing the journal entry for Franco to purchase Germano. Franco increases its Net Assets (debit) by the market value of $40,000. Cash decreases (credit) by the amount paid for the purchase. The remaining amount in the entry to make it balance is Goodwill:

Journal Entry: Date Accounts July 1 Net Assets Goodwill (to balance) Cash

Post Ref.

Dr. 40,000 10,000

Cr.

50,000


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Requirement 5 Give any necessary entry to adjust the value of Franco’s goodwill if it is determined to be worth $2,500 at the end of the year.

Part 1

6


Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Franco journalized the goodwill at $10,000. Because it is now worth only $2,500, it has a loss in value of: $10,000 – $2,500 " $7,500

The loss increases the Loss on Goodwill account (a debit) and decreases the Goodwill account (a credit).


Date Accounts Dec. 31 Loss on Goodwill ($10,000 – $7,500) Goodwill

Part 1

306


Part 2

Part 3

Dr. 7,500

Cr. 7,500

Part 4

Part 5

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. The cost of land improvements includes fencing, paving, sprinkler systems, and lighting. _____ 2. Land improvements are not subject to annual depreciation. _____ 3. Book value is equal to the cost of the asset less the expected residual value. _____ 4. The modified accelerated cost recovery system of depreciation is used for income tax purposes and segments assets into classes by asset life. _____ 5. A loss on sale of an asset occurs when the book value is less than the cash received. _____ 6. The depreciable cost of a plant asset is the original cost less the expected residual value. _____ 7. Depletion expense is computed in the same manner as units-of-production. _____ 8. Goodwill is recorded only by a company when it purchases another company and is not subject to amortization. _____ 9. A characteristic of a plant asset is that it is used in the production of income for a business. _____10. Routine repairs and maintenance are capital expenditures.


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Multiple Choice 1. Which of the following is not a plant asset? a. Land b. Building c. Copyright d. Equipment 2. The cost of a building would include all of the following except: a. Architectural fees b. Clearing and grading the land prior to construction of the building c. Cost of repairs made to an old building to get it ready for occupancy d. Costs of construction 3. Five hundred acres of land are purchased for $130,000. Additional costs include $5,000 brokerage commission, $10,000 for removal of an old building, $6,000 for paving, and an $800 survey fee. What is the cost of the land? a. $135,800 b. $145,800 c. $155,000 d. $155,800

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4. Westchester Company recently sold some used furniture for $3,800 cash. The furniture cost $19,600 and had accumulated depreciation through the date of sale totaling $17,300. Which entry is used to journalize the sale of the furniture?


Accounts Cash Accumulated Depreciation, Furniture Furniture

Post Ref.

Dr. 3,800 15,800

Cr.

19,600

Journal Entry: Date b.

Accounts Cash Furniture

Post Ref.

Dr. 3,800

Cr. 3,800


Accounts Cash Gain on Sale of Furniture

Post Ref.

Dr. 3,800

Cr. 3,800

Journal Entry: Date d.

Accounts Cash Accumulated Depreciation, Furniture Furniture Gain on Sale of Furniture

Post Ref.

Dr. 3,800 17,300

Cr.

19,600 1,500

5. New equipment with a list price of $100,000, credit terms of 3/10, n/30, and transportation cost of $7,000 is acquired by a company. Insurance while in transit amounts to $200. Insurance on the equipment during its first year of use amounts to $800. Assuming the equipment is paid for within the discount period, what is the amount debited to Equipment? a. $97,000 b. $104,200 c. $105,000 d. $107,200


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6. Which of the following expenditures would be debited to an expense account? a. Cost to replace the company car’s engine b. Addition of elevator to a building c. Replacement of tires d. All of the above 7. What is the effect of treating a revenue expenditure as a capital expenditure? a. Understates expenses and understates owner’s equity b. Overstates assets and overstates owner’s equity c. Overstates expenses and understates net income d. Understates expenses and understates assets 8. What type of account is Accumulated Depreciation? a. A contra-liability account b. An expense account c. A contra-asset account d. A contra-equity account 9. When the amount of use of a plant asset varies from year to year, which method of determining depreciation best matches revenues and expenses? a. Straight-line method b. Double-declining-balance method c. Units-of-production method d. Either the straight-line method or the double-declining-balance method 10. Which depreciation method generally results in the greatest depreciation expense in the first full year of an asset’s life? a. Double-declining-balance method b. Units-of-production method c. Straight-line method d. Either the straight-line or the double-declining-balance method

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Quick Exercises 9-1. Morgan Construction bought land, a building, and equipment for a lump sum of $740,000. Following are the appraised fair market values of the newly acquired assets: Land, $450,000 Building, $400,000 Equipment, $150,000 Determine the cost of each asset. a. ________ Land b. ________ Building c. ________ Equipment 9-2. Sue Glover purchased a tract of land and contracted with a builder to build an office building on the property. She also engaged other contractors for lighting, fencing, paving, and so forth. Based on the following transactions, determine the total costs allocated to the Land, Building, and Land Improvements accounts. a. Purchased land for $135,000. b. Paid a contractor $333,000 to design and build the office building. c. Paid a demolition company $40,000 to remove an old structure on the property. d. Paid $14,000 in delinquent taxes on the property. e. Paid $34,700 for fencing. f. Paid $39,500 for paving. g. Paid an electrical contractor $14,900 for outdoor lighting. Cost of land __________ Cost of building __________ Cost of land improvements __________ 9-3. Venus Company acquired equipment on January 1, 2008, for $470,000. The equipment has an estimated useful life of 5 years and an estimated residual value of $30,000. Calculate depreciation expense for 2008 and 2009 under each of the following methods. The equipment is estimated to produce 150,000 units. During 2008 and 2009, the equipment produced 24,000 and 60,000 units, respectively. Round the answer to the nearest dollar where necessary. a. Straight-line method b. Double-declining-balance method c. Units-of-production method

2008 _________ _________ _________

2009 __________ __________ __________


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9-4. On April 1, 2008, Carter Craft & Company purchased a mineral deposit by paying $50,000 in cash and signing a $440,000 promissory note. A geological report estimated the mineral deposit contained 140,000 tons of ore. Carter Craft & Company expects the asset to have a zero residual value when fully depleted. During 2008, 40,000 tons of ore were mined. Prepare the journal entry for December 31, 2008, to record the depletion of the mineral deposit.


Post Ref.

Dr.

Cr.

9-5. On July 31, 2007, Austin Manufacturing acquired an existing patent for $340,000. The remaining legal life of the patent is 13 years; however, management thinks the patent will hold economic benefit for the company for only 7 more years. Prepare journal entries for July 31, 2007, to acquire the patent and for December 31, 2007, to amortize the patent.

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

312

Accounts


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Do It Yourself! Question 1 Depreciation Winters Co. purchased equipment for $8,000 cash on January 1, 2008. The equipment had a residual value of $500 and a useful life of 6 years or 2,000 hours of operation. Winters has a December 31 year-end. The equipment was used for 400 hours in 2008, 200 hours in 2009, and 300 hours in 2010.

Requirements 1. Calculate the Depreciation Expense and Accumulated Depreciation account balances at December 31, 2008, 2009, and 2010, using the straight-line method.

Year



3


3


3


Book Value (Cost – Accumulated Depreciation)

2008 2009 2010 2. Calculate the Depreciation Expense and Accumulated Depreciation account balances at December 31, 2008, 2009, and 2010, using the units-ofproduction method.

Year




2008 2009 2010 3. Calculate the Depreciation Expense and Accumulated Depreciation account balances at December 31, 2008, 2009, and 2010, using the double-decliningbalance method.

Year




2008 2009 2010


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7

Report long-term assets on the balance sheet

3

Calculate and record depreciation of plant assets Calculate and record the disposal of plant assets

4

Page 314

4. Using the units-of-production method only, show how the equipment would look on the December 31 balance sheets for 2008, 2009, and 2010.

5. Winters sold the equipment on March 1, 2011, for $4,000 cash. Show journal entries for depreciation and for the sale transaction using each method. (The equipment was used for 100 hours in 2011.) Straight-Line Method

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

Units-of-Production Method

Journal Entry: Date

314

Accounts


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Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Double-Declining-Balance Method

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts


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Do It Yourself! Question 2 Natural Resource Assets Woody Inc. purchased logging rights in a county forest for $800,000 cash. Woody estimates that 40,000 tons of lumber can be harvested from the forest. Because Woody only purchased the right to log, it does not own the land.

Requirement

5


Show the journal entry for Woody’s depletion expense for the first year, assuming that 15,000 tons of lumber were cut and sold.

Journal Entry: Date

316

Accounts


Post Ref.

Dr.

Cr.

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Do It Yourself! Question 3 Intangible Assets On October 1, 2008, Kevin Inc. acquired a trademark from Daniel Co. for $10,000 cash. Kevin believes that the trademark will have a life of 20 years.

Requirements 1. Journalize Kevin’s purchase of the trademark.

6


6


Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

2. Journalize Kevin’s amortization expense for the trademark in 2008.

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.


317

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318

T

1. The cost of land improvements includes fencing, paving, sprinkler systems, and lighting. (p. 473)

F

2. Land improvements are not subject to annual depreciation. False–Land improvements are subject to depreciation. (p.473)

F

3. Book value is equal to the cost of the asset less the expected residual value. False–Book value is equal to the cost of the asset less the accumulated depreciation. (p. 478)

T

4. The modified accelerated cost recovery system of depreciation is used for income tax purposes and segments assets into classes by asset life. (p. 483)

F

5. A loss on a sale of an asset occurs when the book value is less than the cash received. False–A gain on a sale of an asset occurs when the book value is less than the cash received. (p. 485)

T

6. The depreciable cost of a plant asset is the original cost less the expected residual value. (p. 476)

T

7. Depletion expense is computed in the same manner as units-of-production. (p. 487)

T

8. Goodwill is recorded only by a company when it purchases another company and is not subject to amortization. (pp. 489–490)

T

9. A characteristic of a plant asset is that it is used in the production of income for a business. (p. 470)

F

10. Routine repairs and maintenance are capital expenditures. False–Routine repairs and maintenance are expenses, or revenue expenditures. (p. 475)


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Multiple Choice 1. Which of the following is not a plant asset? (p. 489) a. Land b. Building c. Copyright d. Equipment 2. The cost of a building would include all of the following except: (p. 473) a. Architectural fees b. Clearing and grading the land prior to construction of the building c. Cost of repairs made to an old building to get it ready for occupancy d. Costs of construction 3. Five hundred acres of land are purchased for $130,000. Additional costs include $5,000 brokerage commission, $10,000 for removal of an old building, $6,000 for paving, and an $800 survey fee. What is the cost of the land? (p. 473) a. $135,800 b. $145,800 ($130,000 + $5,000 + $10,000 + $800) c. $155,000 d. $155,800


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4. Westchester Company recently sold some used furniture for $3,800 cash. The furniture cost $19,600 and had accumulated depreciation through the date of sale totaling $17,300. Which entry is used to journalize the sale of the furniture? (pp. 473–474) Journal Entry: Date a.

Accounts Cash Accumulated Depreciation, Furniture Furniture

Post Ref.

Dr. 3,800 15,800

Cr.

19,600


Accounts Cash Furniture

Post Ref.

Dr. 3,800

Cr. 3,800


Accounts Cash Gain on Sale of Furniture

Post Ref.

Dr. 3,800

Cr. 3,800

Journal Entry: Date d.

320

Accounts Cash Accumulated Depreciation, Furniture Furniture Gain on Sale of Furniture


Post Ref.

Dr. 3,800 17,300

Cr.

19,600 1,500

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5. New equipment with a list price of $100,000, credit terms of 3/10, n/30, and transportation cost of $7,000 is acquired by a company. Insurance while in transit amounts to $200. Insurance on the equipment during its first year of use amounts to $800. Assuming the equipment is paid for within the discount period, what is the amount debited to Equipment? (pp. 473–474) a. $ 97,000 b. $104,200 ($100,000 – $3,000 + $7,000 + $200) c. $105,000 d. $107,200 6. Which of the following expenditures would be debited to an expense account? (p. 475) a. Cost to replace the company car’s engine b. Addition of elevator to a building c. Replacement of tires d. All of the above 7. What is the effect of treating a revenue expenditure as a capital expenditure? (p. 475) a. Understates expenses and understates owner’s equity b. Overstates assets and overstates owner’s equity c. Overstates expenses and understates net income d. Understates expenses and understates assets 8. What type of account is Accumulated Depreciation? (p. 484) a. A contra-liability account b. An expense account c. A contra-asset account d. A contra-equity account 9. When the amount of use of a plant asset varies from year to year, which method of determining depreciation best matches revenues and expenses? (p. 478) a. Straight-line method b. Double-declining-balance method c. Units-of-production method d. Either the straight-line method or the double-declining-balance method 10. Which depreciation method generally results in the greatest depreciation expense in the first full year of an asset’s life? (p. 483) a. Double-declining-balance method b. Units-of-production method c. Straight-line method d. Either the straight-line or the double-declining-balance method


321

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Quick Exercises 9-1. Morgan Construction bought land, a building, and equipment for a lump sum of $740,000. Following are the appraised fair market values of the newly acquired assets: Land, $450,000 Building, $400,000 Equipment, $150,000 Determine the cost of each asset. (p. 474) a. $333,000 Land = ($450,000/$1,000,000) × $740,000 = $333,000 b. $296,000 Building = ($400,000/$1,000,000) × $740,000 = $296,000 c. $111,000 Equipment = ($150,000/$1,000,000) × $740,000 = $111,000 9-2. Sue Glover purchased a tract of land and contracted with a builder to build an office building on the property. She also engaged other contractors for lighting, fencing, paving, and so forth. Based on the following transactions, determine the total costs allocated to the Land, Building, and Land Improvements accounts. (p. 473) a. Purchased land for $135,000. b. Paid a contractor $333,000 to design and build the office building. c. Paid a demolition company $40,000 to remove an old structure on the property. d. Paid $14,000 in delinquent taxes on the property. e. Paid $34,700 for fencing. f. Paid $39,500 for paving. g. Paid an electrical contractor $14,900 for outdoor lighting. Cost of land Cost of building Cost of land improvements

$189,000 ($135,000 + $40,000 + $14,000 = $189,000; transactions a, c, and d) $333,000 (transaction b) $ 89,100 ($34,700 + $39,500 + $14,900 = $89,100; transactions e, f, and g)

9-3. Venus Company acquired equipment on January 1, 2008, for $470,000. The equipment has an estimated useful life of 5 years and an estimated residual value of $30,000. Calculate depreciation expense for 2008 and 2009 under each of the following methods. The equipment is estimated to produce 150,000 units. During 2008 and 2009, the equipment produced 24,000 and 60,000 units, respectively. Round the answer to the nearest dollar where necessary. (pp. 477–479) 2008 $ 88,000

2009 $ 88,000

b. Double-declining-balance method $188,000 DDB rate = 1/5 years × 2 = 40% (0.40) ($470,000 – 0) × 0.40 = $188,000 ($470,000 – $188,000) × 0.40 = $112,800

$112,800

a. Straight-line method $470,000 – $30,000 = $88,000/year 5 years

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c. Units-of-production method

$ 70,400

$176,000

$470,000 – $30,000 $ 24,000 units = $70,400 150,000 $470,000 – $30,000 $ 60,000 units = $176,000 150,000

9-4. On April 1, 2008, Carter Craft & Company purchased a mineral deposit by paying $50,000 in cash and signing a $440,000 promissory note. A geological report estimated the mineral deposit contained 140,000 tons of ore. Carter Craft & Company expects the asset to have a zero residual value when fully depleted. During 2008, 40,000 tons of ore were mined. Prepare the journal entry for December 31, 2008, to record the depletion of the mineral deposit. (pp. 487–488)

Journal Entry: Date Accounts 12/31/08 Depletion Expense Accumulated Depletion, Ore To record depletion of mineral deposits: ($50,000 + $440,000/140,000 tons = $3.50/ton 3 40,000 tons = $140,000).

Post Ref.

Dr. 140,000

Cr. 140,000

9-5. On July 31, 2007, Austin Manufacturing acquired an existing patent for $340,000. The remaining legal life of the patent is 13 years; however, management thinks the patent will hold economic benefit for the company for only 7 more years. Prepare journal entries for July 31, 2007, to acquire the patent and for December 31, 2007, to amortize the patent. (pp. 488–489)


Accounts Patents Cash To record purchase of patent.

Post Ref.

Dr. 340,000

Cr. 340,000

Journal Entry: Post Date Accounts Ref. 12/31/07 Amoritization Expense, Patents Patents To amoritize patents ($340,000 3 5/84 months = $20,238).

Dr. 20,238

Cr. 20,238


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Do It Yourself! Question 1 Solutions Requirement 1 Calculate the Depreciation Expense and Accumulated Depreciation account balances at December 31, 2008, 2009, and 2010, using the straight-line method. $8,000 ! $500 $1,250 Depreciation " Expense per Year 6 years 2008 Accumulated Depreciation " $1,250 2009 Accumulated Depreciation " $2,500 2010 Accumulated Depreciation " $3,750

Year




2008

$1,250

$1,250

$6,750

2009

1,250

2,500

5,500

2010

1,250

3,750

4,250

Requirement 2 Calculate the Depreciation Expense and Accumulated Depreciation account balances at December 31, 2008, 2009, and 2010, using the units-of-production method. $8,000 ! $500 2,000 hours of lifetime operation

"

$3.75 Depreciation Expense per Hour of Actual Operation

Depreciation expense each year is: Actual

Rate

Expense

2008

400 hours × $3.75 per hour = $1,500

2009

200 hours × $3.75 per hour = $ 750

2010

300 hours × $3.75 per hour = $1,125

Accumulated depreciation each year is:

324

2008

Prior Accumulated $0

2009

$1,500

+

$750

= $2,250

2010

$2,250

+ $1,125

= $3,375


Expense + $1,500

Ending Accumulated = $1,500

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Year




2008

$1,500

$1,500

$6,500

2009

750

2,250

5,750

2010

1,125

3,375

4,625

Requirement 3 Calculate the Depreciation Expense and Accumulated Depreciation account balances at December 31, 2008, 2009, and 2010, using the double-decliningbalance method. DDB rate " 2/6 " 1/3 2008 Depreciation Expense " ($8,000 ! $0) × 1/3 " $2,667 Accumulated Depreciation " $0 # $2,667 " $2,667 2009 Depreciation Expense " ($8,000 ! $2,667) $ 1/3 " $1,778 Accumulated Depreciation " $2,667 # $1,778 " $4,445 2010 Depreciation Expense " ($8,000 ! $4,445) $ 1/3 " $1,185 Accumulated Depreciation " $4,445 # $1,185 " $5,630



2008

$2,667

$2,667

$5,333

2009

1,778

4,445

3,555

2010

1,185

5,630

2,370

Year


A

Requirement 4 Using the units-of-production method only, show how the equipment would look on the December 31 balance sheets for 2008, 2009, and 2010.

2008

2009

2010

Equipment

$8,000

$8,000

$8,000

– Accumulated depreciation

(1,500)

(2,250)

(3,375)

Equipment (net)

$6,500

$5,750

$4,625


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Requirement 5 Winters sold the equipment on March 1, 2011, for $4,000 cash. Show journal entries for depreciation and for the sale transaction using each method. (The equipment was used for 100 hours in 2011.) Straight-Line Method 2011 2 months " $208 Depreciation " $1,250 # 12 months Expense


Date Accounts Mar. 1 Depreciation Expense Accumulated Depreciation, Equipment

Dr. 208

Cr. 208

Total accumulated depreciation is: $3,750 ! $208 " $3,958


Post Ref.

Accounts Cash Accumulated Depreciation, Equipment Loss on Sale of Equipment (to balance) Equipment

Dr. 4,000 3,958 42

Cr.

8,000

Units-of-Production Method 2011 Depreciation Expense

Actual "

100 hours

Rate #

$3.75

"

$375


Accounts Depreciation Expense Accumulated Depreciation, Equipment

Total accumulated depreciation is: $3,375 ! $375 " $3,750 326


Post Ref.

Dr. 375

Cr. 375

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Accounts Cash Accumulated Depreciation, Equipment Loss on Sale of Equipment (to balance) Equipment

Post Ref.

Dr. 4,000 3,750 250

Cr.

8,000

Double-Declining-Balance Method 2011 Depreciation Expense " ($8,000 ! $5,630) $ 1/3 " $790 for 12 months $790 $

$132 for 2 2 months " 12 months months


Accounts Depreciation Expense Accumulated Depreciation, Equipment

Post Ref.

Dr. 132

Cr. 132

Total accumulated depreciation is: $5,630 # $132 " $5,762


Accounts Cash Accumulated Depreciation, Equipment Gain on Sale of Equipment (to balance) Equipment

Post Ref.

Dr. 4,000 5,762

Cr.

1,762 8,000


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Do It Yourself! Question 2 Solution Requirement Show the journal entry for Woody’s depletion expense for the first year, assuming that 15,000 tons of lumber were cut and sold. Depletion " Expense per Ton

$800,000 " $20 per ton 40,000 tons

15,000 tons $ $20 per ton " $300,000

Journal Entry: Date

328

Accounts Depletion Expense ($20 ! 15,000) Accumulated Depletion, Lumber

Chapter 9 | Do It Yourself! Question 2 Solution

Post Ref.

Dr. 300,000

Cr. 300,000

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Do It Yourself! Question 3 Solutions Requirement 1 Journalize Kevin’s purchase of the trademark.

Journal Entry: Date Oct. 1

Post Ref.

Accounts Trademark Cash

Dr. 10,000

Cr. 10,000

Requirement 2 Journalize Kevin’s amortization expense for the trademark in 2008. Amortization Expense

"

$500

$

$10,000 20 years 3 months 12 months

"

$500 per year

"

$125 for 3 months

Journal Entry: Date Dec. 31

Accounts Amortization Expense, Trademarks Trademark

Post Ref.

Dr. 125

Cr. 125


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The Power of Practice For more practice using the skills learned in this chapter, visit MyAccountingLab. There you will find algorithmically generated questions that are based on these Demo Docs and your main textbook’s Review and Accounting Practice sections. To go to MyAccountingLab and follow these steps: 1. 2. 3. 4. 5.

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 9, Long-Term Assets: Plant Assets and Intangibles. 6. Click a link to work on the tutorial exercises.

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10

Current Liabilities and Payroll

WHAT YOU PROBABLY ALREADY KNOW You probably already know that as an employee, you do not receive in your paycheck an amount equal to the number of hours worked times your hourly rate. The total that you earn is called gross pay, which is the amount before withholdings are deducted. You probably noticed that money is withheld for federal income tax, social security tax, Medicare tax, and state income tax, if applicable in your state. You did not request that these amounts be deducted; they are required withholdings that your employer must make. Your employer does not keep this money; it is remitted to the appropriate taxing agencies. When you receive your W-2 form by January 31 of the succeeding year, you can see that you are given credit for the amount of these taxes your employer withheld on your behalf. In this chapter, we will see how your employer accounts for your paycheck.

Learning Objectives

1

Account for current liabilities of known amount. Some current liabilities that are recorded at known amounts include accounts payable, short-term notes payable, sales tax payable, current portion of long-term notes payable, accrued expenses or liabilities, and unearned or deferred revenues. Review the “Current Liabilities of Known Amount” section of the textbook, and be sure to take note of the presentation of current liabilities in the balance sheet for Bob’s Sporting Goods on page 524.

2

Account for estimated and contingent liabilities. Sometimes a liability has been incurred but the amount is uncertain. An example of this would be the estimated warranty payable that manufacturers may report as a liability. A contingent liability is only a possible obligation that may occur depending upon future events or circumstances. A lawsuit is an example of a contingent liability. Review Exhibit 10-2 (p. 529) for contingent liability classifications and treatments.

3

Calculate the current ratio and working capital. The current ratio and working capital are two key measures of liquidity. The current ratio indicates the amount of current assets available for each dollar of current liabilities. A higher ratio is usually considered preferable. Working capital = current assets – current liabilities. A larger amount of working capital is usually considered preferable; certainly current assets should exceed current liabilities.

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4

Calculate payroll amounts. The gross pay is the total amount earned by the employee and includes such items as the salary amount, hourly pay rate multiplied by the hours worked, commissions, bonuses, and overtime. Net pay is the amount the employee receives, which is equal to the gross pay less withholdings. Payroll deductions may include income taxes withheld, social security (FICA) tax, insurance premiums, retirement savings, and charitable contributions. Review “Accounting for Payroll” in the main text.

5

Describe the payroll process. A number of documents are involved in a payroll system. Some of these documents include time cards or time sheets, payroll tax forms, W-2 Employee Wage and Tax statements, and the employee earnings record. The employer files a payroll tax form with the state and federal governments. It includes information such as gross wages, income taxes withheld, and Social Security and Medicare taxes. An employee earnings record contains all of the payroll information from gross pay to net pay, by employee. This record is used by the employer to prepare the W-2 forms, Employee Wage and Tax Statements. Both the employee and IRS receive copies of this form for income tax filing.

Review the payroll documents in Exhibits 10-6, 10-9 and 10-10. (pp. 535, 537, and 538). A payroll register contains all of the payroll information for each employee on each pay date. Review the payroll register in Exhibit 10-7 (p. 536).

6

Record basic payroll transactions. To record the periodic payroll, gross pay is debited to Salary Expense. All of the amounts withheld and the net pay due to the employees are credited to current liability accounts. Employers are also liable for payroll taxes. FICA and state and federal unemployment payroll tax expenses are incurred by employers and must be paid. Most employers offer their employees some benefits such as health insurance or retirement benefits. Similar to the gross payroll and payroll taxes, the benefits are additional expenses to the employer. Review the “Payroll Entries” section of the main textbook, particularly the journal entries involved.

7

Report current liabilities on the balance sheet. Review the current liabilities section of the balance sheet at Exhibit 10-11 (p. 542).

332

Chapter 10 | Current Liabilities and Payroll

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Demo Doc 1 General Current Liabilities Learning Objectives

1–3, 7

Freddie Enterprises sells products with one-year warranties included in the selling price. During August 2008, Freddie sold goods for $250,000 cash. These goods cost $180,000 to manufacture. Freddie is required by law to collect 7% sales tax on all sales. Freddie estimates warranty costs to be 1.5% of the selling price. During August 2008, Freddie made $3,000 of repairs under warranty (paid in cash to a repair service). On August 31, 2008, Freddie remitted all sales tax collected in August to the state government.

Requirements 1. Journalize all of Freddie’s transactions in the month of August 2008. 2. Is sales tax payable a contingent liability? Why or why not? 3. Is estimated warranty payable a contingent liability? Why or why not? 4. At August 31, 2008, the only other current liability Freddie had was accounts payable of $1,000. Current assets were $1,900. What is Freddie’s current ratio?


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Demo Doc 1 Solutions Requirement 1 Journalize all of Freddie’s transactions in the month of August 2008. During August 2008, Freddie sold goods for $250,000 cash. These goods cost $180,000 to manufacture. Freddie is required by law to collect 7% sales tax on all sales.

Part 1

1

Account for current liabilities of known amount

Part 2

Demo Doc Complete

Part 3

Freddie sold $250,000 worth of products, which increases Sales Revenue (a credit) by $250,000. However, the cash that Freddie collected was more than $250,000 because it included the sales tax. Freddie collected $250,000 × (1 + 7%) = $267,500 cash from the customer. The $250,000 × 7% = $17,500 Freddie collected in sales tax is not revenue because it was not earned by Freddie and does not belong to Freddie. These taxes belong to the government and are owed/payable by Freddie to the government. Therefore, we increase (a credit) the Sales Tax Payable account by $17,500.

Journal Entry: Date Accounts Cash ($250,000 ! 1.07) Sales Revenue Sales Tax Payable ($250,000 ! 7%)

Post Ref.

Dr. 267,500

Cr. 250,000 17,500

Freddie sold these goods, and so an adjustment to Inventory is necessary as well. COGS increases (a debit) and Inventory decreases (a credit) by $180,000, Freddie’s cost of the products.

Journal Entry: Date Accounts Cost of Goods Sold Inventory

Post Ref.

Dr. 180,000

Cr. 180,000

Freddie estimates warranty costs to be 1.5% of the selling price.

2 334

Account for estimated and contingent liabilities

We must also account for the warranties included in the selling price of the goods. Once the products are sold, the warranty is in effect. The warranty


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means that Freddie has an obligation (that is, a liability) to fix the products if they break down. We must journalize an Estimated Warranty Payable liability (a credit) of: 1.5% ! $250,000 " $3,750

When the liability is journalized, so is the Estimated Warranty Expense (a debit) of $3,750. This journal entry is an example of good matching (as required by the matching principle under GAAP) because the expense is recorded at the same time as the sales revenue, not when the actual cost is incurred.

Journal Entry: Date Accounts Warranty Expense ($250,000 ! 0.015) Estimated Warranty Payable

Post Ref.

Dr. 3,750

Cr. 3,750

During August 2008, Freddie made $3,000 of repairs under warranty (paid in cash to a repair service). When Freddie Enterprises makes warranty repairs, it is meeting its warranty obligation (that is, it is reducing its warranty liability). These repairs decrease Estimated Warranty Payable (a debit) by $3,000. Because the repairs were paid for in cash, the Cash account also decreases (a credit) by $3,000. Notice that the Warranty Expense account is not affected by the repairs. The expense was already journalized at the time of sale. To debit it again now would be double-counting the expense.

Journal Entry: Date Accounts Estimated Warranty Payable Cash

Post Ref.

Dr. 3,000

Cr. 3,000

Note that $3,750 – $3,000 = $750 is left in the Estimated Warranty Payable account. This amount remains to cover any future repairs that might be made under the warranty. On August 31, 2008, Freddie remitted all sales tax collected in August to the state government. In the first transaction, Freddie collected $17,500 in sales tax (7% of the sale of $250,000 worth of products). Sales tax payable is just like any other payable account: As payments are made, both Cash and the payable decrease. Demo Doc 1 Solutions | Chapter 10

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Date Accounts Sales Tax Payable Cash

Dr. 17,500

Cr. 17,500

Requirement 2 Is sales tax payable a contingent liability? Why or why not?

Part 1

7

Report current liabilities on the balance sheet

Part 2

Part 3

Demo Doc Complete

Sales taxes must be collected and remitted to the government by law. Ethical companies have no choice but to meet the sales tax payable obligation. Therefore, this amount will be paid and it is not a contingent liability; it is not dependent upon any outside event.

Requirement 3 Is estimated warranty payable a contingent liability? Why or why not?

Part 1

7


Part 2

Part 3

Demo Doc Complete

The estimated warranty payable is an estimate. It is not known for sure whether the products will break down, or how much it might cost to repair them if they do. For this reason, estimated warranty payable is a contingent liability because it depends upon the performance of the products after they leave Freddie’s control. Because payment for warranty repairs is probable and estimable, warranty expense and estimated warranty payable are recorded in a journal entry, even though they are contingent upon outside events.

Requirement 4

3

Calculate current ratio and working capital

At August 31, 2008, the only other current liability Freddie had was accounts payable of $1,000. Current assets were $1,900. What is Freddie’s current ratio? Current Ratio "

Current Assets Current Liabilities

We know that Freddie’s current assets are $1,900, and current liabilities are the balance of the Estimated Warranty Payable account ($750) and the accounts payable of $1,000. 336


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So Freddie’s current ratio is calculated as follows:

Current Ratio

Part 1

Part 2

"

$1,900 ($750 # $1,000)

"

$1,900 $1,750

"

1.09

Part 3

Demo Doc Complete


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Demo Doc 2 Current Portion of Long-Term Debt Learning Objectives

1, 7

On August 1, 2008, Squirrel Co. signed a $400,000 note payable. Squirrel agreed to pay back $25,000 per month, beginning on January 1, 2009, and ending on April 1, 2010. Interest of 12% is paid monthly beginning January 1, 2009.

Requirement: Show the presentation of this note on Squirrel’s December 31, 2008, balance sheet.

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Demo Doc 2 Solution Requirement Show the presentation of this note on Squirrel’s December 31, 2008, balance sheet.

Demo Doc Complete

Part 1

Of the $400,000 note, payments totaling $25,000 × 12 = $300,000 will be repaid within the next year. This $300,000 is the current portion of the note because it will be repaid within the next year. The remaining $400,000 – $300,000 = $100,000 will be repaid in more than one year, so it is the long-term portion of the note. Interest was incurred on the entire $400,000 liability balance that was outstanding over the five months since August 1, 2008.

1

Account for current liabilities of known amount

7


Interest Interest ! Fraction of Incurred " Total Debt ! Rate Year "

$400,000

"

$20, 000

!

12%

!

5 12

The $20,000 of interest incurred is journalized as Interest Payable. This interest payable is current because it is due in less than one year. Note that this $20,000 is not the total interest due on the note. It is only the amount that has already been incurred at December 31, 2008. Current Liabilities Current portion of note payable Interest payable

$300,000 20,000

Long-Term Liabilities Notes payable (net of current portion)

Part 1

$100,000

Demo Doc Complete


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Demo Doc 3 Payroll Liabilities Learning Objectives

4–6

Gannon Corp. employees earn a total of $500,000 gross pay per week. All employees have the following items withheld from their pay: 15%

Income taxes

8%

FICA taxes

4%

Pension contributions

2%

Union dues

Gannon pays the following payroll taxes: 8%

FICA taxes

6%

Unemployment taxes

Requirements 1. For a normal week, journalize the following transactions: a. Cash payment of employee salaries b. Accrue Gannon’s payroll taxes c. Gannon’s payment of all payroll taxes d. Gannon’s payment of union dues e. Gannon’s payment of pension contributions 2. What is the employees’ net pay in a normal week? 3. What is Gannon’s total payroll expense in a normal week? 4. The employee at Gannon who hires new employees is also the person who processes the payroll. Is this arrangement a practice of good internal control?

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Demo Doc 3 Solutions Requirement 1 For a normal week, journalize the following transactions: a. Cash payment of employee salaries

Part 1

Part 2

Part 3

Demo Doc Complete

Part 4

The entire gross pay of $500,000 is all journalized as Salary Expense (a debit). However, this entire amount is not all paid to the employee in cash.

4 5

Employee Income Tax Payable increases (a credit) by:

6

$500,000 ! 15% " $75,000

Calculate payroll amounts Describe the payroll process Record basic payroll transactions

FICA Tax Payable increases (a credit) by: $500,000 ! 8% " $40,000

Pension Contributions Payable increases (a credit) by: $500,000 ! 4% " $20,000

Union Dues Payable increases (a credit) by: $500,000 ! 2% " $10,000

Cash decreases (a credit) by the pay that is not withheld: $500,000 – $75,000 – $40,000 – $20,000 – $10,000 " $355,000

To summarize: Employee Income Tax Payable FICA Tax Payable Pension Contributions Payable Union Dues Pay yable

500,000 500,000 500,000 500,000

! 15% ! 8% ! 4% ! 2%

" " " "

75,000 40,000 20,000 10,000

Journal Entry: Date

Accounts Salary Expense (gross pay) Employee Income Tax Payable ($500,000 3 15%) FICA Tax Payable ($500,000 3 8%) Pension Contributions Payable ($500,000 3 4%) Union Dues Payable ($500,000 3 2%) Cash (net/take home pay)

Post Ref.

Dr. 500,000

Cr. 75,000 40,000 20,000 10,000 355,000


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The $355,000 cash amount is often referred to as “take home pay” because it is the amount the employees actually receive (that is, take home) on their paychecks. Note that Gannon is not paying these taxes out of its own pocket. It is using money that has been held back from employee paychecks to make these payments. The taxes withheld by Gannon are similar to the treatment of sales taxes payable. Gannon has the cash for them (because Gannon never paid this cash to the employees, but withheld it instead) and will pass it on to the appropriate agencies in the near future just as sales taxes collected are journalized as a payable and passed on to the state government.

4

Calculate payroll amounts

5

Describe the payroll process

6

Record basic payroll transactions

b. Accrue Gannon’s payroll taxes Gannon must journalize Payroll Tax Expense (a debit) for all taxes the company must pay. FICA Tax Payable increases (a credit) by Gannon’s portion of the taxes: $500,000 ! 8% " $40,000

Unemployment Tax Payable increases (a credit) by: $500,000 ! 6% " $30,000 Journal Entry: Date

Accounts Payroll Tax Expense (to balance) FICA Tax Payable ($500,000 3 8%) (matching amount) Unemployment Tax Payable ($500,000 3 6%)

Post Ref.

Dr. 70,000

Cr.

40,000 30,000

Unlike the liabilities journalized in transaction a (that are paid by the employees by being taken out of their paychecks), these amounts are being paid directly by Gannon out of its own pocket.

4 5 6

Calculate payroll amounts Describe the payroll process Record basic payroll transactions

c. Gannon’s payment of all payroll taxes Cash decreases (a credit) by the total of all taxes paid. Employee Income Tax Payable decreases (a debit) by its balance of $75,000. FICA Tax Payable decreases (a debit) by its balance of: $40,000 # $40,000 " $80,000 Unemployment Tax Payable decreases (a debit) by its balance of $30,000. Journal Entry: Date

342

Accounts Employee Income Tax Payable FICA Tax Payable ($40,000 + $40,000 matching amount) Unemployment Tax Payable Cash


Post Ref.

Dr. 75,000 80,000 30,000

Cr.

185,000

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d. Gannon’s payment of union dues Union Dues Payable decreases (a debit) by its balance of $10,000. Cash also decreases (a credit) by $10,000.

6


6


4


4



Date Accounts Union Dues Payable Cash

Dr. 10,000

Cr. 10,000

e. Gannon’s payment of pension contributions Pension Contributions Payable decreases (a debit) by its balance of $20,000. Cash also decreases (a credit) by $20,000.


Date Accounts Pension Contributions Payable Cash

Dr. 20,000

Cr. 20,000

Requirement 2 What is the employees’ net pay in a normal week?

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Employees’ net pay is the amount of cash they receive each week. It is the $355,000 calculated in Requirement 1a.

Requirement 3 What is Gannon’s total payroll expense in a normal week?

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Payroll expense is the total cost of having an employee, which includes the employee’s salary as well as any additional taxes that do not come out of that salary (that is, that are paid out of the employer’s pocket).


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So payroll expense includes salary expense of $500,000 and payroll taxes expense of $70,000. Total Payroll Expense " $500,000 # $70,000 " $570,000

Requirement 4 The employee at Gannon who hires new employees is also the person who processes the payroll. Is this arrangement a practice of good internal control?

Part 1

5

Describe the payroll process

Part 3

Part 4

Demo Doc Complete

This practice is an internal control weakness. It is possible for this person to create fictitious employees and then issue payroll checks to them. This situation creates an opportunity for fraud. The person who is responsible for hiring employees should not be the person who processes payroll.

Part 1

344

Part 2


Part 2

Part 3

Part 4

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. Sales tax payable is shown as a long-term liability on the balance sheet. _____ 2. An accrued expense is an expense that has not yet been paid. _____ 3. A contingent liability is not an actual liability. _____ 4. Optional deductions would include employee income tax, social security tax, union dues, and insurance premiums. _____ 5. State and federal unemployment taxes are two required payroll deductions for employees. _____ 6. The FICA Social Security tax is withheld from employees and is also paid by the employer in the same amount. _____ 7. The document that includes every employee’s gross pay, deductions, and net pay for the payroll period is called the Wage and Tax Statement. _____ 8. Two employees who have the same gross pay may have different amounts withheld for income taxes depending on the number of allowances claimed on the W-4 form. _____ 9. An example of a contingent liability would be when you cosign a note payable for a friend. _____10. If a company has a note payable at December 31 for $300,000, which will be paid in three equal installments every five months, $100,000 should be classified as a current liability.

Multiple Choice 1. Which of the following is true about current liabilities? a. Are due within one year or one operating cycle, whichever is longer b. Must be of a known amount c. Must be of an estimated amount d. Are subtracted from long-term liabilities on the balance sheet 2. Which of the following best describes unearned revenue? a. Revenue that has been earned and collected b. Revenue that has been earned but not yet collected c. Revenue that has been collected but not yet earned d. Revenue that has not been collected nor earned 3. When is Warranty Expense debited? a. In the period the product under warranty is repaired or replaced b. In the period after the product is sold c. In the period after the product is repaired or replaced d. In the period the revenue from selling the product was earned Quick Practice Questions | Chapter 10

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4. When a product is repaired under warranty, the entry includes which of the following? a. A debit to Warranty Expense b. A credit to Warranty Expense c. A debit to Estimated Warranty Payable d. A credit to Estimated Warranty Payable 5. Consider the following account balances for Philip’s Rentals as of December 31, 2008: Cash

$10,300

Prepaid Rent

3,600

Accounts Payable

7,800

Equipment

15,000


2,000

Supplies

1,200

Philip Browning, Capital

9,300

Unearned Revenue

1,600

Philip Browning, Withdrawals

2,200

Notes Payable (due 12/31/2010)

7,500

What is the current ratio for Philip’s Rentals? a. 1.61 b. 1.03 c. 1.29 d. 1.38 6. Which of the following taxes have a ceiling on the amount of annual employee earnings subject to the tax? a. Only the FICA tax b. Only the FICA tax and the federal unemployment tax c. Only the state and federal unemployment taxes d. The FICA tax and the state and federal unemployment taxes 7. Sumiko Greer is paid $26 per hour with time and a half her regular hourly pay rate for all hours exceeding 40 per week. During the week ended January 12, Sumiko worked 45 hours. What is the gross payroll? a. $1,105 b. $1,170 c. $1,235 d. $1,365 8. Travel America has 24 employees who are paid on a monthly basis. For the most recent month, gross earnings were $78,000, of which $27,000 is subject to unemployment taxes (federal at 0.8% and state at 5.4%). Federal income tax withholdings are 20% of total earnings. All employees have $15 per month withheld for charitable contributions. All earnings are subject to 8% FICA tax. What is the total employer’s payroll tax expense? a. $4,216 b. $7,114 c. $7,914 d. $9,656 9. Referring to the information in the preceding question, what is the amount of salaries payable? a. $51,309 b. $54,471 c. $55,800 d. $56,160 346


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10. Under what condition is a contingent liability journalized as an expense and a liability? a. Under no condition b. When the likelihood of an actual loss is remote c. When the likelihood of an actual loss is reasonably possible d. When the likelihood of an actual loss is probable and the amount can be estimated

Quick Exercises 10-1. Federal United purchased equipment costing $88,000 on October 2, 2008, by paying a 30% cash down payment and signing a 9%, 120-day note payable for the balance. Federal United’s year-end is December 31. Journalize the following: a. The purchase of the equipment on October 2, 2008 b. The accrual of interest on December 31, 2008 c. Payment of the note on January 30, 2009


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.




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10-2. Ideal Food Services had cash sales of $787,000 during the month of August 2008 and collected the 7% sales tax on these sales required by the state in which Ideal Food Services operates. a. Journalize the cash sale and the sales tax on August 31. b. Journalize the September 15 transaction when the sales tax is remitted to the proper agency.


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.


10-3. Freedom Vacuums warrants all of its products for one full year against any defect in manufacturing. Sales for 2007 and 2008 were $731,000 and $854,000, respectively. Freedom Vacuums expects warranty claims to run 4.5% of annual sales. Freedom paid $30,150 and $38,290, respectively, in 2007 and 2008 in warranty claims. a. Compute Freedom’s warranty expense for 2007 and 2008.

b. Compute the balance in Estimated Warranty Payable on December 31, 2008, assuming the January 1, 2007, balance in the account was $2,980.

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10-4. Curtis Building Services has one employee, George North, who earns $36 per hour for a 40-hour work week. He earns time and a half for all overtime hours. George has earned $89,200 in wages prior to the current week. From George’s pay, Curtis Building Services deducts 20% for federal income tax, and 8% for FICA taxes (up to $90,000 per year). The company also withholds $100 per week for his health insurance. The federal unemployment tax rate is 0.8% up to $7,000 of employee earnings per year. The state unemployment tax rate is 5.4% up to $7,000 of employee earnings per year. Curtis pays $100 per week for medical insurance premiums for his employee. a. Compute the gross pay and the net pay for George North for the current week ending December 18, 2008. George worked 48 hours. Round all amounts to the nearest dollar. Gross Pay: Net Pay:

b. Journalize the payroll expense on December 18, 2008. c. Journalize the payroll taxes imposed on Curtis Building Services on December 18, 2008.


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.



349

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10-5. Use the data in Quick Exercise 10-4 for the following: a. Journalize the payment of payroll to the employee on December 18, 2008. b. Journalize the payment of the income tax withheld and FICA for the employee and employer on December 18, 2008. c. Journalize the payment of the health insurance premiums withheld on December 31, 2008.


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.



350


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Do It Yourself! Question 1 General Current Liabilities Nitro Brothers sells products with warranties included in the selling price. During October 2008, Nitro sold goods for $10,000 cash. These goods cost $8,000 to manufacture. Nitro is required by law to collect 8% sales tax on all sales. Nitro estimates warranty costs to be 1% of selling price. During October 2008, Nitro made $60 of repairs under warranty (paid in cash to a repair service). On October 31, 2008, Nitro remitted all sales tax collected in October to the state government.

Requirement Journalize all of Nitro’s transactions in the month of October 2008.

1


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

2

Account for current liabilities of known amount Account for estimated and contingent liabilities




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Dr.

Cr.

Post Ref.

Dr.

Cr.


352


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Do It Yourself! Question 2 Current Portion of Long-Term Debt On October 1, 2008, Pulter Industries signed a $2,000 note payable. Pulter agreed to pay back $100 per month, beginning on November 1, 2008 and ending on June 1, 2010. Pulter is also required to pay 10% interest on the note each month.

Requirement Show the presentation of this note on Pulter’s December 31, 2008, balance sheet.

7



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Do It Yourself! Question 3 Payroll Liabilities Oxygen Co. employees earn $200,000 gross pay per week. All employees have the following items withheld from their pay: 20%

Income taxes

8%

FICA taxes

3%

401(k) plan contributions

1%

Union dues

Oxygen pays the following payroll taxes: 8%

FICA taxes

6%

Unemployment taxes

Requirement For a normal week, journalize the following transactions: a. Cash payment of employee salaries

4 6

Calculate payroll amounts Record basic payroll transactions


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

b. Oxygen’s payroll taxes

4


6


354



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c. Oxygen’s payment of all payroll taxes

6


Post Ref.

Dr.


Cr.

d. Oxygen’s payment of union dues Journal Entry: Date Accounts

Post Ref.

Dr.

6


6


Cr.

e. Oxygen’s payment of 401(k) plan contributions Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.


355

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356

F

1. Sales tax payable is shown as a long-term liability on the balance sheet. False–Sales tax payable is shown as a current liability on the balance sheet. (p. 524)

T

2. An accrued expense is an expense that has not yet been paid. (p. 526).

T

3. A contingent liability is not an actual liability. (p. 528)

F

4. Optional deductions would include employee income tax, social security tax, union dues, and insurance premiums. False–Employee income tax and Social Security tax are required deductions. (p. 532)

F

5. State and federal unemployment taxes are two required payroll deductions for employees. False–State and federal unemployment taxes are paid by the employer. (p. 532)

T

6. The FICA Social Security tax is withheld from employees and is also paid by the employer in the same amount. (p. 533)

F

7. The document that includes every employee’s gross pay, deductions, and net pay for the payroll period is called the Wage and Tax Statement. False–The document that includes every employee’s gross pay, deductions, and net pay for the payroll period is called the payroll register. A Wage and Tax Statement is a W-2 Form, which is sent to employees and the IRS for tax filing purposes. (p. 536)

T

8. Two employees who have the same gross pay may have different amounts withheld for income taxes depending on the number of allowances claimed on the W-4 form. (p. 532)

T

9. An example of a contingent liability would be when you cosign a note payable for a friend. (p. 528)

F

10. If a company has a note payable at December 31 for $300,000, which will be paid in three equal installments every five months, $100,000 should be classified as a current liability. False–$200,000 should be classified as a current liability because that amount will be paid within 10 months, less than 1 year. (pp. 541–542)


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Multiple Choice 1. Which of the following is true about current liabilities? (p. 524) a. Are due within one year or one operating cycle, whichever is longer b. Must be of a known amount c. Must be of an estimated amount d. Are subtracted from long-term liabilities on the balance sheet 2. Which of the following best describes unearned revenue? (p. 526) a. Revenue that has been earned and collected b. Revenue that has been earned but not yet collected c. Revenue that has been collected but not yet earned d. Revenue that has not been collected nor earned 3. When is Warranty Expense debited? (p. 527) a. In the period the product under warranty is repaired or replaced b. In the period after the product is sold c. In the period after the product is repaired or replaced d. In the period the revenue from selling the product was earned 4. When a product is repaired under warranty, the entry includes which of the following? (p. 527) a. A debit to Warranty Expense b. A credit to Warranty Expense c. A debit to Estimated Warranty Payable d. A credit to Estimated Warranty Payable 5. Consider the following account balances for Philip’s Rentals as of December 31, 2008: Cash

$10,300

Prepaid Rent

3,600

Accounts Payable

7,800

Equipment

15,000


2,000

Supplies

1,200

Philip Browning, Capital

9,300

Unearned Revenue

1,600

Philip Browning, Withdrawals

2,200

Notes Payable (due 12/31/2010)

7,500

What is the current ratio for Philip’s Rentals? (p. 530) a. 1.61 b. 1.03 c. 1.29 d. 1.38 6. Which of the following taxes have a ceiling on the amount of annual employee earnings subject to the tax? (pp. 533–534) a. Only the FICA tax b. Only the FICA tax and the federal unemployment tax c. Only the state and federal unemployment taxes d. The FICA tax and the state and federal unemployment taxes


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7. Sumiko Greer is paid $26 per hour with time and a half her regular hourly pay rate for all hours exceeding 40 per week. During the week ended January 12, Sumiko worked 45 hours. What is the gross payroll? (p. 531) a. $1,105 b. $1,170 c. $1,235 d. $1,365 8. Travel America has 24 employees who are paid on a monthly basis. For the most recent month, gross earnings were $78,000, of which $27,000 is subject to unemployment taxes (federal at 0.8% and state at 5.4%). Federal income tax withholdings are 20% of total earnings. All employees have $15 per month withheld for charitable contributions. All earnings are subject to 8% FICA tax. What is the total employer’s payroll tax expense? (pp. 532–533) a. $4,216 b. $7,114 c. $7,914 d. $9,656 9. Referring to the information in the preceding question, what is the amount of salaries payable? (pp. 532–533) a. $51,309 b. $54,471 c. $55,800 d. $56,160 10. Under what condition is a contingent liability journalized as an expense and a liability? (pp. 528–529) a. Under no condition b. When the likelihood of an actual loss is remote c. When the likelihood of an actual loss is reasonably possible d. When the likelihood of an actual loss is probable and the amount can be estimated

Quick Exercise 10-1. Federal United purchased equipment costing $88,000 on October 2, 2008, by paying a 30% cash down payment and signing a 9%, 120-day note payable for the balance. Federal United’s year-end is December 31. (pp. 523–524) Journalize the following: a. The purchase of the equipment on October 2, 2008 b. The accrual of interest on December 31, 2008 c. The payment of the note on January 30, 2009 Journal Entry: Date a. Oct. 2

Accounts Equipment Cash Notes Payable To record purchase of equipment.

Post Ref.

Dr. 88,000

Cr. 26,400 61,600

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Journal Entry: Date Accounts b. Dec. Sept.31 15 Interest Sales TaxExpense Payable Interest Cash Payable To accrue interest expense 10/2/08–12/31/08 To record sales tax remittance. ($61,600 3 0.09 3 90/360 = $1,386).

Post Ref.

Dr. 1,386

Cr. 55,090 1,386 55,090

Dr. 61,600 1,386 462

Cr.

Journal Entry: Date c. Jan. 30

Accounts Notes Payable Interest Payable Interest Expense Cash To pay off the note payable plus interest ($61,600 3 0.09 3 30/360 = $462).

Post Ref.

63,448

10-2. Ideal Food Services had cash sales of $787,000 during the month of August 2008 and collected the 7% sales tax on these sales required by the state in which Ideal Food Services operates. (pp. 524–525) a. Journalize the cash sale and the sales tax on August 31. b. Journalize the September 15 transaction when the sales tax is remitted to the proper agency.

Journal Entry: Date Accounts a. Aug. 31 Cash Sales Sales Taxes Payable To record cash sales including 7% sales tax.

Post Ref.

Dr. 842,090

Cr. 787,000 55,090

Journal Entry: Date Accounts b. Sept. 15 Sales Tax Payable Cash To record sales tax remittance.

Post Ref.

Dr. 55,090

Cr. 55,090


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10-3. Freedom Vacuums warrants all of its products for one full year against any defect in manufacturing. Sales for 2007 and 2008 were $731,000 and $854,000, respectively. Freedom Vacuums expects warranty claims to run 4.5% of annual sales. Freedom paid $30,150 and $38,290, respectively, in 2007 and 2008 in warranty claims. (pp. 527–528) a. Compute Freedom’s warranty expense for 2007 and 2008. For 2007: $731,000 × 0.045 = $32,895 For 2008: $854,000 × 0.045 = $38,430 b. Compute the balance in Estimated Warranty Payable on December 31, 2008, assuming the January 1, 2007, balance in the account was $2,980. $5,865 = ($2,980 + $32,895 + $38,430 – $30,150 – $38,290) 10-4. Curtis Building Services has one employee, George North, who earns $36 per hour for a 40-hour work week. He earns time and a half for all overtime hours. George has earned $89,200 in wages prior to the current week. From George’s pay, Curtis Building Services deducts 20% for federal income tax, and 8% for FICA taxes (up to $90,000 per year). The company also withholds $100 per week for his health insurance. The federal unemployment tax rate is 0.8% up to $7,000 of employee earnings per year. The state unemployment tax rate is 5.4% up to $7,000 of employee earnings per year. Curtis pays $100 per week for medical insurance premiums his employee. (pp. 531–534) a. Compute the gross pay and the net pay for George North for the current week ending December 18, 2008. George worked 48 hours. Round all amounts to the nearest dollar. Gross Pay: (40 × $36) + (8 × $36 × 1.5) = $1,440 + $432 = $1,872 Net Pay: FICA tax withheld = ($800 × 0.08) = $64 Federal tax withheld = ($1,872 × 0.20) = $374 Health insurance withheld = $100 Total deductions = $64 + $374 + $100 = $538 Net pay = $1,872 – $538 = $1,334 b. Journalize the payroll expense on December 18, 2008. c. Journalize the payroll taxes imposed on Curtis Building Services on December 18, 2008.

Journal Entry: Date Accounts b. Dec. 18 Salary Expense FICA Tax Payable Employee Income Tax Payable Health Insurance Payable Salary Payable To record payroll expense.* *Note: Maximum unemployment taxes have been incurred.

360


Post Ref.

Dr. 1,872

Cr. 64 374 100 1,334

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Journal Entry: Date c. Dec. 18

Accounts Payroll Tax Expense FICA Tax Payable To record payroll tax expense. ($90,000 – $89,200) 3 0.08 = $64

Post Ref.

Dr.

Cr. 64 64

10-5. Use the data in Quick Exercise 10-4 for the following: (pp. 539–541) a. Journalize the payment of payroll to the employee on December 18, 2008. b. Journalize the payment of the income tax withheld and FICA for the employee and employer on December 18, 2008. c. Journalize the payment of the health insurance premiums withheld on December 31, 2008.

Journal Entry: Accounts Date a. Dec. 18 Salary Payable Cash To record payroll paid to employees.

Post Ref.

Dr. 1,334

Cr. 1,334


Accounts Employee Income Tax Payable FICA Tax Payable Cash To record remittance of income tax and FICA taxes.

Post Ref.

Dr. 374 128

Cr.

502

Journal Entry: Date c. Dec. 31

Accounts Health Insurance Payable Cash To record payment of health insurance premium.

Post Ref.

Dr. 100

Cr. 100


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Do It Yourself! Question 1 Solutions Requirement Journalize all of Nitro’s transactions in the month of October 2008. During October 2008, Nitro sold goods for $10,000 cash. These goods cost $8,000 to manufacture. Nitro is required by law to collect 8% sales tax on all sales.

Journal Entry: Date

Accounts Cash ($10,000 ! 1.08) Sales Revenue Sales Tax Payable ($10,000 ! 8%)

Post Ref.

Dr. 10,800

Cr. 10,000 800

Journal Entry: Date

Accounts Cost of Goods Sold Inventory

Post Ref.

Dr. 8,000

Cr. 8,000

Nitro estimates warranty costs to be 1% of the selling price.

Journal Entry: Date

Accounts Warranty Expense ($10,000 ! 0.01) Estimated Warranty Payable

Post Ref.

Dr. 100

Cr. 100

During October 2008, Nitro made $60 of repairs under warranty (paid in cash to a repair service).

Journal Entry: Date

362

Accounts Warranty Payable Cash


Post Ref.

Dr.

Cr. 60 60

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On October 31, 2008, Nitro remitted all sales tax collected in October to the state government.

Journal Entry: Date Accounts Oct. 31 Sales Tax Payable ($10,000 3 8%) Cash

Post Ref.

Dr. 800

Cr. 800


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Do It Yourself! Question 2 Solutions Requirement Show the presentation of this note on Pulter’s December 31, 2008, balance sheet. Payments Already Made " $100 ! 2 " $200 $2,000 – $200 " $1,800 Remaining To Be Repaid 12 ! $100 " $1,200 " Current Portion $1,800 – $1,200 " $600 " Long-Term Portion

Interest payable only relates to the month of December (because November’s interest expense was paid on December 1). Interest Payable " $1,800 ! 10% ! 1/12 " $15

Current Liabilities Current portion of note payable Interest payable

$1,200 15

Long-Term Liabilities Notes payable (net of current portion)

364


$ 600

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Do It Yourself! Question 3 Solutions Requirement For a normal week, journalize the following transactions: a. Cash payment of employee salaries Journal Entry: Date

Post Ref.

Accounts Salary Expense (gross pay) Employee Income Tax Payable ($200,000 3 20%) FICA Tax Payable ($200,000 3 8%) Pension Contributions Payable ($200,000 3 3%) Union Dues Payable ($200,000 3 1%) Cash (net/take home pay)

Dr.

Cr. 200,000 40,000 16,000 6,000 2,000 136,000

b. Oxygen’s payroll taxes Journal Entry: Date

Post Ref.

Accounts Payroll Tax Expense (to balance) FICA Tax Payable ($200,000 3 8%) (matching amount) Unemployment Tax Payable ($200,000 3 6%)

Dr. 28,000

Cr.

16,000 12,000

c. Oxygen’s payment of all payroll taxes Journal Entry: Date

Accounts Employee Income Tax Payable FICA Tax Payable ($16,000 + $16,000 matching amount) Federal Unemployment Tax Payable Cash

Post Ref.

Dr. 40,000 32,000 12,000

Cr.

84,000

d. Oxygen’s payment of union dues Journal Entry: Date

Accounts Union Dues Payable Cash

Post Ref.

Dr. 2,000

Cr. 2,000


365

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e. Oxygen’s payment of 401(k) plan contributions Journal Entry: Date

366

Accounts Pension Contributions Payable Cash


Post Ref.

Dr. 6,000

Cr. 6,000

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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 10, Current Liabilities and Payroll. Click a link to work on the tutorial exercises.


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11

Corporations and Stockholders’ Equity

WHAT YOU PROBABLY ALREADY KNOW You probably already know that you can purchase shares of a company’s stock as an investment. CNBC shows the trading price of various stocks as they take place, and the daily prices are reported in your financial newspapers. Much of the trading taking place is between investors rather than from the issuing corporation. One way that a corporation issues its shares of stock is in an initial public offering (IPO). A recent popular IPO is Google. Google was doing business for six years before its founders took the company public in August 2004. The IPO provided investors an opportunity to purchase Google stock at a stated offer price of $85 a share. The market price of the stock rose quickly in trading and a year and a half after the IPO, the stock traded at more than $300 per share. The cash received from the sale of the Google stock and the shareholders’ equity interest was recorded on the books of Google Corporation. In this chapter, we will see how to account for the equity transactions of a corporation.

Learning Objectives

1

Compare the three forms of business organization. As we know from Chapter 1, the three forms of business organization are a proprietorship, a partnership, or a corporation. Even though the three forms share some similarities, each has its own set of characteristics in terms of organizational structure, ability to raise capital, owner involvement in management, and other key areas. Review Exhibit 11-1 (p. 571) carefully for a comparison of the three forms of organizations.

2

Describe stockholders’ equity and classes of stock. The two main segments of stockholders’ equity are paid-in capital (amounts received from stockholders) and retained earnings (earned from profitable operations). Retained Earnings, which usually carries a credit balance, holds the accumulated earnings or losses of the business, and it is from this account where distributions of earnings (dividends) are taken, thereby reducing the size of the company. Remember, retained earnings are the cumulative profits earned and kept by the business. The main categories of paid-in capital—the two basic classes of stock—are preferred stock and common stock. Common stock, the main source of paidin capital, is issued by every corporation. In a corporation, the common stockholders are the owners of the business and have all of the four basic rights of stockholders. Owners of preferred stock also have the four basic

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rights, but some rights, such as the right to vote, are sometimes withheld. Preferred stock dividends, while paid before common stock dividends, are also usually fixed. Just like common stock, dividends must be declared by the board of directors for the entity to be legally liable. Preferred stockholders also have the advantage of receiving assets before the common stockholders if the corporation should ever liquidate. Review the “Stockholders’ Equity” and “Classes of Stock” sections of the main text, as well as Exhibit 11-5 (p. 581) to see how the distribution of dividends between common and preferred shareholders works.

3

Record the issuance of stock. When a company incorporates, the par or stated value, if any, will be indicated in the articles of incorporation. The par or stated value is usually a nominal amount assigned to a share of stock that represents the minimum legal stated capital. It does not indicate the value or worth of the stock. When the stock is sold by the corporation, the Common Stock account is credited for the par or stated value. Usually, the stock is sold above par, which is considered a premium. The excess of the stock sales price over the par or stated value is the amount credited to the equity account, Paid-In Capital in Excess of Part. Review the accounting for stock issuances under “Issuing Stock” in the main text.

4

Account for cash dividends. If the board of directors declares dividends, Retained Earnings is decreased (a debit) and Dividends Payable is increased (a credit). On the date of payment, the liability is decreased (a debit) and Cash is also decreased (a credit). The date of record, which falls between the dates of declaration and payment, merely identifies the stockholders who are entitled to receive the dividend. No journal entry needs to be made on that date. Read “Accounting for Cash Dividends” in the main text to review the significance and accounting of each of the dividend dates. Review “Dividends on Cumulative and Noncumulative Preferred Stock” to learn about the effect these characteristics have on dividend payments.

5

Account for stock dividends and stock splits. The board of directors may declare a stock dividend instead of a cash dividend. A stock dividend gives each shareholder more shares of stock based upon the number of shares currently owned. A stock split increases the number of shares issued and outstanding and reduces the par or stated value proportionately. A 3-for-1 split means that each shareholder receives 2 more shares for each 1 currently held, and the par or stated value is 1/3 of the amount before the split. No journal entry is required for a stock split because the change has no impact on the financial position of the company. A stock dividend increases (credits) the Common Stock and Paid-In Capital in Excess of Par accounts for the additional shares issued. The dividend, a return of equity to the shareholders, also decreases (debits) Retained Earnings. Review the section “Comparison of Cash Dividends, Stock Dividends, and Stock Splits” in the main text, including Exhibit 11-6 (p. 585), which overviews the effects of each of these events on stockholders’ equity.

370

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Account for treasury stock. Treasury stock is when the company buys back its own shares from existing shareholders. The cost of the shares is debited to a contraequity account, Treasury Stock. If the treasury stock is subsequently sold, Cash is debited, Treasury Stock is credited for the cost of the shares, and Paid-In Capital from Treasury Stock Transactions is debited or credited for the difference, if any. Review the impact of treasury stock on stockholders’ equity in Exhibit 11-7 (p. 587).

7

Report stockholders’ equity. Remember that different accountants report stockholders’ equity in different ways. Because it is important for you to be able to read the financial statements of real companies, carefully review Exhibit 11-8 (p. 589) and consider the important points about the real-world format noted in the main text. Also review Exhibit 11-9 (p. 590) to understand the format of a statement of stockholders’ equity.

Corporations and Stockholders’ Equity | Chapter 11

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Demo Doc 1 Common Stock Learning Objectives

1–3, 7

Jack, Inc. had the following information at December 31, 2008: Stockholders’ Equity Common stock, 1,600,000 authorized, 350,000 issued and outstanding shares Paid-in capital in excess of par Retained earnings Total stockholders’ equity

$ 437,500 787,500 4,200,000 $5,425,000

Requirements 1. What are Jack’s two main sources of corporate capital? 2. What is the par value per share of the common stock? 3. On average, what was the original per-share issue price of the common stock? 4. On February 12, 2009, Jack issued another 20,000 common shares for $5 cash per share. Journalize this transaction. 5. Jack earned net income of $150,000 and paid no dividends in 2009. No other equity transactions took place in 2009. Prepare the stockholders’ equity section of Jack’s balance sheet on December 31, 2009.

372


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Demo Doc 1 Solutions Requirement 1 What are Jack’s two main sources of corporate capital?

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Corporate capital is another term for the shareholders’ equity. Jack has paid-in capital. This money has been received from the stockholders. Jack also has retained earnings, which represents profits earned on the stockholders’ behalf (and not yet distributed as dividends). Every corporation has these two sources of capital.

1

Compare the three forms of business organization

2

Describe stockholders’ equity and classes of stock

2


Requirement 2 What is the par value per share of the common stock?

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Common Stock and Preferred Stock accounts hold only the par value of the issued shares. So the $437,500 in the Common Stock account represents the par value of all the issued shares. Par Value ! per Share

Common Stock Balance Number of Issued Common Shares

Par Value per Sharre

$437,500 350,000 shares

!

! $1.25 per share

Requirement 3 On average, what was the original per-share issue price of the common stock?

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

When stock is issued for cash, the Cash account increases (a debit) for cash received. The Common Stock account increases (a credit) for the par value, and Paid-In Capital in Excess of Par increases (a credit) for the difference. Because the selling price per share is almost always more than the par value, this excess balancing amount to Paid-In Capital in Excess of Par is usually an increase (a credit).


373

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We know that total debits must equal total credits for any transaction. In this case, the debit is the cash received and the credits are the increases to Common Stock and Paid-In Capital in Excess of Par: Cash Received from Share ! Common Stock $ Paid-in Capital in Excess of Par Issuance

So the total cash received from issuance of the common shares: $437,500 $ $787,500 ! $1,225,000

This amount represents all 350,000 issued shares. $1,225,000/350,000 shares ! $3.50 average cash received per share $3.50 received # $1.25 par ! $2.25 additional cash paid per share $2.25 " 350,000 shares ! $787,500 total additional cash paid

This amount is the balancing credit to Paid-In Capital in Excess of Par.

Requirement 4 On February 12, 2009, Jack issued another 20,000 common shares for $5 cash per share. Journalize this transaction.

Part 1

3

Record the issuance of stock

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Cash increases (a debit) by: $5 " 20,000 ! $100,000

Common Stock increases (a credit) by the par value of the new shares: $1.25 " 20,000 ! $25,000

Paid-In Capital in Excess of Par is the excess cash paid: $100,000 # $25,000 ! $75,000

The balancing amount appears in the journal entry. Journal Entry: Date Feb. 12

374

Accounts Cash (20,000 ! $5) Common Stock (20,000 ! $1.25) Paid-in Capital in Excess of Par (to balance)


Post Ref.

Dr. 100,000

Cr. 25,000 75,000

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Requirement 5 Jack earned net income of $150,000 and paid no dividends in 2009. No other equity transactions took place in 2009. Prepare the stockholders’ equity section of Jack’s balance sheet on December 31, 2009.

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Because of the stock issuance in Requirement 4, the number of outstanding common shares increased:

7

Report stockholders’ equity

350,000 shares $ 20,000 shares ! 370,000 shares

This change must be shown for Common Stock as part of its descriptive line on the balance sheet. The dollar amount in the Common Stock account increased to: $437,500 $ $25,000 ! $462,500

The other impact of this transaction on stockholders’ equity was an increase in Paid-In Capital in Excess of Par: $787,500 $ $75,000 ! $862,500

The net income earned by Jack increases retained earnings: $4,200,000 $ $150,000 ! $4,350,000

These new amounts create a new total stockholders’ equity of $5,675,000. Stockholders’ Equity Common Stock, 1,600,000 authorized, 370,000 issued and outstanding shares

$ 462,500

Paid-in capital in excess of par

862,500

Retained earnings

4,350,000

Total stockholders’ equity

Part 1

Part 2

Part 3

$5,675,000

Part 4

Part 5

Demo Doc Complete


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Demo Doc 2 Preferred Stock Learning Objectives

2–4

Jill Co. issued 25,000 6%, $100 par cumulative preferred shares on January 1, 2008, for $120 cash per share. Jill had never issued preferred shares before this date. Jill paid the following cash dividends (in total, to all shares): 2008

$120,000

2009

$160,000

2010

$200,000

Requirements 1. Journalize the issuance of the preferred shares on January 1, 2008, and the payment of the preferred share dividends in 2008. (Assume the dividends were declared and paid on the same day.) 2. How much in dividends is Jill supposed to pay to the preferred shareholders each year? 3. Did Jill pay all of the required dividends in each year? If not, what happens to the amount not paid? How much in dividends did the preferred and common shareholders receive each year?

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Demo Doc 2 Solutions Requirement 1 Journalize the issuance of the preferred shares on January 1, 2008, and the payment of the preferred share dividends in 2008. (Assume the dividends were declared and paid on the same day.)

Part 1

Part 2

Demo Doc Complete

Part 3

The issuance of preferred shares is the same as the issuance of common shares, except for the account title. Cash increases (a debit) by: $120 " 25,000 ! $3,000,000

Preferred Stock increases (a credit) by the par value of the new shares:

2


3


4

Account for cash dividends

$100 " 25,000 ! $2,500,000

Paid-In Capital in Excess of Par equals the excess cash paid: $3,000,000 – $2,500,000 ! $500,000

This balancing amount appears in the journal entry.

Journal Entry: Date Accounts Jan. 1 Cash (25,000 ! $120) Preferred Stock (25,000 ! $100) Paid-in Capital in Excess of Par (to balance)

Post Ref.

Dr. 3,000,000

Cr. 2,500,000 500,000

When dividends are paid, Retained Earnings decreases because the shareholders are removing some of their capital from the company. So Retained Earnings decreases (a debit) by $120,000. Cash also decreases (a credit) by $120,000.

Journal Entry: Date

Accounts Retained Earnings Cash

Post Ref.

Dr. 120,000

Cr. 120,000


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Requirement 2 How much in dividends is Jill supposed to pay to the preferred shareholders each year?

Part 1

4


Part 2

Part 3

Demo Doc Complete

Each year, every preferred share is supposed to receive: “Required” Preferred Par Value Dividend ! " Share Dividends Per Share Percentage

First, we should calculate the “required” annual dividends per share. In this case, it is: $100 " 6% ! $6 per share

Because 25,000 preferred shares are outstanding, this annual amount works out to $6 × 25,000 = $150,000 in dividends per year for all preferred shares.

Requirement 3 Did Jill pay all of the required dividends in each year? If not, what happens to the amount not paid? How much in dividends did the preferred and common shareholders receive each year?

Part 1

2 4

Describe stockholders’ equity and classes of stock Account for cash dividends

Part 2

Part 3

Demo Doc Complete

2008 For 2008, $120,000 is less than the “required” $150,000, so we know that Jill did not pay all of the required dividends. The preferred shares only received: $120,000/25,000 shares ! $4.80 per share

The difference of $150,000 " $120,000 = $30,000 is dividends in arrears. This amount is not recorded in a transaction because it has not yet been declared and therefore is not a liability. Dividends in arrears do not appear on the balance sheet. However, they are disclosed in a note to the financial statements. Because the full $150,000 was not paid, the entire $120,000 goes to the preferred shareholders as dividends. The common shareholders get no dividends in 2008. 2009 For 2009, Jill must not only pay the $150,000 annual “requirement,” but first must also “catch up” on the dividends in arrears of $30,000 from 2008. So in order to completely fulfill its obligation to the preferred shares, Jill must pay $30,000 + $150,000 = $180,000 in dividends to the preferred shares. We see that $160,000 is less than the $180,000, so we know that Jill did not pay all of the required dividends in 2009. The difference of $180,000 " $160,000 = $20,000 is dividends in arrears. Because the full $180,000 was not paid, the entire $160,000 goes to the preferred shareholders as dividends. The common shareholders get no dividends in 2009. 378


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2010 In 2010, Jill is supposed to pay the annual $150,000 of dividends plus the $20,000 dividends in arrears from 2009, for a total of $170,000. The $200,000 paid is greater than $170,000, so we know that Jill did pay all of the required dividends in 2010. The $170,000 goes to the preferred shareholders, while the rest ($200,000 " $170,000 = $30,000) goes to the common shareholders.

Part 1

Part 2

Part 3

Demo Doc Complete


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Demo Doc 3 Stock Splits and Dividends Learning Objectives

2, 4, 5, 7

On December 31, 2008, Tinker Corp. had 25,000 $1.20 par common shares outstanding with a market price of $9 per share. Retained Earnings had a balance of $60,000, but Paid-In Capital in Excess of Par contained no balance.

Requirements 1. On January 1, 2009, Tinker split its common stock 3-for-1. Give the journal entry for the split. What are the par and market values per share after the split? How does this split affect stockholders’ equity? 2. On February 1, 2009, Tinker issued a 20% stock dividend. Give the journal entry for this dividend. What is the par value per share after the dividend? How does this dividend affect stockholders’ equity? 3. On March 1, 2009, Tinker declared and paid a cash dividend of $0.60 per common share. Journalize this dividend. How does this dividend affect stockholders’ equity?

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Demo Doc 3 Solutions Requirement 1 On January 1, 2009,Tinker split its common stock 3-for-1. Give the journal entry for the split. What are the par and market values per share after the split? How does this split affect stockholders’ equity?

Part 1

Part 2

Demo Doc Complete

Part 3

Before the split, Tinker has 25,000 issued common shares. A 3-for-1 split creates 3 new shares for every 1 old share.

5

Account for stock dividends and stock splits

Number of Shares After Number of Shares Before ! " Split Ratio Stock Split Stock Split Number of Shares After ! Stock Split !

25,000

3/1

"

75,000 Shares

Another result of the split is that the par value and the market price are also split. Par Value Per Share after Split

!

Par Value Per Share Before Split

"

1 Split Ratio

Par Value Per Share after Split

!

$1.20

"

1 3

!

$0.40 per share

1 Market Price Per Share Market Price Per Share ! " Before Split after Split Split Ratio Market Price Per Share ! after Split

$9

"

1 3

The new shares from the split would increase common stock by: 75,000 shares × $0.40 par per share ! $30,000

No change occurred in the account balance of Common Stock. It remains the same, only it is now spread across more shares (resulting in a lower par value per share, as shown in the preceding calculations). A stock split is like getting change for a $1 bill—you still have $1, it’s just not in one piece anymore. The net impact on common stock is zero. Essentially, this means that no journal entry is required for a stock split. However, a stock split is described in the notes to the financial statements. Because no journal entry is required, total equity is not affected by the stock split.


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Requirement 2 On February 1, 2009,Tinker issued a 20% stock dividend. Give the journal entry for this dividend. What is the par value per share after the dividend? How does this dividend affect stockholders’ equity?

Part 1

2


5


7


Part 2

Demo Doc Complete

Part 3

This is a small stock dividend because the dividend percentage (20%) is less than 25%. Remember that after the stock split of January 1, Tinker has 75,000 common shares outstanding with a market price of $3 per share and a par value of $0.40 per share. With a stock dividend, new shares are issued to existing shareholders. Number of New Shares Issued Shares Outstanding Stock ! " for Stock Dividen nd Before Dividend Dividend % Number of New Shares Issued ! for Sttock Dividend !

75,000

"

20%

15,000 New Shares

Each of these new shares is identical to the shares that existed before the stock dividend. They have the same characteristics as the common shares that existed before the stock dividend. The par value of the new shares issued is $0.40 per share, as it is for the other common shares. So Common Stock increases (a credit) by: 15,000 new shares " $0.40 par ! $6,000

With any dividend, Retained Earnings decreases (a debit) because the shareholders receive some of their value/equity back from the company. In the case of a small stock dividend, this value is the market value of the new shares issued. So in this case, Retained Earnings decreases (a debit) by: 15,000 new shares " $3 market price per share ! $45,000

The difference between these two amounts is balanced to Paid-In Capital in Excess of Par—in this case, an increase (a credit) of: $45,000 # $6,000 ! $39,000

Journal Entry: Date Accounts Feb. 1 Retained Earnings (15,000 ! $3) Common Stock (15,000 ! $0.40) Paid-in Capital in Excess of Par (to balance)

Post Ref.

Dr. 45,000

Cr. 6,000 39,000

All these accounts are part of the equity section. Therefore, equal debit (decrease) and credit (increase) effects occur in the equity section. We simply shift value from Retained Earnings to Paid-In Capital. 382


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Total equity does not change as a result of this transaction.

Common Stock Paid-In Capital in Excess of Par Retained Earnings Total Equity

Before Stock Dividend

After Stock Dividend

$30,000

$36,000

0

39,000

60,000

15,000

$90,000

(same)

$90,000

Requirement 3 On March 1, 2009, Tinker declared and paid a cash dividend of $0.60 per common share. Give the journal entry for this dividend. How does this dividend affect stockholders’ equity? Part 1

Part 2

Demo Doc Complete

Part 3

Cash decreases (a credit) by the amount of dividends paid. After the stock dividend of February 1, a total of 75,000 + 15,000 = 90,000 shares are outstanding. Therefore, the cash paid is: 90,000 shares " $0.60 per share ! $54,000

4


7


With any dividend, Retained Earnings decreases (a debit). In this case, it is a decrease of the cash paid of $54,000.


Date Accounts Mar. 1 Retained Earnings Cash ($90,000 ! $0.60)

Part 1

Part 2

Dr. 54,000

Cr. 54,000

Part 3

Demo Doc Complete


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Demo Doc 4 Treasury Stock Learning Objective

6

On January 1, 2008, Unter, Inc. purchased 4,000 shares of treasury stock for $10 each. At this time, Paid-In Capital, Treasury Stock had a balance of $0. Unter sold the treasury stock as follows: April 1, 2008

Sold 1,000 shares for $12.00 cash each.

July 1, 2008


October 1, 2008 Sold 500 shares for $8.25 cash each.

Requirements 1. Journalize all of Unter’s treasury stock transactions. 2. Suppose instead of holding onto the common stock purchased as treasury stock, Unter retired the stock on January 2, 2008. Would it be possible for Unter to later reissue the stock?

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Demo Doc 4 Solutions Requirement 1 Journalize all of Unter’s treasury stock transactions. January 1, 2008 Purchased 4,000 shares of treasury stock for $10 cash each. At this time, Paid-In Capital from Treasury Stock transactions had a balance of $0.

Part 1

Demo Doc Complete

Part 2

The Common Stock account represents all issued common shares. When the company purchases treasury stock, these shares are still issued but are no longer outstanding. To represent this decrease in the number of outstanding shares, the Treasury Stock account has a debit balance. It is a contra-equity account. When treasury stock is purchased, the Treasury Stock account increases (a debit) by the cost of the treasury shares:

6

Account for treasury stock

4,000 × $10 share ! $40,000

Cash decreases (a credit) by $40,000. Journal Entry: Date Accounts Jan. 1 Treasury Stock (4,000 ! $10) Cash

Post Ref.

Dr. 40,000

Cr. 40,000

April 1, 2008 Sold 1,000 shares for $12 cash each. Cash increases (a debit) by: 1,000 shares × $12 ! $12,000

Treasury Stock decreases (a credit) by the original cost of the treasury shares: 1,000 shares × $10 ! $10,000

The difference between these two amounts is a balancing amount to Paid-In Capital from Treasury Stock Transactions of ($12,000 " $10,000) = $2,000 credit (increase). Journal Entry: Date Accounts Apr. 1 Cash (1,000 ! $12) Treasury Stock (1,000 ! $10 cost) Paid-In Capital from Treasury Stock Transaction (to balance)

Post Ref.

Dr. 12,000

Cr. 10,000 2,000 Demo Doc 4 Solutions | Chapter 11

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July 1, 2008


Cash increases (a debit) by: 2,500 shares " $9.50 ! $23,750

Treasury Stock decreases (a credit) by the original cost of the treasury shares: 2,500 shares " $10 ! $25,000

The difference between these two amounts is a balancing debit (decrease) to Paid-In Capital from Treasury Stock Transactions: $25,000 # $23,750 ! $1,250

Note that we cannot have a debit/negative balance in Paid-In Capital from Treasury Stock Transactions. However, from the entry on April 1, we know that the account holds a balance of $2,000. This balance is more than enough to cover a $1,250 debit. Journal Entry: Post Ref.

Date Accounts July 1 Cash (2,500 ! $9.50) Paid-In Capital from Treasury Stock Transaction (to balance) Treasury Stock (2,500 ! $10 cost)

Dr. 23,750

Cr.

1,250 25,000

After this transaction, Paid-In Capital from Treasury Stock Transactions has a balance of $750 credit: Paid-In-Capital from Treasury Stock Transactions Bal. Apr. 1 July 1

0 2,000

Treasury Stock Jan. 1

40,000 Apr. 1 Mar. 1

1,250 Bal.

October 1, 2008

750

Bal.

10,000 25,000

5,000

Sold 500 shares for $8.25 cash each.

Cash increases (a debit) by: 500 shares " $8.25 ! $4,125

Treasury Stock decreases (a credit) by the original cost of the treasury shares: 500 shares " $10 ! $5,000

The difference between these two amounts would normally be a balancing amount to Paid-In Capital from Treasury Stock Transactions, but in this case, the difference is a decrease (a debit) of: $5,000 # $4,125 ! $875

Only $750 remains in the Paid-In Capital from Treasury Stock Transactions account. This amount is not enough to cover the debit that would normally be required. 386


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Instead, we take as much as possible from the Paid-In Capital from Treasury Stock Transactions account. We debit the $750 left in the account. The remaining $875 " $750 = $ 125 is balanced with a decrease (a debit) to Retained Earnings.

Journal Entry: Date Accounts Oct. 1 Cash (500 ! $8.25) Paid-In Capital from Treasury Stock Transactions Retained Earnings (to balance) Treasury Stock (500 ! $10 cost)

Post Ref.

Dr. 4,125

Cr.

750 125 5,000

Requirement 2 Suppose instead of holding onto the common stock purchased as treasury stock, Unter retired the stock on January 2, 2008.Would it be possible for Unter to later reissue the stock?

Part 1

Part 2

Demo Doc Complete

When stock is retired, the stock certificates are canceled and the stock ceases to exist. Retired/canceled stock can no longer be reissued.

Part 1

Part 2

6


Demo Doc Complete


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Quick Practice Questions True/False _____ 1. Stockholders in a corporation are personally liable for the debts of the corporation. _____ 2. Stock dividends increase total stockholders’ equity. _____ 3. Par value is an arbitrary amount assigned by a company to a share of its stock. _____ 4. A credit balance in Retained Earnings is referred to as a deficit. _____ 5. When a corporation sells par value stock at an amount greater than par value, other income is reported on the income statement. _____ 6. Dividends become a liability of the corporation on the payment date. _____ 7. The owners of cumulative preferred stock must receive all dividends in arrears plus the current year’s dividends before the common stockholders get a dividend. _____ 8. A stock split reduces the number of outstanding shares and the par value of the stock. _____ 9. When treasury stock is purchased, the balance in the Common Stock account remains unchanged. _____10. Stock dividends may cause the price of the stock to increase.

Multiple Choice 1. What is the document that is used by a state to grant permission to form a corporation called? a. Charter b. Proxy c. Stock certificate d. Bylaw agreement 2. What is the ownership percentage used as a cutoff point for distinguishing between a small and a large stock dividend? a. 15% b. 10% c. 25% d. 50% 3. Which of the following best describes paid-in capital? a. Investments by the stockholders of a corporation b. Investments by the creditors of a corporation c. Capital that the corporation has earned through profitable operations d. All of the above 388


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4. Which of the following best describes retained earnings? a. It is classified as a liability on the corporate balance sheet b. It does not appear on any financial statement c. It represents capital that the corporation has earned through profitable operations d. It represents investments by the stockholders of a corporation 5. What individual(s) has the authority to obligate the corporation to pay dividends? a. The stockholders b. The board of directors c. The president of the company d. The chief executive officer 6. What entry is made to record a 2-for-1 stock split? a. Credit to Common Stock b. Credit to Retained Earnings c. Debit to Retained Earnings d. No journal entry is made for a stock split 7. Which of the following would be recorded for the issuance of 55,000 shares of no-par common stock at $13.50 per share? a. Credit to Paid-In Capital in Excess of No-Par Value—Common for $742,500 b. Credit to Common Stock for $742,500 c. Credit to Cash for $742,500 d. Debit to Paid-In Capital in Excess of No-Par Value—Common for $742,500 8. Which of the following is true for dividends? a. Dividends are a distribution of cash to the stockholders b. Dividends decrease both the assets and the total stockholders’ equity of the corporation c. Dividends increase retained earnings d. Both (a) and (b) are correct 9. Dividends on cumulative preferred stock of $2,500 are in arrears for 2008. During 2009, the total dividends declared amount to $10,000. The corporation has 6,000 shares of $10 par, 10% cumulative preferred stock outstanding and 10,000 shares of $5 par common stock outstanding. What is the total amount of dividends payable to each class of stock in 2009? a. $5,000 to preferred, $5,000 to common b. $6,000 to preferred, $4,000 to common c. $8,500 to preferred, $1,500 to common d. $10,000 to preferred, $0 to common 10. What effect does the purchase of treasury stock have on the number of a corporation’s shares? a. Issued shares exceed authorized shares b. Outstanding shares exceed issued shares c. Outstanding shares exceed authorized shares d. Outstanding shares are less than issued shares


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Quick Exercises 11-1. Journalize the following transactions. a. Firm Body Corporation sells 12,000 shares of $10 par common stock for $13.00 per share. b. Firm Body Corporation sells 5,000 shares of $50 par, 10%, cumulative preferred stock for $59 per share. c. Received a building with a market value of $115,000, and issued 6,400 shares of $10 par common stock in exchange. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.



11-2. The following is a list of stockholders’ equity accounts appearing on the balance sheet for O’Neil Corporation on December 31, 2008: Common stock, $10 par value Paid-in capital in excess of par—common Retained earnings Preferred stock, $50 par value Paid-in capital in excess of par—preferred

$300,000 200,000 225,000 125,000 30,000

Determine the following: a. How many shares of preferred stock have been issued? b. What was the average issuance price of the preferred stock per share?

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c. How many shares of common stock have been issued? d. What is total paid-in capital? e. What is total stockholders’ equity? 11-3. Papelbon Corporation reports the following transactions for 2009: Jan. 10 Sold 6,000 shares of 9%, noncumulative $50 par, preferred stock for $85 per share. Feb. 19 Sold 3,000 shares of $10 par common stock for $15 per share. Oct. 12 The board announced a 15% stock dividend on the common stock. The current market price of the common stock is $22 per share. Papelbon Corporation has 120,000 shares of common stock outstanding on October 12.

Requirement Journalize these transactions. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.




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11-4. Following is the stockholders’ equity section of the balance sheet for Watson Corporation as of December 1, 2009: Preferred stock, $100 par, 6% cumulative, 10,000 shares authorized, 7,500 shares issued Common stock, $10 par, 200,000 shares issued, 130,000 shares issued Paid-in capital in excess of par—common Total paid-in capital Retained earnings Total stockholders’ equity

$ 750,000 1,300,000 520,000 $2,570,000 450,000 $3,020,000

Watson Corporation reports the following transactions for December 2009: Dec. 5 Declared the required cash dividend on the preferred stock and a $0.40 dividend on the common stock. 20 Paid the dividends declared on December 5.

Requirements 1. Journalize these transactions. Journal Entry: Date Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.


392


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2. What is the total stockholders’ equity after posting the preceding entries? 11-5. Victory Corporation reported the following stockholders’ equity items on December 31, 2008: Preferred stock, 5%, cumulative $100 par, 7,000 shares authorized, 1,000 shares issued Paid-in-capital in excess of par—preferred Common stock, $50 par, 10,000 shares authorized, 5,000 shares issued Paid-in-capital in excess of par—common Retained earnings Treasury common stock, at cost, 700 shares

$100,000 55,000 250,000 235,000 455,300 96,000

Requirements 1. Compute the: a. Number of shares of common stock outstanding b. Number of shares of preferred stock outstanding c. Average issue price of common stock d. Average issue price of preferred stock 2. Assume that Victory Corporation declares a 4-for-1 stock split. Compute the: a. Number of shares of common outstanding b. Par value


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Do It Yourself! Question 1 Common Stock Dinner Co. had the following information at December 31, 2008: Stockholders’ Equity Common stock, 500,000 authorized, 50,000 issued and outstanding shares

$100,000

Additional paid-in capital

$50,000

Retained earnings

$400,000


$550,000

Requirements

2


3


3


1. What is the par value per share of the common stock? 2. On average, what was the original per-share issue price of the common stock? 3. On January 9, 2009, Dinner issued another 10,000 common shares for $4 cash per share. Journalize this transaction.


394


Post Ref.

Dr.

Cr.

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Do It Yourself! Question 2 Preferred Stock Lunch Corp. issued 5,000 8%, $20 par cumulative preferred shares on January 1, 2008 for $25 cash per share. Lunch had never had preferred shares before this date. On December 31, 2008, Lunch paid $5,000 in cash dividends to its shareholders. On December 31, 2009, Lunch paid $15,000 in cash dividends to its shareholders.

Requirements 1. Journalize the issuance of the preferred shares on January 1, 2008.

3


4


4


4



Post Ref.

Dr.

Cr.

2. How much in dividends is Lunch supposed to pay to the preferred shareholders each year? 3. How much of the $5,000 paid as dividends in 2008 went to the preferred and common shareholders? 4. How much of the $15,000 paid as dividends in 2009 went to the preferred and common shareholders?


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Do It Yourself! Question 3 Stock Splits and Dividends On December 31, 2008, Garbage, Inc., had 12,000 common shares outstanding with a market price of $8 per share and a par value of $2 per share.

Requirements

5


1. On January 1, 2009, Garbage issued a 15% stock dividend. Journalize this dividend. Journal Entry: Date Accounts

5


Post Ref.

Dr.

Cr.

2. On January 2, 2009, Garbage split its common stock 2-for-1. Journalize the split. What are the par and market values per share after the split?


4


Post Ref.

Dr.

Cr.

3. On January 3, 2009, Garbage declared and paid a cash dividend of $0.30 per common share. Journalize this dividend.


396


Post Ref.

Dr.

Cr.

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Do It Yourself! Question 4 Treasury Stock On January 1, 2008, Hartnick Co. purchased 1,000 shares of treasury stock for $7 cash each. At this time, Paid-In Capital from Treasury Stock Transactions had a balance of $0. Hartnick sold the treasury stock as follows: February 1, 2008

Sold 200 shares for $10 cash each.

March 1, 2008

Sold 500 shares for $6 cash each.

April 1, 2008

Sold 300 shares for $6.50 cash each.

Requirement Journalize all of Hartnick’s treasury stock transactions.

6


Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.





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398

F

1. Stockholders in a corporation are personally liable for the debts of the corporation. False–Stockholders are not personally liable for the debts of the corporation. (p. 571)

F

2. Stock dividends increase total stockholders’ equity. False–Stock dividends have no effect on total stockholders’ equity. (p. 584)

T

3. Par value is an arbitrary amount assigned by a company to a share of its stock. (p. 575)

F

4. A credit balance in Retained Earnings is referred to as a deficit. False–A debit balance in Retained Earnings is referred to as a deficit. (p. 573)

F

5. When a corporation sells par value stock at an amount greater than par value, other income is reported on the income statement. False–When a corporation sells par value stock at an amount greater than par value, paid-in capital in excess of par value is journalized for the difference. This entry has no effect on the income statement from a company’s stock transactions. (pp. 576–577)

F

6. Dividends become a liability of the corporation on the payment date. False–Dividends become a liability of the corporation on the declaration date. (p. 579)

T

7. The owners of cumulative preferred stock must receive all dividends in arrears plus the current year’s dividends before the common stockholders get a dividend. (p. 581)

F

8. A stock split reduces the number of outstanding shares and the par value of the stock. False–A stock split increases the number of outstanding shares of stock and reduces the par value of the stock. (p. 585)

T

9. When treasury stock is purchased, the balance in the Common Stock account remains unchanged. (pp. 585–586)

F

10. Stock dividends may cause the price of the stock to increase. False–Stock dividends may cause the price of the stock to decrease because of the increased supply of the stock. (p. 583)


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Multiple Choice 1. What is the document that is used by a state to grant permission to form a corporation called? (p. 572) a. Charter b. Proxy c. Stock certificate d. Bylaw agreement 2. What is the ownership percentage used as a cutoff point for distinguishing between a small and a large stock dividend? (p. 583) a. 15% b. 10% c. 25% d. 50% 3. Which of the following best describes paid-in capital? (p. 573) a. Investments by the stockholders of a corporation b. Investments by the creditors of a corporation c. Capital that the corporation has earned through profitable operations d. All of the above 4. Which of the following best describes retained earnings? (p. 573) a. It is classified as a liability on the corporate balance sheet b. It does not appear on any financial statement c. It represents capital that the corporation has earned through profitable operations d. It represents investments by the stockholders of a corporation 5. What individual(s) has the authority to obligate the corporation to pay dividends? (p. 579) a. The stockholders b. The board of directors c. The president of the company d. The chief executive officer 6. What entry is made to record a 2-for-1 stock split? (p. 584) a. Credit to Common Stock b. Credit to Retained Earnings c. Debit to Retained Earnings d. No journal entry is made for a stock split 7. Which of the following would be recorded for the issuance of 55,000 shares of no-par common stock at $13.50 per share? (p. 576) a. Credit to Paid-In Capital in Excess of No-Par Value—Common for $742,500 b. Credit to Common Stock for $742,500 c. Credit to Cash for $742,500 d. Debit Paid-In Capital in Excess of No-Par Value—Common for $742,500


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8. Which of the following is true for dividends? (p. 573) a. Dividends are a distribution of cash to the stockholders b. Dividends decrease both the assets and the total stockholders’ equity of the corporation c. Dividends increase retained earnings d. Both (a) and (b) are correct 9. Dividends on cumulative preferred stock of $2,500 are in arrears for 2008. During 2009, the total dividends declared amount to $10,000. The company has 6,000 shares of $10 par, 10% cumulative preferred stock outstanding and 10,000 shares of $5 par common stock outstanding. What is the total amount of dividends payable to each class of stock in 2009? (p. 581) a. $5,000 to preferred, $5,000 to common b. $6,000 to preferred, $4,000 to common c. $8,500 to preferred, $1,500 to common d. $10,000 to preferred, $0 to common 10. What effect does the purchase of treasury stock have on the number of a corporation’s shares? (pp. 585–586) a. Issued shares exceed authorized shares b. Outstanding shares exceed issued shares c. Outstanding shares exceed authorized shares d. Outstanding shares are less than issued shares

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Quick Exercise 11-1. Journalize the following transactions. (pp. 576–578) a. Firm Body Corporation sells 12,000 shares of $10 par common stock for $13.00 per share. b. Firm Body Corporation sells 5,000 shares of $50 par, 10%, cumulative preferred stock for $59 per share. c. Received a building with a market value of $115,000, and issued 6,400 shares of $10 par common stock in exchange.


Post Accounts Ref. Cash Common Stock Paid-In Capital in Excess of Par—Common

Dr. 156,000

Cr. 120,000 36,000


Accounts Cash Preferred Stock Paid-In Capital in Excess of Par—Preferred

Post Ref.

Dr. 295,000

Cr. 250,000 45,000


Post Accounts Ref. Building Common Stock Paid-In Capital in Excess of Par—Common

Dr. 115,000

Cr. 64,000 51,000

11-2. The following is a list of stockholders’ equity accounts appearing on the balance sheet for O’Neil Corporation on December 31, 2008: Common stock, $10 par value

$300,000

Paid-in capital in excess of par—common

200,000

Retained earnings

225,000

Preferred stock, $50 par value

125,000

Paid-in capital in excess of par—preferred

30,000


401

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Determine the following: (p. 578) a. How many shares of preferred stock have been issued? $125,000/$50 = 2,500 b. What was the average issuance price of the preferred stock per share? ($125,000 + $30,000)/2,500 = $62 c. How many shares of common stock have been issued? $300,000/$10 = 30,000 d. What is total paid-in capital? $300,000 + $200,000 + $125,000 + $30,000 = $655,000 e. What is total stockholders’ equity? $655,000 + $225,000 = $880,000 11-3. Papelbon Corporation reports the following transactions for 2009: (pp. 579–583) Jan. 10 Sold 6,000 shares of 9%, noncumulative $50 par, preferred stock for $85 per share. Feb. 19 Sold 3,000 shares of $10 par common stock for $15 per share. Oct. 12 The board announced a 15% stock dividend on the common stock. The current market price of the common stock is $22 per share. Papelbon Corporation has 120,000 shares of common stock outstanding on October 12.

Requirement Journalize these transactions. Journal Entry: Post Date Accounts Ref. Jan. 10 Cash Common Stock Paid-In Capital in Excess of Par—Common

Dr. 510,000

Cr. 300,000 210,000

Journal Entry: Post Date Accounts Ref. Feb. 19 Cash Preferred Stock Paid-In Capital in Excess of Par—Preferred

Dr. 45,000

Cr. 30,000 15,000

Journal Entry: Date Accounts Oct. 12 Retained Earnings Common Stock Paid-In Capital in Excess of Par–Common

Post Ref.

Dr. 396,000

Cr. 180,000 216,000

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11-4. Following is the stockholders’ equity section of the balance sheet for Watson Corporation as of December 1, 2009: Preferred stock, $100 par, 6% cumulative, 10,000 shares authorized, 7,500 shares issued Common stock, $10 par, 200,000 shares authorized, 130,000 shares issued

$ 750,000

1,300,000

Paid-in capital in excess of par—common

520,000

Total paid-in capital

$2,570,000

Retained earnings

450,000


$3,020,000

Watson Corporation reports the following transactions for December 2009: (pp. 578–581) Dec. 5 20

Declared the required cash dividend on the preferred stock and a $0.40 dividend on the common stock. Paid the dividends declared on December 5.

Requirement 1 Journalize these transactions. Journal Entry: Date Dec. 5

Accounts Retained Earnings Dividends Payable

Post Ref.

Dr. 97,000

Cr. 97,000

Journal Entry: Date Accounts Dec. 20 Dividends Payable Cash

Post Ref.

Dr. 97,000

Cr. 97,000

Requirement 2 What is the total stockholders’ equity after posting the preceding entries? $2,923,000 ($3,020,000 – $97,000)


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11-5. Victory Corporation reported the following stockholders’ equity items on December 31, 2008: (pp. 576–586) Preferred stock, 5%, cumulative $100 par, 7,000 shares authorized, 1,000 shares issued Paid-in-capital in excess of par—preferred

$100,000 55,000

Common stock, $50 par, 10,000 shares authorized, 5,000 shares issued

250,000

Paid-in-capital in excess of par—common

235,000

Retained earnings

455,300

Treasury common stock, at cost, 700 shares

96,000

Requirement 1 Compute the: a. Number of shares of common stock outstanding $250,000/$50 = 5,000 ! 700 = 4,300 b. Number of shares of preferred stock outstanding $100,000/$100 = 1,000 c. Average issue price of common stock $250,000 + 235,000 = 485,000/5,000 = $97 d. Average issue price of preferred stock $100,000 + $55,000 = $155,000/1,000 = $155

Requirement 2 Assume that Victory Corporation declares a 4-for-1 stock split. Compute the: a. Number of shares of common outstanding 4,300 shares × 4 = 17,200 b. Par value $50/4 = $12.50

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Do It Yourself! Question 1 Solutions Requirement 1 What is the par value per share of common stock? $100,000 Par Value " Per Share 50,000 Shares " $2 Per Share

Requirement 2 On average, what was the original per-share issue price of the common stock? Total cash received from issuance of the common shares (par + additional paid-in capital): $100,000 ! $50,000 " $150,000 50,000 Shares

$150,000

" $3 Cash Received Per Share

Requirement 3 On January 9, 2009, Dinner issued another 10,000 common shares for $4 cash per share. Journalize this transaction. Journal Entry: Date Jan. 9

Post Accounts Ref. Cash (10,000 " $4) Common Stock (10,000 " $2) Paid-in Capital in Excess of Par (to balance)

Dr. 40,000

Cr. 20,000 20,000


405

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Do It Yourself! Question 2 Solutions Requirement 1 Journalize the issuance of the preferred shares on January 1, 2008.

Journal Entry: Date Jan. 1

Post Accounts Ref. Cash (5,000 " $25) Common Stock (5,000 " $20) Paid-in Capital in Excess of Par (to balance)

Dr. 125,000

Cr. 100,000 25,000

Requirement 2 How much in dividends is Lunch supposed to pay to the preferred shareholders each year? Preferred shareholders are supposed to receive: $20 par # 8% " $1.60 per share annually $1.60 # 5,000 " $8,000 in dividends per year for all outstanding preferred shares

Requirement 3 How much of the $5,000 paid as dividends in 2008 went to the preferred and common shareholders? The full $8,000 was not paid, therefore, the entire $5,000 goes to the preferred shareholders. Common shareholders get nothing. $8,000 $ $5,000 " $3,000 dividends in arrears

Requirement 4 How much of the $15,000 paid as dividends in 2009 went to the preferred and common shareholders? Preferred shareholders received: $8,000 ! $3,000 " $11,000

Common shareholders received: $15,000 $ $11,000 " $4,000

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Do It Yourself! Question 3 Solutions Requirement 1 On January 1, 2009, Garbage issued a 15% stock dividend. Journalize this dividend. Number of new shares issued for stock dividend: 12,000 # 15% " 1,800 new shares Journal Entry: Date Jan. 1

Post Accounts Ref. Retained Earnings (1,800 " $8) Common Stock (1,800 " $2) Paid-in Capital in Excess of Par (to balance)

Dr. 14,400

Cr. 3,600 10,800

Requirement 2 On January 2, 2009, Garbage split its common stock 2-for-1. Journalize the split. What are the par and market values per share after the split? Common shares before split: 12,000 ! 1,800 " 13,800

Number of shares after stock split: 13,800 # 2/1 " 27,600 shares

Par value per share after split: $2 # 1/2 " $1

Market price per share after split: $8 # 1/2 " $4

No journal entry is needed for a stock split.

Requirement 3 On January 3, 2009, Garbage declared and paid a cash dividend of $0.30 per common share. Journalize this dividend. Journal Entry: Date Jan. 1

Accounts Retained Earnings Cash (27,600 3 $0.30)

Post Ref.

Dr. 8,280

Cr. 8,280


407

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Do It Yourself! Question 4 Solutions Requirement Journalize all of Hartnick’s treasury stock transactions. January 1, 2008 Hartnick Co. purchased 1,000 shares of treasury stock for $7 cash each. At this time, Paid-In Capital from Treasury Stock Transactions had a balance of $0.


Date Accounts Jan. 1 Treasury Stock (1,000 " $7) Cash

Dr. 7,000

Cr. 7,000

February 1, 2008 Sold 200 shares for $10 cash each.

Journal Entry: Date Accounts Feb. 1 Cash (200 " $10) Paid-In Capital from Treasury Stock Transaction (to balance) Treasury Stock (200 3 $7 cost)

Post Ref.

Dr. 2,000

Cr.

600 1,400

March 1, 2008 Sold 500 shares for $6 cash each.


Date Accounts Mar. 1 Cash (500 " $6) Paid-In Capital from Treasury Stock Transactions Treasury Stock (500 3 $7 cost)

Dr. 3,000

Cr.

500 3,500

After this transaction: Paid-In-Capital from Treasury Stock Transactions Bal. Feb. 1 Mar. 1

Jan. 1

7,000 Feb. 1 Mar. 1

500 Bal.

408

0 1,600

Treasury Stock


100

Bal.

2,100

1,000 3,000

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April 1, 2008 Sold 300 shares for $6.50 cash each. Journal Entry: Date Accounts Apr. 1 Cash (300 ! $6.50) Paid-In Capital from Treasury Stock Transactions Retained Earnings (to balance) Treasury Stock (300 3 $7 cost)

Post Ref.

Dr. 1,950

Cr.

100 50 2,100


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Direct your URL to www.myaccountinglab.com. Log in using your name and password Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 11, Corporations and Stockholders’ Equity. 6. Click a link to work on the tutorial exercises.

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12

Long-Term Liabilities

WHAT YOU PROBABLY ALREADY KNOW You probably already know that when you purchase a home, you will likely need to obtain a mortgage. You can choose from various types of mortgages, but a popular form is the fixed-rate mortgage. If you obtain a 30-year fixed-rate mortgage, you know that you are locked into the interest rate specified in the mortgage contract for 30 years. Mortgage interest rates may increase or decrease in subsequent years, but it won’t affect your fixed monthly payment. If the interest rate decrease is material enough, you may choose to refinance the mortgage to save future interest costs. Refinancing means that the old mortgage is paid off with a new mortgage loan. The characteristics of a bond are similar to a mortgage. The issuer of a bond incurs a long-term liability and is committed to pay interest at the fixed interest rate included in the bond agreement. Sometimes an issuer will refinance its debt if the interest rate decreases by issuing new bonds at the lower interest rate and paying off the higher-rate bonds. In this chapter, we learn about bonds and mortgages and how to account for them.

Learning Objectives

1

Describe mortgages and leases, and record mortgage and lease transactions. A mortgage is a long-term loan taken out for the purchase of land, buildings, or both. The loan is secured by the asset mortgaged as collateral. When a mortgage loan is issued, the asset account is debited and the Mortgage Note Payable (a liability) is credited. Payments, which are the same for each period, consist of principal and interest; however, the portion allocated to principal increases with time and the interest expense portion decreases. The Interest Expense and Mortgage Note Payable accounts are debited for their respective amounts and Cash is credited for the periodic payment amount. With a lease, the lessee agrees to pay to use an asset owned by the lessor. Typical lease payments are recorded with a debit to Rent Expense and a credit to Cash. Some leases contain characteristics similar to an asset purchase rather than a usual rental. In these cases, it is considered a capital lease and is accounted for like an asset purchase that is financed; the asset account is debited and Lease Payable is credited for the total lease commitment. Review the amortization schedule in Exhibit 12-1 (p. 627) and the entry to record the mortgage payment.

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Describe bonds payable. A bond is a long-term liability that may be issued by corporations; local, state, or federal governments; and agencies. The principal amount (par value) is the amount to be paid to the investor on the maturity date. This amount is recorded in the Bonds Payable account. Over the life of the bond, interest will be paid at the stated (fixed) interest rate. Bond market prices are quoted as a percentage of the principal amount. If the market price of the bond is less than 100 (100% of par value), the bond will be sold for less than the principal amount. The difference between the principal amount and the amount received in this case is considered a Discount on Bonds Payable. A discount may occur because the market or effective rate is higher than the stated interest rate. The discount compensates the investor for the interest rate differential by providing an additional return to the investor. If the market price of the bond is greater than 100, the bond will be sold for more than the principal amount (a premium). A premium may occur because the market or effective rate is lower than the stated interest rate. The premium reduces the return to the investor and the interest expense incurred by the issuer from the stated to the market rate. Review bond financing compared to stock in Exhibit 12-2 (p. 630). Review the relationship between the stated and market rates of interest and the bond market price in Exhibit 12-5 (p. 634).

3

Account for bond issuance and bond interest. When bonds are issued, the Cash account is debited for the cash received and the Bonds Payable account is credited for the principal amount. When bonds are issued at maturity value, a market price of 100, the Cash and Bonds Payable amounts are the same. If a bond is issued at a price of less than 100, the Discount on Bonds Payable (a contra-liability) is debited, in addition to the Cash account, for the difference between the cash received and the bond principal amount. If a bond is issued at a price of more than 100, the Premium on Bonds Payable (a liability) is credited, in addition to the Bonds Payable account, for the difference between the cash received and the bond principal amount. The issuer will pay the investors the same amount of bond interest, whether the bonds are issued at maturity value, a discount, or premium. Recall that: Interest ! Principal " Stated Rate of Interest " Time When bonds are issued at maturity value, the stated rate of interest equals the market rate of interest and therefore the interest expense is equal to the amount of interest paid. When the bonds are issued at a discount, the discount amount is the additional interest expense that must be recorded over the life of the bonds to record the higher market rate of interest incurred. The Discount on Bonds Payable amount is amortized evenly over the life of the bond using the straight-line method. When the bonds are issued at a premium, the premium amount is the reduction of interest expense that must be recorded over the life of the bonds to record the lower market rate of interest incurred. The Premium on Bonds Payable amount is amortized evenly over the life of the bond using the straight-line method. Review “Issuing Bonds Payable

412

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and Paying Interest” in the main text for bond issuance and interest expense journal entries.

4

Account for bond repayment. When bonds are repaid, the Bonds Payable liability is reduced (debited) and Cash is reduced (credited) for the maturity value. This entry is the reverse of the entry that journalized the issuance of bonds at maturity value. Bonds may be retired before the maturity date. When a company retires the bonds, it is relieved of the net bond liability. This net amount, called the carrying amount, is equal to the Bonds Payable less Discount on Bonds Payable or plus Premium on Bonds Payable amounts. The company must pay the market price to redeem the bonds. Similar to the disposal of a plant asset in Chapter 9, a gain or loss may result and needs to be journalized. If the amount received (elimination of bond carrying amount) is greater than the amount given up (call or market price), then a Gain on Retirement of Bonds Payable must be credited for the difference. If the amount received (elimination of bond carrying amount) is less than the amount given up (call or market price), then a Loss on Retirement of Bonds Payable must be debited for the difference. Review the example and journal entries in the “Retirement of Bonds” section of the main text.

5

Report long-term liabilities on the balance sheet. Mortgages, capital leases, and bonds payable may appear as long-term liabilities on the balance sheet. Recall that the Premium on Bonds Payable is a liability account and would be shown with the Bonds Payable account as a long-term liability. The Discount on Bonds Payable is a contra-liability account and would be shown as a deduction from the Bonds Payable account. The portion of these liabilities that are due within one year may be classified as current liabilities. Interest payable on the liabilities is also included as a current liability. Review the illustration under “Reporting Liabilities on the Balance Sheet” in the main text.

Long-Term Liabilities | Chapter 12

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Demo Doc 1 Bonds Payable (Straight-Line Amortization) Learning Objectives 3–5 Blue Co. issued $50,000 maturity value of bonds payable for $51,788 cash on January 1, 2008. The bonds had a stated rate of 12%, but the market rate was 10%. Interest is paid semiannually, and the bonds are due in two years. Blue uses the straight-line method of amortization.

Requirements 1. Are these bonds issued at a discount or premium? How do you know? 2. Journalize Blue’s issuance of the bonds on January 1, 2008. 3. Journalize Blue’s first two interest payments on June 30, 2008, and December 31, 2008. 4. Show how the bonds would appear on Blue’s December 31, 2008, balance sheet. 5. On January 2, 2009, 30% of the bonds were converted to 10,000 common shares, $1 par. Journalize this transaction. 6. On January 3, 2009, Blue purchased the remaining bonds from the marketplace for $36,000 cash. The bonds were immediately retired. Journalize this transaction.

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Demo Doc 1 Solutions Requirement 1 Are these bonds issued at a discount or premium? How do you know?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

These bonds were issued at a premium. We know it was a premium because the cash received for the bonds is more than the maturity value and because the stated rate is greater than the market rate.

Requirement 2 Journalize Blue’s issuance of the bonds on January 1, 2008.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

Cash increases (a debit) by $51,788. Bonds Payable increases (a credit) by the bonds’ maturity value of $50,000. The difference between these two amounts is balanced to Premium on Bonds Payable. The balancing amount is a credit of:

3

Account for bond issuance and bond interest

$51,788 # $50,000 ! $1,788

Journal Entry: Date Jan. 1, 2008

Post Ref.

Accounts Cash Premium on Bonds Payable (to balance) Bonds Payable (principal amount)

Dr. 51,788

Cr. 1,788 50,000

Requirement 3 Journalize Blue’s first two interest payments on June 30, 2008, and December 31, 2008.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

Under straight-line amortization, the premium will be amortized by the same amount every interest period. Premium Amortization Each Interest Period !

Discount or Premium Number of Interest Periodss

3



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The bonds are due in two years and have two interest payments per year. This results in 2 × 2 = 4 interest payment periods. 1, 788 $1 4 ! $447

Premium Amortization Each Interest Period !

Every time interest expense is recorded, the premium will be amortized (that is, decreased/debited) by $447. Cash will decrease by the cash interest paid. Cash Interest Paid !

Maturity Value " Stated Rate Number of Interest Payments per Year

The question states that the bonds are semiannual: that is, they pay interest twice per year. $50,000 " 12% 2 ! $3, 000

Cash Interest Paid !

Interest Expense increases (a debit) by the balancing amount of: $3,000 – $447 ! $2,553

Because the cash interest paid and the premium amortization do not change from period to period, the entry to record the interest expense and payment is always the same. So the entry for June 30, 2008, and December 31, 2008, is:

Journal Entry: Date

Post Ref.

Accounts Interest Expense (to balance) Premium on Bonds Payable ($1,788/4) Cash ($50,000 ! 12%/2)

Dr. 2,553 447

Cr.

3,000

Requirement 4 Show how the bonds would appear on Blue’s December 31, 2008, balance sheet.

Part 1

5

Report long-term liabilities on the balance sheet

Part 2

Part 3

Part 4

Part 6

Demo Doc Complete

The bonds are reported in the liabilities section of the balance sheet. The premium is added to the bonds payable to create a net value. Long-Term Liabilities: Bonds Payable Plus: Premium on Bonds Payable *$1,788

416

Part 5


$50,000 894*

- $447 (June amortization) - $447 (December amortization)

$50,894

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Requirement 5

4

On January 2, 2009, 30% of the bonds were converted to 10,000 common shares with $1 par per share. Journalize this transaction.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Account for bond repayment

Demo Doc Complete

Immediately before this transaction, the Premium account had a balance of $894: Premium on Bonds Payable Bal. Jan. 1 June 30 Dec. 31

0 1,788

447 447 Bal.

894

If 30% of the bonds are converted, then 30% of the maturity value is converted: 30% ! $50,000 " $15,000

Also, 30% of the premium is converted: 30% ! $894 " $268

Note that these values are rounded to the nearest dollar. The bonds will not exist after the conversion, so the Bonds Payable account decreases (a debit) by $15,000. The Premium also decreases (a debit) by $268. New common stock is issued for the conversion, so Common Stock increases (a credit) by the par value of the new shares: 10,000 ! $1 " $10,000

The remainder is balanced to Paid-In Capital in Excess of Par. This balancing amount is: $15,000 # $268 $ $10,000 " $5,268


Premium on Bonds Payable Bal. Jan. 1 June 30 Dec. 31 Jan. 2

Post Ref.

Accounts Bonds Payable ($50,000 ! 30%) Premium on Bonds Payable ($894 ! 30%) Common Stock (10,000 ! $1) Paid-In Capital in Excess of Par (to balance)

Jan 2

Bal.

Cr.

10,000 5,268

Bonds Payable

0 1,788

447 447 268

Dr. 15,000 268

Bal. Jan. 1

0 50,000

Bal.

35,000

15,000

626 Demo Doc 1 Solutions | Chapter 12

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Requirement 6 On January 3, 2009, Blue purchased the remaining bonds from the marketplace for $36,000 cash.The bonds were immediately retired. Journalize this transaction.

Part 1

4

Part 2

Part 3

Part 4

Part 5

Part 6

Demo Doc Complete

Because 30% of the bonds were converted to common stock, 100% – 30% = 70% remain. These bonds will be retired. If 70% of the bonds are retired, then 70% of the maturity value is retired:


70% " $50,000 ! $35,000

70% of the premium is also retired: 70% " $894 ! $626

The bonds will not exist after retirement, so the Bonds Payable account decreases (a debit) by $35,000. The premium also decreases (a debit) by $626. Cash decreases (a credit) by $36,000. The remainder is balanced to a gain or loss. In this case, the balancing amount is a debit, which means a loss of: $36,000 – $626 – $35,000 ! $374


Part 1

418

Post Ref.

Accounts Bonds Payable ($50,000 ! 70%) Loss of Retirement of Bonds Payable (to balance) Premium on Bonds Payable ($894 ! 70%) Cash


Part 2

Part 3

Dr. 35,000 374 626

Cr.

36,000

Part 4

Part 5

Part 6

Demo Doc Complete

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Demo Doc 2 Bonds Payable (Effective-Interest Amortization) Learning Objectives

1–3, 5

Red Co. issued $2,000 maturity (face) value of bonds payable for $1,930 cash on January 1, 2008. The bonds had a stated rate of 8%, but the market rate was 10%. Interest is paid semiannually, and the bonds are due in two years. Red uses the effective-interest method of amortization.

Requirements 1. Are these bonds issued at a discount or premium? How do you know? 2. Journalize Red’s issuance of the bonds on January 1, 2008. 3. Prepare Red’s effective-interest amortization table for the entire life of the bonds payable. 4. Journalize Red’s first two interest payments on June 30, 2008, and December 31, 2008. 5. On January 2, 2009, 20% of the bonds were converted to 120 common shares with a $2 par value per share. Journalize this transaction. 6. On January 3, 2009, Red purchased the remaining bonds from the marketplace for $1,800 cash.The bonds were immediately retired. Journalize this transaction. 7. How do interest payments on bonds differ from mortgages?


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Demo Doc 2 Solutions Requirement 1 Are these bonds issued at a discount or premium? How do you know?

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Part 9

Part 10

Part 11

Demo Doc Complete

These bonds were issued at a discount. We know because the cash received for the bonds is less than the maturity value and because the stated rate is less than the market rate.

Requirement 2 Journalize Red’s issuance of the bonds on January 1, 2008.

Part 1

3


Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Part 8

Part 9

Part 10

Part 11

Demo Doc Complete

Cash increases (a debit) by $1,930. Bonds Payable increases (a credit) by the bonds’ maturity or face value of $2,000. The difference between these two amounts is balanced to the Discount on Bonds Payable. The balancing amount is a debit of: $2,000 – $1,930 ! $70


Post Ref.

Accounts Cash Discount on Bonds Payable (to balance) Bonds Payable (principal amount)

Dr. 1,930 70

Cr.

2,000

Requirement 3 Prepare Red’s effective-interest amortization table for the entire life of the bonds payable.

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Demo Doc Complete

Interest Payment The cash interest payment is the same every interest period and is calculated the same as under the straight-line method of amortization: Cash Interest Paid !

420

Part 6


Maturity Value " Stated Rate Number of Interest Payments per Year

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The question states that the bonds are semiannual: that is, they pay interest twice per year. $2, 000 " 8% 2 ! $80

Cash Interest Paid !

So every line in the Interest Payment column will show $80. Interest Expense

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Demo Doc Complete

Under the effective-interest method, the interest expense is calculated as: Interest Expense !

Carrying Value " Market Rate Number of Interest Payments per Year

The carrying value changes every time interest expense is recorded and the discount is amortized, which means the interest expense changes as well. The interest expense is calculated as: June 30, 2008

$1,930 × 10%/2 ! $96

Dec. 31, 2008

$1,946 × 10%/2 ! $97

June 30, 2009

$1,963 × 10%/2 ! $98

Dec. 31, 2009

$1,981 × 10%/2 ! $99

Discount Amortization

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Demo Doc Complete

Under the effective-interest method, the discount (or premium) is the balancing amount. It is the difference between the cash interest payment and the interest expense. The discount amortization is calculated as: June 30, 2008

$96 – $80 ! $16

Dec. 31, 2008

$97 – $80 ! $17

June 30, 2009

$98 – $80 ! $18

Dec. 31, 2009

$99 – $80 ! $19

Discount Balance

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Demo Doc Complete

The discount balance is the balance from the Discount on Bonds Payable T-account. By putting the discount amortization into the account, we can calculate the balance after each interest transaction. Demo Doc 2 Solutions | Chapter 12

421

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Discount on Bonds Payable 1/1/08

70

Bal.

6/30/08

16

12/31/08

17

6/30/09

18

12/31/09

19

54

Bal.

37

Bal.

19

Bal.

0

Bond Carrying Value

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Demo Doc Complete

The carrying value is the maturity value of the bonds minus the discount (or plus the premium). The bonds’ carrying value is calculated as the maturity value less the discount. After each interest period, this amount is: Jan. 1, 2008

$2,000 – $70 ! $1,930

June 30, 2008

$2,000 – $54 ! $1,946

Dec. 31, 2008

$2,000 – $37 ! $1,963

June 30, 2009

$2,000 – $19 ! $1,981

Dec. 31, 2009

$2,000 – $ 0 ! $2,000

Combining all this information into the amortization table, we get:

Date

Interest Payment

Interest Expense

Discount Amortization

Jan. 1, 2008

422

Discount Balance

Bonds’ Carrying Value

$70

$1,930

June 30, 2008

$80

$96

$16

54

1,946

Dec. 31, 2008

80

97

17

37

1,963

June 30, 2009

80

98

18

19

1,981

Dec. 31, 2009

80

99

19

0

2,000


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Requirement 4 Journalize Red’s first two interest payments on June 30, 2008, and December 31, 2008. Part 1

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Part 11

3

Demo Doc Complete


June 30, 2008 Interest Expense increases (a debit) by $96, as calculated in the table in Requirement 3. Cash decreases (a credit) by the cash interest paid of $80, as calculated in Requirement 3. The difference between these two amounts is balanced to Discount on Bonds Payable. The balancing amount is a credit of: $96 – $80 ! $16

This is the discount amortization shown in Requirement 3.

Journal Entry: Date June 30, 2008

Accounts Interest Expense ($1,930 ! 10%/2) Discount on Bonds Payable (to balance) Cash ($2,000 ! 8%/2)

Post Ref.

Dr.

Cr. 96 16 80

December 31, 2008 Interest Expense increases (a debit) by $97, as calculated in the table in Requirement 3. Cash decreases (a credit) by the cash interest paid of $80, as calculated in Requirement 3. The difference between these two amounts is balanced to Discount on Bonds Payable. The balancing amount is a credit of: $97 – $80 ! $17

This is the discount amortization shown in Requirement 3.

Journal Entry: Date Dec. 31, 2008

Accounts Interest Expense ($1,946 ! 10%/2) Discount on Bonds Payable (to balance) Cash ($2,000 ! 8%/2)

Post Ref.

Dr.

Cr. 97 17 80


423

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Requirement 5 On January 2, 2009, 20% of the bonds were converted to 120 common shares with a $2 par value per share. Journalize this transaction.

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Demo Doc

Part 11

Complete

If 20% of the bonds are converted, then 20% of the maturity value is converted:


20% ! $2,000 " $400

Also, 20% of the discount is converted: 20% ! $37 " $7

The bonds will not exist after the conversion, so the Bonds Payable account decreases (a debit) by $400. The Discount on Bonds Payable also decreases (a credit) by $7. New common stock is issued for the conversion, so Common Stock increases (a credit) by the par value of the new shares: 120 ! $2 " $240

The remainder is balanced to Paid-In Capital in Excess of Par. The balancing amount is: $400 – $7 – $240 " $153 Journal Entry: Date Jan. 2, 2009

Post Ref.

Accounts Bonds Payable ($2,000 ! 20%) Discount on Bonds Payable ($37 ! 20%) Common Stock (120 ! $2) Paid-In Capital in Excess of Par (to balance)

Bal.

Bonds Payable

0 70 June 30 Dec. 31 Jan. 2

Cr. 7 240 153

Discount on Bonds Payable Bal. Jan. 1

Dr. 400

16 17 7

Jan. 2

Bal. Jan. 1

0 2,000

Bal.

1,600

400

30

Requirement 6 On January 3, 2009, Red purchased the remaining bonds from the marketplace for $1,800 cash.The bonds were immediately retired. Journalize this transaction.

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4


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Demo Doc Complete

Because 20% of the bonds were converted to common stock, 100% – 20% = 80% remain. These bonds will be retired.


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If 80% of the bonds are retired, then 80% of the maturity value is retired: 80% " $2,000 ! $1,600

Also, 80% of the discount is retired: 80% " $37 ! $30

The bonds will not exist after retirement, so the Bonds Payable account decreases (a debit) by $1,600. The Discount also decreases (a credit) by $30. Cash decreases (a credit) by $1,800. The remainder is balanced to a gain or loss. In this case, the balancing amount is a debit, which means a loss of: $1,800 $ $30 # $1,600 ! $230


Post Ref.

Accounts Bonds Payable ($2,000 ! 80%) Loss on Retirement (to balance) Discount on Bonds Payable ($37 ! 80%) Cash

Dr. 1,600 230

Cr.

30 1,800

Requirement 7 How do interest payments on bonds differ from mortgages?

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Demo Doc Complete

Although both bonds and mortgages have set cash payments that are the same every period, the nature of these payments differ. Bonds have their principal paid back as one lump sum at their maturity. So, for the entire life of the bond, the (present value of the) debt is a liability for the company. Because this debt is outstanding for the bond’s entire life, interest expense is high each period and remains high over the bond’s life. Mortgages pay off the principal and interest with each payment. Unlike bonds, the debt and the interest expense are both decreasing over the life of the mortgage. With bonds, large principal payments can lead to bankruptcy if the company is unable to pay off the debt when the bonds mature. This problem is much less likely to happen with mortgage payments.

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1

Describe mortgages and leases, and record mortgage and lease transactions

2

Describe bonds payable

Demo Doc Complete


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Quick Practice Questions True/False _____ 1. The journal entry to record selling $200,000 face value bonds at 98 will involve a credit to Bonds Payable for $196,000. _____ 2. When a bond is issued at a discount, the discount has the effect of raising the interest expense on the bonds to the market rate of interest. _____ 3. The carrying value of bonds will decrease each interest period if the bonds were sold at a discount. _____ 4. An amortization schedule provides the information to divide mortgage payments between the interest expense and the decrease in the principal balance. _____ 5. Callable bonds give the issuer the benefit of being able to take advantage of low interest rates by paying off bonds when it is favorable to do so. _____ 6. If a lease transfers title of the leased asset to the lessee at the end of the lease term, it is considered an operating lease. _____ 7. When reporting a mortgage on the balance sheet, the portion maturing within one year is shown as a current liability. _____ 8. Positive financial leverage can result from using funds borrowed at one rate to earn profit at a lower rate. _____ 9. If bonds with a carrying value of $540,000 are retired early and were purchased at the market price of $550,000, a $10,000 Gain on Retirement of Bonds Payable should be recorded. _____10. Bondholders are creditors of a corporation.

426


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Multiple Choice 1. On January 2, 2008, Lot Corporation issues $200,000 par value, 6% bonds for $196,000. What can be concluded about the effective (market) rate of interest? a. It is less than 6% b. It is more than 6% c. It is equal to 6% d. It is impossible to determine from the given data 2. Dalton Corporation issues 50, $1,000 par value, 10% bonds at 102.5. The journal entry includes which of the following? a. A debit to Cash for $50,000 b. A credit to Premium on Bonds Payable for $1,250 c. A debit to Discount on Bonds Payable for $1,250 d. A credit to Bonds Payable for $51,250 3. Jones Corporation issues $400,000, 10%, 5-year bonds at 103. What is the total interest expense over the life of the bonds? a. $40,000 b. $188,000 c. $200,000 d. $212,000 4. What are bonds issued on the general credit of the issuing corporation called? a. Serial bonds b. Term bonds c. Debenture bonds d. Convertible bonds 5. What are bonds called when the maturities are spread over several dates? a. Term bonds b. Debenture bonds c. Serial bonds d. Callable bonds 6. What is the interest rate specified in the bond indenture called? a. Stated rate b. Discount rate c. Yield rate d. Effective rate 7. Which of the following statements about the discount on bonds payable is correct? a. It is added to bonds payable on the balance sheet. b. It is a contra-asset. c. It is amortized over the life of the bonds. d. Both b and c are correct


427

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8. A corporation may choose to purchase an asset rather than lease it for which of the following reasons? a. Save cash b. Adapt to changes in technology easily c. Obtain easier financing d. Avoid recording the expense for lease payments 9. A bond issued with a face value of $200,000 and a carrying amount of $195,500 is called in at 98 1/2 and retired. What is the gain or loss on this transaction? a. $1,500 loss b. $1,500 gain c. $3,000 loss d. $3,000 gain 10. All except which of the following is an advantage of issuing stock? a. The corporation is not required to pay dividends b. The corporation is not required to repay the amount paid in by the stockholders c. Positive financial leverage exists when issuing stock d. Dividends are not recorded as an expense

428


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Quick Exercises 12-1. For each of the following independent situations, state whether the bonds were issued at a premium, at a discount, or at par. a. Bonds with a maturity value of $50,000 were issued for $53,000. ___________ b. Bonds with a stated rate of 8% were issued to yield 7.5%. ___________ c. Bonds with a maturity value of $75,000 were issued for $75,000. ___________ d. Bonds with a stated rate of 8.25% were issued to yield 8.75%. ___________ e. Bonds with a maturity value of $110,000 were issued for $106,000. ___________ 12-2. Fox Corporation issued 10-year, 10%, $1,000,000 bonds on January 1, 2008. The bonds pay interest every June 30 and December 31. The bonds were issued for $1,065,000. Fox Corporation uses straight-line amortization for any discount or premium amortization. a. Journalize the bonds’ issuance on January 1, 2008. b. Journalize the interest payment and amortize the premium or discount on June 30, 2008. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

c. What is the carrying value of the bonds on June 30, 2008?


429

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12-3. On April 1, 2008, Needy Corporation issued $3,000,000 of 8%, 10-year bonds dated April 1, 2008, with interest payments made each October 1 and April 1. The bonds are issued at 95. Needy Corporation amortizes any premium or discount using the straight-line method. a. Journalize the issuance of bonds on April 1, 2008. b. Journalize the payment of interest and the amortization of any discount or premium on October 1, 2008. c. Journalize the accrued interest and the amortization of any premium or discount on December 31, 2008.

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

Journal Entry: Date

Accounts

12-4. Ryan Company issues a $300,000, 7%, 15-year mortgage on January 1, 2008 to purchase a building. a. Complete the following amortization schedule for Ryan Company. Semiannual Interest Period

Cash Payment

Interest Expense

Decrease in Principal

Jan. 1, 2008

$300,000

Jan. 31, 2008

2,697

1,750

947

299,053

Feb. 28, 2008

2,697

1,745

952

298,101

Mar. 31 , 2008 Apr. 30, 2008 430

Principal Balance


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b. Journalize the issuance of mortgage on January 1, 2008, and the first cash payment on January 31, 2008.

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Dr.

Cr.

Journal Entry: Date

Accounts

12-5. Apex Corporation issued $500,000, 10%, 10-year callable bonds at 93 on January 2, 2008. The bonds are callable at 102 anytime after January 2, 2010. On December 31, 2011, Apex Corporation calls the entire issuance. a. Compute the balance in the Premium or Discount account on December 31, 2011. Apex Corporation uses the straight-line method of amortization.

b. Prepare the entry to call the bonds on December 31, 2011.

Journal Entry: Date

Accounts

Post Ref.


431

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Do It Yourself! Question 1 Bonds Payable (Straight-Line Amortization) Circle Inc., issued $20,000 maturity value of bonds payable for $19,337 cash on January 1, 2008. The bonds had a stated rate of 14%, but the market rate was 16%. Interest is paid semiannually and the bonds are due in 2 years. Circle uses the straight-line method of amortization.

3


Requirements 1. Are these bonds issued at a discount or premium?

2. Journalize Circle’s issuance of the bonds on January 1, 2008. Journal Entry: Date

3

Post Ref.

Accounts


Dr.

Cr.

3. Journalize Circle’s first two interest payments on June 30, 2008, and December 31, 2008.

Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

432

Accounts


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4. Show how the bonds would appear on Circle’s December 31, 2008, balance sheet.

5

Report long-term liabilities on the balance sheet

5. On January 2, 2009, 25% of the bonds were converted to 9,000 common shares with a $0.50 par value per share. Journalize this transaction.

4


Journal Entry: Date

Accounts

Post Ref.

6. On January 3, 2009, Circle purchased the remaining bonds from the marketplace for $14,000 cash. The bonds were immediately retired. Journalize this transaction.

Dr.

4

Cr.


Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.


433

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Do It Yourself! Question 2 Bonds Payable (Effective-Interest Amortization) Square Corp. issued $10,000 maturity value of bonds payable for $10,346 cash on January 1, 2008. The bonds had a stated rate of 14% but the market rate was 12%. Interest is paid semiannually and the bonds are due in 2 years. Square Corp. uses the effective-interest method of amortization.

Requirements

3


1. Are these bonds issued at a discount or premium? 2. Journalize Square’s issuance of the bonds on January 1, 2008.

Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

3


3. Prepare Square’s effective interest amortization table for the entire life of the bonds payable.

3


4. Journalize Square’s first two interest payments on June 30, 2008, and December 31, 2008.

Journal Entry: Date

434

Accounts


Post Ref.

Dr.

Cr.

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Journal Entry: Date

Accounts

Post Ref.

5. On January 2, 2009, 50% of the bonds were converted to 3,000 common shares with a $1.50 par value per share. Journalize this transaction.

Dr.

4

Cr.


Journal Entry: Date

Accounts

Post Ref.

6. On January 3, 2009, Square purchased the remaining bonds from the marketplace for $6,000 cash. The bonds were immediately retired. Journalize this transaction.

Dr.

4

Cr.


Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.


435

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436

F

1. The journal entry to record selling $200,000 face value bonds at 98 will involve a credit to Bonds Payable for $196,000. False–The journal entry to record selling $200,000 face value bonds at 98 will involve a credit to Bonds Payable for $200,000 (p. 635)

T

2. When a bond is issued at a discount, the discount has the effect of raising the interest expense on the bonds to the market rate of interest. (p. 636)

F

3. The carrying value of bonds will decrease each interest period if the bonds were sold at a discount. False–The carrying value of bonds will increase each interest period if the bonds were sold at a discount. (p. 637)

T

4. An amortization schedule provides the information to divide mortgage payments between the interest expense and the decrease in the principal balance. (p. 626)

T

5. Callable bonds give the issuer the benefit of being able to take advantage of low interest rates by paying off bonds when it is favorable to do so. (p. 631)

F

6. If a lease transfers title of the leased asset to the lessee at the end of the lease term, it is considered an operating lease. False–If a lease transfers title of the leased asset to the lessee at the end of the lease term, it is considered a capital lease. (p. 629)

T

7. When reporting a mortgage on the balance sheet, the portion maturing within one year is shown as a current liability. (p. 643)

F

8. Positive financial leverage can result from using funds borrowed at one rate to earn profit at a lower rate. False–Positive financial leverage can result from using funds borrowed at one rate to earn a higher rate. (p. 630)

F

9. If bonds with a carrying value of $540,000 are retired early and were purchased at the market price of $550,000, a $10,000 Gain on Retirement of Bonds Payable should be recorded. False–If bonds with a carrying value of $540,000 are retired early and were purchased at the market price of $550,000, a $10,000 Loss on Retirement of Bonds Payable should be recorded. (p. 642)

T

10. Bondholders are creditors of a corporation. (p. 630)


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Multiple Choice 1. On January 2, 2008, Lot Corporation issues $200,000 face value, 6% bonds for $196,000. What can be concluded about the effective (market) rate of interest? (p. 633) a. It is less than 6% b. It is more than 6% c. It is equal to 6% d. It is impossible to determine from the given data 2. Dalton Corporation issues 50, $1,000 par value, 10% bonds at 102.5. The journal entry includes which of the following? (p. 638) a. A debit to Cash for $50,000 b. A credit to Premium on Bonds Payable for $1,250 c. A debit to Discount on Bonds Payable for $1,250 d. A credit to Bonds Payable for $51,250 3. Jones Corporation issues $400,000, 10%, 5-year bonds at 103. What is the total interest expense over the life of the bonds? (p. 635) a. $40,000 b. $188,000 c. $200,000 d. $212,000 4. What are bonds issued on the general credit of the issuing corporation called? (p. 631) a. Serial bonds b. Term bonds c. Debenture bonds d. Convertible bonds 5. What are bonds called when the maturities are spread over several dates? (p. 631) a. Term bonds b. Debenture bonds c. Serial bonds d. Callable bonds 6. What is the interest rate specified in the bond indenture called? (p. 633) a. Stated rate b. Discount rate c. Yield rate d. Effective rate 7. Which of the following statements about the discount on bonds payable is correct? (p. 636) a. It is added to bonds payable on the balance sheet b. It is a contra-asset c. It is amortized over the life of the bonds d. Both b and c are correct


437

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8. A corporation may choose to purchase an asset rather than lease it for which of the following reasons? (p. 628) a. Save cash b. Adapt to changes in technology easily c. Obtain easier financing d. Avoid recording the expense for lease payments 9. A bond issued with a face value of $200,000 and a carrying amount of $195,500 is called in at 981/2 and retired. What is the gain or loss on this transaction? (p. 636) a. $1,500 loss b. $1,500 gain c. $3,000 loss d. $3,000 gain 10. All except which of the following is an advantage of issuing stock? (p. 630) a. The corporation is not required to pay dividends b. The corporation is not required to repay the amount paid in by the stockholders c. Positive financial leverage exists when issuing stock d. Dividends are not recorded as an expense

438


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Quick Exercise 12-1. For each of the following independent situations, state whether the bonds were issued at a premium, at a discount, or at par. (pp. 635–640) a. Bonds with a maturity value of $50,000 were issued for $53,000. Premium b. Bonds with a stated rate of 8% were issued to yield 7.5%. Premium c. Bonds with a maturity value of $75,000 were issued for $75,000. Par d. Bonds with a stated rate of 8.25% were issued to yield 8.75%. Discount e. Bonds with a maturity value of $110,000 were issued for $106,000. Discount 12-2. Fox Corporation issued 10-year, 10%, $1,000,000 bonds on January 1, 2008. The bonds pay interest every June 30 and December 31. The bonds were issued for $1,065,000. Fox Corporation uses straight-line amortization for any discount or premium amortization. (pp. 638–639) a. Journalize the bonds’ issuance on January 1, 2008. b. Journalize the interest payment and amortize the premium or discount on June 30, 2008. Journal Entry: Date a. Jan. 1

Accounts Cash Bonds Payable Premium on Bonds Payable

b. June 30

Interest Expense Premium on Bonds Payable Cash

Post Ref.

Dr. 1,065,000

Cr. 1,000,000 65,000

46,750 3,250 50,000

c. What is the carrying value of the bonds on June 30, 2008? Carrying Value = $1,000,000 + ($65,000 " $3,250) = $1,061,750 12-3. On April 1, 2008, Needy Corporation issued $3,000,000 of 8%, 10-year bonds with interest payments made each October 1 and April 1. The bonds are issued at 95. Needy Corporation amortizes any premium or discount using the straight-line method. (pp. 635–637) a. Journalize the issuance of bonds on April 1, 2008. $3,000,000 ! 0.95 = $2,850,000 $3,000,000 – $2,850,000 = $150,000 Quick Practice Solutions | Chapter 12

439

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b. Journalize the payment of interest and the amortization of any discount or premium on October 1, 2008. $3,000,000 ! 0.08 ! 6/12 = $120,000 $150,000 ! 6/120 months = $7,500 c. Journalize the accrued interest and the amortization of any premium or discount on December 31, 2008. $3,000,000 ! 0.08 ! 3/12 = $60,000 $150,000 ! 3/120 months = $3,750

Journal Entry: Date a. Apr. 1

Post Ref.

Accounts Cash Discount on Bonds Payable Bonds Payable

Dr. 2,850,000 150,000

Cr.

3,000,000

b. Oct. 1

Interest Expense Discount on Bonds Payable Cash

127,500

c. Dec. 31

Interest Expense Discount on Bonds Payable Interest Payable

63,750

7,500 120,000

3,750 60,000

12-4. Ryan Company issues a $300,000, 7%, 15-year mortgage on January 1, 2008 to purchase a building. (pp. 626–628) a. Complete the following amortization schedule for Ryan Company. Semiannual Interest Period

Cash Payment

Interest Expense

Decrease in Principal

Jan. 1, 2008

440

Principal Balance $300,000

Jan. 31, 2008

2,697

1,750

947

299,053

Feb. 28, 2008

2,697

1,745

952

298,101

Mar. 31, 2008

2,697

1,739

958

297,143

Apr. 30, 2008

2,697

1,733

964

296,179


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b. Journalize the issuance of mortgage on January 1, 2008, and the first cash payment on January 31, 2008.


Accounts Buildings Mortgage Notes Payable Record purchase of building and insurance of mortgage note.

Jan. 31, 2008

Post Ref.

Dr. 300,000

Cr. 300,000

Interest Expense Mortgage Notes Payable Cash Make monthly mortgage payment.

1,750 947 2,697

12-5. Apex Corporation issued $500,000, 10%, 10-year callable bonds at 93 on January 2, 2008. The bonds are callable at 102 anytime after January 2, 2010. On December 31, 2011, Apex Corporation calls the entire issuance. (pp. 641–642) a. Compute the balance in the Premium or Discount account on December 31, 2011. Apex Corporation uses the straight-line method of amortization. $500,000 ! 0.93 $500,000 – $465,000 $35,000/10 years $3,500 ! 4 years $35,000 – $14,000

= $465,000 = $35,000 discount = $3,500 annual amortization of discount = $14,000 amortized discount as of December 31, 2011 = $21,000 unamortized discount as of December 31, 2011

b. Prepare the entry to call the bonds on December 31, 2011.


Accounts Bonds Payable Loss on Retirement of Bonds Payable [$510,000 – ($500,000 – $21,000)] Discount on Bonds Payable Cash ($500,000 3 102%)

Post Ref.

Dr. 500,000

Cr.

31,000 21,000 510,000


441

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Do It Yourself! Question 1 Solutions Bonds Payable (Straight-Line Amortization) Requirement 1 Are these bonds issued at a discount or premium? These bonds were issued at a discount.

Requirement 2 Journalize Circle’s issuance of the bonds on January 1, 2008. Journal Entry: Date Jan. 1, 2008

Accounts Cash Discount on Bonds Payable (to balance) Bonds Payable (principle amount)

Post Ref.

Dr. 19,337 663

Cr.

20,000

Requirement 3 Journalize Circle’s first two interest payments on June 30, 2008, and December 31, 2008. The entries for both June 30, 2008, and December 31, 2008, would be the same:

Journal Entry: Date

Accounts Interest Expense (to balance) Cash ($20,000 ! 14% ! 6/12) Discount on Bonds Payable ($663/4)

Post Ref.

Dr. 1,566

Cr. 1,400 166

Requirement 4 Show how the bonds would appear on Circle’s December 31, 2008, balance sheet. Long-Term Liabilities: Bonds Payable Less: Discount on Bonds Payable

442


$20,000 (331)

$19,669

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Requirement 5 On January 2, 2009, 25% of the bonds were converted to 9,000 common shares with a $0.50 par value per share. Journalize this transaction. Immediately before this transaction, the discount had a balance of $331: Discount on Bonds Payable Bal. Jan. 1

0 663 June 30 Dec. 31

Bal.

166 166

331


Accounts Bonds Payable ($20,000 ! 25%) Discount on Bonds Payable ($133.50! 25%) Common Stock (9,000 ! $0.50) Paid-In Capital in Excess of Par (to balance)

Post Ref.

Dr. 5,000

Cr. 83 4,500 417

Requirement 6 On January 3, 2009, Circle purchased the remaining bonds from the marketplace for $14,000 cash.The bonds were immediately retired. Journalize this transaction.


Accounts Bonds Payable ($20,000 ! 75%) Gain on Retirement (to balance) Discount on Bonds Payable ($331.50 ! 75%) Cash

Post Ref.

Dr. 15,000

Cr. 751 249 14,000


443

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Do It Yourself! Question 2 Solutions Bonds Payable (Effective-Interest Amortization) Requirement 1 Are these bonds issued at a discount or premium? These bonds were issued at a premium.

Requirement 2 Journalize Square’s issuance of the bonds on January 1, 2008.


Post Ref.

Accounts Cash Discount on Bonds Payable (to balance) Bonds Payable (principle amount)

Dr. 10,346

Cr. 346 10,000

Requirement 3 Prepare Square’s effective interest amortization table for the entire life of the bonds payable.

Date

Interest Payment

Interest Expense

Premium Amortization

Jan. 1, 2008

444

Premium Balance

Bonds’ Carrying Value

$346

$10,346

June 30, 2008

$700

$621

$79

267

10,267

Dec. 31, 2008

700

617

83

184

10,184

June 30, 2009

700

611

89

95

10,095

Dec. 31, 2009

700

605

95

0

10,000


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Requirement 4 Journalize Square’s first two interest payments on June 30, 2008, and December 31, 2008.

Journal Entry: Date June 30, 2008

Post Ref.

Accounts Interest Expense ($10,267 ! 12%/2) Premium on Bonds Payable (to balance) Cash ($10,000 ! 14%/2)

Dr. 617 83

Cr.

700


Post Ref.

Accounts Interest Expense ($10,267 ! 12%/2) Premium on Bonds Payable (to balance) Cash ($10,000 ! 14%/2)

Dr. 617 83

Cr.

700

Requirement 5 On January 2, 2009, 50% of the bonds were converted to 3,000 common shares with a $1.50 par value per share. Journalize this transaction.


Accounts Bonds Payable ($10,000 ! 50%) Premium on Bonds Payable ($184 ! 50%) Common Stock (3,000 ! $1.50) Paid-In Capital in Excess of Par (to balance)

Post Ref.

Dr. 5,000 92

Cr.

4,500 592

Requirement 6 On January 3, 2009, Square purchased the remaining bonds from the marketplace for $6,000 cash.The bonds were immediately retired. Journalize this transaction.


Accounts Bonds Payable ($10,000 ! 50%) Loss on Retirement of Bonds Payable (to balance) Premium on Bonds Payable ($184 ! 50%) Cash

Post Ref.

Dr. 5,000 908 92

Cr.

6,000


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446

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 12, Long-Term Liabilities. Click a link to work on the tutorial exercises.


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13

Statement of Cash Flows

WHAT YOU PROBABLY ALREADY KNOW If you find yourself short of cash occasionally, it is not uncommon to wonder where all the money has gone. You probably already know that you need to keep track of all cash received and spent for a period of time to find out the answer. Not only does keeping track show you the amount of money coming in and going out, but you would also identify the source of the cash received and the use of the cash spent. Identifying the cash activities in your life helps you to predict your future cash flows based on past history, review the decisions you made in your financial life that result in the creation and disbursement of cash, and assess your ability to meet future financial obligations. The same issues are important to a business. In this chapter, we see how the statement of cash flows provides this information for an entity.

Learning Objectives

1

Explain the purposes of the statement of cash flows and describe its elements. The statement of cash flows shows the cash receipts and payments for a period of time. It helps to predict future cash flows, evaluate management decisions, and predict a company’s ability to pay dividends. See Exhibit 13-1 (p. 690) to learn how the statement of cash flows fits in with the other financial statements.

2

Distinguish between operating, investing, and financing cash flows. The three sections of a statement of cash flows are operating activities, investing activities, and financing activities. Operating activities affect the income statement and current assets and current liabilities on the balance sheet. Investing activities affect long-term assets. Financing activities affect long-term liabilities and owners’ equity. See Exhibit 13-2 (p. 692) for the relationship between these activity categories and the balance sheet classifications.

3

Prepare a statement of cash flows by the indirect method. The indirect method reconciles the net income from the income statement to the cash flow from operating activities. The investing and financing sections of the statement of cash flows are the same under the

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indirect and direct methods. See Exhibits 13-5 and 13-7 (pp. 698) to view the format of an indirect method statement of cash flows.

4

Prepare a statement of cash flows by the direct method. The direct method lists the amount of cash receipts and cash payments from operating activities by major category. See Exhibits 13-13 and 13-14 (pp. 705–706) to view the structure of a direct method statement of cash flows. Review Exhibit 13-15 (p. 706) to see how to calculate cash receipts and payments under the direct method.

448

Chapter 13 | Statement of Cash Flows

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Demo Doc 1 Statement of Cash Flows (Indirect Method) Learning Objectives

2, 3

Tanker, Inc., had the following information at December 31, 2008:

TANKER, INC. Comparative Balance Sheet December 31, 2008 and 2007 Assets 2008 2007 Change Liabilities Current: Current: $ 700 $1,160 $(460) Accounts payable Cash 300 Accounts receivable 420 (120) 800 Inventory 750 50 Long-term notes payable 120 Prepaid insurance 90 30 Total liabilities Owners’ Equity 1,500 1,400 Common stock (no par) Furniture (400) Retained earnings Less: Accum. Depr. (475) 1,100 Less: Treasury stock Net 925 Total equity $3,020 $3,345 Total liabilities and equity Total assets

2008

2007

Change

$ 680 $ 530 $ 150 660 815 $1,340 $1,345

(155)

1,800 1,800 880 200 (1,000) 0 $1,680 $2,000 $3,020 $3,345

TANKER, INC. Income Statement Year Ended December 31, 2008 Sales revenue Less cost of goods sold Gross margin

$3,400 (1,750) $1,650

Depreciation expense Insurance expense Other operating expenses

$ (110) (230) (390)

Gain on sale of furniture Net income

80 $1,000

Other important information includes the following: • Every year, Tanker declares and pays cash dividends. • During 2008, Tanker sold old furniture for $90 cash. Tanker also bought new furniture by making a cash down payment and signing a $200 note payable. • During 2008, Tanker repaid $500 of notes payable in cash, and borrowed new long-term notes payable for cash. Demo Doc 1 | Chapter 13

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• During 2008, Tanker purchased treasury stock for cash. No treasury stock was sold.

Requirement Prepare Tanker’s statement of cash flows for the year ended December 31, 2008, using the indirect method.

450


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Demo Doc 1 Solution Requirement Prepare Tanker’s statement of cash flows for the year ended December 31, 2008, using the indirect method. Operating Activities Part 1

Part 2

Demo Doc Complete

Part 3

We first set up the statement of cash flows with the proper title, and then start with operating activities.

2

Distinguish between operating, investing, and financing cash flows

3

Prepare a statement of cash flows by the indirect method

Net Income The first item is net income. Because net income is positive, it increases to the Cash balance. Therefore, we add (that is, a positive number) $1,000 on our cash-flow statement. Depreciation Expense Net income includes depreciation expense, which must be removed because it is a 100% noncash item. Remember, no cash was “spent” for depreciation, yet it was still deducted to arrive at the net income number. Because depreciation expense was subtracted to calculate net income, we add it back to remove it. Gains and Losses After depreciation, we must look for gains and losses on disposal of longterm assets. These are treated in a manner similar to the depreciation. No cash was “earned” for the gain, yet it was still added to arrive at the net income number. The gain on sale of furniture was added to calculate net income, so we subtract it to remove it. Accounts Receivable After looking at net income and the depreciation and gain adjustments, we need to incorporate the changes in current assets and current liabilities. The increases and decreases in these accounts do not tell us whether to add or subtract these items on the cash-flow statement. The first current asset (other than cash) is Accounts Receivable. On the balance sheet we see: Assets

2008

2007

Change

$ 700

$ 1,160

$(460)

300

420

(120)

Current: Cash Accounts Receivable

We must add the $120 decrease in accounts receivable. We can reason out this adjustment in two ways: 1. Accounts Receivable went down. Why? Tanker is collecting more of the cash that its customers owe. How does this collection affect Cash? It increases Cash, therefore, we should add the number on the cash-flow statement. Demo Doc 1 Solution | Chapter 13

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2. Accounts Receivable went down. This decrease in an asset appears as a credit. To balance out this credit would require a debit to Cash, which is an increase. If Cash increases, we should add the number on the cash flow statement. Notice that in both cases, we add or subtract on the cash-flow statement because of the item’s effect on cash flow. It doesn’t matter whether Accounts Receivable went up or down; what matters is how that change affects cash flow. Inventory Let’s try the two ways with the next current asset: inventory. On the balance sheet, we see: Assets

2008

2007

Change

$700

$1,160

$(460)

Accounts Receivable

300

420

(120)

Inventory

800

750

50

Current: Cash

During the year, inventory increased by $50. 1. Why did Inventory increase? Tanker purchased inventory with cash. Therefore, this transaction has a negative effect on cash flow. 2. An increase in inventory means an increase in an asset, which is a debit. For this debit to be balanced out by cash, the Cash account is credited, which is a negative effect on cash flow. Prepaid Expenses The last current asset is Prepaid Insurance. On the balance sheet, we see: Assets

2008

2007

Change

$700

$1,160

$(460)

Accounts Receivable

300

420

(120)

Inventory

800

750

50

Prepaid Insurance

120

90

30

Current: Cash

During the year, Prepaid Insurance increased by $30. 1. Why did the Prepaid Insurance account increase? Tanker paid more insurance costs in advance, which caused a negative effect on cash flow. 2. An increase in Prepaid Insurance means an increase in an asset, which is a debit. If this debit is balanced out by cash, then the Cash account is credited, which is a negative effect on cash flow. Accounts Payable The last part of operating activities is to look at the changes in current liabilities. The only current liability in this question is Accounts Payable. On the balance sheet, we see: 452


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Liabilities

2008

2007

Change

$ 680

$ 530

$150

Current: Accounts Payable

During the year, Accounts Payable increased by $150. 1. Why did Accounts Payable increase? Tanker is not paying all of its bills. If they are holding onto their cash by not paying bills, the result is a positive effect on cash flow. 2. An increase in the Accounts Payable account causes an increase in a liability, which is a credit. If this credit is balanced out by cash, then the Cash account is debited, resulting in a positive effect on cash flow. We total these numbers, and we are finished with operating activities. The completed operating activities section would appear as: Operating Activities Net income

$1,000


110

Gain on Sale of Furniture

(80)

Decrease in Accounts Receivable

120

Increase in Inventory

(50)

Increase in Prepaid Insurance

(30)

Increase in Accounts Payable

150

Total Cash Flow Provided by Operating Activities

$1,220

Investing Activities Part 1

Part 2

Part 3

Demo Doc Complete

Investing activities involve cash purchases and cash disposals of long-term assets. We need to know how much cash was paid to purchase new furniture, and how much cash was received when Tanker sold some of the old furniture. Do we have any of these numbers right away? Yes, we are told in the question that Tanker signed a $200 note payable to purchase new furniture. We also know that the old furniture was sold for $90 cash. Before we do anything else, we should point out that the $200 note payable is a noncash transaction. Although we will need to use it in our analysis, it will not appear on the main body of the cash-flow statement. Instead, it will appear in a note for noncash investing and financing activities: Noncash investing and financing activities Purchase of furniture with note payable

$ 200

We need to calculate the cash Tanker paid to purchase new furniture. For this analysis, we need to look at the Furniture (Net) T-account: Bal. 12/31/07 Bal. 12/31/08

Furniture (Net) 925 increases decreases 1,100

2


3


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We know that the Furniture (Net) account increased and decreased. What caused that account to increase? Well, it would increase if Tanker bought new furniture. So obviously the cash paid and the note signed for new furniture went into this account. What would cause the Furniture (Net) account to decrease? If Tanker sold furniture, we would decrease the account, but it would decrease by the book value (that is, the net amount) of the furniture sold. Remember, the book value is another term for net value. We are looking at net value in the T-account, so the Furniture (Net) account decreases by its net/book value. We know that some furniture was sold, so obviously this decrease occurred. We know that this furniture was sold for $90 cash, but this amount is not the net book value (NBV) of the furniture sold. This amount is still unknown. However, we can calculate this amount using the gain/loss formula: Gain or Loss on Sale of Fixed Assets ! Cash Received on Sale of Fixed Assets " NBV of Fixed Assets Sold

For this example, this formula becomes: Gain on Sale of Furniture ! Cash Received on Sale of Furniture " NBV of Furniture Sold

Therefore, $80 ! $90 " NBV of Furniture Sold NBV of Furniture Sold ! $10

What else would decrease Furniture (Net)? Well, when Tanker takes depreciation expense, don’t we decrease the net value of its assets? We know from the income statement that depreciation expense is $110. Let’s now put all of the numbers in and see what comes out: Furniture (Net) Bal. 12/31/07 Cash purchases Noncash purchases

925 X 200 NBV furniture sold Depreciation expense

Bal. 12/31/08

10 110

1,100

So $925 # X # $200 " $10 " $110 ! $1,100

X ! Cash paid to purchase furniture ! $95

The following summary shows how we find missing information for long-term assets: 1. Set up a T-account for the net value of the asset. 2. Fill in as much information as you can in the T-account (such as beginning and ending balances, depreciation expense, and purchases or net book value of disposals). 3. Solve for any missing information. 4. If more than one number is missing, or if the missing information is not the number you need, use the gain/loss formula to calculate any remaining information. 454


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Now we can put our two numbers, $90 and $95, into the statement of cash flows. Cash purchases of equipment were $95. Did this amount cause Cash to increase or decrease? Obviously it is a decrease because Tanker paid cash, so we subtract it. Cash received on sale of equipment is $90, which is an increase to Cash, so we add it. Remember that for investing activities, we cannot combine these two items. They must be listed separately because they are two separate transactions. Totaling these numbers completes investing activities. The completed investing activities section would appear as: Investing Activities Cash paid to purchase new furniture

$ (95)

Cash proceeds from sale of furniture

90

Total cash flow provided by investing activities

$ (5)

Financing Activities

Part 1

Part 2

Demo Doc Complete

Part 3

The financing activities section deals with long-term liabilities (debt) and equity accounts. First, we will look at long-term liabilities.

2


3


Long–Term Liabilities Tanker signed new notes payable (for which it received cash) and repaid some other notes. We need the cash numbers involved so that we can put them into the cashflow statement. Do we have any of them immediately available to us? Yes, we are told that Tanker repaid $500 of notes payable. We also know that Tanker took out a noncash note (to purchase furniture) of $200. This noncash transaction has already been recorded in the note to the cash flow statement (discussed under investing activities). Notes Payable Bal. 12/31/07 decreases increases Bal. 12/31/08

815 660

Now let’s analyze the Notes Payable T-account: What would cause this account to increase? Well, it would increase if Tanker took out new notes payable. What would cause it to decrease? It would decrease if Tanker paid off some of the notes. Let’s put that information into the T-account: Notes Payable Note repayments

Bal. 12/31/07

815

New cash notes New noncash notes Bal. 12/31/08

X 200 660

500


455

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So we can calculate new cash notes: $815 " $500 # X # $200 ! $660

X ! $145

Now we can put these numbers into the cash flow statement. Cash received from new notes was $145. This transaction increased Cash, so it has a positive effect on cash flow. Cash paid to repay old notes was $500. This transaction decreased Cash, so it has a negative effect on cash flow. Treasury Stock Now we must analyze the changes in Tanker’s equity. Tanker had some activity with treasury stock during the year. We know that Tanker purchased treasury stock. Treasury Stock Bal. 12/31/07 Bal. 12/31/08

0 increases decreases 1,000

What could cause this account to go up? It would go up if Tanker purchased treasury stock. What could cause it to go down? It would go down if treasury stock were sold. We know that no treasury stock was sold: Treasury Stock Bal. 12/31/07 0 Treasury stock purchased X Treasury stock sold Bal. 12/31/08

0

1,000

So we can calculate that treasury stock purchased: $0 # X " 0 ! $1,000

X ! $1,000

This balance means that cash was paid by Tanker, which is a negative effect on cash flow. Dividends The other account in equity that changed is Retained Earnings. The two major transactions affecting Retained Earnings are net income and dividends. Net income was already listed in the operating activities section, so all that remains to be included in the financing activities section is dividend activity. The Retained Earnings account looks like this: Retained Earnings Bal. 12/31/07 decreases increases Bal. 12/31/08

200 880

What makes Retained Earnings go up? It goes up when Tanker earns net income. What makes it go down? It goes down when Tanker pays dividends: Retained Earnings Cash dividends paid

456


Bal. 12/31/07

200

Net income Bal. 12/31/08

1,000 880

X

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So cash dividends declared and paid are calculated as: $200 # $1,000 " X ! $880

X ! $320

These dividends were paid in cash so this transaction has a negative effect on cash. Totaling these numbers completes financing activities. The completed financing activities section would appear as: Financing Activities Cash Proceeds from New Notes

$

Cash Repayment of Old Notes

145 (500)

Cash Purchase of Treasury Stock

(1,000)

Cash Dividends Paid

(320)

Total Cash Flow Provided by Financing Activities

$(1,675)

Now we must combine operating activities, investing activities, and financing activities to get the total cash flow (the change in Cash during the year). Next, we show the Cash balance from the prior year (December 31, 2007) and add it to total cash flow to get this year’s Cash balance (December 31, 2008). TANKER, INC. Statement of Cash Flows Year Ended December 31, 2008 Operating Activities Net income + Depreciation expense – Gain on sale of furniture + Decrease in accounts receivable – Increase in inventory – Increase in prepaid insurance + Increase in accounts payable Total cash flow provided by operating activities Investing Activities Cash paid to purchase new furniture Cash proceeds from sale of furniture Total cash flow provided by investing activities

Part 1

$ 1,000 110 (80) 120 (50) (30) 150 $ 1,220

$ $

(95) 90 (5)

Financing Activities Cash proceeds from new notes Cash repayment of old notes Cash purchase of treasury stock Cash dividends paid Total cash flow provided by financing activities Total cash flow (change in Cash balance) Cash, December 31, 2007 Cash, December 31, 2008

145 (500) (1,000) (320) $(1,675) $ (460) $1,160 $ 700

Noncash Investing and Financing Activities Purchase of furniture with note payable

$

Part 2

Part 3

$

200

Demo Doc Complete

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Demo Doc 2 Statement of Cash Flows (Direct Method) Learning Objectives

1, 2, 4

Use the information for Tanker Inc. in the previous question:

TANKER, INC. Comparative Balance Sheet December 31, 2008 and 2007 Assets 2008 2007 Change Liabilities Current: Current: $ 700 $1,160 $(460) Accounts payable Cash 300 Accounts receivable 420 (120) 800 Inventory 750 50 Long-term notes payable 120 Prepaid insurance 90 30 Total liabilities Owners’ Equity 1,500 1,400 Common stock (no par) Furniture (400) Retained earnings Less: Accum. Depr. (475) 1,100 Less: Treasury stock Net 925 Total equity $3,020 $3,345 Total liabilities and equity Total assets

2008

2007

Change

$ 680 $ 530 $ 150 660 815 $1,340 $1,345

(155)

1,800 1,800 880 200 (1,000) 0 $1,680 $2,000 $3,020 $3,345

TANKER, INC. Income Statement Year Ended December 31, 2008 Sales revenues Less cost of goods sold Gross margin

$3,400 (1,750) $1,650

Depreciation expense Insurance expense Other operating expenses

$ (110) (230) (390)

Gain on sale of furniture Net income

80 $1,000

Requirements 1. Prepare the operating activities section of Tanker’s statement of cash flows using the direct method. 2. How is the information a cash flow statement provides different from the information an income statement provides?

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Demo Doc 2 Solutions Requirement 1 Prepare the operating activities section of Tanker’s statement of cash flows using the direct method. Part 1

Part 2

Demo Doc Complete

We need to list all of the cash transactions involved in Tanker’s day-to-day business operations. For this task, we look at the income statement to get an idea of what these transactions are.

2


Cash Received from Customers

4

Prepare a statement of cash flows by the direct method

What is the first item on the income statement? Revenues. How does this item translate into a cash transaction? Revenues should result in customers giving Tanker cash, so the appropriate line on the direct method cash flow statement is “cash received from customers.” For each income statement account that is not 100% cash, there is always a balance sheet account to record the related accrual. In this case, Accounts Receivable (on the balance sheet) takes care of revenues when cash has not yet been collected. Accounts Receivable Bal. 12/31/07 Bal. 12/31/08

420 increases decreases 300

What could cause this account to increase? It would increase if Tanker had more sales. What could cause it to decrease? It would decrease if Tanker collected the cash. We know from the income statement that sales were $3,400, so: Accounts Receivable Bal. 12/31/07 Sales revenue Bal. 12/31/08

420 3,400 Cash collected

X

300 $420 # $3,400 " X ! $300

X ! Cash collected from customers ! $3,520

This amount appears on the direct method cash-flow statement. Cash Paid to Suppliers The next line on the income statement is cost of goods sold. How does this item relate to a cash transaction? In order to get the goods Tanker sold, it must buy the items from a supplier and pay for them. So the appropriate line on the cash flow statement is “cash paid to suppliers.” Accounts Payable is the balance sheet account that takes care of bills to suppliers that have not yet been paid. Accounts Payable Bal. 12/31/07 decreases increases Bal. 12/31/08

530 680 Demo Doc 2 Solutions | Chapter 13

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What could cause this account to increase? It would increase if Tanker had more bills (that is, if Tanker were to purchase inventory from its suppliers). What could cause it to decrease? It would decrease if Tanker paid the cash it owed to the suppliers. However, we don’t know how much inventory was purchased. We can figure this out using the inventory formula from Chapters 5 and 8: COGS !

Beginning Ending # Purchases " Inventory Inventory

$1,750 ! $750 # Purchases " $800 Purchases ! $1,800

Putting this amount into the Accounts Payable T-account: Accounts Payable Bal. 12/31/07 Cash payments

530

X Inventory purchases Bal. 12/31/08

1,800 680

$530 # $1,800 " X ! $680

X ! Cash payments to suppliers ! $1,650

This amount appears on the direct method cash-flow statement. Cash Paid for Expenses The next item on the income statement is depreciation expense. Because we know that it is 100% noncash, we can ignore it for the direct method. Next is insurance expense. This item would result in “cash paid as insurance.” To calculate this number, we need to analyze the Prepaid Insurance account. Prepaid Insurance Bal. 12/31/07

90 increases decreases 120

Bal. 12/31/08

What could cause this account to increase? It would increase if Tanker paid more insurance in advance. What could cause it to decrease? It would decrease if Tanker incurred that insurance expense. We know from the income statement that insurance expense was $230. Prepaid Insurance Bal. 12/31/07 Cash payments

90 X Insurance expense

Bal. 12/31/08

230

120 $90 # X " $230 ! $300

X ! Cash paid as insurance ! $260

This amount applies to the direct method statement of cash flows. Following insurance expense are other expenses. Let’s leave this item until the end. The gain on sale of furniture is a noncash transaction that does not affect a direct method cash-flow statement. 460


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Now, we come back to other expenses. Do any other current asset or current liability accounts remain with which we have not yet dealt? No, we have analyzed all of them, which means they have no accrual portion (that is, no noncash portion). So we can just assume that they were all paid in cash. Therefore, the last line in the operating activities section is “other cash expenses” of $390. Operating Activities Cash Collected from Customers

$3,520

Cash Paid to Suppliers

(1,650)

Cash Paid for Insurance

(260)

Other Cash Expenses

(390)

Cash Flow Provided by Operating Activities

$1,220

Notice that the “cash flow provided by operating activities” of $1,220 is the same total we calculated under the indirect method. It is always the case that cash flow from operating activities is the same under the direct and indirect methods. This check is a good way to confirm that our calculations are correct. Remember that the investing and financing activities are the same under both methods. So the rest of Tanker’s cash flow statement (investing activities to the end) would be identical to what is shown in Demo Doc 1.

Requirement 2 How is the information provided by a cash flow statement different from the information provided by an income statement?

Part 1

Part 2

Demo Doc Complete

The income statement shows the determination of net income. Net income is calculated on an accrual basis. Net income not only includes cash transactions; it also includes noncash transactions. We record revenue earned and expenses incurred regardless of whether cash has been received or paid. The cash flow statement shows the determination of cash flow (that is, the change in the cash balance during the year). Because the cash flow statement distills all transactions down to their cash components only, it is missing certain noncash transactions that are included in net income. Cash flow is actually net income under the cash basis of accounting. So the primary difference is that the income statement is prepared under the accrual basis of accounting whereas the cash-flow statement is prepared under the cash basis of accounting.

Part 1

Part 2

1

Explain the purposes the statement of cash flows and describe its elements

Demo Doc Complete


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Quick Practice Questions True/False _____ 1. The statement of cash flows helps to inform the reader about all of the differences between net income and cash flows from operations. _____ 2. A company may have net income but still have a net cash outflow. _____ 3. Cash payments for interest expense would be classified as a financing activity. _____ 4. Under the direct method, cash received from customers is calculated as the sum of Sales Revenue plus the increase in Accounts Receivable. _____ 5. Purchases of plant assets for cash would be classified as a financing activity. _____ 6. Under the indirect method, depreciation expense would be subtracted from net income in the operating activities. _____ 7. The majority of U.S. corporations use the direct method in preparing the statement of cash flows. _____ 8. Under the indirect method, the acquisition of land through the issuance of common stock would be an investing activity on the statement of cash flows. _____ 9. When using the indirect method, a loss on sale of equipment is added to net income under the operating activities. _____10. Interest received on a bond investment would be shown as an investing cash inflow.

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Multiple Choice 1. Which of the following statements is incorrect? a. A statement of cash flows is a basic financial statement required by GAAP b. A statement of cash flows is dated for a period of time as opposed to a point in time c. One purpose of a statement of cash flows is to predict future cash flows d. The statement of cash flows may be combined with the stockholders’ equity section of the balance sheet 2. Operating activities have a relationship with which part of the balance sheet? a. Current assets and current liabilities b. Long-term assets c. Owners’ equity and all liabilities d. Owners’ equity and long-term liabilities 3. Dividend payments would be included in which section of the statement of cash flows? a. Operating activities b. Financing activities c. Investing activities d. Dividend payments are not included on the statement of cash flows 4. Cash dividends received would be included in which section of the statement of cash flows? a. Operating activities b. Financing activities c. Investing activities d. Cash dividends received is not included on the statement of cash flows 5. The purchase of treasury stock would be included in which section of the statement of cash flows? a. Operating activities b. Financing activities c. Investing activities d. The purchase of treasury stock is not included on the statement of cash flows 6. Activities that create revenues and expenses are included in which section of the statement of cash flows? a. Investing activities b. Operating activities c. Financing activities d. Noncash investing and financing activities 7. Where are noncash investing and financing activities reported? a. The financing activities section of the statement of cash flows b. The investing activities section of the statement of cash flows c. Both a and b are correct d. An accompanying schedule to the statement of cash flows Quick Practice Questions | Chapter 13

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8. Where is the gain resulting from the sale of equipment shown under the indirect method? a. In the operating activities section as a deduction b. In the operating activities section as an addition c. In the investing activities section as an addition d. In the financing activities section as a deduction 9. Wilson Company’s 2008 income statement reports depreciation expense of $25,000. How would depreciation be shown on the statement of cash flows using the direct method for 2008? a. As an addition under financing activities b. As a deduction under operating activities c. As an addition under operating activities d. It would not be reported 10. Which of the following would be shown as a deduction to net income under the operating activities section using the indirect method? a. Depletion expense b. Increase in Accounts Payable account balance for the period c. Increase in Inventory balance for the period d. Decrease in Accounts Receivable account balance for the period

464


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Quick Exercises 13-1. Your best friend just lost his job because the company he was working for went bankrupt. He complains to you that even though the company had been profitable for three years in a row, it still went out of business. He wonders how such a thing can happen. a. Explain the most likely reason for the company’s declaring bankruptcy. Could your friend have seen it coming? How?

b. Discuss the four purposes of the statement of cash flows.

13-2. State whether each of the following events should be classified as an operating activity (O), investing activity (I), financing activity (F), shown in a separate schedule of noncash investing and financing activities (N), or not disclosed on the statement of cash flows (NA). ________ a. ________ b. ________ c. ________ d. ________ e. ________ f. ________ g. ________ h. ________ i. ________ j.

Received cash dividends. Retired bonds payable by issuing common stock. Paid for merchandise purchased on account. Paid interest on a short-term note payable. Received stock dividends. Paid for a three-year insurance policy on property. Issued preferred stock in exchange for land. Issued common stock for cash. Received cash from sale of land. Purchased equipment for cash.


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13-3. Using the following data, prepare the operating activities section of a statement of cash flows for Washington Corporation for the year ended December 31, 2008. Assume the indirect method is used. Increase in Salary Payable Decrease in Accounts Payable

2,000

Increase in Accounts Receivable

3,500

Net Income

98,000

Decrease in Inventory

5,800

Increase in Prepaid Expenses

1,200

Depreciation Expense, Equipment

5,000

Depreciation Expense, Buildings

7,500

Gain on Sale of Equipment

1,300

Loss on Sale of Patent

2,500

WASHINGTON CORPORATION Partial Statement of Cash Flows Year Ended December 31, 2008

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Chapter 13 | Quick Practice

$ 1,500

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13-4. For each of the following events, determine whether it should be classified as an operating activity (O), investing activity (I), or financing activity (F). Then determine the cash inflow or (outflow). Transaction Description

Type of Activity

Cash Inflow (Outflow)

a. Declared cash dividends of $21,000 during the current period. Dividends payable on January 1 were $1,500, the December 31 balance was $2,300.

___________

_____________

b. Interest income on the income statement for the current period is $22,000. Interest receivable on January 1 was $2,700; the December 31 balance was $2,250.

___________

_____________

c. Issued $1,000,000, 10-year, 10% bonds at 102.

___________

_____________

d. Sales on account for the current period amount to $160,000. The January 1 balance in Accounts Receivable was $95,000; the December 31 balance was $106,000.

___________

_____________

e. Purchased equipment for $215,000 cash.

___________

_____________

f. Sold 1,000 shares of $20 par common stock for cash at $29.

___________

_____________

g. Salary expense on the income statement for the current year is $151,500. The Salary Payable balance on January 1 was $20,300; the December 31 balance was $17,800.

___________

_____________


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13-5. Aycoth, Inc., gathered the following data from its accounting records for the year ended December 31, 2008: Depreciation Expense Payment of Income Taxes Collections of Accounts Receivable

$ 15,900 24,500 166,700

Purchase of Treasury Stock

40,000

Declaration of Stock Dividend

65,000

Loss on Sale of Plant Assets

8,400

Collection of Dividend Revenue

13,800

Payments of Salaries and Wages

83,600

Cash Sales

102,900

Net Income

61,200

Acquisition of Land

73,500

Payment of Interest

19,400

Interest Received on Investments Issuance of Bonds Payable Increase in Accounts Payable Payments to Suppliers Acquisition of Equipment by Issuing Long-Term Note Payable

3,100 500,000 20,300 170,300 50,000

Prepare the operating activities section of the statement of cash flows using the direct method.

AYCOTH INC. Partial Statement of Cash Flows Year Ended December 31, 2008

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Do It Yourself! Question 1 Indirect Method Clean Co. had the following information at December 31, 2008:

CLEAN CO. Comparative Balance Sheet December 31, 2008 and 2007 Assets 2008 Current: $ 460 Cash 510 Accounts receivable 710 Inventory 170 Prepaid rent Equipment Less: Accum. Depr. Net Total assets

1,350 (400) 950

2007 $320 420 750 250 1,500 (650) 850

$2,800 $2,590

Change

Liabilities Current: Accounts payable

$140 90 (40) Long-term notes payable (80) Total liabilities Owners’ Equity Common stock (no par) Retained earnings Total equity Total liabilities and equity

2008

2007

Change

$ 800 $ 540 $ 260 600 900 $1,400 $1,440 $ 200 1,200

(300)

150 1,000

$1,400 $1,150 $2,800 $2,590

CLEAN CO. Income Statement Year Ended December 31, 2008 Sales revenue Less cost of goods sold Gross margin

$1,800 (960) $ 840

Depreciation expense Rent expense Other operating expenses

$

Loss on sale of equipment Net income

(55) $ 360

(90) (140) (195)

Other important information includes the following: • Every year, Clean declares and pays cash dividends. • During 2008, Clean sold old equipment for cash. Clean also bought new equipment for $120 cash and a $140 note payable. • During 2008, Clean repaid $600 of notes payable in cash and borrowed new long-term notes payable for cash. • During 2008, new common stock was issued. No stock was retired.


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Requirement Prepare Clean’s statement of cash flows for the year ended December 31, 2008, using the indirect method. Equipment (Net)

Notes Payable

Common Stock

Retained Earnings

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Do It Yourself! Question 2 Direct Method Use the information for Clean, Inc., in the previous question.

Requirement Prepare the operating activities section of Clean’s statement of cash flows using the direct method. Accounts Receivable

Accounts Payable

Prepaid Rent

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1. The statement of cash flows helps to inform the reader about all of the differences between net income and cash flows from operations. (p. 690)

T

2. A company may have net income but still have a net cash outflow. (p. 691)

F

3. Cash payments for interest expense would be classified as a financing activity. False–Cash payments for interest expense would be classified as an operating activity. (p. 691)

F

4. Under the direct method, cash received from customers is calculated as the sum of Sales Revenue plus the increase in Accounts Receivable. False–Under the direct method, cash received from customers is calculated as Sales Revenue minus the increase in Accounts Receivable. (p. 692)

F

5. Purchases of plant assets for cash would be classified as a financing activity. False–Purchases of plant assets for cash would be classified as an investing activity. (pp. 692–693)

F

6. Under the indirect method, depreciation expense would be subtracted from net income in the operating activities. False–Under the indirect method, depreciation expense would be added to net income in the operating activities. (p. 692)

F

7. The majority of U.S. corporations use the direct method in preparing the statement of cash flows. False–The majority of U.S. corporations use the indirect method in preparing the statement of cash flows. (p. 702)

F

8. Under the indirect method, the acquisition of land through the issuance of common stock would be an investing activity on the statement of cash flows. False–Under the indirect method, the acquisition of land through the issuance of common stock would be a noncash investing and financing activity. (p. 702)

T

9. When using the indirect method, a loss on sale of equipment is added to net income under the operating activities. (pp. 697–698)

F

10. Interest received on a bond investment would be shown as an investing cash inflow. False–Interest received on a bond investment would be shown as an operating cash inflow. (p. 704) Quick Practice Solutions | Chapter 13

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Multiple Choice 1. Which of the following statements is incorrect? (p. 690) a. A statement of cash flows is a basic financial statement required by GAAP b. A statement of cash flows is dated for a period of time as opposed to a point in time c. One purpose of a statement of cash flows is to predict future cash flows d. The statement of cash flows may be combined with the stockholders’ equity section of the balance sheet 2. Operating activities have a relationship with which part of the balance sheet? (p. 691) a. Current assets and current liabilities b. Long-term assets c. Owners’ equity and all liabilities d. Owners’ equity and long-term liabilities 3. Dividend payments would be included in which section of the statement of cash flows? (p. 692) a. Operating activities b. Financing activities c. Investing activities d. Dividend payments are not included on the statement of cash flows 4. Cash dividends received would be included in which section of the statement of cash flows? (p. 691) a. Operating activities b. Financing activities c. Investing activities d. Cash dividends received is not included on the statement of cash flows 5. The purchase of treasury stock would be included in which section of the statement of cash flows? (pp. 691– 692) a. Operating activities b. Financing activities c. Investing activities d. The purchase of treasury stock is not included on the statement of cash flows 6. Activities that create revenues and expenses are included in which section of the statement of cash flows? (p. 691) a. Investing activities b. Operating activities c. Financing activities d. Noncash investing and financing activities 7. Where are noncash investing and financing activities reported? (p. 693) a. The financing activities section of the statement of cash flows b. The investing activities section of the statement of cash flows c. Both a and b are correct d. An accompanying schedule to the statement of cash flows 474


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8. Where is the gain resulting from the sale of equipment shown under the indirect method? (p. 694) a. In the operating activities section as a deduction b. In the operating activities section as an addition c. In the investing activities section as an addition d. In the financing activities section as a deduction 9. Wilson Company’s 2008 income statement reports depreciation expense of $25,000. How would depreciation be shown on the statement of cash flows using the direct method for 2008? (p. 696) a. As an addition under financing activities b. As a deduction under operating activities c. As an addition under operating activities d. It would not be reported 10. Which of the following would be shown as a deduction to net income under the operating activities section using the indirect method? (p.697) a. Depletion expense b. Increase in Accounts Payable account balance for the period c. Increase in Inventory balance for the period d. Decrease in Accounts Receivable account balance for the period


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Quick Exercise 13-1. Your best friend just lost his job because the company he was working for went bankrupt. He complains to you that even though the company had been profitable for three years in a row, it still went out of business. He wonders how such a thing can happen. (pp. 690–692) a. Explain the most likely reason for the company’s declaring bankruptcy. Could your friend have seen it coming? How? A profitable company is one in which revenues exceed expenses on an accrual basis. It does not necessarily mean that the company is generating enough cash to pay its bills. The most likely reason your friend’s company went bankrupt is lack of cash. If your friend had access to the statement of cash flows, the cash flow problems would likely have been evident. b. Discuss the four purposes of the statement of cash flows. 1. To help predict future cash flows 2. To evaluate management decisions 3. To determine the company’s ability to pay dividends to stockholders and interest and principal to creditors 4. To show the relationship of net income to changes in the business’s cash 13-2. State whether each of the following events should be classified as an operating activity (O), investing activity (I), financing activity (F), shown in a separate schedule of noncash investing and financing activities (N), or not disclosed on the statement of cash flows (NA). (pp. 691–692) O N O O NA O N F I I

476


a. b. c. d. e. f. g. h. i. j.

Received cash dividends. Retired bonds payable by issuing common stock. Paid for merchandise purchased on account. Paid interest on a short-term note payable. Received stock dividends. Paid for a three-year insurance policy on property. Issued preferred stock in exchange for land. Issued common stock for cash. Received cash from sale of land. Purchased equipment for cash.

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13-3. Using the following data, prepare the operating activities section of a statement of cash flows for Washington Corporation for the year ended December 31, 2008. Assume the indirect method is used. (pp. 696–697) Increase in Salary Payable

$ 1,500

Decrease in Accounts Payable

2,000

Increase in Accounts Receivable

3,500

Net Income

98,000

Decrease in Inventory

5,800

Increase in Prepaid Expenses

1,200

Depreciation Expense, Equipment

5,000

Depreciation Expense, Buildings

7,500

Gain on Sale of Equipment

1,300

Loss on Sale of Patent

2,500

WASHINGTON CORPORATION Partial Statement of Cash Flows Year Ended December 31, 2008 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation on equipment Depreciation on buildings Loss on sale of patent Gain on sale of equipment Increase in accounts receivable Increase in prepaid expenses Decrease in inventory Increase in salary payable Decrease in accounts payable Net cash inflow from operating activities

$ 98,000

$5,000 7,500 2,500 (1,300) (3,500) (1,200) 5,800 1,500 (2,000)

14,300 $112,300


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13-4. For each of the following events, determine whether it should be classified as an operating activity (O), investing activity (I), or financing activity (F). Then determine the cash inflow or (outflow). (pp. 704–707) Transaction Description a. Declared cash dividends of $21,000 during the current period. Dividends payable on January 1 were $1,500, the December 31 balance was $2,300. b. Interest income on the income statement for the current period is $22,000. Interest receivable on January 1 was $2,700; the December 31 balance was $2,250. c. Issued $1,000,000, 10-year, 10% bonds at 102. d. Sales on account for the current period amount to $160,000. The January 1 balance in Accounts Receivable was $95,000; the December 31 balance was $106,000. e. Purchased equipment for $215,000 cash. f. Sold 1,000 shares of $20 par common stock for cash at $29. g. Salary expense on the income statement for the current year is $151,500. The Salary Payable balance on January 1 was $20,300; the December 31 balance was $17,800.

478


Type of Activity

F

Cash Inflow (Outflow)

$

(20,200)

O

$22,450

F

$1,020,000

O

$ 149,000

I

$(215,000)

F

$ 29,000

O

$(154,000)

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13-5. Aycoth, Inc., gathered the following data from its accounting records for the year ended December 31, 2008: Depreciation Expense Payment of Income Taxes Collections of Accounts Receivable

$ 15,900 24,500 166,700

Purchase of Treasury Stock

40,000

Declaration of Stock Dividend

65,000

Loss on Sale of Plant Assets

8,400

Collection of Dividend Revenue

13,800

Payments of Salaries and Wages

83,600

Cash Sales

102,900

Net Income

61,200

Acquisition of Land

73,500

Payment of Interest

19,400

Interest Received on Investments Issuance of Bonds Payable Increase in Accounts Payable Payments to Suppliers Acquisition of Equipment by Issuing Long-Term Note Payable

3,100 500,000 20,300 170,300 50,000

Prepare the operating activities section of the statement of cash flows using the direct method. (pp. 702–706)

AYCOTH, INC. Partial Statement of Cash Flows Year Ended December 31, 2008 Cash flows from operating activities: Receipts Collections from customers Interest received Dividends received Total cash receipts Payments: To suppliers To employees For interest For income tax Total cash payments Net cash outflow from operating activities

$ 269,600* 3,100 13,800 $286,500 $(170,300) (83,600) (19,400) (24,500) (297,800) $ (11,300)

*($166,700 + $102,900 = $269,600)


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Do It Yourself! Question 1 Solution Requirement Prepare Clean’s statement of cash flows for the year ended December 31, 2008, using the indirect method.

2

3

Distinguish between operating, investing, and financing cash flows Prepare a statement of cash flows by the indirect method

Calculations: Investing Activities The $140 note payable is a noncash transaction Equipment (Net) Bal. 12/31/07 850 Cash purchases 120 Noncash purchases 140 NBV equipment sold X Depreciation expense 90 Bal. 12/31/08

950

X ! NBV of Equipment Sold ! $70 Loss ! – $55 ! Cash Received – $70 Cash Received on Sale of Equipment ! $15

2

3

Distinguish between operating, investing, and financing cash flows Prepare a statement of cash flows by the indirect method

Calculations: Financing Activities Notes Payable Bal. 12/31/07 Note repayments

900

600 New cash notes X New noncash notes 140 Bal. 12/31/08

600

New Cash Notes ! X ! $160 Common Stock Bal. 12/31/07 Retirements

150

0 New stock issued Bal. 12/31/08

X 200

New Stock Issued ! X ! $50 Retained Earnings Bal. 12/31/07 Cash dividends paid

Net Income Bal. 12/31/08 Cash Dividends Paid ! X ! $160

480


1,000

X 360 1,200

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CLEAN CO. Statement of Cash Flows Year Ended December 31, 2008 Operating Activities Net income + Depreciation expense + Loss on sale of equipment – Increase in accounts receivable + Decrease in inventory + Decrease in prepaid rent + Increase in accounts payable Total cash flow provided by operating activities

$360 90 55 (90) 40 80 260 $795

Investing Activities Cash paid to purchase new equipment Cash proceeds from sale of equipment Total cash flow provided by investing activities

$(120) 15 $(105)

Financing Activities Cash proceeds from new notes Cash repayment of old notes Cash proceeds from new stock issue Cash dividends paid Total cash flow provided by financing activities Total cash flow (change in Cash during year) Cash, December 31, 2007 Cash, December 31, 2008

$160 (600) 50 (160) $(550) $140 $320 $460

Noncash Investing and Financing Activities Purchase of equipment with note payable

$140


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Do It Yourself! Question 2 Solutions Requirement

2


4

Prepare a statement of cash flows by the direct method

Prepare the operating activities section of Clean’s statement of cash flows using the direct method. Accounts Receivable Bal. 12/31/07 Sales revenue

420 1,800 Cash collected

Bal. 12/31/08

X

510

X ! Cash Collected from Customers ! $1,710 COGS ! $960 ! $750 # Purchases – $710 Purchases ! $920 Accounts Payable Bal. 12/31/07 Cash payments

540

X Inventory purchases 920 Bal. 12/31/08

800

X ! Cash Payments to Suppliers ! $660 Prepaid Rent Bal. 12/31/07 Cash payments

250 X Rent expense

Bal. 12/31/08

140

170

X ! Cash Paid as Rent ! $60

Operating Activities Cash Collected from Customers Cash Paid to Suppliers Cash Paid for Rent Other Cash Expenses Cash Flow from Operating Activities

482


$1,710 (660) (60) (195) $ 795

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The Power of Practice For more practice using the skills learned in this chapter, visit MyAccountingLab. There you will find algorithmically generated questions that are based on these Demo Docs and your main textbook’s Review and Accounting Practice sections. To go to MyAccountingLab and follow these steps: 1. Direct your URL to www.myaccountinglab.com. 2. Log in using your name and password. 3. Click the MyAccountingLab link. 4. Click Study Plan in the left navigation bar. 5. From the table of contents, select Chapter 13, The Statement of Cash Flows. 6. Click a link to work on the tutorial exercises.


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14

Financial Statement Analysis

WHAT YOU PROBABLY ALREADY KNOW For years now, you have been a student and have taken many exams. You probably already know that receiving your grades evokes some typical responses. Your first reaction may be the level of satisfaction you have with your grade compared to your previous grades received in that class and the established grading norms for your institution. You may then ask your friends what grade they received so that you can compare your results with theirs. The instructor may announce the average exam results and you could then determine whether you performed better or worse than the average. Students often like to assess their performance by comparing their grade to a standard, their peers, and the average. Businesses do the same thing. In this chapter, you study various techniques and ratios that a business can use to assess its performance using comparisons to previous results, competitors, and the industry average.

Learning Objectives

1

Perform a horizontal analysis of comparative financial statements. Horizontal analysis provides comparisons of financial information over time. To analyze a line item in the financial statements, the difference between the current and earlier time period amounts is computed. The dollar amount change of the line item between the periods is useful, but it is more informative to determine the percentage change by dividing the dollar change (current period amount, or this year’s balance, minus the earlier period amount, or last year’s balance) by the earlier period amount. Review the horizontal analysis of the income statement and the balance sheet in Exhibits 14-1 and 14-2 (pp. 750–751).

2

Perform a vertical analysis of financial statements. Vertical analysis provides comparisons of individual items on a financial statement to a relative base. The base, which serves as the denominator, is usually net sales for the income statement and total assets for the balance sheet. The vertical analysis percentage is calculated by dividing each financial statement item amount by the relevant base of net sales or total assets. The vertical analysis percentage is shown next to the item amount on the financial statement. Review the vertical analysis of the income statement and the balance sheet in Exhibits 14-4 and 14-5 (pp. 753–754).

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Prepare and use common-size financial statements. A common-size statement is similar to the vertical analysis but shows only the vertical analysis percentages of each item in the financial statement. This presentation permits ready comparisons between companies of various sizes. Review the common-size comparisons of Target versus the industry average and Wal-Mart in in Exhibits 14-6 (p. 755 ) and 14-7 (p. 755).

4

Compute the standard financial ratios. Financial ratios are helpful to assess a company’s performance and financial position. Trends can be determined and comparisons to competing companies can be made. Various ratios are presented to measure the following: • • • • •

Ability to pay current liabilities Ability to sell inventory and collect receivables Ability to pay long-term debt Profitability Return on stock investment

Review “Using Ratios to Make Decisions” in the main text for descriptions and formulas for the financial ratios.

5

Measure economic value added. Economic value added, which is used to evaluate a company’s operating performance, is equal to Net income plus Interest expense minus Capital charge. Capital charge is the amount that stockholders and lenders charge a company for the use of their money. It is calculated by adding notes payable, loans payable, long-term debt, and stockholders’ equity, then multiplying that sum by the cost of capital (a weighted average of the returns demanded by the company’s stockholders and lenders). Review the section entitled “Economic Value Added” in the main textbook.

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Demo Doc 1 Financial Statement Analysis Learning Objectives

1–5

MeMe Co. had the following information at December 31, 2008:

MEME CO. Comparative Balance Sheet December 31, 2008 and 2007 2008

2007

$150 80 130 $360

$130 145 190 $465

$ 90 140 $230

$140 220 $360

20 110 $130 $360

10 95 $105 $465

(Dollar amounts in millions) Sales revenue Less: Cost of goods sold Gross profit

2008 $650 430 $220

2007 $580 350 $230

Salary expense Interest expense Total expense Net income

120 70 $190 $ 30

140 80 $220 $ 10

(Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Bonds payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

MEME CO. Comparative Income Statement December 31, 2008 and 2007

At December 31, 2006, MeMe’s inventory was $160,000,000 and total equity was $95,000,000.

Requirements 1. Prepare horizontal and vertical analyses for MeMe’s financial statements. 2. Calculate MeMe’s inventory turnover and rate of return on stockholders’ equity ratios for both years. 3. Assuming a 10% cost of capital, what is MeMe’s economic value added for 2008? Demo Doc 1 | Chapter 14

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Demo Doc 1 Solutions Requirement 1 Prepare horizontal and vertical analyses for MeMe’s financial statements. Horizontal Analysis Part 1

1

Perform a horizontal analysis of comparative financial statements

Part 2

Part 3

Part 4

Demo Doc Complete

As its name implies, horizontal analysis goes across the rows of the financial statements, looking at one account and how it has changed. For each number on the balance sheet and income statement, we calculate the dollar change and the percent change. Dollar This Year’s Last Year’s ! " Change Balance Balance

For example, the dollar changes in Accounts Receivable and Sales Revenue: Accounts Receivable ! $800,000,000 – $145,000,000 ! $(65,000,000) Change Sales Revenue ! $650,000,000 – $580,000,000 ! $70,000,000 Change

Notice that the parentheses around the change in Accounts Receivable indicates a decrease, while the positive value for the change in Sales Revenue indicates that it increased. Extra care must be taken when using this calculation on expenses (because they are assumed to be subtracted/negative numbers on the income statement). The absolute value of the expense (that is, ignoring the fact that it is subtracted) must be used to calculate dollar change. For example, the dollar change of COGS and Interest Expense is: COGS ! $430,000,000 – $350,000,000 ! $80,000,000 Change Interest Expense ! $70,000,000 – $80,000,000 ! $(10,000,000) Change

Again, the positive value indicates that COGS increased and the negative value indicates that Interest Expense decreased. Dollar Change Percent ! Change Last Year’s Balance

For example, the percent change of Accounts Receivable and Sales Revenue is: Percent Change

!

Dollar Change Last Year's Balance

Accounts Receivable

!

$(65,000,000) $145,000,000

!

(44.8)% Change

Sales Revenue ! !

$70,000,000 $580,000,000 12.1% Change

Again, the percent change numbers are negative for Accounts Receivable (which decreased in 2008) and positive for Sales Revenue (which increased in 2008). 488


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The percent change is calculated the same way for expenses, again using the absolute value of the expenses. For example, the percent change of COGS and Interest Expense is: COGS

! !

Interest Expense

$80,000,000 $350,000,000 22.9% Change

!

$(10,000,000) $80,000,000

!

(12.5)% Change

MEME CO. Horizontal Analysis of Comparative Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Bonds payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2007

Increase (Decrease) Amount Percent 15.4 % $ 20 (44.8) (65) (31.6) (60) (22.6) $(105)

$150 80 130 $360

$130 145 190 $465

$ 90 140 $230

$140 220 $360

$ 50 80 $(130)

(35.7)% (36.4) (36.1)

20 110 $130 $360

10 95 $105 $465

10 15 $ 25 $(105)

100.0 % 15.8 23.8 (22.6)%

MEME CO. Horizontal Analysis of Comparative Income Statement Years Ended December 31, 2008 and 2007 (Dollar amounts in millions)

2008

2007

Sales revenue Less: Cost of goods sold Gross profit

$650 430 $220

$580 350 $230

Salary expense Interest expense Total expenses Net income

120 70 $190 $ 30

140 80 $220 $ 10

Increase (Decrease) Amount Percent 12.1 % $ 70 22.9 80 (4.3) $(10) (20) (10) $(30) $ 20

(14.3) (12.5) (13.6) 200.0 %


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Vertical Analysis

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

As its name implies, vertical analysis takes each number on the financial statement and compares it to others in the same year (that is, down the columns of the financial statements). Vertical analysis is sometimes called common-size analysis because it allows two companies of different sizes to be compared (through the use of percentages). Balance Sheet Vertical Analysis On the balance sheet, each number, whether it be an asset, a liability, or an equity account, is calculated as a percentage of total assets. Account Balance Total Assets

Vertical Analysis Percent ! (Balance Sheet)

So in the case of accounts receivable: Vertical Analysis Percent ! eivable) (2008 Accounts Rece !

$80,000,000 $360,000,000 22.2%

In other words, about 22% of all the assets in 2008 are in Accounts Receivable. Income Statement Vertical Analysis On the income statement, each number is calculated as a percentage of net sales revenues. Vertical Analysis Percent ! (Income Statement)

Account Balance Net Sales Revenues

So in the case of gross profit: Vertical Analysis Percent ! (2008 Gross Profit)) !

$220,000,000 $650,000,000 33.8%

This figure means that for every dollar in sales revenues, about $0.34 went to gross profit. For expenses, the calculation is the same. So in the cases of COGS and interest expense: Vertical Analysis Percent ! (2008 COGS) ! Vertical Analysis Percent ! (2008 Interest Expense) ! 490


$430,000,000 $650,000,000 66.2% $70,000,000 $650,000,000 10.8%

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MEME CO. Vertical Analysis of Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Bonds payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2008%

2007

2007%

$150 80 130 $360

41.7 % 22.2 36.1 100.0 %

$130 145 190 $465

28.0 % 31.1 * 40.9 100.0 %

$ 90 140 $230

25.0 % 38.9 63.9 %

$140 220 $360

30.1 % 47.3 77.4 %

5.5 %* $ 10 30.6 95 36.2 % $205 100.0 % $465

2.2 % 20.4 33.6 % 100.0 %

$ 20 110 $130 $360

*Rounded down to balance

MEME CO. Vertical Analysis of Income Statement Years Ended December 31, 2008 and 2007 (Dollar amounts in millions) Sales revenue Less: Cost of goods sold Gross profit

2008 2008% $650 100.0 % 430 66.2 $220 33.8 %*

2007 2007% $580 100.0 % 350 60.4 $230 39.6 %*

Salary expense Interest expense Net income

120 70 $ 30

140 80 $ 10

18.4 10.8 4.6 %

24.1 13.8 1.7 %

*Rounded to balance

Requirement 2 Calculate MeMe’s inventory turnover and rate of return on stockholders’ equity ratios for both years.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

4

COGS Inventory ! Turnover Average Inventory

Compute the standard financial ratios

Remember that average (when used in a financial ratio) generally means the beginning balance plus the ending balance divided by two. Demo Doc 1 Solutions | Chapter 14

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2008 Inventory Turnover 2007 Inventory Turnover

Rate of Return on Stockholder’s Equity

!

$430,000,000 ($190,000,000 # $130,000,000)/2

!

2.7 times

!

$350,000,000 ($160,000,000 # $190,000,000)/2

!

2 times

!

Net income " Preferred Dividends Average Common Share Equity

2008 Rate of Retturn on ! Stockholders’ Equity ! 2007 Rate of Return on ! Stockholders’ Equity !

$30,000,000 " $0 ($105,000,000 # $130,000,000)/2 25.5% $10,000,000 " $0 ($95,000,000 # $105,000,000)/2 10%

Requirement 3 Assuming a 10% cost of capital, what is MeMe’s economic value added for 2008?

Part 1

5

Part 2

Part 3

Part 4

Demo Doc Complete

Economic Value Added (EVA)

Measure economic value added

! Net Income # Interest Expense – Capital Charge

Where, in this case, the capital charge is: Capital Charge ! (Bonds Payable # Equity) $ Cost of Capital MeMe’s 2008 Capital Charge ! ($140,000,000 # $130,000,000) $ 10% ! $27,000,000

So, MeMe’s 2008 EVA: ! $30,000,000 Net Income # $70,000,000 Interest Expense – $27,000,000 Capital Charge ! $73,000,000

Part 1

492


Part 2

Part 3

Part 4

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. It is generally considered more useful to know the percentage change in financial statement amounts from year to year than to know the absolute dollar amount of their change. _____ 2. Benchmarking may be done against an industry average or against a key competitor. _____ 3. Vertical analysis of financial statements reveals changes in items on the financial statements over time. _____ 4. Inventory turnover is the ratio of average inventory to cost of goods sold. _____ 5. Dividend yield is the ratio that measures the percentage of a stock’s market value that is returned annually as dividends. _____ 6. A high current ratio means that a company’s current assets represent a relatively large portion (or ratio) of total liabilities. _____ 7. The debt ratio measures the ability to pay current liabilities. _____ 8. The acid-test (quick) ratio includes the sum of Cash, Net Accounts Receivable, and Inventory accounts in the numerator. _____ 9. Earnings per share indicate the net income earned for each share of common and preferred stock. _____10. There is a direct relationship between leverage and the debt ratio; the higher the debt ratio, the greater the leverage.

Multiple Choice 1. Horizontal analysis can be described as which of the following? a. Percentage changes in various financial statement amounts from year to year b. The changes in individual financial statement amounts as a percentage of some related total c. The change in key financial statement ratios over a certain time frame or horizon d. None of the above 2. Trend percentages can be considered a form of which of the following? a. Ratio analysis b. Vertical analysis c. Profitability analysis d. Horizontal analysis Quick Practice Questions | Chapter 14

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3. In 2008, net sales were $1,600,000 and in 2009, net sales were $1,750,000. How is the percent change calculated? a. Divide $1,600,000 by $1,750,000 b. Divide $1,750,000 by $1,600,000 c. Divide $150,000 by $1,750,000 d. Divide $150,000 by $1,600,000 4. Vertical analysis can be described as which of the following? a. Percentage changes in the balances shown in comparative financial statements b. The change in key financial statement ratios over a specified period of time c. The dollar amount of the change in various financial statement amounts from year to year d. Individual financial statement items expressed as a percentage of a base (which represents 100%) 5. What is the base that is used when performing vertical analysis on an income statement? a. Net sales b. Gross sales c. Gross profit d. Total expenses 6. What is the base that is used when performing vertical analysis on a balance sheet? a. Total assets b. Stockholders’ equity c. Total liabilities d. Net assets 7. Which ratio measures the ability to pay long-term debt? a. Rate of return on net sales b. Earnings per share c. Times-interest-earned ratio d. Acid-test (quick) ratio 8. Which of the following would be most helpful in the comparison of different-sized companies? a. Performing horizontal analysis b. Looking at the amount of income earned by each company c. Comparing working capital balances d. Preparing common-size financial statements 9. Which ratio(s) help(s) in the analysis of working capital? a. Current ratio b. Acid-test ratio c. Debt ratio d. Both a and b are correct 10. Assume that collections from customers on account are being received faster. Which of the following would be true? a. The accounts receivable turnover would be higher b. The days’ sales in receivables would be higher c. The current ratio would be higher d. None of the above 494


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Quick Exercises 14-1. Selected items from the balance sheet and income statement are shown as follows for the Brothers Company for 2007 and 2008. Calculate the amount of the change and the percentage of change for each item. 2008

2007

$121,000

$100,000

117,000

125,000

Merchandise inventory

70,000

85,000

Accounts payable

63,500

50,000

144,000

135,000

74,000

67,500

Cash Accounts receivable

Sales Cost of goods sold

$ Change % Change

14-2. The income statement for Commerce Corporation for the year ended December 31, 2007, follows.

COMMERCE CORPORATION Income Statement Year Ended December 31, 2007 Net sales Expenses Cost of goods sold General expenses Selling expenses Interest expense Income tax expense Total expenses Net income

$661,000 $268,500 49,300 45,000 35,000 30,000 427,800 $233,200

a. Prepare a vertical analysis of the income statement showing appropriate percentages for each item listed in the income statement.

COMMERCE CORPORATION Vertical Analysis Income Statement For theYear Ended December 31, 2007 Amount Percentage Net sales Expenses Cost of goods sold General expenses Selling expenses Interest expense Income tax expense Total expenses Net income Quick Practice Questions | Chapter 14

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b. What additional information would you need to determine whether these percentages are good or bad?

14-3. Financial ratios and analytical functions are listed as follows. Match the function with the appropriate ratio. Functions: a. Gives the amount of net income earned for each share of the company’s common stock b. Measures the number of times operating income can cover interest expense c. Shows ability to pay all current liabilities if they come due immediately d. Shows the percentage of a stock’s market value returned to stockholders as dividends each period e. Measures ability to collect cash from credit customers f. Measures ability to pay current liabilities with current assets g. Indicates the market price of $1 of earnings h. Measures the difference between current assets and current liabilities i. Indicates percentage of assets financed with debt j. Shows the percentage of each sales dollar earned as net income Ratios: 1. ________ Dividend yield 2. ________ Rate of return on net sales 3. ________ Accounts receivable turnover 4. ________ Working capital 5. ________ Debt ratio 6. ________ Current ratio 7. ________ Price/earnings ratio 8. ________ Times-interest-earned ratio 9. ________ Acid-test ratio 10. ________ Earnings per share of common stock

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14-4. Following are the data for Dream Corporation for 2008: Market price per share of common stock at 12/31/08

$

Net income

$50,000.00

Number of common shares outstanding Dividend per share of common stock

9.00

25,000.00 $

0.71

Using the data, calculate the following ratios for Dream Corporation: a. Earnings per share of common stock

b. Price/earnings ratio

c. Dividend yield


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14-5. Following are selected data from the comparative income statement and balance sheet for Deerfield Corporation for the years ended December 31, 2008 and 2007: 2008 Net sales (all on credit)

2007

$97,600

$93,000

Cost of goods sold

53,500

52,500

Gross profit

44,700

40,500

Income from operations

16,300

15,000

Interest expense

3,100

3,500

Net income

9,800

9,000

Cash

7,700

7,500

Accounts receivable, net

10,700

12,500

Inventory

20,000

26,000

1,000

900

Total current assets

39,400

46,900

Total long-term assets

50,000

67,000

Total current liabilities

32,000

44,500

Total long-term liabilities

11,000

39,800

Common stock, no par*

10,000

10,000

Retained earnings

25,400

19,600

Prepaid expenses

*Note: 2,000 shares of common stock have been issued and outstanding since the company started operations. During the entire fiscal year ended December 31, 2008, the stock was selling for $45 per share.

Calculate the following ratios at December 31, 2008: a. Acid-test ratio b. Inventory turnover c. Days’ sales in receivables d. Price/earnings ratio e. Rate of return on total assets f. Times-interest-earned ratio g. Current ratio h. Debt ratio

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Do It Yourself! Question 1 Tykes, Inc., had the following information at December 31, 2008:

TYKES, INC. Comparative Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Loans payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2007

$400 290 150 $840

$300 350 220 $870

$140 450 $590

$ 75 600 $675

40 210 $250 $840

40 155 $195 $870

TYKES INC. Comparative Income Statement Years Ended December 31, 2008 and 2007 Sales revenue Less: Cost of goods sold Gross profit

2008 2007 $1,200 $1,000 600 800 $ 400 $ 400

Insurance expense Interest expense Net income

190 200 80 60 $ 140 $ 130

At December 31, 2006, Tykes’ inventory was $200,000,000 and total equity was $165,000,000.


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Requirements 1. Prepare a horizontal analysis of Tykes’ financial statements.

TYKES, INC. Horizontal Analysis of Comparative Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Loans payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2007

$400 290 150 $840

$300 350 220 $870

$140 450 $590

$ 75 600 $675

40 210 $250 $840

40 155 $195 $870

Increase (Decrease) Amount Percent

TYKES, INC. Horizontal Analysis of Comparative Income Statement Years Ended December 31, 2008 and 2007 (Dollar amounts in millions)

500

2008

2007


$1,200 $1,000 600 800 $ 400 $ 400


190 200 80 60 $ 140 $ 130


Increase (Decrease) Percent Amount

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2. Prepare a vertical analysis of Tykes’ financial statements.

TYKES, INC. Vertical Analysis of Comparative Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Loans payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2008%

2007

$400 290 150 $840

$300 350 220 $870

$140 450 $590

$ 75 600 $675

$ 40 210 $250 $840

$ 40 155 $195 $870

2007%

2

Perform a vertical analysis of financial statements

3

Prepare and use common-size financial statements

4

Compute the standard financial ratios

TYKES, INC. Vertical Analysis of Comparative Income Statement Years Ended December 31, 2008 and 2007 (Dollar amounts in millions) Net sales revenue Less: Cost of goods sold Gross profit

2008 2008% 2007 2007% $1,200 $1,000 800 600 $ 400 $ 400


200 60 $ 140

190 80 $ 130

3. Calculate Tykes’ inventory turnover and rate of return on stockholders’ equity ratios for both years.


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1. It is generally considered more useful to know the percentage change in financial statement amounts from year to year than to know the absolute dollar amount of their change. (p. 749)

T

2. Benchmarking may be done against an industry average or against a key competitor. (p. 753)

F

3. Vertical analysis of financial statements reveals changes in items on the financial statements over time. False–Horizontal analysis of financial statements reveals changes in items on the financial statements over time. (p. 749)

F

4. Inventory turnover is the ratio of average inventory to cost of goods sold. False–Inventory turnover is the ratio of cost of goods sold to average inventory. (p. 760)

T

5. Dividend yield is the ratio that measures the percentage of a stock’s market value that is returned annually as dividends. (p. 763)

F

6. A high current ratio means that a company’s current assets represent a relatively large portion (or ratio) of total liabilities. False–A high current ratio means that a company’s current assets represent a relatively large portion (or ratio) of total current liabilities. (p. 757)

F

7. The debt ratio measures the ability to pay current liabilities. False–The debt ratio measures the percentage of assets financed with debt. (p. 761)

F

8. The acid-test (quick) ratio includes the sum of Cash, Net Accounts Receivable, and Inventory accounts in the numerator. False–The acid-test (quick) ratio includes the sum of Cash, ShortTerm Investments, and Net Receivables in the numerator. (p. 757)

F

9. Earnings per share indicate the net income earned for each share of common and preferred stock. False–Earnings per share indicate the net income earned for each share of the company’s common stock. (p. 759)

T

502

10. There is a direct relationship between leverage and the debt ratio; the higher the debt ratio, the greater the leverage. (p. 757)


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Multiple Choice 1. Horizontal analysis can be described as which of the following? (p. 749) a. Percentage changes in various financial statement amounts from year to year b. The changes in individual financial statement amounts as a percentage of some related total c. The change in key financial statement ratios over a certain time frame or horizon d. None of the above 2. Trend percentages can be considered a form of which of the following? (p. 751) a. Ratio analysis b. Vertical analysis c. Profitability analysis d. Horizontal analysis 3. In 2008, net sales were $1,600,000 and in 2009, net sales were $1,750,000. How is the percent change calculated? (p. 750) a. Divide $1,600,000 by $1,750,000 b. Divide $1,750,000 by $1,600,000 c. Divide $150,000 by $1,750,000 d. Divide $150,000 by $1,600,000 4. Vertical analysis can be described as which of the following? (p. 752) a. Percentage changes in the balances shown in comparative financial statements b. The change in key financial statement ratios over a specified period of time c. The dollar amount of the change in various financial statement amounts from year to year d. Individual financial statement items expressed as a percentage of a base (which represents 100%) 5. What is the base that is used when performing vertical analysis on an income statement? (p. 752) a. Net sales b. Gross sales c. Gross profit d. Total expenses 6. What is the base that is used when performing vertical analysis on a balance sheet? (p. 752) a. Total assets b. Stockholders’ equity c. Total liabilities d. Net assets


503

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7. Which ratio measures the ability to pay long-term debt? (p. 762) a. Rate of return on net sales b. Earnings per share c. Times-interest-earned ratio d. Acid-test (quick) ratio 8. Which of the following would be most helpful in the comparison of different-sized companies? (p. 754) a. Performing horizontal analysis b. Looking at the amount of income earned by each company c. Comparing working capital balances d. Preparing common-size financial statements 9. Which ratio(s) help(s) in the analysis of working capital? (p. 757) a. Current ratio b. Acid-test ratio c. Debt ratio d. Both a and b are correct 10. Assume that collections from customers on account are being received faster. Which of the following would be true? (p. 760) a. The accounts receivable turnover would be higher b. The days’ sales in receivables would be higher c. The current ratio would be higher d. None of the above

504


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Quick Exercise Solutions 14-1. Selected items from the balance sheet and income statement are shown as follows for the Brothers Company for 2007 and 2008. Calculate the amount of the change and the percentage of change for each item. (p. 749) 2008

2007

$121,000

$100,000

$21,000

21.0%

117,000

125,000

(8,000)

(6.4)

Merchandise inventory

70,000

85,000

(15,000)

(17.6)

Accounts payable

63,500

50,000

13,500

27.0

144,000

135,000

9,000

6.7

74,000

67,500

6,500

9.6

Cash Accounts receivable

Sales Cost of goods sold

$ Change

% Change

14-2. The income statement for Commerce Corporation for the year ended December 31, 2007, follows: (p. 752) COMMERCE CORPORATION Income Statement For theYear Ended December 31, 2007 Net sales Expenses Cost of goods sold General expenses Selling expenses Interest expense Income tax expense Total expenses Net income

$661,000 $268,500 49,300 45,000 35,000 30,000 427,800 $233,200

a. Prepare a vertical analysis of the income statement showing appropriate percentages for each item listed in the income statement. COMMERCE CORPORATION Vertical Analysis Income Statement For theYear Ended December 31, 2007 Net sales Expenses Cost of goods sold General expenses Selling expenses Interest expense Income tax expense Total expenses Net income

Amount Percentage 100.0 % $661,000 268,500 49,300 45,000 35,000 30,000 427,800 $233,200

40.6 7.5 6.8 5.3 4.5 64.7 35.3 %


505

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b. What additional information would you need to determine whether these percentages are good or bad? Additional information to determine whether these percentages are good or bad might include: • industry averages to compare to Commerce Corporation, and • the change in each line item percentage over a relevant period of time 14-3. Financial ratios and analytical functions are listed as follows. Match the function with the appropriate ratio. (pp. 756–762) Functions: a. Gives the amount of net income earned for each share of the company’s common stock b. Measures the number of times operating income can cover interest expense c. Shows ability to pay all current liabilities if they come due immediately d. Shows the percentage of a stock’s market value returned to stockholders as dividends each period e. Measures ability to collect cash from credit customers f. Measures ability to pay current liabilities with current assets g. Indicates the market price of $1 of earnings h. Measures the difference between current assets and current liabilities i. Indicates percentage of assets financed with debt j. Shows the percentage of each sales dollar earned as net income Ratios: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

d j e h i f g b c a

Dividend yield Rate of return on net sales Accounts receivable turnover Working capital Debt ratio Current ratio Price/earnings ratio Times-interest-earned ratio Acid-test ratio Earnings per share of common stock

14-4. Following are the data for Dream Corporation for 2008: (pp. 759–763) Market price per share of common stock at 12/31/08

$

Net income

$50,000

Number of common shares outstanding Dividend per share of common stock

506


9.00

25,000 $

0.71

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Using the data, calculate the following ratios for Dream Corporation: a. Earnings per share of common stock $50,000/25,000 = $2.00 b. Price/earnings ratio $9.00/$2.00 = 4.5 c. Dividend yield $0.71/$9.00 = 0.08 14-5. Following are selected data from the comparative income statement and balance sheet for Deerfield Corporation for the years ended December 31, 2008 and 2007: (pp. 756–762) 2008 Net sales (all on credit)

2007

$97,600

$93,000

Cost of goods sold

53,500

52,500

Gross profit

44,700

40,500

Income from operations

16,300

15,000

Interest expense

3,100

3,500

Net income

9,800

9,000

Cash

7,700

7,500

Accounts receivable, net

10,700

12,500

Inventory

20,000

26,000

1,000

900

Total current assets

39,400

46,900

Total long-term assets

50,000

67,000

Total current liabilities

32,000

44,500

Total long-term liabilities

11,000

39,800

Common stock, no par*

10,000

10,000

Retained earnings

25,400

19,600

Prepaid expenses

*NOTE: 2,000 shares of common stock have been issued and outstanding since the company started operations. During the entire fiscal year ended December 31, 2008, the stock was selling for $45 per share.

Calculate the following ratios at December 31, 2008: a. Acid-test ratio ($7,700 # $10,700)/$32,000

!

0.58

b. Inventory turnover $53,500 ($20,000 # $26,000)/2

!

2.33

!

43.4 days

c. Days’ sales in receivables ($10,700 # $12,500)/2 ($97,500/365) Quick Practice Solutions | Chapter 14

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d. Price/earnings ratio $45

!

9.18

($9,800 # 2000)

e. Rate of return on total assets $9.800 # $3,100

!

0.13

!

5.26 times

!

1.23

!

0.48

($39,400 # $50,000 # $46,900 # $67,000)/2

f. Times-interest-earned ratio $16,300 $3,100

g. Current ratio $39,400 $32,000

h. Debt ratio $ 32,000 # $11,000 $ 39,400 # $50,000

508


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Do It Yourself! Question 1 Solutions Requirement 1 Prepare a horizontal analysis of Tykes’ financial statements.

TYKES, INC. Horizontal Analysis of Comparative Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Loans payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2007

Increase (Decrease) Percent Amount 33.3 % $100 (17.1) (60) (31.8) (70) $ (30) (3.4) %

$400 290 150 $840

$300 350 220 $870

$140 450 $590

$ 75 600 $675

$ 65 (150) $ (85)

86.7 (25.0) (12.6) %

40 210 $250 $840

40 155 $195 $870

0 55 $ 55 $ (30)

0.0 35.5 28.2 % (3.4) %

TYKES, INC. Horizontal Analysis of Income Statement Years Ended December 31, 2008 and 2007 (Dollar amounts in millions)

2008

2007


$1,200 $1,000 600 800 $ 400 $ 400


190 200 80 60 $ 140 $ 130

Increase (Decrease) Amount Percent 20.0 % $200 33.3 200 0.0 % $ 0 10 (20) $ 10

5.3 (25.0) 7.7 %


509

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Requirement 2 Prepare a vertical analysis of Tykes’ financial statements.

TYKES, INC. Vertical Analysis of Comparative Balance Sheet December 31, 2008 and 2007 (Dollar amounts in millions) Assets Cash Accounts receivable Inventory Total assets Liabilities Accounts payable Loans payable Total liabilities Stockholder’s equity Common stock Retained earnings Total stockholder’s equity Total liabilities and stockholder’s equity

2008

2008%

2007

2007%

$400 290 150 $840

47.6% 34.5 17.9 100.0%

$300 350 220 $870

34.5% 40.2 25.3 100.0%

$140 450 $590

16.7% 53.5 70.2%

$ 75 600 $675

8.6% 69.0 77.6%

$ 40 210 $250 $840

4.8 25.0 29.8% 100.0%

$ 40 155 $195 $870

4.6 17.8 22.4% 100.0%

TYKES, INC. Vertical Analysis of Comparative Income Statement Years Ended December 31, 2008 and 2007

510

(Dollar amounts in millions) Net sales revenue Less: Cost of goods sold Gross profit

2008 2008% 2007 2007% $1,200 100.0 % $1,000 100.0 % 800 66.7 600 60.0 $ 400 33.3 % $ 400 40.0 %


200 60 $ 140


16.6 190 5.0 80 11.7 % $ 130

19.0 8.0 13.0 %

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Requirement 3 Calculate Tykes’ inventory turnover and rate of return on stockholders’ equity ratios for both years. 2008 Inventory Turnover

2007 Inventory Turnover

2008 Rate of Return on Stockholders’ Equity

2007 Rate of Return on Stockholders’ Equity

!

$800,000,000 ($220,000,000 # $150,000,000)/2

!

4.3 times

!

$600,000,000 ($200,000,000 #$220,000,000)/2

!

2.9 times

!

$140,000,000 " $0) ($195,000,000 # $250,000,000)/2

!

62.9%

!

$130,000,000 " $0 ($165,000,000 # $195,000,000)/2

!

72.2%


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512

Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 14, Financial Statement Analysis. Click a link to work on the tutorial exercises.


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15

Introduction to Management Accounting

WHAT YOU PROBABLY ALREADY KNOW If you have ever baked a cake, you probably already know that certain ingredients are required to produce the desired result. It may be a mix that only requires eggs and water, or you may follow a recipe where you must add in all of the ingredients separately. Whichever it may be, you know that the more ingredients that are necessary to make the cake, the more costly it is. Assume you ask your sister to apply the icing because you’re short on time and offer to pay her $5. The amount paid for her services, labor, adds to the cost of the cake. It is certain that without utilities to run the mixer and the oven, you could not make the cake. In business, these inputs would be referred to as overhead. So, it seems that the costs of materials, labor, and overhead are involved in making the cake. In this chapter, we will study these three components of cost for manufacturers.

Learning Objectives

1

Identify trends in the business environment and the role of management accountability. Some of the changes that have taken place over recent years include an increasing shift toward a service economy, global competition and increasing opportunities for worldwide expansion, time-based competition (including ERP, e-commerce, and JIT management), and an increased focus on promoting continuous improvement in the quality of goods and services produced (total quality management). Review the section called “Today’s Business Environment” in the main text, as well as management’s accountability to stakeholders in Exhibit 15-2 (p. 803).

2

Distinguish management accounting from financial accounting. Management accounting provides financial and nonfinancial information to managers and other internal users of information. The data help management plan and control the operations of the business. Financial accounting provides financial information to users outside of the business such as creditors, investors, and governmental agencies. Review Management Accounting versus Financial Accounting in Exhibit 15-3 (p. 804).

3

Classify costs and prepare an income statement for a service company. All of the costs of a service company are considered period costs. Period costs include selling, general, and administrative costs that are included as expenses on the income statement in the period incurred. A service

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company has no inventory, and therefore none of the costs incurred are inventoriable. Similarly, no cost of goods sold appears on the income statement. Review the income statement for a service company in Exhibit 15-4 (p. 807).

4

Classify costs and prepare an income statement for a merchandising company. Some costs are inventoriable product costs, included in the cost of inventory on the balance sheet, until sold. These costs include the total cost of purchasing the inventory, plus the freight that may be required to obtain the goods. When the inventory is sold, it becomes cost of goods sold, one of the largest expenses on the income statement for a merchandising company. Recall from Chapter 5 the calculation of cost of goods sold for a periodic inventory system is to add beginning inventory, purchases, and freight-in and subtract ending inventory. Review the income statement for a merchandising company in Exhibit 15-5 (p. 808).

5

Classify costs and prepare an income statement for a manufacturing company. Manufacturers use three stages and accounts for inventory: raw materials (including the components, ingredients, or parts used in manufacturing), work in process (including raw materials that have some degree of work done but not completed), and finished goods (completed and ready for sale). The inventoriable product costs in finished goods for a manufacturing company include the elements of cost required to make the goods, including direct materials, direct labor, and manufacturing overhead. As described under Objective 4, merchandisers consider the cost of purchases and freight-in to determine the cost of goods sold. Because manufacturers don’t purchase their inventory, the cost of the goods manufactured must be considered to calculate the cost of goods sold for manufacturers. The approach, similar to that used to calculate the cost of goods sold for a merchandiser, is to start with beginning inventory, add direct materials, labor, and manufacturing overhead, and subtract ending inventory. Review the inventoriable product and period costs analysis in Exhibit 15-8 (p. 811). Also, review the income statement for a manufacturing company in Exhibit 15-7 (p. 811) and carefully study the schedule of cost of goods manufactured, which can be particularly troublesome, in Exhibit 15-10 (p. 813).

6

Use reasonable standards to make ethical judgments. It is more important than ever to be mindful of making ethical judgments. Professional accounting associations have standards of ethical conduct, as do most other professions. In addition, employees are often provided with a code of ethics from their employer. Management accountants are required to maintain their professional competence, preserve the confidentiality of the information they handle, and act with integrity and objectivity. Review the excerpt of the Institute of Management Accountants’ Standards of ethical conduct in Exhibit 15-12 (p. 815).

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Chapter 15 | Introduction to Management Accounting

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Demo Doc 1 Introduction to Management Accounting Learning Objectives

1–4

Dark Spray Tanning hired you as its new management accountant. Data for the month ended April 30 are as follows: Wages expense

$ 8,000

Supply expense

3,000

Utility expense

2,000

Rent expense

1,000

Service revenue

17,000

Requirements 1. Your new boss has heard of the term management accountability, but doesn’t really understand what it means. Explain the concept of management accountability. 2. Explain to your boss the scope of information you can produce as a management accountant. 3. Prepare an income statement for Dark Spray Tanning for the month ended April 30, 2010. 4. In the month of May, Dark Spray decided to sell tanning spray. Based on the following data, prepare Dark Spray’s income statement for the month ended May 31, 2010. Wages expense

$11,000

Supply expense

3,000

Utility expense

2,000

Rent expense

1,000

Sales revenue

30,000*

Purchases

15,000

Ending inventory

6,000

*Assume that 100% of Sales Revenue is from selling tanning spray.

5. Suppose Dark Spray sold 900 bottles of tanning spray in the month of May. What is its cost per bottle?


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Demo Doc 1 Solutions Requirement 1 Your new boss has heard of the term management accountability, but doesn’t really understand what it means. Explain the concept of management accountability.

Part 1

1

Identify trends in the business environment and the role of management accountability

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Management accountability is the idea that the manager is responsible to manage the resources of the organization. Many different groups and individuals, called stakeholders, have an interest in an organization (that is, owners, creditors, customers, suppliers, and the various government organizations). To satisfy the needs of these stakeholders, managers provide information that communicates the decisions made and the results obtained from these decisions. Management accountability requires two forms of accounting: • Financial accounting for external reporting • Management accounting for internal planning, controlling, and decision making Remember, planning means choosing goals and deciding how to achieve them. Controlling means evaluating the results of business operations by comparing the actual results to the plan.

Requirement 2 Explain to your boss the scope of information you can produce as a management accountant. Part 1

1

Distinguish management accounting from financial accounting

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Management accounting provides more detailed and timely information than does financial accounting. Managers use this information in the following ways: • Identify ways to cut costs • Set prices that will be competitive and yet yield profits • Identify the most profitable products and customers so the sales force can focus on key profit makers • Evaluate employees’ job performance

516


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Requirement 3 Prepare an income statement for Dark Spray Tanning for the month ended April 30, 2010. Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

As you recall from earlier chapters, an income statement reports the organization’s revenues and expenses for a period of time. Dark Spray is a service company, so all of its costs are period costs. Because it doesn’t carry an inventory of product, no cost of goods sold appears on its income statement. Period costs are costs incurred and expensed in the current accounting period. Dark Spray’s period costs include all expenses for the month of April (wages, supplies, utilities, and rent). Dark Spray’s period costs are $8,000 + $3,000 + $2,000 + $1,000 = $14,000 for the month of April 2010. Here is the income statement for Dark Spray for the month of April 2010.

3

Classify costs and prepare an income statement for a service company

DARK SPRAY TANNING Income Statement Month Ended April 30, 2010 Service revenue Expenses: Wages expense Supply expense Utility expense Rent expense Total expenses Operating income

$17,000

100%

14,000 $ 3,000

82% 18%

$ 8,000 3,000 2,000 1,000

Notice that Dark Spray includes no cost of goods sold because it is a service company. Its largest expense on the income statement is for employee salaries. They also show an 18% profit margin for the month of April.

Requirement 4 In the month of May, Dark Spray decided to sell tanning spray. Based on the following data, prepare Dark Spray’s income statement for the month ended May 31, 2010. Wages expense

$11,000

Supply expense

3,000

Utility expense

2,000

Rent expense

1,000

Sales revenue

30,000*

Purchases

15,000

Ending inventory

6,000

*Assume that 100% of Sales Revenue is from selling tanning spray.


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Part 1

4

Classify costs and prepare an income statement for a merchandising company.

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Because Dark Spray has purchased products from a supplier that they now resell, Dark Spray is now a merchandiser (retailer). Dark Spray now maintains an inventory. Dark Spray’s income statement will now include cost of goods sold as a major expense. Any product not sold in one period will be shown as an asset called merchandise inventory. Merchandise inventory is NOT an expense until it is sold— then the expense becomes cost of goods sold. The goods available for sale are computed by adding purchases during the period to beginning inventory. Ending inventory is subtracted from cost of goods available for sale to get cost of goods sold. Cost of goods sold is subtracted from sales revenue to get gross profit. Consider the following formula: Beginning Inventory ! Purchases Goods Available for Sale – Ending Inventory Cost of Goods Sold

So in the case of Dark Spray: Beginning Inventory ! Purchases

$

Goods Available for Sale " Ending Inventory Cost of Goods Sold

0 15,000 15,000 6,000

$ 9,0 000

Subtract $9,000 from sales revenue of $30,000 for a gross profit of $21,000. Here is Dark Spray’s income statement for the month ended May 31, 2010: DARK SPRAY TANNING Income Statement Month Ended May 31, 2010 Sales revenue Cost of goods sold: Beginning inventory $ 0 Purchases 15,000 Cost of goods available for sale 15,000 Ending inventory (6,000) Cost of goods sold Gross profit Operating expenses: Wages expense 11,000 Supply expense 3,000 Utility expense 2,000 Rent expense 1,000 Operating income

518


$30,000

100%

9,000 21,000

30% 70%

17,000 $ 4,000

57% 13%

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Gross profit is what remains from sales after the cost of goods sold is subtracted from sales revenue. Gross profit is then used to cover operating expenses and yield a profit (or loss). Managers want to keep an eye on the gross profit percentage, which is a measure of profitability, to make sure that it doesn’t fluctuate too much from period to period. In this case, Dark Spray had a gross profit percentage of 70% and a 13% profit margin. These figures are calculated as follows: Gross Profit Sales Revenue $21,000 Dark Spray's Gross Profit # Percentage $30,000 Gross Profit Percentage

#

#

70%

In other words, Dark Spray retains $0.70 from each dollar of revenue for the period, which is used to cover their operating expenses and then generate operating income. Gross Profit Sales Revenue $4,000 Dark Spray's Profit Margin # $30,000 # 13% Profit Margin

#

Profit margin represents the percentage of revenue that the company keeps as earnings. In this case, Dark Spray retains $0.13 from every revenue dollar as income. Managers watch this percentage as well to make sure that it doesn’t drop from period to period. Even if overall earnings increase, it’s still possible for a company’s profit margin to diminish if, for example, costs increase at a rate greater than sales. Changes in this ratio would signal to managers that they may need to exercise greater control over costs.

Requirement 5 Suppose Dark Spray sold 900 bottles of tanning spray in the month of May. What is its cost per bottle?

Part 1

Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

Cost per unit is determined by dividing total cost by the number of units. Knowing the costs the company incurs per unit it sells helps managers make pricing decisions. They obviously want to make sure they are charging their customers enough to cover their own costs and generate a profit. To calculate the cost per unit: Cost per Unit

#

Total Cost of Goods Sold Total Number of Units Sold


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Dark Spray wants to know its cost for each bottle of tanning spray it sells. In this case, the total cost of selling 900 bottles is $9,000. $9,000 900 bottles # $10 per bottle

Cost per Bottle #

Managers will use the per-unit cost information to help them make better decisions. Knowing that its per-unit cost is $10, Dark Spray managers may decide they need to adjust the price.

Part 1

520


Part 2

Part 3

Part 4

Part 5

Demo Doc Complete

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Demo Doc 2 Manufacturing Companies Learning Objectives 5, 6 Chase Toys produces toys for dogs. The following information was available for the month ended November 30, 2010 (assume no beginning or ending raw materials inventory). Sales revenue

$106,500

Direct materials used

32,000

Direct labor

16,000

Manufacturing overhead*

17,000

Beginning work in process

8,000

Ending work in process

6,000

Operating expenses

32,000

Finished goods, Nov. 1, 2010

4,000

Finished goods, Nov. 30, 2010

7,200

*All indirect production costs are included in Manufacturing Overhead.

Requirements 1. Prepare a schedule of cost of goods manufactured for the month ended November 30, 2010. 2. Prepare an income statement for the month ended November 30, 2010. 3. At an internal Chase Toys meeting, you learned that Chase Toys has developed a new product that is expected to produce record profits. Before Chase Toys went public with this product, you advised your girlfriend to invest in Chase Toys. Which standard of ethical conduct for management accountants did you violate? Explain.


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Demo Doc 2 Solutions Requirement 1 Prepare a schedule of cost of goods manufactured for the month ended November 30, 2010.

Part 1

5

Classify costs and prepare an income statement for a manufacturing company

Part 2

Part 3

Demo Doc Complete

The cost of goods manufactured summarizes the manufacturing activities that took place for the month of November 2010. The three manufacturing costs—direct materials, direct labor, and manufacturing overhead—are added together to get the total manufacturing costs incurred during November ($32,000 + $16,000 + $17,000). These costs are added to beginning inventory to yield the total accountable manufacturing costs. Ending inventory is then subtracted from total accountable manufacturing costs to get cost of goods manufactured. Consider the following formula: Beginning Work in Process ! Direct Materials Used ! Direct Labor Used ! Factory/Manufacturing Overhead Applied Current Manufacturing g Costs " Ending Work in Process Cost of Goods Manufacture ed

So for Chase Toys: Beginning Work in Progress ! Direct Materials Used ! Direct Labor Used ! Factory/Manufacturing Overhead Applied

$ 3,000 32,000 16,000 17,000

Current Manufacturing g Costs " Ending Work in Progress

73,000 6,000

Cost of Goods Manufactured

$67,000

Here is Chase Toys’ schedule of cost of goods manufactured for the month ended November 30, 2010:

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CHASE TOYS Schedule of Cost of Goods Manufactured Month Ended November 30, 2010 Beginning work in process inventory Add: Direct materials used Direct labor Manufacturing overhead Total manufacturing costs incurred during the period Total accountable manufacturing costs Less: Ending work in process Cost of goods manufactured

$ 8,000 $32,000 16,000 17,000 65,000 73,000 (6,000) $67,000

Notice the similarity between calculating cost of goods manufactured and calculating cost of goods sold for a merchandiser: Start with the beginning inventory balance, increase it for the additions during the period, and subtract the ending inventory balance. The cost of goods manufactured becomes part of the finished goods inventory, which will be shown as an asset until the period in which it is sold, when it flows to cost of goods sold. Note that the inventoriable product costs in finished goods for a manufacturing company include the elements of cost required to make the goods: • Direct materials. Physical components required to manufacture the product, which can be traced directly to the finished good. • Direct labor. Labor of employees who work directly on the finished product. • Manufacturing overhead. Manufacturing costs other than direct materials and direct labor, including factory costs such as insurance, depreciation, and utilities. Overhead also includes indirect materials (low value materials that cannot be traced directly to a finished product) and indirect labor (supportive factory labor of janitors, managers, and equipment operators that cannot be traced directly to a finished product).

Requirement 2 Prepare an income statement for the month ended November 30, 2010.

Part 1

Part 2

Demo Doc Complete

Part 3

5


The Cost of Goods Manufactured account summarizes the activities that take place in a manufacturing plant over a period of time. It represents the manufacturing cost of goods that Chase Toys finished during November. Cost of goods sold is computed as follows: Beginning Inventory ! Cost of Goods Manufactured Cost of Goods Available for Sale " Ending Inventory Cost of Goods Sold

$ 4,00 00 67,000 71,000 7,200 $63,800 Demo Doc 2 Solutions | Chapter 15

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Following is Chase Toys’ income statement for the month of November:

CHASE TOYS Income Statement Month Ended November 30, 2010 Sales revenue Cost of goods sold: Beginning finished goods inventory Cost of goods manufactured Cost of goods available for sale Ending finished goods inventory Cost of goods sold Gross profit Operating expenses Operating income

$106,500

100%

63,800 42,700 32,000 $ 10,700

60% 40% 30% 10%

$ 4,000 67,000 71,000 (7,200)

Notice how the cost of goods manufactured amount computed on the schedule in Requirement 1 is part of finished goods here—the only inventory that is ready to sell. It becomes part of cost of goods sold on the income statement. Note that Finished Goods for a manufacturer is like the Inventory account for a merchandiser. In both cases, these accounts represent the inventory that is complete and available to be sold.

Requirement 3 At an internal Chase Toys meeting, you learned that Chase Toys has developed a new product that is expected to produce record profits. Before Chase Toys went public with this product, you advised your girlfriend to invest in Chase Toys. Which standard of ethical conduct for management accountants did you violate? Explain.

Part 1

6

Use reasonable standards to make ethical judgments

Part 3

Demo Doc Complete

Providing confidential company information to your girlfriend is a clear violation of the confidentiality standard. Employees must refrain from disclosing confidential information acquired in the course of work except when authorized, unless legally obligated to do so.

Part 1

524

Part 2


Part 2

Part 3

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. A system that integrates all of a company’s worldwide functions, departments, and data is called supply-chain management. _____ 2. A budget is a quantitative expression of a plan that helps managers coordinate and implement the plan. _____ 3. Goods that are partway through the manufacturing process, but not yet complete, are referred to as materials inventory. _____ 4. Manufacturers use labor, plant, and equipment to convert raw materials into new finished products. _____ 5. Period costs are operating costs that are expensed in the period in which the goods are sold. _____ 6. Indirect labor and indirect materials are part of manufacturing overhead. _____ 7. Trends in the modern business environment include the shift to a service economy and the rise of the global marketplace. _____ 8. Management has a responsibility to meet regulatory obligations to federal and local government agencies. _____ 9. Total quality management applies only to manufacturers and promotes the creation of superior products. _____10. The cost of goods manufactured is equal to the sum of direct materials used, direct labor, and manufacturing overhead.


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Multiple Choice 1. The primary goal of financial accounting is to provide information to which of the following? a. Investors b. Creditors c. Company managers d. Both a and b 2. Which of the following is true about management accounting? a. Management accounting provides information to customers b. Management accounting provides information that is required to be audited by certified public accountants c. Management accounting primarily focuses on reporting on the company as a whole on a quarterly or annual basis d. Management accounting is not restricted by GAAP 3. Manufacturers may have which accounts on their balance sheet? a. Materials, Work in Process, and Finished Goods b. Merchandise, Materials, and Finished Goods c. Direct Materials, Direct Labor, and Manufacturing Overhead d. Work in Process, Materials, and Manufacturing Overhead 4. In which category would glue or fasteners to manufacture a table be included? a. Direct materials b. Manufacturing overhead c. Period costs d. Indirect labor 5. Inventoriable product costs include which of the following? a. Marketing costs b. Costs of direct materials, direct labor, and manufacturing overhead used to produce a product c. Costs of direct materials and direct labor used to produce a product d. Period costs, overhead, and direct labor 6. When do inventoriable costs become expenses? a. When the manufacturing process begins b. When the manufacturing process is completed c. When the direct materials are purchased d. When the units in inventory are sold 7. In which category would selling and administrative costs be included? a. Direct materials b. Manufacturing overhead c. Period costs d. Work in process

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8. All except which of the following are manufacturing overhead costs? a. Materials used directly in the manufacturing process of the product b. Insurance on factory equipment c. Salaries of production supervisors d. Property tax on factory building 9. Cost of goods sold for a manufacturer equals cost of goods manufactured plus which of the following? a. Beginning work in process inventory less ending work in process inventory b. Ending work in process inventory less beginning work in process inventory c. Beginning finished goods inventory less ending finished goods inventory d. Ending finished goods inventory less beginning finished goods inventory 10. At the beginning of 2008, the Taylor Company’s Work in Process Inventory account had a balance of $30,000. During 2008, $68,000 of direct materials were used in production, and $66,000 of direct labor costs were incurred. Manufacturing overhead in 2008 amounted to $90,000. The cost of goods manufactured was $220,000 in 2008. What is the balance in the work in process inventory on December 31, 2008? a. $34,000 b. $24,000 c. $66,000 d. $6,000

Quick Exercises 15-1. Use the correct number to categorize each item that follows: 1. 2. 3. 4.

Direct materials Selling and general expenses Manufacturing overhead Direct labor a. __________ Rent expense on factory building b. __________ Sales supplies used c. __________ Factory supplies used d. __________ Indirect materials used e. __________ Wages of assembly line personnel f. __________ Cost of primary material used to make product g. __________ Depreciation on office equipment h. __________ Rent on office facilities i. __________ Insurance expired on factory equipment j. __________ Utilities incurred in the office k. __________ Advertising expense l. __________ Taxes paid on factory building


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15-2. The Carter Company reports the following information for 2007: Sales Direct materials used Depreciation on factory equipment Indirect labor Direct labor Factory rent Factory utilities Sales salary expense Office salary expense Indirect materials

$70,600 7,300 4,700 5,900 11,300 4,200 1,200 16,300 8,900 1,200

Compute the following: a. Inventoriable product costs

b. Period costs

15-3. Indicate whether each of the following costs is a product cost or a period cost: a. b. c. d. e. f. g. h. i. j. k. l. m.

528


__________ __________ __________ __________ __________ __________ __________ __________ __________ __________ __________ __________ __________

Direct materials used Factory utilities Salespersons’ commissions Plant manager’s salary Indirect materials used Depreciation on store equipment Indirect labor incurred Advertising expense Direct labor incurred Factory machinery repairs and maintenance Depreciation on factory machinery Office supplies used Plant insurance expired

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15-4. South State Company financial information for the year ended December 31, 2008, follows: Direct materials used Direct labor incurred Indirect labor Indirect materials used Other factory costs: Utilities Maintenance Supplies Depreciation Property taxes

$71,000 37,000 2,700 1,600 3,100 4,500 1,800 7,900 2,600

South State had no beginning or ending finished goods inventory, but work in process inventory began the year with a $5,500 balance and ended the year with a $7,500 balance. Prepare a schedule of cost of goods manufactured for South State Company for the year ending December 31, 2008.

SOUTH STATE COMPANY Schedule of Cost of Goods Manufactured Year Ended December 31, 2008

15-5. Briefly describe a just-in-time management philosophy.


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Do It Yourself! Question 1 Introduction to Management Accounting Stay Fit Exercise Company has hired you as their new management accountant. Data for the month ended February 28 is as follows: Wages expense

22,000

Supply expense

3,000

Utility expense

1,000

Rent expense Service revenue

4,500 32,000

Requirements 1. Your new boss has heard of the term total quality management, but doesn’t really understand what it means. Explain the concept of total quality management.

2. Prepare an income statement for Stay Fit for the month ended February 28, 2010.

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3. In the month of March, Stay Fit decided to sell exercise balls. Based on the following data, prepare Stay Fit’s income statement for the month ended March 31, 2010. Calculate Stay Fit’s gross profit percentage and profit margin (round to the nearest percentage point). Wages expense

24,000

Supply expense

3,000

Utility expense

1,000

Rent expense

4,500

Sales revenue

42,000*

Purchases

8,000

Ending inventory

2,000

*Assume that 100% of Sales Revenue is from selling exercise balls.

4. Suppose Stay Fit sold 375 exercise balls in the month of March. What is its cost per ball?


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Do it Yourself! Question 2 Manufacturing Companies Theme Cans Company produces metal popcorn cans. The following information was available for the month ended August 31, 2010. Sales

$104,250


36,000

Direct labor

25,000

Manufacturing overhead

12,000

Beginning work in process

5,000

Ending work in process

3,000

Operating expenses

28,400

Finished goods, August 1, 2010

2,500

Finished goods, August 30, 2010

5,200

Requirements 1. Prepare a schedule of cost of goods manufactured for the month ended August 31, 2010.

532


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2. Prepare Theme Cans’ income statement for the month ended August 31, 2010.

3. As the management accountant for Theme Cans, you are in the process of purchasing new software for the company. One of the suppliers of software gave you a brand new set of expensive golf clubs. Was the acceptance of the golf clubs a violation of any management accountant standard of ethical conduct? Explain.


533

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534

F

1. A system that integrates all of a company’s worldwide functions, departments, and data is called supply-chain management. False–A system that integrates all of a company’s worldwide functions, departments, and data is called enterprise resource planning. (p. 805)

T

2. A budget is a quantitative expression of a plan that helps managers coordinate and implement the plan. (p. 804)

F

3. Goods that are partway through the manufacturing process, but not yet complete, are referred to as materials inventory. False–Goods that are partway through the manufacturing process, but not yet complete, are referred to as work in process. (p. 809)

T

4. Manufacturers use labor, plant, and equipment to convert raw materials into new finished products. (p. 808)

F

5. Period costs are operating costs that are expensed in the period in which the goods are sold. False–Period costs are operating costs that are expensed in the period incurred. (p. 806)

T

6. Indirect labor and indirect materials are part of manufacturing overhead. (p. 809)

T

7. Trends in the modern business environment include the shift to a service economy and the rise of the global marketplace. (p. 805)

T

8. Management has a responsibility to meet regulatory obligations to federal and local government agencies. (p. 803)

F

9. Total quality management applies only to manufacturers and promotes the creation of superior products. False–Total quality management promotes the creation of superior products and services. It applies to entities other than manufacturers. (p. 806)

F

10. The cost of goods manufactured is equal to the sum of direct materials used, direct labor, and manufacturing overhead. False–The cost of goods manufactured is equal to the sum of direct materials used, direct labor, and manufacturing overhead plus beginning work in process inventory minus ending work in process inventory. (p. 813)


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Multiple Choice 1. The primary goal of financial accounting is to provide information to which of the following? (p. 803) a. Investors b. Creditors c. Company managers d. Both a and b 2. Which of the following is true about management accounting? (p. 804) a. Management accounting provides information to customers. b. Management accounting provides information that is required to be audited by certified public accountants. c. Management accounting primarily focused on reporting on the company as a whole on a quarterly or annual basis. d. Management accounting is not restricted by GAAP 3. Manufacturers may have which accounts on their balance sheet? (pp. 808–809) a. Materials, Work in Process, and Finished Goods b. Merchandise, Materials, and Finished Goods c. Direct Materials, Direct Labor, and Manufacturing Overhead d. Work in Process, Materials, and Manufacturing Overhead 4. In which category would glue or fasteners to manufacture a table be included? (pp. 809–810) a. Direct materials b. Manufacturing overhead c. Period costs d. Indirect labor 5. Inventoriable product costs include which of the following? (pp. 810–811) a. Marketing costs b. Costs of direct materials, direct labor, and manufacturing overhead used to produce a product c. Costs of direct materials and direct labor used to produce a product d. Period costs, overhead, and direct labor 6. When do inventoriable costs become expenses? (p. 810) a. When the manufacturing process begins b. When the manufacturing process is completed c. When the direct materials are purchased d. When the units in inventory are sold 7. In which category would selling and administrative costs be included? (p. 811) a. Direct materials b. Manufacturing overhead c. Period costs d. Work in process


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8. All except which of the following are manufacturing overhead costs? (pp. 809–811) a. Materials used directly in the manufacturing process of the product b. Insurance on factory equipment c. Salaries of production supervisors d. Property tax on factory building 9. Cost of goods sold for a manufacturer equals cost of goods manufactured plus which of the following? (p. 812) a. Beginning work in process inventory less ending work in process inventory b. Ending work in process inventory less beginning work in process inventory c. Beginning finished goods inventory less ending finished goods inventory d. Ending finished goods inventory less beginning finished goods inventory 10. At the beginning of 2008, the Taylor Company’s Work in Process Inventory account had a balance of $30,000. During 2008, $68,000 of direct materials were used in production, and $66,000 of direct labor costs were incurred. Manufacturing overhead in 2008 amounted to $90,000. The cost of goods manufactured was $220,000 in 2008. What is the balance in the work in process inventory on December 31, 2008? (p. 813) a. $34,000 b. $24,000 c. $66,000 d. $6,000

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Quick Exercise 15-1. Use the correct number to categorize each item that follows: (p. 809) 1. 2. 3. 4.

Direct materials Selling and general expenses Manufacturing overhead Direct labor a. 3 Rent expense on factory building b. 2 Sales supplies used c. 3 Factory supplies used d. 3 Indirect materials used e. 4 Wages of assembly line personnel f. 1 Cost of primary material used to make product g. Depreciation on office equipment 2 h. 2 Rent on office facilities i. 3 Insurance expired on factory equipment j. 2 Utilities incurred in the office k. 2 Advertising expense l. 3 Taxes paid on factory building

15-2. The Carter Company reports the following information for 2007: (pp. 810–811) Sales Direct materials used Depreciation on factory equipment Indirect labor Direct labor Factory rent Factory utilities Sales salary expense Office salary expense Indirect materials

$70,600 7,300 4,700 5,900 11,300 4,200 1,200 16,300 8,900 1,200

Compute the following: a. Inventoriable product costs $7,300 ! $4,700 ! $5,900 ! $11,300 ! $4,200 ! $1,200 ! $1,200 # $35,800

b. Period costs $16,300 ! $8,900 # $25,200

15-3. Indicate whether each of the following costs is a product cost or a period cost: (pp. 810–811) a. product b. product c. period d. product e. product f. period g. product

Direct materials used Factory utilities Salespersons’ commissions Plant manager’s salary Indirect materials used Depreciation on store equipment Indirect labor incurred Quick Practice Solutions | Chapter 15

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h. period i. product j. product k. product l. period m. product

Advertising expense Direct labor incurred Factory machinery repairs and maintenance Depreciation on factory machinery Office supplies used Plant insurance expired

15-4. South State Company financial information for the year ended December 31, 2008, follows: (p. 813) Direct materials used Direct labor incurred Indirect labor Indirect materials used Other factory costs: Utilities Maintenance Supplies Depreciation Property taxes

$71,000 37,000 2,700 1,600 3,100 4,500 1,800 7,900 2,600

South State had no beginning or ending finished goods inventory, but work in process inventory began the year with a $5,500 balance and ended the year with a $7,500 balance. Prepare a schedule of cost of goods manufactured for South State Company for the year ending December 31, 2008.

SOUTH STATE COMPANY Schedule of Cost of Goods Manufactured Year Ended December 31, 2008 Beginning work in process inventory Add: Direct materials used Direct labor Manufacturing overhead: Indirect labor Indirect materials Utilities Maintenance Suppplies Depreciation Property taxes Total manufacturing costs incurred during the year Total manufacturing costs to account for Less: Ending work in process inventory Cost of goods manufactured

538


$

5,500

$71,000 37,000 $2,700 1,600 3,100 4,500 1,800 7,900 2,600

24,200 132,200 137,700 (7,500) $130,200

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15-5. Briefly describe a just-in-time management philosophy. (p. 805) In a just-in-time system, an organization purchases materials and produces products just when they are needed in the production process. Goods are not produced until it is time for them to be shipped to a customer. The goal is to have zero inventory because holding inventory does not add value to the product. Reducing inventory and speeding the production process reduces throughput time—the time between buying raw materials and selling the finished products. Manufacturers adopting just-in-time depend on their suppliers to make on-time deliveries of perfect-quality raw materials. JIT requires close communication with suppliers. Companies that adopt JIT must strive for perfect quality. Defects stop production lines. To avoid disrupting production, defects must be rare.


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Do It Yourself! Question 1 Solutions Requirement 1 Your new boss has heard of the term total quality management, but doesn’t really understand what it means. Explain the concept of total quality management.

1

Identify trends in the business environment and the role of management accountability

Total quality management is a management philosophy that promotes the goal of providing customers with superior products and services. Companies achieve this goal by continuously improving quality and reducing or eliminating defects and waste. Companies design and build quality into their products and services rather than depending on finding and fixing defects later.

Requirement 2 Prepare an income statement for Stay Fit for the month ended February 28, 2010.

3

Classify costs and prepare an income statement for a service company

STAY FIT EXERCISE COMPANY Income Statement Month Ended February 28, 2010 Service revenue Expenses: Wages expense Supply expense Utility expense Rent expense Total expenses Operating income

$32,000

100%

30,500 $ 1,500

95% 5%

$ 22,000 3,000 2,000 4,500

Requirement 3 In the month of March, Stay Fit decided to sell exercise balls. Based on the following data, prepare Stay Fit’s income statement for the month ended March 31, 2010. Calculate Stay Fit’s gross profit percentage and profit margin (round to the nearest percentage point). Wages expense

$24,000

Supply expense

3,000

Utility expense

1,000

Rent expense

4,500

Sales revenue

42,000*

Purchases

8,000

Ending inventory

2,000

*Assume that 100% of Sales Revenue is from selling exercise balls.

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4

STAY FIT EXERCISE COMPANY Income Statement Month Ended March 31, 2010 Sales revenue Cost of goods sold: Beginning inventory Purchases Cost of goods available for sale Ending inventory Cost of goods sold Gross profit Operating expenses: Wages expense Supply expense Utility expense Rent expense Operating income

$

$42,000

100%

6,000 36,000

14% 86%

32,500 $ 3,500

77% 8%

0 8,000 8,000 (2,000)

24,000 3,000 1,000 4,500


Gross Profit Percentage

!

Stay Fit’s Gross Profit Percentage

!

$36,000 $42,000

!

86%

Profit Margin

!

Operating Income Sales Revenue

Stay Fit’s Profit Margin

! !

Classify costs and prepare an income statement for a merchandising company

$3,500 $42,000 8%

Requirement 4 Suppose Stay Fit sold 375 exercise balls in the month of May. What is its cost per ball? Cost per Unit !

Total Cost of Goods Sold Total Number of Units Sold

Cost per Ball

$6,000 375 Balls

!

! $16 per Ball


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Do It Yourself! Question 2 Solutions Requirement 1

5


Prepare a schedule of cost of goods manufactured for the month ended August 31, 2010.

THEME CANS Schedule of Cost of Goods Manufactured For the Month Ended August 31, 2010 Beginning work in process inventory Add: Direct materials used Direct labor Manufacturing overhead Total manufacturing costs incurred during the period Total accountable manufacturing costs Less: Ending work in process Cost of goods manufactured

$ 5,000 $36,000 25,000 12,000 73,000 78,000 (3,000) $75,000

Requirement 2 Prepare Theme Cans’ income statement for the month ended August 31, 2010.

5


THEME CANS Income Statement Month Ended August 31 2010 Sales revenue Cost of goods sold: Beginning finished goods inventory Cost of goods manufactured Cost of goods available for sale Ending finished goods inventory Cost of goods sold Gross profit Operating expenses Operating income

542


$104,250

100%

72,300 31,950 28,400 $ 3,550

69% 31% 27% 3%

2,500 75,000 77,500 (5,200)

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Requirement 3 As the management accountant for Theme Cans, you are in the process of purchasing new software for the company. One of the suppliers of software gave you a brand new set of expensive golf clubs. Was the acceptance of the golf clubs a violation of any management accountant standard of ethical conduct? Explain. The integrity standard indicates that the accountant must refuse any gift, favor, or hospitality that would influence or would appear to influence actions. The acceptance of a new set of golf clubs is a gift that would appear to influence actions.

6

Use reasonable standards to make ethical judgments


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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 15, Introduction to Management Accounting. 6. Click a link to work on the tutorial exercises.

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16

Job Order Costing

WHAT YOU PROBABLY ALREADY KNOW If you own a car, you may have already had the unpleasant task of taking your car to a repair shop. Then you probably already know that before work is performed, a cost estimate is usually stated as a certain amount for parts and an hourly amount for labor. The hourly labor charge is much higher than the employees are paid. The charge must be sufficient to cover the overhead costs of running the shop such as rent, utilities, maintenance, and supplies. An additional amount is added on top of the costs to create a profit. It is important to be able to accurately identify all of the projected costs and estimated hours of work that will take place to calculate the cost per hour. We will study in this chapter how an overhead rate is calculated and allocated to jobs performed.

Learning Objectives

1

Distinguish between job order costing and process costing. Job order costing accumulates costs for each unique job, assignment, or batch. A construction company, photographer, and law firm may use job order costing because the required work may vary amongst customers and clients. Other companies operate by performing a similar set of production steps or processes. These companies would use a process costing system, which accumulates the costs for each process or department. A cereal manufacturer, bank, and automotive manufacturer might all use process costing.

2

Record materials and labor transactions in a manufacturer’s job order costing system. A job cost record is created when the job is started. All of the costs of production will be recorded on this record: direct materials used, direct labor used, and manufacturing overhead. In Demo Doc 1, you will see how materials and labor transactions are recorded in a manufacturer’s job order costing system. Review the “Accounting in Action—Job Order Costing: Tracing Direct Materials and Direct Labor” in the main text.

3

Record manufacturing overhead transactions in a manufacturer’s job order costing system. Manufacturing overhead includes factory depreciation, repairs, insurance, utilities and other factory costs. The accumulation of these costs is debited

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to Manufacturing Overhead and credited to the appropriate accounts, as you will see in Demo Doc 2.

4

Record transactions for completion and sales of finished goods and adjustment for under- or overallocated manufacturing overhead. As goods continue to be worked on and completed, the costs will transfer from the Work in Process Inventory account to the Finished Goods inventory account. The inventory costs remain in the Finished Goods asset account until they are sold. When the goods are sold, two entries are required under the perpetual inventory system, as we learned in Chapter 5. One entry is made to record the sale on account or for cash. The other entry removes the cost of inventory and charges Cost of Goods Sold. Manufacturing Overhead is debited for the actual overhead costs and credited for the assigned overhead costs. At yearend, as you will see in Demo Doc 2, the balance in Manufacturing Overhead should be transferred into Cost of Goods Sold.

5

Calculate unit costs for service companies. The costs for service companies include the labor component and the other indirect office costs. The hourly cost per employee can be calculated as follows: Hourly Labor Cost !

Salary and Fringe Benefits Total Number of Hours Worked

Other indirect office costs may include rent, utilities, taxes, and support salaries. An hourly cost for indirect costs can be calculated as follows: Predetermined Total Expected Indirect Costs Indirect Cost ! abor Hours Total Direct La Allocation Rate

To determine the cost of a job, the actual number of hours applied to the job should be multiplied by the hourly labor cost and the predetermined indirect cost allocation rate.

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Demo Doc 1 Job Order Costing for Manufacturers Learning Objectives 1, 2 Clearance Douglas manufactures specialized art for his customers. Suppose Douglas has the following transactions during March: a. Purchased raw materials on account, $67,000. b. Materials costing $45,000 were requisitioned for production. Of this total, $5,000 were indirect materials. c. Labor time records show that direct labor of $30,000 and indirect labor of $2,000 were incurred, but not yet paid.

Requirements 1. Why would Douglas use the job order costing system? 2. What document would Douglas use to accumulate direct materials, direct labor, and manufacturing overhead costs assigned to each individual job? How do managers use this document to direct and control operations? 3. Prepare summary journal entries for each transaction.


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Demo Doc 1 Solutions Requirement 1 Why would Douglas use the job order costing system?

Part 1

1

Distinguish between job order costing and process costing

Part 2

Part 3

Demo Doc Complete

Companies that manufacture batches of unique or specialized products would use a job order costing system to accumulate costs for each job or batch. Because Douglas manufactures specialized art for his customers and the required work may vary from customer to customer, Douglas would use the job order costing system. You will learn about the process costing system, which accumulates costs for production processes as opposed to individual jobs, in Chapter 17.

Requirement 2 What document would Douglas use to accumulate direct materials, direct labor, and manufacturing overhead costs assigned to each individual job? How do managers use this document to direct and control operations?

Part 1

2

Record materials and labor in a manufacturer’s job order costing system

548

Part 2

Part 3

Demo Doc Complete

Douglas would use a job cost record to accumulate direct materials, direct labor, and manufacturing overhead costs assigned to each individual job. Managers use job cost records to determine how much each job (and each unit in the job) costs to produce. This cost information helps managers set prices and control costs. Cost data allow managers to identify their most profitable products so that marketing can concentrate on selling these products. Managers also use cost data to make outsourcing decisions and to prepare the company’s financial statements. Managers also use the job cost record to see how they can use materials and labor more efficiently. For example, if a job’s costs exceed its budget, managers must do a better job controlling costs on future jobs, or raise the sale price on similar jobs, to be sure that the company remains profitable. Similarly, managers use labor time records to control labor costs. Together, labor time records and job cost records help managers determine whether employees are working efficiently. If they spend longer than expected on a job, it may not yield a profit. Managers also use the materials inventory subsidiary ledger to control inventory levels.


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Requirement 3 Prepare summary journal entries for each transaction.

Part 1

Part 2

Part 3

Demo Doc Complete

a. Purchased raw materials on account, $67,000. When materials are purchased on account, you want to record the increase in materials inventory, so you would debit Materials Inventory (an asset) by the cost of the materials, $67,000.

2

You also want to record the increase in liability, so you would credit Accounts Payable (a liability) by $67,000 because this amount is still payable.


Journal Entry: Date

Accounts Materials Inventory Accounts Payable To record the purchase of materials on account.

Post Ref.

Dr. 67,000

Cr. 67,000

b. Materials costing $45,000 were requisitioned for production. Of this total, $5,000 were indirect materials.

2

When materials are requisitioned, it means that they move from materials inventory into production to be used. You want to record this movement in the appropriate accounts.


If the materials can be directly traceable to a job, Work in Process will be debited. If the materials do not represent a major component and cannot be traced directly to a job, they are considered indirect materials and are debited to Manufacturing Overhead. Because $40,000 ($45,000 total materials less $5,000 indirect materials) of the materials can be traced to specific jobs, this amount goes directly into Work in Process Inventory, increasing that asset by $40,000. The $5,000 in indirect materials is debited (an increase) to Manufacturing Overhead. Because we are taking all materials out of the Materials Inventory, we reduce this asset with a credit for the total, $45,000.

Journal Entry: Date

Accounts Work in Process Inventory (direct material) Manufacturing Overhead (indirect material) Materials Inventory To record direct and indirect materials used.

Post Ref.

Dr. 40,000 5,000

Cr.

45,000


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c. Labor time records show that direct labor of $30,000 and indirect labor of $2,000 were incurred, but not yet paid. First, we debit Manufacturing Wages for the full amount of labor, direct and indirect, to accumulate total labor costs. We then credit Wages Payable to show the increased liability to our employees.

Journal Entry: Date

Post Ref.

Accounts Manufacturing Wages Wages Payable To record the direct and indirect labor incurred.

Dr. 32,000

Cr. 32,000

The manufacturing wages need to be assigned to the appropriate accounts. A labor time record is completed by each employee who works directly on a job. Each of the jobs and hours worked are identified on the record. In this case, some of the labor, $30,000, can be traced to specific jobs. This amount, called direct labor, is assigned as a debit (increase) to the asset Work in Process Inventory. The rest of the labor, $2,000, is for indirect labor such as maintenance and janitorial services, and cannot be traced to specific jobs. Therefore, it is debited to Manufacturing Overhead. Manufacturing Wages is credited for the full amount (a decrease), bringing its balance to zero.

Journal Entry: Date

Part 1

550

Post Ref.

Accounts Work in Process Inventory (direct labor) Manufacturing Overhead (indirect labor) Materials Inventory To record direct and indirect labor used.


Dr. 30,000 2,000

Cr.

32,000

Part 2

Part 3

Demo Doc Complete

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Demo Doc 2 Allocating Manufacturing Overhead Learning Objectives 3, 4 Macho Mike Machine Shop manufactures specialized metal products per its customers’ specifications. Macho Mike uses direct labor cost to allocate manufacturing overhead. Macho Mike expects to incur $160,000 of manufacturing overhead costs and to use $400,000 of direct labor cost during 2010. During November 2010, Macho Mike’s Machine Shop had the following selected transactions: a. Actual indirect manufacturing labor incurred, $4,200. b. Actual indirect materials used, $3,000. c. Other manufacturing overhead incurred, $2,800 (credit Accounts Payable). d. Allocated overhead for November (the machine shop incurred $36,000 of direct labor cost during the month). e. Finished jobs that totaled $6,500 on their job cost records. f. Sold inventory for $70,000 (on account) that cost $42,000 to produce.

Requirements 1. Compute the predetermined manufacturing overhead rate for Macho Mike. 2. Journalize the transactions. 3. Prepare the journal entry to close the ending balance of manufacturing overhead.


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Demo Doc 2 Solutions Requirement 1 1. Compute the predetermined manufacturing overhead rate for Macho Mike.

Part 1

3

Record manufacturing overhead transactions in a job order costing system

Part 2

Part 3

Demo Doc Complete

Because Macho Mike uses direct labor cost to allocate overhead to jobs, the predetermined manufacturing overhead rate is computed as follows: Manufactturing Overhead Rate !

Total Estimated Manufacturing Overhead Costts Total Estimated Direct Labor Cost

In this case, the estimated manufacturing overhead cost is $160,000 and estimated direct labor cost is $400,000. Dividing $160,000 by $400,000 equals 0.40, or a predetermined manufacturing overhead rate of 40% of actual direct labor cost. Another way to think of this is that for every $1 spent on direct labor, we incur $0.40 of manufacturing overhead. It’s important to remember that this rate is determined at the beginning of the period, before any production has started because actual overhead costs and the actual quantity of the allocation base are not known until the end of the period. Managers need this estimate to make decisions and allocate overhead to individual jobs throughout the period. Because the allocation base used may be direct labor hours, direct labor cost, machine hours, and other bases, it’s important to label this rate accordingly. The predetermined manufacturing overhead rate is multiplied by the allocation base activity to determine the amount of overhead applied to each of the jobs.

Requirement 2 Journalize the transactions. Part 1

Part 2

Part 3

Demo Doc Complete

a. Actual indirect manufacturing labor incurred, $4,200. b. Actual indirect materials used, $3,000. c. Other manufacturing overhead incurred, $2,800 (credit Accounts Payable).

3

Record manufacturing overhead transactions in a job order costing system.

In this case, all actual manufacturing overhead costs incurred during the period are debited to Manufacturing Overhead because they cannot be traced to any specific job (that is, they are indirect costs). So Manufacturing Overhead is debited by $4,200 + $3,000 + $2,800 = $10,000. Indirect manufacturing labor results in a decrease of $4,200 to Manufacturing Wages (a credit). Indirect materials used results in a decrease of $3,000 to Materials Inventory (a credit), because the materials have been used and are therefore removed from materials inventory. Other manufacturing overhead of $2,800 is credited to Accounts Payable, as indicated in the question.

552


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Journal Entry: Date

Post Ref.

Accounts Manufacturing Overhead Manufacturing Wages Materials Inventory Accounts Payable

Dr. 10,000

Cr. 4,200 3,000 2,800

d. Allocate overhead for November (the machine shop incurred $36,000 of direct labor cost during the month). To determine the total overhead allocated to jobs in November, multiply the actual direct labor cost ($36,000) by the predetermined allocation rate of 40% (from Requirement 1): $36,000 (direct labor cost)

"

0.40 (predetermined overhead rate)

!

3

Record manufacturing overhead transactions in a job order costing system

$14,400 allocated overhead for November

Allocate the overhead to work in process by debiting Work in Process Inventory and crediting Manufacturing Overhead by $14,400.

Journal Entry: Date

Accounts Work in Process Inventory Manufacturing Overhead

Post Ref.

Dr. 14,400

Cr. 14,400

4

e. Finished jobs that totaled $6,500 on their job cost records. When the goods are completed, they are transferred from Work in Process to Finished Goods. This transaction reflects how work in process leaves the plant floor and is moved into the finished goods storage area.

Record transactions for completion and sales of finished goods and adjustment for underor overallocated overhead

Journal Entry: Date

Accounts Finished Goods Inventory Work in Process Inventory

Post Ref.

Dr. 6,500

Cr. 6,500

f. Sold inventory for $70,000 (on account) that cost $42,000 to produce. Debit the asset Accounts Receivable to record the increased amount of $70,000 that is owed to Macho Mike. Credit the revenue account, Sales Revenue, by the same amount.

4

Record transactions for completion and sales of finished goods and adjustment for underor overallocated overhead


553

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Debit the expense Cost of Goods Sold to record the cost of the sale. Because the goods are no longer in the finished goods inventory, we must credit Finished Goods Inventory to reduce that asset account.

Journal Entry: Date

Post Ref.

Accounts Accounts Receivable Sales Revenue

Dr. 70,000

Cr. 70,000

Cost of Goods Sold Finished Goods Inventory

42,000 42,000

Requirement 3 Prepare the journal entry to close the ending balance of manufacturing overhead.

Part 1

4

Record transactions for completion and sales of finished goods and adjustment for underor overallocated manufacturing overhead

Part 2

Demo Doc Complete

Part 3

The balance of the Manufacturing Overhead account should be zero at the end of the accounting period. To zero out the account when Manufacturing Overhead has a debit balance, you would credit Manufacturing Overhead and debit Cost of Goods Sold. If Manufacturing Overhead has a credit balance, then you would debit Manufacturing Overhead and credit Cost of Goods Sold. In this case, manufacturing overhead was overallocated, because the overhead allocated to Work in Process Inventory ($14,400 from Requirement 2, transaction d) is more than the amount actually incurred ($4,200 + $3,000 + $2,800 = $10,000 from transactions a, b, and c). The result is a credit balance of $4,400 in Manufacturing Overhead. To close the ending balance, then, we debit Manufacturing Overhead by $4,400 and credit Cost of Goods Sold by $4,400.

Journal Entry: Date

Post Ref.

Accounts Manufacturing Overhead Cost of Goods Sold

Dr. 4,400

Cr. 4,400

Why? Because Macho Mike allocated too much manufacturing overhead to each job, resulting in cost of goods sold being too high (meaning the jobs were charged too much overhead during the period). To close the balance in Manufacturing Overhead, Macho Mike applies a decrease to Cost of Goods Sold.

Part 1

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Part 2

Part 3

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. Process costing is used by companies that produce large numbers of identical units in a continuous fashion. _____ 2. A food and beverage company would most likely use a job order costing system. _____ 3. A job cost record is a document that accumulates direct materials, direct labor, and manufacturing overhead costs assigned to each individual job. _____ 4. For jobs that the company has started but not yet finished, the job cost records form the subsidiary ledger for the general ledger account Work in Process Inventory. _____ 5. When materials are requisitioned for a job, the Materials Inventory account is debited. _____ 6. A labor time record identifies the employee, the amount of time spent on a particular job, and the labor cost charged to the job. _____ 7. Manufacturing Overhead is credited for actual manufacturing overhead costs incurred throughout the year. _____ 8. The allocation base is a common denominator that links indirect manufacturing overhead costs to the cost objects. _____ 9. Work in Process Inventory is credited for the cost of direct labor in a job order costing system. _____10. The required adjustment for an underallocation of manufacturing overhead results in a credit to Cost of Goods Sold.

Multiple Choice 1. What are the two basic types of costing systems? a. Job order costing and process costing b. Periodic costing and perpetual costing c. Product costing and materials inventory costing d. Periodic costing and process costing 2. Which type of business can use a job order costing system? a. Service and manufacturing businesses b. Manufacturing and merchandising businesses c. Service and merchandising businesses d. Service, merchandising, and manufacturing businesses 3. Which of the following industries is most likely to use a process costing system? a. Paint b. Aircraft c. Construction d. Unique furniture accessories Quick Practice Questions | Chapter 16

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4. Which of the following companies is most likely to use job order costing? a. Kellogg’s Cereal Company b. Elizabeth’s Custom Furniture Company c. ExxonMobil Oil Refinery d. DuPont Chemical Company 5. Which of the following would be necessary to record the purchase of materials on account using a job order costing system? a. Credit to Work in Process Inventory b. Debit to Accounts Payable c. Debit to Materials Inventory d. Debit to Work in Process Inventory 6. Which of the following would be debited to record the direct materials used? a. Finished Goods Inventory b. Materials Inventory c. Work in Process Inventory d. Cost of Goods Manufactured 7. Which of the following would be debited to assign direct labor costs actually incurred? a. Finished Goods Inventory b. Manufacturing Overhead c. Wages Payable d. Work in Process Inventory 8. Which of the following would be debited to assign the costs of indirect labor? a. Manufacturing Overhead b. Work in Process Inventory c. Finished Goods Inventory d. Wages Payable 9. What is the document that is prepared by manufacturing personnel to request materials for the production process? a. Materials requisition b. Cost ticket c. Job order card d. Manufacturing ticket 10. Opaque Corporation uses a job order costing system. The Work in Process Inventory balance on December 31, 2007 consists of Job No. 120, which has a balance of $19,000. Job No. 120 has been charged with manufacturing overhead of $5,100. Opaque allocates manufacturing overhead at a predetermined rate of 85% of direct labor cost. What is the amount of direct materials charged to Job No. 120? a. $7,565 b. $5,900 c. $7,000 d. $7,900

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Quick Exercises 16-1. State whether each of the following companies would be more likely to use a job order costing system or a process costing system. a. Custom furniture manufacturer _______________ b. Paint manufacturer _______________ c. Carpet manufacturer _______________ d. Concrete manufacturer _______________ e. Home builder _______________ f. Soft drink bottler _______________ g. Custom jewelry manufacturer _______________ 16-2. Gadgets Company has two departments, X and Y. Manufacturing overhead is allocated based on direct labor cost in Department X and direct labor hours in Department Y. The following additional information is available: Estimated Amounts Direct labor costs Direct labor hours Manufacturing overhead costs

Department X

Department Y

$249,600

$427,500

24,960

45,000

259,000

262,000

Actual data for completed Job No. 140 is as follows: Direct materials requisitioned Direct labor cost Direct labor hours

$23,700

$48,600

34,400

38,800

4,300

3,800

a. Compute the predetermined manufacturing overhead rate for Department X.

b. Compute the predetermined manufacturing overhead rate for Department Y.

c. What is the total manufacturing overhead cost for Job No. 140?

d. If Job No. 140 consists of 350 units of product, what is the average unit cost of this job?


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16-3. Peterson Corporation uses a job order costing system. Journalize the following transactions in Peterson’s general journal for the current month: a. Purchased materials on account, $74,000. b. Requisitioned $47,700 of direct materials and $6,500 of indirect materials for use in production. c. Factory payroll incurred and due to employees, $72,000. d. Allocated factory payroll, 85% direct labor, 15% indirect labor. e. Recorded depreciation on factory equipment, $10,500, and other manufacturing overhead of $45,900 (credit Accounts Payable). f. Allocated manufacturing overhead based on 130% of direct labor cost. g. Cost of completed production for the current month, $155,000. h. Cost of finished goods sold, $131,000; selling price, $183,000 (all sales on account). General Journal Date

Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

General Journal Date

Accounts


Accounts


Accounts


Accounts

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Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.


Accounts


Accounts


Accounts

16-4. The following activities took place in the Work in Process Inventory account during April: Work in process balance, April 1

$ 15,000


123,000

Total manufacturing labor incurred in April was $163,500. Direct labor represents 75% of manufacturing labor. The predetermined manufacturing overhead rate is 120% of direct labor cost. Actual manufacturing overhead costs for April amounted to $150,000. Two jobs were completed with total costs of $118,000 and $85,000, respectively. They were sold on account for $258,000 and $150,000, respectively.

Requirements 1. Compute the balance in Work in Process Inventory on April 30.


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2. Journalize the following: a. Direct materials used in April. b. The total manufacturing labor incurred in April. c. The entry to assign manufacturing labor to the appropriate accounts. d. The allocated manufacturing overhead for April. e. The entry to move the completed jobs into finished goods inventory. f. The entry to sell the two completed jobs on account. General Journal Date

Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.


Accounts


Accounts


Accounts


Accounts


Accounts

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16-5. The following account balances as of January 1, 2008, were selected from the general ledger of Browning Manufacturing Company: Work in process inventory

$

0

Materials inventory

21,000

Finished goods inventory

44,000

Additional data: Actual manufacturing overhead for January, $59,000. Total direct labor cost for January, $56,000. The predetermined manufacturing overhead rate is based on direct labor cost. The budget for 2008 called for $300,000 of direct labor cost and $369,000 of manufacturing overhead costs. The only job unfinished on January 31, 2008, was Job No. 410, for which total labor charges were $5,600 (700 direct labor hours) and total direct material charges were $10,000. Cost of direct materials placed in production during January, $100,000. No indirect material requisitions were made during January. January 31 balance in Materials Inventory, $29,000. Finished Goods Inventory balance on January 31, $30,000. a. Calculate the predetermined manufacturing overhead rate.

b. Determine the amount of materials purchased during January.

c. Determine cost of goods manufactured for January.

d. Determine the Work in Process Inventory balance on January 31.

e. Calculate cost of goods sold for January.

f. Is manufacturing overhead overallocated or underallocated? What is the account balance at January 31?


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Do It Yourself! Question 1 Bell Boxers is a customized clothing manufacturer. Bell has the following transactions: a. Purchased raw materials on account, $20,000. b. Materials costing $15,000 were requisitioned for production. Of this total, $1,500 worth were indirect materials. c. Labor time records show that direct labor of $24,000 and indirect labor of $3,000 were incurred, but not yet paid.

Requirements 1. Why would Bell Boxers use the job order costing system?

2. What document would Bell Boxers use to accumulate direct materials, direct labor, and manufacturing overhead costs assigned to each job?

3. Journalize each transaction.


Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.


Accounts


562

Accounts

Chapter 16 | Do It Youself! Question 1

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Do It Yourself Question 2 Quality Cabinet Maker manufactures specialized cabinets. Because of its unique specialization, Quality Cabinet is labor intensive, so it uses direct labor cost to allocate its overhead. Quality Cabinet expects to incur $240,000 of manufacturing overhead costs and to use $300,000 of direct labor cost during 2010. During May 2010, Quality Cabinet actually incurred $22,000 of direct labor cost and recorded the following transactions: a. Indirect actual manufacturing labor, $5,100. b. Indirect actual materials used, $6,200. c. Other manufacturing overhead incurred, $7,000 (credit accounts payable). d. Allocated overhead for May. e. Transferred 45,000 of product to finished goods. f. Sold product on account, $60,000; cost of the product, $33,000.

Requirements 1. Compute the predetermined manufacturing overhead for Quality.

2. Journalize the transactions in the general journal. General Journal Date

Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.


Accounts


Accounts

Do It Youself! Question 2 | Chapter 16

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Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.


Accounts


Accounts

3. Prepare the journal entry to close the ending balance of Manufacturing Overhead.


564

Accounts

Chapter 16 | Do It Youself! Question 2

Dr.

Cr.

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1. Process costing is used by companies that produce large numbers of identical units in a continuous fashion. (p. 849)

F

2. A food and beverage company would most likely use a job order costing system. False–A food and beverage company would most likely use a process costing system. (p. 849)

T

3. A job cost record is a document that accumulates direct materials, direct labor, and manufacturing overhead costs assigned to each individual job. (p. 849)

T

4. For jobs that the company has started but not yet finished, the job cost records form the subsidiary ledger for the general ledger account Work in Process Inventory. (p. 850)

F

5. When materials are requisitioned for a job, the Materials Inventory account is debited. False–When materials are requisitioned for a job, the Materials Inventory account is credited. (p. 851)

T

6. A labor time record identifies the employee, the amount of time spent on a particular job, and the labor cost charged to the job. (p. 852)

F

7. Manufacturing Overhead is credited for actual manufacturing overhead costs incurred throughout the year. False–Manufacturing Overhead is debited for actual manufacturing overhead costs incurred throughout the year. (p. 857)

T

8. The allocation base is a common denominator that links indirect manufacturing overhead costs to the cost objects. (p. 856)

F

9. Work in Process Inventory is credited for the cost of direct labor in a job order costing system. False–Work in process inventory is debited for the cost of direct labor in a job order costing system. (p. 857)

F

10. The required adjustment for an underallocation of manufacturing overhead results in a credit to Cost of Goods Sold. False–The required adjustment for an underallocation of manufacturing overhead results in a debit to Cost of Goods Sold. (p. 860)


565

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Multiple Choice 1. What are the two basic types of costing systems? (pp. 848–849) a. Job order costing and process costing b. Periodic costing and perpetual costing c. Product costing and materials inventory costing d. Periodic costing and process costing 2. Which type of business can use a job order costing system? (pp. 848–849) a. Service and manufacturing businesses b. Manufacturing and merchandising businesses c. Service and merchandising businesses d. Service, merchandising, and manufacturing businesses 3. Which of the following industries is most likely to use a process costing system? (p. 849) a. Paint b. Aircraft c. Construction d. Unique furniture accessories 4. Which of the following companies is most likely to use job order costing? (pp. 848–849) a. Kellogg’s Cereal Company b. Elizabeth’s Custom Furniture Company c. ExxonMobil Oil Refinery d. DuPont Chemical Company 5. Which of the following would be necessary to record the purchase of materials on account using a job order costing system? (p. 850) a. Credit to Work in Process Inventory b. Debit to Accounts Payable c. Debit to Materials Inventory d. Debit to Work in Process Inventory 6. Which of the following would be debited to record the direct materials used? (pp. 850–851) a. Finished Goods Inventory b. Materials Inventory c. Work in Process Inventory d. Cost of Goods Manufactured 7. Which of the following would be debited to assign direct labor costs actually incurred? (p. 853) a. Finished Goods Inventory b. Manufacturing Overhead c. Wages Payable d. Work in Process Inventory

566


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8. Which of the following would be debited to assign the costs of indirect labor? (p. 853) a. Manufacturing Overhead b. Work in Process Inventory c. Finished Goods Inventory d. Wages Payable 9. What is the document that is prepared by manufacturing personnel to request materials for the production process? (p. 851) a. Materials requisition b. Cost ticket c. Job order card d. Manufacturing ticket 10. Opaque Corporation uses a job costing system. The Work in Process Inventory balance on December 31, 2007, consists of Job No. 120, which has a balance of $19,000. Job No. 120 has been charged with manufacturing overhead of $5,100. Opaque allocates manufacturing overhead at a predetermined rate of 85% of direct labor cost. What is the amount of direct materials charged to Job No. 120? (p. 855) a. $7,565 b. $5,900 c. $7,000 d. $7,900

Quick Exercise 16-1. State whether each of the following companies would be more likely to use a job order costing system or a process costing system: (pp. 848–849) a. Custom furniture manufacturer job costing b. Paint manufacturer process costing c. Carpet manufacturer process costing d. Concrete manufacturer process costing e. Home builder job costing f. Soft drink bottler process costing g. Custom jewelry manufacturer job costing


567

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16-2. Gadgets Company has two departments, X and Y. Manufacturing overhead is allocated based on direct labor cost in Department X and direct labor hours in Department Y. The following additional information is available: (p. 855) Estimated Amounts Department X Direct labor costs Direct labor hours Manufacturing overhead costs

Department Y

$249,600

$427,500

24,960

45,000

259,000

262,000

Actual data for completed Job No. 140 is as follows: Direct materials requisitioned Direct labor cost Direct labor hours

$23,700

$48,600

34,400

38,800

4,300

3,800

a. Compute the predetermined manufacturing overhead rate for Department X. $259,000/$249,600 ! 104% of direct labor cost

b. Compute the predetermined manufacturing overhead rate for Department Y. $262,000/45,000 hours ! $5.82 per direct labor hour

c. What is the total manufacturing overhead cost for Job. No.140? Dept. X ! $34,400 " 104% ! $35,776 Dept. Y ! $5.82 " 3,800

! 22,116 $57,892

d. If Job No. 140 consists of 350 units of product, what is the average unit cost of this job? $23,700 # $34,400 # $35,776 # $48,600 # $38,800 # $22,116 ! $203,392 $203,392/350 units ! $581.12

16-3. Peterson Corporation uses a job costing system. Journalize the following transactions in Peterson’s general journal for the current month: (pp. 850–859) a. Purchased materials on account, $74,000. b. Requisitioned $47,700 of direct materials and $6,500 of indirect materials for use in production. c. Factory payroll incurred and due to employees, $72,000. d. Allocated factory payroll, 85% direct labor, 15% indirect labor. e. Recorded depreciation on factory equipment $10,500 and other manufacturing overhead of $45,900 (credit Accounts Payable). f. Allocated manufacturing overhead based on 130% of direct labor cost. g. Cost of completed production for the current month, $155,000. h. Cost of finished goods sold, $131,000; selling price, $183,000 (all sales on account).

568


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General Journal Date a.

Accounts Materials Inventory Accounts Payable

Dr. 74,000

Cr. 74,000

General Journal Date b.

Accounts Work in Process Inventory Manufacturing Overhead Materials Inventory

Dr. 47,700 6,500

Cr.

54,200

General Journal Date c.

Accounts Manufacturing Wages Wages Payable

Dr. 72,000

Cr. 72,000

General Journal Date d.

Accounts Work in Process Inventory Manufacturing Overhead Manufacturing Wages

Dr. 61,200 10,800

Cr.

72,000

General Journal Date e.

Accounts Manufacturing Overhead Accumulated Depreciation, Factory Equip. Accounts Payable

Dr. 56,400

Cr. 10,500 45,900

General Journal Date f.


Dr. 79,560

Cr. 79,560


569

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General Journal Date g.


Dr. 155,000

Cr. 155,000

General Journal Date h.


Dr. 183,000

Cost of Goods Sold Finshed Goods Inventory

131,000

Cr. 183,000

131,000

16-4. The following activities took place in the Work in Process Inventory account during April: (pp. 850–859) Work in process balance, April 1 Direct materials used

$ 15,000 123,000

Total manufacturing labor incurred in April was $163,500. Direct labor represents 75% of manufacturing labor. The predetermined manufacturing overhead rate is 120% of direct labor cost. Actual manufacturing overhead costs for April amounted to $150,000. Two jobs were completed with total costs of $118,000 and $85,000, respectively. They were sold on account for $258,000 and $150,000, respectively.

Requirement 1 Compute the balance in Work in Process Inventory on April 30. $15,000 ! $123,000 ! (75% ! $163,500) ! (120% ! $122,625) – $118,000 – $85,000 " $204,775

Requirement 2 Journalize the following: a. Direct materials used in April. b. The total manufacturing labor incurred in April. c. The entry to assign manufacturing labor to the appropriate accounts. d. The allocated manufacturing overhead for April. e. The entry to move the completed jobs into finished goods inventory. f. The entry to sell the two completed jobs on account.

570


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Accounts Work in Process Inventory Materials Inventory

Dr. 123,000

Cr. 123,000



Dr. 163,500

Cr. 163,500


Accounts Work in Process Inventory Manufacturing Overhead Manufacturing Wages

Dr. 122,625 40,875

Cr.

163,500



Dr. 147,150

Cr. 147,150



Dr. 203,000

Cr. 203,000



Dr. 408,000

Cost of Goods Sold Finshed Goods Inventory

203,000

Cr. 408,000

203,000


571

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16-5. The following account balances as of January 1, 2008, were selected from the general ledger of Browning Manufacturing Company: (pp. 850–860) Work in process inventory

$

0

Materials inventory

21,000

Finished goods inventory

44,000

Additional data: Actual manufacturing overhead for January, $59,000. Total direct labor cost for January, $56,000. The predetermined manufacturing overhead rate is based on direct labor cost. The budget for 2008 called for $300,000 of direct labor cost and $369,000 of manufacturing overhead costs. The only job unfinished on January 31, 2008, was Job No. 410, for which total labor charges were $5,600 (700 direct labor hours) and total direct material charges were $10,000. Cost of direct materials placed in production during January, $100,000. No indirect material requisitions were made during January. January 31 balance in Materials Inventory, $29,000. Finished Goods Inventory balance on January 31, $30,000. a. Calculate the predetermined manufacturing overhead rate. $369,000/$300,000 ! 123% of direct labor cost

b. Determine the amount of materials purchased during January. $21,000 # X - $100,000 ! $29,000 $79,000 # X ! $29,000

X ! $108,000

c. Determine cost of goods manufactured for January. $56,000 # (123% " $56,000) # $100,000 – $5,600 – $10,000 – (123% " $5,600) ! $202,392

d. Determine the Work in Process Inventory balance on January 31. $5,600 # (123% " $5,600) # $10,000 ! $22,488

e. Calculate cost of goods sold for January. $44,000 # $202,392 – $30,000 ! $216,392

f. Is manufacturing overhead overallocated or underallocated? What is the account balance at January 31? Actual manufacturing overhead ! $59,000 Allocated manufacturing overhead ! $68,880 $68,880-$59,00 ! $9,880 overallocated

572


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Do It Yourself! Question 1 Solutions Requirement 1 Why would Bell Boxers use the job order costing system? Companies that manufacture batches of unique or specialized products would use a job order costing system to accumulate costs for each job or batch. Because Bell Boxers manufactures specialized clothing for customers and the required work may vary from customer to customer, Bell would use the job order costing system.

1

Distinguish between job order costing and process costing

2

Record materials and labor transactions in a job order costing system

2

Record materials and labor transactions in a job order costing system

Requirement 2 What document would Bell use to accumulate direct materials, direct labor, and manufacturing overhead costs assigned to each job? Bell would use a job cost record to accumulate direct materials, direct labor, and manufacturing overhead costs assigned to each individual job.

Requirement 3 Journalize each transaction.


Accounts Materials Inventory Accounts Payable

Dr. 20,000

Cr. 20,000


Accounts Work in Process Inventory Manufacturing Overhead Materials Inventory

Dr. 13,500 1,500

Cr.

15,000



Dr. 27,000

Work in Process Inventory Manufacturing Overhead Manufacturing Wages

24,000 3,000

Cr. 27,000

27,000

Do It Youself! Question 1 Solutions | Chapter 16

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3

Record manufacturing overhead in a manufacturer’s job order costing system

Compute the predetermined manufacturing overhead for Quality. $240,000/$300,000 ! 0.80, or 80% of direct labor cost

Requirement 2 Journalize the transactions in the general journal.


Accounts Manufacturing Overhead Manufacturing Wages

Dr. 5,100

Cr. 5,100


Accounts Manufacturing Overhead Materials Inventory

Dr. 6,200

Cr. 6,200


Accounts Manufacturing Overhead Accounts Payable

Dr. 7,000

Cr. 7,000



Dr. 17,600

Cr. 17,600


574



Dr. 45,000

Cr. 45,000

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Dr. 60,000

Cost of Goods Sold Finished Goods Inventory

33,000

Cr. 60,000

33,000

Requirement 3 Prepare the journal entry to close the ending balance of Manufacturing Overhead.


Accounts Cost of Goods Sold Manufacturing Overhead

Dr. 700

4

Record transactions for completion and sales of finished goods and adjustment for under- or overallocated overhead

Cr. 700

Do It Yourself Question 2 Solutions | Chapter 16

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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 16, Job Order Costing. Click a link to work on the tutorial exercises.


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17

Process Costing

WHAT YOU PROBABLY ALREADY KNOW Sometimes when you have the opportunity, like on vacation, you may want to catch up on reading several books of interest. Assume that you started reading three books and were approximately twothirds done reading each of them at the end of the week. If you were asked how many books you finished reading, you would have to say none. But that answer would not indicate the amount of time spent during the week reading. You read two-thirds of each of the three books, which is equivalent to reading two complete books (2/3 ! 3 = 2) over the course of the week. Using an equivalent number of books accurately quantifies the amount of work completed during the week. In this chapter, we study the computation of inventory costs. To determine the cost of work in process, we use this concept of equivalent units for those inventory items that are partially complete.

Learning Objectives

1

Distinguish between the flow of costs in process costing and job order costing. In Chapter 16, we learned that job order costing is an appropriate system for companies that produce unique jobs, batches, or assignments. Process costing is an appropriate system for companies that mass-produce many similar products in a continuous fashion such as food and beverage, paint, or chemical manufacturers. The flow of costs through both of these systems is similar.The three components of cost—direct materials, direct labor, and manufacturing overhead—are included in the product cost. After the goods are produced, they are transferred from Work in Process to Finished Goods. When the goods are sold, the costs are transferred from Finished Goods to Cost of Goods Sold. The difference between the two systems occurs during the processing stage. When direct materials, direct labor, and overhead are applied, the Work in Process account is debited under both systems. The job order costing system includes a subsidiary ledger of job cost records.The sum of the job cost records, which include the direct materials, direct labor, and manufacturing overhead for each job, should always equal the one Work in Process account balance. Under process costing, each of the processing departments may have a Work in Process account. The Work in Process costs will flow from department to department while in production until the product is complete and the costs are transferred into Finished Goods. Review Exhibit 17-1 (p. 900) for a comparison between the cost flows of job order and process costing systems.

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Compute equivalent units. Equivalent units express the amount of work done during a period in terms of fully complete units of output in order to calculate the cost incurred for each unit. At the end of the period, some of those costs will be transferred either to the next Work in Process account or to Finished Goods. To calculate equivalent units, the department’s physical flow of inventory is first determined. Inputs must equal outputs. Beginning units in process plus those started in the department are the inputs or accountable units. The ending units in process and those completed and transferred out are the outputs, or units accounted for. Equivalent units are determined for direct materials and conversion costs separately for the outputs. Those units completed and transferred out are 100% complete for direct materials and conversion costs; the physical units and equivalent units are the same. For ending Work in Process units, a determination of the percentage complete for direct materials and conversion costs must be made. The physical units multiplied by the percentage complete equals the equivalent units. Review Exhibit 17-3 (p. 903) and Exhibits 17-5 and 17-6 (pp. 906–907) for an illustration and calculation of equivalent units.

3

Use process costing to assign costs to units completed and to units in ending work in process inventory. The direct materials and conversion costs are determined by adding the costs from beginning inventory, if any, to the costs added to the department for the period. The total costs are divided by the respective equivalent units to determine the cost per equivalent units, as shown in Demo Doc 1. The units completed will be assigned the full unit cost— direct materials plus conversion cost. The equivalent units of ending work in process are allocated the respective cost per equivalent unit to determine the cost of ending work in process inventory. Review Exhibits 17-8 and 17-9 (pp. 908–909) for the calculation of costs to units completed and in ending work in process inventory.

4

Use the weighted-average method to assign costs to units completed and to units in ending work in process inventory in a second department. The procedure to calculate the cost of units completed and of units in ending work in process in a second department is similar to that described in objective 3. The difference is a third column for the transferred in equivalent units and costs. All of the units completed and in ending work in process will be allocated the transferred in cost per unit. Review Exhibits 17-12 to 17-16 (pp. 913–917) for illustrations of calculating and assigning costs to units completed and to units in ending work in process inventory in a second department.

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Demo Doc 1 Illustrating Process Costing Learning Objectives

2, 3

Clear Bottled Water produces packaged water. Clear has two production departments: blending and packaging. In the blending department, materials are added at the beginning of the process. Conversion costs are added throughout the process for blending. Data for the month of April for the blending department are as follows:

Requirement Use the four-step process to calculate (1) the cost of the units completed and transferred out to the packaging department, and (2) the total cost of the units in the blending department ending work in process inventory.

CLEAR BOTTLED WATER Blending Department Month Ended April 30, 2010

Units: Beginning work in process Started in production during April Completed and transferred out to Packaging in April Ending work in process inventory (70% completed) Costs: Beginning work in process Costs added during April: Direct materials Conversion costs Total costs added during April

0 units 116,000 units 98,000 units 18,000 units $

0

54,520 32,074 $86,594


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Demo Doc 1 Solution Requirement Use the four-step process to calculate (1) the cost of the units completed and transferred out to the packaging department, and (2) the total cost of the units in the blending department ending work in process inventory. Steps 1 and 2: Summarize the flow of physical units and compute output in terms of equivalent units.

Part 1

2

Compute equivalent units

Part 2

Part 3

Demo Doc Complete

Total units to account for is the equivalent of units completed and transferred out of packaging in April (98,000) plus the ending work in process inventory of April 30 (18,000):

CLEAR BOTTLED WATER Blending Department Month Ended April 30, 2010

Flow of Production Units to account for: Beginning work in process, March 31 Started in production during April Total accountable physical units

Step 1 Flow of Physical Units

Step 2: Equivalent Units Direct Conversion Materials Costs

0 116,000 116,000

Materials are added at the beginning of the blending production process, so equivalent units for materials are the same as the total units. Completed units are 100% for conversion costs (98,000). Conversion costs are added evenly throughout the blending process, so the conversion equivalent units for ending work in process inventory are the total units in ending work in process multiplied by the percent complete. 18,000 ! 70% " 12,600

Remember, conversion costs include both direct labor and manufacturing overhead.

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CLEAR BOTTLED WATER Blending Department Month Ended April 30, 2010 Step 1 Flow of Physical Units

Flow of Production Units to account for: Beginning work in process, March 31 Started in production during April Total accountable physical units


0 116,000 116,000

Units accounted for: Completed and transferred out during April Ending work in process, April 30 Total physical units accounted for

98,000 18,000 116,000

Equivalent units

98,000 18,000

98,000 12,600

116,000

110,600

We can see that the total units accounted for is 116,000 units, with 98,000 completed units + 18,000 work in process units = 116,000 equivalent units for direct materials, and 98,000 completed units + 12,600 work in process units = 110,600 equivalent units for conversion costs. Step 3: Compute the cost per equivalent unit.

Part 1

Part 2

Part 3

Demo Doc Complete

The cost per equivalent unit is computed by dividing the costs added during the period by the equivalent units: Total Direct Material Cost Cost per Equivalent Unit for " Direct Materials s Equivalent Units for Direct Material Cost

3

Use process costing to assign costs to units completed and to units in ending work in process inventory

Total Conversion Cost Cost per Equivallent Unit for " Conversion Cost Equivalent Units for Conversion Cosst

We know from Step 1 that Clear has 116,000 equivalent units. From the question, we know that Clear has $54,520 of total direct materials costs in April. Using the formula for cost per equivalent unit for direct materials, we divide the total direct materials costs by the equivalent units of materials, as determined in Step 2. $54,520/116,000 units " $0.47 per equivalent unit for direct materials

By using equivalent units, we indicate that $32,074 of conversion costs will blend 110,600 units from the start of the blending process to the end of the blending process. To calculate costs per equivalent unit for conversion costs, we must divide the total conversion costs by the number of equivalent units for conversion, as determined in Step 2. $32,074/110,600 " $0.29 per equivalent units for conversion costs Demo Doc 1 Solutions | Chapter 17

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CLEAR BOTTLED WATER Blending Department Month Ended April 30, 2010 Step 3: Cost per Equivalent Unit Direct Conversion Materials Costs $ 0 $ 0 32,074 54,520 $ 32,074 $ 54,520 "110,600 "116,000 $ 0.29 $ 0.47

Beginning work in process, March 31 Cost added during April Total costs for April Divide by equivalent units Cost per equivalent unit

Step 4: Assign costs to units completed and to units in ending work in process inventory.

Part 1

3


Part 2

Part 3

Demo Doc Complete

Because the units completed and transferred out were started and finished in the month of April, their cost is the full unit cost of $0.76. Shown another way: 98,000 ! $0.47 " $46,060 direct materials (100%) 98,000 ! $0.29 " $28,420 conversion costs (100%) 98,000 ! $0.76 " $74,480

The ending work in process is complete regarding materials because they are added in their entirety at the beginning of the mixing process. The conversion costs in ending work in process are only 70% complete because conversion costs occur evenly throughout the mixing process. Multiplying each by their respective per-unit cost: 18,000 ! $0.47 " $ 8,460 direct materials (100%) 12,600 ! $0.29 " $ 3,654 conversion costs (70%) " $12,114

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The solution to the problem is the $74,480 cost of the goods completed and transferred out of the blending department to the packaging department during April added to the $12,114 cost of the ending work in process in the blending department as of the April 30. $74,480 # $12,114 " $86,594 total costs

CLEAR BOTTLED WATER Blending Department Month Ended April 30, 2010 Step 4: Assign Costs Direct Conversion Materials Costs Units completed and transferred out to Packaging in April Ending work in process, April 30: Direct materials Conversion costs Total ending work in process, April 30 Total costs accounted for

Part 1

Part 2

Part 3

[98,000 3 ($0.47 + $0.29)] [18,000 3 0.47] [12,600 3 0.29]

Total = $74,480 8,460 3,654 $12,114 $86,594

Demo Doc Complete


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Demo Doc 2 Weighted-Average Process Costing Learning Objectives 2, 3, 4 Easy Flow produces tubes for toothpaste. Easy has two departments: molding and packaging. In the second department, packaging, conversion costs are incurred evenly throughout the process. Packaging materials are not added until the end of the packaging process. Costs in beginning work in process inventory include transferred in costs of $28,360, direct labor of $12,369, and manufacturing overhead of $10,000. October data from the packaging department are as follows:

EASY FLOW Packaging Department Month Ended October 31, 2010 Beginning inventory, Sept. 30 (60% complete) Production started: Transferred in Direct materials Conversion costs: Direct labor Manufacturing overhead Total conversion costs Total to account for Transferred out Ending inventory (30% complete)

Units 5,700

$

120,000

125,700 110,000 15,700

Dollars 50,729 575,000 155,100

240,000 185,000 $ 425,000 $1,205,829 $ ? $ ?

Easy Flow uses weighted-average process costing.

Requirements 1. Compute Easy Flow’s equivalent units for the month of October. 2. Compute the cost per equivalent unit for October. 3. Assign the costs to units completed and transferred out and to ending inventory.

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Demo Doc 2 Solutions Requirement 1 Compute Easy Flow’s equivalent units for the month of October.

Part 1

Part 2

Part 3

Demo Doc Complete

Part 4

The 110,000 units completed and transferred out are 100% completed regarding transferred in, direct materials, and conversion costs, so the equivalent units are 100%. The ending work in process inventory is 100% complete regarding transferred in. In other words, Easy Flow doesn’t need to transfer any additional costs from another department to complete the units in ending inventory. Because direct materials are added at the end of the packaging process, they are zero complete in terms of work in process. Units in ending inventory are only 30% finished in terms of conversion costs. Another way to think of this situation is that the conversion costs applied to the ending inventory so far will complete 15,700 units 30% of the way (15,700 ! 0.30 = 4,710), or those same conversion costs would complete 4,710 units 100% of the way.

2


4

Use the weightedaverage method to assign costs to units completed and to units in ending work in process inventory in a second department

EASY FLOW Packaging Department Month Ended October 31, 2010 Transferred In

Flow of Production Units accounted for: Completed and transferred out during October Ending work in process inventory, October 31 Equivalent units

Equivalent Units Direct Conversion Materials Costs

110,000 15,700 125,700

110,000 4,710 114,710

110,000 0 110,000

So the total equivalent units for the packaging department during October is 125,700 transferred-in units, 110,000 direct material units, and 114,710 conversion costs units.

Requirement 2 Compute the cost per equivalent unit for October.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Determine total costs for each of the three categories. We know from the question that we have beginning inventory of $28,360 transferred in costs and $22,369 in conversion costs ($12,369 for direct labor and $10,000 manufacturing overhead),

4



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for a total of $50,729. The direct materials are zero for beginning work in process because they are added at the end of the packaging process.

EASY FLOW Packaging Department Month Ended October 31, 2010

Flow of Production Beginning work in process inventory, Sept. 30

Transferred In $ 28,360

Equivalent Units Direct Conversion Materials Costs $ 0 $ 22,369

$

Total 50,729

During October, we saw $575,000 in costs transferred in from the molding department, $155,100 in direct materials costs, and $425,000 in conversion costs, for a total of $1,155,100 in costs added during October. As a check, make sure that the sum of the totals of the transferred in, direct materials, and conversion costs equals the sum of the total beginning work in process and the total of costs added during October.


Flow of Production Beginning work in process inventory, Sept. 30 Costs added during October Total costs

Transferred In $ 28,360 575,000 $603,360

Equivalent Units Direct Conversion Materials Costs $ 22,369 $ 0 425,000 155,100 $447,369 $155,100

Total 50,729 1,155,100 $1,205,829 $

Now that we have our total costs, we must divide total costs for each of the categories by the equivalent units for each respective category (as determined in Requirement 1) to determine the cost per equivalent unit. The transferred-in costs are: $603,360 " $4.80 per unit 125,700 units

Direct materials costs are: $155,100 " $1.41 per unit 110,000 units

Conversion costs are: $447,369 " $3.90 per unit 114,710 units

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Beginning work in process inventory, Sept. 30 Costs added during October Total costs Divide by equivalent units Cost per equivalent unit Total costs to account for

Transferred In $ 28,360 575,000 $603,360 "125,700 $ 4.80

Costs per Equivalent Units Direct Conversion Materials Costs $ 22,369 $ 0 425,000 155,100 $447,369 $155,100 "114,710 "110,000 $ 3.90 $ 1.41

Total $0,050,729 1,155,100

$1,205,829

We will use these calculations to assign total costs for October in the packaging department to units completed and to units in ending work in process inventory.

Requirement 3 Assign the costs to units completed and transferred out and to ending inventory. Part 1

Part 2

Part 3

Finished goods inventory consists of all three cost categories, so Easy Flow multiplies the total units transferred out by the sum of the three costs. In this case, 110,000 units have been completed and transferred out during October. We know from Requirement 2 that cost per transferred-in unit is $4.80, cost per unit for direct materials is $1.41, and the per-unit conversion cost is $3.90. The 110,000 completed units receive 100% of their transferred-in, direct material, and conversion costs. Shown another way: ! ! ! !

$ 4.80 $ 1.41 $ 3.90 $10.11

" " " "


4


Demo Doc Complete

Part 4

Completed and Transferred Out

110 , 000 110 , 000 110,000 110,000

3

$ 528, 000 Transferred-in $ 155, 100 Direct Materials $ 429, 000 Conversion Cost $1, 112, 100 Total Transferred

The $1,112,100 will be transferred out to finished goods because the packaging department is the last process in Easy Flow production (debit Finished Goods, credit Work in Process). EASY FLOW Packaging Department Month Ended October 31, 2010 Transferred In Units completed and transferred out to Finished Goods Inventory

Assign Costs Direct Conversion Materials Costs

[110,000 3 ($4.80 + $1.41 + $3.90)] =

Total $1,112,100


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Ending Inventory Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Because direct materials are added at the end of the packaging process, they have not yet been added to the units in ending work in process. We know from Requirement 1 that the ending work in process inventory is 15,700 transferred-in units, 0 direct materials, and 4,710 conversion cost equivalent units. Shown another way: 15,700 ! $4.80 " $75,360 Tansferred-in 0 ! $1.41 " $ 0 Direct Materials 4,710 ! $3.90 " $18,369 Conversion Costs $93,729

The $93,729 ending work in process inventory will be listed as an asset on Easy Flow’s balance sheet (both Work in Process and Finished Goods are inventory and, therefore, assets).

EASY FLOW Packaging Department Month Ended October 31, 2010 Transferred In Units completed and transferred out to Finished Goods Inventory Ending work in process inventory, October 31: Transferred in costs Direct materials Conversion costs Total ending work in process inventory, October 31 Total costs accounted for


[110,000 3 ($4.80 + $1.41 + $3.90)] =

Total $1,112,100 $1,175,360

[15,700 3 4.80] 0 [4,710 3 3.90]

0 18,369 $ 93,729 $1,205,829

Make sure the total costs to account for, $1,112,100 + $93,729 = $1,205,829, match with the total costs from Requirement 2.

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Part 2

Part 3

Part 4

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. In a process costing system, a separate Work in Process Inventory account is maintained for each process. _____ 2. In a process costing system, costs flow into Finished Goods Inventory only from the Work in Process Inventory of the last manufacturing process. _____ 3. Wong Corporation had 25,000 units completed and transferred out and 8,000 units that were 35% complete. The equivalent units total 33,000. _____ 4. The entry to transfer goods in process from Department A to Department B includes a debit to Work in Process, Department A. _____ 5. The cost per equivalent unit must be computed for direct materials, conversion, and transferred-in costs in a subsequent department. _____ 6. The number of equivalent units may be greater than the number of accountable physical units. _____ 7. The cost per equivalent unit is calculated separately for each of the three components of cost—direct materials, direct labor, and manufacturing overhead. _____ 8. Unique or custom-made goods would be accounted for by using a process costing system. _____ 9. Conversion costs are generally added evenly throughout the process. _____10. If a department has beginning inventory of 2,000 units, 23,000 units are started into production, and ending inventory is 1,500 units, then 22,500 units are completed.

Multiple Choice 1. In a process costing system, the number of Work in Process Inventory accounts is equal to what amount? a. The number of products produced b. The number of production departments c. The number used in a job order costing system d. Cannot be determined without additional information 2. In a process costing system, the entry to record the use of direct materials in production would include which of the following? a. Debit to Work in Process Inventory b. Debit to Materials Inventory c. Debit to Finished Goods Inventory d. Credit to Finished Goods Inventory Quick Practice Questions | Chapter 17

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3. The entry to record a $24,000 transfer from the assembly department to the finishing department would include which of the following? a. Debit to Work in Process Inventory, Assembly b. Debit to Finished Goods Inventory c. Credit to Work in Process Inventory, Assembly d. Credit to Materials Inventory 4. During the period, 50,000 units were completed, and 3,600 units were on hand at the end of the period. If the ending work in process inventory was 75% complete as to direct materials and 25% complete as to conversion costs, the equivalent units for direct materials under the weighted-average method would be what amount? a. 45,900 b. 47,700 c. 48,000 d. 52,700 5. Beginning work in process is 900 units, units completed and transferred out in October are 3,200 units, and ending work in process is 500 units. Under weighted-average costing, what are units started into production in October? a. 2,300 b. 2,800 c. 3,200 d. 3,600 6. Conversion costs consist of which of the following? a. Direct materials and direct labor b. Direct labor and manufacturing overhead c. Direct materials and manufacturing overhead d. Product costs and period costs 7. The Lloyd Company uses a process costing system. No units were in beginning work in process, 1,400 were started, and 1,000 units were completed and transferred out. The units at the end of the period were 60% complete regarding materials and 40% complete regarding conversion. The cost of materials added during the current period amounted to $31,944; the cost of conversion added during the current period amounted to $30,016. What are the equivalent units for materials? a. 1,200 b. 1,240 c. 1,320 d. 1,400 8. Refer to Question 7. What are equivalent units for conversion costs? a. 1,160 b. 1,280 c. 1,300 d. 1,320

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9. Refer to Question 7. What is the cost per equivalent unit for materials? a. $22.50 b. $22.82 c. $24.20 d. $25.76 10. Refer to Question 7. What is the cost per equivalent unit for conversion? a. $22.74 b. $23.45 c. $25.01 d. $25.88

Quick Exercises 17-1. Identify which of the following products or services would use a process costing system. a. Paint b. Surgical operation c. Custom kitchen cabinets d. Cellular telephones e. Cereal f. Airplanes g. Soft drinks h. Office buildings i. Custom swimming pools j. Personal computers 17-2. Department A has no beginning work in process inventory. During the current period, 13,500 units were placed into production. At the end of the current period, 12,000 units were transferred to Department B. The ending units in Department A were 90% complete regarding direct materials and 65% complete regarding conversion costs. Compute the equivalent units for direct materials and conversion costs.

17-3. Journalize the following transactions: a. Issued $8,800 of direct materials to production in the Carving department. b. Manufacturing labor in the Carving department amounted to $8,000. c. Allocated manufacturing labor to the appropriate accounts: 90% direct labor; 10% indirect labor. The pay rate for all direct labor is $20 per hour. d. Allocated manufacturing overhead in the Carving department at $15 per direct labor hour. e. Transferred $8,600 of product from the Carving department to finished goods inventory. Quick Practice Questions | Chapter 17

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Accounts

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.


Accounts


Accounts


Accounts


Accounts

17-4. Holland Company makes a variety of chemicals. Its Grinding department reports the following information for June of the current year: HOLLAND COMPANY Grinding Department Month Ended June 30, 2010 Units: Completed and transferred out Unfinished units, work in process, June 30 Costs: Direct materials Direct labor Manufacturing overhead *100% complete for direct materials and 30% complete for conversion costs incurred.

7,400 3,500 *

$110,055 55,000 79,845

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a. Compute the equivalent units for direct materials and conversion costs.

b. Compute the cost per equivalent unit for direct materials and conversion costs.

c. Compute the cost of the goods completed and transferred out.

d. Compute the cost of the work in process at June 30.

17-5. Comfort Corporation manufactures air mattresses. The company uses the weighted-average method of process costing. Information for the Assembly department for the month of July is as follows:

COMFORT CORPORATION Assembly Department Month Ended July 31, 2010 Units: Work in process inventory, July 1 (75% complete for direct materials, 40% complete for conversion costs) Units transferred in from Cutting department Units completed and transferred out Work in process inventory, July 31 (55% complete for direct materials, 20% complete for conversion costs) Costs: Direct materials: Work in process inventory, July 1 Added during July Conversion costs: Work in process inventory, July 1 Added during July Transferred-in costs: Work in process inventory, July 1 Units transferred in from Cutting department during July

30,000 units 150,000 units 140,000 units

40,000 units

$

90,000 567,000 61,800 721,000

315,000 $1,575,000

a. Compute the total cost of units completed and transferred out.

b. Compute the total cost of work in process inventory on July 31.

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Do It Yourself! Question 1 Jiggling Jelly produces packaged jelly. Jiggling has two production departments: blending and packaging. In the blending department, materials are added at the beginning of the process. Conversion costs are added throughout the process for blending. Data for the month of June for the blending department are as follows: JIGGLING JELLY Blending Department Month Ended June 30, 2010 Units: Beginning work in process Started in production during June Completed and transferred out to Packaging in June Ending work in process inventory (20% completed) Costs: Beginning work in process Costs added during June: Direct materials Conversion costs Total costs added during June

0 units 32,500 units 28,000 units 4,500 units $

0

15,925 24,998 $40,923

Use the four-step process to calculate (1) the cost of the units completed and transferred out to the packaging department, and (2) the total cost of the units in the blending department ending work in process inventory. Steps 1 and 2

JIGGLING JELLY Blending Department Month Ended June 30, 2010

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Step 3


Step 4 JIGGLING JELLY Blending Department Month Ended June 30, 2010


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Do It Yourself! Question 2 Quality Chemicals produces a chemical that it sells to hospitals. Quality has two departments: mixing and packaging. In the second department, packaging, conversion costs are incurred evenly throughout the process. Packaging materials are not added until the end of the packaging process. Costs in beginning work in process inventory include transferred-in costs of $88,000, direct labor of $44,000, and manufacturing overhead of $21,000. July data from the packaging department are as follows:

QUALITY CHEMICALS Packaging Department Month Ended July 31, 2010 Beginning inventory, June 30 (80% complete) Production started: Transferred in Direct materials Conversion costs: Direct labor Manufacturing overhead Total conversion costs Total to account for Transferred out Ending inventory (30% complete)

Units 55,000

Dollars $153,000

230,000

293,900 250,800

285,000 220,000 65,000

Quality uses the weighted-average method for process costing.

Requirement 1 Compute Quality’s equivalent units for the month of July.

QUALITY CHEMICALS Packaging Department Month Ended July 31, 2010

596


189,250 105,000 294,250 $991,950 ? $ ?

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Requirement 2 Compute the cost per equivalent unit for July.


Requirement 3 Assign the costs to units completed and transferred out and to ending work in process inventory.



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598

T

1. In a process costing system, a separate Work in Process Inventory account is maintained for each process (p. 899)

T

2. In a process costing system, costs flow into Finished Goods Inventory only from the Work in Process Inventory of the last manufacturing process. (p. 899)

F

3. Wong Corporation had 25,000 units completed and transferred out and 8,000 units that were 35% complete. The equivalent units total 33,000. False–Equivalent units would be 27,800 = 25,000 + (8,000 3 0.35). (p. 902)

F

4. The entry to transfer goods in process from Department A to Department B includes a debit to Work in Process, Department A. False–The entry to transfer goods in process from Department A to Department B includes a credit to Work in Process, Department A. (p. 909)

T

5. The cost per equivalent unit must be computed for direct materials, conversion, and transferred-in costs in a subsequent department. (p. 910)

F

6. The number of equivalent units may be greater than the number of accountable physical units. False–The number of equivalent units cannot be greater than the number of accountable physical units. (p. 902)

F

7. The cost per equivalent unit is calculated separately for each of the three components of cost—direct materials, direct labor, and manufacturing overhead. False–The cost per equivalent unit is calculated separately for direct materials, conversion costs, and transferred-in costs as applicable. (p. 907)

F

8. Unique or custom-made goods would be accounted for by using a process costing system. False–Unique or custom-made goods would be accounted for by using a job order costing system. (p. 898)

T

9. Conversion costs are generally added evenly throughout the process. (p. 902)

F

10. If a department has beginning inventory of 2,000 units, 23,000 units are started into production, and ending inventory is 1,500 units, then 22,500 units are completed. False–If a department has beginning inventory of 2,000 units, 23,000 units are started into production, and ending inventory is 1,500 units, then 2,000 + 23,000 – 1,500 = 23,500 units are completed. (p. 905)


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Multiple Choice 1. In a process costing system, the number of Work in Process Inventory accounts is equal to what amount? (p. 899) a. The number of products produced b. The number of production departments c. The number used in a job order costing system d. Cannot be determined without additional information 2. In a process costing system, the entry to record the use of direct materials in production would include which of the following? (p. 909) a. Debit to Work in Process Inventory b. Debit to Materials Inventory c. Debit to Finished Goods Inventory d. Credit to Finished Goods Inventory 3. The entry to record a $24,000 transfer from the assembly department to the finishing department would include which of the following? (p. 909) a. Debit to Work in Process Inventory, Assembly b. Debit to Finished Goods Inventory c. Credit to Work in Process Inventory, Assembly d. Credit to Materials Inventory 4. During the period, 50,000 units were completed, and 3,600 units were on hand at the end of the period. If the ending work in process inventory was 75% complete as to direct materials and 25% complete as to conversion costs, the equivalent units for direct materials under the weighted-average method would be what amount? (p. 911) a. 45,900 b. 47,700 c. 48,000 d. 52,700 5. Beginning work in process is 900 units, units completed and transferred out in October are 3,200 units, and ending work in process is 500 units. Under weighted-average costing, what are units started into production in October? (p. 911) a. 2,300 b. 2,800 c. 3,200 d. 3,600 6. Conversions costs consist of which of the following? (p. 902) a. Direct materials and direct labor b. Direct labor and manufacturing overhead c. Direct materials and manufacturing overhead d. Product costs and period costs


599

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7. The Lloyd Company uses a process costing system. No units were in beginning work in process, 1,400 were started, and 1,000 units were completed and transferred out. The units at the end of the period were 60% complete regarding materials and 40% complete regarding conversion. The cost of materials added during the current period amounted to $31,944; the cost of conversion added during the current period amounted to $30,016. What are the equivalent units for materials? (p. 906) a. 1,200 b. 1,240 c. 1,320 d. 1,400 8. Refer to Question 7. What are equivalent units for conversion costs? (p. 906) a. 1,160 b. 1,280 c. 1,300 d. 1,320 9. Refer to Question 7. What is the cost per equivalent unit for materials? (p. 907) a. $22.50 b. $22.82 c. $24.20 d. $25.76 10. Refer to Question 7. What is the cost per equivalent unit for conversion? (p. 907) a. $22.74 b. $23.45 c. $25.01 d. $25.88

Quick Exercise Solutions 17-1. Identify which of the following products or services would use a process costing system. (p. 898) a. Paint b. Surgical operation c. Custom kitchen cabinets d. Cellular telephones e. Cereal f. Airplanes g. Soft drinks h. Office buildings i. Custom swimming pools j. Personal computers

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17-2. Department A has no beginning work in process inventory. During the current period, 13,500 units were placed into production. At the end of the current period, 12,000 units were transferred to Department B. The ending units in Department A were 90% complete regarding direct materials and 65% complete regarding conversion costs. Compute the equivalent units for direct materials and conversion costs. (p. 902) Direct materials 12,000 # (1,500 ! 0.90) " 13,350 Conversion costs 12,000 # (1,500 ! 0.65) " 12,975

17-3. Journalize the following transactions. (p. 909) a. Issued $8,800 of direct materials to production in the Carving department. b. Manufacturing labor in the Carving department amounted to $8,000. c. Allocated manufacturing labor to the appropriate accounts: 90% direct labor; 10% indirect labor. The pay rate for all direct labor is $20 per hour. d. Allocated manufacturing overhead in the Carving department at $15 per direct labor hour. e. Transferred $8,600 of product from the Carving department to finished goods inventory.


Accounts Work in Process, Carving Materials Inventory

Dr. 8,800

Cr. 8,800



Dr. 8,000

Cr. 8,000


Accounts Work in Process Inventory, Carving Manufacturing Overhead Manufacturing Wages

Dr. 7,200 800

Cr.

8,000


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Accounts Work in Process Inventory, Carving Manufacturing Overhead

Dr. 6,000

Cr. 6,000


Accounts Finished Goods Inventory Work in Process Inventory, Carving

Dr. 8,600

Cr. 8,600

17-4. Holland Company makes a variety of chemicals. Its Grinding department reports the following information for June of the current year: (pp. 906–909) HOLLAND COMPANY Grinding Department Month Ended June 30, 2010 Units: Completed and transferred out Unfinished units, work in process, June 30

7,400 3,500 *

Costs: Direct materials Direct labor Manufacturing overhead

$110,055 55,000 79,845

*100% complete for direct materials and 30% complete for conversion costs incurred.

a. Compute the equivalent units for direct materials and conversion costs. Direct materials 7,400 # 3,500 " 10,900 equivalent units Conversion costs 7,400 # (3,500 ! 0.30) " 8,450 equivalent units

b. Compute the cost per equivalent unit for direct materials and conversion costs. Direct materials $110,055/10,900 " $10.10 Conversion costs $134,845/8,450 " $15.96

c. Compute the cost of the goods completed and transferred out. 7,400 ! ($10.10 # $15.96) " $192,844

d. Compute the cost of the work in process at June 30. (3,500 ! 1.00) ! $10.10 " $35,350 (3,500 ! 0.30) ! $15.96 "

602


16,758 $52,108

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17-5. Comfort Corporation manufactures air mattresses. The company uses the weighted-average method of process costing. Information for the Assembly department for the month of July is as follows: (pp. 910–915) COMFORT CORPORATION Assembly Department Month Ended July 31, 2010 Units: Work in process inventory, July 1 (75% complete for direct materials, 40% complete for conversion costs) Units transferred in from Cutting department Units completed and transferred out Work in process inventory, July 31 (55% complete for direct materials, 20% complete for conversion costs) Costs: Direct materials: Work in process inventory, July 1 Added during July Conversion costs: Work in process inventory, July 1 Added during July Transferred-in costs: Work in process inventory, July 1 Units transferred in from Cutting department during July

30,000 units 150,000 units 140,000 units

40,000 units

$

90,000 567,000 61,800 721,000

315,000 $1,575,000

a. Compute the total cost of units completed and transferred out. Direct materials equivalent units 140,000 # (40,000 ! 0.55) " 162,000 Conversion costs equivalent units 140,000 # (40,000 ! 0.20) " 148,000 Transferred-in equivalent units 30,000 # 150,000 " 180,000 Cost per equivalent unit: Direct materials $657,000/162,000 " $4.06 Conversion costs $782,800/148,000 " $5.29 Transferred-in $1,890,000/180,000 " $10.50 Costs of units completed and transferred out 140,000 ! ($4.06 # $5.29 # $10.50) " $2,779,000

b. Compute the total cost of work in process inventory on July 31. Cost of July 31 Work in Process " (22,000 ! $4,06) # (8,000 ! $5,29) # (40,000 ! $10.50) " $89,320 # $42,320 # $420,000 " $551,640 Quick Practice Solutions | Chapter 17

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Do It Yourself! Question 1 Solutions Use the four-step process to calculate (1) the cost of the units completed and transferred out to the packaging department and (2) the total cost of the units in the blending department ending work in process inventory. Step 1: Summarize the flow of physical units.

2


Step 2: Compute output in terms of equivalent units.


Flow of Production Units to account for: Beginning work in process, May 31 Started in production during June Total accountable physical units

Step 1 Flow of Physical Units


0 32,500 32,500

Units accounted for: Completed and transferred out during June Ending work in process, June 30 Total physical units accounted for

28,000 4,500 32,500

Equivalent units

28,000 4,500

28,000 900

32,500

28,900

Step 3: Compute the cost per equivalent unit.

3



Beginning work in process, May 31 Cost added during June Total costs for June Divide by equivalent units Cost per equivalent unit

604


Step 3: Cost per Equivalent Unit Direct Conversion Materials Costs $ 0 $ 0 24,998 15,925 $24,998 $15,925 "28,900 "32,500 $ 0.865 $ 0.49

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Step 4: Assign costs to units completed and to units in ending work in process inventory.

3


JIGGLING JELLY Blending Department Month Ended June 30, 2010 Step 4: Assign Costs Direct Conversion Materials Costs Total Units completed and transferred out to Packaging in April Ending work in process, May 31: Direct materials Conversion costs Total ending work in process, June 30 Total costs accounted for

[28,000 ! ($0.49 + $0.865)] = 4,500 ! 0.49 [900 ! 0.865]

$37,940 2,205 778* $ 2,983 $40,923

*900 ! $0.865 = $778.50, rounded to $778.


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4


Compute Quality’s equivalent units for the month of July.

QUALITY CHEMICALS Packaging Department Month Ended July 31, 2010 Transferred In

Flow of Production Units accounted for: Completed and transferred out during July Ending work in process inventory, July 31 Equivalent units

4


Equivalent Units Direct Conversion Materials Costs

220,000 65,000 285,000

220,000 0 220,000

220,000 19,500 239,500

Requirement 2 Compute the cost per equivalent unit for July.


Beginning work in process inventory, June 30 Costs added during July Total costs Divide by equivalent units Cost per equivalent unit Total costs to account for

606


Transferred In $ 88,000 293,900 $381,900 !285,000 $ 1.34

Costs per Equivalent Units Direct Conversion Materials Costs $ 65,000 $ 0 294,250 250,800 $359,250 $250,800 !239,500 !220,000 $ 1.50 $ 1.14

Total $153,000 838,950

$991,950

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Requirement 3

4

Assign the costs to units completed and transferred out and to ending inventory.


QUALITY CHEMICALS Packaging Department Month Ended July 31, 2010 Transferred In Units completed and transferred out to Finished Goods Inventory Ending work in process inventory, July 31: Transferred in costs Direct materials Conversion costs Total ending work in process inventory, July 31 Total costs accounted for


[220,000 " ($1.34 + $1.14 + $1.50)] = 65,000 " 1.34 = 0 19,500 " 1.50 =


Total $875,600 87,100 0 29,250 $116,350 $991,950

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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 17, Process Costing. Click a link to work on the tutorial exercises.


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18

Cost-Volume-Profit Analysis

WHAT YOU PROBABLY ALREADY KNOW If you decide to sign up for cell phone service, you know you have a choice of providers and plans. Assume that you are debating whether to enroll in one of two plans. The first plan has 450 free anytime minutes, which costs $40 a month plus $0.45/minute beyond 450. The second plan has 900 free anytime minutes, which costs $60 a month plus $0.40/minute beyond 900. Your objective is to minimize your cost. To accomplish this evaluation, you are using concepts like fixed and variable costs that we will study in this chapter. The monthly amount of $40 or $60 is fixed; once the plan is selected, you will be charged that monthly amount regardless of the number of minutes you use. In addition, you will be charged a variable cost per minute if you exceed the allowed number of minutes. If you estimate that you will be using about 600 anytime minutes, which plan is cheaper? Plan one would be $40 + [(600 – 450) × $0.45] = $107.50; plan two would be $60 + 0 = $60. The second plan is cheaper.

Learning Objectives

1

Identify how changes in volume of activity affect costs. There are three types of costs: fixed, variable, and mixed. Fixed costs are costs that do not change over wide ranges of volume. The range of volume over which fixed costs are constant is called the relevant range. Building rent, furniture depreciation, and the salary of an office manager would be examples of fixed costs. If fixed costs are $100,000 and 10,000 units are produced, the fixed cost per unit is $100,000/10,000 = $10. If the volume doubles to 20,000 units, the fixed cost per unit is reduced to $5 per unit. Variable costs are costs that increase in total as the volume of activity increases and decreases as the volume of activity decreases. Total variable costs change in direct proportion to changes in volume. Direct materials and direct labor are examples of variable costs. If it costs $3 per unit for direct materials, the total variable costs when 10,000 units are produced is $30,000. If the volume doubles to 20,000, the total variable cost is now $60,000, but the variable cost per unit is unchanged at $3 per unit. Mixed costs have both variable and fixed components. The high-low method is used to separate the mixed cost into the variable and fixed elements. Review Exhibits 18-1 and 18-2 (p. 959) to see the impact of varying volume amounts on total variable and fixed costs.

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Use CVP analysis to compute breakeven points. The breakeven point is the sales level at which operating income is zero. Sales revenue equals total fixed and variable costs. You can use three approaches to compute the breakeven point. The income statement approach uses the income statement to facilitate the calculation of breakeven units sold (see Demo Doc 1). Contribution margin is the difference between sales revenue and variable costs. The contribution margin approach is a shortcut to the income statement approach. The contribution margin ratio approach is used when you don’t have detailed information on individual products. You will use these three approaches in Demo Doc 1. Rounding Note: When calculating the breakeven sales units or sales dollars, it is possible to obtain a fractional amount. To be conservative, you should always round up to the next higher unit or dollar.

3

Use CVP analysis for profit planning, and graph the cost-volumeprofit relations. As you will see in Demo Doc 1, you can use the three approaches to compute breakeven to also determine the number of units that must be sold to create a desired net income. The cost-volume-profit relationship can be graphed using increments of volume within the relevant range as the horizontal axis and dollars as the vertical axis. Total sales revenue is zero at zero volume and would increase linearly $35 for each unit of volume using the example in the section called Using CVP to Plan Profits of the main textbook. Total costs would start on the vertical axis at $7,000, the total fixed costs, and would increase linearly $21 for variable costs for each unit of volume. The point at which the total sales revenue line equals total costs is the breakeven point. Drawing a vertical line from that point would indicate the breakeven volume in units. Review the example in the main textbook for computations of sales units and dollars to achieve desired results. Review the cost-volume-profit graph in Exhibit 18-6 (p. 968).

4

Use CVP methods to perform sensitivity analyses. Sensitivity analysis is a “what if” technique that shows how profits will be affected if sales prices, costs, or underlying assumptions change. Using technology tools with an understanding of the interrelationship between the elements of cost, volume, and profit you can determine what the effect may be on net income of making business decisions.

5

Calculate the breakeven point for multiple product lines or services. Most companies sell multiple product lines or services. Each product or service may have a different contribution margin. It is necessary to calculate the weighted-average contribution margin of all of the sales using a sales mix, as you will see in Demo Doc 2. A sales mix is the combination of products that make up total sales.

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Demo Doc 1 Use CVP to Plan Profits Learning Objectives

2, 3

Crew Cut Mowing Service mows residential lawns. The average amount it charge to mow a single lawn is $30. Crew Cut calculated the average variable cost of mowing a lawn to be about $18. Its monthly fixed cost is $1,200.

Requirements 1. Use the contribution margin approach to calculate how many lawns Crew Cut must mow in a month to break even. 2. Use the contribution margin ratio approach to determine Crew Cut’s breakeven point in sales dollars. 3. Use the income statement approach to prove that your solutions to Requirements 1 and 2 are correct. 4. The owner of Crew Cut currently works for another lawn service and earns $2,800 per month. He doesn’t want to incur the risk of owning his own business unless he believes that he can have a profit of at least the amount he currently earns. Determine the number of lawns Crew Cut must mow in a month to earn a profit of $2,800.


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Demo Doc 1 Solutions Requirement 1 Use the contribution margin approach to calculate how many lawns Crew Cut must mow in a month to break even.

Part 1

2

Use CVP analysis to compute breakeven points

Part 2

Part 3

Demo Doc Complete

Part 4

The contribution margin tells managers how much revenue is left after paying variable costs. That revenue is used for contributing toward first covering fixed costs and then generating a profit. The contribution margin is calculated by subtracting variable costs from the sales revenue. Therefore: Sales Price per Unit – Variable Cost per Unit Contribution Margin per Unit

Crew Cut’s variable cost per lawn (unit) is $18. Therefore, its unit contribution margin is: Sales Price per Lawn " Variable Cost per Lawn Contribution Marrgin per Lawn

$30 (18) $12

After variable costs are covered, Crew Cut has $12 per lawn that then contributes toward fixed costs until fixed costs are covered, after which point Crew Cut will begin to generate a $12 profit per lawn. Breakeven is the level of sales at which total operating revenues is equal to total expenses (fixed and variable). In other words, the level at which income is zero. To compute breakeven using the contribution margin approach: Fixed Cost Contribution Margin per Unit $1,200 ! $12 ! 100 L awns

Breakeven !

In this case, Crew Cut must be able to mow 100 lawns per month to break even. That’s because at 100 lawns, Crew Cut earns just enough contribution margin to cover total fixed costs. Every lawn mowed after the breakeven point contributes the unit contribution margin to profit. For example, if Crew Cut mows 101 lawns, then it would earn a $12 profit.

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Requirement 2 Use the contribution margin ratio approach to determine Crew Cut’s breakeven point in sales dollars.

Part 1

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Demo Doc Complete

So far, we have seen that computing the breakeven point for a simple business that sells only one product is pretty straightforward. Larger companies that don’t have detailed information on individual products use its contribution margin ratio to predict profits, rather than using individual unit contribution margins on each of its products. The contribution margin ratio is the ratio of contribution margin to sales revenue. In other words, it computes its breakeven point in terms of sales dollars. This calculation enables managers to do CVP analysis with aggregated information across many products with varied selling prices. We calculate the contribution margin ratio as follows: Contribution Margin Ratio !

2


Contribution Margin per Unit Sales Revenue per Unit

So, in this case, the contribution margin ratio is equal to the contribution margin per unit (determined in Requirement 1 to be $12 per lawn) divided by the sales revenue per unit ($30 per lawn). Contribution Margin Ratio ! !

$12 $30 $0.40 0 (or 40%)

Each dollar of sales revenue contributes 40% ($0.40) toward fixed costs and profit. To compute breakeven using the contribution margin ratio: Breakeven Sales in Dollars !

Fixed Cost Contribution Margin Ratio

We know that Crew Cut’s fixed cost is $1,200 and its contribution margin ratio is 40%, so: Breakeven Sales in Dollars ! !

$1,200 40% $3,000

Crew Cut must produce revenue of $3,000 per month to cover its fixed costs and variable costs (that is, break even). This result is consistent with our previous calculations for breakeven (that is, 100 lawns × $30 per lawn = $3,000).


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Requirement 3 Use the income statement approach to prove that your solutions to Requirements 1 and 2 are correct.

Part 1

Part 2

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Part 4

Demo Doc Complete

By multiplying Crew Cut’s breakeven in units, 100, by what it charges to mow each lawn, $30, we’ve proven that our answers to Requirements 1 and 2 are the same because the result equals the same as what we calculated in Requirement 2, $3,000. Sales Revenue (100 Units $ $30) $3,000 Less: Variable Cost (100 Units $ $18) 1,800 Total Contribution Margin $1,200 Less: Fixed Cost 1,,200 Operating Income $ 0

3

Use CVP analysis for profit planning, and graph the cost-volumeprofit relations

After deducting the variable cost of $1,800 for 100 lawns and the fixed cost of $1,200, the income statement illustrates that Crew Cut would produce $0 operating income at a breakeven level of 100 units.

Requirement 4 The owner of Crew Cut currently works for another lawn service and earns $2,800 per month. He doesn’t want to incur the risk of owning his own business unless he believes that he can have a profit of at least the amount he currently earns. Determine the number of lawns Crew Cut must mow in a month to earn a profit of $2,800.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Up until now, we’ve computed how many lawns (or sales revenue) Crew Cut needs to mow in order to break even. We know that it must mow 100 lawns, or the equivalent of $3,000 in sales, to break even. Anything less would be a loss. Anything more would be profit. Now, Crew Cut wants to know how many lawns it needs to mow to generate $2,800 in profit. Because Crew Cut wants to know the number of lawns (units), we’ll use the formula based on the unit contribution margin. Using the contribution margin approach, use the desired profit of $2,800 as fixed cost (in CVP analysis, always think of desired profit as a fixed cost):

Desired Profit Sales Level !

614


Fixed Cost # Desired Profit Contribution Margin per Unit

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In this way, it’s similar to calculating breakeven, except now the desired profit is treated as a fixed cost in our calculations (remember, the contribution margin per unit is equal to selling price per unit minus variable cost per unit): Desired Profit Sales Level ! ! !

$1,200 # $2,800 $30 " $18 $4,000 $12 333.33, rounded to 334 lawnss

Once you know the breakeven, another way to think of it is to divide desired profit by contribution margin and add the difference to the breakeven: $2,800/$12 ! 234 lawns (rounded) 234 lawns # 100 breakeven ! 334 lawns

This analysis shows that Crew Cut must mow 334 lawns to earn a profit of $2,800 (remember, we round up in this case to avoid partial units). If Crew Cut also wanted to know how much sales revenue it would need to earn $2,800 profit, it could use this figure to do the calculation: 334 lawns × $30 per lawn ! $10,020 sales revenue

The desired profit is treated as a fixed cost in our calculations. Using 334 lawns to achieve the desired profit, the owner of Crew Cut can decide whether it is worth leaving his current job to start Crew Cut. These data can also be used as a management tool to help determine marketing strategy, hiring policy, and aid in other types of decision making. As before, you can use the income statement approach to prove these figures: Sales Revenue (334 $ $30) Less: Total Variable Costs (334 $ $18)

$10,020 6,012

Total Contribution Margin (334 $ $12) $ 4,008 Less: Total Fixed Costs 1,200 Operating Income

$ 2,808 *

*The $8 operating income results from rounding a lawn [($334 – 333.33) × $12] ! $8.

Whenever rounding must occur in a problem, such as when we rounded up from 333.33 to 334 lawns to avoid a partial unit, a small difference can result when proving the numbers in this way.

Part 1

Part 2

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Part 4

Demo Doc Complete


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Demo Doc 2 Using CVP for Sensitivity Analysis Learning Objectives

2–4

Hacker Golf developed a unique swing trainer golf club. It currently has a production company produce the golf club at a cost of $22. Other variable costs total $6 while monthly fixed costs are $16,000. Hacker currently sells the trainer golf club for $48.

Requirements Note: Solve each requirement as a separate situation.

1. Calculate Hacker’s breakeven point in units. 2. Hacker is considering raising its selling price to $49.95. Calculate the new breakeven in units. 3. Hacker found a new company to produce the golf clubs at a lower cost of $19 each. Calculate the new breakeven in units. 4. Because many customers requested a golf glove to go along with the trainer club, Hacker is considering selling gloves. It only expects to sell one glove for every four trainer clubs it sells. Hacker can purchase the gloves for $5 each and sell them for $9 each.Total fixed costs should remain the same at $16,000 per month. Calculate the breakeven point in units for trainer clubs and golf gloves. 5. Use a contribution margin income statement to prove the breakeven point calculated in Requirement 4.

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Demo Doc 2 Solutions Requirement 1 Calculate Hacker’s breakeven point in units.

Part 1

Part 2

Part 3

Part 4

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Part 6

Part 7

Demo Doc Complete

To determine how changes in sales prices, costs, or volume affect profits, let’s first start by calculating the current breakeven point. To determine the breakeven point, we first must calculate the contribution margin per unit. The contribution margin per unit is calculated by subtracting variable costs from the sales revenue. Therefore:

2


4

Use CVP methods to perform sensitivity analyses

Contribution Margin per Unit ! Sales Price per Unit – Variable Cost per Unit

Hacker’s variable cost per club (unit) is the price it pays for each club ($22) plus its additional variable costs ($6). Therefore, its unit contribution margin is: Selling Price per Club Variable Cost per Club ($22 # $6)

$48

Contribution Margin per Club

$20

(28)

The contribution margin represents the amount from each unit sold that is available to recover fixed costs. That means that after variable costs are covered, Hacker earns $20 per club, which then contributes toward fixed costs until fixed costs are covered, after which point Hacker will begin to generate $20 profit per club sold. Breakeven is the level of sales at which income is zero. To compute breakeven using the contribution margin approach: Breakeven ! ! !

Fixed Cost Contribution Margin per Unit $16,000 $20 800 trainer clubs

Requirement 2 Hacker is considering raising its selling price to $49.95. Calculate the new breakeven in units.

Part 1

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Demo Doc Complete

In this case, the selling price is changing, but Hacker’s variable and fixed costs are staying the same as in the original question ($28 and $16,000, respectively). The new selling price for the club is going to be $1.95 higher than the original price: from $48.00 to $49.95.


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Once we update the original data to reflect the changes, the data are then processed with the same calculations. First, calculate the new contribution margin: Selling Price per Club Variable Cost pe er Club ($22 # $6)

$49.95 (28.00)

Contribution Margin per Club

$21.95

Using the contribution margin approach: Breakeven in Units ! ! !

Fixed Cost Contribution Margin per Unit $16,000.00 $21.95 728.93, rou unded up to 729 trainer clubs

Again, we round because Hacker cannot sell a partial unit (the .93 in the actual calculation). With the increased selling price, breakeven has been reduced from 800 clubs to 729 clubs. The higher price means that each club contributes more to fixed costs. You can prove this using the income statement approach: Sales Revenue (729 $ $49.95) $36,414 Less: Variable Costs (729 $ $28) 20,412 Total Contribution Margin 16,002 Less: Fixed Costs 16,000 Operating Income $ 2* *The $2 profit results from rounding 728.93 clubs to 729 (0.07 × $21.95 ! $2).

We round the sales revenue total in this case to make sure that our figures balance. Remember that as selling prices increase (provided all costs remain the same), the volume required to break even or achieve target profit goals decreases. Conversely, as selling prices decrease, the volume required to break even or achieve target profit goals increases. Consider the following: Selling price goes from $50 to $60, variable costs stay at $20, and total fixed costs are $60,000.

Old contribution margin was $50 – $20 = $30. Old breakeven point in units was $60,000/$30 = 2,000 units. New contribution margin is $60 – $20 = $40. New breakeven point in units is $60,000/$40 = 1,500 units. The relationship between contribution margin (an increase of $10 in this case) and breakeven in units (a decrease of 500 units in this case) is an inverse relationship.

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Requirement 3 Hacker found a new company to produce the golf club at a lower cost of $19 each. Calculate the new breakeven in units.

Part 1

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Demo Doc Complete

Once costs begin to change, a new breakeven must be calculated to determine the effects of the changes. In this case, the variable cost changes, yet fixed costs and the sales price stay the same as in the original question ($16,000 and $48, respectively). In this case, we calculate as we normally would, except that our contribution margin will be different:

4


Contribution Margin per Unit ! Sales Price per Unit – Variable Cost per Unit

Hacker’s variable cost per club (unit) is the price it pays for each club (now $19) plus its additional variable costs ($6). Therefore, its unit contribution margin is: Fixed Cost Total Sales ! in Units Weighted-Average Contribution Margin per Unit

Using the contribution margin approach: Selling price per club $48 " Variable cost per club ($19 # $6) (25) $23 Contribution margin per club

With the reduced variable cost, Hacker’s breakeven in units decreases from 800 clubs to 696 clubs. Using this information, Hacker’s management must decide if it is worth the risk to switch to a new producer. You can also prove this result using the income statement approach: Sales Revenue (696 $ $48)

$33,408

Less: Variable Cost (696 $ $25)

17,400

Total Contribution Margin

16,008

Less: Fixed Costs Operating Income

16,000 $

8*

*The $8 profit results from rounding [(696 – 695.65) × $23] ! $8.

With both fixed and variable costs, remember that as these costs increase, so does the volume needed to break even or achieve target profits. Conversely, as these costs decrease, the volume needed to break even or achieve target profits also decreases.


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Requirement 4 Because many customers requested a golf glove to go along with the trainer club, Hacker is considering selling gloves. It only expects to sell one glove for every four trainer clubs it sells. Hacker can purchase the gloves for $5 each and sell them for $9 each.Total fixed costs should remain the same at $16,000 per month. Calculate the breakeven point in units for trainer clubs and golf gloves.

Part 1

5

Calculate the breakeven point for multiple product lines or services

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7

Demo Doc Complete

Calculating the breakeven point is fairly straightforward when a company is only dealing with one product. But Hacker is now considering selling two products rather than just the one. Now breakeven becomes a little more complicated. Different products will have different effects on the contribution margins because of different costs and selling prices. So the company needs to consider the sales mix (a combination of products that make up total sales) in figuring CVP relationships. You can use the same formulas to determine the breakeven point considering the sales mix, but before calculating breakeven, you must calculate the weighted-average contribution margin of all the products first. You saw another weighted-average for process costing in Chapter 17. In this case, the sales mix provides the weights. Step 1: Calculate the weighted-average contribution margin. Hacker believes that it can sell one glove for every four trainer clubs that it sells, for a 4-to-1 sales mix. So it expect that 4/5 (or 80%) of its sales will be trainer clubs, and 1/5 (or 20%) of its sales will be gloves. Recall that Hacker pays $28 in variable costs for its clubs and sells them for $48, for a contribution margin of $20 per unit. The gloves will cost $5 per pair and sell for $9, for a contribution margin of $4 per unit: Clubs

Gloves

Sales price per unit

$48

$9

Less: Variable cost per unit

(28)

(5)

Contribution margin per unit

$20

$4

Total

The weighted-average contribution margin is calculated by multiplying the contribution margin per unit by the sales mix expected for each. Once we have a total contribution margin ($80 + $4 = $84, in this case), we divide the total contribution margin by the total sales mix in units (5), as follows:

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Sales Mix Percentage 20% Clubs

80% Gloves


$48

$9


(28)

(5)


$20

$4

4

1

$80

$4

Sales mix in units Contribution margin per product

Total

5 $84.00

Weighted-average contribution margin ($84/5)

$16.80

Another way to calculate this is to multiply each product’s contribution margin by its sales mix percentage: Clubs:

$20 ! 80% " $16.00

Gloves:

$4 ! 20% " $ 0.80 $16.80

The $16.80 represents an average contribution margin for all the products Hacker sells. The golf clubs are weighted more heavily because Hacker expects to sell four times as many clubs compared to the gloves. The next step is to calculate the breakeven in units for the bundle of proucts. Step 2: Calculate the breakeven point in units for the total of both products combined using the following formula:

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Part 2

Part 3

Total Sales in Units "

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Demo Doc Complete

Fixed Cost Weighted-Average Contribution Margin per Unit

We know from the question that fixed costs will not be affected, so they should remain at $16,000. The weighted-average contribution margin, as we just calculated, is $16.80 per unit. So we compute as follows: Total Sales " in Units "

$16,000 $16.80 952.38, ro ounded to 953

Recall that we round up because Hacker cannot sell a partial unit. Hacker must sell a combined 953 clubs and gloves to break even. Management needs to know how many units of each product must be sold to break even. The next step is to determine the breakeven point in units for each product.

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Step 3: Calculate the breakeven in units for each product line. Because Hacker believes that it will sell four trainer clubs for every glove, the total breakeven, 953, is multiplied by each product’s respective percent of expected total sales: Breakeven Sales of Clubs (953 $ 80%) ! 762.4, ro ounded to 763 Breakeven Sales of Gloves (953 3 $ 20%) ! 190.6, rounded to 191 ! 954 total units

So from this analysis, we know that Hacker needs to sell 763 trainer clubs and 191 gloves to break even. The breakeven point in sales dollars is: 763 clubs $ $48 ! $36,624 # 191 gloves $ $9 ! $ 1,719 Total ! $38,343

Requirement 5 Use a contribution margin income statement to prove the breakeven point calculated in Requirement 4.

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Demo Doc Complete

To test the calculation of the breakeven point, you would add together the revenue generated from all sales, subtract the variable costs for each of the clubs and gloves, then subtract the total fixed costs. The result should balance to zero (or close to zero, in cases in which rounding occurs).

HACKER GOLF Contribution Margin Income Statement Clubs Sales revenue: Trainer clubs (763 3 $48) Gloves (191 3 $9) Variable costs: Trainer clubs (763 3 $28) Gloves (191 3 $5) Contribution margin Fixed costs Operating income

Gloves

Total

$36,624 $1,719

$38,343

955 $ 764

22,319 $16,024 (16,000) $ 24

21,364 $15,260

A slight $24 profit at the breakeven level occurs because of rounding to whole units.

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Quick Practice Questions True/False _____ 1. Total fixed costs don’t change as production levels decrease. _____ 2. On a CVP graph, the vertical distance between the total expense line and the total sales revenue line equals the operating income or loss. _____ 3. Sensitivity analysis is a “what if” technique that asks what a result will be if a predicted amount is not achieved or if an underlying assumption changes. _____ 4. The margin of safety is the excess of breakeven sales over expected sales. _____ 5. The contribution margin is the band of volume where total fixed costs remain constant and the variable cost per unit remains constant. _____ 6. Gray Company sells two products, X and Y. For the coming year, Gray predicts the sale of 5,000 units of X and 10,000 units of Y. The contribution margins of the two products are $2 and $3, respectively. The weighted-average contribution margin would be $2.50. _____ 7. An easy method to separate mixed costs into variable and fixed components is the high-low method. _____ 8. Sensitivity analysis is the combination of products that make up total sales. _____ 9. If a mixed cost has a high level of activity of 1,200 hours and a cost of $16,500 and a low level of activity of 800 hours and a cost of 12,500, the variable cost per unit is $5. _____10. Using the information in question 9, the fixed cost would be $4,000.

Multiple Choice 1. A cost whose total amount changes in direct proportion to a change in volume is what type of cost? a. Fixed cost b. Variable cost c. Mixed cost d. Irrelevant cost 2. Which of the following is a fixed cost? a. Salary of plant manager b. Sales commissions c. Direct materials d. Delivery costs Quick Practice Questions | Chapter 18

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3. What is the effect on total variable costs of changes in production? a. Remain the same as production levels change b. Decrease as production increases c. Decrease as production decreases d. Increase as production decreases 4. What is the effect on fixed costs per unit of changes in production? a. Increase as production increases b. Decrease as production decreases c. Increase as production decreases d. Remain the same as production levels change 5. What is contribution margin? a. Fixed expenses plus variable expenses b. Sales revenues minus variable expenses c. Fixed expenses minus variable expenses d. Sales revenues minus fixed expenses 6. If the sale price per unit is $75, variable expenses per unit are $40, target operating income is $22,000, and total fixed expenses are $20,000, what is the total number of units that must be sold to reach the target operating income? a. 571 b. 629 c. 1,050 d. 1,200 7. Canine Company produces and sells dog treats for discriminating pet owners. The unit selling price is $10, unit variable costs are $7, and total fixed costs are $3,300. How many dog treats must Canine Company sell to break even? a. 194 b. 330 c. 471 d. 1,100 8. Fixed Company produces a single product selling for $30 per unit. Variable costs are $12 per unit and total fixed costs are $4,000. What is the contribution margin ratio? a. 0.40 b. 0.60 c. 1.67 d. 2.50 9. Which of the following will decrease the breakeven point assuming no other changes in the cost-volume-profit relationship? a. A decrease in the sale price per unit b. An increase in the sale price per unit c. An increase in total fixed costs d. An increase in the variable costs per unit

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10. Gould Enterprises sells computer disks for $1.50 per disk. Unit variable expenses total $0.90. The breakeven sales in units are 3,000 and budgeted sales in units are 4,300. What is the margin of safety? a. $ 780 b. $1,950 c. $2,580 d. $4,500

Quick Exercises 18-1. Indicate whether each cost is typically a fixed cost (F), a variable cost (V), or a mixed cost (M). a. __________ b. __________ c. __________ d. __________ e. __________ f. __________ g. __________ h. __________ i. __________ j. __________

Packing materials Executive salaries Sales commissions Direct materials Units-of-production depreciation Insurance expense Building rent ($2,000 plus 5% of sales revenue per month) Property taxes Delivery expenses Photocopying machine rent (X amount per month plus Y amount per copy)

18-2. Calculate the unknowns for the following situations based on the given data. Actual total sales revenue $400,000 Total fixed cost 76,000 Un nit variable cost 15 Contribution margin ratio 40%

Calculate the following items. a. Breakeven point in dollars

b. Unit selling price

c. Unit contribution margin


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d. Breakeven point in units

e. Margin of safety

18-3. Robinson Company produces swim goggles and has gathered the following information: Total fixed costs $156,000 Unit variable cost 6 Planned sales in units 32,000

Assuming breakeven sales in units of 30,000, compute: a. Sales price per unit

b. Contribution margin ratio

c. Breakeven sales in dollars

18-4. Calculate the unknowns for the following situations based on the following data. All situations are independent of each other. Total fixed costs $180,000 Unit sale price 100 Unit variablle cost 40

a. Calculate the breakeven point in units.

b. Calculate the breakeven point in dollar sales.

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c. Assume the unit sale price increases by 10%. Other data are unchanged. Calculate the breakeven point in units.

d. Assume the unit variable cost increases by 10%. Other data are unchanged. Calculate the breakeven point in units.

e. Assume total fixed costs increase by $5,000. Other data are unchanged. Calculate the breakeven point in units.

18-5. Ultimate Jelly Company manufactures two different types of jelly, one with sugar (Jelly) and one without sugar (Simply Jelly). The following information is available for the two products: Jelly Simply Jelly Sale price per unit

$5

$7

Variable expenses per unit

$3

$6

Total fixed expenses are estimated at $381,500. Two jars of Jelly are sold for every three jars of Simply Jelly. a. Determine the breakeven sales in units of both products.

b. Compute the target sales in dollars if Ultimate Jelly wants to earn $70,000 in operating income.

c. Prove the solution to Requirement 2 by calculating net income using the targeted sales.


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Do It Yourself! Question 1 Easy Wear T-shirts prints T-shirts for local organizations. The average amount it charges for a printed T-shirt is $10. Easy Wear calculated the average variable cost of a printed T-shirt to be $6. Its monthly fixed cost is $18,000.

Requirements 1. Use the contribution margin approach to calculate how many T-shirts Easy Wear must sell in a month to break even.

2. Use the contribution margin ratio approach to determine Easy Wear’s breakeven point in sales dollars.

3. Use the income statement approach to prove that the solutions to Requirement 1 and 2 are correct.

4. The owner of Easy Wear currently works for another T-shirt company and earns $3,200 per month. She doesn’t want to incur the risk of owning her own business unless she believes that she can have a profit of at least the amounts she currently earns. Determine the number of T-shirts Easy Wear must print in a month to earn a profit of $3,200.

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Do It Yourself! Question 2 Cool Board sells a snowboard for $240 that it can purchase for $100. It has additional variable costs of $40 and a monthly fixed cost of $22,000.

Requirements Note: Solve each requirement as a separate and independent situation.

1. Calculate Cool Board’s breakeven point in units.

2. Cool Board is considering raising its selling price to $249. Calculate the new breakeven in units.

3. Cool Board has found a new supplier for the snowboards, who will sell the board to Cool for $95. Calculate the new breakeven in units.

4. Cool Board has had many requests from customers for bindings to go along with the board. Cool believes that for every three boards it sells, it could sell two bindings. Cool can purchase the bindings for $25 and would incur another $5 in other variable costs for a total variable cost on the bindings of $30. Cool can sell the bindings for $55. Total fixed costs should remain the same at $22,000 per month. Calculate the breakeven point in units for snowboards and bindings.


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5. Use a contribution margin income statement to prove the breakeven point calculated in Requirement 4.

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1. Total fixed costs don’t change as production levels decrease. (p. 959)

T

2. On a CVP graph, the vertical distance between the total expense line and the total sales revenue line equals the operating income or loss. (p. 968)

T

3. Sensitivity analysis is a “what if” technique that asks what a result will be if a predicted amount is not achieved or if an underlying assumption changes. (p. 969)

F

4. The margin of safety is the excess of breakeven sales over expected sales. False–The margin of safety is the excess of actual sales over breakeven sales. (p. 971)

F

5. The contribution margin is the band of volume where total fixed costs remain constant and the variable cost per unit remains constant. False - The relevant range is the band of volume where total fixed costs remain constant and the variable cost per unit remains constant. (p. 965)

F

6. Gray Company sells two products, X and Y. For the coming year, Gray predicts the sale of 5,000 units of X and 10,000 units of Y. The contribution margins of the two products are $2 and $3, respectively. The weighted-average contribution margin would be $2.50. False–The weighted-average contribution margin would be $2.67 (p. 965) Sales Mix: 5,000 units/15,000 units ! 1/3; 10,000 units/15,000 units ! 2/3; Sales Mix ! 1:2 (1 × $2) # (2 × $3) ! $8; $8/3 ! $2.67/unit

T

7. An easy method to separate mixed costs into variable and fixed components is the high-low method. (p. 961)

F

8. Sensitivity analysis is the combination of products that make up total sales. False–Sales mix is the combination of products that make up total sales. (p. 972)

F

9. If a mixed cost has a high level of activity of 1,200 hours and a cost of $16,500 and a low level of activity of 800 hours and a cost of 12,500, the variable cost per unit is $5. False–If a mixed cost has a high level of activity of 1,200 hours and a cost of $16,500 and a low level of activity of 800 hours and a cost of 12,500, the variable cost/unit is $10. ($16,500 – $12,500)/(1,200 – 800) = $10/hour. (p. 960)

T

10. Using the information in question 9, the fixed cost would be $4,000. (p. 960) Quick Practice Solutions | Chapter 18

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Multiple Choice 1. A cost whose total amount changes in direct proportion to a change in volume is what type of cost? (p. 958) a. Fixed cost b. Variable cost c. Mixed cost d. Irrelevant cost 2. Which of the following is a fixed cost? (p. 959) a. Salary of plant manager b. Sales commissions c. Direct materials d. Delivery costs 3. What is the effect on total variable costs of changes in production? (p. 958) a. Remain the same as production levels change b. Decrease as production increases c. Decrease as production decreases d. Increase as production decreases 4. What is the effect on fixed costs per unit of changes in production? (p. 959) a. Increase as production increases b. Decrease as production decreases c. Increase as production decreases d. Remain the same as production levels change 5. What is contribution margin? (p. 964) a. Fixed expenses plus variable expenses b. Sales revenues minus variable expenses c. Fixed expenses minus variable expenses d. Sales revenues minus fixed expenses 6. If the sale price per unit is $75, variable expenses per unit are $40, target operating income is $22,000, and total fixed expenses are $20,000, what is the total number of units that must be sold to reach the target operating income? (p. 967) a. 571 b. 629 c. 1,050 d. 1,200 7. Canine Company produces and sells dog treats for discriminating pet owners. The unit selling price is $10, unit variable costs are $7, and total fixed costs are $3,300. How many dog treats must Canine Company sell to break even? (p. 963) a. 194 b. 330 c. 471 d. 1,100

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8. Fixed Company produces a single product selling for $30 per unit. Variable costs are $12 per unit and total fixed costs are $4,000. What is the contribution margin ratio? (p. 966) a. 0.40 b. 0.60 c. 1.67 d. 2.50 9. Which of the following will decrease the breakeven point assuming no other changes in the cost-volume-profit relationship? (pp. 963–966) a. A decrease in the sale price per unit b. An increase in the sale price per unit c. An increase in total fixed costs d. An increase in the variable costs per unit 10. Gould Enterprises sells computer disks for $1.50 per disk. Unit variable expenses total $.90. The breakeven sales in units are 3,000 and budgeted sales in units are 4,300. What is the margin of safety? (p. 971) a. $ 780 b. $1,950 c. $2,580 d. $4,500

Quick Exercise Solutions 18-1. Indicate whether each cost is typically a fixed cost (F), a variable cost (V), or a mixed cost (M). (pp. 958–960) a. b. c. d. e. f. g.

V F V V V F M

h. i. j.

F V M

Packing materials Executive salaries Sales commissions Direct materials Units-of-production depreciation Insurance expense Building rent ($2,000 plus 5% of sales revenue per month) Property taxes Delivery expenses Photocopying machine rent (X amount per month plus Y amount per copy)

18-2. Calculate the unknowns for the following situations based on the given data. (pp. 958–966) Actual total sales revenue $400,000 Total fixed cost 76,000 Un nit variable cost 15 Contribution margin ratio 40%


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Calculate the following items. a. Breakeven point in dollars $76,000/0.40 = $190,000 b. Unit selling price $15/(100% – 40%) = $25 c. Unit contribution margin $25 × 0.40 = $10, or $25 – $15 = $10 d. Breakeven point in units $76,000/$10 = 7,600 units e. Margin of safety $400,000 – $190,000 = $210,000 18-3. Robinson Company produces swim goggles and has gathered the following information: (pp. 958–966) Total fixed costs $156,000 Unit variable cost 6 Planned sales in units 32,000

Assuming breakeven sales in units of 30,000, compute: a. Sales price per unit Let X = contribution margin per unit $156,000/X = 30,000 $156,000 = 30,000X X = $156,000/30,000 = $5.20 $5.20 + $6 = $11.20 b. Contribution margin ratio $5.20/$11.20 = 0.4643 c. Breakeven sales in dollars 30,000 × $11.20 = $336,000, or $156,000/0.4643 = $336,000, rounded 18-4. Calculate the unknowns for the following situations based on the following data. All situations are independent of each other. (pp. 963–966) Total fixed costs $180,000 Unit sale price 100 Unit variablle cost 40

a. Calculate the breakeven point in units. $180,000/($100 – $40) = 3,000 b. Calculate the breakeven point in dollar sales. 3,000 units × $100 = $300,000, or $180,000/0.60 = $300,000 c. Assume the unit sale price increases by 10%. Other data are unchanged. Calculate the breakeven point in units. $100 × 1.10 = $110 – $40 = $70 $180,000/$70 = 2,571 units (rounded)

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d. Assume the unit variable cost increases by 10%. Other data are unchanged. Calculate the breakeven point in units. $40 × 1.10 = $44; $100 – $44 = $56 $180,000/$56 = 3,214 units (rounded) e. Assume total fixed costs increase by $5,000. Other data are unchanged. Calculate the breakeven point in units. $185,000/$60 = 3,083 units (rounded) 18-5. Ultimate Jelly Company manufactures two different types of jelly, one with sugar (Jelly) and one without sugar (Simply Jelly). The following information is available for the two products: (pp. 963–966) Jelly Simply Jelly Sale price per unit

$5

$7

Variable expenses per unit

$3

$6

Total fixed expenses are estimated at $381,500. Two jars of Jelly are sold for every three jars of Simply Jelly. a. Determine the breakeven sales in units of both products. $5 – $3 = $2 $2 × 2 = $4 $7 – $6 = $1 $1 × 3 = $3 $4 + $3 = $7 $7/5 = $1.40 weighted-average contribution margin $381,500/$1.40 = 272,500 sets 272,500 × 2/(2 + 3) = 109,000 units of Jelly 272,500 × 3/(2 + 3) = 163,500 units of Simply Jelly b. Compute the target sales in dollars if Ultimate Jelly wants to earn $70,000 in operating income. $381,500 + $70,000 = $451,500 $451,500/$1.40 = 322,500 sets 322,500 × 2/(2 + 3) = 129,000 units 129,000 units × $5 = $645,000 Jelly 322,500 × 3/(2 + 3) = 193,500 units 193,500 units × $7 = $1,354,500 Simply Jelly $645,000 + $1,354,500 = $1,999,500 c. Prove the solution to Requirement 2 by calculating net income using the targeted sales. Revenue – Variable Costs – Fixed Costs = Net Income $1,999,500 – (129,000 × $3) – (193,500 × $6) – $381,500 = $70,000 Quick Practice Solutions | Chapter 18

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Do It Yourself! Question 1 Solution Requirement 1 Use the contribution margin approach to calculate how many T-shirts Easy Wear must sell in a month to break even.

2


Contribution Margin per Unit ! Sales Price per Unit " Variable Cost per Unit Sales Price per Unit $10 Variable Cost per Unit (6) Contribution Margin per Unit $ 4 Breakeven in Un nits ! Fixed Cost/Contribution Margin per Unit Breakeven in Units ! $18,000/$4 ! 4, 500 T-shiirts

Requirement 2 Use the contribution margin ratio approach to determine Easy Wear’s breakeven point in sales dollars.

2


Contribution Margin Ratio ! Contribution Margin per Unit/ Sales Revenue per Unit Contribution Margin Ratio ! $4/$10 ! 0.40 (or 40%) Breakeven in Sales Dollars ! Fixed Cost/Contribution Margin Ratio Breakeven in Sales Dollars ! $18,000/0.40 ! $45,000

Requirement 3 Use the income statement approach to prove that the solutions to Requirements 1 and 2 are correct.

2

Sales Revenue ($10 $ 4,500 Units) $45,000 Less: Variable Costs (4,500 $ $6) 27,000 Total Contribution Margin 18,000 Less: Fixed Costs 18 8,000 Operating Income $ 0


Requirement 4 The owner of Easy Wear currently works for another T-shirt company and earns $3,200 per month. She doesn’t want to incur the risk of owning her own business unless she believes that she can have a profit of at least the amount she currently earns. Determine the number of T-shirts Easy Wear must print in a month to earn a profit of $3,200. Desired Profit Sales Level in Units ! (Fixed Cost # Desired Profit)/ Contribution Margin

3

Use CVP analysis for profit planning, and graph the cost-volumeprofit relations

Desired Profit Sales Level in Units ! ($18,000 # $3,200)/($10 – $6) Desired Profit Sales Level in Units ! $21,200/$4 ! 5,300 Units

Another way to think of this calculation is to divide your desired profit by your contribution margin and add the difference to your breakeven: $3,200/$4 ! 800 units 800 units # 4,500 breakeven ! 5,300 units

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Do It Yourself! Question 2 Solution Requirement 1 Calculate Cool Board’s breakeven point in units. Breakeven in Units ! Fixed Cost/(Selling Price per Unit – Variable Cost per Unit)

2


4


4


5


Breakeven in Units ! $22,000/($240 – $140) ! 220 Boards

Requirement 2 Cool Board is considering raising its selling price to $249. Calculate the new breakeven in units. Breakeven in Units ! Fixed Cost/(Selling Price per Unit – Variable Cost per Unit) Breakeven in Units ! $22,000/($249 – $140) ! 201.83, Rounded to 202 Snowboards

Requirement 3 Cool Board has found a new supplier for the snowboards, who will sell the board to Cool Board for $95. Calculate the new breakeven in units. Breakeven in Units ! Fixed Cost/(Selling Price per Unit – Variable Cost per Unit) Breakeven in Units ! $22,000/($240 – $135) ! 209.52, Rounded to 210 Snowboards

Requirement 4 Cool Board has had many requests from customers for bindings to go along with the board. Cool Board believes that for every three boards it sells, it could sell two bindings. Cool Board can purchase the bindings for $25 and would incur another $5 in other variable cost for a total variable cost on the bindings of $30. Cool Board can sell the bindings for $55. Total fixed costs should remain the same at $22,000 per month. Calculate the breakeven point in units for snowboards and bindings. Step 1: Calculate the weighted-average contribution margin. Boards

Bindings


$240

$55


(140)

(30)


$100

$25

×3

×2

5

$300

$50

$350

Sales mix in units Contribution margin Weighted-average contribution margin per unit ($350/5)

Total

$70

Step 2: Calculate the breakeven point in units for the total of both products combined. Total Sales in Units ! Fixed Cost/Weighted-Average Contribution Margin per Unit Total Sales in Units ! $22,000/$70 ! 314.28, rounded to 315 Do It Yourself! Question 2 Solution | Chapter 18

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Step 3: Calculate the breakeven in units for each product line. Breakeven Sales of Boards 315 $(3/5) !189 Snow wboards Breakeven Sales of Gloves 315 $(2/5) ! 126 Bindings 315 Total Units

Requirement 5 Use a contribution margin income statement to prove the breakeven point calculated in Requirement 4.

5


A slight $50 profit occurs at the breakeven level because of rounding to whole units.

COOL BOARDS Contribution Margin Income Statement Boards Bindings Sales revenue: Boards (189 3 $240) Bindings (126 3 $55) Variable costs: Boards (189 3 $140) Bindings (126 3 $30) Contribution margin Fixed costs Operating income

638


Total

$45,360 $6,930

$52,290

3,780 $3,150

$30,240 $22,050 (22,000) $ 50

26,460 $18,900

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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 18, Cost-Volume-Profit Analysis. Click a link to work on the tutorial exercises.


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19

The Master Budget and Responsibility Accounting

WHAT YOU PROBABLY ALREADY KNOW You may have wanted to purchase something you’ve had to save for over a period of time. To project how you would accomplish your goal, you might have made a plan. You would consider the amount of money available at the beginning of your plan plus the forecasted cash receipts less cash disbursements over the period to reach your goal. You probably already know that by addressing your financial goal and creating a cash budget, you are able to plan for the future and make decisions to facilitate achieving your goal. If the period of time is sufficiently long, you can compare your actual to your budgeted cash flows during interim periods and make changes as warranted. Some of these may include: • Initiate steps to increase cash inflows, perhaps work more hours. • Initiate steps to decrease cash outflows, cut back on lesserimportant spending. • Initiate steps to finance the shortfall, pursue borrowing opportunities. • Postpone or abandon the purchase plan. In this chapter, we will study the various budgets that companies create and look at the usefulness of the budgeting process for all financial entities.

Learning Objectives

1

Learn how to use a budget. Budgeting helps managers plan and control their actions. Management creates organizational goals. Action steps are planned to achieve those goals. The budget is the anticipated financial results of taking those action steps. The actual results can be compared to the budget and corrective action taken where necessary. Review Exhibits 19-2 and 19-3 (pp. 1009–-1010) for the usefulness and benefits of budgets.

2

Prepare an operating budget. The sales budget is the first part of the operating budget that must be prepared. Expected sales units and future sales prices are used in the budget. This budget will drive the remainder of the operating budget, such as the cost of goods sold, inventory, purchase, and operating expense budgets. Review Exhibits 19-6 through 19-8 (p. 1013) for examples of operating budgets.

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Prepare a financial budget. The financial budget includes the cash and balance sheet budgets. The cash budget contains the beginning cash balance, projected cash collections, cash payments, financing required, and the ending cash balance. The period in which items as sales and purchases on account result in cash flows must be projected and integrated into the cash budget. After completing all of the operating and cash budgets, a projection of the balance sheet account balances can be determined. This information is used to prepare the balance sheet budget. Review Exhibits 19-10 to 19-13 (pp. 1017–1019) for components of a cash budget. Review Exhibit 19-15 (p. 1023) for the computation of balance sheet projected account balances and Exhibit 19-14 (p. 1022) for a budgeted balance sheet.

4

Prepare performance reports for responsibility centers. A responsibility center is a part or subunit of an organization whose manager is accountable for specific activities. Performance reports compare the budget to the actual results for each responsibility center. The performance of the managers of each center can then be evaluated. There are four responsibility centers: • Cost center. Only costs or expenses are incurred. The human resources, acounting, and information technology departments are examples of cost centers. The goal of the manager is to minimize costs. • Revenue center. Primarily revenues are incurred although some related expenses may also be relevant. A sales department would be a revenue center. Managers are assessed based upon the revenues generated. The goal of the manager is to maximize revenues. • Profit center. Responsible for revenues and expenses, and ultimately profits or net income. The goal of the manager is to exceed the profit projection. The sales and costs related to the Lipton Cup-a-Soup product line would be an example of a profit center. • Investment center. Responsible for the results of the investment as well as the profits of the entity. The foods division of Lipton would be considered an investment center. Managers are responsible for making sales, maintaining expenses, and managing the investment required to generate profits.

Review Exhibit 19-17 (p. 1028) for examples of responsibility centers and responsibility accounting performance reports in Exhibit 19-19 (p. 1027).

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Chapter 19 | The Master Budget and Responsibility Accouting

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Demo Doc 1 Master Budget Learning Objectives

2

Joe University sells college sweatshirts. Actual sales for the month ended September 30, 2008, were $20,000. Joe expects sales to increase 8% in October and increase another 4% over October sales in November. Cash sales are expected to be 60% of total sales and credit sales about 40% of sales. Cost of goods sold should be 60% of total sales. Joe doesn’t want inventory to fall below $4,000 plus 10% of cost of goods sold for the next month. Sales of $25,000 are expected for December. Inventory on September 30 is $6,000. Operating expenses include sales commission, 10% of sales; rent expense of $1,000; depreciation expense of $1,200; utility expense of $800; and insurance expense of $400. Round all figures to the nearest dollar.

Requirement 1. Prepare the following budgets for October and November: a. Sales budget b. Inventory, purchases, and cost of goods sold budget c. Operating expense budget d. Budgeted income statement


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Demo Doc 1 Solution Requirement 1. Prepare the following budgets for October and November: a. Sales budget

Part 1

2

Prepare an operating budget

Part 2

Part 3

Demo Doc Complete

Part 4

We prepare the sales budget first because sales affect most elements of the other budgets we will be preparing for this period. In order to complete the sales budget, we start by calculating the total sales for each month. We will then compute the split between cash sales and credit sales for each month based on Joe’s estimation that cash sales will be 60% of the total sales for each month and credit sales will be 40% of total sales for each month. Let’s begin by calculating Joe’s total sales for October and November. The question tells us that actual sales for the month ended September 30 were $20,000, and that Joe expects sales to increase by 8% over that in October and another 4% over October’s sales in November: October Total Sales ! September Sales "108% October Total Sales ! $20,000 "108% ! $21,600 Novemb ber Total Sales ! October Sales "104% November Total Sales ! $21,600 "104% ! $22,464

So we begin to build our sales budget with these data:

JOE UNIVERSITY Sales Budget October Cash sales, 60% Credit sales, 40% Total sales

$21,600

November

$22,464

Total

$44,064

Now we work backwards to calculate the split between cash and credit sales for each month. In this case, cash sales are 60% of total sales and credit sales are 40% of total sales for the current months: Cash Sales October Cash Sales November Cash Sales Credit Sales October Credit Sales November Credit Sales 644


! Total sales " 60% ! $21,600 " 60% ! $12,960 ! $22,464 " 60% ! $13,478.40 (rounded to $13,478) ! ! !

Total sales " 40% $21,600 × 40% ! $8,640 $22,464 × 40% ! $8,985.60 (rounded to $8,986)

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Following is the completed sales budget:

JOE UNIVERSITY Sales Budget October November Total $12,960 $13,478 $26,438 17,626 8,640 8,986 $21,600 $22,464 $44,064

Cash sales, 60% Credit sales, 40% Total sales

A total sales budget for October and November comes to $44,064, with 60% of that ($26,438.40, rounded to $26,438) from cash and 40% ($17,625.60, rounded to $17,626) from credit. Because the sales budget calculates values that you will use when preparing other budgets, it’s always a good idea to check your work. These calculations can be performed in a number of ways. Here’s one alternative: October Total Sales ! ! ! October Ca ash Sales ! ! ! October Credit Sales ! ! ! November Total Sale es ! ! ! November Cash Sales ! ! ! November Credit Sales ! ! !

Previous Month"108% $20,000 "108% $21,600 October Expected Sales "6 60% $21,600 " 60% $12,960 October Expected Sales " 40% $21,600 " 40% $8,640 Previous Month Sales "104% $21,600 "104% $22,464 November Expected Sales " 60% $22,464 " 60% $13,478 November Expected sales " 40% $22,464 " 40% $8,986

b. Inventory, purchases, and cost of goods sold budget Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

The inventory, purchases, and cost of goods sold budget statement takes the following format:

2


Cost of Goods Sold # Desired Ending Inventory Total Inventory Required – Beginning Inventory Purchases Demo Doc 1 Solution | Chapter 19

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So we first calculate the cost of goods sold. We know from the question that cost of goods sold is expected to be 60% of total sales for the period. From the sales budget, we know that total sales for October are expected to be $21,600, and total sales for November are expected to be $22,464. So we can calculate cost of goods sold as follows: Cost of Goods Sold ! 60% of Budgeted Sales from the Sales Budget October ! $21,600 " 60% ! $12,960 November ! $22,464 " 60% ! $13,478

So here’s our budget so far:

JOE UNIVERSITY Inventory, Purchases, and Cost of Goods Sold Budget

Cost of goods sold ! Desired ending inventory Total inventory required " Beginning inventory Purchases

October November $12,960 $13,478

Next, we need to add the desired ending inventory for each month. The question states that Joe doesn’t want inventory to fall below $4,000 plus 10% of cost of goods sold for the next month. So in order to calculate the desired ending inventory for November, we need to know the cost of goods sold for December. The question tells us that December’s sales are expected to be $25,000. Returning to our calculation for cost of goods sold: Cost of Goods Sold ! 60% of Budgeted Sales from the Sales Budget December ! $25,000 " 60% ! $15,000

Desired ending inventory is now calculated as follows: Desired Ending Inventory ! $4,000 # 10% of Cost of Goods Sold for the Next Month October ! $4,000 # (10% " $13,478) ! $5,348 November ! $4,000 # (10% " $15,000) ! $5,500

We can now calculate the total ending inventory required:

JOE UNIVERSITY Inventory, Purchases, and Cost of Goods Sold Budget


646


October November $12,960 $13,478 5,348 5,500 $18,308 $18,978

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Beginning inventory is equal to the previous month’s desired ending inventory. We are told in the question that the inventory on September 30 is $6,000, so this figure becomes October’s beginning inventory. Once we determine beginning inventory, we subtract it from the total inventory required to determine total purchases for the period:

JOE UNIVERSITY Inventory, Purchases, and Cost of Goods Sold Budget October November $12,960 $13,478 5,348 5,500 $18,308 $18,978 6,000 5,348 $12,308 $13,630


c. Operating expense budget

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

With the exception of the sales commission, which we know from the question to be 10% of sales, all expenses remain constant between October and November, as follows:

2


JOE UNIVERSITY Operating Expense Budget October Sales commission Depreciation expense Rent expense Utility expense Insurance expense Total operating expenses

1,200 1,000 800 400

November 1,200 1,000 800 400

Total 2,400 2,000 1,600 800

So the only calculation to perform here is sales commission. We can compute sales commissions for October and November using the respective sales computations ($21,600 and $22,464) from the sales budget: Sales Commission ! Expected Sales "10% October Sales Commission ! $21,600 "10% ! $2,160 November Sales Commis ssion ! $22,464 "10% ! $2,246.40 (rounded to $2,246)

So here’s our completed operating expense budget for October and November: Demo Doc 1 Solution | Chapter 19

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JOE UNIVERSITY Operating Expense Budget

Sales commission Depreciation expense Rent expense Utility expense Insurance expense Total operating expenses

October November $2,160 $2,246 1,200 1,200 1,000 1,000 800 800 400 400 $5,560 $5,646

Total $ 4,406 2,400 2,000 1,600 800 $11,206

d. Budgeted income statement

Part 1

2


Part 2

Part 3

Part 4

Demo Doc Complete

The results of the budgets you’ve created so far are carried over into the fourth element: the budgeted income statement. Sales revenue is traced from the sales budget in part a. Cost of goods sold is traced from the inventory, purchases, and cost of goods sold budget in part b. We compute gross profit by subtracting the cost of goods sold from sales revenue:


Sales revenue Cost of goods sold Gross profit Operating expenses Net income

October November $21,600 $22,464 12,960 13,478 8,640 8,986

Total $44,064 26,438 17,626

Operating expenses are traced from the operating expenses budget from part c, We compute net income (loss) by subtracting operating expenses from gross profit. So our completed budgeted income statement looks like this:



648


October November $21,600 $22,464 12,960 13,478 8,640 8,986 5,560 5,646 $ 3,080 $ 3,340

Total $44,064 26,438 17,626 11,206 $ 6,420

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So, for the period, our totals are as follows:

JOE UNIVERSITY Budgeted Income Statement Two months Ending November 30, 2008 Sales revenue Cost of goods sold Gross profit Operating expenses: Salary and commissions Depreciation expense Rent expense Utility expense Insurance expense Operating income

Part 1

Part 2

Part 3

$44,064 26,438 17,626 $4,406 2,400 2,000 1,600 800

Part 4

11,206 $ 6,420

Demo Doc Complete


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Demo Doc 2 Financial Budget Learning Objectives

3

Joe University prepared its sales budget; inventory, purchases, and cost of goods sold budget; operating expense budget; and budgeted income statement. Joe would now like to prepare the cash budget for the months of October and November. Actual sales for the month ended September 30, 2008, were $20,000. Actual sales for the month ended August 31 were $16,000. Joe believes that sales will increase 8% in October and increase another 4% over October sales in November. Cash sales are expected to be 60% of sales and credit sales about 40% of sales. Cost of goods sold is expected to be 60% of total sales. Joe doesn’t want inventory to fall below $4,000 plus 10% of cost of goods sold for the next month. Sales of $25,000 are expected for December. Joe purchased $11,000 inventory during September and ended the month with $6,000 in ending inventory. Operating expenses include sales commission, 10% of sales; rent expense of $1,000; depreciation expense of $1,200; utility expense of $800; and insurance expense of $400. September 30 cash balance was $4,000. Of the credit sales, Joe expects to collect 70% in the month following the sale and the remaining 30% in the next month. Purchases made by Joe University are paid for in the month after the purchase. Sales commissions are paid 50% in the month incurred and 50% in the next month. Rent, utility, and insurance are paid in the month incurred.

Requirements 1. For the months of October and November, prepare the following: a. Budgeted cash collections from customers b. Budgeted cash payments for purchases c. Budgeted cash payments for operating expenses d. The cash budget

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Demo Doc 2 Solution Requirement 1. For the months of October and November, prepare the following: a. Budgeted cash collections from customers

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Armed with the budget data we calculated in Demo Doc 1, we can start to prepare the cash budget. We begin with the budgeted cash collections from customers, which we’ll use in part d of this Demo Doc to calculate total cash available for the period. We computed the cash sales for October and November on the sales budget as $12,960 and $13,478, respectively. To cash sales we add any credit collections that Joe makes in this period. Joe expects to collect on credit sales at a rate of 70% in the month following the sale and 30% in the next month. In October, then, Joe expects to collect 70% of any credit sales made in September and 30% of credit sales made in August. Likewise, in November, Joe will collect 70% of October’s credit sales and 30% of September’s credit sales. Before we can calculate how much in credit sales Joe will collect in October and November, we need to see the sales data for August and September because collections are being made from those two months. We know from the question that total August sales were $16,000 and total September sales were $20,000. We also know that Joe expects 40% of total sales each month to be credit sales. So if we were to figure Joe’s sales budget data for August and September, credit sales would look like this:

3

Prepare a financial budget

August Credit Sales ! August Total Sales " 40% ! $16, 000 " 40% ! $6, 400 September Credit Sales ! September Total Sales " 40% ! $20, 000 " 40% ! $8, 000

Given these data, Joe’s sales budget for the period August through November would look like the following (although note that the only data you’re interested in at this point are the highlighted data):

JOE UNIVERSITY Sales Budget

Cash sales, 60% Credit sales, 40% Total sales

August September $ 9,600 $12,000 6,400 8,000 $16,000 $20,000

October November $12,960 $13,478 8,640 8,986 $21,600 $22,464


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Remember that credit sales for October and November came from the sales budget in Demo Doc 1. So for October, Joe expects to collect 30% of credit sales made in August and 70% of credit sales made in September: October Collections from August Credit Sales ! $6,400 " 30% ! $1,920 October Collections from September Credit Sales ! $8,000 " 70% ! $5,600

For November, Joe expects to collect 30% of credit sales made in September and 70% of credit sales made in October ($8,640, taken from the sales budget created in Demo Doc 1, part a): November Collections from September Credit Sales ! $8, 000 " 30% ! $2, 400 November Collections from October Credit Sales ! $8, 640 " 70% ! $6, 048

Cash sales on the statement come directly from the sales budget. So the completed budget looks like this:

JOE UNIVERSITY Budgeted Cash Collections from Customers

Cash sales Collections of previous month’s credit sales Collections of two-months previous credit sales Total collections

October November Total $12,960 $13,478 $26,438 11,648 5,600 6,048 4,320 1,920 2,400 $20,480 $21,926 $42,406

Shown another way: October

November

Total

Month of Sale: August

$16,000

Cash Credit

16,000 # 40% # 30%

1,920

Cash

20,000 # 40% # 70%

5,600

Credit

20,000 # 40% # 30%

September

October Cash

$20,000

Cash

2,400

8,000

6,048

19,008

13,478

13,478

21,926

42,406

$21,600 60% # 21,600

Credit November

1,920

12,960 21,600 # 40% # 70%

$22,464 60% # 22,464

Credit TOTALS 652


20,480

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b. Budgeted cash payments for purchases

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Purchases made by Joe are paid in the month following the purchase. So in October, Joe paid for the purchases made in September and in November, Joe paid for the purchases made in October. The question states that Joe purchased $11,000 of inventory in September (which he will pay for in October). We know from the inventory, purchases, and cost of goods sold budget that we prepared in Demo Doc 1 (part b) of this chapter that Joe’s purchases in October were $12,308 (which he will pay for in November):

3


3


JOE UNIVERSITY Budgeted Cash Payments for Purchases

Purchases paid from previous month Total cash payments for purchases

October November $11,000 $12,308 $11,000 $12,308

Total $23,308 $23,308

c. Budgeted cash payments for operating expenses

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Following is Joe’s operating expense budget, which we prepared in Demo Doc 1, part c:




Total $ 4,406 2,400 2,000 1,600 800 $11,206

The question tells us that sales commissions are paid 50% in the month incurred and 50% in the next month. Other expenses are paid in the month incurred. So we must calculate the sales commission payments for the current month and for the previous month each for October and November. Demo Doc 2 Solution | Chapter 19

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We can calculate commissions from the current month for October and November as: October ! $2,160 " 50% ! $1, 080 November ! $2, 246 " 50% ! $1,123

So far, we have sales commissions from the current month and all other operating expenses, as follows:

JOE UNIVERSITY Budgeted Cash Payments for Operating Expenses

Sales commission from current month Sales commission from previous month Rent expense Utility expense Insurance expense Total operating expenses

October November $1,080 $1,123 1,000 800 400

1,000 800 400

Total $ 2,203 2,000 1,600 800

The question tells us that actual sales for the month ending September 30 were $20,000 and that sales commissions amount to 10% of actual sales. So total sales commissions for September are $20,000 # 10% = $2,000. Knowing these numbers, we can compute the sales commission payments from the previous month for October and November as: October ! $2,000 " 50% ! $1,000 November ! $2,160 " 50% ! $1,080

Our final statement now looks like this:

JOE UNIVERSITY Budgeted Cash Payments for Operating Expenses

Sales commission from current month Sales commission from previous month Rent expense Utility expense Insurance expense Total operating expenses


Total $ 2,203 2,080 2,000 1,600 800 $8,683

Shown another way, we can also compute sales commission payments from the current and previous months using each month’s actual sales:

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Sales Commission from Current Month ! Current Month Sales "10% Sales Commission" 50% Payment this Month October ! $21,600 "10% " 50% ! $1,080 November ! $22,464 "10% " 50% ! $1,123..20 (rounded to $1,123) Sales Commission fro om Previous Month ! Previous Month Sales "1 10% Sales Commission" 50% Payment this Month October ! $20,000 "10% " 50% ! $1,000 November ! $21,600 "10% " 50% ! $1,080

Rent, utilities, and insurance expense are fixed amounts from the operating expense budget Remember that depreciation expense is a noncash expense and therefore is not included in the cash budget. d. The cash budget

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

To prepare the cash budget, you start with the beginning cash balance and add the budgeted cash collections that you computed in part a. Cash payments for purchases and operating expenses are then subtracted to achieve the ending cash balance. Beginning cash balance is from the ending cash balance of the previous month. September’s ending balance as given in the question becomes October’s beginning cash balance, $4,000. Cash collections are from budgeted cash collections from customers. Adding the beginning cash balance to the collections gives you the available cash for the month:

3


JOE UNIVERSITY Cash Budget

Beginning cash balance Cash collections Cash available Cash payments Purchases of inventory Operating expenses Total cash payments Ending cash balance

October November $ 4,000 20,480 $21,926 24,480

Total


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Cash payments for purchases of inventory are from the budgeted cash payments for purchases. Cash payments for operating expenses are from the budgeted cash payments for operating expenses, giving us the total cash payments:



October November $ 4,000 20,480 $21,926 24,480 11,000 4,280 15,280

12,308 4,403 16,711

Ending cash balance is equal to cash available less total cash payments. October’s ending cash balance then becomes November’s beginning cash balance, and the calculations continue in this manner until the budget is complete:



Part 1

656


Part 2

Part 3

October November $ 4,000 $ 9,200 20,480 21,926 24,480 31,126 11,000 4,280 15,280 $ 9,200

Part 4

12,308 4,403 16,711 $14,415

Demo Doc Complete

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Quick Practice Questions True/False _____ 1. Budgets provide a benchmark that helps managers evaluate performance. _____ 2. Managers should build “slack” into the budget. _____ 3. A company’s plan for purchases of property, plant, equipment, and other long-term assets is part of the financial budget. _____ 4. The cash budget is a projection of the cash inflows and cash outflows for a future period. _____ 5. The cash budget is prepared before the budgeted balance sheet is prepared. _____ 6. Sensitivity analysis is a what-if technique that asks what a result will be if a predicted amount is not achieved or if an underlying assumption changes. _____ 7. Responsibility accounting is a system for evaluating the performance of each responsibility center and its manager. _____ 8. Management by exception directs executives’ attention to all differences between actual and budgeted variable cost amounts. _____ 9. Most companies consider company divisions as cost centers. _____10. The research and development department would be considered a profit center.


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Multiple Choice 1. Which of the following statements regarding the budgeting process is (are) true? a. The budget should be designed from the bottom up, with input from employees at all levels b. The budget should be approved by the company’s external auditors c. The budget should be designed by top management and communicated to lower-level personnel d. All the preceding statements are true regarding the budgeting process 2. Which of the following budgets is an operating budget? a. Capital expenditures budget b. Budgeted balance sheet c. Budgeted income statement d. Cash budget 3. Which of the following alternatives reflects the proper order of preparing components of the master budget? 1. Financial budget 2. Operating budget 3. Capital expenditures budget a. b. c. d.

2, 3, 1 1, 3, 2 1, 2, 3 3, 1, 2

4. Desired ending inventory is 80% of beginning inventory. If cost of goods sold is $300,000, purchases will always have what relationship with cost of goods sold? a. Be more than cost of goods sold b. Be 80% of cost of goods sold c. Equal cost of goods sold d. Be less than cost of goods sold 5. During April, Cherry Company had actual sales of $180,000 compared to budgeted sales of $195,000. Actual cost of goods sold was $135,000, compared to a budget of $136,500. Monthly operating expenses, budgeted at $28,000, totaled $25,000. Interest revenue of $2,500 was earned during April but had not been included in the budget. What is the net income variance on the performance report for April? a. $( 8,000) b. $(13,000) c. $ 8,000 d. $ 13,000 6. Heath Company has beginning inventory of 21,000 units and expected sales of 48,000 units. If the desired ending inventory is 15,500 units, how many units should be produced? a. 27,000 b. 42,500 c. 45,000 d. 53,500

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7. York Enterprises recorded sales of $160,000 during March. Management expects sales to increase 5% in April, 3% over April in May, and 5% over May in June. Cost of goods sold is expected to be 70% of sales. What is the budgeted gross profit for June? a. $ 54,508 b. $112,000 c. $127,184 d. $181,692 8. Which of the following is an example of a financial budget? a. Sales budget b. Budgeted balance sheet c. Budgeted income statement d. Operating expense budget 9. Jay Corporation desires a December 31 ending inventory of 1,500 units. Budgeted sales for December are 2,300 units. The November 30 inventory was 850 units. What are budgeted purchases? a. 2,350 b. 2,950 c. 3,150 d. 3,800 10. Bolin’s, an elite clothier, expects its November sales to be 30% higher than its October sales of $200,000. Purchases were $100,000 in October and are expected to be $150,000 in November. All sales are on credit and are collected as follows: 30% in the month of the sale and 70% in the following month. Purchases are paid 25% in the month of purchase and 75% in the following month. The beginning cash balance on November 1 is $9,000. What is the ending cash balance on November 30? a. $ 87,000 b. $114,500 c. $140,000 d. $149,000


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Quick Exercises 19-1. Solve for the following independent situations: a. A sporting goods store budgeted September purchases of ski jackets at $17,900. The store had ski jackets costing $1,200 on hand at the beginning of September, and to cover part of anticipated October sales, they expect to have $4,200 of ski jackets on hand at the end of September. What was the budgeted cost of goods sold for September?

b. A department store has budgeted cost of goods sold for October of $29,300 for its women’s coats. Management also wants to have $8,000 of coats in inventory at the end of the month to prepare for the winter season. Beginning inventory in October was $6,000. What dollar amount of coats should be purchased to meet these objectives?

19-2. Redfield Company prepared the following forecasts of monthly sales:

Sales (in units)

January

February

March

April

4,500

5,200

4,700

2,800

Redfield Company decided that the number of units in its inventory at the end of each month should equal 75% of next month’s sales. The budgeted cost per unit is $20. a. How many units should be in January’s beginning inventory?

b. What amount should be budgeted for the cost of merchandise purchases in January?

c. How many units should be purchased in February?

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19-3. The sales budget of Mulls Company for the fourth quarter of 2008 is as follows:

Sales

October

November

December

$91,000

$76,000

$108,000

Sales are 20% cash, 80% credit. Cost of goods sold is 70% of total sales. Desired ending inventory for each month is equal to 25% of cost of goods sold for the following month. Collections on credit sales are as follows: 50% in the month of sale 30% in the month following sale 15% in the second month following sale 5% uncollectible October 1 inventory is $16,000. Expected sales for January 2009, are $84,000. Payments for inventory are 70% in the month following purchase and 30% two months following purchase. a. Compute the cash collections for December.

b. Compute the cash disbursements for purchases during December.

19-4. Soccer Forever gathered the following information as of May 31, 2007: May 31 inventory balance

$11,100

May payments for inventory

8,300

May payments of accounts payable and accrued liabilities

9,800

May 31 accounts payable balance

5,400

April 30 equipment balance

37,500

April 30 accumulated depreciation, equipment balance

20,900

Cash purchase of equipment in May

2,700

May operating expenses, excluding depreciation (75% paid in May, 25% accrued on May 31)

4,200

May depreciation expense

600

April 30 stockholders’ equity

42,485

April 30 cash balance

27,040

May budgeted sales

17,300

May cash receipts from sales on account

12,110 Quick Practice Questions | Chapter 19

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Cost of goods sold is 65% of sales. May 31 accounts receivable balance is 30% of May sales. Prepare the budgeted balance sheet on May 31, 2007.

19-5. Answer the following completely. a. Define the term budget.

b. Identify four benefits of budgeting.

c. Should employees participate in the budgeting process or should management prepare the budgets alone? Explain.

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Do It Yourself! Question 1 Blake’s Brakes sells highly specialized brakes for travel trailers. Actual sales for the month ended June 30 were $80,000. Blake believes that sales will increase 2% in July and an additional 3% over July in August. Cash sales are expected to be 10% of sales and credit sales about 90% of sales. Cost of goods sold is expected to be 75% of total sales. Blake doesn’t want inventory to fall below $12,000 plus 5% of cost of goods sold for the next month. Sales of $85,000 are expected for September. Inventory on June 30 is $13,000. Operating expenses include sales commission, 5% of sales; rent expense of $6,000; depreciation expense of $4,000; utility expense of $1,500; and insurance expense of $1,400. Round all figures to the nearest dollar.

Requirement Prepare the following budgets for July and August: a. Sales budget

b. Inventory, purchases, and cost of goods sold budget


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d. Budgeted income statement.

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Do It Yourself! Question 2 Blake’s Brakes prepared its sales budget; inventory, purchases, and cost of goods sold budget; operating expense budget; and budgeted income statement for July and August. Blake would now like to prepare the cash budget for the months of July and August. Actual sales for the month ended June 30 were $80,000. Actual sales for the month ended May 30 were $78,000. Blake believes that sales will increase 2% in July and increase another 3% over July sales in August. Cash sales are expected to be 10% of sales and credit sales about 90% of sales. Cost of goods sold is expected to be 75% of total sales. Blake doesn’t want inventory to fall below $12,000 plus 5% of cost of goods sold for the next month. Sales of $85,000 are expected for September. Blake purchased $56,000 of inventory during June and ended the month with $13,000 in ending inventory. Operating expenses include sales commission, 5% of sales; rent expense of $6,000; depreciation expense of $4,000; utility expense of $1,500; and insurance expense of $1,400. June 30 cash balance is $14,000. Of the credit sales, Blake expects to collect 20% in the month of the sale, 50% in the month following the sale, and the remaining 30% in the next month. Purchases are paid for in the month after the purchase. Sales commissions are paid 50% in the month incurred and 50% in the next month. Rent, utility, and insurance are paid in the month incurred.

Requirement For the months of July and August, prepare the following: a. Budgeted cash collections from customers


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d. The cash budget

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1. Budgets provide a benchmark that helps managers evaluate performance. (p. 1009)

F

2. Managers should build “slack” into the budget. False–Managers should not build “slack” into the budget, it makes the budget less accurate. (pp. 1022–1023)

F

3. A company’s plan for purchases of property, plant, equipment, and other long-term assets is part of the financial budget. False–A company’s plan for purchases of property, plant, equipment, and other long-term assets is part of the capital expenditures budget. (p. 1011)

T

4. The cash budget is a projection of the cash inflows and cash outflows for a future period. (p. 1011)

T

5. The cash budget is prepared before the budgeted balance sheet is prepared. (p. 1011)

T

6. Sensitivity analysis is a what-if technique that asks what a result will be if a predicted amount is not achieved or if an underlying assumption changes. (p. 1024)

T

7. Responsibility accounting is a system for evaluating the performance of each responsibility center and its manager. (p. 1025)

F

8. Management by exception directs executives’ attention to all differences between actual and budgeted variable cost amounts. False–Management by exception directs executives’ attention to all significant differences between actual and budgeted amounts. (p. 1029)

F

9. Most companies consider company divisions as cost centers. False–Most companies consider company divisions as investment centers. (p. 1027)

F

10. The research and development department would be considered a profit center. False–The research and development department would be considered a cost center because the managers only control costs. (p. 1025)


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Multiple Choice 1. Which of the following statements regarding the budgeting process is (are) true? (p. 1010) a. The budget should be designed from the bottom up, with input from employees at all levels b. The budget should be approved by the company’s external auditors c. The budget should be designed by top management and communicated to lower-level personnel d. All the preceding statements are true regarding the budgeting process 2. Which of the following budgets is an operating budget? (p. 1011) a. Capital expenditures budget b. Budgeted balance sheet c. Budgeted income statement d. Cash budget 3. Which of the following alternatives reflects the proper order of preparing components of the master budget? (p. 1011) 1. Financial budget 2. Operating budget 3. Capital expenditures budget a. b. c. d.

2, 3, 1 1, 3, 2 1, 2, 3 3, 1, 2

4. Desired ending inventory is 80% of beginning inventory. If cost of goods sold is $300,000, purchases will always have what relationship with cost of goods sold? (p. 1015) a. Be more than cost of goods sold b. Be 80% of cost of goods sold c. Equal cost of goods sold d. Be less than cost of goods sold 5. During April, Cherry Company had actual sales of $180,000 compared to budgeted sales of $195,000. Actual cost of goods sold was $135,000, compared to a budget of $136,500. Monthly operating expenses, budgeted at $28,000, totaled $25,000. Interest revenue of $2,500 was earned during April but had not been included in the budget. What is the net income variance on the performance report for April? (p. 1027) a. $ (8,000) b. $(13,000) c. $ 8,000 d. $ 13,000 6. Heath Company has beginning inventory of 21,000 units and expected sales of 48,000 units. If the desired ending inventory is 15,500 units, how many units should be produced? (p. 1014) a. 27,000 b. 42,500 c. 45,000 d. 53,500 668


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7. York Enterprises recorded sales of $160,000 during March. Management expects sales to increase 5% in April, 3% over April in May, and 5% over May in June. Cost of goods sold is expected to be 70% of sales. What is the budgeted gross profit for June? (pp. 1012–1016) a. $ 54,508 b. $112,000 c. $127,184 d. $181,692 8. Which of the following is an example of a financial budget? (p. 1011) a. Sales budget b. Budgeted balance sheet c. Budgeted income statement d. Operating expense budget 9. Jay Corporation desires a December 31 ending inventory of 1,500 units. Budgeted sales for December are 2,300 units. The November 30 inventory was 850 units. What are budgeted purchases? (pp. 1012–1016) a. 2,350 b. 2,950 c. 3,150 d. 3,800 10. Bolin’s, an elite clothier, expects its November sales to be 30% higher than its October sales of $200,000. Purchases were $100,000 in October and are expected to be $150,000 in November. All sales are on credit and are collected as follows: 30% in the month of the sale and 70% in the following month. Purchases are paid 25% in the month of purchase and 75% in the following month. The beginning cash balance on November 1 is $9,000. What is the ending cash balance on November 30? (p. 1018) a. $ 87,000 b. $114,500 c. $140,000 d. $149,000


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Quick Exercise Solutions 19-1. Solve for the following independent situations: (p. 1015) a. A sporting goods store budgeted September purchases of ski jackets at $17,900. The store had ski jackets costing $1,200 on hand at the beginning of September, and to cover part of anticipated October sales they expect to have $4,200 of ski jackets on hand at the end of September. What was the budgeted cost of goods sold for September? Let X ! Cost of Goods Sold $1,200 # $17,900 – X ! $4,200 $19,100 – X ! $4,200 X ! $14,900

b. A department store has budgeted cost of goods sold for October of $29,300 for its women’s coats. Management also wants to have $8,000 of coats in inventory at the end of the month to prepare for the winter season. Beginning inventory in October was $6,000. What dollar amount of coats should be purchased to meet these objectives? Let X ! Purchases $6,000 # X – $29,300 ! $8,000 X – $23,300 ! $8,000 X ! $31,300

19-2. Redfield Company prepared the following forecasts of monthly sales:

Sales (in units)

January

February

March

April

4,500

5,200

4,700

2,800

Redfield Company decided that the number of units in its inventory at the end of each month should equal 75% of next month’s sales. The budgeted cost per unit is $20. (p. 1015) January February Next month’s budgeted sales (units)

5,200

4,700

# 75% 3,900

# 75% 3,525

Budgeted sales for the month (units) Required units of available merchandise

4,500 8,400

5,200 8,725

Deduct beginning inventory Number of units to be purchased

3,375 5,025

3,900 4,825

Ratio of inventory to future sales Desired ending inventory

a. How many units should be in January’s beginning inventory? 75% " 4,500 units ! 3,375 units

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b. What amount should be budgeted for the cost of merchandise purchases in January? 5,025 units " $20 ! $100,500

c. How many units should be purchased in February? 4,825

19-3. The sales budget of Mulls Company for the fourth quarter of 2008 is as follows: (pp. 1017–1018)

Sales Purchases

October

November

December

$91,000

$76,000

$108,000

61,000

58,800

65,000

Sales are 20% cash, 80% credit. Cost of goods sold is 70% of total sales. Desired ending inventory for each month is equal to 25% of cost of goods sold for the following month. Collections on credit sales are as follows: 50% in the month of sale 30% in the month following sale 15% in the second month following sale 5% uncollectible October 1 inventory is $16,000. Expected sales for January 2009, are $84,000. Payments for inventory are 70% in the month following purchase and 30% two months following purchase. a. Compute the cash collections for December. October Credit Sales

$10,920 ! ($ 91,000 " 0.80 " 0.15)

November Credit Sales

18,240 ! ($ 76,000 " 0.80 " 0.30)

December Cash Sales

21,600 ! ($108,000 " 0.20)

December Credit Sales

43,200 ! ($108,000 " 080 " 0.50)

December Cash Collection

$93,960 !

b. Compute the cash disbursements for purchases during December. October Purchases

($62,00 " 0.30)

November Purchases ($58,800 " 0.70) December Cash Disbursements for Purchases

$18,300 41,160 $59,460


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19-4. Soccer Forever gathered the following information as of May 31, 2007: May 31 inventory balance

$11,100

May payments for inventory

8,300

May payments of accounts payable and accrued liabilities

9,800

May 31 accounts payable balance

5,400

April 30 equipment balance

37,500

April 30 accumulated depreciation, equipment balance

20,900

Cash purchase of equipment in May

2,700

May operating expenses, excluding depreciation (75% paid in May, 25% accrued on May 31)

4,200

May depreciation expense

600

April 30 stockholders’ equity

42,485

April 30 cash balance

27,040

May budgeted sales

17,300

May cash receipts from sales on account

12,110

Cost of goods sold is 65% of sales. May 31 accounts receivable balance is 30% of May sales. Prepare the budgeted balance sheet on May 31, 2007. (pp. 1021–1022)

SOCCER FOREVER Budgeted Balance Sheet May 31, 2007 Assets Current assets: Cash Accounts receivable ($17,300 3 0.30) Inventory Total current assets Plant assets: Equipment Less: Accumulated depreciation Total assets Liabilities Current liabilities Accounts payable Accrued liabilities ($4,200 3 0.25) Total liabilities Stockholders’ equity Total liabilities and stockholders’ equity

$15,200* 5,190 11,100 31,490 40,200 (21,500)

$55,400 1,050

*[$27,040 " $8,300 " $9,800 " $2,700 " (0.75 3 $4,200) ! $12,110] $ $15,200 **Net income for May $ $17,300 " (0.65 3 $17,300) " $4,200 " $600 $ $1,255 $42,485 ! $1,255 $ $43,740

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18,700 $50,190

$ 6,450 43,740** $50,190

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19-5. Answer the following completely. (pp. 1008–1011) a. Define the term budget. A budget is a quantitative expression of a plan of action that helps managers coordinate and implement the plan. b. Identify four benefits of budgeting. The four benefits of budgeting include: 1. Budgeting compels planning. Budgeting helps managers set realistic goals by requiring them to plan specific actions to meet their goals. Budgeting also helps managers prepare for a range of conditions and plan for contingencies. 2. Budgeting promotes coordination and communication. The master budget coordinates the activities of the organization. It forces managers to consider relationships among operations across the entire value chain. 3. Budgeting aids performance evaluation. To evaluate a department or activity, its actual results may be compared either to its budget or its past performance. In general, the budget is a better benchmark because it considers current changes stemming from past conditions. 4. Budgeting can affect behavior and motivate employees. The budgeting process prompts managers to look further into the future than they would look otherwise and foresee and avoid problems. c. Should employees participate in the budgeting process or should management prepare the budgets alone? Explain. Employees should participate in the budgeting process so that they can bear ownership of the plan. If employees are excluded from this process and unrealistic goals are set, employee morale can be deflated, especially if the employees’ performance is judged against these standards. If employees help to create the budget, it can be a motivating factor to achieve the desired outcome.


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Do It Yourself! Question 1 Solutions Requirement Prepare the following budgets for July and August: a. Sales budget

2


BLAKE’S BRAKES Sales Budget

Cash sales, 10% Credit sales, 90% Total

July $ 8,160 73,440 $81,600

August $ 8,405 75,643 $84,048

Total $ 16,565 149,083 $165,648

b. Inventory, purchases, and cost of goods sold budget

2


BLAKE’S BRAKES Inventory, Purchases, and Cost of Goods Sold Budget July $61,200 15,152 76,352 13,000 $63,352


August $63,036 15,187 78,223 15,152 $63,071


2


BLAKE’S BRAKES Operating Expense Budget


674


July $ 4,080 6,000 4,000 1,500 1,400 $16,980

August $ 4,202 6,000 4,000 1,500 1,400 $17,102

Total $ 8,282 12,000 8,000 3,000 2,800 $34,082

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d. Budgeted income statement

2 BLAKE’S BRAKES Budgeted Income Statement


July $81,600 61,200 20,200 16,980 $ 3,420

August $84,048 63,036 21,012 17,102 $ 3,910


Total $165,648 124,236 41,412 34,082 $ 7,330


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Do it Yourself! Question 2 Solutions Requirement For the months of July and August, prepare the following: a. Budgeted cash collections from customers

3


BLAKE’S BRAKES Budgeted Cash Collections from Customers July $ 8,160 14,688 36,000 21,060 $79,908

Cash sales Collections from current month credit sales Collections from previous month credit sales Collections from two-months previous credit sales Total collections

August $ 8,405 15,129 36,720 21,600 $81,854


3


BLAKE’S BRAKES Budgeted Cash Collections from Customers

Payment of last month purchases

July $56,000

August $63,352

Total $119,352


3


BLAKE’S BRAKES Budgeted Cash Payments for Operating Expenses

Sales commission from this month Sales commission from last month Rent expense Utility expense Insurance expense Total

676


July $ 2,040 2,000 6,000 1,500 1,400 $12,940

August $ 2,101 2,040 6,000 1,500 1,400 $13,041

Total $ 4,141 4,040 12,000 3,000 2,800 $25,981

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d. The cash budget

3 BLAKE’S BRAKES Cash Budget


July $14,000 79,908 93,908

August $ 24,968 81,854 106,822

56,000 12,940 68,940 $24,968

63,352 13,041 76,393 $ 30,429



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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 19, The Master Budget and Responsibility Accounting. 6. Click a link to work on the tutorial exercises.

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20

Flexible Budgets and Standard Costs

WHAT YOU PROBABLY ALREADY KNOW Various budgets including a cash budget were covered in Chapter 19. Assume you had budgeted $400 as your monthly automobile expenditures and found that you actually spent $425. At first glance, it appears to be an unfavorable difference. The budget of $400 was created assuming that your travel would be 1,000 miles and your costs consist of auto insurance of $100, gasoline of $125 (1,000 miles/20 miles per gallon ! $2.50 per gallon), and a $175 repayment of the car loan. If you find that you used the car 1,200 miles this month, you probably already know that you should not be held to the original, static budget. The budget should be “flexible” to allow for differences in the level of activity that impacts costs. The flexible budget for 1,200 miles should be $100 + $175 + (1,200 miles/20 miles per gallon ! $2.50 per gallon) = $425. When the actual results are compared to the flexible budget, the result is no variance. In this chapter, we will study the creation and evaluation of flexible budgets.

Learning Objectives

1

Prepare a flexible budget for the income statement. Flexible budgets are budgets that summarize cost and revenue information for several different volume levels within a relevant range. To prepare a flexible budget, the variable cost per unit and total fixed costs must be determined. You will prepare a flexible budget in Demo Doc 1. Review the flexible budget in Exhibit 20-2 (p. 1069).

2

Prepare an income statement performance report. The income statement performance report shows the difference between the actual results and expected results. The difference between the actual results at actual volume and the budgeted results at expected sales volume is the static budget variance. A component of the variance may be due to the actual sales volume differing from the budgeted sales volume, called the sales volume variance. The other component of the variance may be due to the actual amounts at actual volume differing from the budgeted amounts at actual volume; this difference is called the flexible budget variance. The static budget variance is the total of the sales volume variance and the flexible budget variance. Review Exhibit 20-3 (p. 1070) for an illustration of the relationship between the static budget variance, the flexible budget variance, and the sales volume variance. Review the income statement performance report in Exhibit 20-4 (p. 1071).

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Identify the benefits of standard costs and learn how to set standards. Many managers use standard costing because it helps them better plan and control levels of performance and provide a goal for employees to work toward. In addition, record-keeping costs are reduced because it’s easier to value all inventory at standard, and it provides cost information to determine the sales prices. See Exhibit 20-5 (p. 1073) for standard setting issues relating to standard costing.

4

Compute standard cost variances for direct materials and direct labor. The actual production costs are compared to the standard costs periodically. A variance may result due to the price or the quantity used. A price variance measures the difference between the actual price and the standard price multiplied by the actual quantity. A quantity or efficiency variance measures how well the business uses its materials or human resources. The quantity variance measures the difference in the actual and standard quantities multiplied by the standard price per unit. Review Exhibit 20-7 (p. 1076) for an illustration of the relationship between the variances, and Exhibit 20-9 (p. 1078) for a computation of price and quantity variances.

5

Analyze manufacturing overhead in a standard cost system. The total manufacturing overhead variance is the difference between the actual overhead incurred and the standard overhead. The standard overhead amount is the product of the standard overhead rate and the standard allocation base at the actual volume. Recall that the standard overhead rate is computed before the period begins as: Standard Overhead Rate !

Expected Manufacturing Overhead Costs Expected Quantity of Alloccation Base

The total overhead variance can be separated between the overhead flexible budget variance and the production volume variance. The overhead flexible budget variance shows how well management has controlled overhead costs. It is computed in exactly the same way as the flexible budget variances for direct materials and direct labor. The overhead flexible budget variance can be measured as the difference between the actual overhead cost and the flexible budget overhead for the actual number of outputs. The production volume variance arises when actual production differs from expected production. It is the difference between the flexible budget for the actual outputs and the standard overhead allocated to actual production.

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Record transactions at standard cost and prepare a standard cost income statement. The standard cost system requires that the cost of inventory be recorded at the standard amount. This procedure permits variances to be recorded as soon as possible. If the variance is unfavorable, actual costs exceed the standard costs. The unfavorable variance is recorded as a debit to the Variance account and is treated as an expense on the income statement. If the variance is favorable, actual costs are less than the standard costs. The favorable variance is recorded as a credit to the Variance account and is treated as a contra-expense on the income statement. The recorded variances are shown on the standard cost income statement as an adjustment to the cost of goods sold. Review the Standard Cost Accounting System section in the main text for sample journal entries and Exhibit 20-12 (p. 1086) for the flow of costs in a standard costing system. Review Exhibit 20-13 (p. 1086) for a sample standard cost income statement.

Chapter 20 | Flexible Budgets and Standard Costs

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Demo Doc 1 Flexible Budgets and Income Statement Performance Report 1

Prepare a flexible budget for the income statement

2

Prepare an income statement performance report

Management at Virus Detection Sensor predicted 2010 sales of 5,400 sensors at a price of $1,000 per sensor. Actual sales for the year were 5,200 sensors at $1,050 per sensor. Following is a breakdown of its costs for 2010: Budgeted Units sold Variable costs Fixed costs

Actual

5,400

5,200

$620

$630

$2,100,000

$2,050,000

Requirements 1. Why would Virus Detection prepare a flexible budget? Using Virus Detection’s estimated budget values for costs and sales price, develop flexible budgets for 5,200, 5,400, 5,600, and 6,000 sensors. Would Virus Detection Sensor’s managers use this flexible budget for planning or controlling? What specific insights can Virus Detection Sensor’s managers gain from this flexible budget? 2. Using the format shown in Exhibit 20-4 (p. 1071) of the textbook, prepare Virus Detection’s income statement performance report for 2010. 3. What was the effect on Virus Detection’s operating income of selling 200 units less than the static budget level of sales?

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Demo Doc 1 Solutions Requirement 1 Why would Virus Detection prepare a flexible budget? Using Virus Protection’s estimated budget values for costs and sales price, develop flexible budgets for 5,200, 5,400, 5,600, and 6,000 sensors. Would Virus Detection Sensor’s managers use this flexible budget for planning or controlling? What specific insights can Virus Detection Sensor’s managers gain from this flexible budget?

Part 1

Part 2

Part 3

Demo Doc Complete

It is difficult for management to analyze results when the actual volume differs from the static budget. Therefore, companies will produce flexible budgets, which are budgets that summarize cost and revenue information for several different volume levels within a relevant range. Virus Detection would prepare a flexible budget if managers aren’t sure about their projected sales volume of 5,400 sensors. Virus Detection’s flexible budget would show how its revenues and expenses should vary at different volume levels. Depending upon the volume within the relevant range, a budget can be determined for each amount of activity using the following formula:

1


 Number of Variable Cost  Flexible Budget Total Cost !  " # Total Fixed Cost Out p ut Units per Output Unit  

For Virus Detection, the following would be its flexible budget for 5,200, 5,400, 5,600, and 6,000 sensors:

VIRUS DETECTION SENSOR Flexible Budget Year Ending 2010 Flexible Budget per Output Unit Sales revenue Variable expenses Fixed expenses Total expenses Operating income (loss)

Output Units (sensors) 5,200 5,400 5,600 6,000 $1,000 $5,200,000 $5,400,000 $5,600,000 $6,000,000 3,720,000 3,472,000 3,348,000 620 3,224,000 2,100,000 2,100,000 2,100,000 2,100,000 5,820,000 5,572,000 5,448,000 5,324,000 $ (124,000) $ (48,000) $ 28,000 $ 180,000

Notice how the total fixed expenses stay constant at $2,100,000 across all four scenarios, yet revenue and variable expenses change. Remember that variable expenses are constant per unit; they are called variable because total variable costs change with level of activity. As you can see, with an output of 5,200 units, Virus Detection would generate 5,200 ! $1,000 per unit = $5,200,000 in sales revenue. Meanwhile, its expenses would be 5,200 ! $620 = $3,224,000 variable expenses, plus $2,100,000 fixed expenses = $5,324,000 in total expenses. Demo Doc 1Demo Solutions Doc 1| |Chapter Chapter20 1

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So with an output of 5,200 units, Virus Detection would incur a loss of $5,200,000 – $324,000 = $124,000. Because the output levels in the flexible budget are estimated levels of sales, these flexible budgets are being developed before the period to help managers plan. In this case, the budgets indicate a danger for Virus Detection Sensor of operating at a loss for 2010 at sales levels below 5,600 units. Managers should devote considerable effort to ensure that Virus Detection Sensor sells more than 5,600 sensors, or find ways to either decrease the expenses associated with manufacturing each sensor or increase the sales price per unit.

Requirement 2 Using the format shown in Exhibit 20-4 (p. 1071) of the textbook, prepare Virus Detection’s income statement performance report for 2010. Part 1

2


Part 2

Demo Doc Complete

Part 3

Columns 1 and 5 of the income statement performance report represent Virus Detection’s actual 2010 results and its expected (budgeted) results, respectively. These figures come directly from the comparison of actual results with the static budget statement for 5,400 units. Actual results at actual prices are what actually happened. This column (1) represents Virus Detection’s true income statement for 2010, calculated by multiplying actual quantity by actual price. Static budget (column 5) represents Virus Detection’s original budget with budgeted volume and costs. This budget uses output of 5,400 sensors, when in reality Virus Detection only had a volume of 5,200 sensors in 2010. We can begin to build our performance report using the actual results and the static budget. VIRUS DETECTION SENSOR Income Statement Performance Report Year Ended 2010 1

Output Units Sales revenue Variable expenses Fixed expenses Total expenses Operating income (loss)

Actual Results at Actual Prices 5,200 $5,460,000 3,276,000 2,050,000 5,326,000 $ 134,000

2

3 Flexible Budget Flexible Budget for Actual Number of Output Units Variance

4

5

Sales Volume Variance

Static (Master) Budget 5,400 $5,400,000 3,348,000 2,100,000 5,488,000 $ (48,000)

The next column that we can complete is the flexible budget for actual number of output units (column 3), which represents budgeted amounts based on what Virus Detection actually sold (the other two variance columns depend on the values calculated in this column). So for this column, we forget about the number of units that Virus Detection expected to sell in 2010, but we instead calculate what its operating income would have been had it sold the 5,200 sensors 684


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using its actual budget figures for revenues and expenses. These figures give management the basis with which to compare the flexible budget variance with the sales volume variance. Remember that a flexible budget based upon actual outputs provides the greatest ability to evaluate and control because you are comparing what you expected it to be against what it actually is. From the question, we know that Virus Detection budgeted to sell each sensor at $1,000. Regardless of how many sensors it expected to sell, if it had priced the 5,200 sensors it did sell at its original estimate of $1,000 per sensor, Virus Detection’s sales revenue would have been 5,200 ! $1,000 = $5,200,000. This number is called the flexible budget for sales revenue based on actual units produced. Virus Detection budgeted its variable costs at $620 per sensor. If its budgeted variable costs had stayed at $620, then its flexible budget for variable costs would be 5,200 sensors ! $620 = $3,224,000. Similarly, had Virus Detection’s budgeted fixed costs remained at $2,100,000, then its flexible budget for total costs would be $3,224,000 variable costs + $2,100,000 fixed costs = $5,324,000. Given these data, then, Virus Detection’s flexible budgeted operating income would be calculated as: $5,200,000 sales revenue – $5,324,000 total costs ! $(124,000) operating loss

VIRUS DETECTION SENSOR Income Statement Performance Report Year Ended 2010 1


2

Actual Results Flexible Budget at Actual Prices Variance 5,200 $5,460,000 3,276,000 2,050,000 5,326,000 $ 134,000

3 Flexible Budget for Actual Number of Output Units 5,200 $5,200,000 3,224,000 2,100,000 5,324,000 $ (124,000)

4

5



So, how do we use these data? We use them to complete the two variance columns of the income statement performance report. The differences between columns 1 and 3 are presented in column 2, which shows us the flexible budget variance. Flexible budget variance is the difference between the actual results (at actual prices) and the flexible budget (for actual number of output units). This variance represents more or less revenue earned than expected, and more or less expenses incurred than expected, for the actual level of output. For sales revenue, the variance is favorable if the actual is greater than the flexible budget. In this case, actual sales revenue of $5,460,000 exceeds the flexible budget of $5,200,000 by $260,000, which is a favorable outcome.


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For costs, the variance is unfavorable if the actual is greater than the flexible budget. In this case, actual total costs of $5,326,000 exceed the flexible budget of $5,324,000 by $2,000, which is unfavorable. However, total operating income demonstrates a favorable result of $258,000.



2

Actual Results Flexible Budget at Actual Prices Variance 5,200 0 $5,460,000 $260,000 F 3,276,000 52,000 U 2,050,000 50,000 F 5,326,000 2,000 U $ 134,000 $258,000 F


4

5



So what does this result mean? The flexible budget variance of $260,000 for sales revenue indicates that Virus Detection actually received $260,000 more for the 5,200 sensors than it would have had if it sold the 5,200 units at its budgeted sales price of $1,000. On average, it received $50 more per sensor than it thought it would. At the same time, it spent $52,000 more in variable costs than it expected to, and while fixed costs were trimmed by $50,000, it still spent $2,000 more than it budgeted on total costs. Even though the overall results are favorable, management will still want to know why costs exceeded expectations. The last column to compute is the sales volume variance column (4). The differences between columns 3 and 5 are presented in column 4. Sales volume variance is the difference between the flexible budget (for actual number of output units) and the static budget. The only reason for this variance is because the number of units actually sold differs from the static budget, but knowing whether these variances are favorable or unfavorable gives managers insight into how sales and marketing are performing in relation to the overall report. For sales revenue, this variance is favorable if the flexible budget is greater than the static budget, which is not the case with Virus Detection, however. The flexible budget sales revenue of $5,200,000 is lower than the budgeted sales of $5,400,000 because the sales force sold fewer units than expected. For costs, this variance is favorable if the flexible budget is less than the static budget. In this case, the results are favorable, with the flexible budget showing $5,324,000 in total costs and the static budget showing $5,448,000, for a favorable variance of $124,000 in total costs. However, this variance results from the fact that the sales force sold fewer units than expected. In actuality, variable costs increased by $10 per unit over what Virus Detection had budgeted. This variance is favorable only because Virus Detection budgeted costs for more units than it actually made.

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2

Actual Results Flexible Budget at Actual Prices Variance 5,200 0 $5,460,000 $260,000 F 3,276,000 52,000 U 2,050,000 50,000 F 5,326,000 2,000 U $ 134,000 $258,000 F


4

5

Sales Volume Variance 200U $200,000 U 124,000 F 0 124,000 F $ 76,000 U


Requirement 3 What was the effect on Virus Detection’s operating income of selling 200 units less than the static budget level of sales?

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2 Virus Detection’s sales volume variance is $200,000 unfavorable. So, Virus selling 200 fewer units than budgeted reduced its sales volume by $200,000. Virus was able to more than overcome this reduction in sales volume by selling at a higher price than anticipated, as indicated by the favorable flexible budget sales revenue variance of $260,000. Had Virus Detection sold what it budgeted for, it would have incurred a loss of $48,000. But, by increasing the sales price and reducing the fixed expense costs, even by selling 200 fewer units, Virus incurred an operating income of $134,000 instead of incurring the loss.

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Demo Doc 2 Standard Costs Learning Objectives 3–6 Bumpy Road Maps manufactures road maps. Bumpy uses a standard cost system to control manufacturing costs. The following standard unit cost information is based on the static budget volume of 120,000 road maps per month: Direct materials (40 sq. yards @ $0.015 per sq. yard) Direct labor (0.10 hours @ $12.00 per hour) Manufacturing overhead: Variable (0.10 hours @ $3.00 per hour) Fixed (0.10 hours @ $8.00 per hour) Total cost per map

$0.60 1.20 0.30 0.80

1.10 $2.90

In this example, total budgeted fixed manufacturing overhead: $0.80 ! 120,000 road maps ! $96,000

Actual cost and production volume information: • Actual production was 118,000 maps. • Actual direct materials usage was 41 square yards per map, at an actual cost of $0.016 per square yard. • Actual direct labor usage of 11,600 hours at $12.10 per hour, total cost of $140,360. • Total actual overhead was $126,000.

Requirements 1. Bumpy developed its standards. What are the five benefits of standard costing? 2. Compute the price and efficiency variances for direct materials and direct labor. Are these variances favorable or unfavorable? Why? 3. Journalize the usage of direct materials, including the related variance. 4. For manufacturing overhead, compute the total variance, the flexible variance, and the production volume variance. Are these variances favorable or unfavorable? Why?

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Demo Doc 2 Solutions Requirement 1 Bumpy developed its standards. What are the five benefits of standard costing?

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A standard cost is a budget for a single unit. A standard is developed for the quantity and price of direct materials, direct labor, and manufacturing overhead. Material price standards consider the cost of purchases plus freight in and receiving costs less discounts. Direct labor cost standards include the labor rates, payroll taxes, and fringe benefits. Overhead cost standards are developed by dividing estimated variable and fixed overhead costs by an appropriate allocation base. The quantity standards are usually developed using the input from knowledgeable employees taking into account an expected amount of spoilage, waste, and downtime. Standards help managers in five areas:

3

Identify the benefits of standard costs and learn how to set standards

4

Compute standard cost variances for direct materials and direct labor

1. Plan by providing unit amounts for budgeting. 2. Control by setting target levels of performance. 3. Motivate employees by serving as performance benchmarks. 4. Set sales prices of products or services by providing unit costs. 5. Simplify record keeping and reduce clerical costs.

Requirement 2 Compute the price and efficiency variances for direct materials and direct labor. Are these variances favorable or unfavorable? Why?

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Direct Materials Price Variance The actual quantity of direct materials used was the total number of maps produced (118,000) multiplied by the amount of direct materials used per map. Actual direct materials usage was 41 square yards per map, for an actual quantity of 4,838,000 square yards of materials. To compute the variance, multiply the difference between the actual and standard costs per unit by the actual quantity. Bumpy estimated a cost of $0.015 per square yard, but the actual cost was $0.016 per square yard, for a difference of $0.001, which multiplied by 4,838,000 yields a variance of $4,838: Direct Materials Price Variance ! (Actual Price " Standard Price) # Actual Quantity of Material ! ($0.016 " $0.015) # (41sq. Yards Usage per Unit #118, 000 Units) ! $0.0013 4, 838, 000 ! $4, 838 U


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This variance is unfavorable because the actual price is greater than the standard price. Direct Materials Quantity Variance This variance measures whether the quantity of materials actually used to produce the actual number of output units is within the standard allowed for that number of outputs. It is calculated by multiplying the difference between quantities of material (actual vs. standard) by the standard price per unit of material. We know from computing the direct materials price variance that the actual quantity of direct materials used was 41 square yards per map ! 118,000 maps = 4,838,000 square yards. From this amount, we subtract the standard quantity (40 square yards per map ! 118,000 maps = 4,720,000 square yards) for a difference of 118,000 square yards. We then multiply that difference in quantity by the standard price per unit (remember, efficiency variance is measured against the standard flexible budget, not actual costs), for a total variance of 118,000 ! $0.015 = $1,770: Direct Materials Quantity Variance ! (Actual Quantity $ Standard Quantity) " Standard Price ! [(41"118, 000) $ (40 "118, 000)] " $0.015 ! (4, 838, 000 $ 4,720, 000) " $0.015 ! 118, 000 " $0.015 ! $1,770 U

This variance is unfavorable because the actual material used per map, 41 square yards, was greater than the standard per map, 40 square yards. Part 1

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Direct Labor Rate Variance This variance measures the difference between the actual price per unit (in this case, rate per hour for labor) and the standard price per unit, multiplied by the actual quantity of input (that is, hours worked). In this case, Bumpy estimated a rate of $12.00 per hour for labor, and actual costs were $12.10, so the difference is $0.10 per hour, which multiplied by the actual hours of 11,600 yields a variance of $1,160: Direct Labor Rate Variance ! (Actual Rate $ Standard Rate) " Actual Hours ! ($12.10 $ $12.00) "11, 600 ! $0.10 "11, 600 ! $1,160 U

This variance is unfavorable because the actual hourly rate for labor, $12.10, was greater than the standard rate for labor, $12.00. Direct Labor Efficiency Variance This variance measures the difference between the actual quantity of input (in this case, the number of hours Bumpy actually purchased) and the standard quantity of input, multiplied by the standard price per input unit (hourly cost of the labor). In this case, we know that the actual hours purchased was 11,600. To compute standard hours, multiply the standard rate per map, 0.10, by the actual number of maps produced, 118,000 = 11,800. So the difference between actual 690


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and standard hours is 200, multiplied by the standard price per hour of $12.00 = $2,400: Direct Labor Efficiency Variance ! (Actual Hours $ Standard Hours) " Standard Price ! [11, 600 $ (0.10 "118, 000)] " $12.00 ! (11, 600 $ 11, 800) " $12.00 !$ 200 " $12.00 ! $2, 400 F

This variance is favorable because actual hours used were fewer than standard hours.

Requirement 3 Journalize the usage of direct materials including the related variance.

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Usage of Direct Materials Bumpy debits Work in Process Inventory for the standard price multiplied by the standard quantity of direct materials that should have been used for the actual output of 118,000 maps. This maintains inventory at standard cost. Materials Inventory is credited for the actual quantity of materials put into production multiplied by the standard price:

6

Record transactions at standard cost and prepare a standard cost income statement

Journal Entry: Date

Accounts Work in Process Inventory (118,000 3 40 3 $0.015) ??? Materials Inventory (118,000 3 41 3 $0.015)

Post Ref.

Dr. 70,800 1,770

Cr.

72,570

So where does the rest of the debit side of this entry come from? We learned in Requirement 2 that because Bumpy used more materials than the standard, its direct materials quantity variance was $1,770 unfavorable. This unfavorable variance increases the cost of production. Unfavorable variances will always be debited.

Journal Entry: Date

Accounts Work in Process Inventory (118,000 3 40 3 $0.015) Direct Materials Quantity Variance (118,000 3 $0.015) Materials Inventory (118,000 3 41 3 $0.015)

Post Ref.

Dr. 70,800 1,770

Cr.

72,570 Demo Doc 2 Solutions | Chapter 20

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Requirement 4 For manufacturing overhead, compute the total variance, the flexible variance, and the production volume variance. Are these variances favorable or unfavorable? Why? Part 1

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Analyze manufacturing overhead in a standard cost system

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Total Overhead Variance Total overhead variance is the difference between actual overhead cost and standard overhead allocated to production. The standard overhead allocated to production is the standard cost of the overhead per map times the number of maps actually produced. We know from the question that the standard overhead cost per map is $0.30 (variable cost) + $0.80 (fixed cost) = $1.10. So the standard overhead allocated to production = 118,000 ! $1.10 = $129,800. Actual overhead cost as given in the question is $126,000, the difference being $3,800: Total Overhead Variance ! Actual Overhead Cost " Standard Overhead Allocated to Production ! $126, 000 " (118, 000 # $1.10) ! $126, 000 " $129, 800 ! $3, 800 F

The variance is favorable because the actual overhead is less than the standard overhead. Overapplied overhead is favorable because enough cost was put into production.

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Overhead Flexible Budget Variance The flexible budget variance is equal to the difference between the actual overhead cost and the flexible budget overhead for the actual number of maps produced. To compute the flexible budget overhead variance, the fixed portion of the overhead must be separated from the variable part. The variable part of the overhead is flexible, therefore the variable cost of overhead per map ($0.30) is multiplied by the actual number of maps produced (118,000); the variable part of overhead is thus $35,400. The fixed portion of the overhead is not flexible within the relevant range, so to compute the full fixed part of the overhead, the fixed cost of overhead per map ($0.80) must be multiplied by the static expected budget output of 120,000 maps. The fixed part of overhead is thus $96,000, the same as the original budgeted amount. Total flexible budget overhead is $35,400 + $96,000 = $131,400. We know that the actual overhead cost was $126,000, the difference between actual and flexible thus being $5,400: Overhead Flexible Budget Variance ! Actual Overhead Cost – Flexible Budget Overhead for the Actual Number of Outputs ! $126, 000 " [(118, 000 # $0.30) + (120, 000 # $0.80)] ! $126, 000 " ($35, 400 + $96, 000) ! $126, 000 " $131, 400 ! $5, 400 F 692


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The flexible budget variance is favorable because the actual overhead cost is less than the flexible budget.

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Production Volume Variance The production volume variance arises when actual production differs from expected production. It is calculated as the difference between the flexible budget overhead for the actual number of outputs and the standard overhead allocated to actual production. Standard overhead allocated to actual production is calculated by multiplying the number of maps actually produced by the standard overhead per unit: 118,000 ! $1.10 ! $129,800

We know the flexible budget overhead for the actual number of outputs from calculating the overhead flexible budget variance: Flexible Budget Overhead for Actual Number of Outputs ! (118, 000 " $0.30) # (120, 000 " $0.80) ! $35, 400 # $96, 000 ! $131, 400

So the difference is calculated as follows: Production Volume Variance ! Flexible Budget Overhead for Actual Number of Outputs $ Standard Overhead Allocated to Actual Produ uction ! $131, 400 $ ($1.10 "118, 000) ! $131, 400 $ $129, 800 ! $1, 600 U

This variance accounts for Bumpy producing fewer maps, 118,000, than expected output, 120,000. Bumpy didn’t use its production capacity as efficiently as possible. Whenever a business produces less than expected, the production volume variance will be unfavorable.

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Demo Doc 2Demo Solutions Doc 1| |Chapter Chapter20 1

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Quick Practice Questions True/False _____ 1. Total variable costs change as production volume changes in a flexible budget. _____ 2. At the end of the period, all variance accounts are closed to zero out their balances. _____ 3. The sales volume variance arises because the number of units actually sold differs from the number of units expected to be sold according to the master budget. _____ 4. A price variance is the difference between the actual unit price of an input and the standard unit price of the input, multiplied by the standard input quantity. _____ 5. If the standard quantity allowed is less than the actual quantity used, the efficiency variance is favorable. _____ 6. An efficiency variance is the difference between the actual quantity of input and the standard quantity of input, multiplied by the actual unit price of input. _____ 7. Manufacturing overhead allocated to production equals the standard predetermined manufacturing overhead rate times the actual quantity of allocation base allowed for the standard number of outputs. _____ 8. The overhead flexible budget variance is the difference between the actual overhead cost and the flexible budget overhead for budgeted production. _____ 9. The production volume variance is favorable whenever actual output is less than expected output. _____10. In standard costing, the journal entry to record the direct labor costs incurred includes a debit to Manufacturing Wages for the actual hours worked at the standard price for direct labor.

Multiple Choice 1. Which of the following is true for a static budget? a. Adjusted for changes in the level of activity b. Prepared for only one level of activity c. A budget that stays the same from one period to the next d. Also known as a fixed budget

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2. Sweet Baby Diaper Company sells disposable diapers for $0.20 each. Variable costs are $0.05 per diaper while fixed costs are $75,000 per month for volumes up to 850,000 diapers and $112,500 for volumes above 850,000 diapers. What is the monthly operating income for 800,000 diapers and 900,000 diapers of volume? a. $22,500 and $7,500, respectively b. $60,000 and $45,000, respectively c. $45,000 and $22,500, respectively d. $7,500 and $60,000, respectively 3. A graph of a flexible budget formula reflects fixed costs of $30,000 and total costs of $90,000 at a volume of 6,000 units. Assuming the relevant range is 1,000 to 12,000 units, what is the total cost of 10,000 units on the graph? a. $100,000 b. $130,000 c. $160,000 d. $180,000 4. The sales volume variance is the difference between which amounts? a. Number of units actually sold and number of units expected to be sold according to the static budget b. Amounts in the flexible budget and the static budget c. Actual results and amounts in the flexible budget d. Actual sales volume and normal sales volume 5. The flexible budget variance is the difference between which amounts? a. Actual results and amounts in the static budget b. Amounts in the flexible budget and the actual results c. Amounts in the flexible budget and the static budget d. The budgeted amounts for each level of activity in the flexible budget 6. What does a flexible budget help to measure? a. The efficiency of operations at the actual activity levels b. The amount by which standard and expected prices differ c. Both a and b d. None of the above 7. Global Engineering’s actual operating income for the current year is $50,000. The flexible budget operating income for actual volume achieved is $40,000, while the static budget operating income is $53,000. What is the sales volume variance for operating income? a. $10,000 U b. $10,000 F c. $13,000 U d. $13,000 F 8. Tiger’s Golf Center reported actual operating income for the current year of $60,000. The flexible budget operating income for actual volume achieved is $55,000, while the static budget operating income is $58,000. What is the flexible budget variance for operating income? a. $2,000 F b. $3,000 U c. $5,000 F d. $5,000 U Quick Practice Questions | Chapter 20

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9. What does a favorable direct materials efficiency variance indicate? a. Actual cost of direct materials was less than the standard cost of direct materials b. Actual quantity of direct materials used was less than the standard quantity for actual output c. Standard quantity of direct materials for actual output was less than the actual quantity of direct materials used d. Actual quantity of direct materials used was greater than the standard quantity for budgeted output 10. Western Outfitters Mountain Sports projected 2008 sales of 75,000 units at a unit sale price of $12.00. Actual 2008 sales were 72,000 units at $14.00 per unit. Actual variable costs, budgeted at $4.00 per unit, totaled $4.75 per unit. Budgeted fixed costs totaled $375,000, while actual fixed costs amounted to $400,000. What is the flexible budget variance for variable expenses? a. $12,000 F b. $25,000 F c. $54,000 U d. $54,000 F

Quick Exercises 20-1. Smart Toys Manufacturing projected 2008 sales of 10,000 units at $12.00 per unit. Actual sales for the year were 15,000 units at $12.50 per unit. Actual variable expenses, budgeted at $5.00 per unit, amounted to $4.80 per unit. Actual fixed expenses, budgeted at $60,000, totaled $62,500. Prepare Smart Toys’ income statement performance report for 2008, including both flexible budget variances and sales volume variances.

SMART TOYS MANUFACTURING Income Statement Performance Report Year Ended 2008 1 Actual Results at Actual Prices Output Units Sales revenue Variable expenses Fixed expenses Total expenses Operating income (loss)

696


2


4

5


Static (Master) Budget

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20-2. Dawkins Company established a master budget volume of 19,500 units for September. Actual overhead costs incurred amounted to $17,800. Actual production for the month was 22,000 units. The standard variable overhead rate was $0.50 per direct labor hour. The standard fixed overhead rate was $0.25 per direct labor hour. One direct labor hour is the standard quantity per finished unit. a. Compute the total manufacturing overhead cost variance.

b. Compute the overhead flexible budget variance.

c. Compute the production volume variance.

20-3. Standard Products Company recognizes variances from standards at the earliest opportunity, and the quantity of direct materials purchased is equal to the quantity used. The following information is available for the most recent month: Direct Materials

Direct Labor

Standard quantity/unit

6.00 lbs.

2.5 hrs.

Standard price/lb. or hr.

$8.10/lb.

$8.00/hr.

Actual quantity/unit

6.25 lbs.

2.8 hrs.

Actual price/lb. or hr.

$8.00/lb.

$7.50/hr.

Price variance

$562.50 F

$1,260.00 F

Efficiency variance

$1,822.50 U

$2,160.00 U

Static budget volume

800 units

Actual volume

900 units

Actual overhead

$11,000.00

Standard variable overhead

$5/unit

Standard fixed overhead

$5,600

Overhead flexible budget variance

$900 U

Production volume variance

$700 F


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a. Journalize the purchase and usage of direct materials including the related variances. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

b. Journalize the direct labor costs incurred and the application of direct labor, including the related variances. Journal Entry: Date

Accounts

Post Ref.

Dr.

Cr.

Post Ref.

Dr.

Cr.

Journal Entry: Date

Accounts

c. Journalize the application of overhead costs including the recognition of the overhead variances. Journal Entry: Date

698

Accounts


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Journal Entry: Date

Post Ref.

Accounts

Dr.

Cr.

20-4. Jeremy Industries has the following information regarding direct materials: Actual pounds purchased and used Standard quantity Actual production Direct materials efficiency variance Direct materials price variance

42,000 3 pounds per finished good 15,000 finished goods $10,500 F $8,820 U

Compute Jeremy’s standard price per pound and actual price per pound.

20-5. Parkland, Inc., sells board games for $15.00, resulting in a contribution margin of $9.00 per game. Fixed costs are budgeted at $212,000 per quarter for volumes up to 30,000 games and $242,000 for volumes exceeding 30,000 games. Prepare the flexible budget for the next quarter for volume levels of 25,000, 30,000, and 37,000 games.

PARKLAND, INC. Flexible Budget Year Ending 2010 Flexible Budget per Output Unit

Output Units (games) 25,000 30,000 37,000

Sales revenue Variable expenses Fixed expenses Total expenses Operating income (loss)


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Do It Yourself! Question 1 Flexible Budgets and Income Statement Performance Report Management at Fluffy Foam Beds predicted 2010 sales of 32,000 beds at a price of $180 per bed. Actual sales for the year were 34,200 beds at $185 per bed. Following is a breakdown of Fluffy’s costs for 2010: Budgeted Units sold Variable costs Fixed costs

Actual

32,000

34,200

$ 70

$ 75

$3,000,000

$3,100,000

Requirements 1. Using Fluffy’s estimated budget values for costs and sales price, develop flexible budgets for 32,000, 34,000, and 36,000 beds.

FLUFFY FOAM BEDS Flexible Budget Year Ending 2010 Flexible Budget per Output Unit

Output Units (beds) 32,000 34,000 36,000


2. Prepare Fluffy’s income statement performance report for 2010.

FLUFFY FOAM BEDS Income Statement Performance Report Year Ended 2010 1 Actual Results at Actual Prices



700


2

4

5


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Do It Yourself! Question 2 Standard Costs Circle CD manufactures blank CD cases. Circle uses a standard cost system to control manufacturing costs. The following standard unit cost information is based on the static budget volume of 80,000 CD cases per month: Direct materials (100 sq. ft. @ $0.25 per sq. ft.) Direct labor (0.50 hours @ $18.00 per hour) Manufacturing overhead: Variable (1 hour @ $2.00 per hour) Fixed (2 hours @ $5.00 per hour) Total cost per CD case

$25.00 9.00 2.00 10.00

12.00 $46.00

In this example, Total Budgeted Fixed Manufacturing Overhead ! $10 " 80, 000 CD Cases ! $800, 000

Actual cost and production volume information: • Actual production was 88,000 cases. • Actual direct materials usage was 102 square feet per case, at an actual cost of $0.24 per square foot. • Actual direct labor usage of 42,000 hours at $18.15, total cost of $762,300. • Total actual overhead was $980,000.

Requirements 1. Compute the price and efficiency variances for direct materials and direct labor. Direct materials price variance Direct materials efficiency variance Direct labor rate variance Direct labor efficiency variance 2. For manufacturing overhead, compute the total variance, the flexible variance, and the production volume variance. Total overhead variance Overhead flexible budget variance Production volume variance

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702

T

1. Total variable costs change as production volume changes in a flexible budget. (p. 1069)

T

2. At the end of the period, all variance accounts are closed to zero out their balances. (p. 1087)

T

3. The sales volume variance arises because the number of units actually sold differs from the number of units expected to be sold according to the master budget. (p. 1070)

F

4. A price variance is the difference between the actual unit price of an input and the standard unit price of the input, multiplied by the standard input quantity. False–A price variance is the difference between the actual unit price of an input and the standard unit price of the input, hmultiplied by the actual input quantity. (p. 1075)

F

5. If the standard quantity allowed is less than the actual quantity used, the efficiency variance is favorable. False–If the standard quantity allowed is less than the actual quantity used, the efficiency variance is unfavorable. (p. 1075)

F

6. An efficiency variance is the difference between the actual quantity of input and the standard quantity of input, multiplied by the actual unit price of input. False–An efficiency variance is the difference between the actual quantity of input and the standard quantity of input, multiplied by the standard unit price of input. (p. 1075)

F

7. Manufacturing overhead allocated to production equals the standard predetermined manufacturing overhead rate times the actual quantity of allocation base allowed for the standard number of outputs. False–Manufacturing overhead allocated to production equals the standard predetermined manufacturing overhead rate times the standard quantity of allocation base allowed for the actual number of outputs. (p. 1081)

F

8. The overhead flexible budget variance is the difference between the actual overhead cost and the flexible budget overhead for budgeted production. False–The overhead flexible budget variance is the difference between the actual overhead cost and the flexible budget overhead for the actual number of outputs. (p. 1082)


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9. The production volume variance is favorable whenever actual output is less than expected output. False–The production volume variance is unfavorable whenever actual output is less than expected output. (p. 1083) 10. In standard costing, the journal entry to record the direct labor costs incurred includes a debit to Manufacturing Wages for the actual hours worked at the standard price for direct labor. (p. 1084)

Multiple Choice 1. Which of the following is true for a static budget? (p. 1068) a. Adjusted for changes in the level of activity b. Prepared for only one level of activity c. A budget that stays the same from one period to the next d. Also known as a fixed budget 2. Sweet Baby Diaper Company sells disposable diapers for $0.20 each. Variable costs are $0.05 per diaper while fixed costs are $75,000 per month for volumes up to 850,000 diapers and $112,500 for volumes above 850,000 diapers. What is the monthly operating income for 800,000 diapers and 900,000 diapers of volume? (p. 1068) a. $22,500 and $7,500, respectively b. $60,000 and $45,000, respectively c. $45,000 and $22,500, respectively d. $7,500 and $60,000, respectively 3. A graph of a flexible budget formula reflects fixed costs of $30,000 and total costs of $90,000 at a volume of 6,000 units. Assuming the relevant range is 1,000 to 12,000 units, what is the total cost of 10,000 units on the graph? (p. 1069) a. $100,000 b. $130,000 c. $160,000 d. $180,000 4. The sales volume variance is the difference between which amounts? (p. 1070) a. Number of units actually sold and number of units expected to be sold according to the static budget b. Amounts in the flexible budget and the static budget c. Actual results and amounts in the flexible budget d. Actual sales volume and normal sales volume 5. The flexible budget variance is the difference between which amounts? (p. 1070) a. Actual results and amounts in the static budget b. Amounts in the flexible budget and the actual results c. Amounts in the flexible budget and the static budget d. The budgeted amounts for each level of activity in the flexible budget Quick Practice Solutions | Chapter 20

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6. What does a flexible budget help to measure? (p. 1069) a. The efficiency of operations at the actual activity levels b. The amount by which standard and expected prices differ c. Both a and b d. None of the above 7. Global Engineering’s actual operating income for the current year is $50,000. The flexible budget operating income for actual volume achieved is $40,000 while the static budget operating income is $53,000. What is the sales volume variance for operating income? (p. 1070) a. $10,000 U b. $10,000 F c. $13,000 U d. $13,000 F 8. Tiger’s Golf Center reported actual operating income for the current year of $60,000. The flexible budget operating income for actual volume achieved is $55,000, while the static budget operating income is $58,000. What is the flexible budget variance for operating income? (p. 1070) a. $2,000 F b. $3,000 U c. $5,000 F d. $5,000 U 9. What does a favorable direct materials efficiency variance indicate? (p. 1078) a. Actual cost of direct materials was less than the standard cost of direct materials b. Actual quantity of direct materials used was less than the standard quantity for actual output c. Standard quantity of direct materials for actual output was less than the actual quantity of direct materials used d. Actual quantity of direct materials used was greater than the standard quantity for budgeted output 10. Western Outfitters Mountain Sports projected 2008 sales of 75,000 units at a unit sale price of $12.00. Actual 2008 sales were 72,000 units at $14.00 per unit. Actual variable costs, budgeted at $4.00 per unit, totaled $4.75 per unit. Budgeted fixed costs totaled $375,000 while actual fixed costs amounted to $400,000. What is the flexible budget variance for variable expenses? (p. 1060) a. $12,000 F b. $25,000 F c. $54,000 U d. $54,000 F

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Quick Exercise Solutions 20-1. Smart Toys Manufacturing projected 2008 sales of 10,000 units at $12.00 per unit. Actual sales for the year were 15,000 units at $12.50 per unit. Actual variable expenses, budgeted at $5.00 per unit, amounted to $4.80 per unit. Actual fixed expenses, budgeted at $60,000, totaled $62,500. (p. 1071) Prepare Smart Toys’ income statement performance report for 2008, including both flexible budget variances and sales volume variances.

SMART TOYS MANUFACTURING Income Statement Performance Report Year Ended 2008 1


2

Actual Results Flexible Budget at Actual Prices Variance 15,000 0 $7,500 F $187,500 3,000 F 72,000 2,500 U 62,500 500 F 134,500 $8,000 F $ 53,000

3 Flexible Budget for Actual Number of Output Units 15,000 $180,000 75,000 60,000 135,000 $ 45,000

4 Sales Volume Variance 5,000F $60,000 F 25,000 U 0 25,000 U $35,000 F

5 Static (Master) Budget 10,000 $120,000 50,000 60,000 110,000 $ 10,000

20-2. Dawkins Company established a master budget volume of 19,500 units for September. Actual overhead costs incurred amounted to $17,800. Actual production for the month was 22,000 units. The standard variable overhead rate was $0.50 per direct labor hour. The standard fixed overhead rate was $0.25 per direct labor hour. One direct labor hour is the standard quantity per finished unit. (pp. 1080–1083) Actual overhead ! $17,800 Flexible budget overhead for actual production ! ($0.50 ! 22,000) # ($0.25 ! 19,500) ! $15,875 Standard overhead allocated to production ! ($0.50 ! 22,000) # ($0.25 ! 22,000) ! $16,500

a. Compute the total manufacturing overhead cost variance. Total manufacturing overhead cost variance ! $17,800 – $16,500 ! $1,300 U

b. Compute the overhead flexible budget variance. Overhead flexible budget variance ! $17,800 – $15,875 ! $1,925 U

c. Compute the production volume variance. Production volume variance ! $15,875 – $16,500 ! $625 F


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20-3. Standard Products Company recognizes variances from standards at the earliest opportunity, and the quantity of direct materials purchased is equal to the quantity used. The following information is available for the most recent month: (pp. 1083–1085) Direct Materials

Direct Labor

Standard quantity/unit

6.00 lbs.

2.5 hrs.

Standard price/lb. or hr.

$8.10/lb.

$8.00/hr.

Actual quantity/unit

6.25 lbs.

2.8 hrs.

Actual price/lb. or hr.

$8.00/lb.

$7.50/hr.

Price variance

$562.50 F

$1,260 F

Efficiency variance

$1,822.50 U

$2,160 U

Static budget volume

800 units

Actual volume

900 units

Actual overhead

$11,000

Standard variable overhead

$5/unit

Standard fixed overhead

$5,600

Overhead flexible budget variance

$900 U

Production volume variance

$700 F

a. Journalize the purchase and usage of direct materials including the related variances. b. Journalize the direct labor costs incurred and the application of direct labor, including the related variances. c. Journalize the application of overhead costs including the recognition of the overhead variances.


Accounts Materials Inventory Accounts Payable Direct Materials Price Variance

Dr. 45,562.50

Cr. 45,000.00 562.50


706

Accounts Work in Process Inventory Direct Materials Efficiency Variance Materials Inventory


Dr. 43,740.00 1,822.50

Cr.

45,562.50

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Accounts Manufacturing Wages Wages Payable Direct Labor Price Variance

Dr. 20,160.00

Cr. 18,900.00 1,260.00


Accounts Work in Process Inventory Direct Labor Efficiency Variance Manufacturing Wages

Dr. 18,000.00 2,160.00

Cr.

20,160.00


Accounts Work in Process Inventory Manufacturing Overhead [($7 ! 900) " ($5 ! 900)]

Dr. 10,800.00

Cr. 10,800.00


Accounts Overhead Flexible Budget Variance Production Volume Variance Manufacturing Overhead

Dr. 900.00

Cr. 700.00 200.00

Quick Practice | Chapter 20 Chapter 20 | Questions Quick Practice Solutions

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20-4. Jeremy Industries has the following information regarding direct materials: (pp. 1076–1080) Actual pounds purchased and used Standard quantity Actual production Direct materials efficiency variance Direct materials price variance

42,000 3 pounds per finished good 15,000 finished goods $10,500F $8,820U

Compute Jeremy’s standard price per pound and actual price per pound. Let Y ! Standard price per pound Direct materials efficiency variance ! [(3 " 15,000) – 42,000]Y ! $ 10,500 3,000Y ! $10,500 Y ! $3.50 Let Y ! actual price per pound Direct materials price variance ! (Y – $3.50) " 42,000 ! $8,820 Y – $3.50 ! $8,820/42,000 Y – $3.50 ! $0.21 Y ! $3.71

20-5. Parkland, Inc., sells board games for $15.00, resulting in a contribution margin of $9.00 per game. Fixed costs are budgeted at $212,000 per quarter for volumes up to 30,000 games and $242,000 for volumes exceeding 30,000 games. (p. xx) Prepare the flexible budget for the next quarter for volume levels of 25,000, 30,000, and 37,000 games.

PARKLAND, INC. Flexible Budget Year Ending 2010 Flexible Budget per Output Unit Sales revenue Variable expenses Fixed expenses Total expenses Operating income (loss)

708


$15.00 6.00

Output Units (games) 25,000 30,000 37,000 $555,000 $450,000 $375,000 222,000 180,000 150,000 242,000 212,000 212,000 464,000 392,000 362,000 $991,000 $558,000 $113,000

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Do It Yourself! Question 1 Solutions Requirement 1 Using Fluffy’s estimated budget values for costs and sales price, develop flexible budgets for 32,000, 34,000, and 36,000 beds.

FLUFFY FOAM BEDS Flexible Budget Year Ending 2010 Flexible Budget per Output Unit $180 70


1


2


Output Units (beds) 32,000 34,000 36,000 $5,760,000 $6,120,000 $6,480,000 2,520,000 2,380,000 2,240,000 3,000,000 3,000,000 3,000,000 5,520,000 5,380,000 5,240,000 $ 520,000 $ 740,000 $ 960,000

Requirement 2 Prepare Fluffy’s income statement performance report for 2010.

FLUFFY FOAM BEDS Income Statement Performance Report Year Ended 2010 1


2

Actual Results Flexible Budget at Actual Prices Variance 0 34,200 $171,000 F $6,327,000 171,000 U 2,565,000 100,000 U 3,100,000 271,000 U 5,665,000 $100,000 U $ 662,000

3 Flexible Budget for Actual Number of Output Units 34,200 $6,156,000 2,394,000 3,000,000 5,394,000 $ 762,000

4 Sales Volume Variance 2,200F $396,000 F 154,000 U 0 154,000 U $242,000 F

5 Static (Master) Budget 32,000 $5,760,000 2,240,000 3,000,000 5,240,000 $ 520,000


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Do it Yourself! Question 2 Solutions Requirement 1

4

Compute standard cost variances for direct materials and direct labor

Compute the price and efficiency variances for direct materials and direct labor. Direct Materials Price Variance Direct Material Price Variance ! (Actual Price $ Standard Price) " Actual Quantity ! ($0.24 $ $0.25) " (102 " 88, 000 units) ! $89,760 F

Direct Materials Efficiency Variance Direct Materials Quantity Variance ! (Actual Quantity $ Standard Quantity) " Standard Price ! [(102 " 88, 000) $ (100 " 88, 000)] " $0.25 ! $44, 000 U

Direct Labor Rate Variance Direct Labor Rate Variance ! (Actual Rate $ Standard Rate) " Actual Hours ! ($18.15 $ $18.00) " 42, 000 Hours ! $6, 300 U

Direct Labor Efficiency Variance Direct Labor Efficiency Variance ! (Actual Hours $ Standard Hours) " Standard Price ! [42, 000 $ (0.50 " 88, 000)] " $18.00 ! $36, 000 F

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Requirement 2 For manufacturing overhead, compute the total variance, the flexible variance, and the production volume variance.

5

Analyze manufacturing overhead in a standard cost system

Total Overhead Variance Total Overhead Variance ! Actual Overhead Cost $ Standard Overhead Allocated to Production ! $980, 000 $ (88, 000 " $12) ! $76, 000 F

Overhead Flexible Budget Variance Overhead Flexible Budget Variance ! Actual Overhead Cost $ Flexible Budget Overhead for Actual Number of Outputs ! $980, 000 $ [(88, 000 " $2.00) # (80, 000 " $10.00)] ! $4, 000 U

Production Volume Variance Production Volume Variance ! Flexible Budget Output for Actual Number of Outputs $Standard Overhead Allocated to Actual Productiion ! $976, 000 $ ($12 " 88, 000) ! $80, 000 F


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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 20, Flexible Budgets and Standard Costs. 6. Click a link to work on the tutorial exercises.

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21

Special Business Decisions and Capital Budgeting

WHAT YOU PROBABLY ALREADY KNOW People purchase lottery tickets in the hopes of winning the grand jackpot. On November 15, 2005, seven employees of a medical center won the Mega Millions grand prize of $315,000,000. Winners can choose to receive the money in 26 equal payments over the upcoming 25 years or in a lump sum. The seven winners decided to take a lump-sum payment. You probably already know that opting for the lump-sum payment means that something less than $315,000,000 is received. The reason is the time value of money. Receiving a dollar now is worth more than receiving it in a year, 5 years, or 25 years in the future. The winnings are “discounted,” reduced to the present value. The seven winners received $187,100,000. In this chapter, we will study how to calculate the present value of future cash flows and how that information is used to help management make decisions.

Learning Objectives

1

Identify the relevant information for a special business decision. To make business decisions, management will compare relevant information between alternative courses of action. Relevant information includes items that will differ between alternatives and be incurred in the future. Relevant information, therefore affects the decisions that are made.

2

Make five types of short-term special business decisions. Some short-term special business decisions that management makes include accepting a special sales order (see Exhibit 21-4, p. 1121), dropping a business segment (see Exhibits 21-5 through 21-7, pp. 1122–1123), which product to emphasize in a product mix (see Exhibit 21-8, p. 1124), when to outsource production (see Exhibits 21-9 and 21-10, pp. 1126–1127, and selling as is or processing further (see Exhibit 21-12, p. 1128).You will explore these types of decisions in Demo Doc 1. In terms of product mix, a constraint is something that restricts the production or sale of a product, such as labor hours, machine hours, or available materials. Given sufficient demand, the products that generate the highest contribution margin per constrained resource will maximize operating income. When deciding to sell a product as is or process it further, management should consider the split-off point, which is the point at which the product is complete and can be sold or continues to be processed further and then

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sold after incurring more costs. The analysis compares the revenue from selling the product as it is to the higher revenue less additional costs from selling the product after processing further. Whichever option results in a higher net revenue is the more profitable alternative.

3

Use payback and accounting rate of return models to make longer-term capital budgeting decisions. The decision to purchase a long-term asset is referred to as capital budgeting. The focus of capital budgeting is on the net cash inflows that are projected in the future. One tool, used to assess capital investments, is the payback period which is the amount of time it takes to recover the initial investment. You will calculate the payback period for two different products in Demo Doc 2. Review Exhibit 21-13 (p. 1130) for an illustration of the payback period concept. You can use the accounting rate of return to determine the rate of return from an asset over its useful life. You will calculate the accounting rate of return for two different products in Demo Doc 2. The average annual operating income can be computed as the net cash inflow from the asset less depreciation expense. The average amount invested in the asset is the average of the cost amount and the residual value. Review Exhibit 21-14 (p. 1132) for an accounting rate of return calculation.

4

Use discounted cash flow models to make longer-term capital budgeting decisions. Discounted cash flow models use the concept of present value or the time value of money. It simply means that it is more valuable to receive money now than in the future. To make the best capital budgeting decision, the value of future cash flows must be considered in terms of the current or present value. The discounted cash flow models widely used to evaluate potential expenditures are the net present value and the internal rate of return (IRR). You will explore these methods in Demo Doc 2. Review Exhibit 21-16 (p. 1135) for a computation of the net present value method assuming equal net cash inflows and Exhibit 21-18 (p. 1136) assuming unequal net cash inflows.

5

Compare and contrast the four capital budgeting methods. • Payback period.This method is simple to employ, but it does not consider the project profitability or the time value of money. • Accounting rate of return.This method measures profitability, but it does not consider the time value of money. • Net present value (NPV). NPV considers the time value of money, but it does not indicate the investment’s projected rate of return. • Internal rate of return (IRR). IRR considers the time value of money and determines the project’s rate, but does not indicate the dollar difference between the project’s present value and its investment cost.

Review Exhibit 21-20 (p. 1138) for a summary of the strengths and weaknesses of the payback period, accounting rate of return, NPV, and IRR methods. 714

Chapter 21 | Special Business Decisions and Capital Budgeting

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Demo Doc 1 Special Business Decisions Learning Objectives 1–2 Doctor Key produces key blanks. A Kenya company offered to purchase 2,000 cases of keys at a per-case price of $30. Assume selling to the Kenya company will not affect regular customers, will not change fixed costs, will not require any additional variable nonmanufacturing expenses, and will use manufacturing capacity that would otherwise be idle.

DOCTOR KEY Income Statement (without considering the special sale) Sales revenue (35,000 cases @ $38.00 per case) Less: Manufacturing cost of goods sold Gross profit Less: Marketing and administrative expenses Operating income

$1,330,000 800,000 $ 530,000 410,000 $ 120,000

Requirement 1. Assuming $500,000 of the manufacturing costs is fixed and $200,000 of the marketing and administrative costs is fixed, should Doctor accept the order from the Kenya company? Pack-It offered to package the key blanks for Doctor Key. Currently, Doctor packages the product in-house at the following per-case costs: Direct Materials $ 30,000 Direct Labor 55,00 00 Variable Overhea ad 5,000 Fixed Overhead 15,000 Total Manufacturing Cost $105,000 Cos st per Case ($105,000/35,000) $3.00


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Requirement 2. Pack-It’s price per case is $2.80. Doctor would avoid all variable costs associated with the packaging and would reduce the fixed cost by $5,000 if Pack-It packages Doctor’s key blanks. Should Doctor outsource the packaging work to Pack-It? Doctor sells 35,000 cases of keys. Of those, 3,000 cases are for a special blue-colored key made for one customer. The blue key sells for the same price, $38, as all the other keys, but seems to require more expenses to produce. Doctor is considering dropping the blue key. An analysis determined that the variable cost of producing the blue key is $20 per case. If the blue key was not produced, fixed costs would not change.

Requirement 3. Should Doctor stop producing the blue key?

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Demo Doc 1 Solutions Requirement 1 Assuming $500,000 of the manufacturing costs is fixed and $200,000 of the marketing and administrative costs is fixed, should Doctor accept the order from the Kenya company?

Part 1

Part 2

Demo Doc Complete

Part 3

The key to this problem is to determine what effect the special sale would have on Doctor’s operating income. Fixed costs will not change as a result of the sale; therefore, we will compare only the change in revenue with the change in variable costs as a result of the special sale. The decision to accept a special order will be made if the incremental revenues exceed the incremental expenses for the special order. The increase in revenue is determined by multiplying the additional cases sold by the offered selling price per case:

1

Identify the relevant information for a special business decision

2

Make five types of short-term special business decisions

2,000 ! $30 " $60,000

To determine the variable cost of producing the additional 2,000 units, we must first determine the variable cost per unit. The manufacturing cost of producing 35,000 cases was $800,000. Of the $800,000, fixed cost makes up $500,000. Therefore, manufacturing variable cost is $300,000. The variable marketing and administrative cost is determined by subtracting the fixed portion, $200,000, from the total marketing and administrative cost of $410,000, to get variable marketing and administrative cost of $210,000. Thus, the total variable cost of producing the 35,000 cases is: $300,000 # $210,000 " $510,000

The variable cost per unit is computed by dividing the total variable cost by the number of units. $510,000/35,000 cases " $14.57

The increase in variable cost with the special sales order is: 2,000 cases ! $14.57 variable cost per unit " $29,140

Incremental Analysis of Special Sales Order Increase in revenues: Sale of 2,000 cases @ $30 per case

$60,000

Increase in variable expenses: 2,000 cases ! $14.57 Increase in operating income

29,140 $30,860

Creating a profit of $15.43 per case ($30,860/2,000 cases). Demo Doc 1 Solutions | Chapter 21

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Doctor should accept the special order because it would increase operating income.

Requirement 2 Pack-It’s price per case is $2.80. Doctor would avoid all variable costs associated with the packaging and would reduce the fixed cost by $5,000 if Pack-It packages Doctor’s key blanks. Should Doctor outsource the packaging work to Pack-It?

Part 1

1


2


Part 2

Part 3

Demo Doc Complete

Outsourcing decisions consider whether management will make or buy (outsource) products or services. Incremental analysis can be performed comparing (1) the cost to make the product, which includes direct materials, direct labor, and overhead, to (2) the cost to buy, which includes the purchase price plus possibly some portion of the fixed overhead that will continue with outsourcing. In addition, a relevant opportunity cost may need to be considered. An opportunity cost represents the benefit forgone by not choosing an alternative course of action. If the production process is outsourced and the goods are purchased, other opportunities may be available to use the idle resources to generate profits. The opportunity cost reduces the cost of outsourcing. In this case, the key to this decision is to compare the Doctor’s cost savings of not packaging their keys with the additional cost charged by Pack-It. On the surface, it might seem that Pack-It is making an attractive offer to package the key blanks for $0.20 cheaper per case than Doctor spends to package the key blanks themselves. An incremental analysis is necessary to consider the overall effects of total costs and savings on the make-or-buy decision. The following shows the differences in costs between making and outsourcing (buying) the packaging:

Packaging Costs Direct materials

Make

Buy

Difference

$ 30,000

$30,000

55,000

55,000

5,000

5,000

Direct labor Variable factory overhead Avoidable fixed costs

15,000

Purchase cost from Pack-It (35,000 units ! $2.80 per unit)

10,000

5,000

(98,000)

98,000

Total cost of packaging

$105,000

$108,000

$(3,000)

Cost per unit (divide by 35,000 cases)

$

$

$ (0.09)

3.00

3.09*

*Rounded. This analysis makes it clear that the fixed costs have an impact on this decision. In this case, Doctor will incur that $10,000 in fixed costs whether it outsources the 718


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packaging to Pack-It or packages their own key blanks. The total cost for the 35,000 cases is $3,000 higher if Doctor decides to outsource the packaging to Pack-It. So it would make sense for Doctor to continue packaging its own product.

Requirement 3 Should Doctor stop producing the blue key?

Part 1

Part 2

Part 3

Demo Doc Complete

As in this case, management may want to consider whether discontinuing a product line, department, or component of the business would increase the operating income. The decision to eliminate a business segment may be made if dropping the segment results in a decrease in total expenses greater than the decrease in revenues. In this case, fixed costs remain the same whether the blue key product line is continued or dropped; therefore, fixed costs are not relevant to the decision. Only the revenues and variable expenses are relevant. Segment margin is calculated as:

1


2


Sales $ Variable Costs Contribution Margin $ Discretionary Fixed Costs Segment Margin

In the absence of any discretionary fixed costs, contribution margin is the criteria for deciding whether a product or product line should be dropped. If the blue key product line is dropped, revenues will decrease by: 3,000 ! $38 " ($114,000)

Variable costs will decrease: 3,000 ! $20 " ($60,000)

Contribution margin will decrease as well: 3,000 ! $18 " ($54,000)

A cost savings of $60,000 is realized, which is really a “negative” cost. Therefore, the “income” generated from dropping this line is $60,000. The actual revenue generated from having this line is $114,000. Because $114,000 is greater than $60,000 (a $54,000 difference), the company is better off by NOT dropping this product. A decision rule might be: If the actual revenue of the product exceeds the cost savings (in reduced costs, either variable or fixed or both), then the product should not be dropped.

Part 1

Part 2

Part 3

Demo Doc Complete Demo Doc 1 Solutions | Chapter 21

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Demo Doc 2 Capital Budgeting Learning Objectives

3–4

Yummy Eats produces packaged food products. The company desires to produce one of two possible new products: either yogurt or cottage cheese. Each product would require an additional investment of $400,000. Yogurt would have a useful life of six years, with no residual value. Cottage cheese would have a useful life of four years, with no residual value. The expected annual net cash inflows are as follows: Net Cash Inflows Useful Life

Yogurt

Cottage Cheese

Years

Annual

Accumulated

Annual

Accumulated

1

$110,000

$110,000

$140,000

$140,000

2

110,000

220,000

140,000

280,000

3

110,000

330,000

140,000

420,000

4

110,000

440,000

140,000

560,000

5

110,000

550,000

6

110,000

660,000

Requirements 1. Determine the payback period for each product. What is the major weakness of payback analysis? 2. Calculate the accounting rate of return. What is the major weakness of the accounting rate of return? 3. Assuming that Yummy requires a 14% return on each possible new product, what is the net present value of each project? 4. Compute the internal rate of return for each product.

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Demo Doc 2 Solutions Requirement 1 Determine the payback period for each product. What is the major weakness of payback analysis?

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

Payback period is a simple approach that is used sometimes to screen potential projects. A company would want to recoup the investment amount as quickly as possible, assuming all other factors are constant. In this case, payback is the length of time it takes Yummy to recover, in net cash inflows, the $400,000 initial outlay. Yogurt and cottage cheese each have equal cash inflows each year, so the payback period is calculated as: Payback Period " Payback Period for Yogurt Payback Period for Cottage Cheese

3

Use payback and accounting rate of return models to make longer-term capital budgeting decisions

3


Amount Invested Expected Annual Net Cash Inflow

"

$400,000 $110,000

"

3.636 Years

"

$400,000 $140,000

"

2.857 Years

The payback method favors the cottage cheese because it recovers the initial investment more quickly. The major weakness of payback analysis is that it only focuses on time, not on profit. The payback period must be shorter than the useful life to provide any profit.

Requirement 2 Calculate the accounting rate of return. What is the major weakness of the accounting rate of return?

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete

The rate of return calculated is compared to the required return set by management. The company will invest in the asset if the return is more than that required and will not invest if the return is less than the required return. When evaluating several alternatives, the higher the return, the better the alternative is. The accounting rate of return is determined by dividing the average operating income from the asset by the average amount invested in the asset. The average amount invested in the asset is calculated by dividing the cost of the asset less the residual value by two.


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Average amount invested in yogurt and cottage cheese is: $400,000 $ $0 " $200,000 2

To determine the average operating income, depreciation must first be calculated. The depreciation associated with the yogurt is: $400,000 " $66,667 6-Year Life

Depreciation associated with the cottage cheese is: $400,000 " $100,000 4-Year Life

The depreciation expense is now subtracted from the expected annual net cash inflows to calculate the average operating income: Yogurt Average Operating Incom me " $110, 000 $ $66, 667 " $43, 333 Cottage Cheese Average Operating Income " $140, 000 $ $100, 000 " $40, 000

The accounting rate of return can now be calculated: Yogurt

Cottage Cheese

$43,333 " 21.667% $200,000 $40,000 " 20% $200,000

The major weakness of the accounting rate of return is that it doesn’t consider the timing of the income. The accounting rate of return doesn’t consider whether the income is greater early in the life of the asset or near the end of the useful life of the asset. Management would prefer greater income early in the life of the asset so the funds could be used to generate additional income.

Requirement 3 Assuming that Yummy requires a 14% return on each possible new product, what is the net present value of each project?

Part 1

4

Use discounted cash flow models to make longer-term capital budgeting decisions

722

Part 2

Part 3

Part 4

Demo Doc Complete

Net present value brings future cash inflows and future cash outflows to a common time period, which makes the feasibility of each product easier to compare. The net present value (NPV) method compares the present value of the net cash inflows to the initial investment of the capital project. To obtain the present value of the net cash inflows, the minimum desired rate of return is used to find the appropriate discounting factor in the present value tables. If the cash flows


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are equal each year, it is considered to be an annuity and Exhibit 21-15 (p. 1134 of the textbook) is used; if the cash flows are unequal, Exhibit 21-17 (p. 1136 of the textbook) is used for each year’s present value calculation. If the present value of the inflows to be received is equal to or greater than that invested, the project is considered to be desirable. Consider the following: Net Present Value "

Present Value Present Value of $ of ALL Cash Flows IN ALL Cash Flows OUT

" PVCFI - PVCFO

Both of these projects expect a stream of equal periodic cash flows, which is called an annuity. The present value of an annuity is the periodic cash flow multiplied by the present value of an annuity of $1. Exhibit 26-15 (reproduced here) shows the present value of annuity factors for various interest rates and numbers of periods: Present Value of Annuity of $1 Period

4%

6%

8%

10%

12%

14%

16%

1

0.962

0.943

0.926

0.909

0.893

0.877

0.862

2

1.886

1.833

1.783

1.736

1.690

1.647

1.605

3

2.775

2.673

2.577

2.487

2.402

2.322

2.246

4

3.630

3.465

3.312

3.170

3.037

2.914

2.798

5

4.452

4.212

3.993

3.791

3.605

3.433

3.274

6

5.242

4.917

4.623

4.355

4.111

3.889

3.685

7

6.002

5.582

5.206

4.868

4.564

4.288

4.039

8

6.733

6.210

5.747

5.335

4.968

4.639

4.344

9

7.435

6.802

6.247

5.759

5.328

4.946

4.607

10

8.111

7.360

6.710

6.145

5.650

5.216

4.833

Appendix C-2 provides a more comprehensive table for the present value of an annuity of $1.

As shown in the table, the present value factor for the yogurt investment, 14% and 6 periods, is 3.889, and the present value factor for the cottage cheese investment, 14% and 4 periods, is 2.914. The present value of a project is equal to the present value factor multiplied by one period’s cash flow. The net present value is the present value less the cost of the investment, where the investment is made at time zero (today), giving an interest factor of 1.0000, for a “present value” approach. So to calculate net present value for each product: Yogurt: PVCFI PVCFO

$110,000 ! 3.889 $400,000 !1.000 Net Present Value

" " "

$427,790 400,000 $ 27,790

PVCFI PVCFO

$140,000 ! 2.914 $400,000 !1.000 Net Present Value

" " "

$407,960 400,000 $ 7,960

Cottage Cheese:


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Because the net present value of both products are positive, accept both products, unless coming up with the needed funds of $800,000 is a problem. In that case, the company should choose the product with the highest net present value. In our case, the product with the highest net present value is yogurt: $27,790.

Requirement 4 Compute the internal rate of return for each product.

Part 1

4


Part 2

Part 3

Part 4

Demo Doc Complete

The internal rate of return (IRR) method calculates the estimated rate of return Yummy can expect to earn by investing in the product. The IRR uses the same concepts as the net present value. The net present value uses management’s minimum desired rate of return to determine whether the present value of the future net cash inflows equals or exceeds the cost of the initial investment. If they are equal, the product is earning exactly the minimum desired rate of return. If the amount is positive, the product is earning a rate of return in excess of the minimum, but it is unknown. The IRR method calculates the projected rate of return this way: a. Identify the projected future cash flows (as is done with the net present value method). b. Estimate the present value of an annuity factor as: Annuity PV Factor "

Investment Expected Annual Net Cash Flow

c. Referring to the present value of an annuity table, find the number of cash flow periods in the left column and follow that row to the right until you locate the factor that is closest to the present value of an annuity factor computed in part b. Follow that number up to the interest rate at the top of the column to determine the rate of return. If the rate of return calculated is equal to or higher than management’s minimum desired rate of return, the product is acceptable. To determine the internal rate of return, we must find the discount rate that makes the total present value of the cash inflows equal to the present value of the cash outflows. Work backward to find the discount rate that makes the present value of the annuity of cash inflows equal to the amount of the investment by solving the following equation for the annuity present value factor (which is, in reality, the figure obtained when calculating the payback period, as we did in Requirement 1): Annuity PV Factor for Yogurt

" "

Annuity PV Factor for Cottage Cheese

" "

724


$400,000 $110,000 3.636 $400,000 $140,000 2.857

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Scan the row in the present value of an annuity table corresponding to the product’s expected life: period 6 for yogurt, period 4 for cottage cheese. Choose the column with the number closest to the annuity PV factor previously calculated. The 3.636 annuity factor for yogurt is closest to the 16% column and the 2.857 annuity factor for cottage cheese is closest to the 14% column. Therefore, the internal rate of return for yogurt is approximately 16% and the internal rate of return for cottage cheese is approximately 14%.

Part 1

Part 2

Part 3

Part 4

Demo Doc Complete


725

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Quick Practice Questions True/False _____ 1. Relevant information is future data that differ among alternatives. _____ 2. If the lost revenues from dropping a product exceed the cost savings from dropping the product, it should be retained. _____ 3. Investments with longer payback periods are more desirable, all else being equal. _____ 4. A sunk cost is a past cost that cannot be changed regardless of which future action is taken. _____ 5. The payback method can only be used when net cash inflows are the same for each period. _____ 6. To maximize profits, produce the product with the highest contribution margin per unit of the constraint. _____ 7. The accounting rate of return is a measure of profitability computed by dividing the average annual cash flows from an asset by the average amount invested in the asset. _____ 8. Fixed costs are irrelevant to a special decision when those fixed costs differ between alternatives. _____ 9. Net present value and the payback period are examples of discounted cash flow models used in capital budgeting decisions. _____10. In calculating the net present value of an investment in equipment, the required investment and its terminal residual value should be subtracted from the present value of all future cash inflows.

726


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Multiple Choice 1. For incremental analysis, which of the following would be irrelevant? a. The cost of an asset that the company is considering replacing b. Fixed overhead costs that differ among alternatives c. The cost of further processing a product that could be sold as is d. The expected increase in sales of one product line as a result of a decision to drop a separate unprofitable product line 2. Which of the following is an irrelevant cash inflow or outflow? a. Future disposal value of an asset b. Future operating cash flows c. Current cash outlay to acquire a new asset d. Cash outlay to acquire equipment 10 years ago 3. Lowwater Sailmakers manufactures sails for sailboats. The company has the capacity to produce 25,000 sails per year, but is currently producing and selling 20,000 sails per year. The following information relates to current production: Sale price per unit Variable costs per unit: Manufacturing Marketing and administrative Total fixed costs: Manufacturing Marketing and administrative

$

150 55 25

640,000 $280,000

If a special sales order is accepted for 5,000 sails at a price of $125 per unit, and fixed costs remain unchanged, what would the effect on operating income be? a. Decrease by $5,000 b. Increase by $190,000 c. Decrease by $125,000 d. Increase by $225,000 4. Using the data in Question 3, compute the effect on operating income if a special sales order is accepted for 2,500 sails at a price of $70 per unit, when fixed costs increase by $10,000, and variable marketing and administrative costs for the order decrease by $5 per unit? a. Increase by $10,000 b. Decrease by $22,500 c. Increase by $22,500 d. Decrease by $82,500


727

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5. DC Electronics uses a standard part in the manufacture of several of its radios. The cost of producing 30,000 parts is $90,000, which includes fixed costs of $33,000 and variable costs of $57,000. The company can buy the part from an outside supplier for $2.50 per unit, and avoid 30% of the fixed costs. If DC Electronics makes the part, what is the effect on its operating income? a. $6,500 greater than if the company bought the part b. $8,100 greater than if the company bought the part c. $15,000 less than if the company bought the part d. $5,100 less than if the company bought the part 6. The following data are available for the Forte Co.: Toaster Ovens

Bread Machines

$60

$135

38

62

Sale price Variable costs

The company can manufacture five toaster ovens per machine hour and three bread machines per machine hour. The company’s production capacity is 1,500 machine hours per month. To maximize profits, what should the company produce? a. 4,500 bread machines b. 2,250 toaster ovens and 3,750 bread machines c. 3,750 toaster ovens and 2,250 bread machines d. 7,500 toaster ovens 7. Shine Bright Company has three product lines: D, E, and F. The following information is available: D Sales

E

F

$60,000

$38,000

$26,000

Variable costs

36,000

18,000

12,000

Contribution margin

24,000

20,000

14,000

Fixed expenses

12,000

15,000

16,000

$12,000

$ 5,000

$ (2,000)

Operating income (loss)

Shine Bright Company is thinking of dropping product line F because it is reporting an operating loss. Assuming Shine Bright Company drops line F and does not replace it, what is the effect on the operating income? a. Increase $2,000 b. Increase $14,000 c. Decrease $14,000 d. Increase $16,000 8. Using the data in Question 7, assume that Shine Bright Company drops line F and rents the space formerly used to produce product F for $17,000 per year. What is the effect on the operating income? a. Decrease $3,000 b. Increase $3,000 c. Decrease $14,000 d. Increase $15,000 728


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9. Logan, Inc., is evaluating two possible investments in depreciable plant assets. The company uses the straight-line method of depreciation. The following information is available: Investment A

Investment B

Initial capital investment

$60,000

$90,000

Estimated useful life

3 years

3 years

0

0

$25,000

$40,000

10%

12%

Estimated residual value Estimated annual net cash inflow Required rate of return

The present value of $1 due 3 years from now: 8% 0.7938 10% 0.7513 12% 0.7118 14% 0.6750 16% 0.6407 The present value of $1 per year due at the end of each of 3 years: 8% 2.5771 10% 2.4869 12% 2.4018 14% 2.3216 16% 2.2459 What is the internal rate of return for Investment A? a. 8% b. 10% c. 12% d. 14% 10. Using the information in Question 9, what is the net present value of Investment B? a. $ (164) b. $ 6,072 c. $40,000 d. $61,528


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Quick Exercises 21-1. Label each of the following items as relevant or irrelevant in making a decision. a. Cost of insurance on a new vehicle b. Cost of roof repair made on rental property last year c. Original cost of old equipment that is being evaluated for replacement d. Cost of new equipment under evaluation to replace used equipment e. Accumulated depreciation on old equipment being evaluated for replacement f. Cost of previous year’s insurance policy on old equipment being evaluated for replacement

21-2. Dynamic Enterprises produces and sells a part used in the production of automobiles. The unit costs associated with this part are as follows: Direct Materials Direct Labor Variab ble Manufacturing Overhead Fixed Manufa acturing Overhead Total Cost

$0.15 $0.30 $0.25 $0.10 $0.80

Jupiter Company approached Dynamic Enterprises with an offer to purchase 20,000 units of this part at a price of $0.75 per unit. Accepting this special sales order will put idle manufacturing capacity to use and will not affect regular sales. Total fixed costs will not change. Determine whether the special order should be accepted. Justify your conclusion.

730


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21-3. Lightning Shoes manufactures kids’ sneakers and kids’ shoes. The company’s product line income statement follows: Kids’

Kids’

Total

Sneakers

Shoes

$841,000

$580,000

$261,000

Variable

220,000

116,000

104,000

Fixed

290,000

184,000

106,000

Total cost of goods sold

510,000

300,000

210,000

Gross profit

331,000

280,000

51,000

Variable

140,000

58,000

82,000

Fixed

105,000

79,000

26,000

Total marketing and administrative expenses

245,000

137,000

108,000

$ 86,000

$143,000

$ (57,000)

Sales revenue Cost of goods sold

Marketing and administrative expenses


Management is considering dropping the kids’ shoes product line. Accountants for the company estimate that dropping the kids’ shoes line will decrease fixed costs of goods sold by $50,000 and fixed marketing and administrative expenses by $6,000. Prepare an analysis supporting your opinion about whether the kids’ shoes product line should be dropped. Currently

If Dropped


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21-4. Sharp Image Company makes a part used in the manufacture of video cameras. Management is considering whether to continue manufacturing the part or to buy the part from an outside source at a cost of $21.30 per part. Sharp Image needs 100,000 parts per year. The cost of manufacturing 100,000 parts is computed as follows: Direct Materials $ 765,000 Direct Labor 612,000 Variable Manufacturing Overhead 510,000 Fixed d Manufacturing Overhead 663,000 Total Manufacturing Costs $2,550,000

Sharp Image would pay $0.30 per unit to transport the parts to its manufacturing plant. Purchasing the part from an outside source would enable the company to avoid 35% of fixed manufacturing overhead. Sharp Image’s factory space freed up by purchasing the part from an outside supplier could be used to manufacture another product with a contribution margin of $59,000. Prepare an analysis to show which alternative makes the best use of Sharp Image’s factory space assuming Sharp Image: a. Makes the part b. Buys the part and leaves facilities idle c. Buys the part and uses facilities to make another product Costs

Make

Buy part and leave facilities idle

Buy part and use facilities to make another product

21-5. Identify four capital budgeting models described in the chapter and discuss the strengths and weaknesses of each model.

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Do It Yourself! Question 1 Special Business Decisions Part 1 Easy Access produces keyless entry remotes for automobiles. A Yemen company has offered to purchase 500 cases of keyless entry remotes at a per-unit price of $80. Assume selling to the Yemen company will not affect regular customers, will not change fixed costs, will not require any additional variable nonmanufacturing expenses, and will use manufacturing capacity that would otherwise be idle.

EASY ACCESS Income Statement (without considering the special sale) Sales revenue (5,000 cases @ $140.00 per case) Less: Manufacturing cost of goods sold Gross profit Less: Marketing and administrative expenses Operating income

$700,000 400,000 $300,000 220,000 $ 80,000

Requirement 1. Assuming $250,000 of the manufacturing cost is fixed and $100,000 of the marketing and administrative cost is fixed, should Easy Access accept the order from the Yemen company?

Part 2 Great Graphics offered to print the graphics on the keyless remotes. Currently, Easy Access does the printing themselves at the following per-case costs: Direct materials Direct labor Variable overhead Fixed overhead Total manufacturing cost Cost per case ($80,000/5,000)

$20,000 40,000 5,000 15,000 $80,000 $ 16


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Requirement 2. Great Graphics’ price per case is $15. Easy Access would avoid all variable costs associated with the printing and would reduce the fixed cost by $3,000 if Great Graphics prints Easy Access’s graphics. Should Easy Access outsource the printing work to Great Graphics? Graphics Cost

Make

Buy

Difference

Part 3 Easy Access’s sales of 5,000 cases include 200 cases of a special shaped keyless remote made for one customer. The special keyless remote sells for the same price, $140, as all the other keyless remotes, but seems to require more expenses. Easy Access is considering dropping the special shaped keyless remote. An analysis determined that the variable cost of producing the special keyless remote is $135 per case. If the special keyless remote was not produced, fixed costs would not change.

Requirement 3. Should Easy Access stop producing the special shaped keyless remote?

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Do It Yourself! Question 2 Capital Budgeting Office Home produces various office products. It wants to produce one of two possible new products: either pens or pencils. Each product would require an additional investment of $340,000. Useful life for the pencils would be seven years, while useful life for the pens would be four years. The expected annual net cash inflows are as follows: Useful Life Pencils Years

Pens

Annual

Accumulated

Annual

Accumulated

1

$60,000

$ 60,000

$90,000

$90,000

2

60,000

120,000

90,000

180,000

3

60,000

180,000

90,000

270,000

4

60,000

240,000

90,000

360,000

5

60,000

300,000

6

60,000

360,000

7

60,000

420,000

Requirements 1. Determine the payback period for each product.

2. Calculate the accounting rate of return.

3. Assuming that Office Home requires a 12% return on each possible new product, what is the net present value of each project?

4. Compute the internal rate of return for each project.


735

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736

T

1. Relevant information is future data that differ among alternatives. (p. 1118)

T

2. If the lost revenues from dropping a product exceed the cost savings from dropping the product, it should be retained. (p. 1123)

F

3. Investments with longer payback periods are more desirable, all else being equal. False–Investments with shorter payback periods are more desirable, all else being equal. (p. 1129)

T

4. A sunk cost is a past cost that cannot be changed regardless of which future action is taken. (p. 1127)

F

5. The payback method can only be used when net cash inflows are the same for each period. False–The payback method can be used when net cash inflows are equal or unequal for each period. (p. 1131)

T

6. To maximize profits, produce the product with the highest contribution margin per unit of the constraint. (p. 1124)

F

7. The accounting rate of return is a measure of profitability computed by dividing the average annual cash flows from an asset by the average amount invested in the asset. False–The accounting rate of return is a method of profitability computed by dividing the average annual operating income of the asset by the average amount invested in the asset. (p. 1121)

F

8. Fixed costs are irrelevant to a special decision when those fixed costs differ between alternatives. False–Fixed costs are relevant to a special decision when those fixed costs differ between alternatives. (p. 1120)

F

9. Net present value and the payback period are examples of discounted cash flow models used in capital budgeting decisions. False–Net present value and the internal rate of return are examples of discounted cash flow models used in capital budgeting decisions. (p. 1133)

F

10. In calculating the net present value of an investment in equipment, the required investment and its terminal residual value should be subtracted from the present value of all future cash inflows. False–In calculating the net present value of an investment in equipment, only the required investment should be subtracted from the present value of all future cash flows. (p. 1134)


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Multiple Choice 1. For incremental analysis, which of the following would be irrelevant? (p. 1121) a. The cost of an asset that the company is considering replacing b. Fixed overhead costs that differ among alternatives c. The cost of further processing a product that could be sold as is d. The expected increase in sales of one product line as a result of a decision to drop a separate unprofitable product line 2. Which of the following is an irrelevant cash inflow or outflow? (p. 1129) a. Future disposal value of an asset b. Future operating cash flows c. Current cash outlay to acquire a new asset d. Cash outlay to acquire equipment 10 years ago 3. Lowwater Sailmakers manufactures sails for sailboats. The company has the capacity to produce 25,000 sails per year but is currently producing and selling 20,000 sails per year. The following information relates to current production: Sale price per unit Variable costs per unit: Manufacturing Marketing and administrative Total fixed costs: Manufacturing Marketing and administrative

$

150 55 25

640,000 $280,000

If a special sales order is accepted for 5,000 sails at a price of $125 per unit, and fixed costs remain unchanged, what would the effect on operating income be? (pp. 1120–1121) a. Decrease by $5,000 b. Increase by $190,000 c. Decrease by $125,000 d. Increase by $225,000 4. Using the data in Question 3, compute the effect on operating income if a special sales order is accepted for 2,500 sails at a price of $70 per unit, when fixed costs increase by $10,000, and variable marketing and administrative costs for the order decrease by $5 per unit? (pp. 1120–1121) a. Increase by $10,000 b. Decrease by $22,500 c. Increase by $22,500 d. Decrease by $82,500


737

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5. DC Electronics uses a standard part in the manufacture of several of its radios. The cost of producing 30,000 parts is $90,000, which includes fixed costs of $33,000 and variable costs of $57,000. The company can buy the part from an outside supplier for $2.50 per unit, and avoid 30% of the fixed costs. If DC Electronics makes the part, what is the effect on its operating income? (pp. 1125–1127) a. $6,500 greater than if the company bought the part b. $8,100 greater than if the company bought the part c. $15,000 less than if the company bought the part d. $5,100 less than if the company bought the part 6. The following data are available for the Forte Co.: Toaster Ovens

Bread Machines

$60

$135

38

62

Sale price Variable costs

The company can manufacture five toaster ovens per machine hour and three bread machines per machine hour. The company’s production capacity is 1,500 machine hours per month. To maximize profits, what should the company produce? (p. 1124) a. 4,500 bread machines b. 2,250 toaster ovens and 3,750 bread machines c. 3,750 toaster ovens and 2,250 bread machines d. 7,500 toaster ovens 7. Shine Bright Company has three product lines: D, E, and F. The following information is available: D

E

$60,000

$38,000

$26,000

Variable costs

36,000

18,000

12,000

Contribution margin

24,000

20,000

14,000

Fixed expenses

12,000

15,000

16,000

$12,000

$ 5,000

$ (2,000)

Sales


F

Shine Bright Company is thinking of dropping product line F because it is reporting an operating loss. Assuming Shine Bright Company drops line F and does not replace it, what is the effect on the operating income? (pp. 1122–1123) a. Increase $2,000 b. Increase $14,000 c. Decrease $14,000 d. Increase $16,000

738


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8. Using the data in Question 7, assume that Shine Bright Company drops line F and rents the space formerly used to produce product F for $17,000 per year. What is the effect on the operating income? (pp. 1122–1123) a. Decrease $3,000 b. Increase $3,000 c. Decrease $14,000 d. Increase $15,000 Investment A

Investment B

Initial capital investment

$60,000

$90,000

Estimated useful life

3 years

3 years

0

0

$25,000

$40,000

10%

12%

Estimated residual value Estimated annual net cash inflow Required rate of return

9. Logan, Inc., is evaluating two possible investments in depreciable plant assets. The company uses the straight-line method of depreciation. The following information is available: The present value of $1 due 3 years from now: 8% 0.7938 10% 0.7513 12% 0.7118 14% 0.6750 16% 0.6407 The present value of $1 per year due at the end of each of 3 years: 8% 2.5771 10% 2.4869 12% 2.4018 14% 2.3216 16% 2.2459 What is the internal rate of return for Investment A? (p. 1137) a. 8% b. 10% c. 12% d. 14% 10. Using the information in Question 9, what is the net present value of Investment B? (pp. 1133–1134) a. $(164) b. $6,072 c. $40,000 d. $61,528


739

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Quick Exercise Solutions 21-1. Label each of the following items as relevant or irrelevant in making a decision. (p. 1118) a. Cost of insurance on a new vehicle relevant b. Cost of roof repair made on rental property last year irrelevant c. Original cost of old equipment that is being evaluated for replacement irrelevant d. Cost of new equipment under evaluation to replace used equipment relevant e. Accumulated depreciation on old equipment being evaluated for replacement irrelevant f. Cost of previous year’s insurance policy on old equipment being evaluated for replacement irrelevant 21-2. Dynamic Enterprises produces and sells a part used in the production of automobiles. The unit costs associated with this part are as follows: Direct Materials

$0.15

Direct Labor Variab ble Manufacturing Overhead Fixed Manufa acturing Overhead Total Cost

$0.30 $0.25 $0.10 $0.80

Jupiter Company approached Dynamic Enterprises with an offer to purchase 20,000 units of this part at a price of $0.75 per unit. Accepting this special sales order will put idle manufacturing capacity to use and will not affect regular sales. Total fixed costs will not change. Determine whether the special order should be accepted. Justify your conclusion. (pp. 1120–1121) Variable manufacturing expenses per unit: $0.15 # $0.30 # $0.25 " $0.70 $0.75 – $0.70 " $0.05/unit $0.05/unit ! 20,000 units " $1,000 increase in operating income

Dynamic Enterprises should accept the offer as because it would increase operating income by $1,000. Points to consider: Total fixed costs will not change Idle capacity exists No effect on regular sales

740


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21-3. Lightning Shoes manufactures kids’ sneakers and kids’ shoes. The company’s product line income statement follows: Kids’

Kids’

Total

Sneakers

Shoes

$841,000

$580,000

$261,000

Variable

220,000

116,000

104,000

Fixed

290,000

184,000

106,000

Total cost of goods sold

510,000

300,000

210,000

Gross profit

331,000

280,000

51,000

Variable

140,000

58,000

82,000

Fixed

105,000

79,000

26,000

Total marketing and administrative expenses

245,000

137,000

108,000

$ 86,000

$143,000

$ (57,000)

Sales revenue Cost of goods sold

Marketing and administrative expenses


Management is considering dropping the kids’ shoes product line. Accountants for the company estimate that dropping the kids’ shoes line will decrease fixed costs of goods sold by $50,000 and fixed marketing and administrative expenses by $6,000. Prepare an analysis supporting your opinion about whether the kids’ shoes product line should be dropped. (p. 1124) Contribution margin income statement for kids’ shoes: Currently Sales revenue

$261,000

If Dropped $

0

Variable expenses: Manufacturing

104,000

0

Marketing and administrative

82,000

0

Contribution margin

75,000

0

106,000

56,000

26,000

20,000

Fixed expenses: Manufacturing Marketing and administrative Operating income (loss)

$ (57,000)

$(76,000)

The company should keep producing and selling kids’ shoes because operating income would decrease by $19,000 if the product line is dropped.


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21-4. Sharp Image Company makes a part used in the manufacture of video cameras. Management is considering whether to continue manufacturing the part, or to buy the part from an outside source at a cost of $21.30 per part. Sharp Image needs 100,000 parts per year. The cost of manufacturing 100,000 parts is computed as follows: Direct Materials $ 765,000 Direct Labor 612,000 Variable Manufacturing Overhead 510,000 Fixed d Manufacturing Overhead 663,000 Total Manufacturing Costs $2,550,000

Sharp Image would pay $0.30 per unit to transport the parts to its manufacturing plant. Purchasing the part from an outside source would enable the company to avoid 35% of fixed manufacturing overhead. Sharp Image’s factory space freed up by purchasing the part from an outside supplier could be used to manufacture another product with a contribution margin of $59,000. Prepare an analysis to show which alternative makes the best use of Sharp Image’s factory space assuming Sharp Image: (pp. 1125–1127) a. Makes the part b. Buys the part and leaves facilities idle c. Buys the part and uses facilities to make another product

Buy part and leave facilities idle

Make

Buy part and use facilities to make another product

Costs Direct materials

$ 765,000 Direct labor

Variable manufacturing overhead

612,000

510,000

Variable transportation

$

Fixed manufacturing overhead

663,000

30,000

$

30,000

430,950

430,950

2,130,000

2,130,000

0

0

(59,000)

$2,550,000

$2,590,950

$2,531,950

Purchase price Profit contribution from another Product Total cost

Sharp Image should buy the part and use the facilities to make another product.

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21-5. Identify four capital budgeting models described in the chapter and discuss the strengths and weaknesses of each model. (pp. 1129–1138) The four capital budgeting models discussed in the chapter were the payback model, the accounting rate of return model, the net present value model, and the internal rate of return model. The strengths and weaknesses of the different models are as follows: The payback model is easy to understand, highlights risks, and is based on cash flows, which are of primary concern to many businesses. However, it ignores profitability and the time value of money. The accounting rate of return model measures profitability, but it ignores the time value of money. The net present value model and the internal rate of return model are both based on cash flows, profitability, and the time value of money. These models don’t have any of the weaknesses identified with the payback method and the accounting rate of return.


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Do It Yourself! Question 1 Solutions Part 1

Requirement 1

2


Assuming $250,000 of the manufacturing cost is fixed and $100,000 of the marketing and administrative cost is fixed, should Easy Access accept the order from the Yemen company? Variable Cost per Unit "

($400,000 $ $250,000) #(($220,000 $ $100,000) 5,000 Cases

"

$150,000 # $120,000 5,000 Cases

"

$270,000 5,000 Cases

"

$54 per Case

Increase in revenues: 500 cases ! $80 " $40,000

Increase in expenses variable costs: 500 cases ! $54 " $27,000

Increase in operating income: $40,000 – $27,000 " $13,000

Therefore, Easy Access should accept the special order because it increases operating income. Part 2

Requirement 2

2


Great Graphics’ price per case is $15. Easy Access would avoid all variable costs associated with the printing and would reduce the fixed cost by $3,000 if Great Graphics prints Easy Access’s graphics. Should Easy Access outsource the printing work to Great Graphics? Graphics Costs

Make

Direct materials

$20,000

$20,000

40,000

40,000

5,000

5,000

Direct labor Variable factory overhead Fixed costs

$15,000

Purchase cost from Great Graphics (5,000 cases ! $15 per case)

744

Buy

$12,000

3,000

75,000

(75,000) $ (7,000)

Total cost of labels

$80,000

$87,000

Cost per unit (divide by 5,000 cases)

$ 16.00

$ 17.40


Difference

$1.40

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Therefore, Easy Access should not accept the printing offer from Great Graphics. Part 3

Requirement 3 Should Easy Access stop producing the special shaped keyless remote? Reduction in revenue by dropping special keyless remote:

2


200 ! $140 " $28,000

Reduction in expenses by dropping special keyless remote: 200 ! $135 " $27, 000 Decrease in Operating Income " $ 1, 000

Because the difference between the absolute value of the loss of revenue less the cost savings from dropping the product is positive, Easy Access would not drop the special keyless remote.


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3


Determine the payback period for each product. Pencils Payback "

$340,000 " 5.67 years $60,000

Pens Payback "

$340,000 " 3.78 years $90,000

Requirement 2

3


746

Calculate the accounting rate of return. Average Amount Invested "

$340,000 " $170,000 2

Depreciation per Year, " $340,000 " 7 Pencils $340,000 Depreciation per Year, Pens " " 4

$48,571 $85,000

Average Annual Operating " Income From Pencils

$60,000

$

$48,571

" $11,429

Average Annual Operating " Income From Pens

$90,000

$

$85,000

"

$11,429 Accounting Rate of Return " " (Pencils) $170,000

6.722%

$5,000 Accounting Rate of Return " " (Pens) $170,000

2.941%


$5,000

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Requirement 3 Assuming that Office Home requires a 12% return on each possible new product, what is the net present value of each product? Pencils

Pens

PVCFI PVCFO

$ 60,000 ! 4.564 " $273,840 $340,000 !1.000 " $340,000 Net Present Value " ($66,160)

PVCFI PVCFO

$ 90,000 ! 3.037 " $273,330 $340,000 !1.000 " $340,000 Net Present Value " ($66,670)

4


4


Both products’ net present value is negative, therefore neither product should be accepted.

Requirement 4 Compute the internal rate of return for each product. Annuity PV Factor

"

Annuity PV Factor for Pencils

"

" Pencil Internal Rate e of Return " Annuity PV Factor " for Pens " Pen Internal Fate of Return "

Investment Expected Annual Net Cash Flow $340,000 $60,000 5.667 6% $340,000 $90,000 3.778 4%


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Direct your URL to www.myaccountinglab.com. Log in using your name and password. Click the MyAccountingLab link. Click Study Plan in the left navigation bar. From the table of contents, select Chapter 21, Special Business Decisions and Capital Budgeting. 6. Click a link to work on the tutorial exercises.

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A Combined Glossary/Subject Index

Accounting. The information system that measures business activity, processes the results of activities into reports, and communicates the results to decision makers, 2 Accounting cycle. The process of accounting for the transactions of a business for a period of time so that results of these transactions can be reported in financial statements, 107 Accounting equation. The basic tool of accounting that measures the resources of the business and the claims to those resources: Assets = Liabilities + Owner’s Equity, 2 Accounting principles, 71 Accounting rate of return. A measure of profitability computed by dividing the average annual operating income from an asset by the average amount invested in the asset, 714 exercise, 721–722 Accounts. The basic summary device of accounting; the detailed record of all the changes in a particular asset, liability, or owner’s equity as a result of transactions, 1 role of, 33 Accounts receivable. An asset representing amounts due from customers to whom the business has sold goods or for whom the business has performed services, 207 internal control, 207 See also Uncollectible accounts Accrued expense (liability). An expense that the business has incurred but not yet paid, 72 Accrued liability (expense). An expense that the business has incurred but not yet paid, 72 Accrued revenue, 72 Accumulated depreciation. A contraasset account that holds the cumulative sum of all depreciation recorded for an asset, 286 Acid-test (quick) ratio. Ratio that reveals how well the entity can pay its current liabilities, 208 Additional Paid-In Capital (Paid-in Capital in Excess of Par). The amount received above par value from issuing stock at a premium, 370 Adjusted trial balance. A list of all the accounts of a business with their adjusted balances, 72

Adjusting entries. Entry made at the end of the accounting period to accurately measure the period’s income and bring the related asset and liability accounts to correct balances before the financial statements are prepared, 71–72 exercise, 73–80 process, 72 types of, 72 Allowance for Uncollectible Accounts. A contraasset account that holds the estimated amount of uncollectible accounts receivable, 208 Allowance method. The method of accounting for uncollectible accounts that estimates these amounts and uses an allowance account so that the balance sheet shows the amount of accounts receivable expected to be collected in the future, 208 Amortization. The allocation of the cost of an intangible asset to expense over its useful life, 286 Assets. Economic resources that are expected to be of benefit in the future, 9, 33 double-entry accounting, 34 See also Current assets; Intangible assets; Long-term assets Average cost method. Inventory costing method where, after each purchase of inventory, a new weighted average cost per unit is computed and used to value ending inventory and cost of goods sold, 246 exercise, 258–261

B

Bad debts. See Uncollectible accounts Balance sheet. An entity’s assets, liabilities, and owner’s equity as of a specific date, 2 cash reported on, 172 current liabilities reported on, 332 inventory reported on, 246 long-term assets on, 286 preparation of, 11 vertical analysis, 490–491 Bank reconciliation. A document that identifies and explains the differences between a depositor’s record of a cash account and a bank’s record of the same cash account, 173–181 Bonds payable or bonds. Groups of loans issued to multiple lenders called bondholders, 412 on balance sheet, 413

effective-interest amortization, 419–425 interest, 412 issuance of, 412 vs. mortgages, 425 par value, 412 pricing of, 412 repayment, 413 straight-line amortization, 414–418 Breakeven point. The sales level at which operating income is zero: Total revenues equal total expenses, 610 contribution margin approach, 612 contribution margin ratio approach, 612–613 income-statement approach, 613–614 Budgeted income statement, 648–649 Budgeted (predetermined) manufacturing overhead rate. Estimated manufacturing overhead allocation rate computed at the beginning of the year, calculated as the total estimated quantity of the manufacturing overhead allocation base, 552 Budgets and budgeting, 641 See also Capital budgeting; Financial budget; Flexible budgets; Master budget Businesses. An organization that sells products or services to customers, 1 forms of, 2, 369 types of, 1

C

Capital. See Owner’s equity Capital budgeting. Budgeting for the acquisition of capital assets-assets used for a long period of time, 714 exercises, 720–725 Capital lease. Lease that essentially represents a purchase agreement for an asset, 411 Cash. Coin, currency, checks, petty cash, checking accounts, payroll accounts, money orders, traveler’s checks, and anything the bank will accept as a deposit, 172 internal control over, 172 Cash budget. Details how the business expects to go from the beginning cash balance to the desired ending balance, 642 exercise, 651–656 Cash dividend. Distribution of a corporation’s earnings to stockholders in the form of cash, 370 exercises, 383 Cash equivalents. Highly liquid, highly safe investments that so closely resemble

G-1


G-2

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Glindex

cash they may be shown with cash on the balance sheet, 172 Chart of accounts. A list of all the accounts of a business and the numbers assigned to those accounts, 36 Closing entries. Journal entries that complete the accounting cycle at the end of the accounting period; to close the revenue, expense, and withdrawals accounts to set their balances to zero so that accounting can begin for the next period, 108 exercises, 109–118 Collection period. The number of days it takes to collect the average level of receivables, 208 Common-size statement. Financial statement in which all amounts are expressed as percentages of a common base amount, 486 Common stock. The class of stock that represents the basic ownership of the corporation, 369 exercises, 372–375 issuance, 373–374 par value, 370, 373 Constraint. To restrict production or sale of a product that varies from company to company, 713 Contingent liability. A potential liability that is dependent on a future event, 331 exercises, 336 Contributed (paid-in) capital. Capital invested by stockholders, 369 Contribution margin income statement. Income statement that groups costs by behavior—variable costs or fixed costs—and highlights the contribution margin, 610 Contribution margin ratio. Ratio of contribution margin to sales revenue, 610 Corporate capital. See Stockholders’ equity Corporations. A business owned by stockholders that is an entity legally separate from its owners, 2 Cost centers, 642 Costing systems, 577 See also Job order costing; Process costing Cost of goods manufactured. The manufacturing or plant-related costs of the goods that finished the production process this period, 514, 522–523 Cost of goods sold. The cost of the inventory that the business has sold to customers, 514 budget, 643–645 calculation of, 248–261 Cost per unit, 519–520 Cost-volume-profit (CVP) analysis. Expresses the relationships among costs, volume, and profit or loss, 609–610

breakeven points, 610 cost behavior, 609 for profit planning, 610, 611–612 for sensitivity analysis, 608, 614–620 Credit. The right side of any account; an entry made to the right side of an account, 33–34 Current assets. Assets that are expected to be converted to cash, sold, or consumed within one year or the business’s operating cycle if the cycle is longer than a year, 108 exercise, 117 Current liabilities. Debts due to be paid with cash or with goods and services within one year or the entity’s operating cycle if the cycle is longer than a year, 108 on balance sheet, 332 contingent, 331 current ratio, 331 estimated, 331 exercises, 118, 333–337, 339 of known amount, 331 working capital, 331 See also Payroll Current ratio. The ratio of current assets to current liabilities; a key measure of liquidity, 331 exercise, 336–337 CVP. See Cost-volume-profit (CVP) analysis

D

Days’ sales in receivables. The number of days it takes to collect the average level of receivables, 208 DDB. See Double-declining balance (DDB) method Debit. The left side of any account; an entry made to the left side of an account, 33–34 Deferred (unearned) revenue. A liability created when a business collects cash from customers in advance of providing goods or services, 72 Depletion expense. Portion of a natural resource’s cost used in a particular period. Computed in the same way as units-of-production depreciation, 286 exercise, 299–300 Depreciation. Allocation of the cost of a long-term asset to expense over its useful life, 285 exercise, 287–297 methods of, 285–286 Direct labor. The compensating of employees who physically convert materials, not the company’s products’ labor costs, that are directly traceable to finished products, 548 exercises, 549–550 variances, 690–691

Direct materials. Materials that become a physical part of a finished product and whose costs are traceable to the finished product, 548 exercises, 549 variances, 689–691 Direct method. Format of the operating activities section of the statement of cash flows that lists the major categories of operating cash receipts and cash payments, 448, 458–461 Direct write-off method. The method of accounting for uncollectible accounts that writes off a customer’s account as an uncollectible when the business knows the customer will not pay, 207 exercise, 210–211 Discount. Amount of a bond’s maturity value over its issue price, 412, 420 Disposal, of plant assets, 286 Dividends. Distributions of earnings by a corporation to its stockholders, 369 See also Cash dividend; Stock dividend Double-declining-balance (DDB) method. An accelerated depreciation method that computes annual depreciation by multiplying the plant asset’s decreasing book value by a constant percent that is two times the straight-line rate, 286 exercises, 291–293, 296–297 Double-entry accounting. The rule of accounting that specifies, because transactions are measurable exchanges, every transaction involves at least two accounts and will thus be recorded with equal amounts of debits and credits, 33–34

E

Economic value added (EVA®). EVA = Net income + Interest expense - Capital charge; used to evaluate a company’s operating performance, 486 Effective-interest amortization, 419–425 Efficiency (quantity) variance. Measure whether the quantity of materials or labor use to make the actual number of outputs is within the standard allowed for that number of outputs. This is computed as the difference in quantities (actual quantity of input used minus standard quantity of input allowed for the actual number of outputs) multiplied by the standard price per unit of the input, 680 direct labor, 690 direct materials, 690 Employee compensation. See Payroll Employee earnings record. Payroll record that contains the pay information of an employee, 332


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Equivalent units. The amount of work done during a period in terms of fully complete units of output, 578 exercise, 585 Estimated warranty payable, 331, 336 Ethics. Principles of right behavior, 2 exercise, 11 standards, 514, 524

F

Factory overhead. See Manufacturing overhead FIFO. See First-in, first-out (FIFO) method Financial accounting. Accounting that provides information for people outside the business, 513 vs. management accounting, 513, 516 Financial budget. The cash budget (cash inflows and outflows), the budgeted period-end balance sheet, and the budgeted statement of cash flows, 642 exercise, 650–656 Financial statement analysis. The process of using financial statements and other data to predict the future of a business and make decisions about it, 485–486 common-size statements, 486 economic value added, 486 horizontal analysis, 485, 488–489 ratio analysis, 486, 491–492 vertical analysis, 485, 490–491 Financial statements. Historical, objective reports, prepared according to GAAP, that communicate financial information about a business to those outside the business, 1 preparation from trial balance, 34, 72–73 preparation with worksheet, 108 for retailers, 142 types of, 2 Financing activities. The activities of a business that involve transactions with long-term creditors and stockholders, 447, 455–457 Finished goods inventory. Completed goods that have not yet been sold, 514 job order costing, 546 First-in, first-out (FIFO) method. Inventory costing method in which the first inventory costs incurred are the first costs to be assigned to cost of goods sold; FIFO leaves in ending inventory the last, most recent costs incurred during the period, 245 cost of goods sold, 246 exercise, 249–253 Fixed costs. Costs that tend to remain the same in amount, regardless of variations in level of activity, 609 Flexible budgets. A summarized budget that managers can easily compute for

several different volume levels. Flexible budgets separate variable costs from fixed costs; it is the variable costs that put the “flex” in the flexible budget, 679 preparation of, 683–684 Flexible budget variance. The difference arising because the company actually earned more or less revenue, or incurred more or less cost, than expected for the actual level of output. This equals the difference between the actual amount and a flexible budget amount, 679 FOB destination. Shipping term specifying that title to goods passes to the buyer when the goods are received at buyer’s destination; thus, the seller pays the cost of shipping the goods to this destination, 142 FOB shipping point. Shipping term specifying that title to goods passes to the buyer when the goods are shipped at the seller’s place of business; thus, the buyer pays the cost of shipping the goods to its location, 142 Form W-2, Wage and Tax Statement. Internal Revenue Service form prepared by employers used to report employee earnings and withholdings for a calendar year, 332 Fraud. Deceit or trickery involving intentional actions that cause harm to a business or its stakeholders; according to the accounting profession, fraud results in misstatements of the financial statements, 171

G

Generally Accepted Accounting Principles (GAAP). Accounting rules, created by the Financial Accounting Standards Board, that govern how accountants measure, process, and communicate financial information, 2 Goodwill. Excess of the cost of an acquired company over the sum of the market values of its net assets, 286 exercise, 303–304 Google, 369 Gross margin. Net sales revenue minus cost of goods sold, 261 Gross margin percentage. A measure of profitability equal to gross margin divided by net sales revenue, 142 Gross pay. Total amount of salary, wages, commission, bonus, or any other employee compensation before taxes and other deductions, 332 Gross profit. Net sales revenue minus cost of goods sold, 261 Gross profit method. A way of estimating inventory by estimating gross profit, using estimated gross profit to estimate

G-3

cost of goods sold, and using estimated cost of goods sold to estimate ending inventory, 246 exercise, 263–264 Gross profit percentage. A measure of profitability equal to gross profit divided by net sales revenue, 142

H

High-low method. A method used to separate mixed costs into variable and fixed components, using the highest and lowest total cost, 609 Horizontal analysis. Analysis of a percentage change in an item on comparative financial statements, 485 exercise, 488–489

I

Income-statement approach, to breakeven points, 608 Income statements. Summary of a business’s revenues, expenses, and net income or net loss for a specific period, 2 budgeted income statement, 648–649 for manufacturing company, 523–524 performance reports, 679, 684–687 preparation of, 9–10 vertical analysis, 490 Indirect labor. Labor costs that are difficult to trace to specific products, 549–550 Indirect manufacturing costs. See Manufacturing overhead Indirect materials. Materials whose costs cannot conveniently be directly traced to particular finished products, 549 Indirect method. Format of the operating activities section of the statement of cash flows that starts with net income and reconciles to net cash provided by operating activities, 447–448 statement of cash flows using, 449–457 Initial public offering (IPO), 369 Intangible assets. Long-lived resources without physical form that represent rights, 286 exercise, 301–304 Internal control. The organizational plan and all related measures to safeguard assets, report financial information properly, operate efficiently and effectively, and comply with applicable laws and regulations, 171 for cash, 172 over inventory, 245 over receivables, 207 Internal rate of return (IRR). The rate of return (based on discounted cash flows) that a company can expect to earn by investing in the project. The discount rate that makes the net


G-4

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present value of the project’s cash flows equal to zero, 714 exercise, 724–725 Inventoriable product costs. All costs of a product that GAAP requires companies to treat as an asset for external financial reporting. These costs are not expensed until the product is sold, 514 for manufacturing companies, 514 for merchandise companies, 514 Inventory. All the goods purchased for resale to customers in the normal course of merchandising operations, 141 on balance sheet, 246 budgeting, 645–647 errors, 246, 263–264 estimation of ending, 246, 264 internal control over, 245 manufacturing companies, 514 transaction analysis exercise, 143–150 valuation methods, 245–246, 247–262 Inventory turnover. The ratio of cost of goods sold to average inventory. Measures the number of times a company sells its average level of inventory during a year, 142 financial statement analysis, 491–492 Investing activities. The activities of a business that involve buying or disposing of long-term assets, 447 exercises, 453–455 Investment centers, 642 IRR. See Internal rate of return (IRR)

J

Job cost record. Document that accumulates the direct materials, direct labor, and manufacturing overhead costs assigned to each individual job, 545, 548 Job order costing. A system that accumulates costs for each batch or job. Law firms, music studios, health-care providers, mail-order catalog companies, building contractors, and custom furniture manufacturers are examples of companies that use job order costing systems, 545–546 manufacturing companies, 545–546, 547–554 vs. process costing, 545

L

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Labor, 548–550 Last-in, first-out (LIFO) method. Inventory costing method in which the last inventory costs incurred are the first costs to be assigned to cost of goods sold; LIFO leaves in ending inventory the first, oldest costs incurred during the period, 245–246 cost of goods sold, 246 exercise, 253–258 LCM. See Lower-of-cost-or-market (LCM) rule

Lease Payable. The amount owed for a capital lease, 411 Leases. A rental agreement in which the lessee obtains the use of an asset by paying rent to the property owner, the lessor, 411 Ledgers. The accounting record summarizing, in accounts, the transactions of a business and showing the resulting account balances, 41 Liabilities. Outsider claims to the assets of a business; the debts owed to outsiders, 33 double-entry accounting, 34 See also Current liabilities; Long-term liabilities LIFO. See Last-in, first-out (LIFO) method Liquidity ratios, 208 Long-term assets. Long-lived, tangible assets such as land, buildings, equipment, and furniture used in the operation of a business lasting for more than a year, 108 on balance sheet, 286 exercise, 117 life cycle of, 285 Long-term business decisions, 714 Long-term debt, 338–339 Long-term liabilities. Liabilities other than those that are current, 108 on balance sheet, 413 exercise, 118 See also Bonds payable or bonds; Leases; Mortgages (mortgage notes payable) Lower-of-cost-or-market (LCM) rule. Rule that a business must report inventory in the financial statements at whichever is lower, the historical cost or the market value, of each inventory item, 246 exercise, 262

M

Management accountability. The manager’s fiduciary responsibility to manage the resources of an organization, 513, 516 Management accounting. The branch of accounting that focuses on information for internal decision makers of a business, 513–515 ethical standards, 514, 524 vs. financial accounting, 513, 516 for manufacturing companies, 514 for merchandise companies, 514 role of, 513, 516 for service companies, 513–514 in today’s business environment, 513 Manufacturing companies. 1. Businesses that make their own products that are sold to the final customer or to other companies 2. A company that uses labor, plant, and equipment to convert

raw materials into new finished products, 1–2 accounting characteristics, 514 cost of goods manufactured, 514, 522–523 income statement, 523–524 inventory, 514 job order costing, 545–546, 547–554 overhead (See Manufacturing overhead) unit product cost, 519–520 Manufacturing overhead. All manufacturing costs other than direct materials and direct labor. Also called factory overhead or indirect manufacturing costs, 545–546 allocation of, 551–554 job cost record, 548 variances, 680, 692–693 Master budget. The budget prepared for only one level of sales volume, 641–642 exercise, 643–649 Matching principle. Recording expenses in the time period they were incurred to produce revenues, thus matching them against the revenues earned during that same period, 71 Merchandise companies. 1. Businesses that sell products made by another company 2. A company that resells products previously bought from suppliers, 1 accounting characteristics, 514 financial statements, 142 gross profit percentage, 142 income statement, 518–519 inventory transaction analysis, 143–150 inventory turnover, 142 shipping and delivery, 142 transactions with customers, 141 transactions with suppliers, 141 Merchandise inventory. See Inventory Mixed costs. Costs that have both variable and fixed components, 609 Mortgages (mortgage notes payable). Long-term note or loan taken out for the purchase of land, buildings, or both and secured by lender’s right to take the specified assets, called collateral, if the borrower is unable to repay the loan, 411 vs. bonds, 425 Multistep income statement. Income statement format that calculates net income or net loss by listing important subtotals such as gross profit and operating income, 142

N

Natural resources. Plant assets existing in or on land, 286 depletion expenses, 286 exercise, 298–300


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Net income. See Profit Net pay. Gross pay minus all deductions, 332 Net present value (NPV). The decision model that brings cash inflows and outflows back to a common time period by discounting these expected future cash flows to their present value using a minimum desired rate of return, 714 exercise, 722–724 Note receivable. A written promise of future payment received by the business, 208 exercise, 217–220

O

Operating activities. The activities of a business that determine net income or net loss, 447 exercises, 451–453, 459–461 Operating budget. Projects sales revenue, cost of goods sold, and operating expenses, leading to the budgeted income statement that projects operating income for the period, 641 preparation of, 644–649 Overallocated (manufacturing) overhead. When the manufacturing overhead allocated to Work in Progress Inventory is more than the amount of manufacturing overhead costs actually incurred, 546, 554 Overhead flexible budget variance. Shows how well management has controlled overhead costs. It is the difference between the actual overhead cost and the flexible budget overhead for the actual number of outputs, 680 Owner’s equity. The insider claims to the assets of a business by the owner; the owner’s interest in the business, 33 double-entry accounting, 34

P

Paid-in (contributed) capital. Capital invested by stockholders, 369 Paid-in Capital in Excess of Par (Additional Paid-In Capital). The amount received above par value from issuing stock at a premium, 370 Partnership. A business with two or more owners, 2 Par value (bonds). The amount the borrower must pay back to the lender; also called the maturity value when amounts are borrowed by issuing bonds, or principal, 412 Par value (stocks). Arbitrary amount assigned to a share of stock and used to establish legal capital, 370 exercise, 373 Patent. A federal government grant giving the holder the exclusive right to produce and sell an invention for 20 years, 286 exercise, 301–304

Payback. The length of time it takes to recover, in net cash inflows, the dollars of a capital outlay, 714 exercise, 721 Payroll. A major expense of businesses with employees, 332 basic transactions, 332 deductions, 332 employee earnings record, 332 exercise, 340–344 gross vs. net pay, 332 process, 332 Payroll register. Payroll record that contains information about a pay period, 332 Payroll tax form, 332 Period costs. Operating costs that are expensed in the period in which they are incurred, 513–514 Periodic inventory system. An inventory system in which the business does not keep a continuous record of inventory on hand. At the end of the period, a physical count of inventory is taken and determines the inventory owned as well as the cost of the goods sold, 141 Perpetual inventory system. An inventory system in which the business keeps a continuous record of inventory owned and the cost of the goods sold, 141 exercise, 143–150 Petty cash. Fund containing a small amount of cash that is used to pay for minor expenditures, 172 exercise, 182–184 Plant assets. The tangible, long-lived assets of a business including land, buildings, furniture, fixtures, and equipment. Also called fixed assets and are commonly shown on the balance sheet as property, plant, and equipment, 285 costs of, 285 depreciation of, 285–286 disposal of, 286 Posting. Copying amounts from the journal to accounts in the ledger, 34 Predetermined (budgeted) manufacturing overhead rate. Estimated manufacturing overhead allocation rate computed at the beginning of the year, calculated as the total estimated quantity of the manufacturing overhead allocation base, 552 Preferred stock. Stock that gives its owners certain advantages over common stockholders, 369–370 dividends, 377–379 exercises, 376–379 issuance, 377 Premium (bonds). Amount of a bond’s issue price over its maturity value, 412, 415 Premium (stock). Amount received above par value when issuing stock, 370 Prepaid expenses. Amounts that are assets of a business because they repre-

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sent items to be used later but are already paid for, 72 Present value. Amount a person would invest or pay now, 712 Price (rate) variance. Measures how well the business keeps unit prices of material and labor inputs within standards. This is computed as the difference in prices (actual price per unit minus standard price per unit) of an input multiplied by the actual quantity of the input, 680 direct labor, 690 direct materials, 689–690 Process costing. System for assigning costs to large numbers of identical units that usually proceed in a continuous fashion through a series of uniform productions steps or processes, 545 cost flows, 578 exercises, 579–583 vs. job order costing, 577 weighted-average method, 578, 584–588 Production volume variance. Arises when actual production differs from expected production. It is the difference between (1) the manufacturing overhead cost in the flexible budget or actual outputs and (2) the standard overhead allocated to production, 680, 693 Profit. The difference between the revenues, the sales price of the goods or services sold by the business, and expenses, the cost of the resources used to provide these goods and services, 9 CVP for planning, 610, 611–615 Profit centers, 642 Proprietorship. A business with a single owner, 2 Purchase discount. Discount received on purchases by paying early with cash within a discount period, 141 Purchase returns and allowances. A reduction in the amount owed for a purchase from returning merchandise or accepting damaged goods, 141

Q

Quantity variance. See Efficiency (quantity) variance Quick ratio. Ratio that reveals how well the entity can pay its current liabilities, 208

R

Rate of return on common stockholders’ equity. A ratio of net income minus preferred dividends, divided by average common stockholders’ equity that measures profitability, 491–492 Ratio analysis, 486, 491–492 Raw materials. Inventory items used in the production of goods, 514 Receivables internal control over, 207 types of, 207


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Receivables (cont.) See also Accounts receivable; Note receivable Relevant information. Expected future data that differs among alternatives, 713 Relevant range. The band of volume where total fixed costs remain constant and the variable cost per unit remains constant, 609 Responsibility center. A part or subunit of an organization whose manager is accountable for specific activities, 642 Retail companies. See Merchandise companies Retained earnings. Capital earned through profitable operation of the business, 369 Return on equity. A ratio of net income minus preferred dividends, divided by average common stockholders’ equity that measures profitability, 491–492 Revenue centers, 642 Revenue recognition principle. Recording revenues when they are earned by providing goods or services to customers, 71

S

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Sales internal control over, 207 types of, 207 Sales budget. A detailed plan that shows the estimated sales revenue for a future period, 641 preparation of, 644–645 Sales discount. Discount granted on sales for the customer’s early payment within a discount period; a contra account to Sales Revenue, 141 Sales mix. Combination of products that make up total sales, 610 Sales returns and allowances. A reduction in the amount owed by a customer from returning merchandise or accepting damaged goods; a contra account to Sales Revenue, 141 Sales tax, 336 Sales volume variance. The difference arising only because the number of units actually sold differs from the static budget units. This equals the difference between a static budget amount and a flexible budget amount, 679 Sensitivity analysis. A “what if ” technique that asks what results will be if actual prices or costs change, or if an underlying assumption changes, 610 exercise, 616–622 Service companies. 1. Businesses that provide services to customers 2. A company that sells intangible services, rather than tangible products, 1

accounting characteristics, 513–514 income statement, 516–517 unit costs, 546 Shipping and delivery, 142 Short-term business decisions, 713 Single-step income statement. Income statement format that groups all revenues together and lists all expenses together, subtracting total expenses from total revenues and calculating net income or net loss without computing any subtotals, 142 Standard cost. A budget for a single unit, 680 exercises, 688–693 income statement, 681 journal entries, 681, 691 variance analysis, 680, 689–691 Stated value. An arbitrary amount assigned to a share of stock that accountants treat as though it were par value, 370 Statement of budgeted cash receipts and payments. See Cash budget Statement of cash flows. Summary of the changes in a business’s cash balance for a specific period, 2 direct method of, 448, 458–461 elements in, 447 vs. income statement, 461 indirect method of, 447–448, 449–457 operating, investing, and financing activities, 447 Statement of financial position. See Balance sheet Statement of owner’s equity. Summary of the changes in a business’s owner’s equity during a specific period, 2 preparation of, 10 Static budget. See Master budget Static budget variance, 679 Stock. Ownership interest in a corporation, 369–370 classes of, 369–370 issuance of, 370 See also Common stock; Preferred stock Stock dividend. Distribution of corporate earnings to stockholders in the form of additional shares of stock, 370 exercises, 380, 381–382 Stockholders’ equity. Owners’ equity of a corporation, 369 reporting of, 371 sources of, 369 Stock split. Increase in the number of shares authorized, issued, and outstanding and the corresponding decrease in its par value, 370 exercises, 380, 381 Straight-line amortization, 414–418 Straight-line depreciation. 1. A method of estimating depreciation: (Cost of the Asset - Salvage Value)/ Useful Life of the

Asset 2. Depreciation method that allocates an equal amount of depreciation to each year of plant asset’s useful life, 268 exercises, 288–289, 293–295 Supply chain. The chain of transactions between businesses that supply goods and the customers who ultimately use them, 141

T

T-account. An informal account form used to summarize transactions, where the top of the T holds the account title and the base divides the debit and credit sides of the account, 41 exercises, 36–37 Take-home pay. Gross pay minus all deductions, 332 Time period concept. Accounting periods must be of equal length so that income measurement is comparable from one period to another; ensures that information is reported at regular intervals, 71 Time value of money. The fact that money can be invested to earn income over time, 712 Total variable costs. Costs that change in total in direct proportion to changes in volume, 609 Transactions. An event that affects the financial position of a particular entity and can be measured reliably, 2 exercises, 3–11, 35–43 recording and summarizing, 34 Treasury stock. Shares of stock repurchased by a corporation, 371 exercises, 384–387 Trial balance. A list of all the accounts of a business and their balances in balance sheet order; its purpose is to verify that total debits equal total credits, 34 Turnover, of inventory. See Inventory turnover

U

Uncollectible accounts. Receivable amounts due that are never collected, 207–208 exercise, 209–216 Underallocated (manufacturing) overhead. When the manufacturing overhead allocated to Work in Progress Inventory is less than the amount of manufacturing overhead costs actually incurred, 546 Unearned (deferred) revenue. A liability created when a business collects cash from customers in advance of providing goods or services, 72 Units-of-production (UOP) method. Depreciation method that allocates a


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fixed amount of depreciation assigned to each unit of output produced by a plant asset, 286 exercises, 289–291, 295–296

V

Variable costs. Costs that change in total in direct proportion to changes in volume, 609 Vertical analysis. Analysis of a financial statement that shows the relationship of each statement item to a specified base,

expressing every item on the statement as a percentage of that base, 485 exercise, 490–491

W

Weighted-average process costing method. A process costing method that costs all equivalent units of work with a weighted average of the previous period’s and the current period’s cost per equivalent unit, 578 exercise, 584–588

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Working capital. The excess of current assets over current liabilities; a key measure of liquidity, 331 Work in process inventory. Goods that are partway through the manufacturing process but not yet complete, 514 Worksheet. A document holding the trial balance, adjustments, and adjusted trial balance of a business and issued to prepare financial statements, 107–108

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